Corporations and Salary Payments to Shareholders
A Major Issue for the IRS
James A. Fellows and John F. Jewell
2006 - The IRS has modified the “notice of acceptance
of S corporation status” that it sends to corporations
that have made the subchapter S election. The IRS no longer
simply tells a corporation that it now qualifies as an S
corporation. The new notice devotes most of its language
to informing the S corporation and its shareholder-employees
of its “tax obligations related to the payment of
compensation to shareholder-employees of S corporations.”
The notice goes on to say that “when a shareholder-employee
of an S corporation provides services to the S corporation,
reasonable compensation needs to be paid.” If it is
not paid, then the IRS will recharacterize dividends or
other distributions to shareholder-employees when these
are paid in lieu of reasonable compensation. The salaries
and wages paid must reflect economic reality. From the IRS’s
point of view, collecting employment taxes on the salaries
is an additional issue.
IRS’s position is the result of the difference in
how tax law treats the business income of S corporations
versus partnerships. Partnership net earnings are net earnings
from self-employment to other than limited partners, and
most partners are therefore subject to self-employment tax
on their share of the earnings. On the other hand, a shareholder’s
pro rata share of S corporation income that is “passed
through” to the shareholder’s K-1 is not subject
to self-employment tax [Revenue Ruling 59-221, 1959-1 CB
225; Paul B. Ding v. Commissioner, T.C. Memo 1997-435,
affd. 200 F. 3d 587 (9th Cir. 1999)]. An incentive therefore
exists to not pay much, if any, in salaries to shareholder-employees,
in order to escape the imposition of both FICA and FUTA
taxes. From this point of view, simply reporting all income
on the K-1 as an allocation is better than splitting it
between a K-1 allocation and a salary payment.
issue of unreasonably low salary payments to S corporation
shareholder-employees has long been a chief audit concern
of the IRS. An analysis of recent rulings and decisions
on the topic gives taxpayers little hope of circumventing
the reach of the IRS on this issue. This article reviews
the means that taxpayers use to avoid the payment of employment
taxes, and also describe the logic of the IRS and the courts
in preventing this avoidance.
compensation is always a matter of facts and circumstances,
so any salary to an S corporation shareholder-employee (SE)
that is below a reasonable amount is a red flag to the IRS—especially
when the salary is zero. Indeed, in almost all of the court
decisions on this issue, no salaries had been paid to the
SE. For this reason, the example below uses no salary; however,
any salary to an SE below a reasonable amount is subject
to IRS scrutiny.
Harry is the sole shareholder and CEO of an
S corporation and works “full time” for the
corporation. Before considering any salary payment to Harry,
the corporation has $100,000 of net taxable income from
business operations for 2005. Harry also took a $100,000
cash distribution during the year. If Harry takes no salary
from the corporation, the $100,000 is simply “passed
through” to Harry on his K-1 for reporting in his
own Form 1040 tax return. In this scenario, the $100,000
would be free of any FICA and FUTA tax, at both the corporate
and the employee level.
that Harry has significant investment income, so that he
is in the 30% marginal tax bracket. His income tax on the
$100,000 is $30,000, generating after-tax cash flow of $70,000.
assume that two years later the IRS audits the corporate
tax return. The IRS determines that a reasonable compensation
to Harry for his services is $90,000. This is the maximum
amount in 2005 that is subject to the 6.2% Social Security
portion of FICA, so when combined with the 1.45% Medicare
portion, the entire $90,000 is subject to the 7.65% FICA
tax. Because the $90,000 salary is deductible by the S corporation,
the income reported to Harry on his K-1 is reduced. The
corporation and Harry must pay, respectively, the employer
and employee shares of FICA tax: 7.65% of $90,000, or $6,885
each. In addition, the IRS assesses the corporation a FUTA
tax of 6.2% on the first $7,000 of the salary ($434).
IRS adjustments reduce the corporation’s net taxable
income from $100,000 to $2,681, as shown in the Exhibit.
The $2,681 is “passed through” to Harry on his
K-1, and his income tax on this amount is $804. Harry also
pays an income tax on his salary payment, $90,000 times
30%, or $27,000, as well as the $6,885 in FICA tax. The
IRS adjustments reduce Harry’s net cash-flow to $57,992,
almost $12,000 less than without a salary, as also shown
in the Exhibit.
perhaps more important, at least as far as the IRS is concerned,
is the increase in tax revenues collected. The IRS not only
collects total FICA tax of $13,770 and FUTA tax of $434,
but it may also collect penalties from the corporation for
not filing its employment tax returns (Forms 940 and 941),
for late deposit of the employment taxes, and also for failure
to withhold income taxes on Harry’s salary. Under
IRC section 6651, the penalty for failure to file employment
tax returns is 25% of the amount due. IRC section 6656 imposes
a penalty of 10% of the amount due for failure to deposit
the taxes. These penalties are assessed not only on the
FICA and FUTA taxes due but also on required income-tax
withholding. Assume that in Harry’s case the corporation
should have withheld 20% of the recharacterized salary payments,
which is $18,000. The penalties are assessed on this amount
plus the $13,770 and $434, totaling $32,204. The Exhibit
shows that the IRS may assess penalties on this amount that
IRS may also impose a 20% negligence penalty under IRC section
6662(a) if it believes that the actions of the corporation
are due to a “failure to make a reasonable attempt
to comply with the provisions” of the Tax Code or
to any “careless, reckless, or intentional disregard”
of the rules and regulations. Depending on the facts, then,
Harry’s corporation may also have to pay a negligence
penalty of $6,441. These penalties, totaling $17,712 if
the negligence penalty is included, could reduce Harry’s
cash flow to almost $40,000, before considering any interest
payment on the underpayment of tax.
shown, the IRS can seriously impact S corporation and shareholder
cash flow through any recharacterization of distributions
as salaries. Although the courts have consistently supported
the IRS, taxpayers and their advisors continue to try and
avoid these employment taxes. A review of relatively recent
court decisions reveals taxpayers’ unsuccessful arguments.
cases take as their starting point the decisions in Radtke
v. United States [712 F. Supp. 143 (E.D. Wis. 1989),
affd. 895 F.2d 1196 (7th Cir. 1990)] and Spicer Accounting
v. United States [918 F.2d 90 (9th Cir. 1990)]. In
Radtke, a lawyer formed an S corporation and was the sole
shareholder, the president, and the only full-time employee.
The corporation did not pay any salary to the SE, but did
make a cash distribution of its entire net income to the
SE. Similar facts existed in Spicer Accounting,
where the SE was the only accountant performing accounting
services for the corporation, and the corporation did not
pay any salary to him.
courts in both cases noted that IRC sections 3121(a), pertaining
to the FICA tax, and 3306(b), pertaining to the FUTA tax,
define wages as “all remuneration for employment.”
The SE was clearly an employee of the corporation and even
admitted so, but claimed that because he technically did
not receive any wages from the corporation, but rather a
“dividend,” no employment taxes were due. The
courts, however, said that they were obligated to look at
the economic substance of the transactions rather than their
legal form. In doing so, they determined that the distributions
were simply disguised salary payments, and thus upheld the
IRS in its assessment of employment taxes.
Loans as Wages?
Joly v. Comm’r [T.C. Memo 1998-361, affd.
211 F.3d 1269 (6th Cir. 2000)], the Tax Court and the Sixth
Circuit Court of Appeals held that an S corporation’s
distributions to a controlling shareholder were in substance
wages subject to employment taxes. Furthermore, the court
upheld the IRS’s assessment of a 20% negligence penalty.
In deciding that the distributions were disguised salaries,
the court considered irrelevant a written agreement between
the corporation and SE stating that no salary would be paid.
A second agreement further stipulated that all distributions
were merely advances against profits, and that if the distributions
exceeded profits for the year, then the excess would be
treated as a loan to the shareholder. This agreement too
was ignored by the court, which looked at the true economic
substance of the payments rather than their legal form.
showed that the IRS and the courts will not be bound
by specific written agreements between the corporation and
the SE. Also, Joly signified that more than just
distributions of profits are subject to reclassification
as wages. Loans from the corporation to the shareholder
could also be reclassified, if the loan did not in substance
appear to be a loan. In Joly there was no written
evidence of a loan, merely bookkeeping entries adjusting
a loan receivable account whenever distributions exceeded
corporate income for the year. Nor was there stated interest
on the loan. The court decided that no bona fide loan existed,
so that these amounts could be classified as disguised wages.
The 530 Plan
a flurry of court decisions, the Tax Court, supported by
the Third Circuit Court of Appeals, chose to make “public
announcements” about its view on a technique that
taxpayers have resurrected to avoid employment taxes. The
authors call this the “530 plan.” The first
of the Tax Court decisions was Veterinary Surgical Consultants
(VSC) v. Comm’r (117 T.C. 141, 10/15/2001; affd.,
unpublished opinion, 3rd Cir. 3/10/2004). In VSC, an S corporation
distributed all of its business income to its sole shareholder
and only corporate officer. The SE spent an average of 33
hours per week performing corporate activities. The S corporation
did not treat any of the distributions during the year as
wages, but the IRS asserted that most of the distributions
were wages subject to employment tax.
its argument that the SE was not an employee for purposes
of FICA and FUTA, the taxpayer raised two points. First,
it argued that IRC section 1366 mandates that the shareholder
report all income from the S corporation in the same manner
as it is earned by the corporation. For example, if $100,000
of business income is earned by the S corporation, the shareholders
report $100,000 of business income, with no requirement
that the $100,000 be reduced by any salary payment to the
SE. The court rejected this argument as a misreading of
the statute, noting that IRC section 1366 simply mandates
that the corporate income be reported by the shareholders
for income tax purposes. It does not apply in any way to
the computation of employment taxes owed by the corporation.
Therefore, IRC section 1366 had no bearing on the case.
second point raised by the taxpayer in VSC was
the “530 plan,” a technique that was raised
about a decade earlier in Spicer Accounting. The
technique is based not on IRC section 530, which deals with
Coverdell education savings accounts, but on section 530
of the Revenue Act of 1978. Under this rule, which was never
included as part of the IRC itself, relief from employment
tax liability is granted if the corporation has never treated
the SE as an employee for any period, and all federal tax
returns are filed consistent with the SE not being treated
as an employee. This simply means that the SE reports all
the corporate income in his tax return, with payments treated
as distributions of income rather than wages. However, section
530(a)(1) states that employment tax relief will not occur
if the corporation “had no reasonable basis for not
treating such individual as an employee.”
Act section 530(a)(2) goes on to say that the corporation
can have a reasonable basis for not treating the SE as an
employee only if there is sufficient judicial precedent
or published rulings to do so; if a past IRS audit of the
corporation did not treat the SE or similarly situated individuals
as employees; or if there is long-standing industry practice
not to treat such individuals as employees. In its decision
in VSC, the court reasoned that none of the three stipulations
were met, so that the SE was classified as an employee,
resulting in employment tax liabilities for the corporation.
Because there are no cases or rulings favorable to taxpayers
here, the only chances of getting Section 530 relief is
under the industry standard or if the taxpayers have already
passed muster in a previous IRS audit.
and Similar Decisions
“530 plan” became a focus of attention within
the Third Circuit due to a series of connected cases in
Pennsylvania, including VSC. The cases were connected
because the affected taxpayers shared the same accountant,
Joseph M. Grey, who was also the subject of one case.
Joseph M. Grey v. Commissioner (119 T.C. 5, 9/16/2002,
affd. unpublished opinion, 3rd Cir. 4/7/2004, cert. denied,
125 S.Ct. 60, 10/4/2004), Grey operated his accounting practice
through an S corporation in which he was sole shareholder
and president. He took no salaries from the corporation,
although he performed most of the services of the corporation.
Instead, he withdrew money from the corporate accounts when
needed, treating these withdrawals as distribution of profits.
The corporation did, however, make small payments each year
to Grey that were classified as payments to an independent
court held that the SE (Grey) was an employee and that the
money withdrawals were wages subject to employment tax.
The SE was a corporate officer, and under IRC section 3121(d)(1)
officers are “statutory employees.” Only if
a corporate officer performs no services, or performs only
minor services and receives no remuneration, can he be considered
not to be an employee. Because the SE worked full-time for
the corporation, his status was that of an employee.
court also dispensed with the “530 plan,” holding
that the corporation had no reasonable basis for not treating
the SE as an employee. The fact that some small remuneration
was paid to Grey as an independent contractor was not controlling,
and in no way provided a reasonable basis for treating him
as something other than an employee. In fact, the court
went out of its way to state that section 530 relief did
not even apply to “statutory employees” such
as corporate officers. Rather, section 530 relief applies
only to a determination of whether “common law employees”
should be treated as independent contractors. The court’s
argument involved a detailed discussion of the legislative
history of the section 530 rule, and the court went to lengths
to state that “this issue is over and done with.”
“children” of Grey. Five other
decisions connected to Grey were subsequently handed down
by the Tax Court, with affirmations from the Third Circuit
(see the Sidebar).
The Tax Court decisions were all dated February 26, 2003,
and it is no coincidence that they read almost identically
except for the names of the taxpayers involved. The cases
all dealt with a group of corporations to whom Joseph Grey
had rendered services. All had basically the same issues
as Grey: lack of payment of reasonable salaries
to the corporate officers who were controlling shareholders
and who rendered significant services to the company. In
all of the cases the “530 plan” was argued by
the taxpayers, and in all cases, the Tax Court and the Third
Circuit held that section 530 relief does not apply to “statutory
employees” such as corporate officers.
cases all involved payments to corporate officers (i.e.,
“statutory employees”) who were either the sole
or controlling shareholders of the S corporation. All were
the primary employees of the corporation, working full-time
in that capacity. None received any salary payments, though
distributions of the corporate profits were made. At this
point the Tax Court and the Third Circuit were adamant in
reclassifying the payments as wages subject to employment
tax. One can confidently conclude at this point that taxpayers
have lost the battle with the IRS and the courts on the
issue of salary payments by S corporations to their shareholder-employees.
Is Reasonable Compensation?
compensation is a question of fact, not of law. As for determining
reasonable compensation, the courts usually let the IRS
and taxpayers negotiate this. Unsurprisingly, the more skilled
and critical the role of the SE, the higher the salary should
be. An S corporation that lists no deduction for salary
payments to officers on the 1120S is inviting IRS scrutiny.
Paying the SE a token salary does not ensure against an
IRS audit, although the red flag is not quite so obvious.
If at least $7,000 is paid to the SE, no failure-to-file
penalties are assessed as long as Forms 940 and 941 are
filed and deposits are made. Nor will there be any FUTA
tax concerns. Of course, this does not mean that the reasonable
compensation issue will go away; it just mitigates the damage.
is not necessary for the SE to work full-time for the S
corporation for payments to be reclassified as wages. Indeed,
in VSC, the SE was a full-time employee of another corporation,
devoting his spare time to the S corporation. The critical
factor in the court’s decision was that the SE was
the only employee of the S corporation. In other words,
reasonable compensation must be paid the SE, even if the
SE is only a “part-time” employee.
is also no restriction on reclassifying payments for years
in which the S corporation does not earn a profit. Many
people receive wages from companies that incur losses, and
S corporations are not immune from this economic fact.
the Type of Distribution Matter?
of corporate income are not all that can be reclassified
as wages. As shown in Joly, the IRS and the courts
can also reclassify corporate loans to the SE as wages.
Although not cited by the Joly court, an earlier decision
by a U.S. district court in Colorado (Greenlee Inc.
v. United States, 661 F. Supp 642, 7/10/85) also reclassified
loans as wages. In Greenlee, the S corporation and the SE
entered into an agreement stating that no distributions
of corporate income were to be made and no salaries were
to be paid to the SE. Rather, all payments to the SE were
to be considered loans to the SE. The court noted that the
loans did not carry any rate of interest, were unsecured
demand notes, and there were no specifications about how
the loan was to be repaid. In fact, a large balance of the
loan was repaid simply by charging it against retained earnings,
using a simple journal entry.
essence, this meant that the loans to the shareholder were
no more than distributions of corporate income. Coupled
with the fact that no salaries were paid, the court believed
it had no choice but to reclassify all of the loan advances
as wages subject to employment taxes.
lesson here is that loans to shareholders, if they are truly
loans, must be documented with a written contract, bear
a reasonable rate of interest, and have strict payment terms.
Without such written evidence of a loan, the IRS may reclassify
loans to an SE as wages, even if the true intent of the
advance was for it to be a loan.
must also be wary of using corporate bank accounts to pay
personal expenses. These are nothing more than constructive
distributions to the shareholder. Even if they are treated
as loans on the corporate books, the IRS would have little
difficulty reclassifying such loan advances as wages if
the corporation was not paying the SE a reasonable salary.
This was the case in Olde Raleigh Realty Corporation
v. Commissioner (T.C. Summary Opinion 2002-61), where
the court upheld an IRS determination that the S corporation’s
payment of personal expenses of the sole shareholder and
president were wages and subject to employment taxes. The
corporation did not pay any salary to the SE, nor was there
any specific distribution of the corporate income. The only
payments made by the corporation on the SE’s behalf
were the payment of his personal expenses. Because the SE
rendered substantial services to the corporation, the court
reasoned that the expense payments should be classified
as wages. As an added measure, the court also upheld an
IRS assessment of negligence penalties, as well as penalties
for failure to file and failure to pay.
distributions are made in-kind, is the IRS restricted to
reclassifying payments of cash? What if the S corporation
distributes inventory or some other form of tangible property
to the SE? The IRS is not restricted in these situations.
IRC sections 3121(a) and 3306(b) both define “wages”
for employment tax purposes as including “the cash
value of all remuneration … paid in any medium other
than cash.” Therefore,
if an S corporation’s only payment to an SE for the
year is the SE’s withdrawal of inventory with a fair
market value of $40,000, the IRS will undoubtedly consider
this a disguised wage payment.
A. Fellows, PhD, CPA, is a professor of accounting,
John F. Jewell, JD, LLM, CPA, is a lecturer
of accounting and law, both at the University of South Florida,