Question

Your newest client, Alvarez, PC, is a law firm that provides legal services in the Houston area. The PC is a professional corporation under Texas law and is owned equally by Silvia Alvarez, a practicing attorney, and Jose Alvarez, also an attorney. Silvia and Jose have been married for 35 years and file personal returns jointly. Silvia is President of the corporation and manages the law practice for the firm. Jose is secretary of the corporation but is not involved in the practice or operations of the firm. He serves as a capital investor as needed.

For the past five years, Alvarez, PC has been organized as an S corporation, which they would like to continue. Prior to being an S corporation, it was organized as a sole proprietorship under Silvia Alvarez. Jose, who previously worked as an attorney at an oil and gas company, joined Silvia as a 50% shareholder when the PC was created.

For the current year the PC plans to pay Silvia a salary of $30,000 but no salary to Jose since he is not involved in the operations of the firm. The PC expects business net ordinary income for the current year to be $250,000 (before any salary payments to the owners). The owners will each take cash distributions of $100,000. Because the business is structured as an S corporation, the owners assume that they will not be subject to any payroll taxes on their share of the profits or their distributions, but only on Silvia’s $30,000 salary.

Required:

Help the two owners addressing in detail the issue of reasonable compensation to shareholder-employees of S corporations. In addition, address the issue of any tax penalties that they may face in an IRS audit of the corporation.

Answer 1

Answer:

The company is following the right tax policy.

Silvia and Jose are not liable to pay payroll taxes on their share of profit. They will pay individual income tax on their share of profit or dividend.

Silvia is liable to pay her share of FICA (Federal Insurance Contribution Act) taxes as well as income taxes on wages and the S corporation will also pay its share of FICA taxes.

Explanation:

In an S corporation, shareholders are liable to pay individual income taxes on dividends they receive but in case shareholder-employee receives a salary, shareholder-employee are liable to pay FICA taxes with income tax on the salary with individual income tax on the share of profit.

Reasonable compensation is the amount of compensation provided to any other employee for the same work. For example, if an accountant receives a salary of $10,000 and a shareholder-employee is also doing the same work, he would be liable to receive $10,000 as compensation. In this case, compensation is not provided to Jose which is fair because he is not working in the company.

Also, analyze the average compensation paid by the S corporation to shareholders -employees through different websites like www.irs.gov website provided by IRS and www.bls.gov provided by the bureau of labor statistics.

Compensation to be provided to shareholder-employee like compensation provided to any other employee.