Eighth Circuit Court of Appeals Gives Service A Major Victory To Recharacterize Distributions from an S Corporation to Its Shareholder(s) as Wages for FICA Purposes
In David E. Watson, P.C. v. Commissioner, 668 F.3d 1008 (8th Cir. 2012), aff’g 757 F. Supp. 2d 877 (DC Iowa) the Eighth Circuit affirmed a federal district court of Iowa’s decision recharacterizing a substantial portion of dividend distributions made by an S corporation to its sole shareholder as wages for FICA purposes. Presumably, such characterization would control for purposes of withholding, FICA and would be required to be reported as compensation for services (“wages”) rendered.
Watson specialized in partnership taxation. After leaving his position and Ernst & Young, Watson obtained a 25% interest in an accounting firm located in West Des Moines, Iowa, known as Larson, Watson, Bartling & Eastman. At trial, Watson testified he received no salary when the firm first began operations because the entity did not have money to pay him. Eventually, one partner exited and the firm added a new partner, reemerging as Larson, Watson, Bartling & Juffer, LLP (LWBJ). In 1996, Watson incorporated David E. Watson, P.C. Watson (DEWPC) transferred his individual 25% interest in LWBJ to DEWPC, and thereafter DEWPC replaced Watson as a partner in LWBJ. Watson served as DEWPC's sole officer, shareholder, director, and employee. Through an employment agreement, DEWPC employed Watson, but Watson exclusively provided his accounting services to LWBJ for the period relevant to this dispute. From its inception, DEWPC elected to be taxed as an S Corporation.
In both 2002 and 2003, DEWPC distributed $24,000 to Watson as employment compensation. Watson testified that the LWBJ partners made the determination that LWBJ had sufficient cash flow where it could distribute $2,000 a month to each partner, regardless of the seasonality of the business. There were no documents reflecting these salary discussions, and no other LWBJ partner testified at trial. Ultimately, DEWPC is the entity that authorized and paid Watson's salary. In addition to salary, Watson, through DEWPC, received $203,651 from LWBJ as profit distributions for 2002. In 2003, Watson, through DEWPC, received $175,470 as profit distributions from LWBJ. Thus, in 2002 and 2003, after DEWPC paid Watson's salary and other expenses, it distributed all remaining cash to Watson as dividends.
The IRS, in examining DEWPC, determined that it underpaid certain employment taxes pursuant to FICA, see I.R.C. §§ 3111(a), (b), in 2002 and 2003. The IRS assessed additional tax and penalties against DEWPC for the eight quarters covering 2002 and 2003. On April 14, 2007, DEWPC paid the delinquent tax, penalty, and interest for the fourth quarter of 2002 and sought a refund from the IRS. The IRS denied DEWPC's refund claim, and DEWPC then sued the United States in district court. The United States counterclaimed, seeking to recover employment taxes, penalties, and interest that remained unpaid for 2002 and 2003.
Federal District Court of Iowa’s Decision in Favor of Service
After denying DEWPC's motion for summary judgment, the district court held a bench trial on the merits. At trial, the government's expert, Igor Ostrovsky, opined that the market value of Watson's accounting services was approximately $91,044 per year for 2002 and 2003. Ostrovsky is a general engineer with the IRS and has worked on approximately 20 to 30 cases involving reasonable compensation issues. In forming his opinion as to Watson's salary, Ostrovsky relied on several compensation surveys and studies particular to accountants. Primarily, Ostrovsky focused on the Management of an Accounting Practice (MAP) survey conducted by the American Institute of Certified Public Accountants, which contained adjustments for specific regions. Ostrovsky discovered that an owner–defined as an investor and an employee–in a firm the size of LWBJ would receive approximately $176,000 annually, which reflected both compensation and return on investment. Ostrovsky also discovered that a director–an employee with no investment interest–would receive approximately $70,000 in compensation alone. Because owners billed at rates 33% higher than directors, and because Ostrovsky viewed Watson as a de facto partner of LWBJ, Ostrovsky increased the director compensation by 33% to arrive at owner compensation or $93,000. Ostrovsky then made a downward adjustment to $91,044, accounting for untaxable fringe benefits. In reaching his conclusion, Ostrovsky used average billing rates rather than Watson's actual billing rates.
Ultimately, the district court adopted Ostrovsky's opinion and determined that the reasonable amount of Watson's remuneration for services performed totaled $91,044. Therefore, the district court rendered a tax deficiency judgment against DEWPC, which included unpaid employment taxes, penalties, and interest in the amount of $23,431.23. DEWPC appealed to the Eighth Circuit.
Eighth Circuit Affirms Federal District Court’s Holding In Favor of IRS
The Eighth Circuit did not have a difficult time affirming the trial court’s decision. It first cited the Seventh Circuit’s decision in Joseph Radtke, S.C. v. United States, 895 F2. 1196, 1197 (1990) as the leading authority in resolving the FICA issue presented for appeal as to “whether, based on the statutes and unusual facts involved, the payments at issue were made to [Watson] as remuneration for services performed.”It then cited its own precedent in Schneider. Where, as here, “the corporation is controlled by the very employees to whom the compensation is paid, special scrutiny must be given to such salaries, for there is a lack of arm's length bargaining.” Charles Schneider & Co. v. Commissioner, 500 F.2d 148, 152 (8th Cir. 1974). Ultimately, whether payments to a shareholder “represent compensation for services or constitute a distribution of profits is essentially the determination of a matter purely of fact.” Standard Asbestos Mfg. & Insulating Co. v. Commissioner, 276 F.2d 289, 294 (8th Cir. 1960) (internal quotation omitted).
When it determined the amount that constituted remuneration for employment, the district court required DEWPC to prove it paid Watson reasonable compensation, which DEWPC claims was error. According to DEWPC, because the district court allegedly applied an incorrect legal standard, it incorrectly found that $91,044 constituted Watson's wages in 2002 and 2003. To buttress this argument, DEWPC repeatedly asserted that there is no statute, regulation, or rule requiring an employer to pay minimum compensation. And, by requiring proof of reasonable compensation, DEWPC argues, the district court imposed a minimum compensation requirement. Rather than looking to whether compensation was reasonable, DEWPC contends that the district court should have focused on taxpayer intent when characterizing the payments.
The Eighth Circuit viewed that the trial court had the right to determine to what extent was what Watson received from DEWPC was “reasonable compensation” for §162(a) purposes which is determined in this Circuit by a factors test . In applying the factors, the district court found the value of Watson's services was $91,044 for 2002 and 2003.
Although reasonable compensation is usually an issue found in the context of an income tax deduction, the IRS finds the concept equally applicable to FICA tax cases. In Revenue Ruling 74-44, 1974-1 C.B. 287, an S corporation distributed dividends to its two sole shareholder-employees but did not pay any wages for their services. The IRS took the position that it could recharacterize the nature of “dividend” payments for FICA tax purposes because “the “dividends” paid to the shareholders ... were in lieu of reasonable compensation for their services.” Id. (emphasis added). Notwithstanding Revenue Ruling 74-44, we have not had the opportunity to decide whether a reasonableness analysis is appropriate in determining if certain payments are in fact remuneration for employment subject to FICA tax.
In Joseph Radtke, S.C. v. United States, 712 F. Supp. 143, 144, (E.D. Wis. 1989), aff'd per curiam, 895 F.2d 1196 (7th Cir. 1990), the taxpayer-S corporation made dividend distributions to its only shareholder-employee but did not pay him any salary. Because the shareholder-employee also served as the corporation's only director, who authorized the dividend payment, the district court applied a substance-over-form analysis and determined the employee's ““dividends” were in fact “wages” subject to FICA ... taxation.” On appeal, the Seventh Circuit affirmed, concluding that the payments “were clearly remuneration for services performed by [the shareholder-employee].” Joseph Radtke, S.C., 895 F.2d at 1197.
Other courts addressing similar FICA characterization cases have looked a the economic substance of the transaction rather than the form chosen by the taxpayer. See, e.g., Veterinary Surgical Consultants, P.C. v. Commissioner, 117 T.C. 141, 145–46 (2001) (characterization of payments as corporate distribution of net income “is but a subterfuge for reality”), aff'd sub nom., Yeagle Drywall Co. v. Commissioner, 54 F. App'x 100 (3d Cir. 2002); Spicer Accounting, Inc. v. United States, 918 F.2d 90, 93 (9th Cir. 1990) (finding that “intention of receiving the payments as dividends has no bearing on the tax treatment of these wages”). See Boulware v. United States, 552 U.S. 421, 430 (2008), and one the applicable Treasury Regulations seem to compel in this case, and Treas. Regs. §§ 31.3121(a)-1(c) to (e). Stated somewhat differently, by looking at compensation paid (or omitted) for its reasonableness can be a guide in deciding how to characterize payments for FICA purposes. See Joly v. Comm'r, 76 T.C.M. (CCH) 633, 1998 (1998) (rejecting claim that compensation was reasonable and finding that amount did “not reflect the true character of such payments”), aff'd, 211 F.3d 1269 (6th Cir. 2000) (unpublished table decision).
Here, the finding made by the trial court was proper. DEWPC had understated wage payments to Watson by $67,044 based on certain findings: (i) Watson was an exceedingly qualified accountant with an advanced degree and nearly 20 years experience in accounting and taxation; (ii) he worked 35–45 hours per week as one of the primary earners in a reputable firm, which had earnings much greater than comparable firms; (iii) LWBJ had gross earnings over $2 million in 2002 and nearly $3 million in 2003; (iv) $24,000 is unreasonably low compared to other similarly situated accountants; (v) given the financial position of LWBJ, Watson's experience, and his contributions to LWBJ, a $24,000 salary was exceedingly low when compared to the roughly $200,000 LWBJ distributed to DEWPC in 2002 and 2003; and (vi) the fair market value of Watson's services was $91,044. Based on the record, the district court did not clearly err.
Still, Watson had not given up. He argued that instead of focusing on the reasonableness of the compensation, the trial court should have focused on DEWPC’s intent. See Treas. Reg. §1.162-7(a). Taxpayer intent, like reasonableness, is usually part of a § 162(a)(1) compensation deduction analysis, although less commonly employed. See O.S.C. & Assocs. v. Commissioner, 187 F.3d 1116, (9th Cir. 1999). Under §162(a)(1), a deduction may be made if salary is both (1) “reasonable” and (2) “in fact payments purely for services.” Treas. Reg. § 1.162-7(a).
In response, the opinion issued by the Court noted that the Ninth Circuit views this as a two-pronged test, the second prong of which requires proof of a “compensatory purpose.” Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1243 (9th Cir. 1983). Usually, courts only need to examine the first prong, i.e., whether compensation was reasonable. Indeed, “[t]he inquiry into reasonableness is a broad one and will, in effect, subsume the inquiry into compensatory intent in most cases.” Id. at 1245. However “[i]n the rare case where there is evidence that an otherwise reasonable compensation payment contains a disguised dividend, the inquiry may expand into compensatory intent apart from reasonableness.” Id. at 1244. This “intent is subjective and difficult to prove.” O.S.C. & Assocs., 187 F.3d at 1120.
Finally, DEWPC argued the Tax Court Memorandum decision in Pediatric Surgical Assocs., P.C. v. Commissioner, 81 T.C.M. (CCH) 1474, 2001 (2001), to illustrate that intent is the determining factor for characterization purposes. Pediatric Surgical Assocs., P.C., involved a § 162(a)(1) compensation deduction where reasonableness was not at issue. The Eighth Circuit rejected the intent test and felt the factual setting for that decision was different from the one at bar, …. Pediatric Surgical Assocs., P.C., was a “rare case where there is evidence that an otherwise reasonable compensation payment contains a disguised dividend.” Elliotts, Inc., supra, 716 F.2d at 1243. However, even if intent does control, after evaluating all the evidence, the district court specifically found “Watson's assertion that DEWPC “intended” to pay Watson a mere $24,000 in compensation for the tax years 2002 and 2003 to be less than credible.” DEWPC further argues that if the district court applied the principles of Pediatric Surgical Assocs., P.C., it would have limited the amount it characterized as wages to the amount of revenue each shareholder-employee personally generated, less expenses.
In this case, like Pediatric Surgical Assocs., P.C., non-shareholder-employees also contributed to LWBJ's earnings. Thus, determining Watson's compensation is more complicated than if Watson had served as the only employee generating income for LWBJ. Compare Veterinary Surgical Consultants, P.C., 117 T.C. at 145 (determining that distributions of corporate net income to sole shareholder-employee were wages); see also Walter D. Schwidetzky, Integrating Subchapters K and S–Just Do It, 62 Tax Law. 749, 799 (2009) (opining that in a pure services S corporation with a sole practitioner, nearly all of the corporation's income may likely be treated as remuneration for employment under FICA).
Therefore, as noted earlier, since the district court applied the correct legal standard, the Eighth Circuit affirmed its determination of Watson's FICA wages.
The government has been very successful in applying its long standing ruling to impute “wages” for shareholder-employees of an S corporation whom it may believe underreport the value of their services rendered to reduce payroll taxes, including HI tax, to the government. With this new “win” it should be expected that the Service will press on and attack “low service” income personal service S corporations where the facts under review lend themselves to this type of argument. Tax advisors should continue to look at Rev. Rul. 74-44 and the case law which follows its holding on imputing "wages" to shareholder-employees of S corporations.