The IRS last week won a battle in the war against S corporation owners who pay less salary -- and less FICA and Medicare tax -- than the government would wish. A U.S. District Court in Des Moines ruled against a Des Moines-area CPA who took only $24,000 annual salary of his approximately $200,000 in earnings for 2002 and 2003 from his CPA business. The court reclassed $67,044 of his S corporation distributions as salary for each year, giving him FICA/Medicare wages of $91,044.
The IRS hates the use of S corporations to minimize FICA taxes -- the so-called "John Edwards Shelter." S corporations are not taxed on their own income; instead the income is taxed directly on the tax returns of their owners via a K-1 information return. Unlike partnership income, S corporation K-1 earnings are not subject to the 12.4% combined employer-employee FICA tax and the 2.9% Medicare tax, S corporation shareholders try to get away with as low a salary as possible. That's why every IRS letter accepting an S election includes a stern warning to take an appropriate salary.
This case involved a CPA firm that was apparently set up as a partnership of S corporations, with a separate S corporation for each partner. Each S corporation would pay salary to its shareholder. The judge decided that $24,000 just wasn't enough (emphasis added):
A reasonable person in [the Taxpayer’s] role within [The CPA firm partnership] would unquestionably be expected to earn far more than a $24,000 salary for his services. As such, the $24,000 salary [the Taxpayer] opted to pay himself as [the S corporation’s] sole shareholder, officer, and employee, is incongruent with the financial position of [The CPA firm partnership] and in light of [the Taxpayer’s] experience and contributions to [The CPA firm partnership], and when compared to the approximately $200,000 in distributions [The S corporation] received in each of 2002 and 2003. Moreover, the $24,000 salary is low when compared to salaries that could reasonably be expected to be earned by persons with experience similar to that of [the Taxpayer], and holding a position such as [the Taxpayer] held in a firm comparable to [The CPA firm partnership]. Indeed, upon evaluation of all of the facts and circumstances in this case, the Court is convinced that [The S corporation] structured [the Taxpayer’s] salary and dividend payments in an effort to avoid federal employment taxes, with full knowledge that dividends paid to [the Taxpayer] were actually "remuneration for services performed."
So what does this mean for S corporation shareholders who don't want to pay more employment taxes than necessary, but who don't want trouble with the IRS? The decision is very fact-specific, with expert testimony on appropriate salary levels, so conclusions are tricky.
A good place to start is with the compensation of your best-paid non-shareholders. If a shareholder has comparable or heavier responsibilities than the best-paid non-shareholder, it seems unwise to pay the shareholder less than the non-shareholder. In this case the shareholder was paid less than a newly-minted accountant coming out of school.
Cite: David E. Watson, P.C., USDC IA-SC, #4:08-cv-442 (12/23/2010).
Reputation and skill (covering failed 2010 proposed legislation to force some S corporation K-1 income to be subject to self-employment tax).
The items included in the Tax Update Blog are informational only and are not meant as tax advice. Consult with your tax advisor to determine how any item applies to your situation.
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