S Corporation Stockholder-Employee Compensation

August 16, 2011

by Michael W. Blitstein, CPA 

S corporation stockholder-employees and their tax advisers often find themselves with conflicting goals when setting the stockholder-employee’s compensation. Typically, the stockholder-employee prefers to minimize compensation in favor of distributions to reduce payroll taxes. Tax advisers, however, are faced with a body of governing authority providing that the stockholder-employee cannot avoid the imposition of payroll taxes by forgoing reasonable compensation. Unfortunately, until recently this governing authority had offered little in terms of how to actually compute reasonable compensation, leaving tax advisers with sparse guidance upon which to rely when recommending salary amounts to their clients.

In late 2010, an Iowa district court decided Watson, a reasonable compensation case that, together with the North Dakota District Court’s 2006 decision in JD & Associates, provides the direction tax advisers have been seeking. These two cases shed much needed light on the methodology the IRS and the courts use to determine reasonable compensation in the S corporation arena.

S Corporations and Employment Taxes

As passthrough entities, S corporations generally do not pay entity level tax on their taxable income. Instead, taxable income and other attributes are allocated among the stockholders, who report the items and pay the corresponding tax on their personal income tax returns.

This S corporation flowthrough income has long enjoyed an employment tax advantage over that of sole proprietorships, partnerships, and LLCs. The advantage finds its genesis in that a stockholder’s undistributed share of S corporation income is not treated as self-employment income. In contrast, earnings attributed to a sole proprietor, a general partner, or many LLC members are subject to self-employment taxes.

As the need to fund Social Security and Medicare payments has risen, the employment tax burden on employers, employees, and the self-employed has increased dramatically. In 2011, employers will pay 6.2% of the first $106,800 of an employee’s wages toward the Social Security tax, with employees paying an additional 4.2% through wage withholding. Employers and employees will split the 2.9% Medicare tax on all wages, without limitation.

Self-employed individuals will be responsible for the entire 10.4% Social Security tax—again limited to the first $106,800 of self-employment income—and the 2.9% Medicare tax on all self-employment income.

As these employment tax obligations have climbed, the advantage of operating as an S corporation has become magnified. Since S corporation income is not subject to self-employment tax, there is tremendous motivation for stockholder-employees to minimize their salary in favor of distributions, which are not subject to payroll or self-employment tax. Consider the following examples.

Example 1: John owns 100% of the stock of S Corporation, an S corporation. John is also S’s president and only employee. S generates $100,000 of taxable income in 2011, before considering John’s compensation. If John draws a $100,000 salary, S’s taxable income will be reduced to zero. John reports $100,000 of wage income on his individual income tax return, and S and John are liable for the necessary payroll taxes. S is required to pay $7,650 (7.65% of $100,000) as its share of payroll tax, and S withholds $5,650 (5.65% of $100,000) from John’s salary toward John’s payroll obligation, resulting in a total payroll tax bill of $13,300.

Example 2: Alternatively, John withdraws $100,000 from S as a distribution rather than a salary. S’s taxable income will remain at $100,000 and will be passed through to John and reported on his individual income tax return, where it is not subject to self-employment tax. The $100,000 distribution is also not taxable to John, as it represents a return of basis. By choosing to take a $100,000 distribution rather than a $100,000 salary, S and John have saved a combined $13,300 in payroll taxes.

Reasonable Compensation History: No Salary Taken

In light of these potential employment tax savings, the IRS has long challenged attempts by stockholder-employees to minimize compensation in favor of distributions. IRS opened its attack on these perceived abuses in Revenue Ruling 74-44. In the ruling, the IRS imputed the payment of reasonable salaries to an S corporation that paid distributions but no compensation to two stockholders who provided services to the corporation.

Fifteen years later, an oft-cited decision further clarified the IRS’s position on reasonable compensation. In Radtke, the taxpayer was the sole stockholder and director of a law firm established as an S corporation. Although the taxpayer devoted all his working time to the law firm, he took no compensation for the year at issue, opting instead to withdraw $18,225 in distributions.  The IRS argued, and the district court agreed, that the distributions represented wages subject to payroll taxes, with the court adding, “where the corporation’s only director had the corporation pay himself, the only significant employee, no salary for substantial services . . . [h]is ‘distributions’ functioned as remuneration for employment.”

Soon after, the Ninth Circuit Court of Appeals expanded on this line of reasoning with its decision in Spicer.  In that case, the taxpayer was Spicer Accounting Inc. (SAI), an accounting firm established as an S corporation. SAI was owned by Spicer, who was a CPA, and his spouse. Spicer also served as president, director, and treasurer. As SAI’s lone accountant, Spicer performed substantial services, working approximately 36 hours per week.

Spicer had an arrangement with his corporation whereby he donated his services to the corporation in exchange for no compensation, and as a stockholder he withdrew his earnings as distributions. Accordingly, Spicer did not pay payroll taxes on the amounts he received.

The Ninth Circuit, in analyzing the nature of the payments made to Spicer, stated that “salary arrangements between closely held corporations and [their] stockholders warrant close scrutiny.”  In an effort to determine if the distributions truly represented remuneration for services, the Ninth Circuit established a line of analysis that would be followed repeatedly in the years to follow.

The Ninth Circuit first looked to Sec. 3121(d), which defines an employee for payroll tax purposes in part as “any officer of a corporation.”  Because Spicer was the president of SAI, this requirement was easily met. The Ninth Circuit then turned its attention to Regulations Section 31.3121(d)-1(b), which provides an exception to employee status for some officers, but only to an officer who “does not perform any services or performs only minor services.”

In arriving at its decision, the Ninth Circuit held that Spicer’s services were substantial. As the firm’s lone CPA, Spicer was the only person capable of signing tax returns, performing audits, and preparing opinion letters. The Ninth Circuit concluded that distributions paid to Spicer were classified properly as compensation subject to payroll taxes because “a corporation’s sole full-time worker must be treated as an employee.”

A line of nearly identical rulings followed, with one Pennsylvania CPA at the heart of many of the decisions. In Grey, the sole stockholder of an accounting firm took no salary despite rendering significant services, opting instead to withdraw amounts as independent contractor fees. The Tax Court, using the line of reasoning established in Spicer, held that the stockholder was an employee and the accounting firm was liable for payroll taxes on the independent contractor fees.

After its victory in Grey, the IRS zeroed in on the accounting firm’s client list. In all, six of those clients found themselves in front of the Tax Court, defending the reasonableness of their compensation.  In each case, stockholder-employees who provided significant services to their S corporation withdrew the entire taxable income of their corporation as distributions, neglecting to take any salary. The Tax Court held that the stockholders were employees and recharacterized the distributions as compensation.

The abuses evidenced in these decisions did not go unnoticed. In 2005, the Treasury Inspector General for Tax Administration (TIGTA) issued a report examining the payroll tax advantage that S corporations enjoyed over sole proprietorships. The report, which analyzed S corporation tax returns filed in 2000, revealed the following:

  • Approximately 80% of all S corporations were more than 50% owned by one stockholder, giving that stockholder control in setting his or her compensation.
  • Owners of single-stockholder S corporations paid themselves salaries equaling only 41.5% of the corporation’s profits, down from 47.1% in 1994.
  • There were 36,000 situations in which the sole owners of S corporations generating over $100,000 of income took no salaries. These corporations passed through $13.2 billion to their owners free from payroll tax.
  • In total, the payroll taxes paid by single-stockholder S corporations were $5.7 billion less than the self-employment taxes that would have been imposed if the taxpayers were sole proprietors.

In 2009, a U.S. Government Accountability Office (GAO) report to the Senate Committee on Finance echoed the concerns expressed in the TIGTA findings. The GAO report noted that in 2003 and 2004 combined, S corporations had underreported their stockholder compensation by $24.6 billion, with corporations with fewer than three stockholders responsible for nearly all the underreporting.

A Rare Defeat for the IRS

Although a stockholder faces a heavy burden in proving that services provided to a corporation are not substantial, it can be accomplished. For example, in Davis, a district court held that the stockholder had proved this point and rejected the IRS’s attempt to recharacterize distributions made to a stockholder of an S corporation as “arbitrary and capricious.”

Davis was the president of the corporation but did not actively participate in its activities. The court, citing Spicer, found that based on the uncontroverted evidence of the stockholder, she did not provide substantial services to the corporation and met the exception from employee treatment provided for in the Section 3121 regulations. While this decision remains an anomaly in the relevant case history, it confirms that stockholders need not draw a salary provided they render only minimal services to the corporation.