IRS Recharacterizes Dividend Payments to S Corp Shareholder as Wages

Watson, P.C. v. U.S., (DC IA 12/23/10) 

An Iowa district court has concluded that an S corporation shareholder-employee’s $24,000 salary in 2002 and 2003 was unreasonably low, and allowed the IRS to reclassify over $134,000 of dividend payments to the shareholder-employee as salary.  As a result, the corporation now owes employment taxes, penalties and interest on an additional $134,000 of wages.

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Certain industries are well known for planning to minimize Medicare and Social Security taxes by routing what would otherwise be self-employment income through an S corporation and then paying the shareholder-employee a nominal salary.  Since the amount of compensation that an S corporation pays its employee-shareholder is within the employee-shareholder’s discretion, he or she has an incentive to claim less than a reasonable salary and take from the S corporation other payments (e.g., dividends) that are not subject to employment taxes.  Because of the ease in which this type of financial manipulation takes place, it is a long-standing compliance priority for the IRS to limit these types of abusive arrangements.

The Facts of Watson v. U.S.  David E. Watson, an accountant, owned a professional corporation called DEWPC that, since its inception, has been taxed as an S corporation.  Watson was its sole shareholder, employee, director, and officer, and was the only person to whom DEWPC distributed money during the years at issue.  His $24,000 annual salary was documented in the corporate minutes, but in selecting his salary, Mr. Watson did not consider what comparable businesses paid for similar professional.  For both years at issue, Watson received dividend distributions from DEWPC that totaled over $175,000 annually.

On Feb. 5, 2007, the IRS assessed $48,519 in taxes, penalties, and interest against DEWPC for the eight calendar quarters of 2002 and 2003.  The IRS made these assessments after it determined that the wages paid to Mr. Watson were not reasonable given the circumstances, and that portions of the dividend distributions from DEWPC to Watson should have been characterized as wages subject to employment taxes.  DEWPC later paid $4,063.93 toward these assessments and then filed a claim for refund of the payments.  The IRS denied the refund claim and DEWPC sued in federal district court.

What is a “Reasonable Salary?”  IRS Fact Sheet 2008-25, August 2008, lists the following factors that courts have considered in determining reasonable compensation:

  • – 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
  • – use of a formula to determine compensation.

The District Court’s Ruling.  The district court said that the proper tax treatment of funds disbursed by an S corporation to its employees or shareholders turns on an analysis of whether the payments were remuneration for services performed.  After reviewing the facts, the court concluded that DEWPC structured Watson’s salary and dividend payments in an effort to avoid federal employment taxes, with full knowledge that the dividends paid to Watson were actually “remuneration for services performed.”  With the assistance of expert testimony, the court determined that a reasonable salary for a person acting in Watson’s role as DEWPC’s sole shareholder, officer, and employee would be $91,044 – far more than the $24,000 salary he had been paying himself.  The court pointed out that Watson was an exceedingly qualified accountant, with both bachelor’s and advanced degrees, working as one of the primary earners in a reputable firm that had over $2 million in gross revenues in 2002 and nearly $3 million in 2003.  Accordingly, DEWPC now owes employment taxes, penalties, and interest on $134,000 of dividend distributions paid in 2002 and 2003, that the court reclassified as wages.

Although this ruling originates from Iowa, it is instructive for Virginia taxpayers because it is based on the interpretation of the Internal Revenue Code and the application of federal case law.  Accordingly, any closely held corporation, which may be attempting to bail out ordinary income in the form of dividends or non-taxable shareholder distributions, must be cognizant of the possibility that IRS may recharacterize those distributions as wages, causing the business to owe additional employment taxes, including penalties and interest.