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S Corporation Payouts Ruled As Wages By Tax Court

The IRS is always on the lookout for creative tax avoidance techniques, and one that has proven effective in recent years was treating wages as other forms of payment, such as distributions. The Tax Court ruled against these claims earlier this year, offering some much-needed clarity about how S corporation owners should be reporting their wage payments going forward.

In a recent case, Ward, TC 2021-32, 3/15/21, the Tax Court has ruled that payments from a law firm to its sole shareholder are, in fact, wages for tax purposes.

What You Need To Know

Whether you’re a small business owner or an active citizen, knowing your rights when dealing with taxes is essential. The S corporation is one of the most popular forms for corporations in America because they offer two key benefits: lower rates and no double taxation on profits both within their company.

Notably, S corporations might pay their employee-shareholders little or nothing in the way of wages. Suppose distributions are paid instead to these taxpayers, and they do not have payroll taxes withheld on amounts received from an entity classification as employment income for federal tax purposes. This could lead the IRS to challenge how it was characterized.

In the case mentioned above, an attorney in Minneapolis was the sole shareholder of her law firm. One other lawyer at the firm was paid an annual salary for 2011 through 2013, but the taxpayer herself didn’t report any of her wages during those years.

Making The Case

The payments reported by the S corporation didn’t match up with what was shown in their tax returns. The corporation correctly reported the wages paid to another attorney but did not treat the $62,000 spent in 2011 as subject payroll taxes. The taxpayer didn’t even report any income on their tax returns.

Then, in 2012, she reported approximately $73,000 as income but didn’t list them as wages or any other type of compensation. And when both the taxpayer and S Corp claimed some for themselves last year–it was reported as “other income.”

The taxpayer, in this case, argued in court that the payments were drawn from a partnership and not wages subject to payroll taxes. However, there is no evidence to support this claim. The Tax Court judge couldn’t have been more clear about how unlikely it was that an attorney, who was the sole shareholder of an S-corporation, didn’t provide any legal services which should be treated as wages. Due to this simple fact, the case was closed.