Scrutiny of S Corporation Distributions
Watters, Michael P., Persellin, Mark B., Greenstein, Brian, The CPA Journal
Profitable Subchapter C corporations often pay unreasonably high salaries to shareholder/employees while maintaining a conservative dividend policy. This maneuver can effectively avoid the double taxation of dividends by providing the corporation with a deductible salary expenditure. The IRS frequently challenges the deductibility of these salaries under the reasonable compensation requirement set forth under Sec. 162(a)(1).
The recent increase in the use of S corporations, combined with ever increasing FICA taxes, has stimulated the IRS's interest on the other side of the reasonable compensation issue. Since S corporation taxable income and dividend distributions escape FICA taxation, some S corporation shareholder/employees have significantly reduced their compensation in favor of increased dividend distributions. If successful, this maneuver reduces employment taxes at both the S corporation and shareholder-employee level.
The IRS, in protecting employment tax revenue, recently increased its scrutiny of compensation paid by S corporations to shareholder/employees. In the typical "inadequate compensation" case, the IRS will recharacterize S corporation dividend distributions as wages, resulting in a deficiency for unpaid employment taxes, penalties, and interest.
FICA TAX SAVINGS
The wage cap on the old-age survivor and disability insurance (OASDI) portion of FICA tax increased from $53,400 for 1991 to $55,500 for 1992, and the cap on the hospital insurance (HI) portion of FICA tax increased from $125,000 for 1991 to $130,200 for 1992. The combined employer and employee FICA tax rate of 15.3% in effect for 1991 remains unchanged for 1992.
The rise in taxable FICA wages translates into a potential four percent increase from 1991 in combined employer and employee FICA taxes. More dramatic, however, is that the potential combined FICA liability for 1992 represents a 145% increase over that of 1982. The 1992 combined FICA liability associated with various levels of taxable wages is illustrated in Table 1. (Table 1 omitted)
Motivated by the prospect of significant FICA tax savings, S corporation shareholder/employees may be enticed to reduce their compensation in lieu of a more generous dividend distribution policy. Neither the shareholder's pro rata share of the S corporation's taxable income nor dividend distributions are subject to self-employment tax. See Rev. Rul. 59-221, 1959-1 CB 225! Therefore, each dollar decrease in wages with a corresponding increase in dividends distributed represents a potential savings of employment taxes. Table 2 illustrates the FICA tax savings associated with a reduction in taxable wages. (Table 2 omitted)
The tax savings associated with a reduction in wages is further enhanced if there are multiple shareholder-employees involved. Additional savings accrue in the form of reduced federal unemployment tax (FUTA) liabilities when wages are reduced below $7,000. It is clear however, that the IRS has the authority to recharacterise S corporation dividend distributions as compensation to shareholder/employees, and to assess significant deficiencies as a result of this recharacterization. These deficiencies typically include FICA, FUTA, and income taxes that should have been withheld or paid along with any associated failure to file and failure to deposit penalties and interest.
WAGES INCLUDE ALL REMUNERATION
The IRS has had great success in litigating the inadequate compensation issue. However, the cases litigated to date have encompassed truly abusive situations where a sole shareholder performed substantial services for an S corporation and received dividend distributions but no salary. These cases provide insight into the IRS's approach in the recharacterization issue and the resolution of that issue in the courts.
The recharacterization of S corporation distributions as wages is generally the result of a two-pronged test. …