COURT SUPPORTS IRS AGAINST “S” CORPORATION FOR UNDERPAYING EMPLOYEE-OWNER

Background
A “S” Corporation if a regular corporation that is treated like a sole proprietorship or partnership for tax purposes resulting in the net income of the corporation flowing through the individual tax returns and taxed at the lower individual tax rate in lieu of the corporate rate. Unlike an unincorporated self-employed person, that income is not subject to self-employment taxes. Consequently, the tax code requires employee – owners of “S” Corporations to be paid a “reasonable” salary thus requiring the withholding and payment of Social Security, Disability and Unemployment taxes. The salary is treated as a corporation expense, reducing the amount of income that flows through the sole proprietor or partner.

In times past, a common practice was to pay a minimal salary to the employee-owner and take out cash as a dividend. This will reduce total taxes by reducing the amount paid in Social Security, Disability and Unemployment taxes. For example, the employee-owner would take a $24,000 salary per year and withdraw cash from the corporation of $100,000 as a dividend. The Social Security, Disability and Unemployment tax would be paid on the $24,000 but not on the $100,000.

Court Ruling
In Watson v. U.S the district court ruled that a portion of the dividend distributions by an “S” corporation to its sole owner should be recharacterized as wages subject to employment taxes, the court rejected the corporation's assertion that IRS could not compel the corporation to pay a higher salary to the owner. This resulted in underreporting and underpayment penalties and interest on the corporation’s payroll tax returns over a two-year period.

Conclusion
Employee-owners of “S” corporations should pay a “reasonable” salary. What is a “reasonable” salary? That is a good question; there is no guidance in tax law or by the IRS. It is a case-by-case determination. To determine a reasonable salary, one needs to look at the prevailing wages paid for the same job description of the employee-owner and the income of the corporation.

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