Court: IRS Can Reclassify S Corp Distributions as Wages

If you run your business as an S corporation, you are probably both a shareholder and an employee. As such, the corporation pays you a salary that reflects the work you do for the business. The first $110,100 of any employee's 2012 salary (including yours) is subject to a 13.3 percent federal employment tax rate. Of that, 10.4 percent is for the Social Security tax and 2.9 percent is for the Medicare tax. The 10.4 percent Social Security tax cuts out above the $110,100 wage ceiling, but the 2.9 percent Medicare tax continues to hit an unlimited amount of wages.

Note: For 2012 wages, the Social Security tax rate is reduced from the normal 12.4 percent to 10.4 percent (same as for 2011). However, the Social Security tax rate will return to the standard 12.4 percent in 2013 and beyond unless Congress takes further action.

A portion of the Social Security and Medicare taxes are withheld from your paychecks and the remainder is paid directly to the government by the S corporation in its role as your employer. (You must, of course, pay income tax at your personal level on salary received from the corporation.)

On its annual federal income tax return (Form 1120S), the corporation deducts your salary and the employer's share of Social Security and Medicare taxes. These corporate-level write-offs reduce the taxable income passed through to you on the Schedule K-1 you receive from the corporation. Whatever amount of corporate-level taxable income is left after deducting your salary and related employment taxes can then be paid out to you as a cash distribution without any Social Security or Medicare taxes due.

S Corp Status Can Reduce Employment Taxes

As the following example illustrates, the federal employment tax rules leave an opening that can potentially save you major amounts of taxes over the years.

Example with a Modest S Corp Salary: Let's say you're trying to decide if you should establish a single-member LLC (SMLLC) or an S corporation for your solely-owned small business. Assume that for 2012, you expect the business to earn about $100,000 after paying all expenses but before paying any Social Security or Medicare taxes. Also assume that if you choose the S corporation option, a $40,000 salary would be reasonable for your work in the business, albeit on the low side of reasonable.

· With an SMLLC, you would have to pay the 10.4 percent Social Security tax plus the 2.9 percent Medicare tax on all of your net self-employment income. The employment tax hit would be about $12,300.

· With an S corporation, you would only have to pay Social Security and Medicare taxes on the $40,000 amount taken out as salary. The employment tax hit would only be about $5,300.

You can expect to reap comparable federal employment tax savings year after year, assuming your business continues to generate about $100,000 of income adjusted for inflation.

Note: Setting a relatively low salary can also mean reduced deductible contributions to your tax-deferred retirement plan account. So if you place a premium on maximizing deductible retirement plan contributions, the modest salary approach illustrated in this example might not be right for you.

The IRS Knows the Game

The IRS is aware of the strategy of using modest S corporation salaries to reduce federal employment taxes for shareholder-employees. The tax-saving advantage is lost if the government successfully asserts that S corporation cash distributions are actually disguised salary payments. Then, the corporation can be hit with back employment taxes, interest, and penalties.

Back in 2002, a Treasury Inspector General for Tax Administration report said IRS auditors should be devoting substantial attention to the issue of understated compensation for S corporation shareholder-employees. Therefore, be prepared to defend stated shareholder-employee salary amounts as being reasonable for the work performed.

The Courts Have Weighed in, Including a Recent Decision

There have been several court decisions on the subject of paying minimal salaries to S corporation shareholder-employees in order to minimize federal employment taxes. These decisions make it clear that the IRS has the power to reclassify purported S corporation cash distributions as disguised shareholder-employee wages when stated compensation payments are unreasonably low. This means they are subject to federal employment taxes. (Cases include Joseph Radtke, S.C., 7th Circuit, 1990, and Veterinary Surgical Consultants, P.C., 3rd Circuit, 2004.)

These cases may not be very illuminating because they involve obvious compensation understatements where stated salaries for shareholder-employees were zero or next to nothing. A recent decision was more informative.

Facts of the New Case: An individual replaced his partnership interest (the net income from which was subject to the Social Security and Medicare taxes in the form of the self-employment tax) with a 100 percent owned S corporation. The individual then functioned as an employee of the S corporation. For the two years in question, the S corporation paid him annual salaries of $24,000 and also paid him cash distributions of about $203,000 and $175,000, respectively. Upon audit, the IRS reclassified a portion of the cash distributions as wages subject to federal employment taxes. An Iowa District Court agreed. The shareholder-employee appealed to the Eighth Circuit, which agreed with the District Court. An IRS expert estimated that the shareholder-employee's services were worth an annual salary of about $91,000. Therefore, both courts concluded that the IRS was justified in reclassifying about $67,000 ($91,000 minus $24,000) of the purported cash distributions paid in each of the two years in question as additional wages that were subject to federal employment taxes (David Watson, P.C., 8th Circuit, 2012).

What's a Reasonable Salary?

The instructions to the Form 1120S, U.S. Income Tax Return for an S Corporation, state that "Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation."

The amount of the compensation never exceeds the amount received by the shareholder, either directly or indirectly. However, if cash or property (or the right to receive cash and property) did go to the shareholder, a salary amount must be determined and the salary level must be reasonable and appropriate.

There are no specific guidelines for reasonable compensation in the tax code or regulations. Various courts that have ruled on this issue have based their determinations on the facts and circumstances of each case.

Factors considered in determining reasonable compensation include:

· 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

· The use of a formula to determine compensation.

Conclusion: Because of the risk of assessments for back federal employment taxes, penalties, and interest, S corporation shareholder-employees should be sensitive to the issue of understated compensation paid to them. This is especially true for professional service S corporations. Gathering evidence to demonstrate that outsiders could be hired to perform the same work for salaries equal to the stated (modest) salaries paid to shareholder employees is a good idea. Contact your tax adviser if you have questions or want more information on this issue.