Sometimes for the fun of it, I read Tax Court cases. In a recent case, the IRS prevailed against a taxpayer who was trying to game the system and avoid payroll taxes by taking out little salary and a lot of dividends.

Just the Facts Ma’am

  • Funny thing is this taxpayer was a CPA in public practice. He was partners with two other CPAs that held their partnership interests in S-corporations.
  • Firm profits were paid to the individual partner’s S-corporations, where the individuals could decide how to spend the money.
  • This taxpayer took an annual salary of approximately $24,000, and dividends in the amount of over $200,000 during the same time period.
  • The taxpayer was the only officer, director, shareholder, and employee of the S-corporation.
  • No other payments were made from the corporation except to the shareholder as wages and as dividends.
  • The partner was responsible for approximately $200,000 in billings to the clients of the firm, such that there was almost a 100% pass through to his S-corporation.
  • The IRS testified that the amount of compensation paid to the taxpayer would be determined the same regardless of whether the corporation had S or C corporation status.

What the Court Said

During testimony, the taxpayer said that he did not look at what comparable business paid for similar services. Personally, I think this was beyond stupid because all of the case law has said, an employee has to take “reasonable compensation”. Now “What is reasonable?” is a debatable question, and is the subject of several Tax Court cases, but to just say up front that he didn’t even consider what the marketplace paid was foolish.

Other factors that the Court concluded were:

  • The intent of the corporation to pay the amounts as salary or dividends was not legally relevant.
  • The fact that a corporation was an S or C was irrelevant when determining if payments made to shareholders were wages.
  • The amounts paid by the corporation were in substance compensation for the personal work he performed for the corporation.

In the end, the Court determined that the payments were in substance “compensation for services rendered”.

What it Means

Nothing earth shattering here, but some interesting conclusions just the same. Although the Court looked at the expert testimony about what the taxpayer should have been paid based upon the market ($94,000), that was NOT what the Court ended up looking at for their decision. Rather they looked at the total amount paid, and the facts supported that ALL of it was compensation for services rendered.

My advice is you better have some good substantiation for what you are paying yourself out of your closely held corporation. The days of taking a minimal salary and the rest as dividends is over. Coupled with the new preparer penalties, fewer and fewer tax preparers are going to be willing to take an unreasonable position on a tax return since they share some of the risks.

Would the IRS go after this guy if he wasn’t a CPA, who was promoting this tax strategy to prospects and clients? Would the IRS have left him alone if he gave them substantiation to justify a more reasonable salary (say $94,000)? What did the other partners do with their S-corporations? Would it have made a difference if the taxpayer had left the money in the corporation and not paid the dividends? All good questions, without known answers, but remember, Pigs Get Fat, and Hogs Get Slaughtered.

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