U.S. Supreme Court Not Interested in S Corporation Payroll Tax Planning
The IRS has been chasing this one for years: Many service professionals try to minimize Medicare and Social Security taxes by routing what would otherwise be self-employment income through an S corporation (making it dividend income) and then paying themselves a nominal salary. Since the amount of compensation that an S corporation pays its employee-shareholder is within the employee-shareholder's discretion, he has an incentive to claim less than a reasonable salary and take other payments (e.g., dividends) that aren't subject to employment taxes. In the Watson case, the lower courts found that the shareholder-employee's $24,000 salary in 2002 and 2003 was unreasonably low and allowed IRS to reclassify as salary over $67,000 in dividend payments in each of those years. This resulted in the corporation owing employment taxes on the reclassified dividend payments.
The IRS lists these factors that courts have considered in determining reasonable compensation:
- training and experience;
- duties and responsibilities;
- time and effort devoted to the business;
- dividend history;
- payments to non-shareholder employees;
- timing and manner of paying bonuses to key people;
- what comparable businesses pay for similar services;
- compensation agreements; and
- use of a formula to determine compensation.
In this case, an accountant (Watson) provided accounting services exclusively to an accounting firm and its clients as an employee of his own separate S corporation (DEWPC).
At shareholder meetings Watson held with himself in 2000-2002, he authorized a salary from DEWPC in the amount of $24,000 annually. In 2002 and 2003, DEWPC paid Watson $24,000 in funds designated as salary and paid federal employment taxes on that amount.
The IRS assessed $48,519 in taxes, penalties, and interest against DEWPC for the eight calendar quarters of 2002 and 2003. It made these assessments after it determined that portions of the dividend distributions from DEWPC to Watson should have been characterized as wages paid to Watson that were subject to employment taxes. DEWPC later paid $4,063.93 toward these assessments and then filed a claim for refund of the payments. IRS denied the claim and DEWPC sued in U.S. district court. The district court held the IRS was right in that the salaries were too low. The U.S. Court of Appeals agreed.
The Supreme Court is not a big fan of tax issues and, this month, declined to review this case. Accordingly, the decision is now final. The moral is that compensation can be lowered (and payroll tax managed), but making salary less than a third of income is pushing it.
