Compensation of S shareholders: is it reasonable?

Tax practitioners and the IRS have fought for years over whether compensation paid to shareholders of closely held corporations is reasonable. Most commonly, the Service argues that compensation is unreasonably large and that the excess is a nondeductible dividend.

Until recently, the issue of unreasonable compensation was generally confined to C corporations. Before the Subchapter S Revision Act of 1982, the courts had suggested that the issue of unreasonable compensation did not apply to S corporations. However, in recent years, the issue of unreasonable compensation (specifically, unreasonably low compensation) has become an issue for S corporations.

Payment of salaries rather than distributions to S shareholders may be beneficial when higher salaries produce greater retirement plan contributions. On the other hand, salaries paid to shareholders are subject to payroll taxes, while S distributions are not. The Medicare tax is imposed on all wages at a 2.9% rate (borne equally by the employee and employer). Since the amount of wages subject to the Medicare tax became unlimited in 1994, many S corporations may have reduced salaries and increased distributions to shareholders.

When use of this technique results in an unreasonably low salary, the IRS can recharacterize these distributions as salaries subject to payroll taxes. This issue is of particular interest to corporations whose income is substantially attributable to their shareholders' services.

In Rev. Rul. 74-44, two S shareholders performed services for the corporation. The shareholders received dividends, but no salary, for the services they performed. The Service ruled that these payments constituted wages that were subject to payroll taxes. (See Tax Clinic, "Reducing Shareholder-Employees' Salaries to Save Employment Taxes," TTA, May 1982, p. 291.)

In Joseph Radtke, S.C., 895 F2d 1196 (7th Cir. 1990), an attorney incorporated his law practice and was the corporation's only full-time employee. He did not draw a salary, but instead received only dividends, which were found to be disguised compensation that was subject to payroll taxes.

Similarly, in Spicer Accounting, Inc., 918 F2d 90 (9th Cir. 1990), the shareholder was an officer and director of a corporation engaged in the practice of accounting, but received only dividends, not salary. The Ninth Circuit upheld the IRS's assessment of payroll taxes, finding that the corporation did not have a reasonable basis for not treating the shareholder as an employee.

In addition, Sec. 1366(e) provides that "If an individual who is a member of the family (within the meaning of section 704(e)(3)) of one or more shareholders of an S corporation renders services for the corporation or furnishes capital to the corporation without receiving reasonable compensation therefor, the Secretary shall make such adjustments in the items taken into account by such individual and such shareholders as may be necessary in order to reflect the value of such services or capital."

To avoid these problems, compensation of S shareholders should be determined by reference to the services rendered. Payments based solely on stock ownership should be clearly labeled as distributions. Consideration should be given to paying both salary and distributions and clearly distinguishing why each payment has been made.