Employee-Owner Compensation in C and S Corporations

Recent developments could have a significant effect on how the IRS treats C and S corporations on owner-employee compensation issues. Two significant occurrences in the last 14 months indicate a pending change in regulatory attitude. One of these, a U.S. Treasury report issued in July 2002, questioned the large percentage of S corporations that insufficiently compensate their owner-employees. The other was a Tax Court ruling against a personal service C corporation on the issue of overcompensation. Both C and S corporations give owners a level of financial and legal assurance. However, using owner salaries to produce beneficial tax consequences, combined with mounting regulatory focus, has increased the risk of an IRS challenge on audit.

TIGTA Audit

A new Treasury Inspector General for Tax Administration (TIGTA) report, titled "The Internal Revenue Service Does Not Always Address Subchapter S Corporations’ Officer Compensation during Examinations," may signal the beginning of a new Service position on the compensation issue. The report looked at an entity’s incentive to underpay owner-employees’ salaries and wages, and then distribute their "actual" salaries in a property distribution. This compensation package allows the owner-employee to avoid paying FICA and Medicare taxes on salaries and wages, but not on distributive shares of S earnings.

According to the report, the IRS does not give employee-owner compensation enough attention and leaves a tremendous amount of tax revenue on the table. It sampled 84 S corporations whose returns the IRS had examined. The selection criteria were that the companies "reported officer compensation less than $10,000 and ordinary income of greater than $50,000." Companies reported an average of $5,300 in wages on their Forms 1120-S, while reporting $349,323 as the average distribution on their schedules M-2.

This statistical evidence suggested that S corporations were underpaying owner-employees salaries to avoid FICA and Medicare taxes. Treasury concluded that this was a blatant abuse of the S corporation tax structure and recommended that the Service be more vigilant in its examination of S returns and to place more attention on partners’ compensation.

Pediatric Surgical Associates, P.C.

In April 2001, the Tax Court ruled in Pediatric Surgical Associates, P.C. (PSA), TC Memo 2001-81, on whether the compensation paid to employee-owners was adequate. Unlike the underpayment in the S corporation situation, this was an overpayment issue.

PSA, a C corporation, was a medical organization comprised of surgeons who were stockholders and nonstockholders. The nonstockholders’ salaries were fixed at much lower amounts than those of their stockholding counterparts. Each month, the practice’s income was determined after taking into account all the cash expenses and additional compensation (bonuses) given to the stockholders. The IRS contended that the corporation had intentionally inflated the shareholders’ salaries to create a deductible expense to circumvent the double taxation on corporate distributions. According to the Service, this additional pay was a poorly disguised earnings distribution used to save corporate tax.

The Court ruled that the burden of proof as to the salaries’ reasonableness was on the taxpayer. It then ruled that only a portion of PSA’s compensation to shareholders be sustained, declaring that the remaining portion was merely disguised dividends. Thus, the court disallowed the deduction of the dividend portion. Perhaps the most shocking aspect of this case was not that the court upheld the IRS’s assessed tax on the disguised dividends, but that negligence penalties were also upheld.

Conclusion

These developments illustrate the importance of the tax community’s awareness of the regulatory environment. Tax advice that is conscious of the IRS’s tolerance level of certain tax strategies enables clients to maximize their tax savings, while minimizing their risk of adjustments being made on audit. Being cognitive of the tax laws is not enough; advisers must also be mindful of the attitudes and culture of the regulatory bodies that enforce the laws.

From Jason R. Lewis, Tax Specialist, Aidman, Piser & Co., Tampa, FL