Repayment of Salary to Corporation is DeductibleThe Tax Court has ruled that an S corporation's major shareholder and president, who repaid a portion of his president's salary to the corporation, was entitled to an ordinary deduction for the repayment. The corporation treated the payment as ordinary income in the year paid. The IRS unsuccessfully argued that such a payment was a non-taxable contribution of capital by the shareholder to the corporation. In the employment agreement between the corporation and the shareholder, the shareholder was required to repay his bonus if the corporation sustained a net operating loss during the year in which the payment was made.
The Tax Court held that the payment was required by the compensation agreement, the shareholder was in the business of acting as the corporation's president, and the repayment had the business purpose of motivating the president to run the corporation profitably.
This case provides planning opportunities for S corporations which pay out large salaries and bonuses to their shareholder/employees. By requiring a pay-back provision in the employment agreement, funds transferred to the corporation under the agreement will be deductible to the employee, rather than treated as a non-deductible contribution of capital.
Gifts
of stock received a 30% Marketability Discount in Addition to a
Minority DiscountThe Tax Court in a memorandum decision (6/12/95) permitted a 30% lack of marketability discount for gifts of stock in a family-owned corporation. The court also apparently allowed a minority discount on the stock as well, although the size of the minority discount was not part of this case. The court rejected expert witness testimony which considered both restricted stock and initial public offering ("IPO") stock as comparable transactions. In determining the lack of marketability discount, the tax court started with a restricted stock discount of 35% and an IPO discount of 45% and then made the following adjustments: (1) financial statement analysis; (2) dividend policy; (3) outlook for the company; (4) company management; (5) control in the transferred shares; (6) restrictions on transferability; (7) holding period of the stock; (8) corporation's redemption policy; and (9) costs associated with an IPO.
Even though the court's 30% discount was much less than the taxpayer's claim of a 50% discount, the court ruled that the taxpayer reasonably relied on its attorney and accountant in establishing the discount and, consequently, was not liable for penalties for understatement. The court held the IRS abused its discretion for failing to waive the penalties.
This case is extremely important since the IRS has officially recognized minority and lack of marketability discounts on gifts of stock. These discounts can lower the value of stock for gift tax purposes dramatically. If a 20% minority discount and a 30% lack of marketability discount applied to gifted stock, the donor could give $15,000 of stock and still could qualify for the annual gift tax exclusion of $10,000 (married couples can double the gift under the gift tax rules).
Shareholders
in an S corporation Received Salary Subject to Employment TaxesTwo attorneys who formed an S corporation could not characterize the distributions from the corporation as dividends. The Ninth Circuit Court of Appeals held that since the attorneys were the only persons licensed to provide the legal services on behalf of the corporation, they were considered statutory employees and payments to themselves constituted compensation subject to employment taxes.
This case is the most recent in a trend to recharacterize distributions from S corporations as salary subject to withholding and employment taxes, especially when the shareholders provide personal services. Many taxpayers have attempted to avoid payment of these taxes by forming S corporations and treating the distributions to them as dividends instead of compensation.
Using an S corporation to avoid employment taxes still may be useful when the corporation's income is not derived though the personal services of its employees, such as corporations engaged in the sale or lease of goods or equipment, or businesses that involve inventories or large capital investments.
Lease
Payments from an S corporation to its Shareholder did not Work
EitherA shareholder of an S corporation who materially participated in the production and management of a poultry-raising facility attempted to characterize payments received from the corporation as lease payments for the rental of the chickens. The tax court held the payments were compensation subject to withholding and employment taxes.
This case further illustrates how the courts are piercing through questionable arrangements between shareholders and their S corporations and recharacterizing many of these transactions as payments of compensation.
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**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**