IRS hot button issue

IRS Issues
Attacking S Corporations for paying unreasonably low wages

By Ralph A. Castelli, Jr.

Historically, one of the reasons C Corporations were converted to S Corporations dealt with situations where the shareholder/employees were being paid such substantial salary and bonus compensation that there was a fear the IRS could successfully attack the compensation as being unreasonably high (allowing the IRS to disallow a portion of the compensation deduction by recharacterizing part of the payments as dividends). This then would result in double tax (the imposition of corporate tax, and then individual tax to the shareholder/employee recipient).

With the substantial increase in the Social Security wage base over the last several years, coupled with the imposition of the Medicare tax which is not subject to any wage base limitation, many owners of S Corporations preferred to take S Corporation distributions, rather than substantial salaries. This has led the IRS to attack the salaries of shareholder/employees as being unreasonably low.

On October 1, 2012, the U.S. Supreme Court declined to review a decision of the Eighth Circuit Court of Appeals which held that an S Corporation paying unreasonably low salary was liable for employment taxes on dividends which were reclassified as salary. The Eighth Circuit decision affirmed the decision of a district court, which found that the shareholder/employee’s $24,000 salary in 2002 and 2003 was unreasonably low. It allowed the IRS to reclassify over $67,000 in dividend payments for each year as salary to the shareholder/employee during those years. This resulted in the corporation owing employment taxes on the reclassified dividend payments.

The Eighth Circuit did note that while the reasonable compensation issue normally comes up in determining whether a business is attempting to deduct too high an amount of compensation, the IRS has found the concept equally applicable to employment tax cases.

For further information regarding these matters, please contact Mr. Castelli at 248.740.5668 or click here to send an email.