Many taxpayers have tried to limit their exposure to payroll taxes by creating an S corporation that pays them income attributable to their personal services. The taxpayer causes the corporation to pay him only a very small salary that is subject to payroll taxes. The balance of the earnings are passed through under Subchapter S as dividends, which are not subject to payroll or self-employment taxes. The S corporation does not depend on paying deductible compensation to reduce its own taxable income because it’s generally not subject to federal income tax.

The IRS became aware of this strategy a number of years ago and announced that it would impose additional payroll taxes if an S corporation paid its shareholder-employees an unreasonably low salary. In Watson P.C. v. United States (February 21, 2012), the U.S. Court of Appeals for the Eight Circuit affirmed a district court finding that the salary paid by the corporation was too low because it did not adequately reflect the value of the services performed by the shareholder-employee. Watson is not the first of these cases and likely will not be the last. Taxpayers have been warned that the IRS is aware of this strategy and will not permit its use. In addition, in 2010, the House of Representatives passed legislation that would have stopped this technique, but the Senate failed to pass the bill. Congress may eventually pass legislation prohibiting this practice if these cases continue in the courts.