The tension between the IRS and S corporation owner-employees over compensation has been a perennial issue in tax law, and the Tax Court continues to scrutinize arrangements where shareholder-officers take disproportionately low salaries while extracting the remaining profits as distributions that avoid employment tax. The court's reasoning in Sean McAlary Ltd. Inc. v. Commissioner, T.C. Memo. 2013-62, and the line of cases it represents, provides a clear warning: the IRS has both the authority and the inclination to recharacterize distributions as wages when officer compensation does not reflect the fair market value of the services performed.[1]
The Reasonable Compensation Standard
The legal framework is straightforward. Under IRC § 3121(a), wages subject to FICA tax include all remuneration for employment, and an officer of a corporation is generally treated as an employee for this purpose. S corporation distributions, by contrast, are not subject to employment taxes. This differential creates an obvious incentive for S corporation shareholder-officers to minimize their salary and maximize their distributions. The IRS has long taken the position that when a shareholder-officer performs services for the corporation, the corporation must pay reasonable compensation for those services before making distributions.[2]
The standard is one of reasonableness under all the circumstances. There is no bright-line rule or safe harbor percentage. Instead, courts evaluate whether the compensation paid to an officer-shareholder reflects what would be paid to a hypothetical employee performing the same services in the same market. The analysis is inherently fact-intensive, and the burden of proof in a Tax Court proceeding typically falls on the taxpayer to demonstrate that the compensation level was reasonable.
The Multi-Factor Test
Courts apply a multi-factor test to determine whether officer compensation is reasonable. While different circuits have articulated the factors slightly differently, the Tax Court has consistently considered the following elements: the employee's qualifications, training, and experience; the nature, extent, and scope of the employee's duties; the time and effort devoted to the business; the size and complexity of the business; the prevailing economic conditions; the compensation paid by comparable businesses for comparable services; the corporation's salary policy for all employees; the amount of distributions relative to salaries; and the corporation's dividend history.[3]
No single factor is dispositive, and the weight given to each factor varies depending on the facts. In practice, however, courts pay particular attention to the relationship between the officer's role in generating revenue and the total compensation received. When a single shareholder-officer is responsible for substantially all of the corporation's revenue-producing activities and takes a salary that represents only a small fraction of the corporation's net income, the arrangement is virtually certain to attract IRS attention.
How Courts Have Applied the Standard
In Sean McAlary Ltd. Inc., the Tax Court examined a real estate broker who operated through an S corporation. The shareholder was the sole licensed broker and was personally responsible for generating all of the corporation's commission income. Despite earning several hundred thousand dollars in commissions through the corporation, the shareholder-officer paid himself a relatively modest salary and took the remainder as distributions. The court recharacterized a substantial portion of the distributions as wages subject to employment tax, reasoning that the shareholder's compensation bore no reasonable relationship to the value of the services he performed for the corporation.[1]
The Sean McAlary decision followed the Eighth Circuit's influential opinion in Watson v. United States, 668 F.3d 1008 (8th Cir. 2012), which involved an accountant who operated through an S corporation. In Watson, the shareholder took an annual salary of $24,000 while the corporation earned over $200,000 annually in net income. The district court and the Eighth Circuit both concluded that the salary was unreasonably low and that the IRS was entitled to recharacterize distributions as wages. The court in Watson found persuasive the testimony of an expert witness who analyzed comparable compensation data for accountants with similar experience in similar markets.[4]
These cases share a common thread: the shareholder was the primary revenue generator, the salary was dramatically below market rates for similar services, and the corporation had no reasonable business justification for the low compensation. Courts have been less receptive to IRS challenges where the shareholder can demonstrate that the corporation paid reasonable salaries and the distributions represented a genuine return on the shareholder's capital investment in the business.
Planning Considerations for S Corp Owners
S corporation owners should approach the reasonable compensation issue proactively rather than waiting for an IRS examination. The first step is to establish a compensation level that can withstand scrutiny. This requires analyzing comparable compensation data for the officer's role, the local market, and the industry. Several compensation studies and databases are available for this purpose, and the investment in a formal compensation analysis is modest relative to the potential exposure.
It is also important to document the basis for the compensation level selected. The corporation's board minutes or shareholder resolution should reflect the factors considered, the data relied upon, and the rationale for the compensation level. This documentation can be invaluable in the event of an examination, as it demonstrates that the compensation was the product of a deliberate analysis rather than an arbitrary number selected to minimize employment taxes.
Business owners should be cautious about taking a salary that represents a very small percentage of the corporation's net income, particularly when the shareholder is the primary or sole revenue-generating employee. While there is no magic ratio, a salary that represents less than one-third of the corporation's net income when the shareholder performs substantially all of the revenue-generating work is likely to attract scrutiny. The better practice is to establish a salary that is defensible on its own terms—that is, a salary that a reasonable employer would pay to a non-shareholder employee performing the same services.
Finally, S corporation owners should be aware that the employment tax exposure from a reasonable compensation challenge extends beyond the FICA taxes themselves. If the IRS recharacterizes distributions as wages, the corporation may also face penalties for failure to withhold and deposit employment taxes, as well as interest on the underpayment. In some cases, the responsible persons within the corporation—which in a closely held S corporation is typically the shareholder-officer—may be subject to the trust fund recovery penalty under IRC § 6672, which imposes personal liability for the employee's share of FICA and withheld income taxes.
The reasonable compensation issue is not going away. As the IRS continues to devote resources to S corporation compliance, business owners who take the time to establish and document a defensible compensation level will be well positioned to avoid costly disputes. For those who have not recently reviewed their compensation structure, now is an appropriate time to consult with qualified tax and business advisors to ensure that the arrangement is both tax-efficient and defensible.