- Comparing an S
Corporation and a Partnership.
- Creating a corporation is
less time consuming than forming a partnership. More complex
documentation is required to achieve the same goals in a
partnership. It is always much more expensive to form a partnership
than it is to form a corporation.
Liability, and Management Control.
- Eligibility - Only individuals, estates, and certain trusts are
eligible be S corporation shareholders. No comparable
limitation exists with respect to partnerships. Partnerships
can have more than 75 partners.
- Limited Liability of
an S Corporation - An S corporation insulates the investor from
liability while a general partnership never insulates the
investor. A limited partnership provides the limited partners
with liability protection; however, the general partner is
exposed. In addition, if a corporation is the general
partner, it must avoid the "association" issue under § 7701.
S corporation shareholders may be actively involved in
management control, while limited partners' involvement in
management control of the partnership must be severely
restricted. However, the Revised Limited Partnership Act and
the ability to operate as a limited liability company affords
greater control opportunities to limited
- Use of Nonvoting
Stock to Retain Control and Shift Income
- S corporation rules
permit use of voting and nonvoting stock. This allows the
corporate equivalent of general partners and limited partner
status with respect to control (§
- Selection of Taxable
- Both S corporations and
partnerships are generally limited in selecting taxable years
different from their owners, unless a business purpose is
established (See § 706 and § 1378).
- For taxable years after
1986, partnerships and S corporations are generally limited to a
- Taxation of
Shareholders and Partners.
- Dividend distributions
are not taxed twice. C corporation distributions of dividend income
to its shareholders are taxable at the shareholders' highest then
effective rate to the extent of existing current and accumulated
earnings and profits of the corporation. However, an S corporation
avoids double taxation because the shareholder is taxed only once
on his distributive share. Distributions out of previously-taxed
distributive shares are tax-free to S corporation shareholders.
However, distributions of appreciated property with respect to an S
corporation's stock, will trigger a gain (and tax) at the corporate
level, as will the distribution of property subject to the built-in
gains tax (See §§ 1363(d) and 1374).
- Flow-through avoids
accumulated earnings and personal holding tax issues. Therefore, C
corporations may elect S corporation status to avoid double
taxation, the accumulated earnings tax under § 531 and the personal
holding company tax under § 541. This advantage must be weighed
against the loss of surtax exemption, the potential benefit of
creating multiple corporations under Vogel Fertilizer Co.,
455 U.S. 16 (1982), exposure to additional state taxes, and the
built-in gains tax of § 1374.
- Penalty taxes may be
imposed on built-in gains (§ 1374) or excessive passive income of
an S corporation (§ 1375). No comparable result exists for a
- Partnerships are not
subject to any potential adverse tax liability discussed above. A
partnership is not a taxable entity.
- Transferability of
- There are no statutory
restrictions on the transfer of stock in an S corporation.
Restrictions may be imposed pursuant to a buy-sell agreement or the
- By statute, the transfer
of a general partner's interest may cause a technical dissolution
of the partnership.
- Corporations have
unlimited life and do not terminate as a result of shareholder
transfers or transactions.
- Partnerships will
technically dissolve unless the partners elect to continue them
upon the occurrence of certain events such as death, bankruptcy, or
incompetency of a general partner.
- Contribution and
Characterization of Property.
- For both S corporations
and partnerships, characterization occurs at the entity level
(See § 702(b) and § 1366(b)). However, Reg. § 1.1375-1(d),
under pre-SSRA law, provided that S corporation shareholder
activities could taint characterization at the corporate level
(See GCM 38969 (3/9/83), which applied the same rationale
under SSRA; Compare Podell v. Comm'r, 55 T.C. 429
- In an S corporation,
there are no special rules with respect to the allocation of
pre-contribution gains or losses inherent in contributed property.
Nor are there any special rules with respect to unrealized
receivables, inventory or capital loss property contributed to, or
distributed from, the corporation.
- A partnership may have
problems converting to a corporation via tax-free incorporation
under § 351 if any "negative" capital accounts exist as a result of
- Partnerships are subject
to allocation and characterization rules for contributed property
(See §§ 704(c) and 724). Special characterization rules also
apply with respect to distributed property (See §
- Income shifting and
recharacterization with respect to contributed property is only
available in S corporations.
- Allocating Income and
- Partnership income and
loss is allocated per agreement subject to the substantial economic
effect standard (§ 704(b)). S corporation income and loss is
allocated on a per day/per share basis (§ 1366(a)). Special
allocations are technically possible through the use of stock
options and restricted stock, but mechanics are cumbersome and
potential income results (See § 83; Reg. § 1.83-1(a)(1); and
Rev. Rul. 67-209, 1967-2 C.B. 298).
- Partnership allocations
when interests change are subject to the varying interest rule, and
certain cash-basis items must be allocated to the partners based
upon their respective interests on the day such item is
economically accrued (See § 706(d)).
- No special rules apply
for S corporation allocations when shareholder's interests change
except upon complete termination of interest under § 1377(a) or
unless the S election terminates under §
- An S corporation is a
much better device for shifting income among family members than a
partnership due to the more stringent family partnership rules
under § 704(e). Capital must be a material income producing factor
in the business; if not, a partner who received his partnership
interest by gift is not recognized as a partner under § 704(e).
However, in an S corporation, there is no distinction between
service and capital business for purposes of recognizing the lower
bracket family member as a shareholder. Accordingly, an S
corporation may be used more easily to shift income to lower
bracket family members than a partnership in a "service" business.
However, § 1366(e) provides that the Service can reallocate income
to reflect economic reality if a shareholder-employee does not
receive sufficient income in recognition of services rendered or
capital furnished to the S corporation.
- The six types of trusts
permitted to be Subchapter S shareholder may be used to shift
income and for estate planning.
- A grantor trust may be
an effective estate planning tool. The grantor trust can be made a
shareholder, and the grantor will be the owner of trust property
for income tax purposes (see § 677). Through proper
drafting, the grantor will not be deemed to be the owner of the
trust property for estate tax purposes. However, the grantor must
pay the tax on the S corporation income flowing to the trust. The
grantor can remove appreciated stock out of his and his spouse's
estate, and income generated from the S corporation stock is an
asset of the trust.
- The deemed owner is
taxed on trust income of a § 678 trust and the deemed owner may be
in a lower effective income tax bracket.
- The trust can also
provide certain safeguards so, in effect, the "deemed owner" does
not have control of the income generated from the S
- Section 678 trusts may
have successive income beneficiaries, each of whom could maintain
an existing S corporation election. The qualified subchapter S
trust may pass corporate income among generations by providing for
successor income beneficiaries from younger generations. The S
corporation should be protected from termination by a beneficiary
who rejects the S corporation election.
- In taxable years
beginning after December 31, 1996, an electing small business trust
is permitted to hold shares of stock in an S corporation. An
electing small business trust is a discretionary trust, commonly
referred to as a spray or sprinkle trust, which allows a trustee to
make distributions to two or more beneficiaries. In addition, the
trustee will be permitted to accumulate income in the trust and
thereby achieve the parties' nontax
- Since all the S income
allocated to an electing small business trust is taxed at the
highest income tax bracket, the income shifting advantages for
lower bracket shareholders is eliminated. Therefore, an electing
small business trust is not as favorable as a qualified Subchapter
S trust (a trust which is required to distribute all of its income
to a single beneficiary) or a grantor trust, where the grantor
might be in a lower income tax bracket than the
- Tax Credits
- Tax credits, if
available, flow through to shareholders and even the foreign tax
credit now flows through to shareholders (See §§ 1363(c)(1)
and 1363(d)(1)). Research deductions under § 174 flow through, and
future passive income generated by R & D will not terminate
Subchapter S status.
Termination or Revocation of Status.
- By statute, a majority
of shareholders can revoke an S corporation election. The status of
a partnership can only be changed by incorporation or
- An S corporation
election may be inadvertently terminated; this is not a problem for
partnerships (§ 1362).
- Only a certain kind of
shareholders not exceeding a specified number can qualify for S
corporation elections. Any person or entity can be a partner and
there is no maximum limit on the number of
- Classes of Ownership
- An S corporation can
only have one class of stock outstanding which has the same
dividend rights and liquidation proceeds. Differences in voting
rights are permissible (§ 1362).
- Safe harbor debt, stock
options, and restricted stock are not treated as a second class of
- This generally prohibits
special allocations in an S corporation or, except to the extent
the same result can be achieved through the use of safe harbor
debt, stock options or restricted stock.
- No such problems exist
in a partnership. Special allocations are permitted if there is
substantial economic effect.
- Capital freeze
transactions are harder to accomplish in S corporations than in
- Assumption of Debt
and Transfer of Encumbered Assets.
- Both §§ 351 and 721
contemplate tax-free formation of corporations and
- The nonrecognition rule
of § 351 applies only in situations where the transferor of the
property, immediately after the exchange, controls 80% or more of
the voting stock. This creates problems for individuals
transferring property to an existing S corporation where the
transferor does not acquire 80% of the stock (i.e., a midstream
- No control restriction
applies to transfers to partnerships under §
- Corporate assumption of
shareholder debt without a valid business purpose or in excess of
the shareholder's basis of contributed property triggers gain
(See §§ 357(b) and (c)).
- Contributions of
encumbered property to a partnership, or assumption by the
partnership of a partner's indebtedness, only triggers gain to the
extent that the debt assumed exceeds the partner's basis for his
partnership interest, i.e., that portion of the debt shifted to the
other partners (§§ 752(b), 722 and 731(a)(1); see also Rev.
Ruls. 79-205, 1979-2 C.B. 255, and 84-102, 1984-2 C.B.
- Cash-basis accounts
payable and similar items are not treated as liabilities for these
purposes (See § 704(c) and § 357(c)(3)). However, when these
items are paid, the deduction must be allocated to the contributing
partner under § 704(c), while there is no comparable rule for S
- Inclusion of
Liabilities in Basis and At Risk: Limitation on
- Losses and deductions in
both S corporations and partnerships are limited to basis
(See §§ 704(d) and 1366(d)). Shareholders can deduct losses
to the extent of both stock basis and debt basis. Partners
can deduct losses only to the extent of their basis for their
- A shareholder's ability
to deduct pass-through items is limited to his basis in his S
corporation stock and his basis in debt owed to him by the
corporation (§ 1366(d)(1)). The shareholders basis in his
indebtedness is not increased by nonrecourse loans or any third
party loan to the corporation despite shareholder guarantees. The
shareholder's payment on his guarantee of corporate debt is
required in order to provide basis. Furthermore, delivery of a
shareholder's note to a third party creditor is sufficient as
payment on the guarantee (See Rev. Rul. 75-144, 1975-1 C.B.
277 and Gilday, T.C.M. 1982-242). Shareholders must borrow
directly and then contribute or loan the proceeds to the
corporation to achieve leveraged deductions. Corporate and
shareholder co-signatures do not give rise to shareholders
indebtedness (See PLR 8426006 and Harrington v. United
States, 85-1 USTC ¶ 9336). Loans made to an S corporation by
another S corporation owned by the same shareholders does not
create basis (Bernstein, T.C. Memo 1984-74). Shareholder
borrowing of proceeds which are then reloaned to the S corporation
does create indebtedness, even if the proceeds are used by the S
corporation to repay a corporate loan guaranteed by the shareholder
(PLR 8443002 (July 16, 1984)).
- In a partnership,
recourse liabilities and nonrecourse liabilities can increase a
partner's basis for his partnership interest (Reg. §
- The at-risk rules of §
465 are applied at both the shareholder and partner level. Recourse
partnership liabilities can increase a partner's amount at risk if
assumed by the partner. A shareholder's amount at risk generally is
not increased by corporate liabilities unless assumed by the
shareholder (Rev. Rul. 75-144, 1975-1 C.B.
- Post-termination rules
are more liberal for S corporations than for partnerships, e.g.,
termination of S election allows deduction of carryover in
post-termination period. The incorporation of a partnership causes
the loss of this carryover.
- The S corporation's
basis in its assets cannot be increased or decreased due to the
transfer of stock by sale or death, nor from distributions to
- Optional basis elections
under §§ 743 and 734 are available upon transfers of partnership
interests by sale or death or upon partnership distributions (§
754), but no basis step-up is allowed for either a partnership or S
corporation for IRD items.
- Cash Distributions
Excluding Redemptions and Liquidations.
- Cash distributions from
an S corporation having no earnings and profits are tax-free to the
extent of stock basis. Gain on any distribution in excess of stock
basis is generally capital gain, but could be ordinary income under
collapsible corporation provisions (§§ 1368(b)(2) and 341). If the
S corporation has earnings and profits, the potential exists for
dividend treatment (§ 1368(c)).
distributions are tax free to the extent of the partner's basis in
his partnership interest. Gain is recognized only if the amount of
money distributed exceeds a partner's basis in its partnership
interest, unless § 751 applies.
- Distribution in
- § 302(b) and § 301 apply
to distributions in redemption of a shareholder's S corporation
stock, generally resulting in capital gain or dividend treatment (§
- Distributions by a
partnership to a partner are generally treated as capital gain
distribution only to the extent they exceed basis, except if the
distribution is a disproportionate distribution under §
- Distributions of
- For S corporations, §
311(b) triggers income to the corporation as if the property was
sold to the shareholder at fair market value. The built-in gains
tax of § 1374 may also apply.
- Unless the partnership
distribution constitutes a substantially disproportionate
distribution under § 751(b), no gain is recognized to a
distributions reduce a partner's basis to the extent of the basis
of distributed property, while S corporation distributions reduce
stock basis by the fair market value of distributed
distributions from a partnership generally do not cause § 179
recapture. Recapture is recognized on distribution from an S
corporation (See § 47(b) and Groton, T.C. Memo
- S corporations are taxed
under the general liquidation rules of §§ 331-337, resulting in
capital gain unless the corporation is collapsible (§ 1371(a)).
Under § 453B(h), if an installment obligation is distributed by an
S corporation in a complete liquidation and the receipt of the
obligation is not treated as payment for the stock by reason of §
453(h)(1) (i.e., § 453(h)(1) allows the shareholder to report gain
over the same period of years as payments under such obligation are
required to be made) then, except for purposes of any tax imposed
on the S corporation by § 1374, no gain or loss with respect to the
distribution of the obligation is recognized by the distributing
corporation (i.e., the distribution is not treated as a taxable
disposition of the installment obligation).
distributions of property from a partnership are tax free unless
the partnership owns § 751 assets and the distribution is a
- Gain or Loss on
Transfer of Interest.
- Transfers of S
corporation stock generally result in capital gains treatment
unless the corporation is collapsible (§ 341) and capital loss
treatment unless the stock is dealer stock or § 1244 stock. Gain is
never fragmented and recapture income will not cause collapsible
treatment. The gain on disposition of stock in an S corporation
does not qualify for the 50% exclusion under § 1202. Any unrealized
inventory income may cause collapsibility. Substantial realization
of the taxable income from the property eliminates ordinary income
treatment under § 341(b)(1).
- Gain on the transfer of
a partnership interest is generally capital gain unless the
partnership owns § 751 assets (see Rev. Rul. 76-189, 1976-1
C.B. 181). Only substantially-appreciated inventory and unrealized
receivables causes § 751 treatment.
- S corporations may
participate in tax-free reorganizations (§§ 1371(a)(1) and
1363(e)). Section 1371(a)(2), however, provides that for purposes
of subchapter C, an S corporation in its capacity as a shareholder
of another corporation is treated as an individual. However, an S
corporation is eligible to make a § 338 election with respect to an
acquired subsidiary (PLR 9245004, July 28, 1992) and an S
corporation may liquidate a subsidiary tax-free under § 332 and
§337. This is the same result as that allowed in Rev. Rul. 72-320,
1972-1 C.B. 270, which allows an S corporation momentary ownership
of all the stock in another corporation where the stock of the
subsidiary is immediately distributed in connection with a divisive
reorganization under § 368(a)(1)(D).
- Partners may not
participate in tax-free reorganizations with a corporation or in
tax-free exchanges of their partnership interests for other
partnership interests (§ 1031(a)(2)(D)). Incorporation of a
partnership would generally be tax free under § 351 (See
Rev. Rul. 84-111, 1984-2 C.B. 88).
- S corporation
shareholders may utilize loss carryovers even after termination of
the S corporation election if there is sufficient basis during the
post-termination period (§ 1366(d)(3)). Shareholders may also
withdraw cash during the post-termination
- After a partnership is
dissolved or incorporated, there is no carryover of losses or
tax-free distribution provisions.
- Limitations on
Deductions of Accruals and Fringe
- Accrual-basis S
corporations may not defer payment of accrued deductions to any
shareholder (§ 267(a)(2), (e)(1) and (e)(2)). Further, fringe
benefits such as medical reimbursement plans are not available for
any shareholders owning more than 2% of the S corporation (§ 1372).
However, they are available for shareholders owning 2% or
- Fringe benefits are
generally not available to partners and expenses owed to owners are
deducted under the partnership's method of accounting when included
in the partners' income under the same method (See § 707(c);
see also § 267(a)(2), (e)(1) and
- Reallocation of
Income; Family Partnerships vs. Family
- Section 1366(e) allows
the IRS to reallocate income to family members, even though they
are not shareholders, in order to adequately compensate for
services rendered or capital furnished.
- Section 704(e) allows
reallocation of the partnership income to recognize the "true
owner" of a partnership interest, or if capital is not a material
- See Carriage
Square Inc., 69 T.C. 119 (1977), where contributed capital, as
compared to loans, guaranteed by principal shareholder of corporate
general partner caused court to conclude that capital was not a
material income producing factor.
- Reg. § 1.704-1(e)
contains complex rules to determine whether a donee of a
partnership interest is the true owner.
- Adequate compensation
for services rendered by a partner is required or reallocation may
occur (See § 704(e)(1)).
- Only eligible trusts can
be shareholders of an S corporation. No comparable limitation on
trusts owning a partnership interest exists.
- The parents retention of
voting control and the transfer on nonvoting interests to children
should not constitute the retention of a life estate within the
meaning of § 2036(b) in either a corporation or a partnership
(See S. Rept. No. 745, 95th Cong. 2d Sess. 89, 90 (1978) and
Rev. Rul. 81-15, 1981-1 C.B. 457).
- Gain and Loss on
Sales Between Entity and Owner.
- For S corporations and
partnerships, § 1239 requires ordinary income treatment for gain
recognized on the sale of depreciable property if the seller owns
more than 50% of the value of the outstanding stock of the S
corporation. Losses are disallowed under § 267(a) on sales if the
shareholder owns more than 50% of the value of the outstanding
stock of the S corporation.
- For partnerships, §
707(b)(2) converts capital gain into ordinary income on a sale of
non-capital assets if the seller owns more than 50% of the
partnership capital or profits. Losses from the sale or exchange of
property are disallowed if between a partnership and a partner
owning more than 50% of the partnership capital or profits (§
- The attribution rules
under § 1239 conform generally with the attribution rules under §
- An S corporation may be
a vehicle for obtaining a step-up in basis of depreciable property
at capital gain rates. If a taxpayer owns property which has been
completely depreciated, or the corporation owns depreciable
property with a zero basis, he may consider selling it to an S
corporation, or the corporation may sell it to a shareholder.
Provided the sale will be recognized as a sale, and not a capital
contribution or dividend distribution, the corporation, or the
shareholder, will obtain a cost basis under § 1012. Caution must be
exercised, however, since § 1239 causes sales of depreciable
property between a shareholder and a more than 50% owned entity to
be taxed as ordinary income rather than capital gain or § 1231
gain. For purposes of determining whether or not the shareholder
owns more than 50% of the entity, attribution rules similar to the
rules under § 267(c) (other than paragraph (3) thereof) apply (§
1239(c)(2)). This result is comparable to the result obtained upon
a sale from a partner to a partnership. If the sale is an
installment sale, gain may generally be reported on the installment
method unless the sale is an installment sale of depreciable
property between related persons (within the meaning of § 1239(b))
- Basis Step Up for
- The bulk sale of
appreciated land prior to subdivision or of an apartment building
prior to condo conversion to a related entity allows the seller to
recognize pre-sale appreciation at capital gain
- The purchaser cannot be
a family partnership since the asset is other than a capital asset
in the hands of transferee and the more than 50% ownership test
(determined under § 267 family attribution rules) is satisfied. If
these conditions are met, the gain recognized will be considered
ordinary income under § 267(b)(2).
- The gain recognized on
the sale to a family S corporation would similarly be considered
ordinary income if the property is depreciable in the hands of the
- FICA and FUTA taxes are
imposed on compensation and dividends treated as compensation for
- Self-employment tax is
imposed upon the income of a general partner from a business,
whether distributed or not.
- Undistributed S
corporation income, however, is not subject to self-employment
taxes, notwithstanding the characterization pass-through of § 1366.
(See Rev. Rul. 59-221, 1959-1 C.B. 225, which held that a
shareholder's undistributed share of S corporation income under §
1373 (prior law) is not treated as self-employment income since the
corporation, not the individual, was carrying on a trade or
business. The Ruling also held that § 1402 applies to partnerships,
but not S corporations. Section 1402 provides that the net earnings
from self-employment means "gross income derived by an individual
from any trade or business carried on by such individual...plus,
his distributive share (whether or not distributed) of income or
loss described in § 702(a)(8) from any trade or business carried on
by a partnership of which he is a member.")
- In PLR 8716060 (January
21, 1987), the IRS held that a shareholder of an S corporation
engaged in commodities trading could not establish a KEOGH plan
based on his S corporation pass-through income. Citing Rev. Rul.
59-221, the Service stated that the allocated S corporation income
was not self-employment income. Thus, both Rev. Rul. 59-221 and PLR
8716060 indicate that a shareholder's allocated share of S
corporation income is not trade or business income and does not
constitute net earnings from self-employment as defined in §
- In addition, in Rev.
Rul. 74-44, 1974-1 C.B. 287, the Service imputed the payment of
reasonable salaries to an S corporation that did not pay salaries
to its two shareholders. The shareholders performed services for
the corporation but, to avoid payment of Federal Employment Taxes,
they did not draw salaries. Instead, they arranged for the
corporation to pay them dividends in the amount they would have
otherwise received as reasonable compensation for services
- Citing FICA and FUTA
provisions in § 3401(a), the Service concluded that the dividends
were compensation for employment. Thus, the corporation was liable
for FICA and FUTA taxes and income tax
- The Service has
continued to apply the dividends as wages theory of Rev. Rul.
74-44. For example, PLR 7949022 (August 31, 1979) cited Rev. Rul.
74-44 as a self support for recharacterizing distributions to
shareholders of an S corporation that performed diagnostic X-ray
work. The Service concluded in the ruling that S corporation
distributions are wages when they constitute reasonable
compensation for services rendered.
- The first S corporation
case to focus on the reclassification of dividend distributions as
wages was Bramlette Building Corp., Inc., 424 F.2d. 751 (5th
Cir. 1970). In Bramlette, the Service revoked the
corporation's S status because it had excessive passive income. To
avoid double taxation, the corporation argued that the dividend
distributions should be retroactively recharacterized as wages. The
resulting corporate level salary deduction would offset the income
to be reported to the shareholders. However, the Tax Court rejected
this and held that the corporation could not claim a retroactive
deduction for wages it did not pay. The 5th Circuit agreed.
Observing that mere form is not the controlling factor, it stated
that the following facts and circumstances must be considered in
assessing whether the payments are
- Were the services
performed by the shareholder more than one would expect from a
- Did the corporation
authorize the salaries?
- Were the payments made
periodically or in a lump sum?
- Were the payments made
in proportion to stock ownership or to services
The 5th Circuit noted
that the 99.86% shareholder in Bramlette performed
services at a level expected of a major shareholder. In
addition, the payments were made in proportion to stock
ownership not to services rendered. The 5th Circuit thus
concluded that the payments were dividends, not wages (See
also Paula Construction Co. v. Comm'r, 474 F.2d.
1345 (5th Cir. (1973)).
- The IRS also emerged the
victor in a District Court battle over whether dividends paid to
the sole shareholder of an S corporation were wages subject to
Social Security, unemployment, and income tax withholding
(Radtke v. United States, 89-2 USTC ¶ 9466 (D.C. Wisc.
- Joseph Radtke
incorporated his law practice as an S corporation. Radtke was the
sole incorporator, director, and shareholder and was the firm's
only full-time employee. Radtke's employment contract called for an
annual salary to be determined by the board of directors. Although
Radtke devoted all of his working time to the corporation's
clients, his annual base salary was set at $0. He did, however,
receive over $18,000 in dividends from the corporation during the
year in issue. Whenever Radtke needed money, he had the board
declare a dividend and wrote a corporate check to himself. Radtke
paid income tax on the dividend income, but no FICA or FUTA taxes
were paid on the dividend amount.
- On these facts, the IRS
argued and the District Court agreed that Radtke's dividends were
really wages subject to FICA and FUTA taxes. According to the
court, "where the corporation's only director had the corporation
pay himself, the only significant employee, no salary for
substantial services,... his dividends functioned as remuneration
- Similarly, in Spicer
Accounting, Inc. v. U.S., 918 F.2d 90 (9th Cir. 1990), the
Court of Appeals held that because the employee-owner performed
substantial services that were essential to the day-to-day
operations of the accounting firm, the employee-owner was deemed an
employee, and payments to him were deemed wages subject to FICA and
- In Spicer, the
taxpayer was an accounting corporation that elected to be treated
as an S corporation. Its stock was owned by a licensed public
accountant, who also served as president, treasurer and director,
and by his spouse. This accountant performed substantial services
for the taxpayer. He was the only accountant working for the firm,
although his spouse and one other employee prepared tax returns and
performed bookkeeping for clients of the taxpayer. The taxpayer
reported the payments it made to the accountant as distributions
and claimed that these payments were not subject to employment
- The court held that
because the accountant performed substantial services that were
essential to its day-to-day operation, the taxpayer was deemed an
employee, and payments to him should be considered as wages subject
to employment taxes. The accountant was not an independent
contractor because the taxpayer provided him with supplies and a
place to work and he performed accounting services for no other
- For a similar result,
see Esser v. U.S., 750 F. Supp. 421 (D. Ariz, 1990),
Veterinary Surgical Consultants, P.C. v. Comm'r, 117 T.C.
141 (2001), Joseph M. Grey P.A., 119 T.C. 121 (2002), and
Yeagle Drywall, 2003-1 USTC ¶50,141 (3rd Cir.
2002), where amounts received by the sole shareholder-employee were
recharacterized as wages subject to employment tax. The shareholder
received no salary from the corporation during the
- In Dunn & Clark,
P.A. v. Comm'r, 853 F. Supp. 365 (D.C. Id. 1994), attorneys
Robin Dunn and Stephen Clark were the directors, officers, and sole
shareholders of Dunn & Clark P.A., an S corporation. In
addition to providing legal services to the firm's clients, the
attorneys also performed prosecutorial work for Jefferson County,
Idaho. Dunn and Clark were never paid a salary for their non-county
legal work, and they did not have a written employment contract
with the law firm for the provision of services to clients. In
1987, 1988 and 1989, the attorneys received payments from the law
firm that were characterized as dividends. IRS reclassified the
payments as salary and assessed taxes for FICA, FUTA and
withholding against the law firm.
- The District Court
agreed that the payment to Dunn and Clark should be reclassified as
wages. The IRS assessment of FICA, FUTA and withholding, plus
penalties and interest, was sustained.
- The Court observed that
the burden on taxpayers in characterizing payments as dividends
instead of wages is heavy, as salary arrangements between closely
held corporations and stockholders require close scrutiny
(Elliotts, Inc., 716 F.2d 1241 (9th Cir. 1983)). Under §
3121(d), an employee is defined as "any officer of a corporation".
There is an exception to this rule if the officer can prove he or
she "does not perform any services or performs only minor services
and who neither receives nor is entitled to receive...any
remuneration" (Reg. § 31.3121(d)-1(b)).
- The Court stated that in
order to reach the conclusion that the payments were dividends, the
court would have to accept that the attorneys were providing legal
services for the firm's clients "out of the goodness of their
- The Court compared the
instant case to the Ninth Circuit decision in Spicer Accounting.
Inc., 918 F.2d 90 (9th Cir. 1990). In Spicer, the court
held that an accountant provided substantial services to his
corporation and the dividends were actually wages subject to FICA
- The Court determined
that the amount of work performed by Dunn and Clark was more than
"minor services" and that Dunn and Clark were statutory employees
of their S corporation based on Reg. § 31.3121(d)-1(b). Further,
the court was not impressed by the fact that the payments were made
- Consistent with
Spicer, the court also concluded that the firm did not have
a reasonable basis for treating the attorneys as non-employees.
Therefore, it did not qualify for the § 530
dividends as wages subject to Social Security, unemployment and
income tax withholding should only apply in those situations in
which the corporation is involved in performing services, i.e.,
typically the performance of services in the fields of health, law,
engineering, architecture, accounting, advanced sciences,
performing arts, or consulting; or in those situations where the S
corporation attempts to make distributions to a shareholder in an
amount that the shareholder would have otherwise received as
compensation for the services performed (Rev. Rul. 74-44, 1974-1
- Payments to a
Deceased or Retired Shareholder or
- Payments to a deceased
or retired shareholder are generally treated as a redemption,
unless pursuant to a plan of deferred
- Section 736 generally
allows the partners to negotiate whether payments made in
liquidation of the interest of a retiring or deceased partner are
considered as a distributive share of partnership income (i.e.,
ordinary income to the recipient and deductible by the partnership)
or as payments in exchange for the partnership interest of such
partner (i.e., generally capital gain to the recipient and not
deductible by partnership).
- Section 448 prohibits
the use of the cash method of accounting by a partnership which has
a C corporation as a partner, but only if the partnership has
average annual gross receipts of more than $5 million over a
- Section 448 does not
prohibit the use of the cash method for S corporations (See
- Health Insurance
Costs of Self-Employed Individuals.
- Section 162(l) allows
self-employed individuals to deduct 70% of the amount they pay
during a taxable year for their health insurance coverage for
themselves, their spouses, and their dependents (70% in 2002 and
100% for 2003).
- Section 162(l)(5)
provides that the 70% deduction is allowed to an S corporation
shareholder who owns more than 2% of the stock in the corporation.
For purposes of the earned income limitation, however, the
shareholder's earned income is determined exclusively with
reference to the shareholder's wages received from the S
- Estate Planning: S
Corporation vs. Partnership.
- Owners of closely held
businesses traditionally transfer assets to a testamentary
- Partnerships have no
limitations on the types of trusts allowed as partners. Conversely,
the S corporation is limited in the type of trust which may be a
shareholder (§ 1361(b)(1)(B)). Therefore, the partnership offers
- C corporations typically
used the preferred stock recapitalization method to lock-in the
current value of a closely held business.
- The partnership may use
this method by restructuring the business so there are, in essence,
two types of partnership interests. One interest freezes the
current value and the other interest, which has little value,
appreciates as the business appreciates. The interest with little
value may be used to gift lifetime interests to family
- The S corporation is
limited to one class of stock which prevents the preferred stock
method (§ 1361(b)(1)(D)). A partial freeze of the S corporation
value may be obtained through options or warrants (See Rev.
Rul. 67-269, 1967-2 C.B. 298).
- Income shifting can be
used by both partnerships and S corporations by transferring stock
or partnership interests. However, for service-oriented
partnerships, the ability to shift income is limited by the family
partnership rules (§ 704(e)). In S corporations, income shifting is
only limited to the extent that a reasonable and adequate
compensation be paid to corporate employees (§
- A lifetime gift of a
business interest is more easily transferred via the stock of an S
corporation rather than a partnership interest. Also, in the case
of an S corporation, the recipient becomes a shareholder and
generally has little or no control over the management of the
corporation. However, the recipient of a general partnership
interest has an equal right to manage and control the partnership
and may be authorized to act as an agent of the partnership. The
possibility also exists in a partnership, upon transfer of 50% or
more interest, that the partnership will be terminated (§