Many owners of
S companies take low salaries so the bulk of the profits are passed through to
their own returns free of Social Security and Medicare taxes. This has been a good strategy that has saved
thousands of dollars but the approach may be coming to an end. The IRS and now the courts are balking at
this practice.
In a recent
case, a CPA set up an S corporation to serve as a partner in an accounting
firm. He 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. The IRS
brought in an expert who testified that the CPA’s services were worth $91,000.
The Court held that $67,000 of the profits was properly reclassified as salary
and subject to payroll taxes (Watson, 8th Cir.).
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 thus creating income. The
approach did not convince the judge.
