Payroll Tax Audit: S Corporations Distributions Re-Characterized as Wages

Wages paid to shareholder-employees of S corporations are subject to Federal Insurance Contributions Act (FICA) taxes, while distributions made by the S corporations are not.  Some  S corporation shareholder-employees have been saving money by withdrawing funds from the corporation in the form of distribution rather than wages, and not paying the appropriate level of taxes.  This leads to payroll tax audits from the Internal Revenue Service.

Shareholder-employees of S corporations have had agreements where the employee drew an unreasonably low salary from the corporation, but had an arrangement where the corporation would pay out distributions equal to what their actual salary should have been.

Payroll tax audits will occur for these corporations if the IRS agents believe that the employees have unreasonably low compensation, and high amounts of distributions. The IRS and the tax court system have re-characterized these distributions as wages, meaning that FICA tax assessments, interest, and penalties apply.  A recent decision made by the US Court of Appeals for the Eight Circuit reaffirms the IRS re-characterization of S corporation distributions as wages.

Not all cases of distributions are the result of the practice of decreasing wages paid and increasing distributions to reduce FICA taxes.  These distributions can occur because the shareholder-employee may be uncertain on how to establish a salary.  The S corporation’s income or losses are divided up and passes to the shareholders, who must report the income or loss on their individual income tax returns.  Shareholders may be unclear in how to properly report the income on their individual income tax returns.

Improperly reporting income or loss on individual income tax returns has consequences. For example,  by under-reporting and not paying enough taxes, individuals are not paying the 15% Social Security tax. This will lead to problems when the individual retires and has a small amount of Social Security to live on. Companies are more likely to face a payroll tax audit if the shareholder-employees report unreasonably low wages.

By: Timothy S. Hart