One of the major advantages in electing to be taxed as an S corporation is the avoidance of double-taxation on the corporate profits. Double taxation occurs with a C corporation when the profits of the corporation are taxed at the corporate level, then again at the shareholder level when the profits are distributed to the shareholder(s). This double taxation is avoided with an S corporation as the shareholder is allowed to take tax free distributions to the extent of the shareholder's basis. The shareholder of an S corporation cannot take advantage of this difference by not paying "reasonable compensation" to any shareholder that performs services for the corporation.

Determining what constitutes reasonable compensation can be a difficult proposition as there are no rules for measuring the reasonableness of compensation and there is no definition in the internal revenue code. The regulations only provide that reasonable compensation is an amount paid for like service by like enterprise under like circumstances. There have been many court cases that have shown that each situation must be resolved based on its unique facts and circumstances. The IRS has offered very little guidance on the subject of setting reasonable compensation. The IRS did provide the following factors that various courts have generally considered in determining adequate compensation on the basis of the facts and circumstances of the case:

• Training and experience
• Duties and responsibilities
• Time and effort devoted to the business
• Dividend history
• Payments to non-shareholder employees
• Timing and manner of paying bonuses to key people
• What comparable businesses pay for similar services
• Compensation agreement
• The use of a formula to determine compensation

Taxpayers will generally not prevail against the IRS if the compensation paid by the S corporation is deemed to be extremely low or zero. Reasonable compensation must be determined based on the surrounding facts and circumstances; therefore it is impossible to make a general statement as to what amount of compensation is reasonable. Proper documentation and strong support for the business purpose of the transactions can help make the case stronger for the amount of compensation established.

In December 2009, the US Government Accountability Office (GAO) released a report titled "Tax Gap; Actions Needed to Address Noncompliance with S Corporation Tax Rules". As part of this report the GAO looked at S corporation tax returns for tax years 2003 and 2004. The report found that 13% of S corporations paid what they deemed to be inadequate wage compensation in those years. Almost all of the inadequate compensation was paid by S corporations with 3 or less shareholders, with the majority of those being single shareholder S corporations. The GAO report stated that IRS examiners were more likely to pursue this issue in S corporations that paid little or no wages, and also had large distributions to the shareholder(s).

The debate over reasonable compensation for an S corporation originates in part with one of the major advantages of being taxed as an S corporation. Unlike partnerships and LLC's, there is no self-employment tax imposed on the pass-through income of an S corporation. In 2011, employers are responsible to pay 6.2% social security tax on the first $106,800 of an employee's wages, with employees having to pay an additional 4.2%. Both employers and employees also are required to pay an additional 1.45% of wages each for Medicare taxes, without limitation. Self-employed individuals are also responsible to pay these taxes in the form of self-employment tax, which is 10.4% on the first $106,800 of self-employment income plus the 2.9% Medicare tax. Due to the employment taxes imposed on a shareholder's wages, there can be a tremendous tax savings when a shareholder minimizes or even eliminates the wages in favor of distributions.

As a result of the large amount of S corporations that have been deemed to be not paying out proper compensation to its shareholders, several recommendations and proposals have come up in Congress that would change the rules for taxing S corporation income. As the self-employment rate continues to climb, and will most likely continue to climb in the future, the likelihood of abuse in determining shareholder compensation will most likely increase along with the tax rates. As such, the debate over what constitutes reasonable compensation is likely to continue as well.

As always, please contact your tax advisor at Dermody, Burke & Brown if you have any questions or would like further information on this, or any other topic.