Many business people have discovered the advantages of S corporations, including the ability to receive dividends, which are tax advantageous, as opposed to wages. A 2012 case, though, reiterates the importance of ensuring that one’s claims pass the reasonableness test. Paying oneself an artificially low salary, and receiving large dividends, may lead the Internal Revenue Service to recharacterize the payments and charge back taxes, as they did to one accountant in Iowa. The key, the court in David E. Watson, P.C. v. United States explained, was whether the amount categorized as “salary” constitutes a reasonable amount of compensation for the work performed.
David Watson was a CPA who worked at the accounting firm of Larson, Watson, Bartling & Eastman. Watson eventually formed David E. Watson, P.C., an S corporation. Watson was the sole shareholder and lone employee of his S corporation. Watson’s S corporation became a 25 percent shareholder in the Larson firm. This replaced Watson’s personal 25 percent stake in the Larson firm. In 2002 and 2003, Watson received $24,000 as salary, from his S corporation.
Watson also received additional distributions in 2002 and 2003 from the S corporation, which were originally classified as loans and/or dividends. In 2007, the government reclassified those additional payments as wages, and demanded Watson pay back taxes. Watson sued to contest the reclassification. Watson contended that, although his salary was extremely low, the S corporation paid that salary for legitimate business reasons, not to avoid paying employment taxes.
Both the trial court and the 8th Circuit Court of Appeals, however, sided with the government. The key to classifying these payments, the court explained, was their substance, not their form. The court quoted a 2001 U.S. Tax Court case, which explained that “the true analysis is whether the payments represent remunerations for services rendered.” Additionally, the appeals court pointed out that, in cases like Watson’s, “where the corporation is controlled by the very employees to whom the compensation is paid, special scrutiny must be given to such salaries, for there is a lack of arm’s length bargaining.” In Watson’s case, the dividend and/or loan payments clearly were payment for services performed, the court concluded. Watson was, in 2002-03, a CPA with both a bachelor’s and an advanced degree, as well as 20 years of professional experience, and worked full-time at the Larson firm, which was a reputable accounting firm. In light of those credentials, the court found Watson’s contentions that the S corporation intended to pay him only the $24,000 amount as his total wages to be “less than credible,” in light of the work he performed and the success of the Larson firm. The court concluded that Watson actually received in excess of $91,000 in wages in each of 2002 and 2003, and owed the back taxes imposed by the government.
S corporations, when properly implemented an managed, may serve as valuable tools to many business people. To ensure that your corporation works as it should, consult the tax attorneys at Samuel C. Berger, P.C. and the CPAs at S.C. Berger, P.C., who help people throughout New York and northern New Jersey craft business organization and tax plans to work best for them. To consult our attorneys and CPAs, contact us online or call (201) 587-1500 or (212) 380-8117.
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