An S corp couldn’t get away with paying its sole shareholder-employee $24,000 a year in FICA-taxable salary, while also paying him large FICA-free dividends. According to a recent federal appeals court ruling, such an arrangement isn’t reasonable.
The S corp in Watson v. U.S. (Sup. Ct. Dkt. No. 12174, 2012) is now out of options, as the U.S. Supreme Court has refused to hear the case.
The IRS considers this an important case and has been watching it closely. With a win under its belt, it can continue to aggressively pursue S corps on this issue.
Intent doesn’t count. A tax accountant was the sole employee and shareholder of an S corp, which was a partner in an accounting firm. In 2002, his S corp paid him $24,000 in salary and $203,651 in dividends. In 2003, he again received $24,000 in salary and $175,470 in dividends.
The IRS determined that the S corp underpaid salary and FICA taxes and assessed additional FICA taxes, penalties and interest. The S corp paid a portion of the assessment and requested a refund, which was denied. In court, the S corp argued that its intent to pay a salary determined whether the amounts paid to its shareholder were wages or dividends. A trial court disagreed and ruled for the IRS, noting that the S corp’s allocation between salary and dividends wasn’t reasonable.
An appellate court affirmed the trial court’s decision. Court: Although reasonable compensation issues usually arise in the context of corporate, the principle for FICA taxes is the same. Since what counts is the economic substance of a transaction, rather than the form chosen by the taxpayer, it was appropriate for the IRS and the trial court to apply a reasonableness concept to FICA taxes, the court concluded.
REASONABLENESS RULES: Whether a salary is reasonable is a complex but crucial determination. Factors to consider:
- The employee’s qualifications
- The nature, extent and scope of his or her work
- How salaries compare with the company’s gross and net income and with distributions to other shareholders
- The company’s general salary policy
- The prevailing compensation rates for comparable positions at comparable companies.