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S Corp Distributions Can Be Considered Taxable Wages, Court Rules

For self-employment tax purposes, characterization of funds disbursed by an S corporation to employee shareholders should be based on whether the payments were made as compensation for services performed

If you are an owner of a Subchapter S corporation, a recent court decision may affect you. In the summer of 2010, the U.S. District Court for the Southern District of Iowa determined that the characterization of funds disbursed by an S corporation to employee shareholders should be based on whether the payments were made as remuneration for services performed.

Essentially, the court said that you can't lowball your salary and then accept distributions from your S corporation that are not subject to FICA and self-employment taxes.

Background. S corporations are corporations that elect to pass through to their shareholders’ income, losses, deductions and credits for federal tax purposes. Shareholders report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates.

In 1996, David E. Watson incorporated David E. Watson, P.C. Watson later elected to be taxed as an S corporation, with Watson as sole shareholder, employee, director and officer. In 2000-2002, he took a $24,000 annual salary from his P.C. and paid federal employment taxes on that amount. However, in addition to his $24,000 in 2002, Watson received checks from the P.C. totaling $203,651. In 2003, Watson received $221,577 in distributions.

In 2007, the IRS assessed $48,519 in taxes, penalties and interest for the eight calendar quarters of 2002 and 2003. It determined that portions of the distributions to Watson should be re-characterized as wages. Watson later paid $4,064 toward these assessments but filed a claim for refund. The IRS denied the claim and Watson sued in district court, where the IRS prevailed.

Action Step. If you have an S corporation, this case serves as a reminder of the necessity of paying reasonable compensation to shareholders who are actively involved in the company. Structuring a reasonable salary should include basing compensation on market rates for services performed in the business location for similar businesses.