The Court of Appeals for the Eighth Circuit has found that dividends paid to the shareholder-employee of an S corporation was compensation for services and not a distribution of the corporation’s earnings and profits (David E. Watson, P.C. v. United States, CA-8, 2012-1 ustc ¶50,203). The dividends were properly considered wages by the IRS, and the additional wages were subject to FICA taxes.
Taxpayers and the IRS frequently spar over the amount of compensation, and, subsequently, the amount of FICA taxes owed, paid 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 shareholder are not subject to FICA or self-employment taxes.
The taxpayer was a certified public accountant (CPA) who owned a partnership interest in an accounting firm. The taxpayer then formed an S corporation and transferred his partnership interest in the accounting firm to the corporation. Taxpayer was the sole officer, shareholder, director, and an employee of the corporation under an employment agreement. However, taxpayer exclusively provided his services to the accounting firm.
In 2002 and 2003, the corporation paid the taxpayer $24,000 a year as compensation and paid employment taxes on that amount. The corporation received substantial distributions from the accounting firm, which had gross earnings of $2–3 million each year. After the corporation paid the taxpayer’s salary and other expenses, it distributed the remaining cash to the taxpayer as dividends, amounting to $203,651 in 2002 and $175,470 in 2003.
The IRS, applying a reasonableness standard, determined that the corporation underpaid employment taxes and assessed additional tax and penalties. At trial, the IRS presented expert testimony that the taxpayer’s reasonable compensation was valued at $91,044 a year. A federal district court agreed that the distributions should have been included in the taxpayer’s compensation as remuneration for services performed. The district court agreed with the IRS’s position and the taxpayer appealed.
The Eighth Circuit agreed with the district court’s conclusion that the value of the taxpayer’s services was $91,044 and that the corporation owed additional FICA taxes. 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 CPA; 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 accountants; the accounting firm had substantial gross earnings; and the firm made substantial distributions to the taxpayer, especially when compared to the claimed salary.
A reasonable compensation standard is generally used to determine an income tax deduction, but the IRS also uses a reasonableness standard in FICA tax cases. In Rev. Rul. 74-44, 1974-1 CB 287, the IRS concluded that it could recharacterize S corporation dividend payments because the dividends were paid to shareholders in lieu of reasonable compensation. Other courts have also agreed that the reasonableness of compensation is appropriate in employment tax cases.
The Eighth Circuit further rejected the taxpayer’s argument that the taxpayer’s intent should be considered. Even if intent mattered, it was not credible that the corporation intended to pay a mere $24,000 in compensation.