S corp. salary limits.

The question of S corporation salary limits is commonplace, probably because closely held business clients are eager to know the boundaries and often have a vested interest in the answer.

The basic rule is that S officers' salaries must be reasonable in amount and purely for services, according to Regs. Sec. 1.162-7(a). Moreover, under Regs. Sec. 31.3121(d)-1(b), officers are considered employees of a corporation when they provide substantial services to it. Additionally, according to Rev. Rul. 59-221, S income is exempt from self-employment tax.

Determining Reasonableness

S corporations veering from this narrow path are subject to an IRS recharacterization of the payments made from the corporation to an officer, such as dividends, draws and other distributions. This results in corresponding payroll taxes under Secs. 3111, 3301 and 3401 and, potentially, Sec. 6651(a)(1) failure to file penalties, Sec. 6656(b)(1) failure to deposit penalties and negligence penalties under Sec. 6662(c). The burden of proof is on the taxpayer to show that the income is properly characterized and reasonable.

If tax advisers want to be proactive in serving their clients, they should be ready to address the issue of reasonableness from the IRS's viewpoint. The Service determines reasonable salary according to the facts and circumstances. Generally, the nature of an S corporation as a flow through entity will result in less of an arm's-length bargaining position than in a closely held C corporation. The exhibit above presents the factors at which the courts have looked; see Trucks, Inc., DC NE, 5/24/84. The courts generally group their analyses of these variables into three broad categories:

* Employee performance;

* Salary comparisons; and

* Company conditions.

Exhibit: Considerations in determining S officer reasonable
compensation

* Employee qualifications and training;
* Nature, extent and scope of duties;
* Responsibilities and hours involved;
* Size and complexity of the business;
* Results of the employee's efforts;
* Prevailing rates for comparable employees in comparable businesses;
* Ratio of compensation to growth and net income (before salaries and
  tax);
* Absence of usual fringe benefits (pension or profit-sharing plan,
  stock options, etc.), which are available to
  executives of other companies of comparable size;
* Employee's responsibility for company's inception and/or success;
* Time of year compensation was determined and by whom;
* Correlation between stockholder-employee's compensation and his or
  her stockholding;
* Corporate dividend history;
* Prevailing economic conditions;
* Examination of the financial condition of the company after paying
  compensation; and
* Whether an independent investor would be willing to compensate the
  employee as he or she was compensated.

Source: Trucks, Inc., DC NE, 5/24/84.

In Joseph Radtke, S.C., 895 F2d 1196 (7th Cir. 1990)--a seminal, yet extreme case on the topic--payments from an S corporation to an employee, a Milwaukee attorney, were initially characterized as dividends. Radtke was the sole director, sole shareholder and only full-time employee. His annual base salary was zero, but he received more than $18,000 in dividends. The Seventh Circuit upheld the district court's decision that the $18,000 was actually remuneration for services, and not dividends as posited.

One possible explanation for the increase in IRS attention is the fact that ordinary dividends are taxed at the same up-to-35% rate applicable to ordinary income. However, qualified dividend income (i.e., dividends received from domestic corporations or qualified foreign corporations) is taxed at the lower 5%-15% rate if the holding period is met based on the class of stock involved. Thus, the Service has an incentive to examine all dividend distributions carefully, to ensure accuracy and compliance.

Rulings

In Rev. Rul. 82-83, two officers of an S corporation were treated as independent contractors, rather than employees, and were paid a draw. The court found the "duties being performed customarily fall within the scope of duties of corporate officers," such as operational decisions and management; thus, they were employees.

In addition, Rev. Rul. 73-361 distinguished a partner from an employee, finding that an officer-stockholder who performed substantial services as an officer received a salary, not a partnership draw.

Finally, Rev. Rul. 59-221 determined that an S corporation's gross income is not earnings from self-employment (Sec. 1402) based on original intent, because the individual is not in "the conduct of a trade or business"; it is the corporation that conducts business, with the help of employees.

Plan Wisely

Clearly, the safest course of action is to communicate with S corporation management, describing the key factors involved in determining reasonable compensation and characterization of compensation, and examining the profit and loss statements to get a good idea whether amounts claimed as dividends, distributions and other officer compensation are correctly characterized and make sense. It is better to be proactive. For example, the website www.salary.com can help tax advisers determine the average pay rate for almost any job, by zip code; for a small fee, advisers can also obtain comparables by industry.

FROM SHERRY B. HAWN, ESQ., CPA, SOREN MCADAM CHRISTENSON, LLP, REDLANDS, CA