S-Corporation Compensation: Finding a “Reasonable” Balance

S-Corp owners and their tax advisors often approach this topic with different mindsets. The owner will prefer to set their compensation low to reduce payroll taxes, whereas the advisor will want to ensure the owner is not incurring the wrath of governing bodies – bodies that have a penchant for challenging this exact issue.

The IRS has released guidance on this topic in recent years. The first step is to look at three sources of an S-Corp’s gross receipts:

1. Services of shareholder.
2. Services of non-shareholder employees. 
3. Capital and equipment.

In theory, it’s simple: “to the extent gross receipts are generated by the shareholder’s personal services (#1), then payments to the shareholder-employee should be classified as wages that are subject to employment taxes.” As usual, however, it is more complex in practice than in theory – thus, looking at a real-life example, such as the case of JD & Associates vs. United States, will provide valuable insight.

JD & Associates Ltd. vs. United States

JD & Associates Ltd (JDA) was an accounting firm organized as an S-Corp. Jeffrey Dahl was the sole shareholder and had substantial responsibilities in nearly every aspect of the business: hiring decisions, paying bills, maintaining the books, client work, and more.

Dahl’s yearly salary and distributions hovered around $25,000 and $50,000, respectively, from 1997 to 1999. JDA was a successful enterprise – after-tax profit was a percentage of net sales was 250% higher than comparable firms.

The IRS guidance cited above includes nine subjective factors to consider when determining reasonable compensation. The court in the JDA case narrowed it to three key factors:

1. Employee Performance: The course used metrics like the after-tax profit ratio to determine that Dahl excelled in leading JDA. Despite this, his salary was deemed “not congruent to his performance.”
2. Salary Comparisons: It was found that Dahl’s wages were only slightly higher than those of his employees and remained stagnant despite JDA’s growth. Additionally, Dahl’s salary as a percentage of JDA’s net sales was, on average, 225% lower than that of leaders in comparable firms. 
3. Company/Industry Conditions: JDA was a small business in an industry with few non-salary expenses and little need for reinvestment. This, coupled with Dahl’s relatively large distributions, led the court to conclude there were excess funds available for compensation. 

With all three factors landing in the court’s favor, Dahl’s compensation was adjusted to nearly double its original amount. Consequently, assessments of unpaid payroll taxes, penalties, and interest were upheld.