March 28, 2011

S Corporation Distributions Recharacterized As Wages By IRS

By Michael Ostafy, Senior Tax Manager, Tax & Business

S Corporation Distributions Recharacterized As Wages By IRS Tax & Business

In the Watson Case, a recent District Court decision, it was 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 $67,000 of distributions as salary to the officer during each of those years. In addition, the corporation owed employment taxes on the reclassified distribution payments. Prior to the court reaching its decision, the taxpayer sued the IRS claiming it did not have the authority to recharacterize the distributions as wages.

Facts: David E. Watson, an accounting specialist, was the sole shareholder, employee, director, and officer, of an S Corporation, DEWPC. His $24,000 annual salary was documented in the corporate minutes. In selecting his salary, he did not look at what comparable businesses paid for similar services. For both years at issue, Watson received distributions from DEWPC that totaled over $175,000 annually.

Court’s ruling: The district court found that DEWPC’s position was undermined by IRS revenue rulings and case law. The district court said that the proper tax treatment of funds disbursed by an S corporation to its 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 distribution payments in an effort to avoid federal employment taxes, with full knowledge that the distributions paid to Watson were actually “remuneration for services performed.”

There is no firm set of rules for quantifying the reasonableness of compensation. No definition of reasonable is contained in the Internal Revenue Code. The Regulations provide only that reasonable compensation is an amount paid for like service by like enterprise under like circumstances. Recent Tax Court decisions have focused on the following five factors:

  • the character and financial health of the corporation;
  • the functions the shareholder performs in the corporation, and the nature, extent, and scope of the work;
  • the employee-shareholder’s compensation compared with that paid to non-shareholder-employees or paid in prior years;
  • how the compensation compares with employees of other companies in similar roles; and
  • whether a theoretical, independent investor would determine that there is a sufficient return on investment after considering the shareholder’s wages.

This case is a reminder that the IRS can and will wield the authority where the facts allow A closely held S corporation, such as DEWPC, should evaluate the shareholders’ salaries to determine if they are adequate under the given facts and circumstances. The IRS will focus on corporations that generate significant net income while paying little or no stated wages to shareholder-employees. The above 5 factors need to be considered in determining reasonableness of compensation to its shareholders.

S Corporation owners need to discuss their Company’s relevant information with a tax advisor before year-end to either support the reasonable compensation position or to assist in adjusting it to reasonable amounts.

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