Question

Most guaranteed payments from partnerships and wages from S Corporations are subject to the full 15.3% FICA tax. Flow-through income from partnerships is sometimes subject to FICA tax while S corp flow-through income is not subject to FICA tax. Cash distributions are not subject to tax, nor are they a deductible expense. Services contributed to a partnership are often compensated through guaranteed payments from the partnership. These are treated as salary payments on which the partner receiving them must pay payroll taxes which is why partners sometimes try to classify themselves as limited partners who would not be responsible for management of the partnership, so their share of partnership income is not subject to self-employment taxes. S corporation shareholders generally prefer dividend distributions of their S corporations’ profits over compensation payments from their S corporations because the compensation payments are subject to FICA taxes and dividend distributions are not. (We cover S corporations in later in the course.) S Corporations often get the IRS’s attention for paying too little salary—unreasonably low compensation. C Corporations on the other hand want to increase salary to employees and lower dividends distributions because the corporation does not get a tax deduction for the dividends issued to the shareholders. A small closely-held C Corporation pays excess earnings to employee/owners as a bonus so its income tax liability decreases. Often, the employee/owners compensation exceeds the social security wage thresholds so an “end of year bonus” is not subject to the full 15.3% FICA tax. C Corporations often get the IRS’s attention for paying too much salary —unreasonably high compensation. In the eyes of the Service, these distinctions by pass-throughs have caused great abuses and tax avoidance. The GAO has reported in the past that S corporations had underreported their shareholder compensation by $24.6 billion, with corporations with fewer than three shareholders responsible for nearly all the underreporting. This issue reached a boiling point in Watson v. Commissioner, 668 F.3d 1008 (8th Cir. 2012). (I assume no relation to our classmate, Jason). In this case, Watson was an accountant in a firm he owned. He drew a salary of $24,000 even though the firm grossed nearly $3 million in revenue. Watson was a Certified Public Accountant with advanced degrees. The 8th Circuit Court ruled that a reasonable person would consider the dividends paid to Watson to be “remuneration for services performed” as opposed to a return on investment. To support its position, the IRS successfully asserted that the $24,000 shareholder salary was not enough to support Watson’s lifestyle. As such, his dividends were reclassified as wages and the firm was assessed huge employment taxes plus penalties and interest. Using the findings in Watson as a model and to prevent S corporations and their shareholders and LLCs operating as partnerships from avoiding payroll taxes by maximizing distributions and minimizing compensation payments, the IRS now requires S corporations and partnerships to pay shareholders and general partners who provide substantial services reasonable compensation. The IRS makes its compensation determinations using three factors: Employee performance; Salary comparisons; and Company conditions. Do these factors seem fair to you in judging the compensation an employee receives? Yes/No Why? Do you have a better way to determine how much compensation is enough?

Answer 1

Yes, determining compensation using factors Employee performance; Salary comparisons; and Company conditions seems to be fair, but every factors has some limitations or requires proper systems in place to use these factors for compensation determination.

Employee Performance-Many studies have supported that business and employee productivity have a direct correlation to certain level but not completely, so compensation is determined with the performance of the employee in many business like paying much for top performers and descent of mid level performers. If the performance of the employee is not been determined/assessed properly due to human bias or lack of proper evaluation parameters, this method may fail to determine compensation. Obtaining 360 feed back during performance appraisals, designing/determining proper evaluation parameters specific to job role of the employee can be used to nullify the mentioned issues. If the issues for implementation of this factor is properly taken care, this is one of the best method for determination of compensation.

Salary Comparison: This is also one of the best method for determining compensation across several industries. Benchmarking the compensations using the latest Human Resource reports is widely followed method across the globe. This method should be used to determine the salary of both existing and new employee, if salaries are not competitive there are more chances of loosing great hires as well as existing employees. Offering competitive compensation is a key component to determine the salary scale. Factors like defining the job, forecasting the workforce, defining the competitive set and determining the typical wages in the current market can be the used to determine the salary by comparison method.

Company Conditions: This is also one of the widely followed method for determination of compensation across the globe. Most of the companies use this factor for determining the variable pay part of the salary. If the company is making profits, it can pass a determined share of the profits to its shareholders, stakeholders especially employees, many companies does the same. The share of the profit to the employees is determined by each company internally as per its policies.  Passing on the profits motivates the employees and it turn this can be reflected in their performance.

Compensation paid to the employee is very important thing because this will reflect in this behavior and working attitude. There has to be a complete transparency in the compensation policies and program of the company and communicated properly to the employees

Further some more additional factors apart from above mentioned, like skill set/experience of employee, educational qualification, location (cost of living of the location), supply and demand etc., can be considered during the determination of compensation on case to case basis.