IRS Can Reclassify S Corp Distributions as Wages

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).

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 Marini & Associates, P.A. at 888 882 9243 or www.TaxLaw.ms if you have questions or want more information on this issue.