Reasonable Compensation

Reasonable Compensation
Jason Dinesen, Enrolled Agent, LPA

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AN INTRODUCTION TO REASONABLE
COMPENSATION

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• Introduction:
• This course presumes you have some advance knowledge about S-
corps and why businesses convert to an S-Corp
• S-corporation audit rates are low — around 0.2%
• Reasonable compensation is an audit hotspot though
• We look at several court cases today

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• Officers who perform services for their S-corp are considered employees of
the S-corp. See Section 3121 and related regulations.
• Regulations under Section 3121 says the form of payment does not matter;
i.e. the IRS could recharacterize a property distribution shown, as a
distribution on the books and K-1, as wages instead.
• The salary needs to be “reasonable” but there’s no specific definition of the

term reasonable.
• While not formal guidance, this page on the IRS website contains good
information: https://www.irs.gov/businesses/small-businesses-self-
employed/s-corporation-compensation-and-medical-insurance-issues

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Reasonable Compensation Myths

On the next two slides are myths when it comes to reasonable
compensation — through tax pros often use these as “advice.”

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Myth 1
• “The magic number is 60% of profits as salary and 40% as
distribution (or some say 50/50).”
• This is not based in any reality as there is no IRS guidance or court
guidance that has EVER said this.
• Compensation must be “reasonable” for the work being done,
regardless of what percentage of profit is being paid.

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Myth 2
• Set salary equal to the Social Security wage base for the year. This is
another myth.
• The only piece of this that could be beneficial is, if the IRS says salary
should be higher, there wouldn’t be a 12.4% Social Security tax hit
because SS tax is maxed out by setting the wages at the wage base
for the year.
• This part is true, but the “advice” that gets used about this being a “safe” or
“blessed” method is not true.

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• So if compensation needs to be “reasonable,” what does the IRS
look at? One thing they look at is the source of the S-
corporation’s income:
• Services of shareholder.
• Services of non-shareholder employees.
• Capital and equipment.
• The more of the income comes from services of the shareholder,
the more likely the IRS is to say that the shareholder should be
taking a higher amount of profit as a salary.

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• The IRS lists these as factors in determining reasonable compensation:
• 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 agreements
• The use of a formula to determine compensation

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Is a Salary Required
• What if a business can’t afford to pay a salary?
• https://rcreports.com/resources/reasonable-compensation-
blog/what-if-an-s-corp-owner-can-t-afford-to-pay-reasonable-
compensation/
• https://rcreports.com/resources/reasonable-compensation-
blog/surviving-an-irs-reasonable-compensation-challenge/

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Is a Salary Required?
• What if a business can’t afford to pay a salary?
• The requirement to pay a salary for services is NOT tied to whether
the business shows a profit or not, it is tied to reasonable
compensation for services
• However – if there were no distributions paid out, then a shareholder
could probably choose to not take a salary
• Issues with reasonable compensation arise when a shareholder takes
distributions before they have received a reasonable salary
• This would seem to apply to profitable businesses too, if the shareholder
legitimately takes no money at all out of the business

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Odds and Ends
• Issuing a 1099-NEC to a shareholder — can you do it?
• This is not condoned by the IRS but some practitioners, and RC Reports (which many firms use for
determining reasonable compensation), say this may be an option if payroll/941/W-2 deadlines have passed
by the time the client comes to you – do as a one-time fix and then get payroll set up.
• If the deadline for the 941/W-2 hasn’t passed, you might be able to pay a salary in one lump sum, though the
IRS frowns on this, especially if it’s a hypothetical amount rather than an actual amount paid at the end of the
year (i.e. withdrawals were likely coming out along the way during the year, and the IRS could say the
withdrawals should have been salary).
• Note that this slide is not “advice” on what to do – practitioners need to think about these things and what
is best in each situation.
• Consider what Section 3121 says about officers providing services to a corporation

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Our Risk as Preparers
• Preparing a return with $0 (or too low) comp: what is our risk as
preparers? The IRS has assessed Section 6694 penalties against
preparers in this situation. Horror story here:
https://rcreports.com/resources/reasonable-compensation-blog/tax-
man-cometh/
• In that blog post, RC Reports tells of a practitioner was hit with $130,000 in
Section 6694 preparer penalties for preparing S-corp returns with too-low (or
$0) salary
• $5,000 penalty x 13 clients x 2 years examined by the IRS -- even though the practitioner
didn’t advise the client on reasonable compensation, didn’t do bookkeeping for the
client, didn’t do payroll, and was just preparing the 1120S.

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COURT CASE 1

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Sean McAlary LTD vs Commissioner
• McAlary was a real estate broker who owned an S-corp
• He supervised other sales agents
• Often worked 12-hour days most days of the week
• Most of his company’s gross receipts were from sales he generated,
rather than from the sales of other agents

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• In 2006, McAlary’s S-corp showed net income of around $231,000; he
transferred $240,000 to himself (i.e. a distribution) but paid himself
$0 salary.
• The IRS expert witness in the case used a study of the typical wage of
real estate brokers in the state of California (where McAlary operated)
and set his salary at $100,755.

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• McAlary tried to argue that he had an agreement with his S-corp to
pay him a base salary of $24,000 per year. This in fact was true, he
did have such an agreement in writing.
• The Court said the agreement doesn’t matter, as it clearly wasn’t an
arms-length transaction considering it was a corporation he
controlled.
• In addition, he brought in most of the revenue, and did most of the
work himself.
• The Court also noted that the S-corp didn’t pay McAlary ANYTHING,
let alone $24,000.

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• The Court ended up moving the expert’s suggested wage down to
$83,200.
• End result: $83,200 of wages, and around $160,000 as distributions.
• NOTE HOW THE “ADVICE” OF TAX PROS OF A 60/40 SPLIT DOESN’T

HOLD HERE. The IRS and the Court both came up with salaries that
were far less than 50% of the net profit. ($83,200/$231,000 = 36%)
Remember, salary needs to be “reasonable.”
• The IRS and the Court relied on summaries of typical wages paid to
brokers doing similar work.
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COURT CASE 2

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Watson v. United States

• David Watson is a CPA in Iowa
• Worked for a firm grossing over $2 million a year; Watson worked 35-45 hours
a week. The court case noted that he was/is an “exceedingly qualified”
accountant who developed a specialty in partnership taxation.
• He paid himself a salary of $24,000 a year
• He took distributions of over $175,000 each year ($203,651 one year;
$175,470 the next year).
• Adding the salary and the distributions together shows us the net income of
his S-corp was between $200,000 and $230,000 a year.
• (For reference and to account for inflation: the years in question in this case
were 2002 and 2003.)

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• The IRS set his salary at $91,044 a year
• In 2012, the 8th Circuit upheld a prior District Court ruling from 2010,
in favor of the IRS

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• What can we learn from the Watson case?
• His salary was set at $91,000, meaning the adjusted
distribution amounts would be between approximately
$111,000 and $136,000.
• So even in a service business, salary does not need to be 100%
of the profit. Note also that the salary is less than 50% of the
profits! So again the 60/40 ”advice” doesn’t apply.
• There is no magic formula - you must look at what is
“reasonable.”

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• The IRS employed an expert witness — the same one as in the prior
case of the real estate broker— to determine reasonable comp.
• The expert determined, based on studies (including AICPA data) that

a non-owner employee in a similar role would make $70,000 a year
(remember this was 2002 and 2003).
• The expert determined that partners typically bill at a rate 33%

higher than an employee billing rate. This put compensation at
around $93,000, and then the expert reduced it to $91,044 account
for non-taxable fringe benefits.
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• The moral of Watson is: once again, the “advice” of a 60/40 split or
some other “formula” is not how it works. The law requires
“reasonable” compensation.
• In the Watson case, using the “60/40 rule” tax pros throw out so
often, Watson’s salary would have been around $125,000 or so (using
round numbers). In this case, salary was actually set at less than 50%
of the net income.

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COURT CASE 3

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Blossom Day Care

• Blossom Day Care Centers, Inc. vs. Commissioner, T.C. Memo 2021-86
• From July 13th, 2021
• This is a combination reasonable compensation/dangers-of-
management-companies case

Blossom Daycare
• Taxpayers were a husband and wife who ran a daycare organized as an S-
corp
• They formed a “management corporation,” also organized as an S-corp
• The daycare corporation deducted a management fee, which was then

picked up as income on the management company return, and the
taxpayers paid themselves a salary out of the management company
• The daycare paid other employees (upwards of 90 employees) through

the daycare, but they didn’t pay anything to themselves out of the
daycare corporation
Blossom Daycare
• The IRS said the taxpayers were providing services through the daycare
and needed to draw a salary from the daycare.
• The taxpayers argued that the services they provide — 50 to 60 hours a

week working in the daycare — were services provided through the
management company. They also argued that wages paid from the
management company should be counted in any discussion of wages that
might need paid through the daycare.
• The Tax Court sided with the IRS; even if there was a valid management
agreement between the two entities (there was not — more on that
shortly) the Court said the taxpayers worked in the daycare corporation
and needed to draw a salary from the daycare.

Reasonable Comp Case
• End result:
• Nearly $350,000 of payroll taxes owed
• Over $75,000 of penalties owed

Other Problems
• I noticed a number of problems the taxpayers had in this case:
• The taxpayers provide no evidence of a real “management agreement” between the
daycare and the management company.
• The taxpayers bought vehicles, in their name personally, but depreciated in the
corporation.
• The corporation “maintained vehicles” for the taxpayer’s children, parents and a
sibling.
• The corporation provided credit cards to the taxpayers and their children.
• These things mean the taxpayers were taking money out of the company personally
(i.e. distributions). They “might” have had a leg to stand on if they hadn’t taken any
money out of the daycare company.

Things I See in Day-to-Day Practice
• Specific to S-corps:
• Vehicles being depreciated in the S-corp even though the vehicle was not bought in the S-corp name
• Vehicles supposedly used 100% for business purposes; and the personal-use portion not being counted as W-2
income
• The whole “management company” issue — more on that in the next case study
• Sole proprietors forming S-corps without thinking about the whole picture — in the age of the QBI deduction it
might be better to stay a sole proprietor — more on this later too

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COURT CASE 4

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Fleischer v. Commissioner
• This case ties together 3 things we as practitioners will see in the wild
all the time
• Compensation way too low
• Income paid in the name of the individual personally but run through
an S-corp
• Trying to argue that the S-corp is a “management company”

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• Fleischer case:
• Ryan Fleischer was an investment advisor affiliated with LPL Financial
• By law, the commissions he earned were paid in his name personally
• Fleischer formed an S-corp, and nomineed the income to the S-corp using a
Schedule C
• He reported the income from the 1099s on the Schedule C, and then
under “other expenses” nomineed the same amount to his S-corp
• This is a VERY common practice among investment advisors and insurance
agents, where commissions are paid in the advisor’s name personally

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• Let’s pick this case apart, because it should be eye-opening to
investment advisors … and to tax pros who work with them
• This is a reasonable-compensation course but this case has so many
moving parts that we need to talk about all of them, and all of them
tie into the reasonable-compensation discussion

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• In 2010, Fleischer reported $34,856 of W-2 wages from his S-corp,
and $147,642 of income from the S-corp. Put those two together and
his S-corps net income was $182,498.
• In 2011, W-2 wages were $34,996, and the net income was $115,327,
so S-corp net income was $150,323.
• The gross income off his 1099s (again paid in HIS name personally)
was $289,201 in 2010, and $266,292 in 2011.

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• Assignment of income.
• Essentially the court said Fleischer earned the income in HIS name. It
was HIS income, not the S-corp’s.
• With employees of a service business, the Court used the test of

“who controls the earning of the income.”
• Fleischer’s contracts with LPL referenced him personally, and not his
S-corp (because the contracts COULDN’T reference his S-corp);
therefore the Court said HE controlled the earning of the money, and
so it was HIS income to report (via Schedule C).
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• Fleischer tried to argue using the case of Sargent v. Commissioner
from 1991.
• In Sargent, two hockey players each formed personal service
corporations and entered into an agreement to play with the old
Minnesota North Stars of the NHL.
• The IRS audited them, and a court sided with the players.
• The key here was the contracts with the team were always in the
names of the CORPORATIONS, not the names of the individual
players.

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• Fleischer also tried to argue a 1970 Revenue Ruling in which the IRS
said it will generally acknowledge professional service organizations
formed under state law as being recognized as a separate taxable
entity.
• The Court pointed out that the issue here is who earned the income,
not the existence of a corporation. Because the income had to be
paid to Fleischer, as per securities law, HE earned the income, not the
corporation.

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Takeaways
• Some people say Fleischer’s mistake was in not paying himself a
reasonable salary, and that’s why he got audited.
• I have had investment advisors (and a few tax pros) say: “well, if he’d
have just paid a higher salary to himself the IRS never would have
questioned him.”
• This may be true but the takeaway from Fleischer is more than just
reasonable compensation.

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Takeaways
• The real moral/scary thing for investment advisors (and us as tax pros): the S-corp wasn’t doing
anything to earn the money that Fleischer was “nomineeing” to it
• What if Fleischer had entered into a management agreement with the S-corp (preferably in
writing)? I am not sure this would hold water. If Fleischer is the one meeting clients and doing the
work, what is the S-corp really “managing?”
• If he had employees, he could possibly set up an S-corp to pay the employees through it, and
legitimately deduct a management fee on his Schedule C. Maybe he could mark up the
management fee paid out on the Schedule C by some factor to show a bit of profit in the S-corp
that he takes as a distribution? MAYBE. BUT I DON’T LIKE IT.
• Why not just pay employees through the Schedule C and deduct the wages? (A separate entity
might help with liability issues; from a tax perspective there’s really no advantage.)
• In other words it’s hard to say a “management company” is doing any “managing” in Fleischer’s
case.

Reasonable Compensation

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Reasonable Compensation

Jason Dinesen, Enrolled Agent, LPA

Jason Dinesen, Enrolled Agent, LPA

Jason Dinesen, Enrolled Agent, LPA

• The salary needs to be “reasonable” but there’s no specific definition of the

Jason Dinesen, Enrolled Agent, LPA