Your newest client, Alvarez, PC, is a law firm that provides legal services in the Houston area. The PC is a professional corporation under Texas law and is owned equally by Silvia Alvarez, a practicing attorney, and Jose Alvarez, also an attorney. Silvia and Jose have been married for 35 years and file personal returns jointly. Silvia is President of the corporation and manages the law practice for the firm. Jose is secretary of the corporation but is not involved in the practice or operations of the firm. He serves as a capital investor as needed.

For the past five years, Alvarez, PC has been organized as an S corporation, which they would like to continue. Prior to being an S corporation, it was organized as a sole proprietorship under Silvia Alvarez. Jose, who previously worked as an attorney at an oil and gas company, joined Silvia as a 50% shareholder when the PC was created.

For the current year the PC plans to pay Silvia a salary of $30,000 but no salary to Jose since he is not involved in the operations of the firm. The PC expects business net ordinary income for the current year to be $250,000 (before any salary payments to the owners). The owners will each take cash distributions of $100,000. Because the business is structured as an S corporation, the owners assume that they will not be subject to any payroll taxes on their share of the profits or their distributions, but only on Silvias $30,000 salary.

Required:

Help the two owners addressing in detail the issue of reasonable compensation to shareholder-employees of S corporations. In addition, address the issue of any tax penalties that they may face in an IRS audit of the corporation.