S Corporation Shareholders and Distributions
By Renee Pantani, Manager, Tax Services
Tax planning for S Corporation shareholders should include a detailed review of distributions that were paid during the year.
If an S corporation is not paying a “reasonable” salary to a shareholder who provides services to the corporation, distributions to that shareholder may be recharacterized as wages subject to payroll taxes. Several court cases, most recently in the Case of David E. Watson PC, have held that dividend distributions to service-providing shareholders who received no salaries are actually disguised wages and can be recharacterized as salaries.
To determine whether wages paid to a shareholder are reasonable, courts have taken several considerations into account including the character and financial condition of the corporation, the role the shareholder plays in the corporation, the corporation’s compensation policy for all employees and the shareholder’s individual salary history, how the shareholder’s compensation compares with similarly situated employees of similar companies, and the level at which an independent investor would agree to compensate the shareholder.
Lets look at the following example:
Kay is the sole shareholder of KT, Inc., an S corporation. She works full time in the business. During the current year, the corporation has ordinary income from operations of $50,000. The corporation pays no salary to Kay, but distributes $50,000 to her during the year. If $50,000 is a reasonable salary for the services performed by Kay, the IRS could recharacterize the distributions as wages subject to payroll taxes. Payroll tax penalties could also apply. The income from the corporation would be amended to reflect the deemed wages and payroll taxes would be accrued.
Reclassifying distributions as loans to shareholders can be used to avoid taxable distributions when the shareholders want to receive cash from the corporation, and the balances in the shareholders’ bases, accumulated adjustments account (AAA), or previously taxed income (PTI) are insufficient to allow a nontaxable distribution.
Whether a shareholder’s withdrawals from a corporation are loans to the shareholder, repayment of loans from the shareholder, or distributions depends on whether, at the time of the withdrawals, the shareholder intended to repay the amounts received and the corporation intended to require payment. It is not sufficient, however, for a shareholder simply to declare that he or she intended a withdrawal to be treated in a certain way. Rather, the transaction must meet more reliable evidence that it is related to debt. Factors the courts have used to determine whether an advance is a loan or dividend include:
- The controlling shareholder of the corporation
- The size of the advance and whether there are repayment terms, interest charged, and collateral given
- Ceiling limits to the amount of advances
- How the advances are recorded on the books and records
- Notes executed by the parties
- Interest was paid or accrued
- Loan security offered
- Do the notes include a set maturity date
- Has the corporation forced repayment
- Is the shareholder in a position to repay the advances
- Did the shareholder attempt to repay the advances
- Consideration of earnings and dividend history of the corporation
The courts have stated that the preceding factors are not exclusive, and no one factor is determinative.
Jack is the sole owner of Smithco, Inc. Jack regularly withdrew corporate funds for his personal use, including withdrawals that consisted of various personal expenses paid by Smithco on Jack’s behalf. Jack also received a $100 check from Smithco every week on the same day he received his weekly paycheck. Jack’s withdrawals were recorded on Smithco’s books as stockholder advances. When Jack applied for a bank loan, he showed the amounts withdrawn from Smithco as a loan payable to the corporation.
Jack never executed any promissory notes in favor of Smithco for the funds he withdrew from the corporation. No interest was charged and Jack never secured any of the withdrawals with collateral. The corporation did not place a limit on the amounts Jack could withdraw, and there was no specified repayment schedule. No dividends were declared or paid to Jack.
Under these facts, the Tax Court applied the tests listed earlier and ruled that, considering all the facts, there was no intention to create a real debtor-creditor relationship. Thus, the withdrawals were reclassified as distributions.
The recent Watson Case has demonstrated that the IRS was victorious a case that was not clearly abusive. Those S Corporation owners where salaries are low compared to income and distributions may risk review and recharacterization by the IRS. Those shareholders who recognize compensation from an S corporation should consider a tax professional review of related party loans and distributions compared to wages.