When a shareholder takes a distribution from the S corporation, no taxes are payable since income is already taxed to the shareholders as a pass-through.  If the shareholder takes a salary, income tax consequences are essentially the same. The salary is taxable to the shareholder, but it reduces the income of the S corporation, so the net result is a wash.

If not for FICA (Federal Insurance Compensation Act), either of these scenarios would be essentially identical.  This is an especially important consideration because the FICA hit increases every year.  In 2008, the shareholder/employee pays 7.65% (employee’s share; the employer pays a like amount) on up to $102,000 of earnings (in 2007, FICA applied to $97,500 of earnings). Between the employee’s and employer’s share, the total is $15,606. The employer’s share is, of course, deductible, but even so, the net outlay may still be over $11,000.[1]

Other Methods of Withdrawing Money from the Corporation

Aside from distributions, shareholders have other ways of taking money out of the corporation, repayment of loans, for example. . . .

So, why take a salary then?

Quite simply, because the law and the IRS say you must.  In a recent court case, the taxpayers took no salary from their S corporation. Instead, they withdrew funds by means of loans.

The corporation had no loan documents or other records showing the existence or amounts of the alleged loans and the corporation’s tax returns did not show any loans on the balance sheet accompanying the tax return. The taxpayer and his son entered into agreements with the corporation that their sole compensation for services would be their share of corporate profits.

The IRS thought otherwise. It argued that the agreements should be disregarded as devices to avoid paying employment taxes and the amounts paid to or on behalf of the taxpayer and his son should be treated as employee wages for personal services rendered the corporation. Under IRC Sec. 3121(d) an employee is:

Any officer of a corporation, or any individual who, under usual common law rules applicable in determining the employer-employee relationship, has the status of an employee.

The Court looked at the relationship between the taxpayers and the corporation and found that they were employees. After resolving that question, the Court had to determine what would be reasonable compensation. The Court looked at many of the same factors that courts look at when determining reasonable compensation when the IRS claims a shareholder/employee’s compensation is too high. However, because the corporation here kept no books or records, the Court just accepted the IRS's determination.  Had the corporation kept records, the taxpayers could have argued that a lower amount was more appropriate.[2]

S Corporations and Salary Payments to Shareholders - A Major Issue for IRS

The IRS has become increasingly aware of the abuses of the S corporation regarding payment of dividends (distributions) in lieu of salary.  Today, when one files a Form 2553 to elect the S Corporation, they will receive a Notice of Acceptance in 45 to 60 days.  The current notice reads as follows:

We would also like to take this opportunity to inform you of your obligations related to the payment of compensation to shareholder-employees of S Corporations.

When a shareholder-employee of an S Corporation provides services to the S Corporation, reasonable compensation generally needs to be paid. This compensation is subject to employment taxes.

Tax practitioners and Sub-chapter S shareholders need to be aware that revenue ruling 74-44 states that the Internal Revenue Service (IRS) will re-characterize small business corporation dividends paid to shareholders as salary when such dividends are paid to the shareholders in lieu of reasonable compensation for services.

The IRS may also re-characterize distributions other than dividend distributions as salary. This position has been supported in several recent court decisions.

The basic rule is that S officers’ salaries must be reasonable in amount and purely for services, according to Regs. Sec. 1.162-7(a). Moreover, under Regs. Sec. 31.3121(d)-1(b), officers are considered employees of a corporation when they provide substantial services to it.  Additionally, according to Rev. Rul. 59-221, S income is exempt from self-employment tax.[3]

S-Corporations veering from this narrow path are subject to an IRS re-characterization of the payments made from the corporation to an officer, such as dividends, draws and other distributions. This results in corresponding payroll taxes under Secs. 3111, 3301 and 3401 and, potentially, Sec. 6651(a)(1) failure to file penalties, Sec. 6656(b)(1) failure to deposit penalties and negligence penalties under Sec. 6662(c). The burden of proof is on the taxpayer to show that the income is properly characterized and reasonable.

S Corporation vs. Partnership / LLC

The IRS’s harsh position on re-characterization is the result of the difference in how tax law treats the business income of S corporations versus partnerships.  Partnership net earnings are net earnings from self-employment to other than limited partners, and most partners are therefore subject to self-employment tax on their share of the earnings.  On the other hand, a shareholder’s pro rata share of S corporation income that is “passed through” to the shareholder’s K-1 is not subject to self-employment tax [Revenue Ruling 59-221, 1959-1 CB 225; Paul B. Ding v. Commissioner, T.C. Memo 1997-435, affd. 200 F. 3d 587 (9th Cir. 1999)].  An incentive therefore exists to not pay much, if any, in salaries to shareholder/employees, in order to escape the imposition of both FICA and FUTA taxes.  From this point of view, simply reporting all income on the K-1 as an allocation is better than splitting it between a K-1 allocation and a salary payment.

The issue of unreasonably low salary payments to S corporation shareholder-employees has long been a chief audit concern of the IRS.  An analysis of recent rulings and decisions on the topic gives taxpayers little hope of circumventing the reach of the IRS on this issue.

Additional Dangers involved in Re-Characterization

IRS audits of S Corporations which pay out no salary to corporate officers have risen significantly in recent years.  The audits are highly profitable, so it appears that the Treasury Department will continue to target this potential abuse.

For example, in the case of a shareholder who takes a distribution of $100,000 and no salary, IRS can re-characterize this payout as salary and therefore, the corporation and taxpayer will be charged 7.65% FICA tax (plus additional FUTA tax to the Corporation).  Although this will reduce the income passed-through to the taxpayer’s K-1, the increase in revenue is nonetheless substantial to the IRS.

The IRS not only collects total FICA tax of $15,300 in this case and FUTA tax of $434, but it may also collect penalties from the corporation for not filing its employment tax returns (Forms 940 and 941), for late deposit of the employment taxes, and also for failure to withhold income taxes on the taxpayer’s salary.  Under IRC section 6651, the penalty for failure to file employment tax returns is 25% of the amount due. IRC section 6656 imposes a penalty of 10% of the amount due for failure to deposit the taxes. These penalties are assessed not only on the FICA and FUTA taxes due, but also on required income-tax withholding. Assume that in this case the corporation should have withheld 20% of the re-characterized salary payments, which is $20,000.  The penalties are assessed on this amount plus the $15,300 and $434, totaling $35,743. The IRS may assess penalties on this amount that total $12,510.

The IRS may also impose a 20% negligence penalty under IRC section 6662(a) if it believes that the actions of the corporation are due to a “failure to make a reasonable attempt to comply with the provisions” of the Tax Code or to any “careless, reckless, or intentional disregard” of the rules and regulations.  Depending on the facts, then, the corporation may also have to pay a negligence penalty of $7,148.  These penalties, totaling $19,658 would be applied before considering any interest payment on the underpayment of tax.

Any Hope for the Taxpayer?

Although the courts have consistently supported the IRS in these re-characterizations, taxpayers and their advisors continue to try and avoid the employment taxes. A review of relatively recent court decisions reveals taxpayers’ unsuccessful arguments.

More-recent cases take as their starting point the decisions in Radtke v. United States [712 F. Supp. 143 (E.D. Wis. 1989), affd. 895 F.2d 1196 (7th Cir. 1990)] and Spicer Accounting v. United States [918 F.2d 90 (9th Cir. 1990)]. In Radtke, a lawyer formed an S corporation and was the sole shareholder, the president, and the only full-time employee. The corporation did not pay any salary to the shareholder / employee (SE), but did make a cash distribution of its entire net income to the SE. Similar facts existed in Spicer Accounting, where the SE was the only accountant performing accounting services for the corporation, and the corporation did not pay any salary to him.

The courts in both cases noted that IRC sections 3121(a), pertaining to the FICA tax, and 3306(b), pertaining to the FUTA tax, define wages as “all remuneration for employment.”  The SE was clearly an employee of the corporation and even admitted so, but claimed that because he technically did not receive any wages from the corporation, but rather a “dividend,” no employment taxes were due. The courts, however, said that they were obligated to look at the economic substance of the transactions rather than their legal form. In doing so, they determined that the distributions were simply disguised salary payments, and thus upheld the IRS in its assessment of employment taxes.

Loans as Wages?

In Joly v. Comm’r [T.C. Memo 1998-361, affd. 211 F.3d 1269 (6th Cir. 2000)], the Tax Court and the Sixth Circuit Court of Appeals held that an S corporation’s distributions to a controlling shareholder were in substance wages subject to employment taxes. Furthermore, the court upheld the IRS’s assessment of a 20% negligence penalty.  In deciding that the distributions were disguised salaries, the court considered irrelevant a written agreement between the corporation and SE stating that no salary would be paid. A second agreement further stipulated that all distributions were merely advances against profits, and that if the distributions exceeded profits for the year, then the excess would be treated as a loan to the shareholder. This agreement too was ignored by the court, which looked at the true economic substance of the payments rather than their legal form.

Joly showed that the IRS and the courts will not be bound by specific written agreements between the corporation and the SE. Also, Joly signified that more than just distributions of profits are subject to reclassification as wages.  Loans from the corporation to the shareholder could also be reclassified, if the loan did not in substance appear to be a loan. In Joly there was no written evidence of a loan, merely bookkeeping entries adjusting a loan receivable account whenever distributions exceeded corporate income for the year. Nor was there stated interest on the loan. The court decided that no bona fide loan existed, so that these amounts could be classified as disguised wages.