It's Elementary My Dear Watson - S Corp Officer Compensation Must Be Reasonable
S Corps Must Pay Reasonable W-2 Compensation to Shareholders
Owners of S Corporations can generally take their profits out of the company in two ways: as compensation reported on Form W-2 (subject to payroll taxes) or as a distribution (not subject to payroll taxes). Some profitable S Corp owners want to push the envelope to save on payroll taxes by taking a meager amount of W-2 compensation, with the rest in the form of distributions. As the old saying goes,"When a pig becomes a hog, it gets butchered."
The recent district court case of David E Watson PC v US, 714 F.Supp.2d 954 (2010) illustrates this principle that is becoming increasingly risky to profitable S Corporation owners who provide services to their firm. In this case, a professional CPA firm paid shareholder distributions of $203,651 and $175,470 to Mr. Watson through his S Corp for 2002 and 2003, respectively, the years in question. However, Mr. Watson received only $24,000 of W-2 compensation for each of those years. The District Court had no trouble ruling against the taxpayer, affirming the assessment of taxes, penalties and interest.
The IRS is reported to have an initiative underway to flag those S Corp returns which show substantial profit distributions to shareholders, but with little or nothing appearing on the officer compensation line item of the Form 1120S. Additionally, recent proposed legislation would treat treat S Corps the same as partnerships, and characterize all the net profit after W-2 Compensation as subject to self-employment tax (this was blocked in the Senate).
The basic idea of taking profit distributions from your S Corporation, after paying a minimum reasonable W-2 compensation to officer shareholders has a lot of merit to it. A starting point for a reasonable minimum W-2 compensation / distribution mix may be something like a 50/50 split or greater. However, it makes no sense to push the envelope too far like Mr. Watson apparently did.
Clare L Garner Jr CPA LLMT | 01/25/2011