Recently, the IRS successfully challenged a common tax strategy that is often used by owners of S corporations.

An S corporation, as many of you may know, is a corporation operating under state law that elects to be taxed as an S corporation under the Internal Revenue Code. In general, the corporation’s income is taxed to the shareholders, whether or not the profits are actually distributed.

In the case of Watson, P.C. v. U.S., David Watson, a CPA and the sole shareholder of an S corporation, paid himself a $24,000.00 salary and a little over $200,000.00 in S corporation, or profit, distributions in the years reviewed and challenged by the IRS.

The IRS pointed out that Mr. Watson, with over 20 years of relevant work experience, received a salary that was significantly less than the $40,000.00 his firm paid CPAs with little or no accounting experience.

Setting a salary for an S corporation shareholder, in relation to S corporation profit distributions, is always a difficult determination. While salaries are subject to a 2.9% Medicare tax and, up to a certain amount, and are subject to a 12.4% social security tax, corporate distributions are not. Mr. Watson, for example, saved nearly $20,000.00 in the two years the IRS challenged.

The U.S. District Court, in the Watson case, cited several factors to determine the reasonableness of salary: “the employee’s qualifications; the nature, extent and scope of the employee’s work; the size and complexities of the business; a comparison of salaries paid with gross income and the net income; the prevailing general economic conditions; comparison of salaries with distributions to stockholders….”

The Court sided with the IRS and ruled that Mr. Watson’s salary was too low and that he would need to recharacterize some of his S corporation distributions as salary or wages.

Based upon a full line of cases, including the Watson case, we recommend a thorough compensation vs. shareholder distribution analysis for S corporation shareholders.