Opinion ID: 623171
Heading Depth: 2
Heading Rank: 2

Heading: FICA Tax

Text: FICA imposes on every employer an excise tax, with respect to having individuals in [its] employ, calculated as a certain percentage of wages the employer pays with respect to employment. [5] I.R.C. § 3111(a), (b). The term wages is defined as all remuneration for employment, with exceptions that do not apply to this case. Id. § 3121(a). Although the term wages is defined broadly, an employer need not pay FICA taxes on other types of employee income, such as dividends. HB & R, Inc. v. United States, 229 F.3d 688, 690 (8th Cir.2000). In characterizing employer payments, [t]he name by which the remuneration for employment is designated is immaterial. Treas. Reg. § 31.3121(a)-1(c). Similarly, the medium in which remuneration is paid is immaterial. Id. § 31.3121(a)-1(e). When the IRS determines that a taxpayer owes the Federal Government unpaid taxes, the assessment is entitled to a legal presumption of correctness. United States v. Fior D'Italia, Inc., 536 U.S. 238, 242, 122 S.Ct. 2117, 153 L.Ed.2d 280 (2002). Because DEWPC sought a FICA tax refund in this case, the ultimate question for our determination is whether [DEWPC] has overpaid its tax. Iowa 80 Group, Inc. v. IRS, 406 F.3d 950, 952 (8th Cir.2005). The taxpayer bears the burden of proving that it overpaid its taxes, and the IRS's initial assessment was wrong. Id. To meet this burden, the taxpayer must prove the amount he is entitled to recover[,] [and] [i]t is not enough for him to demonstrate that the assessment of the tax for which refund is sought was erroneous in some respects. United States v. Janis, 428 U.S. 433, 440, 96 S.Ct. 3021, 49 L.Ed.2d 1046 (1976) (internal citation omitted). In resolving this FICA tax dispute, the inquiry is whether, based on the statutes and unusual facts involved, the payments at issue were made to [Watson] as remuneration for services performed. Joseph Radtke, S.C. v. United States, 895 F.2d 1196, 1197 (7th Cir.1990) (per curiam). Where, as here, the corporation is controlled by the very employees to whom the compensation is paid, special scrutiny must be given to such salaries, for there is a lack of arm's length bargaining. Charles Schneider & Co. v. Comm'r, 500 F.2d 148, 152 (8th Cir.1974). Ultimately, whether payments to a shareholder represent compensation for services or constitute a distribution of profits is essentially the determination of a matter purely of fact. Standard Asbestos Mfg. & Insulating Co. v. Comm'r, 276 F.2d 289, 294 (8th Cir.1960) (internal quotation omitted). When it determined the amount that constituted remuneration for employment, the district court required DEWPC to prove it paid Watson reasonable compensation, which DEWPC claims was error. According to DEWPC, because the district court applied an incorrect legal standard, it incorrectly found that $91,044 constituted Watson's wages in 2002 and 2003. To buttress this argument, DEWPC repeatedly asserts that there is no statute, regulation, or rule requiring an employer to pay minimum compensation. And, by requiring proof of reasonable compensation, DEWPC argues, the district court imposed a minimum compensation requirement. Rather than looking to whether compensation was reasonable, DEWPC contends that the district court should have focused on taxpayer intent when characterizing the payments.
The concept of reasonable compensation is generally an issue found in the realm of income taxation. See, e.g., Charles Schneider & Co., 500 F.2d at 151. Under I.R.C. § 162(a)(1), a business may deduct a reasonable allowance for salaries or other compensation for personal services actually rendered as ordinary and necessary business expenses. Historically, we have applied a factors test to determine the reasonableness of compensation in the context of a business expense deduction. See Charles Schneider & Co., 500 F.2d at 151-52 (discussing factors). Here, the district court considered these factors, among other things, in finding that the value of Watson's services was $91,044 for 2002 and 2003. Although reasonable compensation is usually an issue found in the context of an income tax deduction, the IRS finds the concept equally applicable to FICA tax cases. In Revenue Ruling 74-44, 1974-1 C.B. 287, an S corporation distributed dividends to its two sole shareholder-employees but did not pay any wages for their services. The IRS took the position that it could recharacterize the nature of dividend payments for FICA tax purposes because the `dividends' paid to the shareholders ... were in lieu of reasonable compensation for their services. Id. (emphasis added). Notwithstanding Revenue Ruling 74-44, [6] we have not had the opportunity to decide whether a reasonableness analysis is appropriate in determining if certain payments are in fact remuneration for employment subject to FICA tax. Other jurisdictions provide guidance. In Joseph Radtke, S.C. v. United States, 712 F.Supp. 143, 144, (E.D.Wis.1989), aff'd per curiam, 895 F.2d 1196 (7th Cir.1990), the taxpayer-S corporation made dividend distributions to its only shareholder-employee but did not pay him any salary. Because the shareholder-employee also served as the corporation's only director, who authorized the dividend payment, the district court applied a substance-over-form analysis and determined the employee's `dividends' were in fact `wages' subject to FICA ... taxation. Id. at 145. On appeal, the Seventh Circuit affirmed, concluding that the payments were clearly remuneration for services performed by [the shareholder-employee]. Joseph Radtke, S.C., 895 F.2d at 1197. Drawing upon Radtke 's reasoning, other courts addressing similar FICA characterization issues have evaluated the economic substance of the transaction rather than the form chosen by the taxpayer. See, e.g., Veterinary Surgical Consultants, P.C. v. Comm'r, 117 T.C. 141, 145-46 (2001) (noting that the characterization of payments as corporate distribution of net income is but a subterfuge for reality), aff'd sub nom., Yeagle Drywall Co. v. Comm'r, 54 Fed.Appx. 100 (3d Cir. 2002); Spicer Accounting, Inc. v. United States, 918 F.2d 90, 93 (9th Cir.1990) (finding that intention of receiving the payments as dividends has no bearing on the tax treatment of these wages). Indeed, looking at the substance of a transaction instead of its form is a hallmark principle in resolving tax disputes, see Boulware v. United States, 552 U.S. 421, 430, 128 S.Ct. 1168, 170 L.Ed.2d 34 (2008), and one the applicable Treasury Regulations seem to compel in this case, see Treas. Reg. § 31.3121(a)-1(c) to (e). Therefore, in discovering all remuneration for employment, the substance of the transaction as revealed by the evidence as a whole controls over the form employed; i.e., the veil of form is pierced and the entire transaction is carefully scrutinized. Haag v. Comm'r, 334 F.2d 351, 355 (8th Cir.1964). And, in light of all the facts and circumstances of the case, scrutinizing compensation for its reasonableness may guide a court in characterizing payments for FICA tax purposes. See Joly v. Comm'r, 76 T.C.M. (CCH) 633, 1998 WL 712528, at  (1998) (rejecting claim that compensation was reasonable and finding that amount did not reflect the true character of such payments), aff'd, 211 F.3d 1269 (6th Cir. 2000) (unpublished table decision). Turning to the present case, we conclude the district court properly determined that the characterization of funds disbursed by an S corporation to its employees or shareholders turns on an analysis of whether the payments at issue were made as remuneration for services performed. See Joseph Radtke, S.C., 895 F.2d at 1197. This fact-intensive inquiry is a matter to be determined in view of all the evidence. Joseph Radtke, S.C., 712 F.Supp. at 145. Here, the district court found that DEWPC understated wage payments to Watson by $67,044 based on the following evidence: (1) Watson was an exceedingly qualified accountant with an advanced degree and nearly 20 years experience in accounting and taxation; (2) he worked 35-45 hours per week as one of the primary earners in a reputable firm, which had earnings much greater than comparable firms; (3) LWBJ had gross earnings over $2 million in 2002 and nearly $3 million in 2003; (4) $24,000 is unreasonably low compared to other similarly situated accountants; (5) given the financial position of LWBJ, Watson's experience, and his contributions to LWBJ, a $24,000 salary was exceedingly low when compared to the roughly $200,000 LWBJ distributed to DEWPC in 2002 and 2003; and (6) the fair market value of Watson's services was $91,044. Based on the record, the district court did not clearly err.
Although we think reasonableness is pertinent to the analysis, DEWPC urges that instead of focusing on reasonableness, the district court should have focused on DEWPC's intent. Taxpayer intent, like reasonableness, is usually part of a § 162(a)(1) compensation deduction analysis, although less commonly employed. See O.S.C. & Assocs. v. Comm'r, 187 F.3d 1116, 1120 (9th Cir.1999). As the language of § 162(a)(1) suggests, a deduction may be made if salary is both (1) reasonable and (2) in fact payments purely for services. Treas. Reg. § 1.162-7(a). The Ninth Circuit views this as a two-pronged test, the second prong of which requires proof of a compensatory purpose. Elliotts, Inc. v. Comm'r, 716 F.2d 1241, 1243 (9th Cir.1983). Usually, courts only need to examine the first prong, i.e., whether compensation was reasonable. Id. Indeed, [t]he inquiry into reasonableness is a broad one and will, in effect, subsume the inquiry into compensatory intent in most cases. Id. at 1245. However [i]n the rare case where there is evidence that an otherwise reasonable compensation payment contains a disguised dividend, the inquiry may expand into compensatory intent apart from reasonableness. Id. at 1244. This intent is subjective and difficult to prove. O.S.C. & Assocs., 187 F.3d at 1120. DEWPC turns our attention to Pediatric Surgical Assocs., P.C. v. Comm'r, 81 T.C.M. (CCH) 1474, 2001 WL 314335 (2001), to illustrate that intent is the determining factor for characterization purposes. Pediatric Surgical Assocs., P.C., involved a § 162(a)(1) compensation deduction where reasonableness was not at issue. Id. at . After reviewing Pediatric Surgical Assocs., P.C., we are not convinced it stands for the proposition that taxpayer intent controls in FICA tax characterization cases. [7] This is especially true because Pediatric Surgical Assocs., P.C., was a rare case where there is evidence that an otherwise reasonable compensation payment contains a disguised dividend. Elliotts, Inc., 716 F.2d at 1243. However, even if intent does control, after evaluating all the evidence, the district court specifically found Watson's assertion that DEWPC `intended' to pay Watson a mere $24,000 in compensation for the tax years 2002 and 2003 to be less than credible. We will not disturb this finding on appeal. See United States v. Bowie, 618 F.3d 802, 814 (8th Cir.2010) (recognizing credibility findings are virtually unreviewable on appeal (quotation omitted)). Therefore, the district court's finding as to DEWPC's intent was not clearly erroneous. DEWPC further argues that if the district court applied the principles of Pediatric Surgical Assocs., P.C., it would have limited the amount it characterized as wages to the amount of revenue each shareholder-employee personally generated, less expenses. In this case, like Pediatric Surgical Assocs., P.C., non-shareholder-employees also contributed to LWBJ's earnings. Thus, determining Watson's compensation is more complicated than if Watson had served as the only employee generating income for LWBJ. See Veterinary Surgical Consultants, P.C., 117 T.C. at 145 (determining that distributions of corporate net income to sole shareholder-employee were wages); see also Walter D. Schwidetzky, Integrating Subchapters K and SJust Do It, 62 Tax Law. 749, 799 (2009) (opining that in a pure services S corporation with a sole practitioner, nearly all of the corporation's income may likely be treated as remuneration for employment under FICA). Nevertheless, although we think evidence of shareholder-employee billings and collections may be probative on the issue of compensation, in view of all the evidence presented to the district court in this case, we see no error. Therefore, as noted earlier, because the district court applied the correct legal standard, we affirm its determination on Watson's FICA wages.