One of the opportunities that S corporations afford its shareholders/employees is the ability to divide its net income between wages and dividends. The advantage of course is that dividend payments are not subject to FICA or other employment related taxes. Thus, there is a desire on the part of shareholder/employee to have as much of the corporation’s net income paid as dividends as possible. The trick is knowing the right proportion that will not raise the interest of the IRS. A recent case gives us guidance on the test to use to determine the right proportion.
In Watson v. US, 2010 WL 5369530 ( S.D. Iowa, December 23, 2010) the court considered the case of an S corporation that together with other S corporations was the owner of an accounting firm. The S corporation’s sole shareholder, director, and employee was an accountant that performed accounting services for the accounting firm through his S corporation. The Service had recharacterized dividend and loan payments from the S corporation to the accountant as wages. The accountant paid the assessment and then challenged the recharacterization in court.
The IRS retained an expert who used compensation data from Robert Half International and the Management of an Accounting Practice survey conducted by the American Institute of Certified Public Accountants to conclude that the accountant’s wages from his S corporation were about one-fourth of what they should have been.
The court concluded that regardless of the form of the payment, distributions to a shareholder/employee that represent remuneration for services would be treated as wages. In making this determination the court looked at “(1) the employee’s qualifications; (2) the nature, extent, and scope of the employee’s work; (3) the size and complexities of the business; (4) a comparison of salaries paid with the gross income and the net income; (5) the prevailing economic conditions; (6) comparison of salaries with distributions to stockholders; (7) the prevailing rates of compensation for comparable positions in comparable concerns; (8) the salary policy of the taxpayer as to all employees; and (9) in the case of small corporations with a limited number of officers the amount of compensation paid to the particular employee in previous years.”
Applying these factors the court concluded that the S corporation structured the salary and dividend payments to avoid paying the federal employment taxes. The court also adopted the IRS expert’s determination of what constitutes a reasonable salary for the accountant.
- Marc Ward