IRS continues to go after S corporations (they do hate these entities) that pay low salaries to owners. Many owners of S companies take too low a salary and pass the bulk of the profits through to their own returns free of Social Security and Medicare taxes (see prior postings on S-Corporations). The IRS and the courts took issue with this practice. In a recent case, a CPA set up an S company to serve as a partner in an accounting firm.
The CPA took a $24,000 salary from the S firm in a year when its share of the partnership’s profits was $203,000. An Appeals Court
agreed with IRS that the pay was unreasonably low, relying on an expert’s testimony that the CPA’s services were worth $91,000. The Court held that $67,000 of the profits are properly reclassified as salary and subject to payroll taxes (Watson, 8th Cir.).
Now this case has been reported by me last year when it first came to light. I am also not surprised by the Appellate Courts ruling, this guy was out of bounds the pay was too little for the amount of profit available.
Determining what is a reasonable salary is the key. In this case, the reason the CPA’s services were valued at less than half of his share of the partnership’s profits was that employees who weren’t partners also performed significant services. This easing is not available in cases where only the S firm owner is providing services. The IRS has Revenue Rulings that allow them to question and establish reasonable salaries when owners are unreasonable.