03/23/2021
Tax Court (2020)I think of corporations as a type of vessel that sails the seas of commerce. Like real ships, corporations are commanded by officers. All crew, including officers, are compensated for their services. At the end of the commercial voyage, however, an end marked either by time or transaction, profits earned are distributed to the owners of the ship. When the officers are also the owners it becomes difficult to distinguish payments that represent wages for their services in commanding the ship from payments that represent distribution of profits. Yet for both employment and income tax reasons, such distinction must be made.
In Lateesa Ward and Ward & Ward Company v. Commissioner, T.C. Memo. 2021-32 (Mar. 15, 2021) (Judge Holmes), we learn why payments from the taxpayer’s S corporation to the taxpayer were wages and not distributions of profit. The case teaches a basic employment tax lesson for S Corps and a basic income tax lesson for sole shareholders. Details below the fold.
I will start with my usual caveat: this is not my core area of teaching. So I invite readers to call me out on errors they find in my reasoning.
Law: S Corp Basics
All corporations—those ships of commerce—have both revenue and expenses. Generally speaking, when revenue exceeds expenses, the corporation has net income, a profit. How that net income gets taxed depends on whether the corporation is taxed under the rules in Subchapter C of the Internal Revenue Code or Subchapter S.
Subchapter C corporations pay taxes on their net income and when they then make distributions to shareholders, those distributions get taxed again as income to the shareholder. In contrast, Subchapter S corporations will not pay tax on that net income. Instead, the income is passed through to the shareholders, who report and pay tax on their proportionate share of that income. §1366. Thus, when there is only one shareholder, that shareholder will report and pay tax on 100% of the income passed-through. S corporations file Form 1020S to report their expenses and revenue.
It is important to see the difference between corporate income and shareholder distributions. Corporations do not have to distribute profits. Any corporation may decide to put its profits back in to operations instead of distributing profits to shareholders. A C corporation shareholder reports and pays tax on any distribution. No distribution? Then no income to be taxed! In contrast, an S Corporation shareholder must report and pay tax on passed-through income regardless of what the corporation decides to do with the profits. See Williams v. Commissioner, 110 T.C. 27 (1998).
So while S Corporations are called “pass through” entities, I prefer to think of it not as passing through actual dollars so much as passing through the obligation to report the income (or report losses). Shareholders increase basis in their shares for undistributed income and later distributions will not be taxable up to the amount of basis. §1367, §1368. See Williams, supra. The S Corporation is supposed to account for all that in its “Accumulated Adjustments Account.” Id.
Law: Employment Tax Basics
The Federal Insurance Contributions Act (F**A), codified as Chapter 21 of the Tax Code, funds the various programs administered by the Social Security Administration through taxes imposed on both employers and their employees. To fund old age, survivor and disability benefits, §3101(a) imposes on employees “a tax equal to 6.2 percent of the wages (as defined in section 3121(a)) received by the individual with respect to employment (as defined in section 3121(b)).” To fund Medicare and Medicare, §3101(b)(1) tosses on an additional tax of 1.45% of wages.
Employers pay more. While employers pay the same amount of F**A taxes on wages paid to employees, see §3111(a) and (b), employers also pay an additional tax on the first $7,000 of wages to each employee, under the Federal Unemployment Tax Act (FUTA). §3301(a). This money goes to help fund state unemployment benefits and services. The rates starts at 6% but can be reduced to as low as 0.6% depending on the employer’s obligations under relevant state unemployment rules.
To ensure these taxes get paid, §3102 requires employers to withhold F**A taxes from employee wages and pay them over on a regular basis. The funds are held in trust for the United States, §7501, and thus are part of what are called “trust fund taxes.” See Slodov v. United States, 436 U.S. 238 (1978). Employers account for both their own F**A obligations and the withheld employee F**A taxes on Form 941, filed quarterly. Employers account for their own FUTA obligations on Form 940 which is generally filed yearly.
Taxpayers who are self-employed pay both the employee and employer share of F**A taxes, §1401, reporting that on their individual Form 1040 and associated schedules.
Law: Distinguishing Wages from Distributions
When a corporation is owned entirely by one person or even a small group of persons, courts give careful attention to salary arrangements. When the corporation is a C corporation, the tendency is to try and disguise distribution of profits as wages, to avoid that double taxation. See e.g. Treas. Reg. 1.162-7(b), Exacto Spring Corporation v. Commissioner, 196 F.3d 833 (1999) (7th Cir.).
S corporations—especially those owned by a single individual—present the opposite problem: there the incentive is characterize all payments as distributions of profits—as ongoing draws against ongoing profits—instead of as wages. The IRS takes a substance over form approach in these situations. In Rev. Rule 74–44, 1974–1 C.B. 287, it decided that an S corporation’s payments to its two sole shareholder-employees were wages. The S corporation had said all the payments were distributions of profits but the IRS said, in effect, “get real.” No, the IRS did not really use that language (although I wish it sometimes would). The IRS said “the ‘dividends' paid to the shareholders ... were in lieu of reasonable compensation for their services.” Id.
The courts have agreed with the IRS approach. For example, in Fred Esser, P.C. v. United States, 750 F.Supp. 421, 423 (D. Ariz. 1990), the individual taxpayer was an attorney who practiced law through a corporation he had created. He elected for the corporation to be taxed under Subchapter S. He received payments from the corporation which he first said were loan repayments, then said were dividend distributions but which the IRS and the Court said were really wages. See also David E. Watson, P.C. v. U.S., 668 F.3d 1008 (8th Cir. 2012) (CPA’s wholly owned S corp., which reported paying CPA $24,000 in wages and $203,000 in dividends, was forced to recharacterize $91,000 of the reported dividends as salary).
The problem with solely-owned corporations is this: someone has to be in charge. Every corporation—just like every ship—must have officers. The basic rule is that corporate officers are employees, both for F**A purposes (§3121(d)) and FUTA purposes (§3306(i)). Treas. Reg. 31.3121(d)-1(b) explains that “Generally, an officer of a corporation is an employee of the corporation. However, an officer of a corporation who as such does not perform any services or performs only minor services and who neither receives nor is entitled to receive, directly or indirectly, any remuneration is considered not to be an employee of the corporation.”
Thus, if the sole shareholder of an S corporation is also an officer who, actually, performs services, that person is an employee because employment includes “any service, of whatever nature, performed” (§3212(b)). That makes payments wages because wages are “any remuneration” (§3121(a)) for employment.
We see how that works in today’s lesson.
Facts
Lateesa Ward operated her law firm, Ward & Ward, as an S corporation providing commercial litigation services. She was the sole shareholder of the corporation. For all the tax years at issue---2011, 2012, and 2013--- the firm appeared to employ one associate attorney, one Tekia S. Jefferson, to whom the firm paid salary. For each year, the firm filed the proper income tax forms (Form 1120S) and the proper employment tax forms (Form 941). For each year, Ms. Ward filed her individual tax return using Form 1040.
As Judge Holmes notes, the problem was that these forms did not all line up correctly. Like Judge Holmes, I think the information is best presented in a table.
Tax year
1120S net profit/loss
1120S officer comp
1120S Ee wages
941 total comp.
1040 wages
1040 other income
2011
(1,373)
62,388
33,925
41,484
-0-
200
2012
5,309
73,448
47,171
52,199
-0-
73,448
2013
(17,402)
-0-
108,469
77,444
24,105
48,136
For all three years Ms. Ward reported the net profit or loss from her S Corp. on her Form 1040. Readers will immediately see multiple problems. While the S Corp properly reported the wages it paid the associate attorney, it’s reporting of payments to Ms. Ward are just goofy. In 2011 the S Corp did not treat the $62,388 it paid her as wages on its 941, and Ms. Ward did not even report any of it as income! In 2012 she at least reported the $73,448 in payments as income but neither she nor the S Corp reported the amounts as wages. And in 2013 both she and the S Corp. reported at least some of the payments as wages, but the IRS thought that all the payments to her (including the $48,136 she claimed as other income) were wages, subject to employment tax.
Lesson: Payments To Officers Are (Almost) Always WagesBy the time the matter came to trial before Judge Holmes, Ms. Ward had conceded that she was indeed an officer of her own S Corp. Once Ms. Ward agreed to that, Judge Holmes found against her because of this logic: (1) payments to employees are wages; (2) officers are employees; therefore (3) payments to officers are wages. On that logic Judge Holmes concluded: “any compensation paid to Ward in her role as an officer is considered wages.” Op. at 7.
That rule is not as absolute as it sounds, however, as Judge Holmes acknowledges later in the opinion when he points out that Ms. Ward “offers no evidence...that any of these payments were anything but compensation.” Id.
Ms. Ward argued that these payments should be treated as draws from a partnership and so her error was in not reporting and paying self-employment tax. The problem with that argument is that she had chosen to sail the sea of commerce in a corporate vessel, not a partnership vessel. They are different structures and the choice of one over the other carries consequences, one of which is to create an employer/employee relationship between the corporation and its officers and thus create associated F**A and FUTA obligations for the entity.
Given that, I think the only argument that would have, in theory, worked here would be proof that (1) Ms. Ward performed only minor services and (2) she neither actually received nor was entitled to receive, compensation for services. Treas. Reg. 31.3121(d)-1(b).
But, c’mon. It was her own law firm! Ms. Ward was the captain of her ship. The big skipper. The sensei of her dojo. The star of her production. Call it what you will, it is hard (to the point of impossible) to argue that in practicing law she was not performing services for her wholly-owned S corp. law firm. You can take that lesson to heart.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return each Monday to TaxProf Blog for another Lesson From The Tax Court.
