Recently, in Watson, P.C. v. Unites States, 668 F.3d 1008 (8th Cir. 2012), the Court of Appeals held that the Internal Revenue Service (IRS) properly re-characterized S-Corporation distributions as wages and were therefore subject to employment taxes. Watson should serve as a reminder to taxpayers that the IRS still is willing to go to court over the issue of reasonable compensation.

In Watson, the court held an S-Corporation accounting firm was liable for additional taxes, interest, and penalties when it classified $24,000 as wages and $203,651 as distributions for one year of income payments it made to its owner/shareholder. The Court provided guidance in determining $24,000 was not “reasonable compensation.”

The Court explained that the intent of the individual taxpayer and the business is only one of many considerations in the analysis of whether compensation is reasonable. Other relevant considerations include, but are not limited to the following:

(1) The individual taxpayer’s qualifications;

(2) The nature, extent, and scope of the individual taxpayer’s work (the more involved, higher wages);

(3) The size and complexities of the business;

(4) A comparison between wages and the gross and net income of the business (wages should be higher if income of the business is higher);

(5) The prevailing general economic conditions;

(6) A comparison of wages with distributions to other stockholders;

(7) The prevailing rates of compensation for comparable positions in comparable businesses (wages should be close to those of the person with a similar position in a similar business);

(8) The wage policy of the business for all employees (wages should be similar to those of other employees in the business and not lower than a subordinate employee’s wages); and

(9) In the case of small businesses, with a limited number of officers, the amount of compensation paid to the individual taxpayer in previous years (current wages compared to historical wages should show reasonable trend).

Another way to evaluate the reasonableness of S-Corporation compensation strategies is to employ the multi-factor approach described in case law related to excessive compensation in the C corporation context. Since we are in California, we can most easily look to Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9th Cir. 1983).

In Elliotts, the Ninth Circuit identified five factors to consider in determining whether compensation is reasonable. These factors are as follows:

(1) The employee’s role in the company;

(2) External comparison to other businesses;

(3) The character and condition of the business;

(4) Whether there is a conflict of interest regarding the negotiation of compensation; and

(5) Whether there is internal consistency in the company’s treatment of payments to employees.

The courts have historically looked to different multi-factor tests in determining whether compensation to a shareholder/owner is considered reasonable. Although these factors and tests may not be all encompassing, they can still provide S-Corporation owners with valuable guidance on how to properly structure their compensation.