8. More guidance provided on how to determine “reasonable” compensation for an S corporation shareholder/employee. Owners of S corporations can get income out of the corporation in the form of wages and also in distributions (dividends). Wages are reported on Form W-2 and are subject to self-employment tax, but distributions are reported on Form K-1 where they are not subject to self-employment or payroll tax (note: the FICA tax wage base for 2013 is $113,700). This creates a built-in incentive for S corporation owners to minimize their salaries and take earnings out of the corporation as distributions. However, IRS requires that an S corporation owner be paid a “reasonable” salary. If the salary is too low, IRS will recharacterize a portion of the dividend distribution as salary with additional tax imposed. IRS uses various factors to determine what constitutes a reasonable salary, including the owner’s training and experience, duties and responsibilities, time and effort devoted to the business, and the dividend history of the business, among other things. In essence, reasonable compensation would be the amount necessary to hire someone to do what the owner is currently doing. For farming and ranching operations, the primary focus is on the labor costs involved, but value would also need to be placed on management services the owner provides.

In 2012, the U.S. Court of Appeals for the Eighth Circuit affirmed a Tax Court decision upholding the IRS position that a full-time CPA with 20 years of experience who worked full-time for his firm that generated between $2 and $3 million annually had too low of a salary when he took $24,000 in salary in one year with $203,651 in distributions and $24,000 in salary in the following year with distributions of $175,470. The court agreed with the IRS that a reasonable salary should be $91,044 each year, which was slightly above the FICA wage base for each year. Later in 2012, the U.S. Supreme Court declined to hear the case. So, there are limits to how low courts will allow S corporation shareholders to set their salaries. But not all income an owner receives has to be in the form of wages — just the amount that is deemed reasonable. Reasonable compensation for S corporation owners is a big audit issue with the IRS. Farm and ranch S corporations need to pay close attention to salary amounts paid to owners so as to avoid problems with the IRS. It is critical to maintain good records, keep personal and corporate spending separate, and account for all expenses. Another case in the Tax Court in late 2012 demonstrates that the IRS doesn’t even care if the S corporation is profitable — a reasonable wage must still be paid. David E. Watson, P.C. v. United States, 668 F.3d 1008 (8th Cir. 2012), aff’g., 757 F. Supp. 2d 877 (S.D. Iowa 2010), cert. den., 133 S. Ct. 364 (2012).