S CORP OFFICERS ARE EMPLOYEES: IF THEY PERFORM SERVICES, DISTRIBUTIONS WILL BE RE-CHARACTERIZED AS WAGES IN AMOUNT OF DETERMINED REASONABLE COMPENSATION

Yet another court has held that under the Federal Insurance Contributions Act (FICPA), an officer of an S Corporation is an employee and must be paid reasonable wages if he or she performs services.  Distributions will be re-characterized as wages, subject to SSA and Medicare withholding if no compensation is paid or if compensation is paid but in an amount that is unreasonably low. 

In David E. Watson PC v. U.S., No 11-1589 (8th Cir. 2/21/12), Mr. Watson worked for his Professional Corporation (PC) as a CPA. His PC became a 25% partner in an accounting firm.  Watson had an employment agreement with his PC but provided all of his services to the accounting firm.  In the years 2002 and 2003, PC paid Watson a salary of $24,000.  In addition, the PC paid cash distributions to Watson in the amount of $203,651 during 2002 and $175,470 during 2003.  The net effect was that all of the net profit of the PC was paid out to Watson as salary and distributions in both 2002 and 2003.

IRS determined that PC underpaid employment taxes for the years at issue under the FICA (IRC Section 3111(a) and (b). IRS assessed additional tax and penalties against PC for the eight quarters covering 2002 and 2003.  PC paid the tax, penalty and interest for the fourth quarter 2002, filed a claim for refund and, after its denial, sued in U.S. District Court.  The U.S. counterclaimed for the balance of the employment tax assessment for the other audited quarters in 2002 and 2003.

The District Court adopted the IRS CVA expert’s opinion that Watson’s reasonable compensation for services performed was $91,044.  The appeals court upheld the findings of the District Court.  The opinion recites some obvious reasons:

  •  The court observed, “The taxpayer bears the burden of proving that it overpaid its taxes and the IRS’s initial assessment was wrong.” Thus, the District Court required PC to prove it paid a reasonable salary to Watson.  PC attacked the IRS’s expert but did not provide its own evidence of reasonable compensation at trial.
  • Citing Joseph Radtke, S.C. v. United States, 895 F.2d 1196, 1197 (7th Cir. 1990), where as here, “The corporation is controlled by the very employees to whom compensation is paid, special scrutiny must be given to such salaries, for there is a lack of arm’s length bargaining.”  There is nothing new or remarkable in this quote.
  • While reasonable compensation disputes arise most frequently in connection with deductible expenses, IRS has long used the concept in employment tax disputes, (Rev Rul. 74-44, 1974-1 C.C. 287), to re-characterize dividends as compensation.  Published rulings of long-standing duration do not carry the weight of regulations, but are given deference by courts.
  • Courts apply the form versus substance doctrine to examine the reality of payments to shareholder-employees, especially for wholly owned professional corporations, regardless what the payments are called or what was the intent of the shareholder-employee or corporation.  Calling a rat a cat in tax law does not carry much weight.

Facts weighing against Watson:

  • He was an exceedingly qualified accounting with an advanced degree and nearly 20 years experience.
  • He worked 35-45 hours per week as one of the primary earners in the accounting firm which had above average earnings.
  • The salary paid to Watson was unreasonably low compared to salaries of similarly situated accountants.
  • The salary was exceedingly low compared to the distributions made by the accounting firm to PC.
  • The fair market value of the services Watson performed to PC was established as $91,044 with admissible expert testimony.

This case is especially noteworthy as the first case in which the shareholder-employee paid a salary that the court found to be unreasonably low.  The earlier cases cited by the 8th Circuit dealt with S Corporations that paid no salary at all. 

Practitioners and taxpayers should also note that unlike common law employees officers are statutory employees under Section 3121(d) (1).  Thus, unless they perform no services or minor services or are not entitled to remuneration, salary must be paid and that is reasonable in relation to the services performed and compensation of similarly situated professionals.  It is hard to argue that a sole shareholder professional investing little capital in his PC reasonably should expect a significant return on capital.  The shareholder is the sole service provider or the significant income producer, if there are other employees, and generated the personal service income.  Thus, it is difficult to justify nominal salaries or worse no salaries being paid with large dividend distributions made instead.

© 2012 by Robert S. Steinberg, Esquire
All rights reserved

This entry was posted in EMPLOYMENT TAXES, TAX and tagged , , , . Bookmark the permalink.

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