IRS wins two cases reclassifying S distribution as wages.

• Author: Koppel, Michael D.
• Position: S Corporations

Several years ago, the IRS won a significant Tax Court case involving classification of an S shareholder's compensation as wages for Federal income tax purposes. In Joly, TC Memo 1998-361, the court concluded that part of the income distributed by Joly to its shareholders was compensation for services and wages for Federal employment tax purposes. Many tax professionals were concerned that Joly was just the beginning of the Service's attempt to reclassify S corporation payments for services. Now two new cases affirm Joly. Each has slightly different facts and circumstances, but the rationale behind the decisions is the same.

In Veterinary Surgical Consultants P.C. (VSC), 117 TC No. 14 (2001), Dr. Kenneth Sadanaga was the sole shareholder, president and officer of Veterinary Surgical Consultants P.C., an S corporation. All of VSC's income derived from consulting and surgical services that Dr. Sadanaga provided to Veterinary Orthopedic Services LTD (VOS). Dr. Sadanaga spent at least 33 hours a week providing services on behalf of VSC to VOS. VOS provided VSC with a Form 1099-MISC for every year, which VSC reported as gross receipts on its S return. VSC did not provide a Form W-2 or 1099-MISC to Dr. Sadanaga, nor did it file any payroll tax returns for him. Dr. Sadanaga reported his share of VSC income as nonpassive S income on his individual return.

In addition to the time Dr. Sadanaga spent at VOS, he was also a full-time employee of Bristol-Myers Squibb Co. (Squibb). Dr. Sadanaga received a W-2 from Squibb that he reported as wages. Squibb withheld Social Security taxes for Dr. Sadanaga. The following table summarizes VSC's net income and the wages Squibb paid to Dr. Sadanaga during the audit period.

In the second case, Yeagle Drywall Company, Inc., TC Memo 2001-284, John Yeagle owned 99% of Yeagle Drywall Company, Inc. (Drywall), a drywall construction contractor; his wife owned the other one percent. Yeagle performed many services for Drywall, including soliciting business, entering into oral and written contracts, overseeing finances, collecting accounts receivable and hiring and firing workers. Although Drywall did not make regular payments to Yeagle, he paid personal expenses from the company's bank account and withdrew money at his discretion. (There is no indication that Yeagle's personal expenses were deducted by Drywall.) Drywall treated all workers, other than Yeagle, as independent contractors and issued Forms 1099-MISC to them...