If you own a company filing an S Corporation tax return, you should be reporting reasonable compensation. Think of "reasonable compensation" as being what you would have to pay somebody else to do the same job you are doing. Many company owners want to pay themselves less, to reduce their payroll tax bill. However, the IRS has successfully argued that business owners should pay themselves more, and assessed tax to business owners many, many times. The following article discusses one of the times the IRS has gone to court over this issue.
The IRS usually wins when it challenges an S Corp.’s Reasonable Compensation in court. Over the years there have been in the neighborhood of 25 to 30 such cases. The IRS has come out on top in all except one: The Davis Case. What made Davis different? What valuable takeaways are there for you?
The case focused on two concepts that every S Corp. and business advisor should understand:
DAVIS v. UNITED STATES (1994)
Background: Mile High Calcium was owned by Carol L. Davis and her husband Henry Adams. This case revolved around transfers in and out of Mile High Calcium from 1987 to 1989. The IRS re-characterized all transfers for the timeframe in question to Reasonable Compensation, resulting in assessed taxes, interest and penalties of $39,220. Carol L. Davis successfully sued the IRS for a partial refund based on the following two-pronged defense focusing on each of the two owners:
Henry Adams: Henry was officially listed as the President of Mile High Calcium. It has been the author’s experience, and we see it demonstrated here in the Davis case, that the IRS will, by default, assume anyone listed as an officer of an S Corp. to be performing services, and therefore an employee who should be paid Reasonable Compensation.
The IRS’s problem here was that Henry didn’t actually provide any services (had NO active participation in the business), and Carol had the documents to prove it:
Therefore, Henry was what is referred to as an “Officer in name only” and there is an exception for officers who perform only minor services in the treasury regulations: Treas. Reg. § 31.3121(d)-(1)(b)
Carol won this portion and half of the recharacterization was wiped off the books. Carol then defended herself.
Carol L Davis: Carol was in fact an employee of Mile High Calcium. However, the IRS’s problem was that her services had minimal value, and she could prove it:
When a new calculation was performed based on the time Carol actually dedicated to the business and the value of that time, the original assessment of $39,222 was reduced to $647.
The Davis case is frequently pointed to as the one the IRS lost. However, I would argue that the IRS did not lose this case as much as they did not win it. Why? Because the IRS was still successful in forcing the taxpayer to pay Reasonable Compensation for the services actually provided to their company. Carol’s ability to prove the services were minimal won out over the IRS’s simplistic assumption that recharacterized all distributions as Reasonable Compensation. The IRS ‘all or nothing’ strategy, which was employed through 2005, failed when countered with real evidence. For more about what changed in 2005 please see: Three Court Cases that Define the Modern Era of Reasonable Compensation
By Paul S. Hamann & Jack Salewski, CPA, CGMA
Reprinted with permission from RC Reports
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