In case you missed it, the IRS has recently updated the CP 261 Notice that is sent to all new S Corporations when their S election has been accepted. In the “Keep in Mind” section, the IRS added the following:
“Payments to shareholder-employees for services rendered:
- You must determine a reasonable salary when a shareholder-employee of an S corporation provides services to the corporation.
- Payments to a shareholder-employee for services provided to an S corporation are wages and are subject to employment taxes.
- We may re-characterize distributions paid to a shareholder as salary if the distribution was paid in lieu of reasonable compensation (Revenue Ruling 74-44).”
This new language indicates a potential IRS intent to monitor and enforce reasonable compensation standards. By means of this change to the CP 261 Notice, the IRS may be foreshadowing a prospective point of emphasis as to tax compliance.
The taxation difference between an S Corporation shareholder and a partner in a partnership is oftentimes a large consideration in the choice of entity decision or choice of taxation method for limited liability companies.
Per the IRS Job Aid on Reasonable Compensation (found at https://www.irs.gov/pub/irs-lbi/Reasonable%20Compensation%20Job%20Aid%20for%20IRS%20Valuation%20Professionals.pdf), taxpayers have the burden of proof that compensation is reasonable. Independent market data, if available, is the best evidence. In the absence of independent market data, the IRS Aid provides that taxpayers should consider the following factors in determining reasonable compensation:
- Employee’s role in the company.
- External comparison of the employee’s salary with those paid by similar employers for similar services.
- Character and condition of the employer.
- Conflict of interest in relationship of the employee to the employer.
- Internal consistency in the employer’s treatment of payments to employees.