Reasonable Compensation

Ask Certified Tax Coach -Reasonable Compensation Rules

Reasonable Compensation
Reasonable Compensation

Question:

“Please elaborate on the reasonable compensation matter. How is it possible to have a one person business and split earnings between reasonable compensation and distributions. How does this help with the Medicare surcharge in 2013?”

Answer:

Certified Tax Coach, Dominique Molina, CPA CTC

While we all have differing preferences on the proper allocation of wages and distributions in an S corp- it is helpful to gain an understanding of how the tax courts are ruling in these cases.

In a recent court case (David E. Watson, P.C., 668 F.3d 1008 (8th Cir. 2012), an Iowa federal district court revealed its logic in applying the reasonable compensation test and it fares well for tax planners(and their clients). In this case, the court looks not to the total income generated . . . by the taxpayer’s own services in calculating his employment income, but rather what a third party expert said the value of his services were worth.

Again, the argument is won not based on the fair market value of the taxpayer’s own services, but those of an average, similarly situated taxpayer, whose services might be worth less than that of a given taxpayer’s.

Anyone surprised by the Watson decision? CPA takes $24k of salary, and 200k of distributions. Hmmm what is the reasonable compensation for a CPA these days?? I made more than that my first year out of college!

Some important issues came out of this case for us. Of note:

The 8th circuit explained that the issue was NOT whether some minimum compensation must be paid, but whether the compensation paid was REASONABLE.

Also of note, the court only reclassified an additional 67k to salary, leaving $133,000 sheltered from FICA.

I see this as a real win for us who use this strategy properly and within the bounds of the law.

Many high profile taxpayers have successfully used this strategy to minimize Medicare tax. When Newt Gingrich released his tax returns during his bid as the Republican Nominee, wise tax planners took note of his use of the S corp strategy. Gingrich treated just $444,000 as compensation and a whopping $2.4 million dollars as profits!
In another example – Senator John Edwards reported salary of $360,000 and distributions of $5million through his S corp law practice. Over a 4 year period, his distributions totaled $27 million.

The tax planning that Gingrich and Edwards implemented using S corporations is not illegal and is not even an abusive tax shelter although it can be misused when not applied properly.

In my humble opinion, so long as we are diligent in advising the client to establish a reasonable salary and are careful in documenting their basis for establishing a reasonable salary, we are complying with the laws and using a solid strategy for creating savings.

Beginning in 2013, the Medicare tax on wages and self-employment income increases to 3.8% on wages in excess of $250,000 for a joint return and $200,000 for singles. (Sec. 3101(b)(2) and Sec. 1401(b)(2). Distributions from an S corporation are excluded from the definition of “Net Investment Income” and the Medicare tax does not apply. Until questions about any changes to this definition are answered by new regulations, Sec 469 would indicate distributions from an S corp where the taxpayer is actively involved would not be subject to the Medicare surcharge.

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**The answers provided to submitted questions are intended to serve solely as discussion on various tax topics, with the understanding that the publisher and the expert/author are not engaged in rendering legal, accounting, or other professional service and that they are not offering such advice in their responses. They do not constitute legal advice nor are they a substitute for legal counsel. All questions may not be answered.

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