Distributions to S shareholders held not to be salary.
S corporations may be inclined to forgo the payment of salaries to shareholder-employees in favor of distributions in order to avoid payroll taxes. However, the IRS has consistently taken the position that S corporations cannot use this technique and this issue has been extensively litigated. In three of the more notable cases, Radtke, S.C., 712 F Supp 143 (DC Wisc. 1989), aff'd per curiam, 895 F2d 1196 (7th Cir. 1990), Spicer Accounting, Inc., 918 F2d 80 (9th Cir. 1990), and Dunn & Clark, P.A., 853 F Supp 365 (DC Idaho 1994), the courts ruled in favor of the Service's attempts to characterize distributions as salaries.
The Davis case involved an S corporation in which all of the stock was owned by a wife and husband (Ms. Davis and Mr. Adams). The corporation was engaged in the operation of a lime slurry brokerage business in Colorado and Utah. Mr. Adams was nominally president of the company, but had virtually no active participation in its day-to-day operations. Mr. Adams held other jobs for various companies in other locations, including working as a ski instructor, a truck driver and a heavy equipment operator. Ms. Davis was company secretary, performing part-time clerical duties, including communicating with independent contractor truck drivers. Ms. Davis also made business decisions for the company and took a few business trips. It was estimated that Ms. Davis performed about 12 hours of work per month for the company.
During the years in question, all amounts distributed by the company to the shareholders were classified as either loan repayments or dividend distributions. Checks were often written to Mr. Adams and deposited in his joint checking account with Ms. Davis. On the Service's determination that Mr. Adams was an employee of the company, it classified all checks written to him as salary. The IRS did not consider the purpose of the payments or the identity of the person who ultimately received the funds.
In its decision, the court noted that the taxpayer had met its burden of proof in characterizing payments from the company as dividend distributions and loan repayments. Even though Sec. 3121(d) defines an employee in part as "any officer of a corporation," Regs. Sec. 31.3121(d)-1(b) provides an exception for officers who perform only minor services and who neither receive nor are entitled to receive remuneration. The court concluded that Mr. Adams clearly fell within this exception. Unlike the Davis case, the shareholders in Radtke, Spicer Accounting and Dunn & Clark provided substantial services to their respective S corporations. In those cases, the corporations argued that the individuals were not employees, because the amounts paid were dividends rather than wages. The corporations asserted that shareholder dividends should not be treated as wages in S corporations. Those courts disagreed, noting that the taxpayer bears a heavy burden in characterizing payments as dividends instead of wages, and salary arrangements between closely held corporations and stockholders require close scrutiny. Since the shareholders performed substantial services for the S corporations, and did not receive reasonable compensation for such services other than dividends, the dividends constituted wages subject to employment taxes.
In the Davis case, the Service had also classified other payments made by the corporation to Ms. Davis as salary, regardless of the nature of the payments, the type and extent of services provided by Ms. Davis or whether her alleged salary was commensurate with the value of those services. It is important to note that the corporation originally did not characterize any portion of these payments to Ms. Davis as salary. The IRS wanted the court to use its "common sense" to determine the extent and value of Ms. Davis's services. The court concluded that the Service's calculation of Ms. Davis's salary for the years in question was without basis in law or fact. Undisputed evidence was presented by Ms. Davis showing that she worked about 12 hours per month for the company, and that the value of her services was about $8 per hour. (The value of her services was based on testimony from the company's accountant.) Thus, according to the court, the salary attributed to Ms. Davis should be based on those facts. Since the IRS did not present evidence as to the extent and value of Ms. Davis's services, the court had to base its findings and conclusions on the evidence presented, not on speculation. Although not expressly stated in the case, if the Service had provided evidence challenging the extent and value of Ms. Davis's services, it is possible the court could have arrived at a different conclusion on the value of those services.
The Davis case is significant in that it is the first taxpayer victory in this area. It is important to note, however, that in the other major cases on this issue the shareholders provided substantial services to their respective S corporations and all amounts paid to them were in the form of dividend distributions. Davis illustrates that the IRS does not have unlimited power to classify dividend distributions as wages subject to employment taxes. However, one issue yet to be addressed is the IRS's ability to claim that compensation should have been paid when the S corporation does not make any distributions to the shareholder for a particular year.