A recent tax court case, David E. Watson, P.C. v United States, has upheld the IRS re-characterization of S corporation distributions as wages.
The individual shareholder-employee in the case, David Watson, CPA, was a partner in an accounting firm. Watson made a mistake in the level of compensation he was entitled to for his business. In 2002, Watson received a salary of $24,000, but was receiving $203,651 in profit distributions from his ownership in the firm. In 2003, the Watson received $24,000 in salary from the S corporation with a distribution of $175,470. The IRS audited and increased the taxable wages for Watson to $91,044 for each of these years.
The IRS has been successful in re-characterizing the S corporation distributions as “deemed wages” that are subject to payroll taxes. The Court of Appeals has continued to uphold the IRS assertion that the S corporation distributions should be wages.
The courts and IRS have been consistently going after S corporation owners that engage in the practice of decreasing wages paid by the S corporation and increasing the distributions to the shareholder-employees for the purpose of reducing FICA taxes. However, in situations where reasonable compensation is being paid to shareholder-employees, the IRS will have more difficulty in trying to re-characterize the distributions made to the shareholders as wages that are subject to the FICA taxes. Some factors considered in the reasonable compensation analysis include the nature of the employee’s duties, employee’s background and experience, and the employee’s contribution to profit making. S corporations should consider these items when assessing how reasonable the wages paid to shareholder-employees are.
Business owners should take note of this case. By improperly reporting income or loss on individual income tax returns, you increase your chance of an IRS tax audit, FICA tax assessments and penalties.
