Does the IRS ever challenge a shareholder-employee’s compensation as too high?

Mary is the 100% shareholder of an S corporation she uses to provide her personal services to her clients. The corporation has no employee or other worker beyond Mary.  Mary is a young 63.

Mary intends to sell her client list to a buyer. The buyer will do an assets purchase. Mary keeps her corporation.

The clients choose whether to get services from the buyer. Clients are free to leave any time, without cause, and without significant notice. Because of this, the deal terms obligate Mary to remain available and devote reasonable time and effort to help the buyer keep Mary’s former clients. This obligation continues for 2022-2026.

After the deal closes, Mary is considering doing no work except the light touches needed to meet her hand-holding obligation.

Unless her tax lawyer (not me) tells her there is a better way, Mary anticipates receiving the buyer’s payments in Mary’s corporation.

Each year, the corporation would receive enough money to pay Mary wages, perhaps up to the IRC § 401(a)(17) limit, and pay pension funding and retirement contributions as generous as the actuary and third-party administrator I refer-in design and advise as proper.

In setting compensation for an S corporation’s shareholder-employee, usually the worry is that the IRS might challenge the compensation as unreasonably below the value of that worker’s services.  But does the IRS ever challenge a salary as too high?

Could the IRS argue that $305,000 is too big a paycheck for someone whose only work is a few calls to calm down a jittery former client and persuade them to stay with the buyer?

Or are there reasons why my question imagines more difficulty or risk than there really is?

And what other issues should I be thinking about?

I have no idea, but the attached article provides some interesting information.

https://www.cpajournal.com/2019/10/28/defining-reasonable-compensation-under-the-tax-code/

Belgarath, thank you.

Has anyone seen, even second-hand, a situation in which the IRS challenged a retirement benefit or contribution because it was determined on compensation the IRS asserted was not really section 415 compensation?

3 hours ago, Peter Gulia said:

Belgarath, thank you.

Has anyone seen, even second-hand, a situation in which the IRS challenged a retirement benefit or contribution because it was determined on compensation the IRS asserted was not really section 415 compensation?

 

Once, a family management company was restarted in order to bump-up the benefits for adult children who were last paid during their college years, but the DB was massively overfunded and could support full 415 limit payments.  They borrowed enough to pay the three kids three years full salaries but due to death of the actuary, got into a late filer and late restatement situation and went through VCP.  Since one was disabled, the other a medical supply company owner, and the third a philanthropist, they were asked to describe the work they did for those three years; but there was not a question as to the amount of service, just that it was for a business related purpose.

Also, consider the opposite perspective, think about a self-employed who works 3000 hours, but who has zero considered income.  The IRS doesn't care about their service, they don't have any considered compensation. 

Retirement plan compensation has to be for personal services performed.  If the S-corp's revenues are coming from the sale of assets, Mary has not provided any personal services to generate the income.  Assisting with keeping clients is to protect the investment.

Another issue - in the S-Corp tax return, the sale will likely show up as a capital gain while the salary and retirement plan expense will be ordinary expenses.  A large ordinary business loss every year with an equally large capital gain could raise a ref flag with the IRS, especially if the plan was audited.

IRS might and could, but it's a complicated facts and circumstances determination. I have been an expert witness in several dozen reasonable comp litigation cases. Several of my cases involved allegations of too-high total compensation  for various reasons. Belgarath provided a great resource for you. The article mentions several cases but the seminal case as I recall was Mayson with the Mayson factors which are quoted under another case name in the article.

Nate S., Dare Johnson, and Bob the Swimmer, thank you for your further information.