Category: Compensation & Employee Benefits; Corporations
Subject: S Corporation
Title: S Corporation Reasonable Compensation Requirement
IRC Sections: 3121
Filename: 1382.html
Date Produced: 04/98

Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com

Background
Taxpayer is an S corporation engaged in the practice of veterinary medicine. Taxpayer is owned by a sole shareholder whose activities create most if not all of the taxpayer's revenues. The taxpayer earns about $150,000 per year before consideration of shareholder's salaries.

Issues
Is it possible to set the shareholder's salary at about $40,000 and take the remainder of the profits out as distributions in order to avoid employment taxes?

Answers
It is clear that the plan described above would not withstand IRS scrutiny.

Discussion
Rev. Rul. 74-44, 1974-1 C.B. 287, describes a situation in which two shareholders of an S corporation who performed substantial services for the corporation drew no salaries, choosing instead to withdraw corporate profits in the form of distributions. The ruling holds that the distributions constitute wages subject to income tax withholding, FICA, and FUTA. The principle set forth in Rev. Rul. 74-44 has been upheld by various courts. See Spicer Accounting, Inc. v. U.S., 918 F.2d 90 (9th Cir. 1990); Radtke v. U.S., 895 F.2d 1196 (7th Cir. 1990); and Dunn & Clark v. Comr., 853 F. Supp. 365 (D. Idaho 1994). Note that Spicer is a Ninth Circuit case which is, I assume, where your clients are located.

Rev. Rul. 74-44 and the cases cited above deal with cases where no salary was paid at all. The IRS is keenly aware of this issue, and I do not think it would too much to say that it would be a "red flag" to submit a return for a profitable S corporation with no officer's compensation. The issue then becomes what about setting a compensation level that is substantially less than the total profits of the corporation. In your case you suggest setting compensation at about 27% of total profit.

I believe strongly that an attempt to remove substantial amounts of profit through distributions would not be respected.

Given the nature of the business, I assume it would be immediately obvious to anyone reviewing the taxpayer's books or tax return that the taxpayer's profits are being generated solely by the efforts of the shareholder. Second, if the profit distributions do not represent compensation for the shareholder's services, then what are they? Normally, corporate dividends serve to compensate shareholders for placing capital at the risk of the business; however, in this case there is very little capital involved. Based on the foregoing constraints, I think it is inescapable that the distributions are disguised wages.

In my practice, I see quite a bit of anecdotal evidence that the inadequate compensation issue is being aggressively pursued by the IRS. Although it is not possible to know this with certainty, it appears that profitable returns with low officer's compensation are routinely flagged for follow-up. Assuming a rather high possibility of scrutiny and in light of my view that the taxpayer's position would be virtually indefensible, I suggest a very conservative approach to this issue.