Tax Court Cases for Reasonable Salary

By Jason Watson, CPA
Posted Thursday, October 7, 2021

The tax court has provided some guidance over the years in several well-known cases. Here is a quick reference list, and later we’ll dive into the finer details-

Ulrich v. United States, 692 F. Supp. 1053 (D. Minn., 1988)

Sole shareholder of an accounting firm whose only income was dividends. The court held “Under both the weight of the case law and under the treasury regulations, a corporate officer is to be treated an employee if he renders more than minor services.”

Spicer Accounting v. United States, 918 F.2d 90 (1990)

Spicer was the only accountant working for the firm and it was owned 50-50 with his wife. He only received dividends, and claimed to donate his services to the S corporation. The court held “The Federal Insurance Contributions Act and Federal Unemployment Tax Act both define ‘wages’ as ‘all remuneration for employment… that the form of payment is immaterial… [therefore] the only relevant factor being whether payments were actually received as compensation for employment.”

Watson v. Commissioner, 668 F.3d 1008 (8th Cir. 2012)

No relation to Jason Watson or WCG CPAs & Advisors! (Jason is a bit crazy from time to time, but not this cra-cra). In this case, David E. 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.

JD & Associates, Ltd. v. United States, No. 3:04-cv-59 (District Court, North Dakota, 2006)

Dahl, an accountant and sole shareholder, paid himself a small salary. The IRS hired a valuation expert who used Risk Management Association (RMA) data to determine what other accountants were paid for similar services. The RMA data was damning enough, however what really sent this case over the edge is the Dahl paid himself less than his staff including clerical positions. Admins cannot make more than you.

These darn accountants are out of control! Here are couple of “wins.”

Davis v. United States, 1994 U.S. Dist. LEXIS 10725 (District Court, Colorado, 1994)

A husband and wife team owned a corporation. The husband worked elsewhere and the wife performed clerical duties (12 hours per month). Her accountant said her services were worth $8 per hour. The IRS did not challenge the value of the time commitment and therefore Davis won this case because the wife was able to prove her minimal hours.

Sean McAlary Ltd. Inc. v. Commissioner (Tax Court Summary Opinion 2013-62)

In a recent tax court case, the IRS hired a valuation expert to determine that a real estate agent should have been paid $100,755 salary out of his S Corp’s net income of $231,454. Not bad. He still took home over $130,000 in distributions, and avoided self-employment taxes (mainly Medicare) on that portion of his income. Then again, this makes sense. Real estate oftentimes sells itself thanks to the internet, and the real estate agents are merely facilitators. In other words, the actions of the real estate agent were not solely responsible for $231,454 in income.

There are two tests that tax courts have used in the past. In Label Graphics, Inc. v. Commissioner, Tax Court Memo 1998-343 which was later affirmed by the 9^th Circuit Court in 2000, the court came up with-

• The employee’s role in the company.

• A comparison of the compensation paid to similarly situated employees in similar companies.

• The character and condition of the company.

• Whether a relationship existed between the company and employee that may permit the company to disguise nondeductible corporate distributions as deductible compensation.

• Whether the compensation was paid pursuant to a (1) structured, (2) formal, and (3) consistently applied program.

In Brewer Quality Homes, Inc. v. Commissioner, Tax Court Memo 2003-200, the court re-iterated several points from another federal court case (Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315 (5th Cir. 1987))-

• The employee’s qualifications.

• The nature, extent, and scope of the employee’s work.

• Size and complexity of the company.

• Comparison of the employee’s salary with the company’s gross and net income.

• Prevailing general economic conditions.

• Comparison of salaries with distributions to stockholders.

• Compensation for comparable positions in comparable concern.

• Salary policy of the company as to all employees.

• Amount of compensation paid to the employee in previous years.

Similar to IRS Fact Sheet 2008-25 no single factor controls. It really is a preponderance of the evidence as civil courts like to say. Tax court judges will go through these lists, depending on the case and the jurisdiction, and will apply the facts and circumstances to each of these factors, and essentially make a list of plusses or a minuses.

For example, the criterion might be “Payment to non-shareholder employees.” The tax court will analyze the evidence to determine the plus or minus. Let’s say the S corporation owner provides evidence that her star employee is the rainmaker and therefore the employee’s salary including bonuses exceeds the S corporation shareholder. Let’s also say that the tax court finds this argument to be compelling. This would a “plus” for the S corporation owner since the criterion of “Payment to non-shareholder employees” favors the S Corp shareholder.

Continuing with this example, assume the owner had $300,000 in net income after expenses, but only paid $30,000 to herself as an S corporation salary. The IRS and tax court would place a “minus” next to the “A comparison of salaries paid to sales and net income” criterion as they did in K & K Veterinary Supply, Inc. v. Commissioner, Tax Court Memo 2013-84.