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S corp liable for paying low salary to sole shareholder

by on
in Small Business Tax Deduction Strategies

In a fight over whether payments from an S corporation to its sole shareholder are non-FICA-taxable dividends or FICA-taxable salary, the IRS has the final word. A federal trial court has ruled that the IRS had authority to recharacterize non-FICA-taxable dividends distributions from an S corp to its sole shareholder as FICA-taxable wages. (David Watson, P.C. v. United States, No. 4:08-cv-442, D.C. S.Iowa, 2010)

It’s lonely at the top

A tax accountant was the sole employee, shareholder, director and officer of an S corp. At corporate meetings, which the accountant conducted with himself, the S corp agreed to pay him an annual salary of $24,000; all other payments would be taken as dividends distributions. This decision was properly documented in the corporate minutes.

The breakdown: In 2002, he received $24,000 in salary and $203,651 in dividends. In 2003, he received $24,000 in salary and $175,470 in dividends. An IRS expert determined that a reasonable salary would have been $91,044. The IRS then assessed the S corp additional payroll taxes, penalties and interest.

Intent doesn’t count

The S corp paid a portion of the assessment and requested a refund, which was denied. The case moved into federal court, where the S corp argued that its intent to pay a salary determined whether the money paid to its shareholder was categorized as wages or dividends.

The court didn’t buy it and ruled for the IRS. Court: The S corp’s self-proclaimed intent to pay $24,000 in salary doesn’t limit the IRS’ ability to recharacterize dividends as wages. Rather, the characterization of funds disbursed by an S corp to its employees or shareholders depends on an analysis of whether the payments were made as remuneration for service provided. Factors in the court’s analysis:

  • The employee’s qualifications
  • The nature, extent and scope of the employee’s work
  • The size and complexity of the business
  • A comparison of salaries paid with gross income and net income
  • The prevailing general economic conditions
  • A comparison of salaries with distributions to shareholders
  • The prevailing rates of compensation for comparable positions in comparable companies
  • The company’s salary policy regarding all employees
  • For small corporations with a limited number of officers, the amount of compensation paid to the particular employee in previous years.

When is it payable?

The S corp tried to limit its losses by arguing that the additional salary it owed would have been payable during the first two quarters of the years at issue. This was a nonstarter for the court, as well. Court: Had the shareholder’s salary been set at $91,044 to begin with, he undoubtedly would have received it in ratable installments throughout the year, as virtually all salaried employees do.

What's a reasonable salary?

The IRS has extensive authority to review salaries to determine whether they’re reasonable, or, as in this case, to determine the character of the payment.

In addition to the factors listed by this court, you can analyze whether a salary is reasonable by comparing it to a typical salary paid to a recent college grad (here, the shareholder’s salary was far below a college grad’s), and whether a shareholder would hire himself out at that salary.

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