A recent federal district court case (Watson v. U.S., 107AFTR 2d 2011-311) has held that the IRS could recharacterize purported dividend payments to an S corporation shareholder-employee as wages. In this case, a CPA was a sole shareholder, employee, director and officer of a professional corporation that was taxed as an S Corporation. The corporation was a member of a firm that rendered accounting services. In the years at issue, the shareholder-employee paid himself a salary of $24,000.00 while he received dividend distributions totaling over $175,000.00 annually.

In this case, the taxpayer’s wholly-owned S corporation was actually a 25% shareholder in an accounting firm with other members. All of the cash income to the taxpayer’s professional corporation came exclusively from the accounting firm.

After reviewing all of the facts of the case, the court concluded that all of the distributions from the S corporation were in fact remuneration for services paid and recharacterized them as wages with all applicable employment taxes and penalties upon the failure to withhold those taxes being due.

This case illustrates the risk associated with structuring a business entity as an S corporation in an effort to minimize these employment taxes. If the taxpayer had structured this differently, he might have had a greater chance of success.