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“Reasonable Compensation” for Payroll Tax Purposes

Posted Friday, May 18, 2012 by John S. Palmer

The Federal Insurance Contribution Act (FICA) imposes a payroll tax on wages paid to employees for services rendered; however an employer need not pay FICA taxes on other types of employee income, such as dividends. The IRS has adopted the concept of “reasonable compensation” to resolve whether an employee is meeting its obligation to pay FICA taxes, or underpaying FICA by labeling wages as some other form of compensation.

For example, Revenue Ruling 74-44 involved an S corporation with two shareholder-employees who paid themselves dividends but no wages. The IRS ruled that the dividends were in fact wages because they were “in lieu of reasonable compensation” for services rendered. Subsequent court decisions have adopted this approach and look at the substance of the transaction to determine if payroll taxes are due.

Perhaps the most recent example of this is a decision issued by the United States Court of Appeals for the Eighth Circuit, ruling against an Iowa CPA who claimed he should only pay FICA taxes on his annual salary of $24,000 and not on partnership distributions in excess of $175,000 per year.

At trial, an IRS analyst testified that reasonable compensation for services the CPA provided to the partnership was $91,044 per year, and the trial court agreed.

On appeal, the CPA argued that the IRS analyst was not qualified to render this opinion; the court of appeals noted that this analyst spends about 40% of his time dealing with compensation issues and has worked on 20 to 30 reasonable compensation cases. Therefore, the court of appeals found that, despite any deficiency in his education and training, he had the “demonstrated practical experience” required by Federal Rule of Evidence 702 to testify as an expert witness on this issue.

The CPA also claimed that the analyst was incompetent because his opinion changed over the course of the proceedings, but the court of appeals found he merely revised his opinion to take into account new information revealed as the case progressed.

Finally, the CPA argued that the IRS must look at the taxpayer’s intent, rather than the reasonableness of the compensation paid, to resolve cases such as this. The court of appeals found this argument unpersuasive, and noted that even if taxpayer intent was controlling, the trial court found that the partnership’s claim that it intended to pay the CPA only $24,000 per year for services rendered was not credible.

The moral of the story is that in order to avoid problems with the IRS over FICA taxes, the principals in a partnership, LLC or closely-held corporation should pay themselves a reasonable wage or salary for services rendered, and pay FICA taxes on those wages; then additional distributions may be made in the form of dividends or other distributions, free of FICA taxes.

David E. Watson, P.C. v. U.S., United States Court of Appeals, Eighth Circuit, Docket No. 11-1589, decided 2/21/2012.

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