S corporations are required to annually file Form 1120S, U.S. Income Tax Return for an S Corporation, although they generally are not subject to federal income taxes. Instead, an S corporation passes its profits and net losses to the shareholders, who are required to report the items on their individual income tax returns. This distribution of the flow-through income, deductions, and other items are reported to the shareholder and the Internal Revenue Service on Form 1120S Schedule K-1, Shareholder’s Share of Income, Deductions, Credits, etc.
S corporation is one of the fastest growing types of business entities and the most common type of corporate entity filing returns ...view middle of the document...
Revenue Ruling 59-221 first held that a shareholder’s undistributed share of S corporation income is not treated as self-employment income (Nutti, 2011). This has not stopped the IRS, however, from contesting attempts by S corporation shareholder-employees to minimize compensation in favor of distributions. In Revenue Ruling 74-44, IRS first challenged the payment of reasonable salaries to an S corporation that paid dividends but no compensation to shareholders who provided services to the corporation.
Since then, there have been more than two dozen reasonable compensation cases that have come through the Tax Court and the taxpayer has not fared well. In most of them, the sole or majority shareholder of a corporation provides substantial services to the corporation, but shuns salary in favor of distributions. The IRS challenges the treatment and re-characterizes all the distribution as compensation, holding the taxpayer liable for payroll taxes. The Tax Court applies the employment tax statute, holds the shareholder to be an employee, and agrees that the entire distribution should be taxed as compensation.
In more recent years, cases have been against S corporations in which the shareholder-employee has taken some compensation. This has forced the Court to make a determination whether the amount was reasonable or if distributions made throughout the year should be re-characterized as salary and be subject to payroll taxes.
In one such defining case, Jeffrey Dahl was the sole shareholder of JD & Associates, an accounting firm. Mr. Dahl, a CPA, drew salaries of $19,000 (1997) and $30,000 (1998 and 1999). Distributions to Dahl for those same years were $47,000, $50,000 and $50,000 respectively.
Asserting that Dahl’s compensation was unreasonably low, the IRS used the services of a certified valuation engineer to determine reasonable compensation for Dahl’s services. Using the Risk Management Association’s Annual Statement Studies in comparison of JDA and Mr. Dahl to other accounting firms with comparable asset levels, the IRS’s expert testified that JDS was more profitable than its peers while Mr. Dahl’s compensation was 166% - 266% less than those same peers.
The IRS determined reasonable compensation to be $69,584 in 1997, $79,823 in 1998, and $79,711 in 1999. The District Court agreed and re-characterized distribution to compensation of $42,827, $33,072, and $35,582.
David Watson, another CPA, was the sole shareholder and employee of an S corporation that was a 25% shareholder in his very successful accounting firm. Mr. Watson’s share of the revenue generated in the firm was allocated to his S corporation, which paid him a salary and distributions. For 2002 and 2003, Mr. Watson set his salary as $24,000 for each year, while receiving distributions of $203,651 and $175,470 respectively.
Again the IRS maintained the Mr. Watson’s compensation was unreasonably low based on the services of the same expert from the...