May 28

Written by: David Keligian
5/28/2014 8:52 AM  RssIcon

The Salary Whipsaw. What is being “whipsawed”? As far as the IRS is concerned, it means them taking different positions on an issue depending on what position results in the most tax. One emerging area where the IRS “whipsaws” taxpayers involves what constitutes a “reasonable” salary.

A “reasonable” (i.e. deductible) salary for income tax purposes is really a factual question. Multiple factors can be considered—education, experience, company size, industry, operating results, and “market” salaries. Issues involving “all facts and circumstances” are always the hardest to argue with the IRS and Franchise Tax Board (“FTB”). But on the salary issue, the IRS devotes much more attention than the FTB to the issue.

The reason has to do with the high level of federal employment taxes (Social Security, Medicare, FICA, and FUTA). A good example of the salary “whipsaw” involves a comparison of a sole shareholder owned C-corporation to a sole shareholder owned S-corporation.

C Corporation Example. Because C-corporations are subject to potentially high corporate tax rates, the C shareholder’s objective is typically to eliminate most of the C-corporation’s income. If the income accumulates inside the C-corporation, the C-corporation pays a top federal tax rate of 35%. If what is left in the C-corporation is taken out as something other than salary, such as a dividend, the shareholder again pays individual taxes, at ordinary tax rates, on that dividend income.

By taking a salary, the resulting deduction avoids double taxation, but only to the extent that the salary is upheld as “reasonable”. So for years, in cases involving C-corporations with high earnings, the IRS was constantly attempting to disallow salaries as “unreasonable” to collect additional tax at both the corporation and shareholder levels.

S Corporation Example. As employment taxes rose, clever CPAs and their clients who had S-corporations would take the opposite tack. They would take little or low salaries, minimizing the employment taxes due on that salary, and allow the rest of the S-corporation’s income to “flow through” to the shareholder as income that was not subject to employment taxes.

So in cases involving S-corporations, IRS income and employment tax auditors have been going out and claiming that taxpayers aren’t taking enough salaries. By increasing the owner salaries, the IRS gets additional employment taxes which can be substantial. That is where the “whipsaw” comes in—on identical facts (same degree of education, experience, company size, industry, operating results, and “market” salaries), the IRS will take different positions depending upon whether the corporation is a C-corporation or an S-corporation.

What can be done? The point is to give thought when adopting a salary, documenting the reasons why the salary amount was chosen in corporate minutes and other documentation prior to the time the salary comes into question. The minutes supporting the salary should not be “generic” minutes merely approving a number. Rather, they should go into detail as to why the number was chosen. For example, salaries can be lower if the objective of retaining funds inside the corporation to help fund future growth is documented (and in fact, funds are retained in the corporation as opposed to being completely distributed to the shareholder).

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Categories: Tax Policy
Location: Blogs Parent Separator David Keligian