Distributions to S shareholders held not to be salary.

• Author: Gendreau, Robert E.

In a 1994 district court case, taxpayers received their first victory against the IRS's attempt to characterize distributions made to S shareholders as wages subject to FICA and FUTA taxes. In an unpublished case, Davis, d/b/a Mile High Calcium, Inc., the court ruled in favor of the taxpayer, stating that the Service was arbitrary and capricious in its attempt to characterize loan repayments and dividend distributions made to the S shareholders as wages subject to employment taxes. The court also awarded the taxpayer reimbursement for reasonable costs, expenses and professional fees incurred in connection with the litigation.

S corporations may be inclined to forgo the payment of salaries to shareholder-employees in favor of distributions in order to avoid payroll taxes. However, the IRS has consistently taken the position that S corporations cannot use this technique and this issue has been extensively litigated. In three of the more notable cases, Radtke, S.C., 712 F Supp 143 (DC Wisc. 1989), aff'd per curiam, 895 F2d 1196 (7th Cir. 1990), Spicer Accounting, Inc., 918 F2d 80 (9th Cir. 1990), and Dunn & Clark, P.A., 853 F Supp 365 (DC Idaho 1994), the courts ruled in favor of the Service's attempts to characterize distributions as salaries.

The Davis case involved an S corporation in which all of the stock was owned by a wife and husband (Ms. Davis and Mr. Adams). The corporation was engaged in the operation of a lime slurry brokerage business in Colorado and Utah. Mr. Adams was nominally president of the company, but had virtually no active participation in its day-to-day operations. Mr. Adams held other jobs for various companies in other locations, including working as a ski instructor, a truck driver and a heavy equipment operator. Ms. Davis was company secretary, performing part-time clerical duties, including communicating with independent contractor truck drivers. Ms. Davis also made business decisions for the company and took a few business trips. It was estimated that Ms. Davis performed about 12 hours of work per month for the company.

During the years in question, all amounts distributed by the company to the shareholders were classified as either loan repayments or dividend distributions. Checks were often written to Mr. Adams and deposited in his joint checking account with Ms. Davis. On the Service's determination that Mr. Adams was an employee of the company, it classified all checks written to him as salary. The IRS did not...