The Eighth Circuit Court of Appeals held that a portion of the dividends paid by an S corporation to its CPA sole shareholder/employee was compensation. In upholding the decision by the District Court of Southern Iowa, the Eighth Circuit agreed that the salary to the sole shareholder/employee used to compute Federal Insurance Contributions Act (FICA) taxes was unrealistically low.
A corporate employer may deduct salary payments for income tax purposes, but it and the payee must pay FICA taxes on those amounts. However, unlike partners and LLC members, S corporation shareholders do not pay FICA taxes on their distributive share of the business’s income. Courts have recharacterized corporate compensation payments as a dividend for income tax purposes when the amount was determined to be unreasonably high, and they have recharacterized corporate dividend payments as compensation for FICA tax purposes when the amount was determined to be unreasonably low (see “Reasonable salary for S corporation owners,” page 60).
David Watson, a CPA, formed David E. Watson PC (DEWPC), an Iowa professional corporation electing to be taxed as an S corporation, in which he was the sole owner, shareholder, director, and employee. Under an employment agreement with DEWPC, Watson provided exclusive accounting expertise to an accounting firm in which he had formerly been a partner. In 2002 and 2003, DEWPC paid Watson a salary of $24,000 each year and distributed dividends to him of $203,651 in 2002 and $175,470 in 2003. In 2007, the IRS assessed FICA taxes, interest, and penalties against DEWPC, recharacterizing a portion of the dividends it had paid to Watson in 2002 and 2003 as compensation.
During the district court bench trial, DEWPC unsuccessfully argued that its intent to pay Watson a salary of $24,000 should control the characterization of the payments. The court held that the character of the payments should rather depend on whether they were remuneration for services performed, as determined by the economic realities of the situation. According to the court, intent was one factor to be considered; however, other factors must be considered as well, including the employee’s qualifications, the nature of his duties, and comparable compensation for similar duties by similar entities. The court accepted the $91,044 annual salary calculated by an IRS expert witness as reasonable, since Watson was an extremely qualified accountant, had about 20 years of experience, and worked 35–45 hours per week for a well-established firm as one of its primary revenue producers. The court concluded that DEWPC’s assertion it intended to pay Watson a salary of $24,000 per year was “less than credible.” DEWPC appealed the decision to the Eighth Circuit.
In its appeal, DEWPC argued that the district court decision had in essence established a minimum salary although no such statutory or regulatory requirement exists. The Eighth Circuit could find no error in the lower court’s use of the reasonable compensation standard for FICA tax purposes or in any other part of its analysis, including its reliance on the finding of the expert witness.
By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota–Duluth.