S corporation K-1 income isn’t subject to self-employment or payroll taxes. This tempts S corporation owners to take minimal salary and take earnings out as S corporation distributions instead. Former vice-presidential nominee and model husband John Edwards famously used an S corporation to minimize his payroll taxes.
The IRS has had success in imposing additional payroll taxes when owners of profitable S corporations take little or no salary. Yesterday the Tax Court also imposed payroll taxes on the owner of a struggling S corporation.
The owner of a small Twin Cities courier business reported wages of $24,452 to $28,452 in 2004-2006. He took only $2,400 in salary in 2007. The IRS found that $55,000 was transferred from the S corporation to the owner’s bank accounts in 2007 and imposed payroll taxes on that amount of salary.
How do we know the business struggled? The Tax Court explains:
During petitioners’ operation of H&H up to some point in 2009, H&H either lost money every year or earned little income. In 2009 petitioners finally closed the business down, after losing their home on account of losses incurred in the business and their inability to make payments on a home equity loan obtained in 2004 to finance their purchase of the business.
This wasn’t like the CPA who earned around $200,000 from his busienss and reported salary of only $24,000. Yet the IRS didn’t let the taxpayer’s financial ruin stand in the way of an assessment of additonal payroll taxes. The Tax Court upheld part of the assesment:
We believe and accept petitioner’s testimony that he in fact paid significant H&H expenses with cash using funds received from H&H. For example, petitioner credibly testified that after finishing deliveries, truck drivers often would assist with repairs on the trucks and that he would pay the drivers cash for their assistance. No evidence indicates any unusual personal use by petitioners of the funds in question received from H&H.
In spite of the limited evidence before us, we believe it improper and excessive to charge petitioner with receipt from H&H in 2007 of $52,600 in additional wages. However, we also believe petitioner’s reported H&H wages of $2,400 are unreasonably low.
Unfortunately, as you might have guessed from this, the taxpayer’s records were a mess. The Tax Court used a very rough estimate:
To estimate what portion of the funds petitioner received from H&H in 2007 is to be treated as wages, we believe it appropriate to average petitioner’s wages for 2002 through 2006 and to use the average wage amount as the total for petitioner’s 2007 H&H wages subject to employment taxes — namely, $30,445.
I think the result would have been better if the taxpayer had kept better records. If the taxpayer had kept personal and company spending separate and could account for all expenses, the Tax Court might have left him alone.
Still, I think the IRS and the Tax Court did the taxpayer a disservice. Lee Iacocca famously took a $1 salary when he was in charge of struggling Chrysler. If Warren Buffett can hold his salary to $100,000 in a fabulously profitable company, it’s plain mean to stick a struggling owner with additional salary just to collect more payroll taxes.
Fortunately this is a “summary opinion,” which isn’t supposed to serve as precedent. A better-represented and better-organized taxpayer might well do better.