S Corp Shareholders Reminded: Pay Yourself a Salary

Will it ever end?  The practice, that is, of some “S” corporation employee-shareholders trying to extract most or all of the corporation’s profits in the form of dividends rather than salaries in an effort to avoid payroll taxes?

So here comes another case of greedy taxpayers trying this longstanding loser practice and, not surprisingly, getting their hand slapped by the courts – specifically in the form of the Supremes declining to review a decision of the Eighth Circuit Court of Appeals (Watson, P.C. v. U.S.)

Regrettably, the taxpayer in this case was an accountant, but we digress.

In any case, the Revenooers have long been on record with guidelines to taxpayers, regarding how all of this is supposed to work.  Fact Sheet 2008-25, in particular, issued in August, 2008 lists these factors which the courts have considered in determining just what, exactly, is reasonable compensation in these cases:

  • Worker’s training and experience
  • Duties and responsibilities
  • Time and effort devoted to the business
  • Corporation’s dividend history
  • Level of payments to non-shareholder employees
  • Timing and manner of paying bonuses to key people
  • Amounts which comparable businesses pay for similar services
  • Existence of compensation agreements; and
  • Use of a formula to determine compensation

In this case, involving service providers (the common scenario in which this issue comes up)

the corporate shareholder ostensibly worked for peanuts (in the form of salary), leaving the bulk of the corporate profits available for dividend distributions – not subject to FICA and Medicare if the strategy actually were to fly.

Curiously, the taxpayer argued at the district court level that IRS did not have the authority to recharacterize any of the dividend payments as compensation.  Nice try – did he learn this one from Irwin Schiff?

The Eighth Circuit rejected this argument, and agreed that the government’s expert witness had enough practical experience in the field to qualify him, and therefore that the district court had not abused its discretion.

Bottom line:  taxpayer loses.  Kind of one of those situations in which pigs get fat, and hogs get slaughtered.

CONSULT YOUR TAX ADVISOR – This article contains general information about various tax matters.  You should consult your CPA regarding the implications to your own particular situation.

Jeff Quinn, the author of this article, is a shareholder in Ashley Quinn, CPAs and Consultants, Ltd., with offices in Incline Village and Reno.  He can be reached at 831-7288, welcomes comments at jquinn@ashleyquinncpas.com, and invites readers to consider his other commentary at http://blog.nolo.com/taxes.

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