IRS recharacterizes distributions as wages.

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. It also cited sections 3121(a) and 3306(b), which define wages as all remuneration for employment. The court ruled that an officer like Sadanaga who performs substantial services for a corporation, and receives compensation in any form for those services, is an employee. Therefore, VSC could not escape employment taxes by characterizing Sadanaga's withdrawals from VSC's bank account as distributions of corporate income.

The court was not impressed by VSC's argument that Bristol Myers already had paid maximum FICA and Medicare taxes on Sadanaga's behalf. It pointed out that in the case of multiple employers the taxable wage base applies separately to each one. Therefore, VSC should have disregarded the doctor's earnings at Bristol Myers in determining its liability to withhold, match and remit employment taxes. Employees (but not their employers) are eligible for a credit or refund of FICA tax applicable to wages in excess of the wage base.

In ruling against VSC, the court also discussed section 530(a)(1) of the Revenue Act of 1978. It provides relief from federal employment taxes when the taxpayer has both

* Not treated the individual as an employee for any period.

* A reasonable basis for not treating the individual as an employee.

VSC satisfied the first requirement since it had not treated Sadanaga as an employee in any period. But it failed to satisfy the second requirement. Simply stated, VSC had no reasonable basis for not treating Sadanaga as an employee. Accordingly, section 530(a)(1) did not apply.

CPAs should emphasize to clients and employers that IRS examiners are on the lookout for attempts to disguise S corporation employee/shareholder wages and salaries as nontaxable distributions. The IRS is fully empowered in abusive and not-so-abusive situations to recharacterize such distributions as wages or salaries and enforce collection of the corresponding federal employment taxes. CPAs should alert clients and employers to this issue as well as to the applicable IRS audit procedures.

* Veterinary Surgical Consultants, PC, vs. Commissioner 117 TC no. 14.

Top Earners = Top Taxpayers

Americans at the upper end of the income scale paid more than one-third
of all 1999 federal individual income taxes collected compared
with a tiny fraction paid by those at the lower end.

                     Percent of U.S.   Percent of total     Percent of
                        taxpayers     federal individual    all income
                                      income taxes paid       earned

More than $293,415          1%              36.2%              19.5%
$26,415 to $293,415        49%              59.8%              67.2%
Less than $26,415          50%                 4%              13.3%

Source: Tax Foundation, www.taxfoundation.org.

Note: Table made from pie chart.

Prepared by R. Dan Fesler, CPA, DBA, professor of accounting and Norberto Gacho, an MBA student, at Tennessee Technological University in Cookeville.