There is a strong incentive to minimize the salaries of officers/shareholders of S corporations given the high level of employment taxes. The IRS is aware of this and has been successful in asserting inadequate compensation levels. The cases involved bring new meaning to the concept of reasonable compensation.

Profitable Subchapter C corporations often pay unreasonably high salaries to shareholder/employees while maintaining a conservative dividend policy. This maneuver can effectively avoid the double taxation of dividends by providing the corporation with a deductible salary expenditure. The IRS frequently challenges the deductibility of these salaries under the reasonable compensation requirement set forth under Sec. 162(a)(1).

The recent increase in the use of S corporations, combined with ever increasing FICA taxes, has stimulated the IRS's interest on the other side of the reasonable compensation issue. Since S corporation taxable income and dividend distributions escape FICA taxation, some S corporation shareholder/employees have significantly reduced their compensation in favor of increased dividend distributions. If successful, this maneuver reduces employment taxes at both the S corporation and shareholder-employee level.

The IRS, in protecting employment tax revenue, recently increased its scrutiny of compensation paid by S corporations to shareholder/employees. In the typical "inadequate compensation" case, the IRS will recharacterize S corporation dividend distributions as wages, resulting in a deficiency for unpaid employment taxes, penalties, and interest.

FICA Tax Savings

The wage cap on the old-age survivor and disability insurance (OASDI) portion of FICA tax increased from $53,400 for 1991 to $55,500 for 1992, and the cap on the hospital insurance (HI) portion of FICA tax increased from $125,000 for 1991 to $130,200 for 1992. The combined employer and employee FICA tax rate of 15.3% in effect for 1991 remains unchanged for 1992. The rise in taxable FICA wages translates into a potential four percent increase from 1991 in combined employer and employee FICA taxes. More dramatic, however, is that the potential combined FICA liability for 1992 represents a 145% increase over that of 1982. The 1992 combined FICA liability associated with various levels of taxable wages is illustrated in Table 1.

Motivated by the prospect of significant FICA tax savings, S corporation shareholder/employees may be enticed to reduce their compensation in lieu of a more generous dividend distribution policy. Neither the shareholder's pro rata share of the S corporation's taxable income nor dividend distributions are subject to self-employment tax. |See Rev. Rul. 59-221, 1959-1 CB 225 Therefore, each dollar decrease in wages with a corresponding increase in dividends distributed represents a potential savings of employment taxes. Table 2 illustrates the FICA tax savings associated with a reduction in taxable wages.

The tax savings associated with a reduction in wages is further enhanced if there are multiple shareholder-employees involved. Additional savings accrue in the form of reduced federal unemployment tax (FUTA) liabilities when wages are reduced below $7,000. It is clear however, that the IRS has the authority to recharacterize S corporation dividend distributions as compensation to shareholder/employees, and to assess significant deficiencies as a result of this recharacterization. These deficiencies typically include FICA, FUTA, and income taxes that should have been withheld or paid along with any associated failure to file and failure to deposit penalties and interest.

WAGES INCLUDE ALL REMUNERATION

The IRS has had great success in litigating the inadequate compensation issue. However, the cases litigated to date have encompassed truly abusive situations where a sole shareholder performed substantial services for an S corporation and received dividend distributions but no salary. These cases provide insight into the IRS's approach in the recharacterization issue and the resolution of that issue in the courts.

The recharacterization of S corporation distributions as wages is generally the result of a two-pronged test. First, there must have been an employer-employee relationship between the S corporation and the shareholder during the tax years in question. Second, the shareholder- employee must have been inadequately compensated for services performed for the corporation during that period. Upon these findings, IRS will assert that some or all of the dividend distributions to the shareholder-employee represent compensation.

Whether an employer-employee relationship exists is determined with reference to the common law definition of an employee. This definition generally includes officers of the corporation. |Sec. 3121(d) However, a shareholder who performs only nominal services for the corporation in the capacity of an officer will not be treated as an "employee."

When determining whether an officer's services are nominal, Rev. Rul. 74-390 makes it clear that the IRS will examine three factors:

* character of the services;

* frequency and duration of the services; and

* actual or potential importance or necessity of the services to the corporation's business.

To be recharacterized as compensation subject to FICA taxes, an alleged dividend distribution must constitute "wages" in the context of the employment tax provisions. For this determination, it is clear under Sec. 3121(a) that the term "wages" encompasses "all remuneration for employment," regardless of the title given to or the form of such remuneration. Since shareholder/employees of S corporations are cash basis individual taxpayers, the IRS will look to situations where monies are extracted from the corporation in some manner other than formal compensation. While the general target of the IRS's attention has been dividend distributions, loans from S corporations to shareholder/employees have also been recharacterized as "remuneration for employment."

S CORPORATION DISTRIBUTIONS TREATED AS WAGES

According to Rev. Rul. 74-44, S corporation distributions may be reclassified as FICA wages when uncompensated services are performed by a shareholder and employment taxes are avoided as a result. |(See also Internal Revenue Manual 4419, Sec 353.1(3)(c) (May 3, 1990) The IRS first asserted this position in C. D. Ulrich Ltd. |692 FSupp 1053 (DC, Minn., 1988). In this case, a CPA operated his practice as an S corporation of which he was sole shareholder, officer, and director. The CPA had no other income producing activities other than the performance of services for the corporation. The corporation did not pay the shareholder a salary for the services performed nor did it treat him as an employee for employment tax purposes. The shareholder did receive "dividend" distributions from the S corporation during the years under audit. The IRS assessed the corporation for both unpaid employment taxes and related penalties and interest as if the "dividend" distributions made to the shareholder were taxable wages. Litigation was commenced by the corporation to enjoin the IRS from collecting the deficiency. The court analyzed existing law defining an "employee" and found that the shareholder's performance of significant services for the corporation required that he be treated as such for employment tax purposes. The court thus refused to enjoin the IRS from collecting the assessed deficiency.

In Joseph Radtke, S.C. |895 F2d 1196 (CA-7, 1990), an S corporation law practice paid no salary to its sole shareholder who served as the company's president, director, and only full time attorney. This level of compensation (or lack thereof) was provided for in an employment contract between the corporation and the shareholder. The shareholder received "dividend" distributions from the corporation during the years in question.

The IRS recharacterized the distributions as wages subject to employment taxes and assessed a deficiency composed of back taxes, penalties, and interest. The court found the shareholder to be an "employee" based on the significant services he performed for the corporation. In accepting the IRS's recharacterization of the dividends as wages, the court emphasized that the employment tax provisions broadly define "wages" as "all remuneration for employment."

The IRS's recharacterization argument was reaffirmed in Fred R. Esser, P.C. |750 FSupp 421 (DC, Ariz., 1990) where an S corporation law practice paid no salary to its sole shareholder who served as the corporation's president and only full-time attorney. Instead, the shareholder "borrowed" monies from the corporation on a consistent basis and offset such "loans" against dividend declarations at year-end. The IRS argued that the "dividend" distributions served as remuneration for services performed. The court found the shareholder to be an employee of the corporation and upheld the IRS's recharacterization of the "dividends" as taxable wages.

A recent case in which the IRS prevailed on the recharacterization argument is Spicer Accounting, Inc. |918 F2d 90 (CA-9, 1990). In this case, the taxpayer was an S corporation accounting practice entirely owned by a CPA and his wife. The CPA served as the corporation's president, treasurer, director, and only full-time accountant but received no salary for his services. Instead, the CPA "donated" his services to the corporation and withdrew earnings from the entity in the form of "dividend" distributions. During the years under audit, the CPA worked for the corporation approximately thirty-six hours per week. In addition to testifying that his work was crucial to the continued success of the corporation's business, the CPA also indicated that dividends were drawn in lieu of salary to reduce employment taxes. The corporation asserted that the CPA was not an employee and even if he was an employee, dividend distributions could not be taxed as wages. The court found the shareholder to be an employee of the corporation who had performed significant services for no formal compensation. Since wages encompassed "all remuneration" for services, the court held that the dividends distributed constituted wages for employment tax purposes.

FAMILY OWNED S CORPORATIONS

When a shareholder-employee receives an inadequate salary for services performed, S corporation taxable income TABULAR DATA OMITTED is overstated. This may result in the overallocation (assignment) of income to other nonemployee family members who are shareholders of the corporation. To prevent the assignment of income through the use of family-owned S corporations, under Sec. 1366(e) the IRS has the authority to reallocate income to shareholder-employees who are inadequately compensated for services performed. While the consequence of the IRS's reallocation activity in this area has been an increase in the shareholder-employee's pro rata share of S corporation taxable income rather than an increase in wages, the issue remains one of inadequate compensation. These cases shed further light on what factors are relevant in resolving the inadequate compensation issue in an employment tax context.

TABLE2

FICATAXSAVINGSWITHSALARYREDUCTION

Presentwages135K60K35K15K

CombinedFICATaxes$10,658$8,622$5,355$2,295

ReducedAmountof

Wages

135K$0

60K$2,036$0

35K$5,303$3,267$0

15K$8,363$6,327$3,060$0

In Walter J. Roob |50 TC 891 (1968), married taxpayers operated a photography studio as an S corporation. While the business activities of the corporation were handled exclusively by the taxpayers, the stock of the S corporation was held equally among the taxpayers and their eight children. For the years under audit, the taxpayers received salaries for services performed as well as pro rata dividends on their stock, while their children received only dividends. The IRS asserted that Mr. Roob was inadequately compensated for the services he performed for the S corporation, and reallocated dividends from the children to the taxpayer to reflect the amount of undercompensation. This case, like the others discussed later, was based on old Sec. 1375(c) effective prior to the Subchapter S Revision Act of 1982.

The Tax Court noted that while this case represented a reversal of the typical reasonable compensation issue argued under Sec. 162(a)(1), the traditional criteria used to determine reasonable compensation should apply equally to the inadequate compensation issue. The court cited the long hours worked by the taxpayers in performing not only managerial functions but also sales activities and lectures for photographic associations. The court also noted that the taxpayers were the recipients of numerous awards for craftsmanship and the efforts of the taxpayers had resulted in a dynamic corporation whose sales over a 15- year period had increased by almost 160 percent. Finding that the taxpayers had not met their burden of proof in establishing that the IRS' determination was in error, the Tax Court accepted the allocations asserted by the IRS.

In a similar case (Pat Krahenbuhl |T. C. Memo 1968-34) the court found the principal shareholder-employee's compensation to be inadequate given the level of services performed by the shareholder. In upholding the IRS' reallocation of dividends, the court considered the following factors:

* the nature and extent of services provided by the taxpayer (14-16 hours daily);

* the taxpayer's competency and skill; and

* the taxpayer's compensation when previously employed for an unrelated party. The court was particularly swayed by the fact that the taxpayer was paid less for his services by the S corporation than he had been when performing substantially equivalent services for an unrelated employer.

THE IRS DOES NOT ALWAYS WIN

Taxpayers have enjoyed some success when faced with an attempted reallocation of family-owned S corporation dividends by the IRS. When a taxpayer has established that only a nominal level of services were performed, the courts have rejected the IRS's reallocation attempts. In Charles Rocco |57 TC 826 (1972), 1972-2 CB 3, the IRS attempted to reallocate all the dividends of two family-owned S corporations to the shareholder/employees. The shareholder/employees performed mainly administrative duties for the corporations for approximately five hours a week and were compensated for these services. The court, in rejecting the IRS's inadequate compensation argument, inferred from the then- controlling regulation |Sec 1.1375-3(a) that the determination of adequate compensation in cases involving family-owned S corporations should employ the same standards traditionally used in the Sec. 162(a)(1) reasonable compensation area. The court found in the instant case that the taxpayers had satisfied their burden of proof in establishing that the amount of compensation paid was reasonable given the level of services they had actually performed.

A similar result was reached in Edwin D. Davis |64 TC 1034 (1975), a case in which the IRS attempted to reallocate the taxable income of two S corporations as compensation for services performed by the taxpayer. The taxpayer, an orthopedic surgeon, had created the two corporations to perform X-rays for, and physical therapy on, patients referred primarily by himself. After forming the corporations, the taxpayer gifted 90% of the corporations' stock to his three minor children. The taxpayer served as the president and a member of the board of directors for each corporation. He also signed checks and performed other administrative duties for the corporations. The taxpayer was not compensated for these services which required a combined total of approximately 20 hours annually. The IRS' position was rejected by the court which found that the services performed by the taxpayer would attract only a nominal salary at best if performed for an unrelated employer.

LOANS RECHARACTERIZED AS WAGES

Funds borrowed from a corporation in which a shareholder-employee is inadequately compensated for services performed may be recharacterized as taxable wages. In several cases, the IRS has successfully argued that such borrowed funds represented remuneration for employment that was taxable as wages.

In Jack Haber |52 TC 255 (1969), the IRS was successful in recharacterizing loans made by the corporation to the shareholder- employee as wages despite payment of some compensation for services performed. An S corporation, controlled and operated by the taxpayer and his brother, made monthly distributions to its two shareholders. The distributions were classified by the corporation partially as compensation and partially as loans. The amounts classified as both compensation and loans were in direct proportion to the two brothers' stock ownership. The IRS recharacterized the loans to the taxpayer as additional compensation for services performed.

The court examined the facts surrounding the "loan" distributions (e.g., absence of loan agreements) and found that such payments did not constitute bona fide loans. Two factors swayed the court into holding that the "loans" represented remuneration for services performed. First, the "loans" were made during years in which the corporation reported losses. Second, the total distributions for the year ("loan" amount plus salary) approximated each shareholder-employee's compensation from the corporation for tax years prior to the S election.

In a similar case, Gale W. Greenlee, Inc. |661 FSupp 642 (DC, Colo., 1985), "loans" from a corporation to its sole shareholder were held to be wages subject to employment taxes. The shareholder performed significant services for the corporation and received no salary. Instead, substantial "loans" were provided by the corporation to the shareholder. The "loans" were in the form of unsecured demand notes bearing no interest. The court found the lack of bona fide indebtedness combined with the performance of services as an employee for no compensation to be sufficient evidence that the "loans" constituted wage payments.

Taxpayer Attempts at Recharacterization

In the earliest cases litigated, the taxpayer has sought to have dividends recharacterized as wages. These cases involved situations in which a corporation's S election was terminated as a result of the receipt of excess passive investment income. Having lost their S election, the corporations attempted to reduce the resulting Sec 11 corporate income tax by recharacterizing nondeductible dividend distributions as deductible compensation payments.

In Bramlette Building Corp. |424 F2d 751 (CA-5, 1970), the taxpayer was a real estate management company operating as an S corporation with 99.86% ownership by the corporation's president. The corporation neither authorized nor paid the principal shareholder a salary. Instead, the shareholder drew monies from the corporation in the form of dividend distributions. When the corporation's S election was terminated, it asserted that the dividend payments to the shareholder constituted deductible compensation for services performed.

The appellate court held the following:

* the determination of whether a payment is compensation or dividend is a question of fact;

* the mere labelling of a payment is only evidence of its character; and

* the label given a payment should be accorded even less weight than usual in a case involving an S corporation.

The court noted several factors that influenced its decision including the nature and extent of the shareholder-president's services, the absence of corporate authorization for the payment of compensation, the timing and amount of the withdrawals, the ratio of withdrawals to the earnings of the corporation, and the relationship between net income and compensation paid. The court found the supervisory services provided by the president to be of a kind generally provided by a major shareholder who would expect dividends rather than salary in recompense for his efforts. Furthermore, the court determined that the payments were made in proportion to the profits of the corporation and not in proportion to the services performed by the shareholder. These factors led the court to reject the taxpayer's attempted recharacterization of dividends as compensation.

In a similar case, Paula Construction Co. |58 TC 1055 (1972), aff'd without published opinion, 474 F2d 1345 (CA-5, 1973), the taxpayer was an S corporation that was owned by three family members. Confronted with a termination of its S election, the corporation asserted the recharacterization of dividend distributions as compensation for services performed by the two principal shareholders--brothers holding 95% of the stock. These brothers had performed substantial and valuable services for and on behalf of the corporation. However, no salary was paid to them for the services nor was there any mention of compensation in the corporate books and records. Additionally, the distributions in question were not treated as compensation by either the corporation or the brothers on their respective tax returns.

Although the IRS conceded that the brothers had performed substantial services for the corporation during the years under audit, the Tax Court refused to reallocate any of the dividend distributions as deductible compensation. The court noted that "it is now settled that only if payment is made with the intent to compensate is it deductible compensation." Whether such intent has been demonstrated is a question of fact to be decided on the basis of the particular circumstances of the case. Aside from documenting that substantial services were performed, no other facts indicated that compensation was paid or intended to be paid. Basing its decision on the original intent of the payments, and not on the question of whether a reasonable compensation had been paid for the services performed, the court disallowed any recharacterization by the corporation.

OTHER RECHARACTERIZATION ISSUES

The IRS has asserted the recharacterization issue in other cases where significant services were performed and the failure to adequately compensate for such services has resulted in lost employment tax revenue. For instance, in Automated Typesetting, Inc. |527 FSupp 515 (DC, Wisc., 1981), the sole shareholder of the taxpayer, a C corporation, transferred all his stock to a family trust in exchange for a beneficial interest in the trust. Prior to this transfer, the former shareholder and his spouse were employees of the taxpayer. However, with the formation of the trust, the couple "contributed" their future lifetime services to the trust. The taxpayer then entered into an agreement with the trust for the services of the couple in exchange for payments to the trust. A similar agreement was also entered into between the taxpayer and a second trust for the services of another former employee--the couple's son who had similarly "contributed" his lifetime services to the second trust.

The family members performed services predominantly at the corporation's business location. These services were little changed in substance (in the amount of time required and in the nature thereof), from the services rendered to the corporation before the trust agreements were executed. The family members also served as the taxpayer's sole officers and directors during the years under audit. The amount of the payments made to the trusts under the service agreements were approximately the same as the compensation paid to the family members before the formation of the trusts. The taxpayer did not treat any of the payments made to the trusts as wages for federal employment tax purposes, but did pay state unemployment taxes with respect to these amounts and continued to provide medical insurance for the family members.

The IRS asserted that the family members were employees of the taxpayer and that the payments to the trusts represented remuneration for services performed by the employees. The court first addressed whether an employer-employee relationship existed between the taxpayer and the family members applying the three criteria set forth in Rev. Rul. 74- 390--character of services, frequency and duration of services, and actual or potential importance or necessity of services in relation to the corporation's business. The court found that the services were substantial in relation to the conduct of the corporation's business and that the services continued uninterrupted after the establishment of the trust agreements. The court held that the purported conveyances of lifetime services to the trusts were an anticipatory assignment of income and granted the IRS's request for a summary judgment for unpaid employment taxes and related penalties and interest.

ESTABLISHING AN ADEQUATE LEVEL OF COMPENSATION

So far, the IRS has litigated only in the truly abusive cases in which a sole shareholder-employee drew no salary for significant services performed. However, the recharacterization argument should be equally applicable in cases where some salary is paid but the amount is deemed to be inadequate given the level of services performed. In such cases, greater emphasis will be given to the determination of what constitutes an adequate level of compensation to avoid recharacterization.

In determining the reasonableness of an officer's salary under Sec. 162(a)(1), the IRS instructs its personnel to refer to the criteria set forth in the Internal Revenue Manual |IRM 4233, Sec. 232.2 (March 11, 1985). The courts have similarly applied these criteria when confronted with the unreasonable compensation issue. |See, e.g., Mayson Manufacturing Co. 178 F2d 115 (CA-6, 1949)) Although the manual specifically addresses the excessive compensation issue, rather than the inadequate compensation issue, factors used to determine reasonable levels of compensation should be equally applicable to both situations. The fact that the courts have applied these excessive compensation factors to the allocation of income in family owned S corporations where a shareholder-employee was undercompensated supports this position.

By applying the excessive compensation criteria in the reverse, the following factors may be supportive of a lower salary:

* Employee's duties are minimal and undemanding.

* Employee has little or no related work experience.

* Employee possesses no special technical skills or training.

* Employee's time and responsibility requirements are minimal.

* Economic conditions are poor.

* Industry salary levels are comparably low.

* Corporate profits are marginal or declining.

* Salary is authorized and the amount is fixed in advance.

* Salary payments are received regularly throughout the year.

Sources of information for establishing an adequate range of compensation include 1) trade association statistics, 2) SEC registration statements, 3) newspaper advertisements in the employment section, and 4) employment agency reports.

CAVEAT OWNER SHAREHOLDERS

Establishing a reasonable range of compensation in the employment tax context is primarily a question of fact. Taxpayers seeking lower employment taxes through the reduction of S corporation shareholder- employee compensation must stand ready to support the adequacy of the salary level. A reduction in a shareholder-employee's compensation without an attendant reduction in the level of services would have to be substantiated by other factors.

All the authors are assistant professors of accounting; Michael P. Watters, CPA, New Mexico State University, Mark B. Persellin, PhD, CPA, St. Mary's University, Brian Greenstein, PhD, Drexel University.