S-Corp Dividends vs. Compensation
January 15, 2010 10:50 AM   Subscribe

What is "reasonable compensation" to determine the equitable split between compensation and dividends for the 100% owner/officer of a profitable S-corp advisory firm?

The firm is an investment banking advisory firm in a major U.S. city with one principal who owns 100% of the firm and a very small number of junior and support staff.

The firm had an awesome year and the owner took out between $2 million and $3 million, the majority of which was derived from a single contingency transaction advisory fee that involved on the principal's part a relatively small amount of work in terms of number of hours (mainly, just some high-level meetings). Overall in the business, during the year the owner only devoted about 25-30 hours per week, which was further reduced by regular travel for a separate business and a 2-month long sickness where no work was performed for the s-corp.

The only other "professional" in the s-corp, a W-2 employee, took out about $400K, though worked full time, completing most of the work product for the entire firm.

We're trying to determine the equitable split between the principal's compensation as an officer and a dividend as the s-corp owner (obviously saving taxes through the use of dividends). Would it be too aggressive to only claim a couple hundred thousand as compensation due to a limited work schedule?

You are not my tax advisor.
posted by anonymous to Work & Money (3 answers total) 2 users marked this as a favorite
We're not your tax advisor, but that's what you totally need. Do not trust any advice strangers on the internet might give you in this sort of situation. You need a professional, big-time. You possibly need a second professional to give a second opinion on what the first professional says. You need somebody with liability insurance who you can sue if they tell you to do the wrong thing, preferably, because this is very likely to involve very large sums of money, and interest and penalties on very large sums of money are even larger and uglier sums of money when owed to the IRS.

I mean, there's a pretty good chance you will get to be way more aggressive here than the worst case scenario of most of it having to be compensation, but you need to get your reasonable number from someone who's handled clients exactly like you, preferably lots of them, and who has the resources to back up your claim and defend it to the IRS. But as much as that? You need someone who also has the expertise to keep your tax burden as low as possible and do better tax planning for future years. (This is an issue that should have been dealt with as soon as the S-corp was put together.)

I'm sorry if this comes off a little harsh, but I got antsy just at the notion of someone asking this online well before the word "million" came into it, and that practically gave me a heart attack.
posted by larkspur at 12:03 PM on January 15, 2010 [2 favorites]

CPAs will give you a wide range of answers to this question because there is no definitive answer. It depends on your willingness to be aggressive in your interpretation of tax law.

The IRS only says "Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation." Reasonable is open to interpretation but they also say "Some factors considered by the courts in determining reasonable compensation:

Training and experience
Duties and responsibilities
Time and effort devoted to the business
Dividend history
Payments to non-shareholder employees
Timing and manner of paying bonuses to key people
What comparable businesses pay for similar services
Compensation agreements
The use of a formula to determine compensation

For someone taking out millions in distributions, the first step would be to make sure that the compensation was at least the maximum for the social security tax, that is $106,800. Then at least the IRS cannot claim that you are evading the social security tax (and you also accrue maximum SS benefits).

However, there is no ceiling on the medicare tax of 2.9%. So by taking a $2 million distribution you are saving $58,000 in medicare taxes. You would have to judge for yourself how to apply the points from above. Ordinarily I would guess that a $200,000 wage would be reasonable. However the one possible red flag would be the employee taking $400,000 might make this seem too small. Only the other hand you have the limited hours. But bumping the compensation up to $400,000 only adds another $5800 in tax. With a $58,000 tax saving at stake I would definitely seek the opinion of a CPA experienced in corporate taxes.

You could take an aggressive stance with the understanding that there might be a possibility of an audit with back taxes and penalties. This wouldn't be the end of the world and such disagreements with the IRS are routine. I very much doubt it would result in a tax evasion charge.
posted by JackFlash at 12:10 PM on January 15, 2010

If the owner worked about ⅔ time for about 9/12 of the year, then it seems reasonable to me (and I've been taking dividends and paying taxes as a partner in a profitable S-corp for 16 years) to pay him ½ what the other similarly qualified employee made working full-time.
posted by nicwolff at 1:28 PM on January 15, 2010

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