In January, I wrote about a Tax Court case (David E. Watson, P.C.) which held that the wages paid to a CPA by his 100% owned S corporation were unreasonably low, and that the difference between these wages and the amount determined by the Tax Court to be reasonable compensation constituted wages subject to FICA tax. In addition to the tax liability, the CPA was assessed penalties and interest. The CPA appealed the Tax Court decision to the US Court of Appeals for the Eight Circuit, which upheld the lower court ruling in favor of the Internal Revenue Service.
In making its ruling, the Court of Appeals found that Mr. Watson was a well qualified and experienced accountant working in a reputable and well-established firm, and that the nominal salary paid to him was unreasonably low in comparison to what a reasonable person in his role would have expected to earn. Further, the Court held that the S corporation "dividend" paid to Mr. Watson was compensation for services paid to him as an employee/shareholder, rather than a distribution of the corporation's earnings and profits. In this case, Mr. Watson received $24,000 of annual wages. During the two years at issue, he received dividend distributions of approximately $203,000 and $175,000.
Many S corporation shareholders employ the same technique, that is, they take relatively low salary and large dividend distributions. In order for this to have any chance of success against an IRS challenge, the wages received must be reasonable in comparison industry standards and services provided, and in relation to the dividends paid. In any event, your case will be strengthened by contemporaneous written documentation of how and why the compensation was determined. In Mr. Watson's case, $91,000 was determined to be reasonable compensation. If his actual salary were not so very low, maybe $52,000 instead of $24,000, perhaps the IRS would not have even made an issue of it. Proper planning and documentation are the key to all successful tax positions.
Please contact me if you would like a copy of the Watson case, or have any comments or questions.
