Reasonable compensation questions affect millions of closely-held corporations whose owners actively participate in the business. The issue involves how much payroll taxes are due from the earnings of the business. Amounts not characterized as salary are reported as S-corporation income on the shareholder’s personal tax return, where it is not subject to payroll taxes. In re: Watson P.C. vs. United States, no. 11-1589 8th Cir. (2/21/12), the Eighth Circuit affirmed the district court’s decision, holding that an S-corporation shareholder-employee (Watson) characterized too little of the amount paid to the owner as taxable salary.
While one might view the case as an IRS victory, the case also stands for the proposition that a professional services business does not have to pay all of its earnings as taxable compensation subject to payroll taxes. In most of the earlier S-corporation reasonable compensation cases, the shareholder-employee failed to take any salary, leaving the IRS and the courts the simple task of reclassifying the distributions as compensation for services. In Watson, the employee-shareholder took as salary an amount that the IRS viewed as being too small. Although Watson has to pay additional payroll taxes, the trial and appellate courts allowed Watson to receive substantial distributions that were not subject to payroll taxes.
As long as one pays a reasonable salary, significant tax savings are possible and appropriate. We provide additional information in this article.