View From McDermott: Recent Cases Confirm IRS Position— Shareholder-Employees of S Corporations Must Pay Themselves Reasonable Compensation

In David E. Watson, P.C. v. U. S., the U.S. Court of Appeals for the Eighth Circuit affirmed the imposition of employment taxes on a portion of dividend distributions made by an S Corporation to its sole shareholder-employee. ¹David E. Watson, P.C. v. U. S., 668 F.3d 1008, 2012 BL 39455 (8th Cir. 2012), cert. denied 133 S. Ct. 364 (2012). Significantly, the Eighth Circuit upheld the Internal Revenue Service’s requirement that reasonable compensation be paid to a shareholder-employee rather than allowing all or most income from the S Corporation to be paid as a dividend distribution exempt from employment taxes. Prior cases and IRS guidance previously focused only on the fact that some reasonable compensation would need to be paid as wages to S Corporation shareholder-employees rather than classified as an S Corporation dividend distribution or nonpassive net investment income. At stake is additional employment tax revenue for the IRS, an additional tax of 3.8 percent on amounts that are reclassified as wages for an S Corporation shareholder-employee rather than classified as a dividend distribution or nonpassive net investment income of the S Corporation. ²The 3.8 percent employment tax is comprised of the 2.9 percent Medicare tax that is part of the Federal Income Contributions Act (FICA) plus an additional .9 percent Medicare tax imposed on high wage earners under the Patient Protection and Affordable Care Act. Employer/employee and self-employment Social Security taxes that are part of FICA are only paid on the first $113,700 for 2013. Thus, depending on the income level of the shareholder-employee of the S Corporation, it is possible that even greater savings from payroll taxes could be realized if all S Corporation income was characterized as dividend income exempt from both Medicare and Social Security taxes.

The Tax Benefits of an S Corporation

In 2005, the Treasury Inspector General for Tax Administration issued a report that examined the payroll tax advantage S Corporations enjoy over sole proprietorships. The report concluded that the total taxes paid by single-shareholder S Corporations were $5.7 billion less than the self-employment taxes that would have been imposed if the taxpayers were sole proprietors. In 2009, a U.S. Government Accountability Office report to the Senate Committee on Finance noted that, in 2003 and 2004 alone, S corporations had underreported their shareholder compensation by a combined $24.6 billion. Based on these figures, the IRS has a clear incentive to scrutinize an S Corporation’s classification of income as a dividend distribution or nonpassive net investment income rather than as compensation to a shareholder-employee.

As background, an S Corporation has a tax advantage because its income can be paid as a dividend distribution without being subjected to two levels of taxation. Dividend distributions by S Corporations are also not subject to the 3.8 percent employment tax discussed above. In addition, dividend distributions may not be subject to the new net investment income tax (NII tax) that applies for income earned after Dec. 31, 2012. Net investment income generally includes dividends, interests, rents, and royalties, but NII excludes S Corporation dividend distributions where the shareholder-owner is an active participant (i.e., 500 or more hours of services) in the business. Thus, S Corporations enjoy a significant advantage over partnerships and sole proprietorships on the employment tax side and over other sources of dividend income on the NII tax side. Naturally, shareholder-employees would like to characterize as much income as possible as S Corporation dividend distributions to avoid payment of employment taxes or NII.

IRS’s Position on Compensation
For S Corporation Shareholder-Employees

Revenue Ruling 74-44, 1974-1 CB 287, first articulated the IRS position that shareholder-employees of an S Corporation must be paid reasonable compensation. In Rev. Rul. 74-44, an S Corporation did not pay any wages to its two shareholders for their services and instead distributed dividends. The IRS took the position that it could re-characterize the nature of “dividend” payments for employment tax purposes because the dividends paid to the shareholders were in lieu of reasonable compensation for services. In later guidance, the IRS summarized its view regarding the payment of reasonable compensation to shareholder-employees of an S Corporation as follows:

Generally … if a shareholder of an S Corporation performs services for the corporation, any distribution to the shareholder, even if legally declared under state law by the S corporation as a dividend, will be characterized as “wages” subject to employment taxes where in reality the payments are for services. An S Corporation cannot avoid employment taxes merely by paying the corporate shareholder “dividends” in lieu of reasonable compensation for services performed. ³IRS Information Letter 2003-0026 (March 31, 2003).

In 2008, the IRS provided some additional guidance on how to determine reasonable compensation for shareholder-employees of S Corporations in IRS Fact Sheet 2008-25. Although this fact sheet does not provide any specific guidelines for determining reasonable compensation, it does provide the following nine factors that an S Corporation should consider when it characterizes income as reasonable compensation or dividends:

• training and experience,

• duties and responsibilities,

• time and effort devoted to the business,

• dividend history,

• payments to nonshareholder employees,

• timing and manner of paying bonuses to key people,

• what comparable businesses pay for similar services,

• compensation agreements, and

• the use of a formula to determine compensation.

Prior Case Law Involving Compensation
For S Corporation Shareholder-Employees

Historically, the IRS has challenged S Corporation distributions paid to shareholder-employees of S Corporations and has attempted to reclassify these amounts as compensation in two situations: where either the shareholder-employee received nonpassive net investment income from the S Corporation or where the shareholder-employee received dividend payments from the S Corporation. The IRS first challenged the nonpassive income characterization in 2002 inVeterinary Surgical Consultants, P.C. v. Commissioner. ⁴Veterinary Surgical Consultants, P.C. v. Commissioner, 117 T.C. 141 (2001), aff’d, 54 Fed. Appx. 100 (3d Cir. 2002). In VSC, the S Corporation shareholder-employee argued that all income from the S Corporation could be characterized as nonpassive income (not subject to employment taxes) rather than classified as passive income or wages (subject to employment taxes).

In VSC, the sole shareholder and officer alone provided all services on behalf of the S Corporation and generated all of the S Corporation’s income. The S Corporation did not pay the shareholder a salary. Rather, the S Corporation distributed its net income to the shareholder and reported the payments as nonpassive income on the Schedule K-1. Consequently, the S Corporation did not pay or withhold any employment taxes. In finding for the IRS, the Tax Court noted that the Internal Revenue Code generally defines “wages” for federal employment tax purposes as all remuneration for employment and includes an officer of a corporation in the term “employee.” The court therefore reasoned that “an officer who performs substantial services for a corporation and who receives remuneration in any form for those services is considered an employee, whose wages are subject to Federal employment taxes.” ⁵Id. at 7. The court further stated that “an employer cannot avoid Federal employment taxes by characterizing compensation paid to its sole director and shareholder as distributions of the corporation’s net income, rather than wages.” ⁶Id. at 8.

In JD & Associates, Ltd. v. U.S., the IRS again challenged the classification of S Corporation distributions. ⁷JD & Associates, Ltd. v. U.S., No. 3:04-cv-59 (D.N.D. May 19, 2006). In this case, the District Court of North Dakota reclassified S Corporation dividends as compensation to its shareholder-employee, determining that approximately 84 percent of S Corporation income should have been characterized as reasonable compensation. In JD & Associates, the sole shareholder of a successful accounting firm, who was a CPA with over 20 years experience, received wages of approximately 35 percent of the S Corporation’s income. The JD & Associates court carefully weighed the nine IRS factors outlined in IRS Fact Sheet 2008-25, but condensed these nine factors into three primary categories: employee performance, salary comparisons, and company conditions. Based on these three categories, the court reclassified a portion of the dividend distribution so that the shareholder-employee received reasonable compensation of approximately 84 percent of the S Corporation’s income, an increase in compensation subject to employment taxes of about 50 percent.

New Developments With Watson

Like the sole shareholder in JD & Associates, the Watson sole shareholder-employee was an experienced CPA. He had a master’s degree in taxation and almost 20 years of experience in accounting and taxation. In 1996, Watson incorporated David E. Watson, P.C. (DEWPC), and was its sole owner, shareholder, and employee. Watson came to own 25 percent of an accounting firm, Larson, Watson Bartling & Jaffer LLP (LWBJ) and transferred that individual interest to DEWPC. Watson was employed by DEWPC, but provided his accounting services exclusively to LWBJ in 2002 and 2003. From its inception, DEWPC elected to be taxed as an S Corporation. In both 2002 and 2003, DEWPC paid $24,000 to Watson as compensation. After DEWPC paid Watson’s salary and other expenses, it distributed all of its remaining income as a dividend to Watson. In addition to salary, Watson, through DEWPC, received total dividend distributions of $203,651 in 2002, and $175,470 in 2003.

The IRS examined DEWPC and applied the nine factors set forth in IRS Fact Sheet 2008-25. Based on an analysis of these nine factors, the IRS concluded that Watson had been underpaid for his services and that some portion of the dividend distributions should be re-characterized as reasonable compensation, subject to employment taxes.

Based on existing case law, Watson argued that the intent of the corporation is controlling and should determine the classification of reasonable compensation and dividend distributions. The IRS argued that the cases cited by Watson were not applicable because his salary was intentionally set low to avoid paying employment taxes. The IRS looked at comparable salaries for accountants and examined the profitability of DEWPC. Importantly, the IRS also used a compensation expert to present evidence that the fair value of Watson’s services was $91,044 for each year.

The Eighth Circuit agreed with the IRS and concluded that Watson had underpaid himself. In reaching its conclusion, the Eighth Circuit relied on the IRS’s evidence showing that the $24,000 salary was unreasonably low as compared to other similarly educated and experienced accountants and was “exceedingly low” when compared to the income allocated to DEWPC by LWBJ. The Eighth Circuit noted that there is little to differentiate an S Corporation that pays no salary from an S Corporation that pays so little salary that the salary does not accurately reflect reasonable compensation. ⁸On Jan. 22, 2013, Rep. Charles B. Rangel (D-N.Y.) introduced legislation in the U.S. House of Representatives to narrow the exception for employment tax withholding used by S Corporation shareholders. H.R. 348 amends the Internal Revenue Code and Title II (Old-Age, Survivors, and Disability Insurance Benefits) of the Social Security Act to require a shareholder of an S Corporation engaged in a professional service business to include all items of income or loss attributable to such business in determining such shareholder’s net earnings from self-employment for purposes of computing employment tax liability. The bill has been referred to the Committee on Ways and Means. The bill is not expected to garner enough votes to be enacted.

Summary

Given the IRS’s position and its successful legal challenges, including the new Watson decision, it is clear that the designation and classification of reasonable compensation for shareholder-employees of S Corporations will continue to be an IRS focus. While the Watson case clearly does not require all profits to be characterized as reasonable compensation subject to employment taxes, some reasonable amount of compensation must be received by an S Corporation shareholder-employee and cannot be classified as dividend distributions or nonpassive net investment income. S Corporations whose shareholders provide professional services similar to those in Watson and JD & Associates should carefully analyze and be ready to defend the amounts designated by their S Corporations as dividend distributions and reasonable compensation. Although the Watson case does not eviscerate the tax advantages of an S Corporation, it does give shareholder-employees more clarity regarding the amount of income that can be designated as reasonable compensation rather than dividend distributions.