IRS MAY RECHARACTERIZE DIVIDEND PAYMENTS TO S CORP SHAREHOLDER--EMPLOYEE AS WAGES

A federal district court recently concluded that an S corporation shareholder-employee's $24,000 salary was unreasonably low, and allowed IRS to reclassify as salary over $67,000 in dividend payments to the officer during each of the years at issue. The corporation will also owe employment taxes on the reclassified dividend payments.

This is a long standing compliance issue with the IRS, which feels that many service professionals try to minimize Medicare and Social Security taxes by routing what would otherwise be self-employment income through an S corporation and then paying themselves a nominal salary. Since the amount of compensation that an S corporation pays its employee-shareholder is within the employee-shareholder's discretion, he may have an incentive to claim less than a reasonable salary and take from the S corporation other payments (e.g., dividends) that aren't subject to employment taxes.

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