S Corporation Reasonable Compensation and the Distribution Trap
Ridgeway Design LLC elected S corporation status three years ago. It has two equal shareholders: Alan, who works full-time as the lead designer and manages operations, and Beth, a passive investor who does no work for the company. In the current year, Ridgeway had net ordinary income of $480,000 before any shareholder payments. The company paid Alan a salary of $40,000 (W-2, with payroll taxes withheld) and made no other distributions. Beth received no salary. At year-end, the shareholders want to distribute the remaining $440,000 equally ($220,000 each) as S corporation distributions, treating the entire amount as tax-free return of basis. Alan's basis before the distribution is $60,000; Beth's is $60,000. Alan asks whether his $40,000 salary is adequate and whether the planned distributions are tax-free.
1. Is Alan's $40,000 salary defensible, and what is the consequence if the IRS recharacterizes part of the distribution as wages?
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The $40,000 salary is highly vulnerable. An S corporation shareholder-employee who performs substantial services must receive reasonable compensation (Rev. Rul. 74-44; Watson v. U.S.). Distributions to an active shareholder are recharacterized as wages to the extent they are really compensation for services. Factors: Alan works full-time, is the lead designer and manager, and the company nets $480,000 - $40,000 is far below what a comparable manager/designer would earn.
If the IRS recharacterizes, say, $150,000 of Alan's $220,000 distribution as wages:
- Payroll taxes (FICA/FUTA) become due on the recharacterized amount, plus penalties and interest.
- The recharacterized amount is deductible by the corporation as wages, reducing ordinary income.
- Alan's W-2 wages increase, which also raises the §199A wage limitation base.
- The distribution is reduced accordingly.
Best practice: set a defensible salary supported by market data before year-end. The exam tests that reasonable compensation is a facts-and-circumstances determination and that the IRS can reclassify distributions.
2. Are the planned $220,000 distributions to each shareholder tax-free? Compute each shareholder's basis and taxable amount.
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Distributions are not automatically tax-free - they are limited by stock basis.
First, basis is increased by the shareholder's share of current-year income (§1367). Assuming the $440,000 remaining is ordinary income allocated equally, each shareholder's share is $220,000, raising basis:
- Alan: $60,000 + $220,000 = $280,000
- Beth: $60,000 + $220,000 = $280,000
Then distributions of $220,000 each are applied against basis:
- $220,000 distribution ≤ $280,000 basis → tax-free to the extent of basis; basis reduced to $60,000 each.
So on these assumptions the distributions are not taxable - but only because current-year income first increased basis. If the distribution had exceeded basis, the excess would be capital gain (§1368(b)(2)). Note the ordering rule: basis is adjusted for income before measuring the distribution.
Caveat: if the IRS recharacterizes part of Alan's distribution as wages (prior task), that portion is compensation, not a distribution, and is taxable wages - reducing the tax-free distribution amount.
3. Beth argues that because she is a passive investor she should receive the same tax treatment as Alan. Is her distribution treated identically, and does the passive activity rules change her result?
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Tax treatment of the distribution itself is the same - S corporation distributions are governed by §1368 basis rules regardless of whether the shareholder is active or passive. Beth's $220,000 distribution is tax-free to the extent of her $280,000 basis, same as Alan's (before any recharacterization of Alan's amount as wages).
However, the character of the income allocated differs under the passive activity rules (§469):
- Beth does not materially participate, so her $220,000 share of ordinary income is passive activity income. It can be offset by passive losses from other activities, but if she has none, it is currently taxable.
- Alan materially participates, so his share is nonpassive and cannot be sheltered by passive losses.
Also note: Beth's distributive share is not self-employment income (she performs no services), whereas Alan's recharacterized wages are subject to payroll tax. The exam tests that distribution mechanics are shareholder-neutral but income character and SE tax treatment are not.