A Blacker Shade of Grey

Yesterday, the Tax Court issued a six-pack of memorandum opinions on the question of avoidance of the requirement to pay F.I.C.A. and F.U.T.A. by declaring the income to be S corporation dividends rather than wages. The cases, Nu-Look Design, Inc., Water-Pure Systems, Inc., Specialty Transport & Delivery Services, Inc., Superior Proside, Inc., Mike J. Graham Trucking, Inc., and Veterinary Surgical Consultants, P.C. (yes, the same guy as before, just different tax years) all share several factors.

First, and perhaps foremost, the same accountant concocted the scheme to avoid tax practiced by all of the taxpayers in this case. The accountant, Joseph M. Grey, himself utilized the scheme, but to no avail. (The opinion in his case was a formal published opinion.)

Second, they were all chozzers. (The term "chozzer," sometimes spelled "chazzer," is a technical tax term derived from the Yiddish word for pig. As explained by Leo Rosten in his book, The Joys of Yiddish, it is rarely used to describe someone dirty, but rather is used for the ungrateful, the cheap, the selfish, greedy, stingy, or flagrantly unfair.) The taxpayers attempted to describe virtually all of their income as being S corporation dividends. Thus, they could not raise the argument that the amount of W-2 income that they did admit to was reasonable.

Third, the taxpayers were represented by the same counsel. I checked and found that this attorney also represented the taxpayer in Yeagle Drywall Company, Inc. Presumably, Mr. Grey was the Yeagle Company's tax preparer as well.

Fourth, the taxpayers all lost.

Now I'll bet that some of you are feeling rather smug after reading this. You're saying to yourself: I'm not a chozzer. My clients will carve out a reasonable salary for themselves and thus they won't meet the same fate as Grey’s clients.

Not so fast. In a e-mail bulletin to North Carolina tax practitioners, the I.R.S. said as follows: "An S Corporation must pay reasonable compensation (subject to employment taxes) to shareholder-employee(s) in return for the services that the employee provides to the corporation, before a non-wage distributions may be made to that shareholder-employee. This issue has been identified as an area of non-compliance and will receive greater scrutiny in the foreseeable future." (Emphasis added.)

While the bulletin goes on to make it clear that the Service will only attack S corporation distributions if the W-2 compensation is not reasonable, don't most business owners really feel that any compensation less than whatever the OASI limit is unreasonably low? In addition to exposing clients to an increased risk of audit, by reclassifying income as S corporation dividends, the amount that the employee (sorry, I mean shareholder) can put away in a qualified plan is limited.

Maybe I'm a traitor to my profession, but I think that the Service has the better part of this argument.