Subchapter S-Corporations   Subchapter S-Corporations have become a target for audit by the IRS.  A recent study of 500 S-corporation returns by the Government Accounting Office (GAO) shows that salaries to shareholders average $53,000 and distributions are $49,000.  The GAO expressed concern to Congress that many S-corporation shareholders are not reporting the proper amount of salary and are possibly evading Social Security tax.  Congress adopted a recommendation that the IRS place an emphasis on conducting audits in this area.  The IRS has announced that it will audit 5000 S-Corporation tax returns across the country after the close of the 2005 filing season.  The emphasis will be on returns that have the characteristics cited in the GAO study.  For more information click on this link: www.hillnews.com/thehill/export/   The following discussion is an excerpt from our tax research service published by the Bureau of National Affairs. We feel it is an excellent synopsis of the history of the tax issues that surround S-Corporations with respect to Self-Employment income, Social Security Tax and the position of the IRS when it comes to these matters.  The IRS has racked up numerous victories in this area including one against a CPA who should have known better.   S Corporation and Self-Employment Income   In Rev. Rul. 59-221,656 the IRS ruled that income passing through from an S corporation to its shareholders is not earnings from self-employment, and therefore is not subject to self-employment tax. Therefore, unlike partners in a partnership, S corporation shareholders could seemingly strip out earnings without paying employment or self-employment. However, the IRS and the courts have ruled that S corporations must at least pay reasonable salaries to employee-shareholders, which would be subject to FICA tax at a combined rate higher than the self-employment tax rate.657 In TAM 9530005, the National Office advised that where a corporate officer of an S corporation performed significant services for the S corporation, the "management fee" paid to the officer constituted "wages." The amount was subject to FICA and FUTA taxes and income tax withholding and not self-employment tax as the taxpayer had asserted. See below for additional discussion on unreasonable compensation resulting from the failure to take compensation. 6561959-1 C.B. 225. 657See also Boles Trucking, Inc. v. U.S. 879 F. Supp. 1019 (D. Neb. 1995). For the current combined FICA and self-employment tax rates, see 392 T.M., Withholding, Social Security and Unemployment Taxes on Compensation.,   Social Security Issues   Salary paid to an S corporation shareholder is treated as earned income for purposes of calculating social security benefits. As a result, such earned income has the potential to reduce social security benefits otherwise payable to the S corporation shareholder. While this concept seems fairly straightforward, the opportunity in an S corporation to manipulate compensation and/or take distributions in lieu of compensation has prompted considerable litigation over the years in an attempt by the Social Security Administration (SSA) to attack S corporation shareholders who are claiming social security benefits, but who are also receiving current economic benefits from their S corporation that allegedly are tantamount to salary.   One area of particular concern arises when an S corporation shareholder performs services for the corporation and takes distributions instead of salary. The SSA argues that the deemed salary that should have been paid will be treated as earned income for social security benefits computation purposes. This argument is identical to the argument that the IRS makes when S corporation shareholder employee take distributions in lieu of salaries to avoid payroll tax exposure.   For example, in Ludeking v. Finch,658 a taxpayer incorporated his sole proprietorship as a subchapter S corporation, retaining the bulk of the stock but giving some stock to his wife and child. The taxpayer also retained the title of corporate president and treasurer and spent the same amount of time in the business. He did not take a salary for such services, but did receive corporate distributions. The court again held that the SSA was empowered to denominate as wages the portion of dividends received by the taxpayer that constituted de facto wages for services performed. 658421 F.2d 499 (8th Cir. 1970). See also Veterinary Surgical Consultants, P.C. v. Comr., 117 T.C. 141 (2001) (where sole shareholder performed substantial services but paid himself no regular compensation, entire amount of S corporation dividend distributed to sole shareholder treated as wages subject to income tax and FICA withholding); Joseph M. Grey Public Accountant, P.C. v. Comr., 119 T.C. 121 (redetermination of employment status).   In Gant v. Celebrezze,659 the taxpayer was president of a newly incorporated subchapter S corporation. He actively participated in its business and received corporate distributions but no salary. The court held that the taxpayer was considered to be an employee of the corporation, receiving wages in excess of the permitted amounts, and thereby agreed that Social Security benefits should be disallowed. 659No. C-124-G-62 (N.D.N.C. 1964). In Somers v. Gardner,660 the district court held that while undistributed net income of a subchapter S corporation could not be reclassified as wages, reclassifying a distribution as wages was acceptable. The court stated that "admittedly, where dividends are in fact received by a sole shareholder who has performed services for his corporation, there may be authority for permitting the secretary to reclassify the de facto dividends as salary to reflect appropriate compensation for such services." 660254 F. Supp. 35 (E.D. Va. 1966). However, the SSA has been unable to recharacterize undistributed S corporation earnings as earned income that must be taken into account for determining social security benefits. In Gardner v. Hall,661 the SSA had contended that the taxpayer received compensation indirectly through his wife who received a salary from the corporation which was deposited in a joint bank account. The court held that the SSA's finding that undistributed subchapter S corporation earnings constituted wages was not supported by substantial evidence and, therefore, there was no basis for readjustment.662 661366 F.2d 132 (10th Cir. 1966).                              662However, in Dondero v. Celebrezze, 312 F.2d 677 (2d Cir.1963), the court held that the SSA had authority to reallocate income from the wife to her husband in a controlled corporation in determining excess earnings of the husband. This result may apply even where the retired shareholder performed services for the corporation without receiving compensation or receiving minimal compensation. In Herbst v. Finch,663 a retired seed broker handed over business operation to his children, but continued to perform services in an advisory capacity. The courts concluded that even though the corporation continued to authorize a $42,000 salary to the taxpayer, the salary was not set apart or otherwise made available to the taxpayer. Therefore, such amounts were not deemed to be wages for social security purposes.                                                        663 473 F.2d 771 (2d Cir. 1972), rev'd, 342 F. Supp. 765 (1972). In Weisenfeld v. Richardson,664 the court concluded that a taxpayer who retained the title of corporate secretary and who performed minor duties for the corporation, such as signing leases, had not performed substantial services for the corporation with a value in excess of the minimum amount necessary to reduce social security benefits. Therefore, the SSA was unable to recharacterize distributions as wages.   664463 F.2d 670 (3d Cir. 1972). Later, in Letz v. Weinberger,665 a taxpayer who wished to retire incorporated a sole proprietorship, retaining 55% of the stock with the remainder going to her children. She retained the title of president and secretary, continuing to act as an employee in return for a salary of $140 per month, the maximum monthly salary which she could earn without deductions being made from her social security benefits for excess earnings. No distributions were made from the corporation that year, though the corporation had earnings. The SSA asserted that she should have been paid more, and imputed additional salary based upon corporate net profit for the year. The court held that there was no evidence that the corporate earnings were available to the taxpayer. Therefore, the court held that the SSA was without authority to reallocate undistributed corporate earnings.                            665401 F. Supp. 598 (D. Colo. 1975). However, in Pointer v. Secretary of Health and Human Services,665.1 the district court held that monthly payments received by the taxpayer, which were described by the taxpayer as a return of capital, should be classified as earnings for old-age benefits purposes. The court noted that one is presumed to have engaged in self-employment in any given month until it is shown to the satisfaction of the Secretary that such individual rendered no substantial services to any trade or business. The court concluded that the value of services rendered is the true test for excess earnings calculations and the taxpayer's services were worth an amount sufficient to reduce his retirement benefits to zero.                                                                      665.1No. 3:92-CV-1468-G (N.D. Tex. 1993). Comment: The SSA has become more active in attacking S corporations and their shareholders who allegedly are attempting to avoid the earned income limitations through manipulation of S corporation distributions and compensation. As a result, S corporations should pay a salary to these shareholders to avoid potential challenges.