The Eighth Circuit affirmed the decision of a district court recharacterizing a significant portion of distributions made by an S corporation to its sole shareholder as wages subject to employment taxes, (David E. Watson P.C., 668 F3d 1008, 109 AFTR2d 2012-1059 (8th Cir. 2012)).
For many years S corporation owner-employees and the IRS have been at odds over the issue of “reasonable compensation”. The IRS targets the issue because an S corporation shareholder that receives a salary that is less than reasonable pays less in employment taxes. The IRS is especially concerned with S corporation shareholders that take a less than reasonable salary, and who also take distributions out of the company. Distributions are not subject to employment taxes and can often be tax-free to the extent a shareholder has basis in their stock.
The problem is exacerbated by the fact that a “reasonable” salary is a subjective term, which leaves it open to interpretation by S corporation owners and the IRS, each with opposing goals; the business owner wanting to minimize taxes and maximize the return from their business, and the IRS’s administration of the tax law. In those instances where the IRS deems a salary as being less than reasonable, they will attempt to recharacterize distributions as wages, resulting in payroll tax deficiencies, penalties, and interest; this was the result of the Watson case.
What should we take away from this case? We have been counseling our clients for years about the problems that can result from not taking a reasonable salary, while trying to find that balance between what is reasonable to the IRS and what is reasonable to the S corporation owner-employee. With the results of the Watson case, it’s time to revisit the issue with our clients once again.
