By Walter G. Antognini

S corporation shareholders might naturally prefer to receive cash from their corporations as distributions instead of wages, so as to avoid employment taxes such as FICA and FUTA. The IRS has long maintained its ability to recharacterize distribution payments as the payment of wages, thereby subjecting that payment to associated employment taxes. Court cases back up the IRS on this strategy and recent advisories from the IRS indicate a renewed interest in addressing these situations. Therefore, S corporations and their advisors should reexamine their situations to determine possible liability exposure.

Background

Treatment of S corporation distributions. As a pass-through entity, the S corporation requires only one level of taxation. S corporation income is passed through to its individual shareholders, who then report their allocable share of the corporation’s income on their individual returns, paying taxes on any income reported. The income passed through then increases the shareholder’s stock basis. If the corporation pays a distribution to the shareholder, the distribution is not taxed again. Unlike the general treatment of C corporation distributions, the general treatment of S corporation distributions is that no one pays a tax. Instead, the shareholder treats the distribution as a return (reduction) of basis. Hence, there is typically no significant downside to paying distributions. The income has already been taxed, and the distribution just completes the analysis.

Treatment of wages paid by an S corporation. The treatment of wages in an S corporation is largely, though not entirely, comparable to that of a C corporation. The wages, if reasonable, provide the corporation a deduction, while increasing the employee’s income. Thus, in one sense, wages provide a C corporation with the ability to limit the taxation on pre-wage operating profit to one level; effectively, the income is taxed to the individual, not the corporation, because the corporation offsets its pre-wage operating profit by the deduction. This comparative advantage generally does not exist for an S corporation because, as a general rule, the S corporation faces a single level of taxation.

Both S and C corporations generally treat wages as simply that. This treatment extends to the income tax treatment (deductible to the corporation) as well as the employment tax treatment. Thus, both S and C corporations must withhold Social Security and Medicare taxes, then match that withholding on wages paid. This combined tax burden equals 12.4% on wages to cover the Social Security obligation and 2.9% for Medicare. While the former, in 2003, applies to only the first $87,000 per employee, the latter has no limit. Other taxes, such as FUTA and state and local obligations, may also be required on wages paid.

Distribution Strategy

Based on the above factors, taxpayers generally gain an advantage by having an S corporation pay cash out to a shareholder/service provider as distributions instead of wages. This strategy, when not addressed by the IRS, allows taxpayers to avoid paying employment taxes, a relatively significant savings. This also has the effect of getting cash out to the individual, without generally changing the overall amount subject to income tax. In some instances, a distribution payment in lieu of wages can have, if not checked, the further benefit of reducing the individual’s earned income for purposes of determining the Social Security benefits that he receives as a “retired” person.

The IRS Addresses the Situation

An obvious issue arises in the context outlined above. Where a shareholder provides services to the S corporation, and especially where those services are a major (if not entire) component in producing corporate revenues, are not its payments to the shareholder/service provider substantively more like wages, notwithstanding the label attached to the payment by the taxpayers? The IRS certainly believes so, and it has had significant success in pressing its position.

In Revenue Ruling 74-44, the IRS established the position that the dividends an S corporation arranged to pay out to two sole shareholders, instead of paying reasonable compensation in the same amounts, constituted wages for which the corporation was liable for employment taxes. This position has been backed by courts in numerous cases, such as Joseph Radtke v. U.S., Spicer Accounting v. U.S., Joly v. Comm., and Veterinary Surgical Consultants v. Comm., some of which involved circuit court appeals that also held for the IRS.

In a variation on this theme, the case of Joseph M. Grey v. Comm., decided by the Tax Court in September, 2002 (119 T.C. No. 5), involved an attempt to avoid wages by having the corporation pay the sole shareholder as an independent contractor. The essence of the taxpayer’s argument was that Grey was not an employee. The court found that as an officer providing substantial services, Grey could not escape being characterized as an employee. Accordingly, the corporation was liable for employment taxes.

While most of the precedents for the IRS position have existed for years, it has recently indicated its intent to more vigorously press its point. The Treasury Inspector General for Tax Administration issued a report intended for the Commissioner, Small Business/Self-Employed Division (“The Internal Revenue Service Does Not Always Address Subchapter S Corporation Officer Compensation During Examinations,” Reference Number: 2002-30-125, Audit #200130027), which reports its position and recommendations on the matter.

Pursuant to the audit of examinations conducted for that report, 84 S corporation cases were “judgmentally selected” from a population where each case involved officer compensation less than $10,000 and ordinary income greater than $50,000. In these cases, average wages reported on Forms W-2 and 1120S were $5,300, while average Schedule M-2 distribution was $349,323. The large variance between wages and distributions suggest a significant underreporting of the former in those cases selected. Of the 84 cases reviewed, no corporate distributions were reported on 26 returns, presumably narrowing the focus to the remaining 58 cases. In 13 of the 58, the IRS examiner apparently did not at all address the inadequate officer compensation issue. Those 13 cases involved distributions in excess of $12 million. An additional five cases did not contain sufficient examiner workpapers for analysis.

The report suggested four recommendations to overcome the problem of underreporting and the IRS examination thereof. Two of the recommendations in essence involved increased education and awareness and three involved better software resources to help identify possible problem cases. The first recommendation was to better train field personnel and also to provide software to evaluate reasonable officer compensation. The next two recommendations involved submitting internal Request for Information Services. It seems that a fairly significant issue for the IRS in tracking this problem is its inability to cross-reference information submitted by taxpayers. In other words, the IRS appears to have the information needed to go after many problem cases, but this information is not in a form or organization that allows ready access and cross-referencing. The final recommendation is to better educate taxpayers and their representatives about S corporation compensation tax obligations. An earlier study suggests that only a minority of the underreporting was intentional, and that, instead, a majority was from either insufficient tax law knowledge on the issue or misinterpretation of reporting requirements.

In his response of July 17, 2002, the Small Business Commissioner largely agreed with the concerns raised in the audit report, recognizing that the problem had “been a concern for quite some time.” The Commissioner set out various actions that had already been taken or were to be taken in response to the problem raised. These responses included actions on each recommendation set out in the report. While some doubt still remains about whether the internal information requests can be effectively satisfied anytime soon, the report and response thereto indicate a clear intent to better train field personnel on the distributions issue, thereby increasing the possibility of it being raised on audit. The two also indicate an intent to provide better resources to attack the problem, and to better inform taxpayers and their representatives of their obligations.

Taxpayer Considerations

The determination of reasonable compensation is seldom an easy one. In the context of large publicly held companies, the issue is almost always irrelevant because parties largely transact at arm’s length. In the context of closely held corporations, compensation paid to large or perhaps even sole shareholders can easily become distorted by tax considerations. This is certainly true for S corporations, where there may be no adverse tax interests between corporation and shareholder, and where distribution payments in lieu of wages suggest employment tax savings.

In order to avoid the taxes, interest, and penalties that might result from a recharacterization of distributions into wages paid to shareholder/employees, the IRS advises taxpayers to reexamine their treatment of payments to these persons. Where the amounts of wages paid are at least an approximation of reasonable compensation, it seems that the IRS’ ability to attack, not to mention its inclination, would be severely limited.