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S Corp Distributions and earned income


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Guest flogger

Does anyone know of an example where an S corp distribution can be considered compensation for benefit calculation?

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Guest flogger

The problem I'm trying to solve is to make a stupid CPA smart. Since the regs are clear on Sub S distributions, maybe a frontal lobotomy is in order. Thanks for you help, but I clearly and timely let the client and his CPA know, in writing, this was a concern.

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I've seen a CPA do the following when it was too late for a W-2: create a sole proprietor! The S-Corp dividends became self-employment income to the S-Corp shareholder. The CPA said he felt comfortable doing it, as the IRS would probably insist the income was earned income, and they just wanted to remedy an error when it was too late to issue a W-2. I'm not sure if this was entirely cricket, but the CPA seemed to think it would work.

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Guest flogger

I like your thinking. However, if the CPA were to shift the S-corp deduction from pension contribution to professional fees (to a sole proprietorship), then the sole proprietorship would have income equal to the pension contribution. The sole proprietorship could not make the entire contribution to a pension plan because, if he did, there would be no earned income upon which to base benefits.

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In the case I was referring to, the sole proprietor was automatically a co-sponsor of the plan due to the standardized document language pulling in common control group members. The CPA decided to take the entire deduction on the S-Corp side. There was some benefit related justification for this, although it may not have been reasonable as the deduction allocation is supposed to be with co-sponsors or common control members. The CPA fell back on what I mentioned earlier, in that the earned income problem is being fixed and this is what would have happened (i.e., deduction taken by the S-corp) if we would have issued a W-2. He felt under audit his argument would prevail (incidentally, he was an auditor for the IRS for many years prior to his CPA practice).

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Guest flogger

We indeed checked this out but there is no income as this is a new corp. Also, no prior sole-proprietorship income.

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In case this comes up again. The following comes from a speech that I just presented on this topic.

3. What about an S corporation shareholder?

a. S Corporation shareholders are common-law employees. In spite of their treatment as self-employed for certain fringe benefits (IRC Section 1372), S corporation shareholders get W-2 income and should be subject to the same standards as other common law employees.

b. Further, S distributions are not earned income for plan purposes. This is in spite of the series of cases discussed below where the IRS succeeded in recharacterizing such distributions as compensation. For a comprehensive discussion of this matter see, Paul B. Ding, Jane C. Ding v. Comm. (CA-9), U.S. Court of Appeals, 9th Circuit, 98-70848, 12/30/99, 200 F3d 587. Affirming the Tax Court, 74 TCM 708, TC Memo. 1997-435.

c. There has been a lot of recent controversy on inadequate compensation, as opposed to excess compensation for S shareholders.

i. In a case involving a veterinarian (Veterinary Surgical Consultants, P.C.), and one involving an accountant (Joseph M. Grey Public Accountant, P.C.), the Tax Court found that payments classified by the corporations as dividends were, in fact, compensation for services and held that the taxpayers were liable for the employment taxes.

ii. In another case, involving a CPA (Wiley L. Barron CPA, Ltd.), the Tax Court reached the same conclusion.

Characterizations of distributions to owners of S corporation stock as dividends, where less than reasonable compensation has been paid to owners and where the amount of the reported dividend exceeds a reasonable return on the owners’ invested capital, will probably not withstand scrutiny by the Internal Revenue Service or the courts. Design impact: Where plan sponsors wish to be aggressive in this regard, care must be taken to define compensation properly within the plan document. Language that specifies that compensation for allocation purposes be based upon the W-2 filed for the year, without regard to any subsequent adjustments may be appropriate.

d. This is not a new position. In Rev. Rul. 74-44 the "dividends" paid to two shareholders were held to be in lieu of reasonable compensation for their services.

4.In some cases, the Social Security Administration has had success in recharacterizing S Corporation distributions as wages for purposes of determining excess earnings for recipients of Social Security benefits. See Owens [Charles B. Owens, Jr., 790 F. Supp. 195 (W.D. Ark. 1991) and Esser [Fred R. Esser, 750 F. Supp. 421 (Ariz. 1990)].

5.The IRS's recharacterization argument was reaffirmed in Fred R. Esser, P.C. 750 F Supp 421 (DC, Ariz., 1990).

6.The IRS prevailed on the recharacterization argument in Spicer Accounting, Inc. 918 F2d 90 (CA-9, 1990).

7.See also In Joseph Radke, 712 F. Supp. 143 (E.D. Wis. 1989), aff'd per curiam, 895 F.2nd 1196 (7th Cir. 1990).

8.In Paula Construction Company [58 TC 1055, 1058 (1972), aff'd by unpub. op. 474 F 2d 1345 (5th Cir. 1973)], the Tax Court stated the standard as follows: "It is now settled law that only if payment is made with the intent to compensate is it deductible as compensation. Whether such intent has been demonstrated is a factual question to be decided on the basis of the particular facts and circumstances of the case."

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