Robert Southey’s fairy tale, Goldilocks and the Three Bears, which was first published in 1837, provides tax practitioners with the proper analysis to determine whether compensation is reasonable. Compensation cannot be too high and compensation cannot be too low. It must be just right to be considered reasonable for tax purposes. Unfortunately, the determination is subjective in nature. Consequently, it may be subject to debate.
Code Section 162 is the starting point in every reasonable compensation case. Code Section 162 provides:
There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including--(1) a reasonable allowance for salaries or other compensation for personal services actually rendered***.
The Treasury Regulations, Section 1.162-7, expand the focus into 2 parts:
- The first part of the analysis is the “Intent Test.” Under this test, the compensation payments must be intended to be made solely as payment for services rendered. In other words, the payments cannot be intended as consideration for anything other than for personal services.
- The second part of the analysis is the “Amount Test.” Under this test, the compensation payments must be reasonable in amount. The payments cannot be greater in amount than what is reasonable under the circumstances for the services actually rendered.
Most S corporation reasonable compensation cases involve allegations of unreasonably low compensation. There are, however, at least four (4) circumstances where taxpayers may be motivated to pay unreasonably high compensation in the S corporation context, including:
- BUILT-IN GAINS TAX AVOIDANCE. The first circumstance is where a taxpayer wishes to avoid the application of the built-in gains tax under Code Section 1374 by zeroing out the corporation’s taxable income determined as if it were a C corporation. Remember, the net recognized built-in gain under Code Section 1374(d)(2)(A) can never exceed the taxable income of the S corporation, determined as if it were a C corporation. So, if the taxable income of the C corporation is zero for the taxable year, there can be no built-in gains tax liability for the year. As a result of TAMRA 1988, however, if the taxable income for the taxable year is zero, the built-in gain gets carried over to future years and gets recognized to the extent of taxable income in the future years. But, if income is zeroed out for each of the remaining years during the built-in gains tax recognition period (by expenses such as compensation), the built-in gain tax is avoided forever. Under current law, Code Section 1374 (d)(7), the built-in gains tax recognition period is ten (10) years. As you recall, Congress shortened the recognition period to as little as five (5) years for tax years 2009, 2010, 2011, 2012 and 2013, in the name of economic stimulus. The law reverted back to ten (10) years on January 1, 2014. An interesting side note: Ways and Means Committee Chairman Dave Camp proposed, as part of his tax simplification legislation that he distributed to members of the House in early February of this year, to permanently reduce the recognition period to five (5) years.
- MAXIMIZE RETIREMENT PLAN CONTRIBUTIONS. The second circumstance is where the taxpayer wishes to maximize shareholder/employee earned income so that it may maximize contributions to a retirement plan. Retirement plan contributions are based on wages. Increasing wages allows the shareholder/employee to maximize the amount contributed to his or her retirement account.
- AVOID VIOLATING THE SINGLE CLASS OF STOCK REQUIREMENT. The third circumstance is where the taxpayer wishes to avoid violating the single class requirement of Code Section 1361(b)(1)(D). If the taxpayer desires to treat shareholders differently, it may attempt to use compensation to meet this objective. When that is done, the Service may throw out the reasonable compensation flag on audit to attack the validity of the S election. The Service generally only prevails in these cases when the fact pattern is egregious. Nevertheless, you need to be aware of the issue and be cautious so that compensation is reasonable and is paid for actual services rendered.
- AVOIDING THE APPLICATION OF CODE SECTION 1411. The fourth circumstance was given life by the Affordable Care Act. S corporation taxpayers may now be motivated to pay compensation to shareholders who do not actively participate in the business of the S corporation in an attempt to avoid the application of the 3.8% Net Investment Tax under Code Section 1411. This new 3.8% tax applies to what is called “net investment income.” Included in the definition of “net investment income” is pass-through income from an S corporation in which the shareholder does not actively participate. So, if there is no colorable argument that the shareholder materially participates in the business of the S corporation, there may be the motivation to pay wages to the shareholder. If the shareholder does not perform work for the corporation, the Service will be able to successfully attack the payment on the theory of unreasonable compensation.
Taproot Administrative Services v. Commissioner, 133 TC 202 (2009), 679 F3d 1109 (9th Cir. 2012), is an S corporation shareholder eligibility case. It was decided by the US Tax Court in 2009 and eventually made its way to the 9th Circuit Court of Appeals, where a decision was rendered in 2012.
Prior to the enactment of the American Jobs Creation Act of 2004, only the following were eligible S corporation shareholders:
- US citizens and resident individuals;
- Tax-exempt 501(c) charities and 401(a) retirement plans; and
- Certain trusts, including QSSTs, ESBTs and grantor trusts
As a result of the lobbying efforts of family-owned rural banks, as of October 22, 2004 (the effective date of the American Jobs Creation Act), a new eligible shareholder was added to the list, IRAs, including Roth IRAs, provided two criteria are met:
- The S corporation must be a bank, as defined in Section 581 of the Code; and
- The shares must have been owned by the IRA on October 22, 2004, the enactment date of the American Jobs Creation Act.
As you might imagine, having an eligible IRA shareholder will be rare. The exception to the S corporation eligibility rules provided by the American Jobs Creation Act is quite narrow.
Larry J. Brant
Larry J. Brant is a Shareholder and the Chair of the Tax & Benefits practice group at Foster Garvey, a law firm based out of the Pacific Northwest, with offices in Seattle, Washington; Portland, Oregon; Washington, D.C.; New York, New York, Spokane, Washington; and Beijing, China. Mr. Brant practices in the Portland office. His practice focuses on tax, tax controversy and transactions. Mr. Brant is a past Chair of the Oregon State Bar Taxation Section. He was the long-term Chair of the Oregon Tax Institute, and is currently a member of the Board of Directors of the Portland Tax Forum. Mr. Brant has served as an adjunct professor, teaching corporate taxation, at Northwestern School of Law, Lewis and Clark College. He is an Expert Contributor to Thomson Reuters Checkpoint Catalyst. Mr. Brant is a Fellow in the American College of Tax Counsel. He publishes articles on numerous income tax issues, including Taxation of S Corporations, Reasonable Compensation, Circular 230, Worker Classification, IRC § 1031 Exchanges, Choice of Entity, Entity Tax Classification, and State and Local Taxation. Mr. Brant is a frequent lecturer at local, regional and national tax and business conferences for CPAs and attorneys. He was the 2015 Recipient of the Oregon State Bar Tax Section Award of Merit.