S CORPORATION ALERT

Significant increase in payroll taxes in recent years has caused some S corporation shareholder-employees to conclude that it is better to take a lower salary and draw out profits of the company through larger dividend distributions. The IRS is aware of this and looks for "inadequate compensation" to shareholder-employees. When it believes that an individual has not been compensated properly, it will re-characterize a part of the dividend distribution as wages and assess employment taxes, penalties and interest on the deficiency. To avoid a successful IRS challenge, it would strengthen any defense to document the adequacy of low compensation. This can often be achieved by showing that:

• The employment duties are limited and undemanding.
• The employee-shareholder’s work experience related to the employment duties is
  negligible.
• The person lacks special skills or training.
• Time spent in performing the functions is minimal.
• Overall economic conditions are poor and others are not compensated any more for
  performing similar duties.
• The company’s earnings are marginal or declining, necessitating the low level of pay.
• The amount of compensation was authorized and fixed in advance of the period for
  which it was paid.
• The compensation was paid regularly throughout the year, and not adjusted based on
  subsequent tax and economic considerations.

Substantiating the level of pay can be further assisted by retaining industry compensation statistics, clipping newspaper ads showing comparable pay for comparable responsibilities, or obtaining employment agency reports about compensation levels. We often discuss this subject with employee-shareholders of S corporation clients and provide input in their attempts to establish compensation levels that can withstand IRS scrutiny.