Tax Court Holds It Does Not Have Jurisdiction to Consider Reasonable Salary Determination in Exams of S Corps

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Last month in Financial Consultant Fails To Avoid Self-Employment Tax With S Corp Structure we discussed the possible ways that service-performing employee/shareholders in S Corps can minimize employment taxes. IRS is aware of the abuses in this area and seems to be looking carefully at S Corps that are profitable and pay what it thinks are low wages to those key employee/shareholders.

In the last few weeks there have been some interesting Tax Court orders considering a jurisdictional issue spinning from IRS audits of S Corps and their shareholders.

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First some background.

Individuals who earn service income directly have to pay Social Security and Medicare taxes, which are often referred to collectively as the self-employment tax. [Note that the tax rate for Social Security taxes is 12.4% and the rate for Medicare taxes is 2.9%; for 2017 Social Security taxes are levied only on the first $127,200 while the Medicare rate applies to all service income]. If the S corporation, rather than the individual, earns that income, then the S corporation does not have a separate employment tax liability and the shareholder does not have self-employment tax liability on his share of the S corporation’s income.

The scheme minimizes employment tax obligations by essentially paying below market wages to the S Corporation’s shareholder/employee; cash still comes out to the shareholder/employee in the form of other distributions.

As part of an IRS audit, IRS will examine the S Corp’s return and analyze the reasonableness of the salaries. If IRS thinks the wages are not high enough, it will send the S Corp a Form 4668, Employment Tax Examination Changes Report, which can propose what it thinks the reasonable salary is and thus propose employment tax increases (as well as penalties). Interestingly, this is the reverse of old reasonable compensation cases where C Corp shareholder/employees would pay themselves a salary that IRS argued was too high. As Keith notes and based on his experience in litigating a couple of those older reasonable compensation cases (see, e.g., Royal Crown v Comm’r) these are time-consuming to litigate and, as with many valuation cases, often involve expert testimony.

As a substantive matter, the key inquiry should be whether the payments that the shareholder received that were not labeled as compensation were remuneration for services. Not surprisingly, comparables are key, and IRS will look to industry and regional standards.

This brings us back to the procedural issues.

In response to the IRS issuing an Employment Tax Examination Changes Report (Form 4668) some S Corps have filed petitions to Tax Court to attempt to get the Tax Court to consider the reasonableness of the salaries.

Employment taxes are generally not subject to the deficiency procedures. The Tax Court has jurisdiction under Section 7436 to consider proceedings relating to determinations of an individual’s employment status. (Lavar Taylor has discussed this provision extensively in his series of posts considering the SECC v Commissioner case).

Even though the S Corps are not getting a notice of deficiency in a couple of recent cases they have essentially claimed that the IRS’s adjustments to the salaries that the corps paid to its shareholders are determinations for purposes of Section 7436.

The Tax Court has disagreed stating that the IRS adjustments have nothing to do with a determination of employee status but only relate to the amount of salary that should have been paid to someone who the parties already agree is an employee.

To that end, see the discussion in Azarian v Commissioner, involving a S Corp that operated a law firm and had a sole shareholder, where the Tax Court granted the IRS’s motion to dismiss on the grounds that it did not have jurisdiction:

Petitioner consistently treated Mr. Azarian as an employee for the taxable periods at issue. Therefore respondent did not make a determination that Mr. Azarian was an employee of petitioner, but rather concluded that petitioner failed to report reasonable wage compensation paid to Mr. Azarian for 2012-14. Section 7436(a)(1) only confers jurisdiction upon this Court to determine the “correct and the proper amount of employment tax” when respondent makes a worker classification determination, not when respondent concludes that petitioner underreported reasonable wage compensation, as is the case here.

The Tax Court took a similar approach in Arroyo Corp v Commissioner, also an S Corp exam looking at the reasonableness of salaries to shareholder/employees, where it stated that while the IRS made a determination with respect to the amount of the compensation, that was insufficient to generate jurisdiction under Section 7436.

Conclusion

S Corps wishing to challenge the IRS on these issues will likely have to go the refund route, though given the divisible nature of employment taxes those corporations need not fully pay any proposed liability. The Tax Court has closed one door though it is possible that a CDP proceeding could allow a taxpayer to challenge the liability, though that issue spins off other procedural issues, including whether the S Corp had a prior opportunity to challenge the liability. That issue is subject to considerable uncertainty, though last week’s Tenth Circuit opinion in Keller Tank v Commissioner sustained the Tax Court and IRS’s restrictive approach to the definition of prior opportunity (stay tuned as we will blog that case this week).

Tip of the hat to our hard-working blogging colleague Lew Taishoff, whose blog on the Tax Court brought these recent orders to my attention.

 

 

Leslie Book About Leslie Book

Professor Book is a Professor of Law at the Villanova University Charles Widger School of Law.

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