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Issue: 74 - Feb 16, 2015
How Much Compensation is Enough?
By: Rachel A. Forthofer, CPA
Marsha L. Heinke, CPA, Inc

Setting compensation for equity participants in closely-held veterinary practices oftenentails tax planning considerations. Many veterinary practices are legally structured asS-Corporations, which provide a unique issue for shareholders: how much compensation is enough?

S-Corporations function as pass-through entities, passing through taxable profit to theirshareholders. As such, an S corporation is generally not subject to federal income taxes at the entity-level. In lieu of an entity-level tax, shareholders report taxable income on their personal income tax returns.

This conduit provides a unique advantage to shareholders of S-Corporations. Income passed through from an S-Corporation to a federal individual income tax return is not subject to self-employment taxes.

To understand this hot-button issue and why the IRS often targets shareholdercompensation in a closely-held S-Corporation, we first need to understand employment
taxes.

A salaried or hourly-waged employee pays Social Security and Medicare tax via paycheck withholdings, and these payments are “matched” by employers. For 2015,
employees pay 6.2% of wages in Social Security tax up to $118,500 of annual compensation. The employer pays a matching 6.2% of wages.

Medicare tax is also split but with no limitation. Both the employee and employer pay 1.45% of the full amount of applicable wages.

In an attempt to avoid some of these payroll taxes, S-Corporation shareholder employees may be tempted to forego reasonable compensation in favor of distributions, sometimes loosely called “draws” or “dividends”. Since compensation paid through wages are subject to payroll taxes and distributions are not, you can easily understand why. As an example, $30,000 of payments to a shareholder as distributions instead of as wages, could duck as much as $4,590 in combined employer and employee Social Security and Medicare taxes.

However, this can cause big problems. The courts have ruled time and again that this method will not pass muster. “Reasonable” compensation must be paid to shareholderemployees for services they provide to the S Corporation.

In Veterinary Surgical Consultants, P.C. vs. Commission, 117 T.C. 141 (2001), the TaxCourt ruled that Kenneth K. Sadanaga, DVM was an employee of the S-Corporation for federal employment tax purposes. Dr. Sadanaga was the sole shareholder and president of VSC, and spent a minimum of 33 hours per week providing consulting and surgical services.

VSC did not make salary payments to Dr. Sadanaga and did not issue a Form W-2. Instead, Dr. Sadanaga withdrew money at his discretion from VSC’s bank account, and contended that none of the withdrawals were payment for services rendered. All payments were reported as non-taxable distributions. The Tax Court ruled that the
payments to Dr. Sadanaga were payments for his services rendered, and reclassified his distributions as wages for the three years of 1994, 1995, and 1996.

In the VSC case, the shareholder reported no wages from his S-Corporation. In other court cases, S-Corporation shareholders received both a salary and distributions, and the IRS questioned whether the compensation reported through wages was enough.

In David E. Watson, PC vs. U.S. (8th Cir. 2012), shareholder-employee David Watson was a sole-shareholder of a Certified Public Accounting firm. In 2002 and 2003, he paid himself a salary of $24K and took more than $375K in distributions. The IRS challenged his salary as too low, and the courts agreed. The IRS determined a reasonable compensation amount for Mr. Watson by looking at a variety of factors, including profitability in comparison to similar firms, years of experience, hours worked per week, and so forth.

In a similar case, JD & Associates, Ltd. v. United States, Jeffrey Dahl, sole-shareholder of an accounting firm, reported only $19K of salary in 1997, $30K of salary in 1998, and $30K of salary in 1999, even though he was a Certified Public Accountant with more than 20 years of experience and a lengthy list of responsibilities at his successful firm. In the same years, Mr. Dahl took $47K of distributions in 1997, and $50K of distributions in
each of 1998 and 1999.

The IRS contended that Mr. Dahl’s compensation was unreasonably low and made a determination of what it deemed to be fair compensation. The District court agreed
with the IRS’s conclusion, and re-characterized more than $111K of distributions as wages over the three-year period.

Guidance Based in Facts and Circumstances

Following this last District court decision, the IRS issued a Fact Sheet to assist SCorporations in establishing reasonable compensation. IRS Fact Sheet 2008-25
summarizes a list of nine factors used by the courts in determining reasonable compensation, as follows:

  • 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

The nature of the S-Corporation’s business is also a consideration when determining reasonable compensation. A professional services corporation, such as a veterinary practice, relies heavily on the personal efforts of employees. Accordingly, a significant amount of practice profits should be paid as compensation.

As a starting point to establishing reasonable compensation, the IRS indicates that a practice should analyze the source of gross receipts, and lists three major sources of receipts in an S-Corporation:

  1. Services of shareholder
  2. Services of non-shareholder employees
  3. Use of invested capital and equipment

The IRS further stipulates that, “If the gross receipts and profits come from items 2 and 3… it is reasonable that the shareholder would receive distributions along with
compensations… if most of the gross receipts and profits are associated with the shareholder’s personal services, then most of the profit distribution should be allocated as compensation”. The IRS reminds shareholder-employees that administrative and management-related duties must also be reasonably compensated.

While the temptation exists for veterinary practice owners of S-Corporations to minimize salary in favor of distributions, the IRS is privy to these attempts. The Veterinary Audit Technique Guide specifically points IRS auditors to the Veterinary Surgical Consultants, P.C. v. Commissioner case, and refers IRS agents to the Journal of the American Veterinary Medical Association as a starting point to evaluating compensation in the veterinary industry.

When planning the annual practice budget, evaluation of reasonable compensation to shareholder-employees must be considered. Annual corporate meeting minutes are a useful tool to document conclusions and reasoning behind the compensation of officers and shareholders. A sound business rationale to support shareholder-employee compensation can be one of the best defenses when under IRS scrutiny.