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.
While designed to be accurate, this publication is not intended to constitute the rendering of legal, accounting, or other professional services or to serve as a substitute for such services.
Redistribution or other commercial use of the material contained in Tax & Business Insights is expressly prohibited without the written permission of Tax and Business Professionals, Inc.
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