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Trepanier MacGillis Battina P.A. 8000 Flour Exchange Building 310 Fourth Avenue South Minneapolis, MN 55415 612.455.0500

8th Circuit Rejects S Corporation Owner’s Characterization of Reasonable Compensation

A recent decision of the 8th Circuit Court of Appeals provides both a cautionary tale and guidance for owners of S corporations that receive significant profit distributions along with salaries deemed unreasonably low. In David E. Watson, P.C. v. United States, 668 F.3d 1008 (8th Cir. 2012), the 8th Circuit (which covers Arkansas, Iowa, Minnesota, Missouri, Nebraska, North Dakota, and South Dakota) affirmed an Iowa federal district court’s determination that the $24,000 annual salary paid by a single member S corporation to its owner, an accountant, was unreasonably low in light of the $200,000 annual profit distribution he received.

Employer’s Obligation to Pay FICA Tax
The Federal Insurance Contribution Act (“FICA”) imposes on every employer an obligation to pay an excise tax on employed individuals (commonly referred to as “social security tax”). This tax is calculated as a certain percentage of wages the employer pays the employee “with respect to employment.” I.R.C. §§ 3111(a), (b). The term “wages” is defined as “all remuneration for employment,” with some exceptions. Id. § 3121(a). It is immaterial what term an employer uses to characterize remuneration for employment. Treas. Reg. § 31.3121(a)-1(c). Likewise, the medium in which remuneration is paid is immaterial. Id. § 31.3121(a)-1(e). The IRS may object when compensation for services, which is subject to the FICA tax, is characterized as distribution of profit, and thus not subject to the FICA tax. This issue is especially important for S corporations, where a business owner can control the amount of his or her salary while also characterizing other payments as profit distributions.

Courts Will Look to Substance Over Form In Determining Whether Payments are Wages
In Watson, the 8th Circuit had to determine whether an accountant’s employer, which was his own S corporation, had properly withheld FICA tax where he received an annual salary of $24,000 (on which the employer paid FICA tax) but also received substantial profit distributions as an owner of the corporation. The Watson court, relying on previous district and appellate decisions, focused on evaluating the economic substance of the transaction rather than the form chosen by the taxpayer. In other words, where payments to a shareholder-employee are clearly remuneration for services performed, a court will reject their characterization as “dividends” or “profit distributions.” Moreover, a taxpayer’s intentions will carry little weight for the evaluating court if the wages paid to the shareholder-employee are not reasonable.

Facts Used to Evaluate Substance of Payments to Shareholder-Employee
In affirming the district court’s conclusion that accountant Watson’s employer, his own S corporation, had failed to properly pay all FICA taxes due, the court considered:

  1. Watson’s qualifications and 20 years experience in and taxation;
  2. Watson worked 35-45 hours per week as one of the primary earners in a reputable accounting firm;
  3. Watson’s annual salary of $24,000 was unreasonably low compared to other similarly situated accountants;
  4. Watson’s salary was exceedingly low when compared to the distributions he received; and
  5. The fair market value of Watson’s services was $91,044, as determined by the government’s expert witness.

Each of these factual considerations reflects the court’s focus on evaluating substance over form.

When calculating the amount of FICA tax due, courts do not recognize a taxpayer’s intentions as a controlling factor in evaluating whether payments to a shareholder-employee are payments for services or profit distributions. Courts and the IRS will evaluate, instead, whether a shareholder-employee is receiving reasonable compensation for services provided. In order to minimize the risk of IRS scrutiny, and the potential liability for back FICA taxes, penalties, and interest, S corporations should ensure that all of their shareholders are receiving reasonable salaries and that FICA taxes are properly calculated based on such salaries. When determining the salary of a shareholder-employee, S corporations should consider the nature of the services being provided, the shareholder-employee’s skills and experience, the market rate for the shareholder-employee’s services at other employers, and the corporation’s historical profit distributions. The S corporation may wish to use salary surveys and outside consultants to help determine the amount of reasonable compensation and provide the corporation with some additional justification for its determination of shareholder salary levels.

If your S corporation or small business would like further guidance on setting reasonable compensation levels for its owner-employees, contact one of the Trepanier MacGillis Battina P.A. corporate law attorneys.
About the Author:
Minnesota business litigation attorney James C. MacGillis practices extensively in the field of business and commercial litigation, and advises clients on corporate and business law matters such as incorporating in Minnesota, business entity formation, and setting appropriate compensation levels. Jim may be reached at 612.455.0503 or Trepanier MacGillis Battina P.A. is a Minnesota corporate law firm located in Minneapolis, Minnesota.