Blog post by John A. Sikora
Employment taxes are, of course, imposed on wages paid to shareholders employed by an S corporation. Employment taxes are not imposed on distributions of S corporation earnings to a shareholder with respect to his or her stock. This difference has apparently led some S corporations to pay lower than market salaries to shareholder-employees.
The Internal Revenue Service successfully asserted such a situation existed in a decision affirmed by the Eighth Circuit Court of Appeals on February 21, 2012. In David E. Watson, P.C. v. United States, a CPA owned an indirect 25% interest in an accounting firm through his wholly-owned S corporation; the accounting firm was a limited liability partnership (the “LLP”), with the S corporation being a 25% partner. The S corporation employed the CPA pursuant to an employment agreement, but the CPA exclusively provided his services to the accounting firm. The CPA was the S corporation’s sole shareholder, director, officer and employee.
The S corporation received profit distributions exceeding $200,000 and $175,000 from the LLP in 2002 and 2003, respectively, and all cash, after payment of expenses, was distributed by the S corporation to the CPA. The S corporation paid the CPA $24,000 in wages for each of those years.
The IRS examined the S corporation and concluded the CPA had been underpaid for his services, and that part of the profit distributions should be considered wages subject to social security tax. The district court, observing that the CPA was exceedingly qualified and worked 35-45 hours per week for a successful accounting firm, concluded the $24,000 salary was exceedingly low when compared to the roughly $200,000 in distributions the LLP made to the S corporation. It concluded a portion of the distributions should be considered compensation to the CPA for his services, and that the S corporation was liable for additional FICA taxes, interest and penalties; the court of appeals agreed.
Obviously, salaries of S corporation shareholder-employees should be “reasonable”, which generally means the salary should be based on the fair market value of the services. The David E. Watson case illustrates the problems associated with underpaying such employees for their services.