Renewed focus on S Corp. officer compensation.

S passthrough income is not subject to self-employment tax (1); only the portion of S income paid to an owner as salary is subject to FICA and FUTA taxes. A 2002 Treasury report (2) refocused attention on determining sufficient compensation for S corporation officers. The IRS is concerned that officer salary is being disguised as a distribution as to officer stock or treated as a loan, not subject to employment taxes.

The report alerted the IRS Commissioner that the issue of sufficient officer compensation is not always addressed during IRS examinations. One of the challenges the IRS faces when examining such compensation is that not all field offices have access to research tools that would allow them to determine reasonable salary. The report recommended making information available to field agents to permit them to compute reasonable compensation; thus, one can expect closer IRS scrutiny in this area.

This item examines the case law on whether the reported compensation of certain S officers is sufficient; in particular, it considers whether amounts paid to a taxpayer are, in substance, remuneration for employment (i.e., wages) under Sees. 3121(a) and 3306(b).

Cases

Spicer: (3) Mr. and Mrs. Spicer each owned 50% of all S corporation engaged in accounting and tax preparation. Mr. Spicer agreed to "donate" his services to the S corporation, but, as a stockholder, withdrew earnings in the form of dividends. Mrs. Spicer and one other employee prepared tax returns and performed bookkeeping duties for clients. Mr. Spicer was the firm's sole accountant and the only person who could sign tax returns, opinion letters and financial statement audits and represent clients in dealings with the IRS. He spent an average of 36 hours per week performing work for the S corporation and approximately 10%-15% of his time on work relating to his rental property.

The S corporation did not report officer wages, nor did Mr. Spicer report wages on his individual return. The Ninth Circuit held that because Mr. Spicer's work was crucial to the business and the S corporation could not function without him, his services were "substantial"; thus, he was an employee with wages subject to employment taxes. Agreeing with the Seventh Circuit in Radtke (4) (discussed below), the Ninth Circuit determined that regardless of how the payments are characterized, the issue is whether the payments are for services rendered.

Radtke: Radtke was the sole owner of a legal practice...