S Corporation Owners Should Take Care in Setting Their Compensation

Posted on May 31, 2007


As someone who frequently assists individuals and business with their tax planning as well as with their audits and other Internal Revenue Service (“IRS”) matters, the headline of the recent Birmingham Business Journal article entitled “How an S Corporation Can Avoid Audit By IRS,” really caught my eye.  My first thought was “I wonder if this article is about ‘reasonable’ compensation?”  A review of this excellent article confirms that it addresses how S corporation owners can make sure their salaries are reasonable in the eyes of the IRS. 

The topic of reasonable compensation—or unreasonably low salaries—is one that is not discussed often enough by tax advisors with their S corporation clients.  This lack of serious discussion of reasonable compensation issues is puzzling given that, as will be discussed below, the reason the S corporation form is so often chosen for small businesses relates primarily to the taxation of wages and distributions paid to its owners.

The single level of taxation on S corporation income is one of the chief reasons tax advisors recommend S corporations.  That is, with some exceptions, S corporations are generally treated like partnerships for federal income tax purposes.  The other key reason (sometimes the only reason) that the S corporation form is recommended is the fact that distributions are not subject to FICA, FUTA, and other employment taxes.  Amounts received by shareholder for their services rendered to the S corporation (i.e., salary) are, however, fully subject to employment taxes.  This creates an incentive for S corporation owners to set their salaries low and take most of their money out of the S corporation in the form of distributions not subject to employment taxes. 

Given the amount of employment taxes that can be saved, the temptation is great to set salaries at below market rates.  In fact, some misguided tax advisors explicitly advise S corporation owners to compensate themselves at below market rates.  Some of the more aggressive and tax savvy S corporation owners will try to pressure cautious tax advisors to sanction or agree with a below market compensation plan—presumably to have someone to point the finger in the even of an IRS audit.  However, it is not a tax advisor’s job to dictate, ratify, or sanction the amount of an owner’s or employee’s compensation.  Setting the compensation of the corporate owners and employees is a business decision to be made by the appropriate officers and/or directors of the corporation.  Thus, tax advisors should refrain from sanctioning or giving a legal opinion regarding the sufficiency of any particular compensation arrangement.  This does not mean, however, that a tax advisor should fill out the return of or otherwise advise or assist an S corporation owner where the tax advisor feels employment taxes are purposefully being evaded.

The IRS is well aware of the incentive S corporation owners have to set their salaries unreasonably low.  Over the past few years, the IRS has greatly increased its audit activity in the S corporation compensation area.  According to the IRS Fiscal Year 2006 Enforcement and Service Results report, audits of S corporations increased by 34 percent over the previous year.  The IRS has been under pressure from Congress to pursue S corporations that are playing games with owner compensation.  This is no surprise given that the U.S. Senate Finance Committee’s 2005 report entitled “Options to Improve Tax Compliance and Reform Tax Expenditures” identified S corporation compensation to be a compliance problem area.

The Birmingham Business Journal article gave two very important recommendations to S corporation owners wishing to avoid an IRS audit:  (1) consult your tax advisor and (2) educate yourself on what constitutes reasonable or competitive compensation.  While it is not a tax advisor’s job to make corporate compensation decisions, a diligent tax advisor should not only point out the reasonable compensation issue to the officers and/or directors responsible for setting compensation but should also:  (1) provide them with some basic advice based on relevant case law and IRS published guidance and (2) point the client in the direction of where to obtain good information on reasonable or competitive salaries—i.e., tell the client where to look for compensation information. 

S corporation clients should be advised that the IRS typically looks at multiple factors in determining the reasonable compensation of a particular S corporation owner.  Some of these factors include:

  • Services a person is providing to the corporation;
  • Amount of time required to complete his/her services to the corporation;
  • Person’s abilities and accomplishments;
  • Gross and net income of the business;
  • Complexities of the business;
  • Person’s compensation history; and
  • Corporation’s salary policy for all its employees.

The IRS’s mission in evaluating reasonable compensation is to determine whether the taxpayer’s compensation is approximate to someone providing comparable services under like circumstances.  Accordingly, the above factors are useful in distinguishing why a person is making more or less than someone else working for a similar corporation.  Obtaining good information about the compensation of similarly situated S corporation owners can present some difficulties if one or more of the owners don’t have extensive industry experience and/or industry contacts willing to discuss compensation structure.  The Birmingham Business Journal article recommends two useful sources of compensation comparables when access to such information is limited:  (1) a staffing agency that routinely fills similar positions and (2) internet salary calculators such as www.salaryexpert.com and www.careerbuilder.com.  Armed with credible information regarding comparable salaries as well as the specifics of an owner’s services, background, etc., an S corporation’s officers and/or directors will most likely be able to make a compensation determination that is defensible to the IRS.

It should be clear from the discussion above that reasonable compensation determinations are matters of considerable importance to S corporation owners.  Avoiding a potential IRS audit is always be high on a business owner’s priority list.  This brief discussion should give S corporation owners and tax advisors the basics of the reasonable compensation issue and the audit threat it presents.  I hope this article will spark some discussion among our S corporation owner and tax advisor readers alike.    

Russell M. Cunningham, IV, Cunningham Firm, LLC