One of the benefits to S-Corps, as opposed to other pass-through entities such as LLC’s or partnerships, is that S-Corp shareholders do not have to pay self employment tax on income. This distinction between the different business entities is key: 13.3% tax on your income key.

The IRS considers business owners self-employed if they are a sole proprietor (including an independent contractor), a partner in a partnership, an LLC member (whether single or multi-member LLC’s), or are otherwise in business for themselves. If you had net earnings from self-employment of $400 or more, you generally must pay self-employment taxes. The amount subject to self-employment tax is 92.35% of your net earnings from self-employment. “Net earnings” are your gross income subtracted by ordinary and necessary trade or business expenses. The 13.3% self-employment tax rate stated above consists of 10.4% for Social Security and 2.9% for Medicare. Lastly, in 2011 only the first $106,800 of your income is subject to self-employment tax.

Sounds great, right? Well, in comes the case of David E. Watson, P.C. v. U.S., No 11-1589 (8th Cir. February 21, 2012). The Eighth Circuit determined reasonable compensation is necessary in closely held S corporations for FICA tax purposes.

FICA taxes refers to the Federal Insurance Contribution Act, which includes both Social Security and Medicare taxes. David Watson (“Watson”) was a certified public accountant with approximately 20 years of experience. Watson would eventually become a 25% partner in a Des Moines based accounting firm (the “Firm”). Watson incorporated as David E. Watson, P.C. (the “Corporation”; Watson was the sole shareholder, director, and officer), an S Corp, and held his partnership interest as the Corporation. Watson classified himself as an employee of the Corporation and in each of 2002 and 2003, the Corporation provided compensation to Watson in the amount of $24,000. Watson also received distributions from the Corporation (originally distributions from the Firm) equal to $203,651 in 2002 and $175,470 in 2003.

The IRS determined that the Corporation underpaid certain FICA taxes for 2002 and 2003. Consequently, the IRS used Revenue Ruling 74-44, 1974-1 CB 287, which allows the IRS to re-characterize dividend distributions to a shareholder-employee when such distributions are received in lieu of wages. The Eighth Circuit addressed both the classification of distributions to a shareholder-employee, and the quantification of reasonable compensation. The Court looked to the substance of the parties’ transaction, and determined that Watson’s 20 years of accounting experience, the 35 to 45 hours per week that he devoted to the Firm, the Firm’s annual gross earnings of approximately $2 million in 2002 and $3 million in 2003, and that $24,000 annual salary to such an accounting professional was unreasonably low. The Eight Circuit affirmed the district court’s holding that $91,044 per year was reasonable compensation given Watson’s services to the Firm on behalf of the Corporation.

The Court outlined the following factors in determining the reasonableness of compensation paid to such shareholder-employees: (i) the shareholder-employee’s experience and training; (ii) the amount of time the shareholder-employee devotes to the business on a weekly basis; (iii) the gross earnings of the business; (iv) the amount paid to similarly situated employees in analogous industries; and (v) the fair market value of the shareholder-employee’s services.

This is not the first time the issue of reasonableness or recharacterization of S-Corp distributions to employee compensation has been tried or resolved. However, the case did scrutinize a situation where there was compensation paid to a S Corp shareholder/employee as opposed to instances where all income were previously classified as S Corp distributions.

In short, while choosing an S-Corp as a tax planning measure to avoid self-employment tax is a keen idea, do not assume your income will never be subject to FICA taxes. The IRS does have authority to recharacterize s-corp distributions to employee compensation income and assess the FICA taxes accordingly.

If you are interested in learning more about business entity selection, please do not hesitate to contact us.