I. A Lesson for the Ages: If You Can’t Beat Them Join Them – continued

b. The Saving Grace: S Corporations

The self-employed businessperson doing business abroad should consider forming an S corporation.

i. Why S Corporations are so Popular Among Small Businesspersons

The short answer is that S corporations allow small businesspersons to avoid paying self-employment taxes on wage payments. Following the lead of C corporation stockholders before them, S shareholders have tried to draw their money out of the corporation in the most tax-advantageous manner possible, whether through salaries, rents, loans, dividends, or more sophisticated forms of executive compensation

The most tax-advantageous way for S shareholders who provide services to the business to draw their money out of the business is by paying themselves dividends. That avoids both the double tax bite of C corporation dividends and the employment taxes due on wage payment. Before doing so, the small businessperson should heed the warning of the IRS. The warning from the IRS, sounding loud and clear in the cases considered next, is this: first, pay “reasonable compensation” to shareholder-employees who perform substantial services for the S corporation or else face recharacterization of whatever payments have been made to the shareholder.

ii. A Recurring Problem: Is an S Corporation liable for FICA, FUTA, and withholding taxes on “dividends” paid to shareholders who receive no wages but who nevertheless perform substantial services?

Since 1989, the IRS has cracked down on small business compliance with the payroll tax regime by recharacterizing dividend and loan payments made to shareholder-employees of S corporations as wages, subject to employment taxes. If that pattern strikes you as being the opposite of the approach that the IRS has traditionally taken, your mind is not playing tricks on you. Traditionally, the pattern has been the reverse. That is, the IRS has attacked wages paid to shareholder-employees as constructive dividends.

The reason for the switch lies in the rising popularity of S corporations. As discussed above, one response to the employment tax regime has been for shareholders in very small S corporations to pay themselves dividends. That avoids both the double tax bite of C corporation dividends and the employment taxes due on wage payment.

Unfortunately for the shareholder-employee of a small S corporation, the courts have sided with the IRS. In doing so, they have recharacterized dividends as wages. Dividend recharacterization cases center on the definition of wages. Under Section 3121(a) of the Internal Revenue Code, wages have two definitions. For purposes of the Social Security Act, wages are broadly defined as “all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash …” Wages for the Federal Unemployment Tax Act are defined with identical language.

The seminal dividend recharacterization case was Joseph Radtke, S.C. v. United States. Radtke was the sole director/shareholder and worker of an S corporation. He did not receive a salary from the corporation but he did receive substantial dividends. The IRS challenged the “dividend” designation and assessed deficiencies against the corporation for failing to pay FICA and FUTA taxes. Courts, Congress, and the IRS had been leaning in this direction even before Radtke but not without fierce opposition from small businesspersons. Radtke finally brought matters to a head.

The court held for the Service, recharacterizing all of Radtke’s dividends as wages. Citing the definition of wages, the court reasoned that Radtke’s “dividends functioned as remuneration for employment.” In bold language, the court issued a stern warning: “An employer should not be permitted to evade FICA and FUTA by characterizing all of an employee’s remuneration as something other than ‘wages.’”

The Service’s success in Radtke was followed by several other victories, re-enforcing Radtke’s binding precedent. In Fred R. Esser P.C. v. United States, an S corporation made regular “loans” to its sole incorporator-director, but paid him no salary. Esser repaid the loans at the end of each year leaving declared dividends in the corporation. He also paid income tax on the dividends.

Again the court upheld the IRS’s assessment for employment taxes on the dividends. In doing so, the court relied on the Radtke precedent and statements in Treasury Regulations §§ 31.3121(a)-1(c) and 31.3306(b)-1(c) that the corporation’s classification of payments as wages was immaterial.

In order to prevent the IRS from recharacterizing dividend payments as wages, taxpayers have advanced several arguments. A popular argument is that no compensation was ever intended. Courts, however, have rejected “intent” as a relevant consideration in the dividend-salary determination. Spicer Accounting, Inc. v. United States, is an example of such a case.

In Spicer, the Ninth Circuit considered a case with facts that were similar to Radtke. A married couple were the sole shareholders of an S corporation. The husband was the sole employee. The husband withdrew only dividends. The court held that the payments to him constituted “wages” for FICA and FUTA purposes. In so holding, the court completely disregarded Mr. Spicer’s argument that he only intended to receive the payments as dividends. The court tersely said, “Mr. Spicer’s intention of receiving the payments as dividends has no bearing on the tax treatment of these wages.”

By rejecting “intent” as a relevant consideration in the dividend-salary determination, the court turned away from a bright-line test used in a line of cases dating back to the 1960’s. That test required payments made to a shareholder-worker to have been intended as compensation before they could be treated as wages.

The only difference between the cases that adopted the “intent” test and Radtke and its progeny is that the taxpayer was the party arguing for recharacterization, not the IRS. Otherwise, the facts remained the same, including, as shocking as this might sound, the taxpayer’s attempt to recharacterize as wages, payments (i.e., dividends or loans) made to a shareholder-worker who received little or no salary.

Paula Construction Co. v. Commissioner is an example of such a case. In Paula Construction Co., the Tax Court refused to allow the recharacterization. The facts are as follows. Two stockholders of a closely held S corporation performed substantial services for the corporation. Neither stockholder received any wages, only dividends.

The taxpayer argued that part of his dividends were compensation for services. Why did the taxpayer attempt to recharacterize part of his dividends as wages? At first blush, this seems counterintuitive because if the court granted the relief that the taxpayer requested, then all that the taxpayer would succeed in doing is increasing his tax liability. After all, wages are subject to social security taxes but dividends aren’t. Only two explanations exist for an argument this unconventional: the taxpayer must either have been ignorant or he must have had a good reason for doing so.

The reason the taxpayer attempted to recharacterize his payments as wages was not only appropriate, but it was essential to the survival of this S corporation. Put simply, the corporation was fighting to reclaim its status as an S corporation. Thus, convincing the court that these payments were actually wages was more important than any tax savings that could result from the status quo – i.e., the continued designation of payments as dividends.

How did the corporation lose its S corporation election in the first place? The corporation made a colossal mistake. It received more than 20% of its income as interest. That resulted in involuntary termination of the S corporation election.

Unfortunately for the taxpayer, the tax court refused to recharacterize part of his dividends as wages. In doing so, the court brushed aside the fact that the stockholder-worker performed substantial services, yet did not receive any compensation. Instead, the court focused exclusively on the intent factor.

The Court held that there was no evidence that the payments made were ever intended to be compensation for services performed. The court explained why. First, the court reasoned that the payments made to the shareholder were not treated as compensation on the corporation’s books or tax returns. Second, the disbursements were in proportion to stock holdings, a trait that is characteristic of dividends, not wages.

The courts and the IRS seem to have adopted a double standard. If the taxpayer attempts to recharacterize dividends as wages, “intent” dominates the decisions. But if the IRS argues for recharacterization, then the courts disregard intent entirely. What can be inferred from this is that courts will apply the “intent” test whenever it benefits the IRS but will disregard the “intent” test whenever it benefits the taxpayer.

This outcome may be justified to the extent that the taxpayer is distorting the actual character of payments received from the corporation for tax advantage. However, the subsequent recharacterization of all the dividends paid to an S corporation shareholder is too harsh of a penalty.

iii. The Costs to a Small Business of Recharacterization

A far worse fate than actually paying employment taxes is when the IRS makes an assessment for unpaid employment taxes. Employers face serious consequences from a successful IRS recharacterization of dividends as wages. The liability falls on the employer in two ways. First, assessments for the employer’s share of past withholding, FICA and FUTA taxes, will be due.

Second, in addition to the actual taxes that must be paid, penalties and interest will likely be added. For failure to file a return, the penalty is up to 25% of the tax due (up to 75% if fraudulent). And for failure to pay taxes, the penalty is up to 10%. With respect to interest, the employer must pay interest at the federal short-term rate plus three percentage points.

In addition to the actual taxes, penalties, and interest that await an employer upon reclassification, other serious consequences may result. For example, if distributions are recharacterized as wages, this may create a second class of stock. This might happen if some shareholders successfully prevent the IRS from recharacterizing their dividends as wages while others fail. In that case, distributions to shareholders in the S corporation would no longer be in proportion to their holdings. This result would be catastrophic. Put simply, the S corporation election could be terminated.

iv. Reasonable Minimum Compensation for S Corporation Shareholder-Employees

1. Compensation Must Be Paid First

With courts turning a deaf ear on taxpayer arguments that dividend payments should not be recharacterized as wages because no compensation was intended, planners should consider a new approach. Earlier dividend recharacterization cases have reinforced the lesson that paying all dividends to a shareholder-employee will invariably lead to an IRS victory in having the entire amount reclassified.

If paying all dividends leads to reclassification of the entire amount, then the only logical way to avoid this draconian result would be to not pay all dividends. Does that mean that corporations should discontinue dividend payments altogether? Of course not. Instead, corporations should pay a reasonable minimum salary to each shareholder-employee. How much is reasonable is addressed in the following section. Inherent in this planning philosophy is the idea that S corporations should apportion payments to shareholder-employees between compensation and dividends.

Paying a minimum salary is a double-edged sword. On the one hand, it is necessary to forestall reclassification. On the one hand, it creates employment tax liability. For example, shareholder-employees who receive minimum salaries must pay employment taxes while shareholder-employees who receive only dividends and who are successful in thwarting the IRS from recharacterizing those dividends as wages do not.

While employment tax liability tips the scales in favor of dividends, several factors indicate the wisdom of paying a minimum salary. Indeed, paying salaries can accomplish important objectives. For example, in light of the fact that S corporations are limited to one class of stock, salaries can give shareholders who make more valuable contributions to the business a larger interest in profits. There is no other way to achieve that result in an S corporation.

Second, some states do not recognize S corporations. In those states, S corporations are treated like C corporations. Wages paid to shareholder-employees in that situation avoid the double tax bite. Third, in order for a shareholder to have any chance of participating in the corporation’s retirement plan and other fringe benefits, he must receive compensation. This is because employer contributions or benefits payable are inextricably tied to a shareholder’s level of income from the corporation or to his status as an employee. Just like the lottery, the shareholder must be “in it to win it.”

Finally, with respect to S corporations which previously operated as C corporations, the built-in gains tax provides a reason to pay shareholders a salary. By reducing or eliminating taxable income, in part by paying deductible wages, the S corporation may minimize the built-in gains tax.

2. What is Reasonable Compensation?

In determining what constitutes “reasonable compensation,” courts conduct a factual inquiry. The recent trend, much to the chagrin of taxpayers who would prefer reasonable compensation to be as little as possible, shows larger salaries being considered reasonable.

Litigation of this issue arises under two sections of the Code: § 162 and § 1366(e). In cases brought under § 162, the IRS argues that executive salaries are unreasonably high. Although these cases involve C corporations, the common law criteria developed in them reveals the type of evidence a taxpayer must be prepared to present in defending the salary level set.

In setting compensation, the goal of the small businessperson is twofold. First, to set salaries as low as possible, thus ensuring employment tax savings. And second, to be able to justify as reasonable these low salaries in the event that the IRS mounts a challenge. To do that, the small businessperson must adhere to the traditional common law factors used in the “reasonable compensation” determination. Those factors are found in Mayson Manufacturing Co. v. Commissioner.

The first four factors relate to the qualifications of the employee and the employment setting. They are the most relevant criteria and involve complex and subjective estimates of the value of an employee’s services to the business. One such measurement is sales made by the employee. In the event that no direct market measurements can be made, then comparison to “comparable positions in comparable business” must be undertaken.

Factors 5 through 9 contain less vital, yet more objective, data with which to support the chosen salary level. Because salary arrangements in a closely held family corporation or in an S corporation lack the arm’s length bargaining that helps to establish “reasonableness,” such arrangements merit special scrutiny by the IRS.

A distinction must be made between setting compensation for a brand new S corporation, on the one hand, and a sole proprietorship or a partnership that just recently converted to an S corporation, on the other hand. For a brand new S corporation, the early years’ salaries can be set low while losses or low profits are being realized.

The same is not true for newly converted S corporations. When a business converts from a sole proprietorship or partnership to an S corporation, the newly converted S corporation may realize losses or low profits in its early years just like a brand new S corporation. Unlike a new S corporation, however, losses or low profits realized by a newly converted S corporation do not justify paying low wages.

To circumvent this obstacle, some newly converted S corporations employ a clever trick. They set salaries at levels lower than pre-conversion self-employment business income but equal to salaries paid by comparable businesses in comparable industries. By doing so, they hope to achieve employment tax savings without attracting the scrutiny of the IRS.

Of course, these salaries must be reasonable if they have any chance of passing the “smell test.” Small businesspersons attempt to justify these salaries as reasonable on the grounds that they have complied with the common law factor requiring salaries to be proportionate to “comparable positions in comparable business.”

Whenever a newly converted S corporation employs this technique, one can be sure that the IRS is lurking in the shadows, only a heartbeat away from launching an attack. In challenging these salaries as unreasonably low, the IRS argues that compensation for shareholder-employees of newly converted S corporations should be measured by business profits of the former business.

Support for that position comes from the case of Bianchi v. Commissioner. In Bianchi, the court defined the issue narrowly: to what extent do profits made before conversion to an S corporation bear on the reasonableness of compensation to shareholder-employees of the newly converted S corporation. The Tax Court held that business profits made before conversion to an S corporation were relevant and admissible in judging the reasonableness of compensation to shareholder-employees of the newly converted S corporation.

This holding presents a whole new challenge for newly converted S corporations. Indeed, it prevents such corporations from setting salaries at levels lower than pre-conversion self-employment business income. However, small businesspersons need not despair. Two strong arguments exist to counter the IRS’s assertion.

First, implicit in the IRS’s argument is the mistaken assumption that a business’s profits are wholly attributable to an employee’s services. That is only partially true. Goodwill and return on physical and financial capital must also be given proper weight. Likewise, the role of general economic conditions and the impact they have on business profits must also be considered. The impact that each of these variables have on a business’s profits is significant.

The view that it is not possible to attribute a business’s profits to a single variable (like an employee’s services) receives support from the IRS’s position in reasonable compensation cases like Charles McCandless Tile Service v. United States.

In McCandless, a C corporation paid substantial salaries to each of its shareholders. No dividends were ever paid. Despite holding that the wages paid were “reasonable,” the Claims Court nevertheless accepted the IRS’s position that some portion of the payments had to be allocated to a return on equity capital: “As surely as the McCandlesses contributed substantially in their employee roles to plaintiff’s success, it is equally clear that they were responsible also in their stockholder roles (i.e., supplying risk capital, assuming corporate obligations, and participating in corporate decisions) for that success.” Therefore, in cases where the IRS attempts to recharacterize dividends as wages, the return due to these other factors should be emphasized.

Second, in attacking as excessive, salary levels in C corporation cases, the IRS uses the ratio of employee-owner wages to pre-salary corporation income as one measure of excessiveness. In Cromer v. Commissioner, the IRS argued that payment of 99% of the corporation’s pre-salary income to the sole shareholder of an S corporation was excessive. The shareholder did not receive any dividends. The tax court agreed with the IRS, settling on only 37% of pre-salary business income as reasonable compensation for the shareholder.

This case seems to offer a ray of hope for newly converted S corporations. Indeed, Cromer supports the notion that compensation for shareholder-employees of newly converted S corporations should be measured by the ratio of employee-owner wages to pre-salary corporation income. Therefore, Cromer’s precedent allows newly converted S corporations to achieve employment tax savings by apportioning only a part of the corporation’s profits to wages, instead of apportioning all of the corporations’ profits to wages.

Because the ratio of employee-owner wages to pre-salary corporation income is typically less than profits of the former business, the newly converted S corporation can achieve employment tax savings by using the formula advanced by the IRS and approved by the tax court. apportioning only a part of the corporation’s profits to wages.

While they might not be able to set salaries below pre-conversion self-employment business income, they certainly do not have to set salaries so high that they are proportionate to business profits of the former business. Instead, Cromer’s precedent allows newly converted S corporations to achieve employment tax savings by using the formula advanced by the IRS and approved by the Tax Court.

In each of the dividend-recharacterization cases discussed above, the entire dividend paid has been successfully recharacterized as salary. On the basis of the IRS’s own arguments, a taxpayer should be able to prevail to the extent that not everything should be reclassified.

3. Planning Considerations

In the “minimum” reasonable compensation area, a variety of potential planning opportunities, not to mention problems, exist. As previously discussed, litigation under I.R.C. § 1366(e) relates to the minimum compensation question. One issue that comes up with great frequency is whether S corporations can make dividend payments to someone other than the shareholder-employee, such as his family members? If so, can the IRS recharacterize those dividends as wages of the shareholder-employee, subject to employment tax, if the shareholder-employee does not receive sufficiently high compensation?

The answer to the first question is “yes.” The answer to the second question is also “yes,” the IRS may reallocate dividend payments made to the family members of shareholder-employees as wages of the shareholder-employee if the shareholder-employee does not receive sufficiently high compensation. Thus, if the family members are the shareholder-employee’s children, then the IRS could reallocate dividends payments made to the children as wages of the parent if the parent does not receive sufficiently high compensation. The only way to avoid recharacterization is for the parent to receive sufficiently high compensation.

Assuming that condition is satisfied, what does it mean for the corporation? The corporation avoids paying employment tax on any business income that it distributes to the children in the form of dividends. Thus, if done correctly, the corporation achieves an employment tax windfall. That is why paying dividends to the family members of a shareholder-employee is such a popular planning technique.

In Davis v. Commissioner, an orthopedic surgeon separated the X-ray and physical therapy portions of a business that he owned and incorporated them as two separate S corporations. He then transferred most of the stock to his children. The IRS argued that the income of both corporations should be taxed to the surgeon. The Tax Court disagreed. It held that the surgeon, who dedicated only twenty hours per year to his duties as director of both corporations, was not responsible for the income earned by either corporation. Instead, the income was due to the equipment and to the services performed by each corporation’s employees. In addition, the court held that valid business reasons existed for setting up the corporations, aside from a tax avoidance motive.

The favorable precedent set by this case could be used whenever a business is split into two or more functions, with the functions of both units capable of being performed entirely by employees other than the shareholder. Of course, to the extent that these employees receive stock, their dividends will be taxed. But that is not a deterrent because dividend tax rates often pale in comparison to employment tax rates.

This is especially true when the employees are the children of the shareholder, as they were in Davis. That’s because dividends paid to children under the age of fourteen are taxed at the parents’ marginal rate (“Kiddie tax”), a rate that is significantly less than the employment taxes that a parent would have to pay if a child’s dividends were recharacterized as wages.

As large as the potential for employment tax savings might be in the previous example, an even larger potential for employment tax savings exists. The largest potential for employment tax savings comes from reducing the salary of a family member whose earnings are below the $ 110,100 OASDI tax base (http://www.ssa.gov/oact/cola/cbb.html). This assumes, of course, that the other family shareholders who receive increased dividends are in a lower income tax bracket.

Care must be taken to protect the interests of minor children who receive stock in the corporation. For example, in Davis, a guardianship was established. Kirkpatrick v. Commissioner is an example of another case in which the taxpayer prevailed.

In Kirkpatrick, the parents transferred stock in their S corporation to their children. Declining to attribute all of the income of the corporation to the parents, the court held that the children’s ownership had economic reality. In support of that holding, the court emphasized two points. First, the active role that the mother played as custodian of her children’s shares. And second, the arm’s length manner in which the father handled a loan to the business from the children’s profits. Specifically, he made timely payments, including interest.

In accordance with Circular 230 Disclosure