Important tax question: Is it salary or dividends?

An S corporation shareholder-employee's $24,000 annual salary was unreasonably low, the Court of Appeals for the Eighth Circuit concluded, so it allowed the IRS to reclassify $67,000 in dividend payments as salary.

As a result, the corporation owed employment taxes on the reclassified dividend payments. This conclusion affirmed a federal district court's decision in Watson, P.C. v. U.S., 109 AFTR 2d 2012-XXXX, (CA-8), Feb. 21, 2012.

The IRS believes that many S corporation service professionals try to minimize Medicare and Social Security taxes by classifying what would otherwise be self-employment income as S corporation distributions. The S corporation then pays the owner-employee a nominal salary.

In 2010, the House of Representatives passed legislation attempting to deal with this situation, but the Senate did not follow suit. It remains to be seen whether Congress will pursue similar legislation as it attempts to balance the federal budget.

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