The Dispute Over Newt Gingrich's Taxes: What is Reasonable Compensation to an S Corporation's Shareholder-Employee?

An article posted by Forbes last month brought up an interesting dispute regarding Newt Gingrich's tax planning technique.

What did Gingrich do? He treated only $444,327 of his S corporation's earnings as wages and reported the remaining $2.4 million in earnings as profits or dividends.  What is wrong with that?  By reporting only $444,327 in wages, he avoided paying Medicare tax on the remaining $2.4 million.  S corporations are flow through entities which means that they do not pay corporate income tax.  Their income flows through to their owners' individual tax returns.

My interest in this dispute came from a bog post by William M. Funk (RealTaxLaw) criticizing Forbes for not understanding tax planning.  The blogger describes Gingrich's allocation as "vanilla tax planning" and explains that the IRS usually only attacks "extreme cases" in which there is a substantial under-reporting of wages (i.e. a CPA who receive $24,000 in wages and takes $203,651 in distributions).  It is difficult to argue that anyone can be underpaid with $444,327 in wages.

On this issue, the IRS provides that "S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee".  In order to determine what is reasonable, the IRS looks to the sources of the S corporations's gross receipts.  These sources come in three major categories: (1) services provided by the shareholder-employee; (2) services of non-shareholder employees, or (3) capital and equipment.  If gross receipts are from second and third categories, they are not associated with the shareholder-employees's services and should not treated as his or her wages.  If, on the other hand, most of the gross receipts come directly from the shareholder-employee's services, they should be treated as wages.

In addition, the IRS goes on to say that the shareholder-employee should also receive wages for administrative work performed with the second and third categories.

So the real issue is what is the source of Gingrich's S corporation's earnings?  Forbes explains that according to Gingrich Productions' website, there is no suggestion that the company profits from anything or anyone other than the work of the Gingriches.  In fact, as Forbes points out, the "About Us" section of the website states that "together, Newt and Callista host and produce historical and public policy documentaries, write books and newsletters, give speeches, record audio books, produce photographic essays, and make television and radio appearances."

While this portion indicates that Gingrich Production relies upon the work of the Gingriches, it seems a little irresponsible to apply the IRS's reasonable compensation test to a public figure almost entirely on the basis of the above statement.  I would hope that if the IRS chooses to audit the Gingriches, they perform a more in-depth look at the sources of income.

Most likely, RealTaxLaw has a good point.  The IRS will probably not attack Gingrich's compensation as unreasonable.  Nevertheless, it is worth noting that public figures sometimes should go above and beyond to avoid public scrutiny.  For example, Forbes points out that President Barack Obama paid Medicare taxes on all his book profits ($1.4 million).

What will this damaging press cost Gingrich?

This content is not intended as legal advice, and cannot be relied upon for any purpose without the services of a qualified professional.