The IRS won a federal district court case last month that is could have serious tax implications for many closely-held businesses. The tax litigation case was against a CPA who is the owner of an S Corporation. Many private firms like to form S Corporations, which have a maximum of one hundred shareholders. By forming an S Corporation, profits pass to owners without an extra layer of tax. In the U.S. today, there are nearly four million S Corporations.
The S Corp. owned by the CPA was one of four principals in an accounting firm. The firm made distributions to the CPA of $203,651 and $175,470 through the S Corp. for 2002 and 2003, respectively.
The CPA only made $24,000 in salary from the company, even though he had twenty years of experience. The IRS pointed out that recent accounting graduates can make $40,000 a year with no experience.
The IRS argued that even though the CPA did not pay less income tax from the way he got his money, he did pay less in payroll taxes. The salary, and not the profit distributions, were subject to a 2.9% Medicare tax and 12.4% FICA tax (Social Security). By taking a low salary, the IRS estimated that the CPA saved $20,000 in payroll taxes. They put his actual pay at $91,044 for the two years in question.
The judge agreed with the IRS. The CPA was ordered to pay the back payroll taxes, with interest and penalties.
The CPA said that the IRS does not have the authority to raise people's pay to try to collect more in payroll taxes. He plans to appeal the decision.
An attempt by Congress to have all S Corporation profits subject to payroll taxes died in the Senate, but the IRS may seek the legislation again.
The IRS has noticed that S Corporation profits have been growing, but salaries have been shrinking at the same time.
So what salary should owners of S Corporations take? There is no correct answer for all. Some recommend that for personal services, salary should be seventy percent. If salary is set too low, the IRS may choose to sue, as the CPA in this case found out.
Source: Wall Street Journal "The IRS Targets Income Tricks" 1/22/2011