The Court of Appeals for the Eighth Circuit, affirming a district court, has concluded that an S corporation shareholder-employee’s $24,000 salary in 2002 and 2003 was unreasonably low. As a result, it allowed the IRS to reclassify as salary over $67,000 in dividend payments to the officer during each of those years. This resulted in the corporation owing employment taxes on the reclassified dividend payments.
HATS observation: This is a long standing compliance issue with IRS, which feels that many service professionals try to minimize Medicare and Social Security taxes by routing what would otherwise be self-employment income through an S corporation and then paying themselves a nominal salary. Since the amount of compensation that an S corporation pays its employee-shareholder is within the employee-shareholder’s discretion, he may have an incentive to claim less than a reasonable salary and take from the S corporation other payments (e.g., dividends) that aren’t subject to employment taxes.
HATS observation: In 2010, the House but not the Senate passed legislation that included a crackdown on service professionals who try to minimize Medicare and Social Security taxes by routing their self- employment income through an S corporation and then paying themselves a nominal salary. In these times of revenue shortfalls and calls for fairness in the tax laws, similar legislation could reemerge.
Background. Employers are liable for FICA (Social Security) taxes on wages paid to their employees (Code Sec. 3111). In August 2008 the IRS warned 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. The IRS 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
- use of a formula to determine compensation
The Eighth Circuit noted that while the reasonable compensation issue normally comes up in determining whether a business is attempting to deduct too high an amount of compensation, IRS finds the concept equally applicable to employment tax cases. 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 bottom line here is that the IRS has been and will continue to be on the lookout to reclassify S-Corporate shareholder dividend payments as compensation when the shareholder is “active” in the day to day business activities of the company. Therefore, it is important for S-Corporation shareholders to determine reasonable salary parameters and document this action within its corporate minutes.