Jul 252012

The IRS is continuing to go after taxpayers who attempt to use S corporations to avoid payroll taxes.  Generally speaking, a wage-earning taxpayer is subject to a variety of payroll taxes, which can include income, Social Security, Medicare, and unemployment taxes.   Sometimes, business owners reach the conclusion that they can pay themselves very little in terms of salary and then call the rest of the company’s earnings a distribution, in order to escape payroll taxes.

The problem with this strategy is that the IRS will aggressively pursue taxpayers whom they feel are paying themselves an “unreasonably” low salary in an effort to avoid these taxes.  In a recent case, Watson v. U.S., the taxpayer, an accountant, attempted to pay himself a salary of $24,000 and claim that the remainder of his share of the company profits, $203,000, was a payroll-tax-free distribution.  The court ruled in favor of the IRS, finding that the compensation was unreasonably low, and held that an additional $67,000 of the profits were properly reclassified as salary, subject to payroll taxes.  The court relied on an expert’s testimony which determined that the accountant’s services were actually worth $91,000.

Unfortunately, there is no clear cut rule which determines what qualifies as a “reasonable” salary for payroll tax purposes.  Practitioners sometimes reference the “60/40 Rule” for allocating salaries and distributions.  Essentially, this concept holds that 60% of the S corporation’s distribution should be allocated to salary and the remaining 40% may be called a dividend.  The problem with this “Rule” is that it is not based on any actual legal precedent and is not officially recognized by the IRS as a safe harbor.  This is not to say that the 60/40 rule is not a viable solution, but merely that each individual set of facts and circumstances will ultimately lead to their own outcome and therefore each compensation arrangement should be evaluated individually.

Taxpayers who own and control their own businesses should speak with a tax professional about what constitutes a “reasonable” salary for their circumstances.  As with most things tax-related, the cost of a consultation at the outset will usually far outweigh the monetary consequences of dealing with the IRS after the fact.

If you own or are thinking about starting a Florida business and have questions regarding the tax consequences of your compensation arrangement, contact a Florida tax attorney who can help you help you understand what is proper for your circumstances.