‘S’ Corporations and Employment Taxes

The age old game of S corporations paying their owner/employees low salaries and taking most of the income out in the form of “dividends” just got another comeuppance in the courts.

The 8th Circuit Court of Appeals (Watson, P.C. v. U.S., 109 AFTR 2d 2012-483) has once again stood up for the proposition that this sort of game plan, in many cases, won’t fly.

Recall that particularly service-providers are motivated to minimize FICA and Medicare taxes by treating what might otherwise be construed as self-employment income to be S corporation dividends.  No income tax advantage, just a FICA/Medicare savings ploy.

In 2010, the House (though not the Senate) actually passed legislation which would plug this loophole with respect to service professionals.  Despite the failure by the legislative bodies to close up this gap, the courts have consistently (and once again in Watson) ruled that this game doesn’t work, pointing to these principal factors in evaluating what is the appropriate level of reasonable compensation:

  • Training and experience
  • Duties and responsibilities
  • Time and effort devoted to the business
  • Dividend history
  • Payments to non-shareholder employees
  • Timing and manner of paying bonuses to key people
  • What comparable businesses pay for similar services
  • Compensation agreements
  • Use of a formula to determine compensation