We have posted a number of articles addressing the income and employment tax issue of “reasonable compensation.” However, the focus of many of these posts has been excessive compensation paid by regular corporations. The position of the Internal Revenue Services in these cases has been that the “excess” compensation was really a disguised dividend, which is not deductible for income tax purposes to the payer corporation, in contrast with compensation, which provides up to a 40% income tax savings to the payer.
Another area of Internal Revenue Service challenge rests with “under compensation” intended to save certain payroll taxes for owners of pass through businesses organized as S corporations. In these instances, owners of S corporations forgo wages and salaries and, instead, take S corporation distributions. In Pennsylvania, such a strategy can save all social security and Medicare taxes (both to the employee/owner and to the employer/S corporation), local wage taxes and S corporation-level employment taxes.
Adopting such a strategy, however, requires great care and an assessment and determination of “reasonable wages” for the personal services provided by the employee/owner. A recent case illustrates some of the complications that can result for lack of careful consideration.
During a routine employment tax audit of an S corporation, the Internal Revenue Service determined that wages paid to the taxpayer’s corporate officer were unreasonably low, and recharacterized portions of the S corporation’s distributions as wages. As such, additional employment tax liabilities would be assessed on those wages.
For employment taxes to apply, an employer-employee relationship must exist. In contrast, a worker classification issue arises when a service recipient (employer) has classified an individual performing service as an independent contractor (or some other non-employee designation) and has not withheld employment taxes from compensation paid to the individual. In these cases, the Tax Court has jurisdiction to review certain employment tax determinations made by the Service and to determine the proper amount of employment tax owed.
In this case, which is addressed in Chief Counsel Advice (CCA) 201735021, the issue raised is whether the audit involved an issue of worker classification. The S corporation being audited had used a professional employer organization (PEO) for its payroll for a number of years. Under the agreement with the PEO, all individuals working for the taxpayer, including the officers of the corporation, were treated as employees of the PEO and received paychecks from that organization.
Corporate officers are considered to be statutory employees under the Internal Revenue Code. In addition, the particular taxpayer treated its officer as an employee by paying wages through a PEO and by withholding employment taxes. Because of the agreement with the PEO, and the manner in which the officer was paid, the CCA concluded that the audit did not involve a worker classification issue.
The Internal Revenue Service then identified the problem as a reasonable compensation issue. The CCA further concluded that the Tax Court lacks jurisdiction to review amounts recharacterized as unreasonable compensation because the Internal Revenue Service did not make the determination on the basis of a worker classification issue as required by the Code.
Planning for unreasonable compensation challenges is a formidable undertaking and one that taxpayers should take seriously. To discuss an issue of unreasonable, excessive or under compensation, please contact Bob Grossman or Don Johnston at 412-338-9300.