1. Comparing an S Corporation and a Partnership.
  1. Formation - 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.
  1. Eligibility, Liability, and Management Control.
  1. 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.
  1. 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 partners.
  1. 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 (§ 1361(c)(4)).
  1. Selection of Taxable Year.
  1. 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).
  1. For taxable years after 1986, partnerships and S corporations are generally limited to a calendar year.
  1. Taxation of Shareholders and Partners.
  1. 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).
  1. 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.
  1. 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 partnership.
  1. Partnerships are not subject to any potential adverse tax liability discussed above. A partnership is not a taxable entity.
  1. Transferability of Interest.
  1. 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 corporate bylaws.
  1. By statute, the transfer of a general partner's interest may cause a technical dissolution of the partnership.
  1. Unlimited Life.
  1. Corporations have unlimited life and do not terminate as a result of shareholder transfers or transactions.
  1. 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.
  1. Contribution and Characterization of Property.
  1. 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 (1970)).
  1. 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.
  1. 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 its operation.
  1. 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 § 735).
  1. Income shifting and recharacterization with respect to contributed property is only available in S corporations.
  1. Allocating Income and Loss.
  1. 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).
  1. 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)).
  1. 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 § 1362(e).
  1. 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.
  1. The six types of trusts permitted to be Subchapter S shareholder may be used to shift income and for estate planning.
  1. 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.
  1. 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.
  1. The trust can also provide certain safeguards so, in effect, the "deemed owner" does not have control of the income generated from the S corporation.
  1. 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.
  1. 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 objectives.
  1. 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 trust.
  1. Tax Credits Flow-Through.
  1. 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.
  1. Inadvertent Termination or Revocation of Status.
  1. By statute, a majority of shareholders can revoke an S corporation election. The status of a partnership can only be changed by incorporation or dissolution.
  1. An S corporation election may be inadvertently terminated; this is not a problem for partnerships (§ 1362).
  1. 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 partners.
  1. Classes of Ownership Interest.
  1. 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).
  1. Safe harbor debt, stock options, and restricted stock are not treated as a second class of stock.
  1. 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.
  1. No such problems exist in a partnership. Special allocations are permitted if there is substantial economic effect.
  1. Capital freeze transactions are harder to accomplish in S corporations than in partnership.
  1. Assumption of Debt and Transfer of Encumbered Assets.
  1. Both §§ 351 and 721 contemplate tax-free formation of corporations and partnerships.
  1. 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 transfer).
  1. No control restriction applies to transfers to partnerships under § 721.
  1. 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)).
  1. 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. 119).
  1. 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 corporations.
  1. Inclusion of Liabilities in Basis and At Risk: Limitation on Losses.
  1. 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 partnership interests.
  1. 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)).
  1. In a partnership, recourse liabilities and nonrecourse liabilities can increase a partner's basis for his partnership interest (Reg. § 1.752-1).
  1. 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. 277).
  1. 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.
  1. Basis Adjustments.
  1. 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 shareholders.
  1. 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.
  1. Cash Distributions Excluding Redemptions and Liquidations.
  1. 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)).
  1. Partnership 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.
  1. Distribution in Redemption.
  1. § 302(b) and § 301 apply to distributions in redemption of a shareholder's S corporation stock, generally resulting in capital gain or dividend treatment (§ 1371(a)(1)).
  1. 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 § 751(b).
  1. Distributions of Appreciated Property.
  1. 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.
  1. Unless the partnership distribution constitutes a substantially disproportionate distribution under § 751(b), no gain is recognized to a partner.
  1. Partnership 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 property.
  1. Nonliquidating 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 1985-45).
  1. Liquidating Distributions.
  1. 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).
  1. Liquidating distributions of property from a partnership are tax free unless the partnership owns § 751 assets and the distribution is a disproportionate distribution.
  1. Gain or Loss on Transfer of Interest.
  1. 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).
  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.
  1. Tax-Free Reorganization.
  1. 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).
  1. 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).
  1. Post-Termination Transition Period.
  1. 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 period.
  1. After a partnership is dissolved or incorporated, there is no carryover of losses or tax-free distribution provisions.
  1. Limitations on Deductions of Accruals and Fringe Benefits.
  1. 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 less.
  1. 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 (e)(2)).
  1. Reallocation of Income; Family Partnerships vs. Family Corporations.
  1. 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.
  1. 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 income-producing factor.
  1. 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.
  1. Reg. § 1.704-1(e) contains complex rules to determine whether a donee of a partnership interest is the true owner.
  1. Adequate compensation for services rendered by a partner is required or reallocation may occur (See § 704(e)(1)).
  1. Only eligible trusts can be shareholders of an S corporation. No comparable limitation on trusts owning a partnership interest exists.
  1. 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).
  1. Gain and Loss on Sales Between Entity and Owner.
  1. 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.
  1. 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 (§ 707(b)).
  1. The attribution rules under § 1239 conform generally with the attribution rules under § 707.
  1. 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)) (§ 453(g)).
  1. Basis Step Up for Inventory Assets.
  1. 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 rates.
  1. 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).
  1. 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 S corporation.
  1. Reasonable Compensation.
  1. FICA and FUTA taxes are imposed on compensation and dividends treated as compensation for services.
  1. Self-employment tax is imposed upon the income of a general partner from a business, whether distributed or not.
  1. 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.")
  1. 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 § 1402(a).
  1. 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 performed.
  1. 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 withholding.
  1. 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.
  1. 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 compensation:
  1. Were the services performed by the shareholder more than one would expect from a major shareholder?
  1. Did the corporation authorize the salaries?
  1. Were the payments made periodically or in a lump sum?
  1. Were the payments made in proportion to stock ownership or to services performed?
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)).
  1. 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. 1989)).
  1. 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.
  1. 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 for employment."
  1. 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 FUTA taxes.
  1. 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 taxes.
  1. 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 accounting firm.
  1. 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 year.
  1. 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.
  1. 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.
  1. 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)).
  1. 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 hearts".
  1. 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 and FUTA.
  1. 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 irregularly.
  1. 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 exception.
  1. Recharacterizing 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 C.B. 287).
  1. Payments to a Deceased or Retired Shareholder or Partner.
  1. Payments to a deceased or retired shareholder are generally treated as a redemption, unless pursuant to a plan of deferred compensation.
  1. 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).
  1. Methods of Accounting.
  1. 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 three-year period.
  1. Section 448 does not prohibit the use of the cash method for S corporations (See § 448(a)).
  1. Health Insurance Costs of Self-Employed Individuals.
  1. 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).
  1. 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 corporation.
  1. Estate Planning: S Corporation vs. Partnership.
  1. Owners of closely held businesses traditionally transfer assets to a testamentary trust.
  1. 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 greater flexibility.
  1. C corporations typically used the preferred stock recapitalization method to lock-in the current value of a closely held business.
  1. 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 members.
  1. 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).
  1. 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 (§ 1366(e)).
  1. 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 (§ 708(b)(1)(B)).