Legislation and Case Law Regarding S Corporations
To see where legislation and case law stand on this matter, we will review some relevant Tax Court cases that outline reasonable officer compensation. So as to avoid singling out any fellow solo attorneys through my case law examples below, let’s review some examples of accountants.
The case Ulrich v. United States, 692 F. Supp. 1053 (D. Minn. 1988), deals with an accounting firm’s sole shareholder who paid himself only in dividends. The court in this case held, “Under both the weight of the case law and under the treasury regulations, a corporate officer is to be treated an employee if he renders more than minor services.” As solo attorneys, we clearly render far greater than minor services and thus are firmly placed into the employee box and required to receive the W-2 payroll that Ulrich was trying so hard to avoid.
In Spicer Accounting v. United States, 918 F.2d 90 (9th Cir. 1990), we see another instance of an accounting firm avoiding W-2 payroll for its shareholders. This case involves a firm owned by a husband accountant and his wife; Spicer, the sole accountant of the firm, only received compensation through dividend distributions and had no W-2 payroll paid to him. Spicer proceeded to argue that he had, in fact, donated his services to the corporation. The court held, “The Federal Insurance Contributions Act and Federal Unemployment Tax Act both define ‘wages’ as ‘all remuneration for employment[,] . . . that the form of payment is immaterial[, and therefore] the only relevant factor [is] whether payments were actually received as compensation for employment.”
Donated labor to for-profit businesses has long been against public policy in the United States, and owners may not donate their labor to their business in order to forgo the payment of payroll taxes. The court in Spicer ruled that Spicer should have been receiving W-2 payroll compensation. But how much W-2 payroll is “reasonable” compensation for the owner of a business working in the business?
For further insight into this question, we turn to Watson v. Commissioner, 668 F.3d 1008 (8th Cir. 2012). In this case, the owner of an accounting firm, Watson, worked as an accountant for that same firm. While the firm grossed nearly $3 million in annual revenue, Watson decided that $24,000 of W-2 salary was reasonable enough. The court took issue with Watson’s professional credentials and education: Watson held advanced degrees and a license as a certified public accountant, leading to the presumption that $24,000 was not a salary commensurate with that level of education and professional credentials.
In the end, the Eight Circuit Court ruled that a reasonable person would consider the dividends paid to Watson not a return on investment but instead “remuneration for services performed.” In achieving this result, the Internal Revenue Service (IRS) was able to successfully assert that the $24,000 shareholder salary was not enough to support Watson’s lifestyle. As such, his dividends were reclassified as wages, and the firm was assessed exorbitant employment taxes plus additional penalties and interest.
While the IRS was able to use one accountant’s lifestyle to assert his W-2 payroll salary was unreasonable, that is not the only method at its disposal. In JD & Associates, Ltd. v. United States, No. 3:04-cv-59 (D.N.D. 2006), we begin with the familiar background where Dahl, an accountant and sole shareholder, paid himself a small salary. In this case, the IRS hired a valuation expert, who used risk management association (RMA) data to determine what other accountants were paid for similar services. The RMA data was damning enough, but what really sent this case over the edge was that Dahl paid himself less than his staff, including clerical positions.
While great file clerks keep us all organized, their W-2 income usually is not larger than that of the professionally licensed and credentialed owner, especially one who had to pass a difficult licensing exam, adhere to strict ethical requirements, and keep up with continuing education, as did the accountant in this case.
So far, we have touched only on cases where shareholders employed at the company had little basis for their salary decisions. In Davis v. United States, 1994 U.S. Dist. LEXIS 10725 (D. Colo. 1994), we see almost the exact opposite. Here, a husband-and-wife team owned a corporation that operated as a brokerage business in Colorado. While they owned the corporation, the husband worked elsewhere, and the wife occasionally performed basic clerical duties around the office. She kept detailed records tracking her 12 hours per month of clerical duties and consulted an accountant who informed her that her services were worth $8 per hour. The IRS chose not to challenge the $8-per-hour valuation of services, and Davis was able to win the case when her detailed records proved her minimal hours worked. Justice favors those with copious documents and third-party verification.
A similar instance of proving reasonable valuation can be seen in the case Charted Services of California v. Department of Benefit Payments, formerly Tax Decision No. T-75-39/T-75-40. The California Unemployment Insurance Appeals Board found that an insurance broker who paid himself no money as a W-2 salary and minimal 1099 income was not unreasonable for the following reasons. The insurance agent performed only administrative tasks for the corporation “in the prospect that at some future time the operation of the petitioner [Charted Services of California] based on override commissions will be successful and will enable the petitioner to pay him a salary as president.” The minimal 1099 income that was paid to him from the corporation was consistent with industry standards in the insurance industry as payment of commissions for policies sold, for which he was an independent contractor.
Reasonable vs. Unreasonable Compensation
With these cases in mind, let’s move on to certain tests that have been and continue to be used to differentiate reasonable from unreasonable officer compensation.
The case of Elliotts, Inc. v. C.I.R, 716 F.2d 1241 (9th Cir. 1983), explained that shareholder/employee compensation must fit into the two boxes of being “reasonable” and “purely for services.” Breaking this down further, the court considered five distinct factors for determining reasonable officer compensation. The first portion of the test considers the employee’s role in the company, while the second part seeks to compare the employee’s compensation “with the compensation paid to similarly situated employees at similar companies.” The test continues by considering “the character and condition of the company” and “whether a conflict of interest exists that might permit the company to disguise dividend payments as deductible compensation.” Finally, the fifth factor is “whether compensation was paid pursuant to a structured, formal, and consistently applied program.” This test has been considered relevant and upheld as applicable in later cases, such as Label Graphics, Inc. v. Commissioner, T.C. Memo 1998-343, and O.S.C. Associates, Inc. v. C.I.R, 187 F.3d 1116 (9th Cir. 1999). While our second Ninth Circuit case does acknowledge the difficulties of proving intent of payments, the decision upholds Elliotts as a relevant test for reasonable compensation.
This five-factor test must also be considered in conjunction with IRS Fact Sheet 2008-25, which states that there is no one rule that will by itself determine whether a salary is considered reasonable compensation or not. Fact Sheet 2008-25 also outlines significant factors considered by the court in the past: 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, and the use of a formula to determine compensation. As a whole, these factors are of a similar character to the five-factor test from Elliotts and support the results of the different cases we have covered so far.
To make matters even more complex, in Brewer Quality Homes, Inc. v. Commissioner, T.C. Memo 2003-200, the court reiterated several points citing a different test from federal court case Owensby Kritikos, Inc. v. C.I.R, 819 F.2d 1315 (5th Cir. 1987). These factors are the employee’s qualifications; the nature, extent, and scope of his or her work; the size and complexity of the company; a comparison of the employee’s salary with the company’s gross and net income; prevailing general economic conditions; comparison of salaries with distributions to stockholders; compensation for comparable positions in a comparable concern; salary policy of the company as to all employees; and the amount of compensation paid to the employee in previous years. These factors do cover much of the same ground as the five-factor test from Elliotts but reflect a greater focus on in-house comparisons and company-specific factors, as well as an allowance for consideration of the current economic climate.
With these tests in mind, Tax Court judges will apply the facts and circumstances to each of these factors. For example, the criterion might be payment to non-shareholder employees. In this case, consider a situation where the S corporation owner provides evidence that her star employee is the rainmaker, and therefore the employee’s salary, including bonuses, exceeds the S corporation shareholder. If the Tax Court judge finds this argument to be compelling, this factor will weigh more heavily in this case than in a case where the shareholder makes a similar salary as the employees and has no evidence to prove the value that these employees bring to the corporation.
Even so, as much evidence, expert testimony, and persuasion as can be brought to the matter, the final say still remains with the Tax Court judge regarding how to weigh the plethora of factors and multiple tests described above. With that level of uncertainty in deducing whether a shareholder salary is reasonable or unreasonable, it is best to check through the tests previously upheld in the U.S. Tax Court and determine whether your salary as a solo attorney is solely for the services provided for your corporation and whether that salary matches up with the value of those services performed.
