By affirming yesterday that a West Des Moines CPA had to pay FICA taxes on about $91,000 of his earnings from his professional S corporation — instead of the $24,000 he put on his W-2 — the Eighth Circuit helped make the first marks in the big unmapped area of how much compensation S corporations must pay their employee owners.
Income reported on an S corporation K-1 isn’t subject to FICA and Medicare taxes. This tempts S corporation owner-employees to skip the W-2 and take out all of their earnings as S corporation distributions. The IRS naturally doesn’t like that, and they have been successful for some time in attacking S corporations paying zero salary.
The case decided yesterday made a bold challenge to the IRS position. Rather than taking a zero salary, the S corporation shareholder took a $24,000 salary, with the rest of his $200,000 or so earnings from his practice coming out as S corporation distributions. This avoided the 12.4% combined FICA tax and the 2.9% Medicare tax on the difference. The taxpayer argued the $24,000 was all the salary he intended to pay, and that the IRS had no authority in the tax law to upset this intent.
The appeals court declined to accept the taxpayer’s stated intent as decisive:
However, even if intent does control, after evaluating all the evidence, the district court specifically found “Watson’s assertion that DEWPC ‘intended’ to pay Watson a mere $24,000 in compensation for the tax years 2002 and 2003 to be less than credible.” We will not disturb this finding on appeal.
So $24,000 compensation for a CPA whose practice earns $200,000 isn’t “reasonable,” but, at least in this case, $91,000 is. What does that tell an S corporation owner trying to set his compensation?
Colorado CPA Anthony Nitti draws this conclusion:
The IRS is taking a formal, quantitative approach towards determining reasonable compensation, so to adequately advise our clients, we must be prepared to do the same thing.
The bottom line is that S corporation salaries must not be set too low in an attempt to avoid payroll taxes. The good news, however, is that