Reasonable compensation and SE taxes.

It is well established that the flowthrough income generated by an S corporation is not subject to self-employment (SE) taxes; see Rev. Rul. 59-221. Likewise, distributions from S corporations are not subject to such taxes. Consequently, S shareholders pay employment taxes only on the wages earned as corporate employees. Of course, in some closely held corporations, the wage-earning shareholders have substantial discretion in determining their own salaries. This discretion, in some cases, has resulted in artificially low salaries (and conversely, artificially high distributions) being paid to S shareholder-employees, reducing, and in some cases eliminating, SE taxes.

This is in marked contrast to the SE tax burden of owners in entities taxed as partnerships. General partners (and in some cases, limited partners) are subject to SE taxes on their entire allocable share of partnership income and any guaranteed payments received, under Sec. 1402(a).Accordingly, the SE tax strategies available to S corporations by reducing shareholder salaries are not available to partnerships.

This distinction appears to be a clear tax advantage of S corporations over partnerships; however, the analysis does not end there. The IRS has attempted to mitigate this advantage by arguing that distributions paid to S shareholders, in lieu of paying a reasonable salary, constitute wages subject to employment taxes; see Rev. Rul. 74-44. The position has been upheld by the courts in several cases; see Joly, 211 F3d 1269 (6th Cir. 2000), and Spicer Accounting, Inc., 918 F2d 90 (9th Cir. 1990) and, as discussed below, the Service intends to capitalize on this support by further scrutinizing shareholder-employee compensation in S corporations.

"Greater Scrutiny in the Foreseeable Future"

The IRS has the following "Headliner" posted on its website at www.irs.gov/businesses/small/article/ o,,id=104468,00.html:

An S Corporation must pay reasonable compensation (subject to employment taxes) to shareholder-employee(s) in return for the services that the employee provides to the corporation, before non-wage distributions may be made to that shareholder-employee. This issue had been identified as an area of non-compliance and will receive greater scrutiny in the foreseeable future. (Headliner Vol. 32, 12/10/02)

This statement was probably a response to a report issued by the Treasury General for Tax Administration, asserting that the Service will focus more resources on S reasonable compensation issues; see "The Internal Revenue Service Does Not Always Address Subchapter S Corporation Officer Compensation During Examinations," Ref. No. 2002-30-125. The report was issued in July 2002; to date, the IRS has reportedly uncovered significant noncompliance. However, across-the-board enforcement has proven difficult, primarily because the determination of reasonable salary is a facts-and-circumstances test requiring a case-by-case analysis. This was one of the concerns expressed in a report (described below) by the Joint Committee on Taxation (JCT), recommending substantial changes in how S shareholders and other owners of passthrough entities should be treated for SE tax purposes.

JCT Recommendations

On May 25, 2005, George K. Yin, JCT Chief of Staff, testified at a hearing of the Senate Finance Committee on "Social Security: Achieving Sustainable Solvency." According to Yin, a JCT proposal (if enacted) would apply the SE tax rule that is currently applicable to general partners, to any owner of a partnership or S corporation (including general and limited partners, limited liability company (LLC) members and S shareholders). Thus, S shareholders would be subject to SE taxes on their distributive shares of S income.

If the proposal were ever enacted, it would certainly even the playing field as to how individuals, partnerships, LLCs and S corporations are treated for SE tax purposes. Additionally, S corporation reasonable compensation would become a nonissue. Moreover, as Yin testified, choice-of-entity decisions would be more likely centered on economic and business factors, rather than on tax factors.

Will Congress Act?

As was noted, the SE tax treatment of S corporations has been in place since 1959. On the surface, it seems unlikely that Congress would change a law that is so entrenched. Further, when faced with a similar issue in 1997, Congress was tentative to allow the expansion of the SE tax base. In fact, when the IRS issued Prop. Regs. Sec. 1.1402(a)-2, which effectively subjected certain limited partners (primarily LLC members) to SE taxes, Congress placed a moratorium on their finalization. Although the moratorium has since expired, neither Congress nor the IRS has taken subsequent action. Thus, the proposed regulations remain the only guidance available to practitioners on limited partners and SE taxes.

If Congress was reluctant to see the expansion of the SE tax base in 1997, why would it support it now? Perhaps because Social Security and tax reform are the two major issues confronting Congress today. Subjecting S shareholders to additional SE taxes may assist Congress on both fronts. Presumably, collecting additional SE taxes would lead to greater Social Security solvency and may delay the unpopular options of increasing payroll tax rates or increasing Social Security eligibility ages. Additionally, standardizing how different entities are treated for SE tax purposes would help simplify the Code (a major goal of tax reform).

Considerations for Tax Practitioners

Although no one knows when or whether Congress will take action, tax advisers should remain focused on the current law, including the Service's focus on reasonable compensation in S corporations. Reportedly, the IRS has been most interested in such matters when the facts are overwhelmingly in its favor (e.g., when a controlling shareholder acts as a company's sole service provider and draws no salary). Accordingly, in these and other cases, practitioners should advise clients that a reasonable salary must be paid to S shareholder-employees. (For a survey of cases in this area, see AICPA Tax Division's S Corporation Taxation Technical Resource Panel, "Renewed Focus on S Corp. Officer Compensation" TTA, May 2004, p. 280.)

FROM STEVEN R. HRITZ, CPA, KFMR KATZ FERRARO MCMURTRY PC., PITTSBURGH, PA