Most business owners think they are undercompensated. The Internal Revenue Service does too for many business S Corporation owner employees. Their perspective is not exactly the same. The focal point is a sometimes hotly contested issue called “reasonable compensation”.

The IRS has come out the big winner. Here’s the story.

Since the publication of IRS Revenue Ruling 59-221 in 1959, shareholder-employees of an S corporation have enjoyed a significant tax advantage over Sole Proprietors, Partners in a partnership and Members of an LLC.

Perhaps “enjoy” is too general a term to describe it. Since that Ruling, taxpayers have had a long and sometimes contentious relationship with the IRS on this tax advantage.

That Revenue Ruling held that a shareholder-employee’s undistributed share of S corporation income is not treated as self-employment income. Thus, not subject to self-employment taxes.

As a result, business owners have elected  S corporation status which still provides limited liability to shareholders, but earnings are taxed directly to the shareholders on their personal returns. (Note: shareholders in a professional corporation still have personal malpractice liability in a law suit).

The advantage of operating as an S corporation has become magnified as employment tax rates have climbed with increasing motivation for shareholder-employees to minimize their salary in favor of distributions.

In response, the IRS has made “reasonable compensation” a central focus on audits going after S corporation shareholders who do not pay themselves “reasonable compensation” to avoid paying employment taxes. If successful, the IRS can collect payroll taxes on officer compensation. The penalty for which can be steep: 100% of the taxes owed.

Taxpayers have not fared particularly well in litigation with the IRS. The burden of proof is on the taxpayer to prove their compensation is reasonable. Courts have based their decisions on the facts and circumstances of each case considering some of the following factors:

  • Training and experience
  • Duties and responsibilities
  • Time and effort devoted to the business
  • Dividend history
  • Payments to non-shareholder employees
  • Timing and manner of paying bonuses to key people
  • What comparable businesses pay for similar services
  • Compensation agreements
  • The use of a formula to determine compensation

There are a number of steps S corporation shareholder-employees can take to make the case that their compensation is reasonable, a job for their CPA or attorney.

Our job is relatively simple. It’s to point out or remind the S corporation shareholder-employee that only the compensation appearing on the owner’s W-2 counts as compensation for purposes of determining a contribution to a qualified retirement plan. The larger the salary, the larger the potential retirement plan contribution.

The 2013 tax year is not over yet. Still time for shareholder-employees to give themselves a raise.