Court Upholds Treatment of S Corporation Dividends as Compensation
The Eighth Circuit Court of Appeals has affirmed a Federal district court decision holding that a portion of the dividends paid to an employee-owner of professional services firm was compensation for services. As a result, the taxpayer earned additional wages and owed additional Social Security taxes.
Taxpayers and the IRS frequently spar over the amount of compensation, and, subsequently, the amount of FICA (Social Security) taxes owed, by a closely-held corporation where the same person owns the company and is its employee. Unlike a partnership, where a general partner’s share of profits is subject to self-employment taxes, distributions to an S corporation stockholder are not subject to FICA taxes.
The taxpayer was working for his own professional corporation (“P.C.”). The P.C. owned 25 percent of a professional services firm that was an S corporation. His P.C. entered into an employment agreement with the S corporation, and he exclusively worked for the firm.
The P.C. paid the taxpayer $24,000 a year as compensation and paid Social Security taxes on that amount. The P.C. received substantial distributions from the firm, which had gross earnings of $2–3 million each year. After the P.C. paid the taxpayer’s salary and other expenses, it distributed the remaining cash to the taxpayer as dividends, amounting to $203,000 in year one and $175,000 in year two.
The IRS determined that the P.C. underpaid employment taxes. A Federal district court agreed, determining (based on the testimony of IRS’s expert) that the taxpayer’s compensation should have been $91,000 a year.
Substance Over Form
To determine the appropriate amount of FICA taxes, the court found that the inquiry was whether payments at issue were remuneration for services performed. Because the corporation was controlled by the employees to whom the compensation was paid, the court gave special scrutiny to the salary amount, since there was a lack of arm’s-length bargaining.
A reasonable compensation determination is usually appropriate to determine the amount of an income tax deduction, but it also applies to FICA tax cases. In an old regulation ruling, the IRS concluded that it could recharacterize S corporation dividend payments because the dividends were paid to stockholders in lieu of reasonable compensation. Courts looking at the FICA issue have also evaluated the economic substance of a transaction.
The Eighth Circuit agreed with the district court’s conclusion that the value of the taxpayer’s services was $91,000 and that the P.C. owed additional FICA taxes. The P.C.’s purported intent to pay $24,000 as compensation was not relevant, the court concluded. Even if intent mattered, it was not credible that the P.C. intended to pay a mere $24,000 in compensation.
The appeals court said that it was appropriate to determine whether the taxpayer’s compensation was reasonable. Based on the following factors, the appeals court concluded that the district court properly determined the fair market value of the taxpayer’s services: the taxpayer was a qualified professional; the taxpayer worked 35 to 45 hours per week as a primary earner of the firm; the $24,000 supposedly paid was unreasonably low compared to similar professionals; the firm had substantial gross earnings; and the firm made substantial distributions to the taxpayer, especially when compared to the claimed salary.
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