Tax & Business Insights

The “S” Conundrum: Can Dividends be Wages or Vice Versa?

Volume 15 Issue 4 --  July/August 2003

If a Sub-Chapter S (“S”) corporation pays no wages to its principals and labels the amounts distributed to its principals as “dividends,” then in theory no employment taxes (FICA and FUTA) are due on such distributions.  But, will this fly and will the IRS acquiesce in such an arrangement?  What if the “S” salaries are  minimal? 

It is axiomatic that a true dividend, say from IBM, to a non-employee shareholder is not subject to FICA and FUTA taxes. But what about a small one-person S corporation, with no other employees, officers or shareholders, who declares that all of the amounts distributed to Ms. A. Void (hereafter “Void”) were dividends?  Can Void avoid all of the FICA and FUTA taxes on all of the amounts received from her S corporation for providing legal services?

This was the situation present in the Radtke case in 1989.  In that case, the attorney took all of his compensation as dividends and did not pay any FICA or FUTA tax. Rejecting Radtke’s argument that not all compensation is wages, the court ruled that the payments clearly were compensation for services rendered by Radtke and thus were subject to FICA and FUTA. The decision was affirmed on appeal.

In situations like Radtke, the IRS may succeed in arguing that the wages paid are too low and increase wages, thus causing the imposition of FICA and FUTA taxes at both the “S” corporation and employee levels.

Flip Side

Any knowledgeable practitioner reading this newsletter will quickly realize that the potential IRS argument that wages are too low is the flip side of the question, when is compensation too high in order to eliminate income for a regular  “C” corporation?  In both “S” and “C” situations the issue is what is reasonable compensation.  In  the “S” situation, the IRS takes the position that the salary of Void is too low, therefore dividends should be wages, in total or in part, thus creating compensation-wages subject to FICA and FUTA taxes.

Since few things in the real world are “black and white,” shades of gray need to be explored.  For example, what if Void=s  S corporation, instead of making a nominal amount of income, earns $10 million?  To make the point more interesting, let=s say that Void, a computer programmer, was previously an LLC and started to receive approximately $10 million per year, all of which was subject to self-employment contribution act tax, “SECA.”  What if Void converts from LLC (partnership) status to chapter S (corporate) status and pays herself $3 million per year and declares the $7 million to be a dividend not subject to employment taxes? By doing so, she would save $203,000 in employment taxes ($7,000,000 X 2.9% Medicare tax). Would this arrangement represent what is called “reasonable compensation” in virtually the only IRS ruling on the subject, Rev. Rul. 74-44 1974-1 C.B. 287? 

“What-ifs” can be added to make the Void matter more interesting.  What if other small corporations doing similar software services were paying approximately $3 million per year for similar types of computer programming but Void lucked out on a new way to process information because she was an exceptionally good software designer, thus making the $10 million? 

Questions of this type abound and there is no clear answer.  What is a practitioner and the client to do?

The IRS is unlikely to come out with guidelines in this area because it is such a fact-specific subject.  The IRS may want to choose to leave the issue flexible in order that there are no fixed guidelines, which guidelines could be avoided or perhaps misguided, thus placing  the IRS in a bind.

Whatever choice Void picks, one thing is clear, she will be in a much better position if challenged by the IRS if she has corporate minutes and other documentation showing that the actions have been approved by the corporation and purport to be reasonable. Another thing which could be done would be a salary survey of those similarly situated. 

It should also be remembered that in some states like Massachusetts and Texas there are special taxes on “S” corporations that need to be factored into the planning.

If you have questions related to this matter, contact The Tax and Business Professionals.

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