Who is an Employee?
The definition of an employee for FICA (Federal Insurance Contributions Act), FUTA (Federal Unemployment Tax Act) and federal income tax withholding under the Internal Revenue Code include corporate officers. When corporate officers perform a service for the corporation and receive or are entitled to payments, those payments are considered wages.
The fact that an officer is also a shareholder does not change this requirement. Such payments to the corporate officer are treated as wages. Courts have consistently held S corporation officers/shareholders who provide more than minor services to their corporation and receive, or are entitled to receive, compensation are subject to federal employment taxes.
If an officer does not perform any services or only performs minor services and is not entitled to compensation, the officer would not be considered an employee.
Distributions, Dividends and Other Compensation as Wages
Courts have found shareholder-employees are subject to employment taxes even when shareholders take distributions, dividends or other forms of compensation instead of wages.
In 2001, in a Tax Court case against a Veterinary Clinic, the Tax Court ruled that an employer cannot avoid federal taxes by characterizing compensation paid to its sole director and shareholder as distributions of the corporation’s net income rather than wages. Veterinary Surgical Consultants, P.C. vs. Commissioner, 117 T.C. 141 (2001).
The Sixth Circuit held that a shareholder-employee of a company used the company bank account for personal use. As such, the Court ruled the shareholder was an employee and owed employment tax. Joly v. Commissioner, T.C. Memo. 1998-361, aff’d by unpub. op., 211 F.3d 1269 (6th Cir. 2000).
In yet another similar case, the Tax Court held that an accountant was taking dividends and performing duties for the company. The Tax Court ruled the dividends were actually wages, subject to employment taxes. Joseph M. Grey Public Accountant, P.C. vs. Commissioner, 119 T.C. 121 (2002).
In the above listed cases the shareholders failed to report any wages from their S corporations. In a 2012 case the shareholder received wages of $24,000 per year and large distributions. Though there was no dispute that the shareholder was an employee, the issue dealt with the reasonableness of the wage amount. When challenged on the reasonableness of the wages, the taxpayer contended that the corporation only intended to pay wages of $24,000 and that its intent was controlling. The 8th Circuit disagreed and sustained the District Court which held that the test is whether the payments received by the shareholder were truly remuneration for services performed, thus the intent to limit wages is not a controlling factor. David E. Watson, PC vs. U.S., 668 F.3d 1008 (8th Cir. 2012). The Supreme Court held that it would not hear an appeal of the 8th Circuit decision.
- Payments made by an S corporation to its president and sole shareholder were wages subject to employment taxes, not distributions or loan repayments. Prior transfers by the shareholder to the corporation were capital contributions and not loans. The court rejected the argument that the distributions would represent unreasonable compensation to its president. Glass Blocks Unlimited v. Comm’r, T.C. Memo. 2013-180.
- The corporation’s payment of the shareholder’s personal expenses for insurance and utilities were made with the intent to compensate the shareholder for services rendered. As such, the corporation was entitled to a deduction as additional compensation. The amounts when combined with small amounts of “management expenses” paid by the corporation were not unreasonable. Ghosn v. Comm’r, T.C. Memo. 1995-192.
- Purported “loans” from S corporation to its sole shareholder, officer, and director, were wages for purposes of FICA and FUTA taxes. The loans were unsecured demand notes bearing no interest, loans were made entirely at the discretion of shareholder, and the shareholder regularly performed substantial, valuable services for taxpayer. Repayment of loan was “simply a paper transaction” in which outstanding loan balance was credited against undistributed income and rental payments owed by the corporation to the shareholder. Gale W. Greenlee, Inc. v. U.S., 661 F. Supp. 642 (D. Colo. 1985).
If the shareholder received or had the right to receive cash or property, then the S corporation must determine and report an appropriate and reasonable salary for that shareholder. See the S Corporation Compensation and Medical Insurance Issues page for more details on what is considered to be reasonable compensation.