Tax & Business Insights

Don't Get Caught in the S Loophole

Volume 25 Issue 6 --November/December 2013

There has long been an employment tax “loophole” for S corporation income that is not paid as wages (assuming reasonable compensation is paid). S corporation distributions that are not “wages” are not subject to payroll taxes or self-employment tax.

It has been nearly a quarter of a century since the court ruled in the Radtke case that S corporation owner-employees must pay themselves reasonable salaries, but taxpayers have been slow to get the message.

There have been legislative efforts to close this loophole, but given the current state of Congress, the prospects for enactment of any significant change in the law remain unclear.

As a result, it is not uncommon to find that aggressive taxpayers will pay a small salary to S corporation shareholders but distribute much of the profit in non-wage dividend distributions.

 As noted above, this loophole works when the S corporation pays “reasonable compensation” to its employee-owners. What “reasonable compensation” is depends upon all of the circumstances. Courts appear to look to what a similar employee with similar success could be expected to earn. No compensation or very little compensation will rarely be reasonable.

The Internal Revenue Manual advises auditors to:

Be aware of inadequate salaries paid to officer/shareholders who receive substantial nontaxable distributions. S corporation earnings are not subject to the self-employment tax, so officer/shareholders often receive minimal small or no wages salary income to avoided employment taxes.

While it is well-known that paying little or no salary is subject to challenge, it is less clear what happens where more substantial amounts of compensation are paid, even if it might be argued that a higher amount of wages would be reasonable. Two recent cases offer some illustrations.

In a 2012 court decision, a CPA who was a partner in an accounting firm set up an S corporation (the PC) to serve as the partner in the accounting firm.  During the tax years in question, the PC which earned income as a partner in the partnership paid the CPA $24,000 a year as salary and distributed $203,651 in the first year and $175,470 in the second year as profit distributions from the partnership. In other words, in the first year the CPA received a total of $227,651 of which $24,000 was treated as wages, while in the second year he received a total of $199,470 of which $24,000 was treated as wages.

IRS expert, concluded that in each year a reasonable wage for the CPA would have been $91,044 and assessed roughly $23,431 in additional payroll taxes, interest, and penalties. The Court of Appeals affirmed.

In a second case, the taxpayer was a real estate broker who received S corporation distributions of $240,000 in one year but reported zero wages. At trial, the IRS expert opined that a reasonable wage for similar real estate brokers would have been $100,755, or about $48.44 an hour. The Tax Court (in a summary opinion) held that a reasonable wage, given the taxpayer’s limited experience, would have been $40 an hour ($83,200 a year). The court also upheld about $6,000 in penalties.

It is interesting to note that although the courts in both cases agreed with the IRS that unreasonably low wages were paid, neither the IRS nor the courts treated the entire amount of the profits distributed as wages. For example, in the first case no more than 46% of the total distributions were treated as wages, while in the second case only about 35% of the total distributions were treated as wages. In both instances, the remainder of the profit was allowed to be distributed without payroll taxes.

Thus while both taxpayers lost the court cases, they were still permitted to receive somewhat more than half the amount of their total business profit as non-wage distributions not subject to employment taxes.

One downside to paying wages significantly less than the Social Security earnings limit is that this practice will likely decrease Social Security benefits. If a portion of the dividend is eventually recharacterized as wages, by the time the tax dispute is resolved it may be too late to obtain Social Security credit for the additional wages.

Thus, under current law, as long as reasonable and substantial wages are paid, it is still possible and permissible to pass a significant portion of business profits through to the S corporation shareholder as dividends not subject to payroll taxes. The key is: Don’t be greedy.

If you have questions about this subject please call the Tax & Business Professionals.

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