Schutte & Hilgendorf – Prescott Accountants

IRS may recharacterize dividend payments to S shareholder-employee as wages
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.
RIA 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.
RIA 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 (see Federal Taxes Weekly Alert 06/03/2010).
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. (Code Sec. 3111) 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.
RIA Research References: For S corporation dividends as wages subject to withholding, see FTC 2d/FIN ¶ H-4329; TaxDesk ¶ 532,002.
Source:  Federal Tax Updates on Checkpoint Newsstand tab 1/13/2011

Should you have questions regarding this post or any other tax needs, contact us at Schutte & Hilgendorf, PLLC, Prescott accountants serving the greater Yavapai County with tax, accounting, auditing, and QuickBooks consulting expertise.