Tax Court Rules S Corp Payouts Are Wages. Frequently, S corporation owners treat wages as other forms of payment, such as distributions of payment to reduce their overall payroll taxes. But the IRS is quick to contest these claims and the Tax Court recently stepped in to offer some clarity.

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

Background: With an S corporation, items of the income is passed through to shareholders, who pay tax on their proportionate share of the income on their personal returns. Unlike C corporation owners, there is no “double taxation” on both the corporate and personal levels.

Notably, S corporations may pay their employee-shareholders little or nothing in the way of wages. If distributions are paid to these taxpayers instead of wages, they do not have to pay any federal payroll taxes on the amounts received. Thus, the IRS may challenge the characterization of payments from an S corporation to its employee-shareholders.

The taxpayer in the new case, an attorney in Minneapolis operated her law firm as an S corporation where she was the sole shareholder. From 2011 through 2013, the firm employed one other attorney, who was paid an annual salary. But the taxpayer herself did not report any wage payments for the tax years in question.

The problem: The payments reported by the taxpayer personally during this time simply did not match up with the reporting by the S corporation and were suspect. For instance, the corporation correctly reported the wages paid to the other attorney but did not treat the $62,000 amount paid to the taxpayer in 2011 as wages subject to payroll taxes. The taxpayer did not even report any of this amount as income.

Subsequently, in 2012 she reported approximately $73,000 in payments as income, but not as wages (nor did the S corporation). And, in 2013 both the taxpayer and the S corporation reported some of the payments as wages but claimed about $48,000 as “other income.”

Normally, amounts paid to the sole shareholder of an S corporation employed by the firm constitute wages subject to payroll taxes. The taxpayer, in this case, argued at trial that the payments were drawn from a partnership and that she was in error only for not paying self-employment tax. But there is no evidence to support this claim.

Bottom line: The Tax Court judge did not exactly come out and say it, but he could have easily asserted, “Are you kidding me?” It is extremely unlikely that an attorney, the sole shareholder of a small law firm operating as an S corporation, did not provide any legal services that should be treated as wages. Case closed.