Ref: Elliotts Inc v. Comm’r 716 F.2d1241 (9th Cir. 1983)
The Internal Revenue Code does not define the term “reasonable compensation” as it relates to S corporation shareholders working in the corporation. This has led to dozens of high-level cases both in Tax Court and federal District Court as the judiciary seeks to define the term from the bench. [Some shareholder-owners attempt to low-ball their compensation to limit FICA/Medicare taxes].
The above case is cited as it reflects the 9th Circuit’s current approach to the definition. The Court has adopted a five factor test:
- the employee’s role in the company;
- a comparison of compensation paid by similar companies (industry comparison;
- the character and condition of the company;
- potential conflicts of interest; and
- the internal consistency of compensation (i.e. comparison of the shareholder/officer compensation with other employees within the corporation)
No one factor is weighted above the other.
Small S corporations have a very real struggle with year-to-year compensation. It usual for a real estate broker, for example, to have a year with a gross of $300k followed by a year with a gross of $120k depending on when large sales closes. Certainly, the officer would do less administrative work in the smaller year by comparison.
Care should be taken to assess the relative sufficiency of the compensation on an annual basis.
