Renewed focus on S Corp. officer compensation.

S passthrough income is not subject to self-employment tax (1); only the portion of S income paid to an owner as salary is subject to FICA and FUTA taxes. A 2002 Treasury report (2) refocused attention on determining sufficient compensation for S corporation officers. The IRS is concerned that officer salary is being disguised as a distribution as to officer stock or treated as a loan, not subject to employment taxes.

The report alerted the IRS Commissioner that the issue of sufficient officer compensation is not always addressed during IRS examinations. One of the challenges the IRS faces when examining such compensation is that not all field offices have access to research tools that would allow them to determine reasonable salary. The report recommended making information available to field agents to permit them to compute reasonable compensation; thus, one can expect closer IRS scrutiny in this area.

This item examines the case law on whether the reported compensation of certain S officers is sufficient; in particular, it considers whether amounts paid to a taxpayer are, in substance, remuneration for employment (i.e., wages) under Sees. 3121(a) and 3306(b).

Cases

Spicer: (3) Mr. and Mrs. Spicer each owned 50% of all S corporation engaged in accounting and tax preparation. Mr. Spicer agreed to "donate" his services to the S corporation, but, as a stockholder, withdrew earnings in the form of dividends. Mrs. Spicer and one other employee prepared tax returns and performed bookkeeping duties for clients. Mr. Spicer was the firm's sole accountant and the only person who could sign tax returns, opinion letters and financial statement audits and represent clients in dealings with the IRS. He spent an average of 36 hours per week performing work for the S corporation and approximately 10%-15% of his time on work relating to his rental property.

The S corporation did not report officer wages, nor did Mr. Spicer report wages on his individual return. The Ninth Circuit held that because Mr. Spicer's work was crucial to the business and the S corporation could not function without him, his services were "substantial"; thus, he was an employee with wages subject to employment taxes. Agreeing with the Seventh Circuit in Radtke (4) (discussed below), the Ninth Circuit determined that regardless of how the payments are characterized, the issue is whether the payments are for services rendered.

Radtke: Radtke was the sole owner of a legal practice operating as an S corporation. On the business's return, he took the position that his payments from the S corporation were dividends. He did not report any wages on his personal income tax return. The Seventh Circuit held that the payments were "remuneration for services performed" (i.e., wages subject to employment taxes).

Mile High: (5) After the Spicer and Radtke courts dealt such devastating blows to taxpayers, the Colorado district court decided a case in which a taxpayer partly prevailed on this issue. Mr. Adams and Ms. Davis jointly owned all of an S corporation's stock. The corporation operated a lime slurry brokerage business. For the tax years at issue, Adams was the corporation's president, but only nominally. He performed almost none of the business's day-to-day activities and worked at jobs in other locations during the years at issue.

Davis was the S corporation's secretary and performed some of its daily functions. During the years in issue, she made business decisions, went on business trips, paid bills. submitted invoices, made bank deposits and coordinated transportation with independent truck drivers. She spent about 12 horns per month operating the S corporation and presented evidence that the value of these services was about $8 per hour.

From time to time, the business required additional working capital, which both Adams and Davis provided. The S corporation repaid these loans. Both Davis and Adams treated distributions beyond the loan repayments as dividends.

The district court determined that the dividends paid to Adams were not salary, as his role was mini real, but reclassified the payments to Davis as salary to the extent of the value of the services she provided, at the rate of $8 per hour. No case since has cited Mile High on the question of sufficient S officer compensation.

Reasonable Compensation

Although this is not a new concern. recent cases have also highlighted whether reasonable compensation was paid to a shareholder-officer.

Veterinary Surgical Consultants: (6) Dr. Sadanaga had a full time job with Bristol-Myers Squibb Co., from which he received wages. He was also the sole shareholder of Veterinary Surgical Consultants, an S corporation, and the only person who earned income for that business. He averaged 33 hours of work per week for the S corporation, handled all administrative duties and had sole signatory authority over its bank account. The S corporation reported cash distributions to him, but no wages. The Tax Court, citing Spicer and Radtke, held that the cash distributions represented remuneration to Dr. Sadanaga for services he had provided and were properly categorized as wages.

Yeagle Drywall Co.: (7) This case built on the rule outlined in Veterinary Surgical Constants, that "an officer who performs substantial services for a corporation and who receives remuneration in any form for those services is considered an employee, whose wages are subject to Federal employment taxes." Yeagle was a 99% S corporation shareholder and his wife held 1%. He performed many of the corporation's routine, day-to-day tasks and generally managed the company's affairs. He was the only person with signature authority over the corporation's bank account, and withdrew funds to pay personal expenses at his discretion. During the years at issue, the Yeagles received all of the corporation's net income. The Tax Court held that Yeagle was an employee and the payments to him were wages subject to employment taxes.

Olde Raleigh Realty: (8) Mr. Henderson worked about 32 hours per week during the years at issue, for an S corporation in which tie was the president and sole shareholder. He had signatory authority over its bank account. The corporation filed payroll tax forms and paid employment taxes for three employees, but not for Henderson. His personal expenses were paid from the corporate bank account. He argued that even if the funds used to pay personal expenses did not qualify as shareholder distributions, they were loans. The Tax Court flatly rejected his argument, holding that the funds used to pay personal expenses were wages subject to employment taxes.

Grey: (9) Joseph Grey operated an S corporation engaged in public accounting, bookkeeping and tax preparation; he was the president and sole shareholder. In lieu of salary, Grey withdrew funds from the business's account (over which he had sole signature authority) to pay for his needs as they arose. The S return did not report any wages paid to him, nor did he report any wages on his individual return. Grey argued that (1) the funds paid to him were not wages (because he was the sole shareholder, there could be no employee-employer relationship) and (2) because he was not a common-law employee, there could be no recharacterization of the funds paid to him as wages. The Tax Court held that Grey was the S corporation's employee and that the funds withdrawn from the business bank account were wages subject to employment taxes.

Relevant Factors

In 2003, a series of six Tax Court memorandum cases, all decided on the same day, arrived at a similar conclusion. (10) Those cases found a combination of some or all of the following factors to be relevant in determining whether officer compensation is inadequate:

1. The officer performs substantial services for the corporation.

2. The officer receives distributions as to stock.

3. No other individuals work in the business.

4. The officer owns most or all of the stock.

5. Distributions are characterized as loans, but no loan documents exist.

6. The officer has worked as an employee elsewhere in other years ill a comparable position, earning a salary that contrasts significantly with the officer compensation reported by the S corporation for the tax year.

7. The business has no fixed formula for determining the annual salaries and bonuses to be paid to the officer.

8. The officer is compensated at a rate less than prevailing rates of compensation for comparable positions in comparable concerns.

9. The officer is compensated at a rate less than other nonowner individuals who also have roles managing the business.

No one factor is determinative. Instead, courts have analyzed all the facts and circumstances in particular situations.

One situation that bears scrutiny occurs when an officer performs most or all of the critical services of the organization, but receives no salary. A shareholder-officer who reports no wages, but performs substantial services and receives reimbursements for personal expenses, a personal-use company car, distributions with respect to stock, etc., risks IRS reclassification of such payments as wages subject to employment taxes.

Conclusion

The problem of whether sufficient officer compensation has been pad to S shareholders is still being developed through case law. Treasury's report will focus attention in this area; thus, tax advisers should be cautious when recommending no-wage strategies, due to potential preparer penalties.

(1) Rev. Rul. 59-221, 1959-1 CB 225.

(2) Treasury Inspector General for Tax Administration report, "The Internal Revenue Service Does Not Always Address Subchapter S Corporation Officer Compensation During Examinations," Ref. No. 2002-30-125 (July 2002). available at www.ustreas.gov/tigta/2002reports/200230125fr.pdf.

(3) Spicer Accounting, Inc., 918 F2d 90 (9th Cir. 1990).

(4) Joseph Radtke, S.C., 895 F2d 1196 (7th Cir. 1990).

(5) Carol Davis, d/b/a Mile High Calcium, Inc., DE CO, 7/15/94.

(6) Veterinary Surgical Consultants. P.C., 117 TC 141 (2001), aff'd, 54 Fed. Appx. 100 (3d Cir. 2002), cert. den.

(7) Yeagle Drywall Co., Inc., TC Memo 2001 284, aff'd, 54 Fed. Appx. 100 (3d Cir. 2002). cert. den.

(8) Olde Raleigh Realty Corp., TC Summ. Op. 2002-61.

(9) Joseph M. Grey Public Accountant, P.C., 119 TC 121 (2002), aff'd, 3d Cir., 4/7/04.

(10) Water-Pure System, Inc., TC Memo 2003-53. aff'd, 3d Cir., 4/7/04; Nu-Look Design, Inc., TC Memo 2003-52, aff'd, 356 F3d 290 (3d Cir. 2004); Specialty Transport & Delivery Services, Inc., TC Memo 2003-51, aff'd, 3d Cir., 3/12/04; Superior Proside, Inc., TC Memo 2003-50, aff'd, 86 Fed. Appx. 510 (3d Cir. 2004); Mike J. Graham Trucking, Inc., TC Memo 2003-49, aff'd, 3d Cir., 4/7/04; and Veterinary Surgical Consultants, P.C., TC Memo 2003-48, aff'd, 3d Cir., 3/10/04.

Authors' note: The S Corporation Taxation Technical Resource Panel (TRP) (Kenneth N. Orbach, Chair) thanks Alan S. Alport, TRP member, and Patty, Sullivan-Snyder, both of Blackman Kallick Bartelstein, LLP, Chicago, IL, for their work on this item.