Supreme Court Declines to Review S Corp Reasonable Compensation Case.
(Parker's Federal Tax Bulletin: October 22, 2012)

The Supreme Court denied certiorari in a case in which a district court and the Eighth Circuit held that an S shareholder did not receive reasonable compensation and thus underpaid his FICA employment taxes. David E. Watson, P.C. v. U.S., No. 12-174 (S. Ct. 10/1/12).

In 1996, David E. Watson, a CPA with a Masters in Tax Law, incorporated a business entity known as David E. Watson, P.C. (DEWPC). He transferred a 25 percent interest he owned in an accounting firm called Larson, Watson, Bartling & Juffer, LLP (LWBJ) to DEWPC, and thereafter DEWPC replaced Watson as a partner in LWBJ. Watson served as DEWPC's sole officer, shareholder, director, and employee. Through an employment agreement, DEWPC employed David, but David exclusively provided his accounting services to LWBJ for the relevant period. From its inception, DEWPC elected to be taxed as an S Corporation.

The IRS investigated DEWPC and determined that it underpaid its FICA employment taxes in 2002 and 2003. The IRS assessed additional tax and penalties against DEWPC for the eight quarters covering 2002 and 2003. DEWPC paid the delinquent tax, penalty, and interest for the relevant periods and sought a refund from the IRS. The IRS denied DEWPC's refund claim, and DEWPC took the case to a district court. The district court ruled in the IRS's favor and David appealed to the Eighth Circuit.

In Watson v. U.S., 2012 PTC 33 (8th Cir. 2012), the Eighth Circuit upheld the district court's decision. In doing so, the court listed the factors that may be relied upon to determine the amount of an S shareholder's reasonable compensation. Among the factors listed by the court in finding that David did not receive reasonable compensation were:

(1) the fact that David was an exceedingly qualified accountant with an advanced degree and nearly 20 year of experience in accounting and tax;

(2) the fact that David was one of the primary earners of a CPA firm that had earnings much greater than comparable firms;

(3) the salary of $24,000 that was reported was exceedingly low when compared to the amount distributed as profits;

(4) the gross earnings of the CPA firm;

(5) the results of a Management of an Accounting Practice (MAP) study done by the AICPA, which set the fair market value of the shareholder's services at a much greater amount.

For a discussion of the reasonable compensation issue as it relates to S corporations, see Parker Tax ¶31,927. (Staff Editor at Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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