- A self-employed individual (sole proprietor) performing services is not subject to reasonable compensation rules in the same way as a shareholder-employee. This is because:
Answer: Sole proprietors pay self-employment tax on their net self-employment income regardless of how they label it - there is no opportunity to recharacterize SE income as distributions to avoid SE tax, unlike with S corporations.
Self-employment tax applies to all net SE income of a sole proprietor - there's no corporate distribution mechanism to avoid SE tax, so the reasonable compensation issue doesn't arise in the same way. Answer C is correct. Sole proprietors do pay SE tax (A). Sole proprietors cannot deduct personal compensation (B). Tax rates vary (D).
- Which of the following correctly describes the tax treatment of a bonus paid to a shareholder-employee that is determined to be reasonable compensation?
Answer: The bonus is deductible by the corporation as compensation expense, included in the shareholder-employee's gross income as wages, and subject to FICA taxes.
Reasonable compensation (including bonuses) is deductible by the corporation and taxable as ordinary income/wages to the recipient, subject to payroll taxes. Answer B is correct. Accrual-basis corps can deduct bonuses paid within 2.5 months after year-end (A - not limited to year-end). Bonuses are ordinary income (C). Deductible compensation reduces E&P (D - incorrect characterization).
- A two-person S corporation pays one shareholder-employee $100,000 in wages and the other shareholder-employee, who works equal hours, $20,000 in wages. The difference reflects the different ownership percentages (70%/30%). Is the compensation structure reasonable?
Answer: Potentially unreasonable - wages must reflect the value of services, not ownership percentages. The 30% shareholder performing equal work should receive compensation comparable to the 70% shareholder's wages.
S corp wages must reflect services provided, not ownership percentages. Equal work should command comparable compensation - tying wages to ownership to shift income tax or payroll taxes is improper. Answer A is correct. Ownership proportionality is not the standard (B). Individual compensation must each be reasonable (C). The IRS may raise this independently (D).
- A shareholder-employee of a profitable S corporation receives no salary but takes $200,000 in distributions. The IRS audits and determines that reasonable compensation for the shareholder-employee's services is $80,000. The most likely adjustment is:
Answer: $80,000 of the distributions will be recharacterized as wages, subject to FICA taxes for both the employee and employer - plus potential penalties for failure to withhold.
The IRS will reclassify $80,000 (the reasonable compensation amount) as wages subject to FICA, not the full $200,000. Answer A is correct. Only the reasonable compensation amount is reclassified (B). Income recharacterization (C) is not the primary adjustment. S corp shareholders pay wages, not SE tax (D).
- A C corporation that has historically paid no dividends and consistently absorbs all profits through compensation to shareholder-employees is most at risk for:
Answer: The IRS recharacterizing a portion of compensation as constructive dividends - the lack of dividend history combined with high compensation is evidence that compensation is being used as a substitute for dividends.
Using all-compensation/no-dividend policy to avoid double taxation is the classic IRS target - compensation may be recharacterized as dividends to prevent deductibility. Answer A is correct. The AET (B) applies to accumulated retained earnings, but the scenario shows no retained earnings. PHC tax (C) relates to passive income. Criminal prosecution (D) requires fraudulent intent.
- Which of the following professionals is most likely to be challenged on reasonable compensation grounds by the IRS?
Answer: A physician who is the sole shareholder-employee of a medical S corporation, performing all patient services, and paying herself $40,000 in wages while taking $300,000 in distributions from $340,000 of net income.
A physician with low wages and high distributions from a professional S corporation is a classic IRS reasonable compensation target - the services are worth far more than $40,000 and the excess is clearly wage income being disguised as distributions. Answer B is correct. Public company compensation (A) has different issues. Non-owner above-market pay (C) is not a reasonable compensation concern. Market-rate C corp compensation (D) has no issue.
- The primary tax consequence when the IRS successfully recharacterizes excessive C corporation compensation as a dividend is:
Answer: The corporation loses the deduction for the excess compensation - it cannot deduct dividends, so the recharacterized amount increases corporate taxable income.
When the IRS recharacterizes excess compensation as dividends, the corporation loses the compensation deduction - dividends are nondeductible. Answer C is correct. The compensation is not deductible at the shareholder level (A). Corporate tax is owed on the amount disallowed, not a dividend-rate tax (B). The shareholder does not return funds to the corporation (D).
- A 100% owner-employee of an S corporation performs services worth $120,000 annually but pays herself only $30,000 in wages, taking $90,000 in distributions. After an IRS audit, the most likely outcome is:
Answer: The IRS will reclassify $90,000 of distributions as wages (up to reasonable compensation of $120,000) and assess back FICA taxes plus penalties and interest.
The IRS will reclassify distributions to reach the $120,000 reasonable compensation level - the $90,000 shortfall in wages will be recharacterized as wages subject to payroll taxes. Answer A is correct. S corp distributions are deductible (B - irrelevant since distributions aren't expenses). Reclassifying wages as distributions (C) is the opposite of what the IRS does. Total compensation includes distributions reclassified as wages (D is misapplied).
- An S corporation pays its shareholder-employee a reasonable salary of $75,000. The S corporation has additional net income of $150,000 that flows through to the shareholder as a distribution. The net income distribution:
Answer: Is not subject to FICA or SE tax - S corporation distributions (beyond reasonable wages) are excluded from employment taxes, which is the key tax advantage of S corporation status for active owner-employees.
S corporation distributions are not subject to FICA or SE tax - only the reasonable salary portion is subject to payroll taxes. The 3.8% NIIT doesn't automatically apply to S corp active owners. Answer C is correct. Distributions are not subject to FICA (A). S corp income is not SE income (B). Active S corp owners are generally excluded from NIIT on their S corp income (D).
- The IRS may challenge compensation paid by a closely held C corporation to a shareholder-employee as unreasonable if:
Answer: The compensation is excessive relative to the services performed, suggesting it is a disguised dividend - allowing the corporation to deduct a distribution that would otherwise not be deductible.
Unreasonable compensation in a C corp context typically involves overpaying shareholder-employees to disguise nondeductible dividends as deductible compensation. Answer B is correct. Market-rate compensation (A) is the safe harbor. Small ownership (C) doesn't trigger IRS concern. Bonus form (D) is not itself improper.
- A closely held C corporation pays its sole shareholder-employee a $500,000 salary. After paying the salary, the corporation has only $10,000 of net income. The IRS examines the reasonableness of the compensation. A key consideration is:
Answer: Whether $500,000 is reasonable for the type and quality of services provided, considering market comparables - the fact that it leaves minimal corporate income is relevant as evidence of disguised dividends.
The near-total absorption of corporate income as compensation is circumstantial evidence of disguised dividends - the key test is whether the amount is reasonable for the services. Answer C is correct. Prior dividend history (A) is relevant but not the key factor. Prior year consistency (B) is one factor but not determinative. Payment timing (D) is irrelevant.
- In planning compensation for a shareholder-employee of an S corporation, the primary tax planning goal is to:
Answer: Set the salary at a 'reasonable' level that reflects market value of services - balancing the payroll tax savings from distributions against the risk of IRS audit and potential penalties for inadequate wages.
The optimal strategy is to pay reasonable wages (meeting the market standard and avoiding IRS challenge) while taking remaining profits as distributions to minimize payroll taxes. Answer D is correct. Maximizing salary (A) increases payroll taxes unnecessarily. Minimizing salary (B) increases audit risk. Zero salary (C) is clearly unreasonable and targets the owner-employee for IRS adjustment.
- Courts typically use multiple factors to evaluate whether compensation is 'reasonable.' Which of the following is NOT a commonly used factor?
Answer: Whether the employee is related to the company's founder.
Family relationship to a founder is generally not a factor in the reasonable compensation analysis - courts look at economic, market, and performance factors. Answer D is correct. Qualifications (A), market comparables (B), and company financials (C) are all commonly used factors.
- Which of the following actions best protects a C corporation from an IRS challenge to shareholder-employee compensation?
Answer: Establishing compensation using an independent compensation study, board approval by disinterested directors, a contemporaneous employment contract, and benchmarking against industry data.
Best practices to defend reasonable compensation include independent studies, objective board approval, contemporaneous documentation, and market benchmarking. Answer D is correct. Inflation adjustment (A) doesn't establish market reasonableness. Profit-based bonuses (B) may be challenged if total compensation is excessive. Related-party approval (C) lacks independence.
- In an S corporation context, the IRS may challenge compensation paid to a shareholder-employee as unreasonably low if:
Answer: The shareholder-employee takes little or no salary while receiving large distributions - allowing avoidance of payroll taxes (FICA) on amounts that should be characterized as wages.
S corp shareholders who work for the company must receive reasonable compensation as wages - distributions avoid FICA, so underpaying wages and overpaying distributions is a common IRS target. Answer A is correct. Above-market pay (B) is an S corp shareholder-employee concern, but lower pay is the typical S corp abuse. Different amounts (C) are acceptable. Hours worked (D) alone don't determine reasonableness.
- A non-shareholder employee at a company earns $80,000 for performing the same duties as the sole shareholder-employee who earns $250,000. The excess of $170,000 ($250,000 - $80,000) is most likely:
Answer: Potentially characterized as an unreasonable and nondeductible compensation to the extent it exceeds market value - the $80,000 market rate is strong evidence that the $170,000 excess represents a disguised dividend.
Market comparables showing $80,000 as the market rate strongly support recharacterizing the $170,000 excess as a nondeductible constructive dividend. Answer C is correct. The excess may not be deductible (A). The excess is taxable as wages if paid as such but subject to reclassification as dividends (B). Management fees must also be reasonable (D).
- A C corporation's shareholder-employee receives compensation that includes both a fixed salary and a year-end bonus tied to corporate profits. The IRS may view the profit-based bonus as:
Answer: Potentially reasonable if the total compensation (salary plus bonus) is within market rates - profit-based bonuses are permissible if the overall compensation is reasonable and reflects the value of services rendered.
Profit-based bonuses are not per se unreasonable - the total compensation must be reasonable in amount. Answer B is correct. Profit bonuses are not automatically unreasonable (A). All compensation must be reasonable to be deductible (C). The qualified performance-based exception for deductibility was largely eliminated by the TCJA (D).
- When evaluating reasonable compensation in a family-owned business, the IRS pays particular attention to:
Answer: Whether compensation paid to family members reflects the actual value of their services or is inflated to shift income within the family - particularly compensation to family members in lower tax brackets.
Income shifting through inflated compensation to lower-bracket family members is an IRS concern - compensation must reflect actual value of services regardless of family relationships. Answer B is correct. Joint filing (A) is irrelevant. Equal compensation (C) is not required. Employment agreements (D) are good practice but don't ensure reasonableness.
- An independent investor test is used by some courts to evaluate reasonable compensation. Under this test:
Answer: Compensation is reasonable if, after paying the compensation, the return on equity is sufficient to attract an independent investor - if the return on equity is adequate, the compensation is presumed reasonable.
The independent investor test asks whether the return on equity after paying the compensation would still be acceptable to an outside investor - if yes, the compensation is reasonable. Answer B is correct. The test is about investment returns, not compensation amounts to investors (A). Board approval (C) is a governance practice. Independent contractor benchmarking (D) is a different approach.
- A shareholder-employee of a C corporation receives excessive compensation relative to the services they perform. What is the primary IRS concern and likely recharacterization?
Answer: A constructive dividend to the shareholder - if the corporation overpays a shareholder-employee relative to services rendered, the IRS may recharacterize the excess as a nondeductible dividend, increasing corporate taxable income.
The standard reasonable-compensation issue in a C corporation involves excessive - not below-market - compensation. When a closely held C corporation pays a shareholder-employee more than the services are worth, the IRS may recharacterize the excess as a constructive dividend. The corporation loses the deduction for the excess (dividends are nondeductible), and the shareholder is treated as receiving a dividend rather than wages. Answer D is correct. A capital contribution (A) flows from shareholder to corporation, not the other way around. A below-market loan (B) is a separate Code provision under Section 7872. No exclusion exists for wages paid to a shareholder-employee (C).
