Our May 26, 2016 article, Reasonable Compensation Issues Remain on the IRS Radar ("Part I"), discussed how the IRS scrutinizes the reasonableness of compensation payments made to C-corporation shareholder-employees. As indicated in Part I, when a C-corporation is involved, the IRS often argues that the compensation is unreasonably high and paid to avoid the double tax on corporate profits. However, the IRS also challenges compensation payments made to S-corporation shareholder-employees. As discussed below, when an S-corporation is involved, there is a risk the IRS will take the opposite approach and argue that the compensation is unreasonably low.

Income Tax Issue

Unlike a C-corporation, an S-corporation's earnings are not typically subject to double tax because its earnings are not taxed at the corporate level. Instead, the S-corporation's earnings "pass through" to the shareholders and are taxed at the shareholder level regardless of whether the earnings are actually distributed to the shareholders (for ease of reference, the distribution of earnings will be referred to in this article as "dividends"). The shareholders generally receive the dividends tax free because the shareholders have already paid tax on the earnings. Read More