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Another Lesson on Unreasonably Low Compensation

Payroll-taxPayroll tax collection continues to vex the Internal Revenue Service despite several court cases that have resulted in rulings favorable for the IRS regarding unreasonably low compensation. A recent high profile case was David E. Watson, P.C. v. United States on which the Eighth Circuit ruled in 2012. Watson was an indirect partner in a CPA firm, practicing through an S corporation that paid him $24,000of salary per year and between $175,000 and $203,000 in profit distributions. The court adjusted his compensation to $93,000.

It isn’t hard to see why shareholders of S corporations attempt to justify wage levels below what the IRS considers “reasonable compensation” (assuming the understated compensation is below the FICA wage base). Both the S corporation and employee save the 7.65% FICA and Medicare taxes on the wages not reported.

Another recent case is Herbert v. Commissioner. Herbert received between $24,000 and $29,000 of wages for the years 2004 through 2006. In 2007, he received $2,400 of wages. Although the Tax Court noted that the corporation lost money or earned very little income in each of the years, and the corporation closed down in 2009, the Court increased the taxable compensation for 2007. The IRS wanted to reclassify all of the draws from the S corporation for 2007 as additional wages (i.e., an additional $52,600). Ultimately, the judge averaged the petitioner’s wages for 2002 through 2006 to arrive at $30,445 as a reasonable wage. (The business was owned by someone else in 2002 and 2003.)

It didn’t help matters that Mr. Herbert used the draws to pay corporate expenses personally. He lost, misplaced or never kept receipts for many corporate expenses he paid with cash. The Court accepted Herbert’s testimony that he in fact paid significant corporate expenses with cash using funds received from the corporation. Nonetheless, the judge also believed that the wages of $2,400 were too low.

The result? Herbert was found to have under-reported his wages, even though the amount of cash drawn out of the corporation covered corporate expenses. If he had maintained a better set of books, paid all of the corporate expenses with corporate (rather than what became to be personal) funds, he wouldn’t have had distributions from the corporation to himself.

Although the wages were quite low, the fact of the matter is the business was failing. There wasn’t an adequate cash flow to pay wages and expenses. By shuffling funds and taking money personally, Mr. Herbert created a payroll tax liability where such liability shouldn’t have existed.

Payroll tax reduction or avoidance is, perhaps, a major reason for the popularity of S corporation status for an operating entity, even though the formation of an LLC under state law provides similar liability protection for the sole proprietor. The IRS projects that 4.6 million Forms 1120-S will be filed for 2012, compared to 3.6 million Forms 1065 (partnership).  

As part of its tax reform efforts, Congress is evaluating the continuing treatment of the bottom-line S corporation as not subject to payroll taxes or self-employment tax. The AICPA will be closely monitoring any developments and keeping you up to date through its tax reform page and other communications.

Chris Hesse, CPA, Partner, CliftonLarsonAllen. Chris is with CliftonLarsonAllen’s Federal Tax Resource Group serving all offices of the firm. FTRG is a firm wide group that assists all offices of the firm on federal income tax matters, in addition to drafting CPE material for in-house presentation.  Chris is also chairman of the S Corporation Technical Resource Panel for the AICPA.

Payroll tax image via Shutterstock

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