Thursday, December 19, 2002

Still No Wine

Perhaps one of the most frequent disputes that I have with accountants involves FICA taxes. Many accountants believe that their clients can lower the amount of FICA taxes that they pay by incorporating their businesses, making S elections, and then paying themselves low or nominal salaries. The clients then take the remainder of their compensation in the form of dividends that are not subject to FICA.

Early this month, the U.S. Court of Appeals for the Third Circuit, in an appeal of two decisions from the Tax Court, rejected this strategy. While the appellate decision is not binding as precedent, one of the Tax Court opinions is.

The two Tax Court opinions, Veterinary Surgical Consultants, P.C. v. Commissioner and Yeagle Drywall Company, Inc. v. Commissioner, were both decided on October 15, 2001. In both cases, the corporations involved had essentially one shareholder, who was also the principal officer, head supervisor, chief rainmaker, and just about everything else. In the Veterinary Surgical case, the owner took no salary. In Yeagle, the owner took a fairly nominal salary. The taxpayers categorized all income from their businesses other than salary as S corporation dividends.

The Tax Court opinions and that of the Third Circuit make short shrift of the taxpayers’ arguments that officers are not employees. In essence, the courts looked to the economic reality of the businesses–the income of the business was principally generated by the efforts of these sole shareholders. The funds paid to them by their corporations were paid to them for their labor.

Interestingly, these opinions can be contrasted with another Tax Court opinion of last year, Pediatric Surgical Associates, P.C. v. Commissioner. In that case, the physicians working for a professional corporation fell into two categories, non-shareholder physicians and shareholder physicians. In essence, they performed identical duties and the lion’s share of their compensation was tied to their performance–hours worked, fees generated, etc. However, the shareholder physicians received additional compensation based essentially on their ownership. There, the shareholder physicians tried to make the argument that the Service made in Veterinary Surgical and in Yeagle, namely that the additional compensation was for services rendered as officers of the corporation. The Tax Court rejected that argument, finding that the time spent by the shareholder physicians on administrative tasks did not materially differ from that spent by the non-shareholder physicians. In that case, the additional payments made to the shareholder physician could only be related to their ownership of the corporation. Thus, the payments were not deductible as compensation, but were recharacterised as dividends. Because the payments were not deductible, the corporation had profits on which it had to pay taxes. Of course, the payments themselves were also taxable, so there were two levels of taxability on the same funds.

I still expect to spar with accountants over this issue. And, given the low level of IRS audits, clients may feel that there is an acceptable level of risk in playing "audit roulette." However, given the growing importance of FICA and SECA as part of the federal tax base, it seems certain that the Service will be devoting additional resources to focus on this issue.

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