IRS Revenue Rulings and Fact Sheet 2008-25

By Jason Watson, CPA
Posted Thursday, November 2, 2023

In 1959, IRS Revenue Ruling 59-221 held that amounts of S corporation undistributed taxable income which are required to be included in each shareholder’s gross income do not constitute net earnings from self-employment to shareholders. However, in 1974, IRS Revenue Ruling 74-44 stated that “dividends” paid to shareholders will be recharacterized as wages when such “dividends” are paid to shareholders in lieu of reasonable compensation for services performed for the S Corp. The word “dividends” is in quotations because in reality we call these shareholder distributions, but in 1974 they referred to them as dividends.

This makes sense. Dividends being used to pay for services are truly wages. If Google or Amazon pays out a dividend to its shareholders, it is considered investment income. If your S corporation does the same thing to its only shareholder without an accompanying shareholder wage, then it is considered self-employment income and subject to the gaggle of taxes with that type of income.

Also, consider the words “in lieu of reasonable compensation.” This is to suggest that if shareholder salary is not processed and only shareholder distributions are paid, those distributions will be recharacterized as shareholder salaries. In other words, paying reasonable shareholder salaries protects shareholder distributions from being recharacterized as salary. But keep on an eye on that word “reasonable.” It is the kicker.

Moving on… There are several factors to consider when coming up with a reasonable salary to pay shareholders. The IRS through Fact Sheet 2008-25 released the following laundry list (last update was in 2008 when Flo Rida was singing Low… apple bottom jeans, boots with the fur, the whole club was looking at her. How time flies!)-

• Training and experience.

• Duties and responsibilities.

• Time and effort devoted to the business.

• Dividend history (IRS nomenclature, really this should be shareholder distributions- however back in the day it was C corporations who later elected to be taxed an S corporation, so dividend history still has some historical merit).

• Payments to non-shareholder employees.

• Timing and manner of paying bonuses to key people.

• What comparable businesses pay for similar services.

• Compensation agreements.

• The use of a formula to determine compensation.

Clear as mud. This is the best the IRS can come up with? What is even more frustrating or perhaps embarrassing is that this list was the final draft after probably several meetings and rough drafts. Having said that, this is how our tax system operates in many ways- leave lots of wiggle room for interpretation so the law and the standards can evolve to meet the needs of today.

This list actually has two applications. Since C corporations have had a historically high tax rate including being double-taxed, many small C corporations want to drive corporate income close to zero by paying high salaries. The IRS and the Tax Court will use this list to say your salary is too high as a C Corp.

Conversely, S corporations want to increase corporate income (and available cash for shareholder distributions) by paying small salaries. The IRS and the Tax Court will talk out of the other side of their mouths by using this list to justify a higher salary. Yes, they get to have it both ways.

Here is a link to IRS Fact Sheet 2008-25-

wcginc.com/8247