IRS wins two cases reclassifying S distribution as wages. (S Corporations).

Several years ago, the IRS won a significant Tax Court case involving classification of an S shareholder's compensation as wages for Federal income tax purposes. In Joly, TC Memo 1998-361, the court concluded that part of the income distributed by Joly to its shareholders was compensation for services and wages for Federal employment tax purposes. Many tax professionals were concerned that Joly was just the beginning of the Service's attempt to reclassify S corporation payments for services. Now two new cases affirm Joly. Each has slightly different facts and circumstances, but the rationale behind the decisions is the same.

In Veterinary Surgical Consultants P.C. (VSC), 117 TC No. 14 (2001), Dr. Kenneth Sadanaga was the sole shareholder, president and officer of Veterinary Surgical Consultants P.C., an S corporation. All of VSC's income derived from consulting and surgical services that Dr. Sadanaga provided to Veterinary Orthopedic Services LTD (VOS). Dr. Sadanaga spent at least 33 hours a week providing services on behalf of VSC to VOS. VOS provided VSC with a Form 1099-MISC for every year, which VSC reported as gross receipts on its S return. VSC did not provide a Form W-2 or 1099-MISC to Dr. Sadanaga, nor did it file any payroll tax returns for him. Dr. Sadanaga reported his share of VSC income as nonpassive S income on his individual return.

In addition to the time Dr. Sadanaga spent at VOS, he was also a full-time employee of Bristol-Myers Squibb Co. (Squibb). Dr. Sadanaga received a W-2 from Squibb that he reported as wages. Squibb withheld Social Security taxes for Dr. Sadanaga. The following table summarizes VSC's net income and the wages Squibb paid to Dr. Sadanaga during the audit period.

In the second case, Yeagle Drywall Company, Inc., TC Memo 2001-284, John Yeagle owned 99% of Yeagle Drywall Company, Inc. (Drywall), a drywall construction contractor; his wife owned the other one percent. Yeagle performed many services for Drywall, including soliciting business, entering into oral and written contracts, overseeing finances, collecting accounts receivable and hiring and firing workers. Although Drywall did not make regular payments to Yeagle, he paid personal expenses from the company's bank account and withdrew money at his discretion. (There is no indication that Yeagle's personal expenses were deducted by Drywall.) Drywall treated all workers, other than Yeagle, as independent contractors and issued Forms 1099-MISC to them. Drywall reported net income of $26,711, $32,973 and $34,509 for 1995-1997, respectively. Yeagle reported these amounts as nonpassive S income.

Although VSC and Drywall made various arguments to support the proposition that Dr. Sadanaga and Yeagle were not employees, the facts of both cases made it clear that the shareholders performed services for the corporations.

While the Tax Court ruled that Dr. Sadanaga and Yeagle were employees, VSC and Drywall still would not be subject to Federal employment taxes if they qualified for relief under Section 530(a)(1) of the Revenue Act of 1978:

(1) In general.-- If

(A) for purposes of employment taxes, the taxpayer did not treat an individual as an employee for any period * * *, and

(B) in the case of periods after December 31, 1978, all Federal tax returns (including information returns) required to be filed by the taxpayer with respect to such individual for such period are filed on a basis consistent with the taxpayer's treatment of such individual as not being an employee, then, for purposes of applying such taxes for such period with respect to the taxpayer, the individual shall be deemed not to be an employee unless the taxpayer had no reasonable basis for not treating such individual as an employee.

In both cases, the shareholders had never been treated as employees. In addition, in both cases the S corporations and the shareholders filed all the returns required in a manner consistent with nonemployee status. However, relief was not granted in either case, because VSC and Drywall failed the second test--the taxpayers had no reasonable basis for not treating the shareholders as employees.

These cases are significantly different from Joly. In Joly the shareholder/ officer, in addition to having no salary, had undocumented loans to the corporation. Joly focused on reasonable compensation. In VSC and Yeagle Drywall, Dr. Sadanaga and Yeager provided "substantial services" to the corporation as employees. Taken together, these cases make it clear that, if a shareholder is a corporate officer, the burden of proof will be on the taxpayer to demonstrate that the shareholder/officer is not an employee. If they are treated as employees, they must receive reasonable compensation.

Year   VSC net income   Squibb wages

1994       $83,996         $91,212
1995      $173,030         $95,891
1996      $161,483        $102,031

FROM MICHAEL D. KOPPEL, CPA, GRAY, GRAY & GRAY LLP, BOSTON, MA