Why FICA Taxes Matter

Recharacterization of Distributions as Wages

Legal Principle:
The IRS and courts have consistently held that if a shareholder-employee provides substantial services to the corporation, any distributions, dividends, management fees, or other payments made instead of reasonable compensation for those services will be recharacterized as wages for employment tax purposes. This applies regardless of how the payments are labeled or structured [5] [2] [3] [4].

Radtke v. United States: The Seventh Circuit affirmed that "dividends" paid to a sole shareholder-employee who performed all the work for the S corporation were actually wages subject to FICA and FUTA taxes, because they were remuneration for services performed [5].
Rev. Rul. 74-44: Payments labeled as "dividends" but made in lieu of reasonable compensation for services are considered wages for employment tax purposes [2].
TAM 9530005: A "management fee" paid to a shareholder-officer for services was held to be wages, not self-employment income or a distribution [3].
CCA 200305007: Amounts designated as "royalty payments" to an accountant for services were recharacterized as wages [4].

Liability for Back Taxes, Penalties, and Interest

If the IRS determines that a shareholder-employee has been underpaid, the corporation will be liable for:

Unpaid FICA Taxes: Both the employer and employee portions of Social Security and Medicare taxes on the recharacterized wages.
Unpaid FUTA Taxes: Federal Unemployment Tax Act taxes on the recharacterized wages.
Income Tax Withholding: The corporation may also be liable for failing to withhold and remit income taxes on the recharacterized wages.
Penalties and Interest: The IRS may assess penalties for failure to withhold and deposit employment taxes, as well as interest on the underpaid amounts [5] [2].

Reasonable Compensation Requirement

Statutory and Regulatory Basis:

IRC § 162(a)(1): Allows a deduction for "a reasonable allowance for salaries or other compensation for personal services actually rendered" [1].
IRC §§ 3121(a), 3306(b), 3401(a): Define "wages" broadly as all remuneration for employment, with limited exceptions [4].
Treas. Reg. § 31.3121(d)-1(b): An officer of a corporation is an employee unless they perform only minor services and receive no remuneration [3].

Determining Reasonableness

The IRS and courts look at all facts and circumstances, including:

The employee’s qualifications and role in the company
The nature, extent, and scope of the work performed
The size and complexity of the business
Comparisons to compensation paid by similar businesses for similar services
The company’s salary policy and history
The relationship between salary and distributions [6].

Impact on Retirement Contributions and Social Security

Retirement Plan Contributions: Underpaying salary can limit the amount that can be contributed to retirement plans (e.g., solo 401(k), SEP, profit-sharing), as these are based on wage income. This can reduce long-term tax-deferred savings and retirement benefits [7].
Social Security Benefits: Lower reported wages result in lower Social Security contributions, which can reduce future Social Security benefits [7].

Increased Audit Risk

IRS Scrutiny: The IRS actively audits S corporations and C corporations where shareholder-employees report little or no salary but receive substantial distributions. Lack of reasonable compensation is a red flag for audit [6].

No Safe Harbor

There is no statutory or regulatory safe harbor for what constitutes "reasonable compensation." Each case is determined on its own facts and circumstances, and the burden is on the taxpayer to substantiate the reasonableness of the compensation paid [6].

Summary

If a shareholder-employee of an S corporation or C corporation pays themselves too little salary to avoid FICA taxes, the IRS can recharacterize distributions or other payments as wages, resulting in liability for back employment taxes, penalties, and interest. The corporation must pay reasonable compensation for services rendered, and failure to do so can also negatively impact retirement contributions and Social Security benefits, while increasing audit risk. The determination of what is "reasonable" is fact-specific and must be substantiated with appropriate evidence and documentation [5] [2] [3] [4] [6] [7].