Judging by the number of recent cases on this issue, both taxpayers and the IRS have figured out that if the owner of an S corporation withdraws all of the earnings of the business conducted by the corporation in the form of dividends rather than as wages, he avoids paying the FICA taxes on those amounts. Where an owner works for his business but takes no salary, upon audit the IRS very likely will take the position that some part of the distributions to the owner must be treated as wages for services rendered. The argument is essentially the opposite of the cases where the IRS argues that shareholders took too much compensation and unduly reduced the taxable income of a C corporation. In the case of an S corporation, the IRS argues that the shareholder did not take enough compensation for the services he performed for his corporation.
The IRS has been successful in the courts with this argument. Most recently, in Patrick M. Herbert v. Commissioner (December 26, 2012), for the 2007 tax year, the taxpayer took only $2,400 of salary from his S corporation although he received total distributions of $60,000. The IRS argued that his compensation was unreasonably low and that a total of $55,000 should be treated as wages. The court agreed that the taxpayer’s wages were unreasonably low but not to the same extent asserted by the IRS. Instead, the court looked at the average salary the taxpayer had received over the prior five years, the earliest two of which were years when the taxpayer did not own the business. On this basis, the court determined that $30,445 of the amount received by the taxpayer should be treated as wages.
This issue may become even more important in the future. Beginning in 2013, the portion of the FICA taxes that is unlimited increases for some taxpayers. Previously, in addition to the FICA tax that is subject to an annual cap, the employer paid an additional tax of 1.45 percent on all of a taxpayer’s wages, and the taxpayer also paid 1.45 percent, for a total of 2.9 percent. Beginning in 2013, the tax imposed on the taxpayer goes up an additional 0.9 percent, to make the total imposed on the taxpayer 2.35 percent of all of his wages. This last 0.9 percent only applies to wages in excess of $250,000 for a married taxpayer filing a joint return or $200,000 if the taxpayer is single.