Feb 08, 2011

Noose Tightens on 'S' Corp Salary-vs-Dividend Issue

So here comes another "S" corporation shareholder who tried to play the "dividend" versus "salary" game and lost.

Say hello to Mr. Watson, a certified public accountant who apparently thought the value of his "services" to his wholly-owned "S" corporation was a mere $24,000 per year in the form of salary during 2002 and 2003, while at the same time receiving dividend distributions totaling over $175,000 annually. The case is Watson, P.C. vs. U.S. (DC IA 12/23/10) 107 AFTR 2d.

Unfortunately, Watson testified at trial that the reason his compensation was set at $24,000 for the years 2002 and 2003 was because he felt this was all the business could afford on a regular and continuous basis, given seasonality factors. He also testified that when setting his salary, he did not look at what comparable businesses paid for similar services, and was surprised to discover that he was paying himself less salary than that typically made by recent college graduates in the accounting field.

This has been an issue which IRS has pressed on for years -- indeed in 2010, they almost made it over the legislative hump (in forcing the issue) with House passage of legislation which would have lowered the boom on service professionals who try to minimize Medicare and Social Security taxes by funneling what is arguably self-employment income through an "S" corporation which pays the dough out in the form of a nominal salary with the rest in dividends. Thanks to non action by the Senate, the matter still languishes amidst a bunch of case law for guidance.

For their part, IRS actually issued some specific guidance in Fact Sheet 2008-25 (August, 2008) which laid out the major factors which the courts have considered in determining "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
  • The use of a formula to determine compensation.

Surely we haven't heard the last on this issue.