S corporation reasonable salary

SMLLC is a consulting company with three or four employees and it nets $500K. Prior to forming the SMLLC, the owner/member worked as a non-owner employee for another company, doing the same type of consulting, and was paid a salary of $300K. The investment into the SMLLC was almost nothing and all profits are withdrawn from the SMLLC.

If a check-the-box election is made to be taxed as an S corporation, the question is how much is reasonable compensation and how can be distributed to the sole shareholder. I worry that in determining reasonable compensation, the $300 W-2 from work for a previous employer sets a benchmark and could cause at least $300K of the $500K earnings of the S corporation be deemed as reasonable compensation.

Is this a realistic concern?

Of course it is. Does that mean it can't be overcome? I don't think so....it will just take some work and documentation. Regardless of what he WAS paid, what's reasonable? Hit payscale.com or salary.com for that data. Have his responsibilities changed now that's he's an owner and manager? i.e. he's not as productive as a money machine now? Have his actual consulting hours decreased? I'd likely explore the case law for other variables....And in the end, IF you think you've got it and end up getting challenged and lose, what's at risk? At worst, they'd take his salary up to SS ceiling....and probably not for all years unless you got picked early. So he'd be money ahead and just pay the taxes he would have anyway, right?

his SE earnings might represent compensation and business profits, not "compensation" per-se

Just don't be Watson: https://ecf.ca8.uscourts.gov/opndir/12/02/111589P.pdf


I've never heard of the IRS challenging an S Corp owner's salary of $137,700 for 2020 (for various reasons)

Exactly what Henry David said. If you try and take a $24,000 salary (like Watson) you will have issues. But on a $500k net, I would be looking at a $175k Salary - $325k profits , maybe even $150k - $350k

As long as you are over the SS ceiling I would not lose a minute of sleep.

I honestly think $300k salary - $200k profits is way to conservative. It does not matter what his prior salary was. Maybe he was overpaid at his prior company.

You would think Joe Biden and his wife (knowing that his returns will be scrutinized) would be hiring competent CPA's to do his taxes. The firm has offices in Washington DC and NY, so they are a good sized return and I would think some of the top talent is working on the Biden return. Here is what they came up with

Joe Biden's S Corp 2018 Salary $300k Profits $2.7 million
Jill Biden's S Corp 2018 Salary $200k Profits $500k

In 2017 their salaries were even lower.

Biden's S Corp 2018 Salary $300k Profits $2.7 million
Jill Biden's S Corp 2018 Salary $200k Profits $500k

they had to amend his 2017 and 2018 returns? I'm spending too much time during tax season

In this case, as a sole member/shareholder he is ultimately responsible for all matters related to the company. His current responsibility must be at least, and probably more, than that which he has as an employee of a competing company.

I will check with the client but I'm confident he will say he was worth more than what his prior employer was paying him. I would say he was pay exactly what he was worth considering you have two independent parties negotiating a salary.

Biden's returns are what they are and who knows if politics had any impact in the final analysis. I'm not sure how much better a comparison there can be of what a reasonable salary would be than what he was paid by an unrelated employer in the same city.

I searched and couldn't find a tax case where the IRS used a taxpayer's prior employment compensation as a benchmark for reasonable compensation.

In 2017, the CPA firm was even more aggressive with the salary vs profits allocation.

Joe Biden's S Corp 2017 Salary $145,833 Profits $9.5 million
Jill Biden's S Corp 2017 Salary $100,000 Profits $558K

That tells me in 2017 he never thought he would have to release his returns to the media again. That allocation is aggressive even by my standards.

I do not place much blame on the CPA firm for the amended returns. In 2017, it looks like the Federal Govt never issued a W-2 to the Vice President even though he would have worked 3 weeks into 2017. And they listed a charitable deduction twice

In 2018, one of their charitable donations was to a non profit based in the UK. That does not qualify (Nor sure I knew that)

If you notice the amended dates they were done the day after he released his tax returns to the media. So you probably had thousands of CPA's (myself included) scanning for errors.

I have a client who was an executive at a large logistics company. His annual salary was well north of $1 million in each of the last 5 years. He left the company and started his own consulting company. He admits he will never make that kind of money again. His prior salary does not have any impact on what my reasonable comp will be for his S Corp.

In my example, the work performed in both instances were the same. Both small companies in the same industry doing the same work in the same city. I would be more inclined to place less credence on the previous W-2 earnings as a benchmark were the two less comparable.

You already said that no where does prior employment have anything to do with it. You need to decide whether you're going to let go of that!

In 2018, one of their charitable donations was to a non profit based in the UK. That does not qualify (Nor sure I knew that)

to continue the tangent...I believe the general rule is no charitable deduction for donations to non-US charities...with some exceptions, including treaties, etc.

I searched and couldn't find a tax case where the IRS used a taxpayer's prior employment compensation as a benchmark for reasonable compensation.

Herbert, T.C. Summary Opinion 2012-124