David E. Watson, Pc v. United States
668 F.3d. 1008, 2012 WL 539784 (2012)
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Rule of Law:
When an S corporation's shareholder-employee is paid an unreasonably low salary, courts may recharacterize payments designated as dividends as wages subject to FICA taxes by looking at the substance of the transaction rather than its form.
Facts:
- David Watson, a highly qualified CPA with a master's degree in taxation, incorporated his professional practice as David E. Watson, P.C. (DEWPC), an S corporation.
- Watson was the sole shareholder, director, officer, and employee of DEWPC.
- DEWPC held Watson's 25% partnership interest in a larger accounting firm, LWBJ, and Watson provided his professional accounting services exclusively to LWBJ on behalf of DEWPC.
- In both 2002 and 2003, DEWPC paid Watson a salary of $24,000.
- During those same years, DEWPC received profit distributions from LWBJ totaling $203,651 in 2002 and $175,470 in 2003.
- After paying Watson's salary and other minor expenses, DEWPC distributed all of its remaining income to Watson, characterizing these payments as dividends.
Procedural Posture:
- The Internal Revenue Service (IRS) investigated DEWPC and assessed additional FICA taxes and penalties for the years 2002 and 2003.
- DEWPC paid the assessed amount for the fourth quarter of 2002 and then filed a claim for a refund with the IRS.
- The IRS denied DEWPC's refund claim.
- DEWPC (plaintiff) filed a lawsuit against the United States (defendant) in the U.S. District Court for the Southern District of Iowa, seeking a tax refund.
- The United States filed a counterclaim against DEWPC to recover the remaining unpaid FICA taxes, penalties, and interest for 2002 and 2003.
- Following a bench trial, the district court entered a judgment in favor of the United States, finding that DEWPC owed additional FICA taxes.
- DEWPC (appellant) appealed the district court's judgment to the U.S. Court of Appeals for the Eighth Circuit.
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Issue:
Did the district court err by recharacterizing a portion of profit distributions an S corporation paid to its sole shareholder-employee as wages subject to FICA taxes, based on a determination that the designated salary was unreasonably low for the services performed?
Opinions:
Majority - Beam, J.
No, the district court did not err. In determining what constitutes 'wages' for FICA tax purposes, courts must examine the substance of the payments over their form, and it is proper to scrutinize the reasonableness of compensation to determine if payments labeled as dividends are, in reality, remuneration for services. The court rejected DEWPC's argument that taxpayer intent is the sole determining factor, holding that in tax disputes, the substance of the transaction controls. Because Watson was an exceedingly qualified accountant providing substantial services to a profitable firm, the district court correctly found that his $24,000 salary was unreasonably low and did not reflect the actual value of his services. The court affirmed the recharacterization of a portion of the 'dividend' payments to a 'reasonable' salary of $91,044, which was then subject to FICA taxes. This approach is necessary where a corporation is controlled by the employee, as there is a lack of arm's-length bargaining over salary.
Analysis:
This decision solidifies the authority of the IRS and the courts to apply the 'substance over form' doctrine to combat a common tax avoidance strategy among S corporation shareholder-employees. It affirms that designating payments as 'dividends' instead of salary does not shield them from FICA taxes if the salary paid is not a reasonable reflection of the value of the services rendered. The case establishes that a 'reasonable compensation' analysis, traditionally used in income tax deduction cases, is an appropriate framework for determining the proper amount of wages in FICA tax disputes. This precedent serves as a strong warning to S corporations that they cannot arbitrarily minimize salaries to avoid payroll tax obligations on funds that are functionally remuneration for labor.
