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

By James A. Fellows and John F. Jewell

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The IRS’s position 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. This article reviews the means that taxpayers use to avoid the payment of employment taxes, and also describe the logic of the IRS and the courts in preventing this avoidance.

Defining Unreasonable Compensation

Unreasonable compensation is always a matter of facts and circumstances, so any salary to an S corporation shareholder-employee (SE) that is below a reasonable amount is a red flag to the IRS—especially when the salary is zero. Indeed, in almost all of the court decisions on this issue, no salaries had been paid to the SE. For this reason, the example below uses no salary; however, any salary to an SE below a reasonable amount is subject to IRS scrutiny.

Example: Harry is the sole shareholder and CEO of an S corporation and works “full time” for the corporation. Before considering any salary payment to Harry, the corporation has $100,000 of net taxable income from business operations for 2005. Harry also took a $100,000 cash distribution during the year. If Harry takes no salary from the corporation, the $100,000 is simply “passed through” to Harry on his K-1 for reporting in his own Form 1040 tax return. In this scenario, the $100,000 would be free of any FICA and FUTA tax, at both the corporate and the employee level.

Assume that Harry has significant investment income, so that he is in the 30% marginal tax bracket. His income tax on the $100,000 is $30,000, generating after-tax cash flow of $70,000.

Furthermore, assume that two years later the IRS audits the corporate tax return. The IRS determines that a reasonable compensation to Harry for his services is $90,000. This is the maximum amount in 2005 that is subject to the 6.2% Social Security portion of FICA, so when combined with the 1.45% Medicare portion, the entire $90,000 is subject to the 7.65% FICA tax. Because the $90,000 salary is deductible by the S corporation, the income reported to Harry on his K-1 is reduced. The corporation and Harry must pay, respectively, the employer and employee shares of FICA tax: 7.65% of $90,000, or $6,885 each. In addition, the IRS assesses the corporation a FUTA tax of 6.2% on the first $7,000 of the salary ($434).

The IRS adjustments reduce the corporation’s net taxable income from $100,000 to $2,681, as shown in the Exhibit. The $2,681 is “passed through” to Harry on his K-1, and his income tax on this amount is $804. Harry also pays an income tax on his salary payment, $90,000 times 30%, or $27,000, as well as the $6,885 in FICA tax. The IRS adjustments reduce Harry’s net cash-flow to $57,992, almost $12,000 less than without a salary, as also shown in the Exhibit.

But perhaps more important, at least as far as the IRS is concerned, is the increase in tax revenues collected. The IRS not only collects total FICA tax of $13,770 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 Harry’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 Harry’s case the corporation should have withheld 20% of the recharacterized salary payments, which is $18,000. The penalties are assessed on this amount plus the $13,770 and $434, totaling $32,204. The Exhibit shows that the IRS may assess penalties on this amount that total $11,271.

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, Harry’s corporation may also have to pay a negligence penalty of $6,441. These penalties, totaling $17,712 if the negligence penalty is included, could reduce Harry’s cash flow to almost $40,000, before considering any interest payment on the underpayment of tax.

Radtke and Spicer

As shown, the IRS can seriously impact S corporation and shareholder cash flow through any recharacterization of distributions as salaries. Although the courts have consistently supported the IRS, taxpayers and their advisors continue to try and avoid these 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 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.

Joly: 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.

VSC: The 530 Plan

In a flurry of court decisions, the Tax Court, supported by the Third Circuit Court of Appeals, chose to make “public announcements” about its view on a technique that taxpayers have resurrected to avoid employment taxes. The authors call this the “530 plan.” The first of the Tax Court decisions was Veterinary Surgical Consultants (VSC) v. Comm’r (117 T.C. 141, 10/15/2001; affd., unpublished opinion, 3rd Cir. 3/10/2004). In VSC, an S corporation distributed all of its business income to its sole shareholder and only corporate officer. The SE spent an average of 33 hours per week performing corporate activities. The S corporation did not treat any of the distributions during the year as wages, but the IRS asserted that most of the distributions were wages subject to employment tax.

In its argument that the SE was not an employee for purposes of FICA and FUTA, the taxpayer raised two points. First, it argued that IRC section 1366 mandates that the shareholder report all income from the S corporation in the same manner as it is earned by the corporation. For example, if $100,000 of business income is earned by the S corporation, the shareholders report $100,000 of business income, with no requirement that the $100,000 be reduced by any salary payment to the SE. The court rejected this argument as a misreading of the statute, noting that IRC section 1366 simply mandates that the corporate income be reported by the shareholders for income tax purposes. It does not apply in any way to the computation of employment taxes owed by the corporation. Therefore, IRC section 1366 had no bearing on the case.

The second point raised by the taxpayer in VSC was the “530 plan,” a technique that was raised about a decade earlier in Spicer Accounting. The technique is based not on IRC section 530, which deals with Coverdell education savings accounts, but on section 530 of the Revenue Act of 1978. Under this rule, which was never included as part of the IRC itself, relief from employment tax liability is granted if the corporation has never treated the SE as an employee for any period, and all federal tax returns are filed consistent with the SE not being treated as an employee. This simply means that the SE reports all the corporate income in his tax return, with payments treated as distributions of income rather than wages. However, section 530(a)(1) states that employment tax relief will not occur if the corporation “had no reasonable basis for not treating such individual as an employee.”

Revenue Act section 530(a)(2) goes on to say that the corporation can have a reasonable basis for not treating the SE as an employee only if there is sufficient judicial precedent or published rulings to do so; if a past IRS audit of the corporation did not treat the SE or similarly situated individuals as employees; or if there is long-standing industry practice not to treat such individuals as employees. In its decision in VSC, the court reasoned that none of the three stipulations were met, so that the SE was classified as an employee, resulting in employment tax liabilities for the corporation. Because there are no cases or rulings favorable to taxpayers here, the only chances of getting Section 530 relief is under the industry standard or if the taxpayers have already passed muster in a previous IRS audit.

Grey and Similar Decisions

The “530 plan” became a focus of attention within the Third Circuit due to a series of connected cases in Pennsylvania, including VSC. The cases were connected because the affected taxpayers shared the same accountant, Joseph M. Grey, who was also the subject of one case.

In Joseph M. Grey v. Commissioner (119 T.C. 5, 9/16/2002, affd. unpublished opinion, 3rd Cir. 4/7/2004, cert. denied, 125 S.Ct. 60, 10/4/2004), Grey operated his accounting practice through an S corporation in which he was sole shareholder and president. He took no salaries from the corporation, although he performed most of the services of the corporation. Instead, he withdrew money from the corporate accounts when needed, treating these withdrawals as distribution of profits. The corporation did, however, make small payments each year to Grey that were classified as payments to an independent contractor.

The court held that the SE (Grey) was an employee and that the money withdrawals were wages subject to employment tax. The SE was a corporate officer, and under IRC section 3121(d)(1) officers are “statutory employees.” Only if a corporate officer performs no services, or performs only minor services and receives no remuneration, can he be considered not to be an employee. Because the SE worked full-time for the corporation, his status was that of an employee.

The court also dispensed with the “530 plan,” holding that the corporation had no reasonable basis for not treating the SE as an employee. The fact that some small remuneration was paid to Grey as an independent contractor was not controlling, and in no way provided a reasonable basis for treating him as something other than an employee. In fact, the court went out of its way to state that section 530 relief did not even apply to “statutory employees” such as corporate officers. Rather, section 530 relief applies only to a determination of whether “common law employees” should be treated as independent contractors. The court’s argument involved a detailed discussion of the legislative history of the section 530 rule, and the court went to lengths to state that “this issue is over and done with.”

The “children” of Grey. Five other decisions connected to Grey were subsequently handed down by the Tax Court, with affirmations from the Third Circuit (see the Sidebar). The Tax Court decisions were all dated February 26, 2003, and it is no coincidence that they read almost identically except for the names of the taxpayers involved. The cases all dealt with a group of corporations to whom Joseph Grey had rendered services. All had basically the same issues as Grey: lack of payment of reasonable salaries to the corporate officers who were controlling shareholders and who rendered significant services to the company. In all of the cases the “530 plan” was argued by the taxpayers, and in all cases, the Tax Court and the Third Circuit held that section 530 relief does not apply to “statutory employees” such as corporate officers.

The cases all involved payments to corporate officers (i.e., “statutory employees”) who were either the sole or controlling shareholders of the S corporation. All were the primary employees of the corporation, working full-time in that capacity. None received any salary payments, though distributions of the corporate profits were made. At this point the Tax Court and the Third Circuit were adamant in reclassifying the payments as wages subject to employment tax. One can confidently conclude at this point that taxpayers have lost the battle with the IRS and the courts on the issue of salary payments by S corporations to their shareholder-employees.

What Is Reasonable Compensation?

Reasonable compensation is a question of fact, not of law. As for determining reasonable compensation, the courts usually let the IRS and taxpayers negotiate this. Unsurprisingly, the more skilled and critical the role of the SE, the higher the salary should be. An S corporation that lists no deduction for salary payments to officers on the 1120S is inviting IRS scrutiny. Paying the SE a token salary does not ensure against an IRS audit, although the red flag is not quite so obvious. If at least $7,000 is paid to the SE, no failure-to-file penalties are assessed as long as Forms 940 and 941 are filed and deposits are made. Nor will there be any FUTA tax concerns. Of course, this does not mean that the reasonable compensation issue will go away; it just mitigates the damage.

It is not necessary for the SE to work full-time for the S corporation for payments to be reclassified as wages. Indeed, in VSC, the SE was a full-time employee of another corporation, devoting his spare time to the S corporation. The critical factor in the court’s decision was that the SE was the only employee of the S corporation. In other words, reasonable compensation must be paid the SE, even if the SE is only a “part-time” employee.

There is also no restriction on reclassifying payments for years in which the S corporation does not earn a profit. Many people receive wages from companies that incur losses, and S corporations are not immune from this economic fact.

Does the Type of Distribution Matter?

Distributions of corporate income are not all that can be reclassified as wages. As shown in Joly, the IRS and the courts can also reclassify corporate loans to the SE as wages. Although not cited by the Joly court, an earlier decision by a U.S. district court in Colorado (Greenlee Inc. v. United States, 661 F. Supp 642, 7/10/85) also reclassified loans as wages. In Greenlee, the S corporation and the SE entered into an agreement stating that no distributions of corporate income were to be made and no salaries were to be paid to the SE. Rather, all payments to the SE were to be considered loans to the SE. The court noted that the loans did not carry any rate of interest, were unsecured demand notes, and there were no specifications about how the loan was to be repaid. In fact, a large balance of the loan was repaid simply by charging it against retained earnings, using a simple journal entry.

In essence, this meant that the loans to the shareholder were no more than distributions of corporate income. Coupled with the fact that no salaries were paid, the court believed it had no choice but to reclassify all of the loan advances as wages subject to employment taxes.

The lesson here is that loans to shareholders, if they are truly loans, must be documented with a written contract, bear a reasonable rate of interest, and have strict payment terms. Without such written evidence of a loan, the IRS may reclassify loans to an SE as wages, even if the true intent of the advance was for it to be a loan.

Shareholders must also be wary of using corporate bank accounts to pay personal expenses. These are nothing more than constructive distributions to the shareholder. Even if they are treated as loans on the corporate books, the IRS would have little difficulty reclassifying such loan advances as wages if the corporation was not paying the SE a reasonable salary. This was the case in Olde Raleigh Realty Corporation v. Commissioner (T.C. Summary Opinion 2002-61), where the court upheld an IRS determination that the S corporation’s payment of personal expenses of the sole shareholder and president were wages and subject to employment taxes. The corporation did not pay any salary to the SE, nor was there any specific distribution of the corporate income. The only payments made by the corporation on the SE’s behalf were the payment of his personal expenses. Because the SE rendered substantial services to the corporation, the court reasoned that the expense payments should be classified as wages. As an added measure, the court also upheld an IRS assessment of negligence penalties, as well as penalties for failure to file and failure to pay.

If distributions are made in-kind, is the IRS restricted to reclassifying payments of cash? What if the S corporation distributes inventory or some other form of tangible property to the SE? The IRS is not restricted in these situations. IRC sections 3121(a) and 3306(b) both define “wages” for employment tax purposes as including “the cash value of all remuneration … paid in any medium other than cash.” Therefore, if an S corporation’s only payment to an SE for the year is the SE’s withdrawal of inventory with a fair market value of $40,000, the IRS will undoubtedly consider this a disguised wage payment.