Mastering the Rules of S Corporation Shareholder-Employee Compensation

FOR LIVE PROGRAM ONLY Mastering the Rules of S Corporation Shareholder-Employee Compensation WEDNESDAY, JANUARY 31, 2018, 1:00-2:50 pm Eastern IMPORTANT INFORMATION FOR THE LIVE PROGRAM This program is approved for 2 CPE credit hours. To earn credit you must: Participate in the program on your own computer connection (no sharing) if you need to register additional people, please call customer service at 1-800-926-7926 ext.1 (or 404-881-1141 ext. 1). Strafford accepts American Express, Visa, MasterCard, Discover. Listen on-line via your computer speakers. Respond to five prompts during the program plus a single verification code. To earn full credit, you must remain connected for the entire program. WHO TO CONTACT DURING THE LIVE EVENT For Additional Registrations: -Call Strafford Customer Service 1-800-926-7926 x1 (or 404-881-1141 x1) For Assistance During the Live Program: -On the web, use the chat box at the bottom left of the screen If you get disconnected during the program, you can simply log in using your original instructions and PIN.

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Mastering the Rules of S Corporation Shareholder-Employee Compensation JANUARY 31, 2018 Stephen D. Kirkland, CPA, CMC, CFC, CFF Atlantic Executive Consulting, Columbia, S.C. stephen.kirkland@aecg.biz Paul S. Hamann, President RCReports, Denver phamann@rcreports.com

Notice ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

Mastering the Rules of S Corporation Shareholder-Employee Compensation Stephen Kirkland Paul Hamann 5

This session includes only general information for discussion and education purposes. The presenters may play devil s advocate to stimulate thought. If any point is not covered as thoroughly as you would like, please contact the presenters afterwards for more information. 6

Owner Pay One of the most interesting topics in business today. Large amounts Subjective Personal Controversial Complex issues 7

Today we will cover Tax rules and IRS positions Comparability Data Examples and a case study Court Cases Incentive Compensation Deferred Compensation Equity Compensation Tax Cuts and Jobs Act Preparer Penalties 8

IRS Position Distributions and other payments by an S corporation to a shareholder must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation. 9

Reasonable for services actually rendered Code Section 162(a)(1) Reasonable compensation is the amount as would ordinarily be paid for like services by like enterprises under like circumstances IRS Reg. Section 162-7(b)(3) Replacement Cost Fair Market Value 10

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The key to establishing reasonable compensation is determining what the shareholder-employee did for the S corporation 1. Services of non-shareholder employees 2. Capital and equipment 3. Services of shareholders 12

Services of non-shareholder employees, or Capital and equipment 13

Services of shareholder In addition to the shareholder-employee direct generation of gross receipts, the shareholder-employee should also be compensated for administrative work performed 14

W-2 or 1099 Revenue Ruling 74-44; IRC states: An officer of a corporation is considered an EMPLOYEE Employee or Independent Contractor Under common-law rules, anyone who performs services for you is your employee if you can control what will be done and how it will be done. 15

Talk to your clients early and often. Ask for all related parties to be identified (long-term clients may assume you know). Document! 16

Three Approaches to Valuation Cost Approach replacement cost for job segments (many hats) Market Approach Industry comparison Income Approach Independent Investor Test 17

The Factors Examples The employee s qualifications, including education and experience The nature and scope of the employee s duties Amounts paid for similar services by similar businesses Prevailing economic conditions 18

The Factors Examples The character/complexity/condition of the business Conflicts of interest Intent to compensate/retain the employee Internal consistency of compensation Covenants and guaranties 19

Gathering the Facts Responsibilities in all areas? How were the historical amounts determined? Any deferred compensation? 20

Ask Specific and Open-ended Questions: Are you multi-lingual? Are you good with technology? How do your spend your time? Would you be difficult to replace? Why? 21

Reliable Sources? Interviews, financial statements, tax returns, websites Can you confirm the facts? 22

Comparability Data 23

Comparability Data Title / Job description Location Company size / Years of experience Industry 24

Industry Codes https://www.census.gov/eos/www/naics/ 25

One Potential Source of Comparability Data: Publicly-Traded Companies Larger? More diversified? More layers of management? Narrower duties? 26

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Other Sources of Compensation Comparability Data 28

Case Study Road construction company owned by the CEO Located in Portland, Oregon Owner s 25-year-old son says he is a VP but he has basic duties; he works 40 hours per week Annual revenue is $50 million 29

Economic Research Institute screenshot 30

ERI screenshot 31

RCReports.com for the Son The son has various basic duties... 32

RCReports.com for the Son We break down his time and enter his proficiency 33

Attributes 2017 Multnomah County, Oregon Hours worked: 2080 Some college no degree Employees: 26 50 NAICS: 237310 Highway, Street, and Bridge Construction 34

The Son s Replacement Compensation 35

There are many Sources of Compensation Data Trade Associations 36

For any Source of Comparability Data: Do you understand their methodology? Do you know where they got their data? What quality controls do they have in place? How did they deal with outliers? 37

Sources of Comparability Data 38

Deferred Comp (Catch-up Pay) Does the liability exist anywhere other than in the owner s head? Documented in corporate minutes? Internal Revenue Code section 409A. 39

Incentive Compensation Total compensation is considered by the IRS Each year usually stands alone except for deferred compensation The owners incentives are compared to those of nonowner employees, and year-by-year comparisons may be made (consistent?) Unreasonable formulas produce unreasonable amounts Compensation agreements Covenants Bonus withholding just before year end 40

Equity Compensation Beware of sharing equity Now more common at start-ups Noncash compensation is taxable Treatment of equity compensation to service provider employees Section 83 41

Employee Benefits Adjust cash pay for excessive or minimal welfare and retirement benefits? 42

S Corporations in Court IRS 25-1* versus 43

Court Cases DAVID E. WATSON, P.C., V. UNITED STATES OF AMERICA (2010) Low Salary versus Profit Distributions 2002 Profit = $203,651 2002 Salary = $24,000 2003 Profit = $175,470 2003 Salary = $24,000 44

DAVID E. WATSON, P.C., V. UNITED STATES OF AMERICA (2010) IRS Objected: Education Graduate Degree Experience Time 20 Years Full Time (35-45 hours per week) 45

DAVID E. WATSON, P.C., V. UNITED STATES OF AMERICA (2010) Reasonable Compensation $91,044 for 2002 $91,044 for 2003 46

DAVID E. WATSON, P.C., V. UNITED STATES OF AMERICA (2010) 2002 2003 Reasonable Compensation $91,044 $91,044 Actual Salary Paid $24,000 $24,000 Re-Characterized $67,044 $67,044 Total Re-Characterization = $134,088 47

DAVID E. WATSON, P.C., V. UNITED STATES OF AMERICA (2010) $48,521 $20,000 48

DAVID E. WATSON, P.C., V. UNITED STATES OF AMERICA (2010) IRS: Graduate Degree 20 Years experience Full Time employee Various Job Duties: CPA/Accountant Partner Re-structured businesses No Research and No Documentation 49

Appeal Denied 50

SEAN MCALARY LTD, INC. v. COMMISSIONER (2013) McAlary Ltd = Real Estate Company 2006 Net Income = $231,454 2006 Distribution = $240,000 2006 Salary = Zero 51

IRS Calculation in McAlary $100,755 Primary Job Function Real Estate Broker Full Time (12 hour days 6-7 days per week) Compared McAlary LTD performance with peers in the real estate industry 52

IRS Calculation in McAlary $100,755 Replacement Cost McAlary LTD could expect to pay $48.44/hour to another individual in exchange for the services Mr. McAlary performed Fair Market Value $100,755 would be FMV of the services Mr. McAlary performed for his S Corp 53

IRS Calculation in McAlary $100,755 $48.44 X 2,080 The Bureau of Labor Statistics defines Year-Round, Full-Time employment as 2,080 hours per year. 40 Hour Work Week X 52 Weeks/Year McAlary often worked 12 hour days with few days off 54

McAlary s Position $24,000 Compensation Agreement BOD Meeting Minutes 04-01-2004 Increases Based on Number of Agents 55

The Court s Calculation $83,200 Various Services Wage Range Hourly Wage = $40.00 2,080 X $40.00 = $83,200 56

McAlary Court Calculation 2,080 X $40.00 = $83,200 Compensation Agreement We are not persuaded that the remuneration agreement represents a sound measure of the value of the services that Mr. McAlary provided The agreement clearly was not the product of an arm's-length negotiation. Industry Comparison (IRS Expert) did not explain how a comparison of compensation measured as a percentage of gross receipts with compensation measured as a percentage of net sales would aid the Court In the end, we do not find this portion of (the experts) report to be persuasive or helpful. 57

Court Calculation 2,080 X $40.00 = $83,200 Various Services Management; Supervision; Recruiting; Sales; Advertising; Purchasing; Bookkeeper; Record Keeping Experience Low; New to the Industry COESS-BLS Range $32.99 to $64.28 Determining an employee's reasonable compensation is dependent upon a number of factors and is far from an exact science. 58

GLASS BLOCKS UNLIMITED v. COMMISSIONER (2013) How an S Corp can Lose Money and Still be Required to Pay Reasonable Compensation 59

Glass Blocks Unlimited Fredrick Blodgett 2007 Net Income = $877 2007 Transferred in = $45,000 2007 Transferred out = $30,844 2007 Salary = Zero 60

IRS Position in Glass Blocks Transfer in was a contribution to capital (basis). Transfer out was a distribution (return of basis). Reasonable Compensation must be paid before a distribution can be made. 61

Glass Blocks Position Transfer in was a shareholder loan to company. Transfer out was a repayment of the shareholder loan. Reasonable Compensation does not apply. 62

Court Finding Transfers in question were capital contributions and not bona fide loans: No written agreements or promissory notes No interest charged No security (collateral) No fixed repayment schedule 63

Court Finding Where the expectation of repayment depends solely on the success of the borrower's business, rather than on an unconditional obligation to repay, the transaction has the appearance of a capital contribution. 64

Math Net Income - before $877 Wages $-30,844 Employment Taxes $-2,360 Penalty & Interest $-1,923 2007 Net Income (Loss) - after $(34,250) 65

DAVIS v. UNITED STATES (1994) Mile High Calcium Carol L. Davis Henry Adams (husband) Transfers In and Out 1987-1989 Assessed Taxes + Interest & Penalties of $39,220 66

DAVIS v. UNITED STATES (1994) Henry Adams President Not an Employee No Active Participation Worked for outside employers Officer in name only There is an exception for officers who perform only minor services (Treas. Reg. 31.3121(d)-(1)(b)) 67

DAVIS v. UNITED STATES (1994) Carol L. Davis Was an Employee 12 hours per month (2.77 per week) $8.00 per hour $39,220.$647 68

Allen L. Davis, et al v. Commissioner (2011) $37 million of compensation was determined to be reasonable largely because other shareholders had agreed to it and they were adversarial to Mr. Davis. 69

Beware Disproportionate distributions Other shareholders Lenders/investors 70

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Preparing Analyses for IRS Scrutiny Facts, Analyses, Conclusions, Bases for conclusions Accepted Methodology? Reliable Sources of data? Assumptions what did you assume and why? 72

Changes in Tax Cuts and Jobs Act Limitations on executive compensation deductions at publicly-traded companies and tax-exempt entities may influence comparability data. 73

Changes in Tax Cuts and Jobs Act New 20% deduction in Code section 199A (available at the shareholder level) - Exception for certain types of businesses 74

Changes in Tax Cuts and Jobs Act New 20% deduction in Code section 199A - Exception for certain types of businesses - Income exception 75

Changes in Tax Cuts and Jobs Act New 20% deduction in Code section 199A - Exception for certain types of businesses - Income exception - Second incentive to keep compensation at the low end of the range? 76

Changes in Tax Cuts and Jobs Act New 20% deduction in Code section 199A - Exception for certain types of businesses - Income exception - Second incentive to keep compensation at the low end of the range? - May want to raise compensation, to increase SEP contribution thereby reducing TI below cut-off - Create new/separate entities so one can qualify? 77

Tax Preparer Penalties $5,000 Code Section 6694(b) IRS expects preparers to have appropriate checklists IRS does not expect the preparer to merely accept the information IRS requires the preparer to be proactive Penalties can and will be imposed on preparers 78

No Tax Court for Reasonable Compensation Notice of Employment Tax Determination under IRC 7436 - Additional Compensation to Officer Employees No resolution at appeals Cannot proceed to Tax Court Pay Tax Sue for refund 79

Documentation protects you and your clients. 80

The IRS Job Aid on Reasonable Compensation Guide for IRS auditors and valuation professionals Now available on the IRS website (It is 96 pages and the Appendix is 26 pages) 81

Thank You! Paul S. Hamann RCReports.com Stephen Kirkland CompensationOpinion.com 82