IRS Recharacterizes Distributions as Wages

By Fesler, R. Dan | Journal of Accountancy, June 2002 | Go to article overview

IRS Recharacterizes Distributions as Wages


Fesler, R. Dan, Journal of Accountancy


To avoid federal employment taxes, S corporations may be tempted to understate the wages and salaries of employee/shareholders. The IRS however, may recharacterize what S corporations classify as nontaxable distributions as wages and salaries subject to employment taxes. For an employee/shareholder who earns wages or salary of $84,900 in 2002, an employer must withhold $5,264 of FICA tax and $1,231 of Medicare tax. The employer match is $6,495; the employer also must remit $434 of federal unemployment tax, less amounts paid to state unemployment funds.

As early as 1968, the Tax Court, in Roob, 50 TC 891, ruled the criteria to determine reasonable compensation of officers and executives also applied to cases involving inadequate or no compensation. Whether IRS personnel are assessing the reasonableness or the adequacy of compensation, the guidelines they use to make these determinations are relevant. The Internal Revenue Manual Handbook says the employee/shareholder's duties, responsibilities, background and time devoted to the business, knowledge of the business, size of the business and the amounts paid such employees by similar-size businesses are all considerations.

The case at hand involved sizeable S corporation distributions. Veterinary Surgical Consultants (VSC) paid Dr. Sadanaga--its sole employee/shareholder--no wages or compensation subject to employment taxes. He worked approximately 33 hours a week, generating all VSC's revenues. Moreover, Sadanaga had sole signature authority over VSC's bank account and handled all its correspondence and administrative tasks. VSC made no regular payments to the doctor; he simply withdrew money at his discretion from the corporation's bank account. Since VSC took the position that none of the withdrawals was remuneration for services, it did not withhold or match any FICA or Medicare taxes nor did it make any federal unemployment tax contributions. VSC did not file Form 941, Employer's Quarterly Federal Tax Return, or Form 940, Employer's Annual Federal Unemployment Tax Return, for any quarter during the periods at issue.

For 1994, 1995 and 1996, VSC reported total income of $418,509.24 on its forms 1120S. According to VSC, the entire amount went to Sadanaga as his share of the S corporation's income. On schedule M-2 the company classified these amounts as "other-than-dividend distributions" paid from accumulated earnings and profits.

In partial defense for nonpayment of employment taxes, VSC pointed out Sadanaga also was a full-time employee of Bristol Myers Squibb for each of the three years in question. Since Bristol Myers withheld and paid the maximum amount of employment taxes due for Sadanaga, VSC argued the IRS was attempting to assess additional taxes the doctor did not owe.

Result. For the IRS. The Tax Court held the IRS had properly characterized VSC's distributions as wages subject to federal employment taxes. In making its ruling, the court cited IRC section 3121(d), which defines an employee, in part, as any officer of a corporation who performs more than minor services. …

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