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Sub S Wages vs. Sub S Dividends? ‒ The Struggle With the IRS Continues

Since at least 1974, the IRS has sought to rein in attempts by S corporations to minimize the FICA tax responsibilities of both the corporation and its shareholder-employees. S corporations have typically attempted to do this by paying minimal salaries to their shareholder-employees, and, if the shareholder-employee needs access to additional corporate funds, letting them pull money out of the corporation in the form of a non-wage distribution. The IRS has, however, recently scored an important victory in this struggle with taxpayers in a case out of the Eighth Circuit U.S. Court of Appeals.

Q:  What are the present rules which govern FICA taxes on wage payments?

A:  FICA (Federal Insurance Contributions Act) taxes are presently imposed on employees and employers up to a prescribed maximum amount of employee "wages." In the case of self-employed individuals, FICA taxes are imposed on the individual up to a prescribed maximum of the self-employed individual's "net earnings from self-employment" (NESE). FICA taxes are comprised of 2 parts, a Social Security (SS) part and a Medicare Hospital Insurance (MI) part.

The SS part, which is only imposed on wages up to the so-called "Social Security Wage Base," is 6.2% on the employer and 4.2% (scheduled to increase to 6.2% beginning in 2013) on the employee. For 2012, the Social Security Wage Base is $110,100, but is increased each year for inflation. The MI part is 1.45% of wages, without limitation, payable by both the employer and the employee. For self-employed individuals, the SS tax rate is 10.4% (scheduled to increase to 12.4% in 2013) on NESE up to the Social Security Wage Base, and the MI tax rate is 2.90% on all of their NESE.

Beginning in 2013, the MI portion of FICA taxes will be increased from 2.90% (combined employer and employee portion of 1.45% each) to 3.80% [see item #4 in "What's Up With Uncle Sam?" from July 2012] (combined employer and employee portion of 2.35% on the employee and 1.45% on the employer) for wages (or NESE, in the case of self-employed individuals) in excess of $250,000 for married filing jointly taxpayers (or $125,000 for married taxpayers filing separately, or $200,000 for other taxpayers). Also, beginning in 2013, a new 3.80% MI tax will be imposed on the "net investment income" of certain high-income taxpayers.

Q:  Since, in most cases, the income of corporations described in Subchapter S of the Internal Revenue Code ("S corporations") automatically flows through to its shareholders, pro-rata with their interest in the corporation, is the entire amount thus allocated to each shareholder subject to FICA tax?

A:  No. In accordance with Rev. Rul. 59-221 and Section 1402(a)(2) of the Internal Revenue Code (the "Code"), neither a shareholder's distributive share of the corporation's income passed through to him nor any S corporation dividend distributions actually received by the shareholder are subject to FICA taxes. Of course, any "wage" payments actually made by the S corporation to a shareholder who is also an employee of the corporation will be subject to FICA taxes.

Q:  As a result of the above general rules, do shareholder-employees of S corporations have the unlimited ability to avoid FICA taxes on S corporation income by minimizing their wage payments from the S corporation?

A:  Not according to the IRS. Since at least 1974, the IRS has been battling shareholder-employees of S corporations over this issue. Interestingly, the fight here is just the reverse of what sometimes occurs with respect to wage payments by Subchapter C corporations to their shareholder-employees. In this latter case, the IRS oftentimes is seeking to recharacterize deductible wage payments as non-deductible dividend payments on the grounds that the alleged wage payments exceed a "reasonable" wage.

Q:  How has the IRS sought to prevent taxpayers from taking advantage of this tactic of minimizing the FICA taxes paid by S corporations and their shareholder-employees?

A:  The IRS has fought against this tactic by (1) litigating those cases that it determines demonstrate an obvious over-reach by taxpayers, and (2) seeking legislative fixes.

Q:  What is the most recently decided case in this area?

A:  The most recent case in this area, one in which the Court upheld the IRS's position that an S corporation had under-reported the wages subject to FICA is the case of David E. Watson, P.C. v. United States, 668 F. 3d 1008 (8th Cir. 2012), aff'g 757 F. Supp. 2d 877 (DC Iowa, 2010).

Q:  What were the facts in the Watson case?

A:  During the years 2002 and 2003, David E. Watson, CPA ("Watson") provided accounting services as an employee of David E. Watson, P.C. ("PC") to another accounting firm of which PC was a 25% partner. Watson was the sole employee, officer, director, and shareholder of PC. In both 2002 and 2003, PC paid Watson a salary of $24,000. For 2002, the gross profit of PC (before taking into account its compensation and other trade and business deductions) was $203,651. For 2003, its gross profit was $175,470. For 2002 and 2003, PC actually distributed to Watson all of its net profit, in addition to his $24,000 salary. For 2002 and 2003, the IRS determined that PC had underpaid FICA taxes by understating Watson's "wages". According to the IRS's expert witness, a reasonable salary for Watson would have been $91,044 for both 2002 and 2003. The U.S. District Court for Iowa agreed with the IRS and the 8th Circuit U.S. Court of Appeals affirmed the District Court's holding.

Q:  What was the basis for the Circuit Court's affirmance in Watson?

A:  According to the Eighth Circuit, the characterization of funds disbursed by an S corporation to its shareholders turns on an analysis of whether the subject payments were made in consideration for services performed by the shareholder-employee. The Court went on to state that the District Court's holding that PC understated the "wages" paid to Watson by $67,044 in 2002 and 2003 was in accordance with prior precedent and was correctly based on a variety of factors, including the following evidentiary findings:

  • Watson was a qualified CPA with nearly 20 years' experience;
  • Watson was full-time engaged in rendering accounting services for a reputable, and very profitable, accounting firm;
  • The accounting firm for whom Watson was rendering accounting services had gross revenue of over $2 million in 2002 and nearly $3 million in 2003;
  • A salary of $24,000 was unreasonably low compared to CPAs of similar experience;
  • A salary of $24,000 was unreasonably low compared to the approximately $200,000 the partnership distributed to PC in 2002 and 2003; and
  • According to the IRS's expert, the fair market value of the accounting services performed by Watson during 2002 and 2003 was $91,044/year.
Q:  Was there anything especially significant about the Watson decision?

A:  Yes. Watson is the first reported decision in which the court was not faced with a fact pattern that demonstrated a clearly abusive over-reach by the S corporation. The prior cases cited by the Eighth Circuit as support for its holding all involved situations where all of the S corporation's income were paid to a sole shareholder-employee as dividend distributions and no salary was being paid to the shareholder-employee. Accordingly, the Watson decision represents an important extension of the recharacterization argument by the IRS to those situations where at least some wage payment (albeit less than a reasonable wage payment) had been paid to the shareholder-employee.

Q:  Is there any proposed legislation that would require shareholder-employees of S corporations to report a minimum amount of wage (or equivalently, NESE) income for FICA purposes?

A:  Yes. The latest legislative attempt to impose FICA taxes on shareholder-employees of S corporations is contained in the Stop Student Loan Interest Rate Hike Act of 2012 (S. 2343) introduced by Senator Harry Reid (D. NV) on April 24, 2012. In general, the Act would require taxpayers with modified adjusted gross incomes exceeding $250,000 (if married filing jointly, or $125,000 if married filing separately, or $200,000 otherwise) to pay FICA taxes on their distributive share of S corporation income if the S corporation is engaged in a professional service business. But, because the bill failed a cloture vote on May 8, 2012, the bill is essentially dead for now.