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Employment taxes: Listen to reason

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in Small Business Tax,Small Business Tax Deduction Strategies

Frequently, owners of C corporations are accused of receiving excessively high compensation amounts, to avoid having profits taxed at both corporate and individual levels. Conversely, S corporation owners may attempt to keep their salaries low to avoid employment taxes on wages.

Strategy: Arrange “reasonable” compensation for services actually rendered. In a case decided by the 8th Circuit early last year, the IRS prevailed when it questioned the amounts paid to the owner of a personal service firm established as an S corporation. (David E. Watson P.C., 668 F.3d 1008, 8th Circ., 2/21/12) Now the U.S. Supreme Court has refused to review the matter. Result: Case closed.  

Facts of the case: A CPA in Iowa was the owner and sole employee of an S corp contracted to work exclusively for another firm in which he was a 25% shareholder. In both 2002 and 2003, he was paid $24,000 in stated annual wages. But he also received $200,000 in purported dividends in 2002 and $175,000 in dividends in 2003. While wages are subject to federal employment taxes, S corporation dividends are not.

When the case went to trial, the government’s expert witness established the fair market value of the CPA’s accounting services to be approximately $91,000 per year. The expert relied on sev­­eral compensation surveys and studies to help form his opinion, taking into account factor such as the absence of any other employees in the S corp.

The 8th Circuit determined that an annual salary of $91,000 would have been a reasonable compensation for the CPA’s services. Accordingly, it sided with the IRS and upheld Social Security and Medicare tax deficiencies, penalties and interest totaling more than $23,000.

Tip: Expect the IRS to continue to take the same approach in other instances involving professional practices organized as S corporations, especially if it appears that the taxpayer has adopted a miniscule salary to reduce employment tax liability.

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