Tax Law and Business Organization Strategy

IRS Successfully Recharacterizes S Corporation Dividends as Salary

Many tax advisors have recommended that their clients use the S election to reduce their social security and medicare tax liability. This type of planning has been on the IRS’ radar screen for a while. Now we have a case where the S corporation did pay some wages to its owner, and a District court found that the portion of the dividend distributions that the IRS claimed to be salary substitutes were in fact salary, making them subject to social security and medicare taxes. The moral of the story: you better have good factual support for what a service corporation is paying the professionals working for the service business.

In Watson, P.C. v. U.S., (DC IA 12/23/10) 107 AFTR 2d ¶2011-305, a district court has concluded that an S corporation shareholder-employee's $24,000 salary in 2002 and 2003 was unreasonably low, and allowed IRS to reclassify as salary over $67,000 in dividend payments to the officer during each of those years. The corporation will also owe employment taxes on the reclassified dividend payments.

Facts. David E. Watson had a bachelor's degree in business administration and a specialization in accounting. He owned a professional corporation (PC) called DEWPC that, since its inception, had elected to be taxed as an S corporation. Watson was its sole shareholder, employee, director, and officer, and was the only person to whom DEWPC distributed money during the years at issue. His $24,000 annual salary was documented in the corporate minutes. In selecting his salary, he did not look at what comparable businesses paid for similar services. For both years at issue, Watson received dividend distributions from DEWPC that totaled over $175,000 annually.

On Feb. 5, 2007, IRS assessed $48,519 in taxes, penalties, and interest against DEWPC for the eight calendar quarters of 2002 and 2003. It made these assessments after it determined that portions of the dividend distributions from DEWPC to Watson should have been characterized as wages paid to Watson that were subject to employment taxes. DEWPC later paid $4,063.93 toward these assessments and then filed a claim for refund of the payments. IRS denied the claim and DEWPC sued in district court.

Background. Employers are liable for FICA (Social Security) taxes on wages paid to their employees. Fact Sheet 2008-25, August 2008 warns S corporations not to attempt to avoid paying employment taxes by having their officers treat their compensation as cash distributions, payments of personal expenses, and/or loans rather than as wages. Fact Sheet 2008-25, August 2008 lists these factors that courts have considered in determining reasonable compensation:

  • training and experience;
  • duties and responsibilities;
  • time and effort devoted to the business;
  • dividend history;
  • payments to non-shareholder employees;
  • timing and manner of paying bonuses to key people;
  • what comparable businesses pay for similar services;
  • compensation agreements; and
  • use of a formula to determine compensation.

DEWPC argued that IRS did not have the authority to recharacterize any of the dividend payments as compensation. DEWPC cited three federal court cases to support its argument.

Court’s ruling. The district court found that DEWPC's position was undermined by IRS revenue rulings and case law. For example, in Rev Rul 74-44, 1974-1 CB 287, IRS concluded that dividends received by an S corporation's two sole shareholders were wages for which the corporation was liable for FICA, FUTA and income tax withholding. In Joseph Radtke v. U.S., (DC WI 4/11/89) 63 AFTR 2d 89-1469, aff'd, (CA 7 2/23/90) 65 AFTR 2d 90-1155, a district court determined that certain funds designated as dividends were actually compensation for which an S corporation owed employment taxes. The district court was not persuaded by the rulings that DEWPC cited because in those rulings, the taxpayer was attempting to recharacterize funds, whereas in DEPW's case, it was the government that was attempting to recharacterize the funds.

 The district court said that the proper tax treatment of funds disbursed by an S corporation to its employees or shareholders turns on an analysis of whether the payments were remuneration for services performed. After reviewing the facts, the court concluded that DEWPC structured Watson's salary and dividend payments in an effort to avoid federal employment taxes, with full knowledge that the dividends paid to Watson were actually “remuneration for services performed.” The court believed that a reasonable person in Watson's role as DEWPC's sole shareholder, officer, and employee would be expected to earn far more than a $24,000 salary for his services. The court pointed out that Watson was an exceedingly qualified accountant, with both bachelor's and advanced degrees, working as one of the primary earners in a reputable firm that had over $2 million in gross revenues in 2002 and nearly $3 million in 2003.

As a result of the ruling, DEWPC will owe employment taxes, penalties, and interest on the 2002 and 2003 dividend distributions to Watson that were reclassified as salary.

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Comments (4) Read through and enter the discussion with the form at the end
John - January 27, 2011 7:47 PM

From 2002-2003? isn't there a statute of limitations in this?

John - January 28, 2011 10:45 AM

Thanks prof,
so IRS said that he did this willfully since he knew /should have known better given his tax education.

I have a question, and I know all the disclaimers about internet advice on a case without knowing 100%, I'm merely just looking for a general idea:

Suppose you make a living with this blog. You work 2-4 hours a day, max. If asked, IRS will be easily convinced, say, you only post 2 stories a day and it's obvious that a story can be written in an hour or two. Now you post an ad for Turbotax or loans and Google just brought you a gazillion people a day, all of the sudden. From those 2-3 hours a day you now make $150,000 a year. How much salary COULD one declare and be fine with it, if audited? Obviously all other taxes are paid on the income and everything is declared.

The financial results are not really the result of your hard work, your blog posts are mediocre, but you got lucky. Most reasonable people would agree with that. Maybe you got a link from CNN or maybe because you have a good domain name. Or say you have the name and people come there make you money mostly for the name. You could absolutely hire a person for $40 a day to do the same work you do and money is definitely not consistent. So, if you are the IRS auditor, what would you do /accept as OK?

Jack Howell - January 31, 2011 11:21 AM

There is a statute of limitations on actions like these. I suspect that it just took several years for the audit to run its course and then to get the case actually tried and decided in the tax course. The wheels of justice do not turn quickly.

The second question actually has layers on layers of issues, particularly, factual issues that it is virtually impossible to respond to. For example, what did I make before on the blog, and who was paying it? But I think fundamentally, John is asking how do you delineate between income from "services" and income from "property." That is something that is still being determined as these cases point out. I expect the IRS auditor would take the position that all of the income is from my labors as the sole blog poster. My response would be that the income is all from my sale of property rights and advertising space, which is not service income. These cases show that it is hard to predict which argument the courts are going to agree with right now.

Alby - March 25, 2011 8:10 AM

I suppose the best thing to do is to gauge your salary on and pay yourself the lowest tier to avoid the IRS claiming you aren't paying yourself enough.

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