Last month, the U.S. Tax Court held in Ward v. Commissioner that payments to a taxpayer from the taxpayer’s S corporation (“S corp”) were wages, not distributions of profit.
Lateesa Ward is an attorney who formed a small law firm organized as an S corporation. Generally speaking, the owners of an S corp are taxed on their pro rata shares of the distributable profits and can deduct their share of distributable losses.
Ward was the only shareholder of the firm. During each of the years at issue in the case, Ward’s personal tax return reported no wages received, but the firm’s return showed wages and officer compensation. Because of this discrepancy, the IRS audited Ward and her firm.
As a result of the audit, the IRS challenged many of the firm’s business expenses, but the primary problem was the failure to appropriately report and pay tax on the compensation that the firm paid Ward.
As you probably know, employers are responsible for paying employment taxes on wages. Ward failed to do so, claiming that much of her “officer compensation” constituted distributions of the firm’s profits.
However, it is well settled that officers are employees, and compensation paid employees serving as officers is considered wages. As a result, the firm was liable for employment taxes on these wages.
On the other hand, when a corporation has not consistently treated an individual as an employee, the corporation is liable for employment tax on compensation paid to that person only when the firm had no reasonable basis for not treating the individual as an employee.
In this case, the court found that the law firm had no reasonable basis for treating Ward as anything other than an employee. Not only does the tax code say officers are employees, but Ward herself said she was an employee.
In some situations, an S corp shareholder could argue that only de minimis (minimal) services were performed and that compensation for services was neither received nor owed, so the shareholder wasn’t an employee. But in this case, Ward was the sole owner, and by practicing law, she was clearly performing services for her S corp.
Aside from the officer compensation issue, there was another problem in that Ward did not report all of the firm’s income on her own return, although she was the sole shareholder.
Ward argued that the tax laws allow an S corp’s shareholder to receive tax-free distributions up to the amount of the shareholder’s basis, but the court pointed out that “income” is different than “distributions.”
Regardless of whether a shareholder removes money from the company (a “distribution”), the shareholder is taxed on the S corp’s net income. As a result, S corp shareholders often want to characterize all payments as distributions of profits instead of wages.
The IRS carefully examines these situations and if dividends are actually paid “in lieu of reasonable compensation” for services, those alleged dividends will be taxed as wages. Because of this, when shareholders perform services for the S corp, they are employees, and payments for their services are wages.
A C corporation (“C corp”), on the other hand, is taxed on its net income, whether or not it is distributed, and when it makes distributions to shareholders, those distributions are taxed again as personal income to the shareholders.
This double taxation is the major disadvantage of conducting business as a C corp. so C corp shareholders often try to disguise the distribution of profits as wages in order to avoid double taxation.
Although shareholders can also avoid taxation of amounts a C corp retains, there are limits on retained earnings. Accumulated earnings beyond $250,000 must be justified as reasonable for the needs of the business or be subject to a tax of 20% in addition to the regular corporate tax.
Please feel free to contact us if you have any questions about the best way to structure your business to protect your earnings from unnecessary taxation.
Photo by Sharon McCutcheon on Unsplash
