Economically Analyzing the Definition of 'Reasonable Compensation' as It Relates to Employment-Tax Liability Under the Analysis of David E. Watson, P.C. v. United States

Abstract:     
This note analyzes the “definition” of “reasonable compensation” under the Internal Revenue Service’s (“IRS”) revenue ruling and how the Internal Revenue Code (the “Code”) applies that definition in determining employment-tax liability. The revenue ruling requires compensation to shareholder-employees of a small corporation to be reasonable. The IRS’s subsequent re-characterization of “unreasonable” payments – i.e., those that should have been originally characterized as wages – subjects the re-characterized portion to penalties, interest, and additional taxes; specifically, taxes under the Federal Insurance Contributions Act (“FICA”).

The case, here, involves a shareholder-employee of a Subchapter S corporation. The IRS challenged the shareholder-employee’s amount of FICA-tax liability after determining his salary was unreasonably low, by re-characterizing a portion of his distributions, or dividends, he received from his S-corporation.

Number of Pages in PDF File: 50

Keywords: shareholder, employee, compensation, wage, salary, salaries, partner, employment, tax, revenue, corporate, corporation, internal, service, federal, insurance, contributions, s corporation, s-corporation, distribution, dividend

JEL Classification: H2, H20, H21, H24, H25, H26, H29, J3, J30, J44, K00, K1, K10, K19, K2, K20, K22, K34, K42, L51, L8

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