TIGTA Report Highlights Major Compliance Issues When Businesses Fail to Pay Salaries to Sole Shareholder S Corporations

We mostly stick to procedure on this blog. So we do not often talk about the taxation of entities. But most of us, even true procedure folks know that S corporations generally do not pay federal income tax on their profits. Instead, the profits flow through to shareholders and are not subject to self-employment taxes. This creates the incentive for shareholders to minimize or even fail to pay any compensation for service-providing S Corps. The savings for S Corps who fail to pay reasonable or in some cases any compensation means that there is a hefty amount of owed Social Security and Medicare taxes that the fisc misses out on (and I leave aside any 199A issues that create further incentives for S corps and their service performing shareholders to avoid or minimize salaries).  

A recent TIGTA report highlights the problem. While IRS has made employment taxes a priority, TIGTA notes that IRS selects few S corporations for examination.  On top of that, “when the IRS does examine S corporations, nearly half of the revenue agents do not evaluate officer’s compensation during the examination even when single-shareholder owners may not have reported officer’s compensation and may have taken tax-free distributions in lieu of compensation.”

This is bad news.  The study looked at a few years of S Corp returns and noted that some really profitable S Corps with only one shareholder pay absolutely no compensation:

TIGTA’s analysis of all S corporation returns received between Processing Years 2016 through 2018 identified 266,095 returns with profits greater than $100,000, a single shareholder, and no officer’s compensation claimed that were not selected for a field examination. The analysis found that the single-shareholder owners had profits of $108 billion and took $69 billion in the form of a distribution, without reporting they received officer’s compensation for which they would have to pay Social Security and Medicare tax. TIGTA estimated 266,095 returns may not have reported nearly $25 billion in compensation and may have avoided paying approximately $3.3 billion in Federal Insurance Contributions Act tax.

As TIGTA notes, there are many cases that hold that shareholder-employees are subject to employment taxes even when shareholders take distributions, dividends, or other forms of compensation instead of wages. The substantive rules require that S Corp shareholders performing services are to take reasonable salaries.  For some of these cases, see Veterinary Surgical Consultants, P.C. v. Commissioner, 117 T.C. 141 (2001). Joly v. Commissioner, T.C. Memo. 1998-361, aff’d by unpub. Op., 211 F.3d 1269 (2002). Joseph M. Grey Public Accountant, P.C. vs. Commissioner, 119 T.C. 121 (2002). David E. Watson, PC vs. U.S., 668 F.3d 1008 (8th Cir. 2012).

Reasonable compensation cases have been around for many decades.  It used to be that the reason for the cases was the flip side because solely owned companies wanted to pay a high salary in order to avoid the problem with dividends.  So, companies with lots of assets would structure their compensation to the executives to avoid having any money left over for dividends and avoid the tax on leaving excess profits in the corporation.

To get to a court case is labor intensive, though for sure in any situation with zero compensation it would be fairly easy for the government to prove that there should be some deemed compensation. S Corp audits are handled in the field. For FY 2017-2019 there were about 5 million S corp returns filed. The audit coverage ranged from a high of 12,169 in FY 2017 to a low of 9,556 in FY 19, with coverage ranging from .2% to .3%.  TIGTA notes that many of the audits failed to even raise the issue of officer compensation. While IRS should audit more and do a better job targeting the issue, I wonder if there needs to be a statutory fix that requires or perhaps presumes some minimum salary that is pegged to earnings. Any legislative fix should consider how to minimize the burdens both to the IRS and taxpayers and remove the temptation for businesses to play the lottery.

As Keith notes, there is a long-term cost to not paying a salary which is that the owner is not building Social Security credits.  So, their social security upon retirement could be significantly less than it would have been otherwise if this goes on for a long time.  While there is a back end savings to the government that may not be reflected in the loss figures that may be much less than the costs to the government relating to the foregone employment taxes.

S Corp Shareholders Unable to Deduct Losses As Guarantee Does Not Create Basis

While not a procedure case, for those wanting a primer in an important nook when it comes to the tax treatment of shareholder positions in S Corporations, I recommend a reading of this week’s Tax Court opinion in Phillips v Commissioner.

Phillips addresses the limits on shareholders’ ability to generate basis when the shareholders guarantee a corporate debt rather than make a bona fide loan themselves to the corporation. The facts in Phillips involve shareholders in S Corps that were in the business of developing and selling real estate in Florida, a business that was hit hard by the great recession. Husband and wife Robert and Sandra Phillips personally guaranteed loans of the S corporations. When the economy turned south, the banks sued the Phillips (and other guarantors) on the guarantees, resulting in millions of dollars in judgments, which the Phillips were unable to pay.


How did this trigger a tax dispute? The Phillips increased their basis by a pro rata amount of the creditor judgments. A shareholder’s basis in an S Corp is important as items of loss are passed through reducing basis. A shareholder in S Corps may only claim the benefit of the loss or deduction to the extent of the shareholder’s basis (and basis in bona fide debt the corporation owes him) under Section 1366(d). The judgments were in the many millions of dollars; so were the losses that the S Corp was racking up. So, with the basis creation, the Phillips claimed losses they otherwise would not have been able to use immediately, generating NOLs that they used to carryback to years when everyone in Florida real estate was living high on the hog.

The problem is that there is a long line of cases holding that a shareholder’s loan guarantee for loans that the S Corp itself incurs is insufficient to generate basis needed to soak up the losses. Those cases provide that absent an economic outlay, (i.e, the shareholder paying on the guarantee), there is no basis impact from the guarantee itself.

This is a useful contrast with subchapter K, where partnership liabilities are generally allocated to partners. In contrast, the liabilities of the S Corp only generate a basis kick up when in fact the shareholder makes the loan to the corporation or actually pony up the dollars as a result of the creditor seeking payment on the guarantee. It does not matter that the S Corp shareholders could have structured the financing differently (e.g., borrowed the money and then loaned the $$$ to the corp).

The taxpayers in this case made the creative argument that while they accepted that a guarantee itself is generally insufficient to generate basis, there was enough adverse economic impact on them to justify a basis boost. To that end, the taxpayers emphasized that the creditors sued them individually, obtaining a judgment resulting in liens against their property.

Phillips notes that the taxpayers attempted to make lemonade out of lemons, but restates the maxim that taxpayers are generally stuck with the consequences of the form they choose. In Selfe v US the 11th Circuit found a limited exception for the “no basis from a guarantee rule” if the shareholders can establish that the lender in substance viewed the shareholder as the primary obligor. No doubt the presence of the liens and the judgment has some economic impact, but under 11th Circuit (and other) precedent it was not enough to move the needle:

Petitioners urge that the deficiency judgments against Mrs. Phillips gave rise to an “actual economic outlay” by (among other things) impairing her credit. This argument misapprehends the theory that formed the basis for the Eleventh Circuit’s remand in Selfe. The theory was that the bank, while nominally lending to the S corporation, may in substance have lent to the shareholder, who then contributed the loan proceeds to the corporation. In order to identify the “true obligor” in such circumstances, it is necessary to examine the lender’s intentions and other economic facts existing when the lender makes the loan. A court’s entry of a deficiency judgment against a guarantor many years later, after the corporation has defaulted and the corporation’s collateral has proven insufficient, is simply not relevant in determining whether the lender, when initially extending credit, looked to the shareholder as the primary source of repayment.

At the end of the day, this is a pretty tough outcome for the taxpayers. The rationale for the difference in treatment for S Corp shareholders and partners is due in part on the theory that the S Corp shareholders are generally not personally liable on the corporate debts. The guarantee is a bit too remote; when the creditor comes knocking and in fact obtains a judgment (as here) that liability is no longer remote.

Philips is a good reminder that form matters, especially when using S Corps (a lesson we also explored in Financial Consultant Fails To Avoid Self-Employment Tax With S Corp Structure) and shareholders seeking to ensure basis to offset losses should structure the transaction in the form of a direct loan to the shareholder, followed by a shareholder loan or contribution to capital.

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

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.


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.


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.



Financial Consultant Fails To Avoid Self-Employment Tax With S Corp Structure

This post originally appeared on the Forbes PT site on January 4, 2017

Late December’s Fleischer v Commissioner involves facts that are common among many small business service-providing taxpayers wishing to minimize self-employment liability by setting up S Corporations and funneling service income to those corporations. Unfortunately for Fleischer, the Tax Court found that he faced a sizable self-employment tax liability as it reallocated income that was reported on the S Corporation’s 1120-S to his Form 1040.

The case is in the category of who is the appropriate taxpayer, an issue that sometimes gets murky when taxpayers are dealing with closely or solely-held separate entities. I will summarize and simplify the facts somewhat and hone in on why the taxpayer lost despite the plans of both a CPA and lawyer advising on his tax structure.


The Facts of Fleischer: Setting up an S Corp to Avoid Self-Employment Tax

Fleischer is a licensed financial consultant. Based on the advice of his CPA and lawyer, he set up an S Corporation. Fleischer was the president, secretary, treasurer and sole shareholder of the corporation. Fleischer entered into an employment agreement with the S Corporation, and pursuant to that agreement the S Corp paid him a salary in his capacity as financial advisor. In his individual capacity, Fleischer also entered into contracts with financial service companies Mass Mutual and LPL. Those contracts generated significant commissions, which Mass Mutual and LPL reported to the IRS and to Fleischer individually on various Form 1099’s over the years.

The key to the employment tax savings when all works well in this structure is that the S Corp pays a salary less than the gross receipts it receives. The shareholder/employee has employment tax liability to the extent only of the wages that the S Corp pays to the shareholder/employee. Fleischer paid employment tax on his wages from the S Corp. And while Fleischer’s status as sole shareholder meant that all of the S Corp’s income would flow through to him, the nature of the income matters. 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.

Fleischer’s S Corp paid him a salary of about $35,000. The net service income the S Corp earned varied over the years, going as high in one year as about $150,000. When, as was the case here, the S Corp’s wages paid are less than its net service income, the shareholder/employee can potentially avoid self-employment income tax if that income were earned directly by the shareholder/employee or employment tax if the S Corporation does not pay a salary commensurate with the corporation’s net business income.

Underlying this form, however, is the IRS’s ability to allocate the income to the party who truly earns the income. In addition, the compensation the S Corporation pays to its shareholder/employee must be reasonable; if too low IRS can argue that some of the distributive share should be characterized as compensation (Peter Reilly discusses one such situation in S Corporation SE Avoidance Still a Solid Strategy). The taxpayer’s reporting of the income and the mere creation of a separate entity do not give the taxpayer unlimited discretion to treat the income in the way most favorable to the taxpayer.

As an important aside, the consequences of an LLC earning service income differ from that of an S Corporation. When an LLC earns service income, the distributive share of partnership income allocated to members of an LLC is generally subject to self-employment tax. This is a key difference between S Corporations and LLCs in this context. For an excellent discussion of the issue, see our Forbes colleague Tony Nitti’s post from a few years ago, IRS: Partners’ Share of LLC Income is Subject to Self-Employment Tax.

Back to Fleischer. While he varied somewhat in the way that he reported the income in the years in question, Fleisher testified that he intended to “zero out” his possible self-employment income by reporting expenses on Schedule C to offset his reported income from MassMutual and LPL. In the years in question he paid employment taxes on his wages from the S Corp but would report the income from MassMutual and LPL on his 1040 as non-passive income that was not subject to self-employment tax.

In this case, recall that Fleischer was paid by Mass Mutual and LPL in his individual capacity pursuant to contracts that Fleischer and not the S corporation entered into. Fleischer testified that he individually entered into the contracts because it would have been costly and perhaps impermissible for his S corporation to become licensed and registered under federal securities laws.

On audit, IRS disregarded the S Corporation and treated Fleischer as individually earning the commission income, generating a sizable self-employment tax liability. Fleischer naturally disagreed and filed a petition with the Tax Court.

The Tax Court Agrees with the IRS

The lack of contracts between Fleischer’s S Corp and Mass Mutual and LPL proved to be Fleischer’s undoing. In describing the appropriate law, the Tax Court opinion notes a first principle of income tax, namely that “income must be taxed to him who earned it.” The opinion goes on to state that “for almost as long as this first principle of income taxation has been in place, the principle that a corporation is a separate taxable entity has been, too.”

The opinion goes on to discuss the key to reconciling these principles:

Because it is impractical to apply a simplistic “who earned the income” test when the Court’s choices are a corporation and its service-provider employee, the question has evolved to one of “who controls the earning of the income.”

To determine if the corporation and not the shareholder controls the earning the opinion notes that the case law looks to two requirements:

(1) the individual providing the services must be an employee of the corporation whom the corporation can direct and control in a meaningful sense, and

(2) there must exist between the corporation and the person or entity using the services a contract or similar indicium recognizing the corporation’s controlling position.

While here Fleischer satisfied the first requirement he flunked the second due to the lack of a contractual relationship between the S Corp and the brokerage companies. In other words, there was no recognition from Mass Mutual or LPL that the S Corp had control over Fleischer even though the agreement that Fleischer and the S Corp signed had the bells and whistles that would satisfy the first requirement. Fleischer was an employee of the S corporation and it had the contractual power to control him, but there was not enough to show that Mass Mutual and LPL recognized the control that the S Corporation had the contractual power to exercise over Fleischer.

What about Fleischer’s argument concerning the practical difficulties associated with registering the S Corp under federal securities laws? According to the Tax Court, it did not matter:

Petitioner testified that it would be overly burdensome and “would cost millions and millions of dollars” for [the S Corp] to register under the Act, but he offered no other evidence to corroborate his testimony. The fact that [the S corp] was not registered, thus preventing it from engaging in the sale of securities, does not allow petitioner to assign the income he earned in his personal capacity to [his S Corp]. See Jones v. Commissioner, 64 T.C. 1066 (1975) (holding that a court reporter improperly assigned income to his personal service corporation because a court reporter was legally required to be an individual, and although the corporation was a valid entity, by law it could not perform such services).

Final Thoughts

Fleischer apparently followed his tax advisors’ advice in setting up his personal service S Corporation under state law. That is a necessary but not sufficient condition to have those entities be treated as the rightful earner of service income. As the Fleischer opinion shows, the party paying the service income must expressly recognize that the separate corporate entity has legal and actual authority over the individual. By failing to dot the i’s and then cross the t’s, the IRS, as here, can allocate income to the individual and leave the shareholder/employee with self-employment tax in the same manner as if there were no S corporation in the first instance. The opinion is a red flag for small business taxpayers who may not follow the exact letter of tax advice or for advisors who may not carefully detail all the steps needed to get the appropriate tax result.