Can S Corp Shareholder Wages Be Unreasonably Low?

In a recent US Tax Court case, the Internal Revenue Service successfully recharacterized dividend distributions from an S corporation to its sole shareholder, employee, and director as wages.  In the case of David E. Watson 2010-1 U.S.T.C. 50,444 (May27, 2010), the Court held that the corporation structured the individual's salary and dividend payments in an effort to avoid employment taxes, with full knowledge that dividends paid were actually remuneration for services performed.

In this case, Mr. Watson, who is a CPA, was the sole shareholder and employee of this CPA firm, which operated as an S corporation.  During the year 2002, he received salary of $24,000 and dividends of $203,651.  In 2003, Mr. Watson received the same $24,000 salary, but received $221,577 of dividend payments from the corporation.  In February 2007, the Internal Revenue Service assessed approximately $48,500 in tax, penalties, and interest for the years 2002 and 2003.

Over the years, I have seen many S corporation shareholders save payroll taxes by using the same technique as Mr. Watson, generally with no problem.  Although I have read and heard about various IRS initiatives to identify S corps that pay unreasonably low wages to their stockholders, I have not seen the issue raised.  Now I have the feeling that the Watson case is a sign of things to come.  Perhaps if Mr. Watson had not been so aggressive in taking only $24,000 annual salary, which he admitted was insufficient to cover his basic living expenses, this would not be an issue.  However, with all the talk about taxing the "rich" this is certainly an easy way to do it.  After all, the people affected by this program are business owners, not employees.  The rich are such an easy target!

There is also a tax proposal before Congress that make earnings of professional service S corporations subject to self employment tax.  Even if this law is not enacted, the Watson case shows how the IRS can accomplish the same result.

What does this mean to you, the S corporation shareholder?  Take a look at your compensation structure, and be sure that your compensation is reasonable.  If it is low, document the reason.  Do you work part time?  Is the business unprofitable?  Are you reinvesting the profits in the business?  How do the amount of dividend distributions compare to shareholder compensation?  Think about these things and talk to your tax advisor today.  Don't wait until the IRS contacts you.