## Facts

- David E. Watson, P.C. (DEWPC) was an S corporation wholly owned by David Watson, a CPA with extensive accounting and tax experience.
- Watson was DEWPC’s sole shareholder and only employee; DEWPC’s income was largely generated by Watson’s personal services.
- For 2002 and 2003, DEWPC paid Watson a fixed salary of $24,000 per year and paid employment taxes on that salary.
- In each of those years, DEWPC also paid Watson approximately $175,000 characterized as “dividends” and/or “loan repayments,” without paying employment taxes on those amounts.
- The IRS determined Watson’s salary was unreasonably low and recharacterized a substantial portion of the distributions as wages subject to FICA and other employment taxes.
- An IRS expert opined that reasonable compensation for Watson’s services was approximately $91,000 per year, based on comparable compensation data.
- DEWPC paid the assessment for one quarter, sought a refund, and after denial filed a refund suit; the United States counterclaimed for the unpaid balance for the other quarters.

## Issues

1. Whether the IRS could recharacterize DEWPC’s S-corporation “dividend” and “loan” payments to its sole shareholder-employee as wages subject to FICA based on reasonable-compensation principles.
2. Whether Watson’s $24,000 annual salary was unreasonably low in light of his services and the corporation’s distributions, justifying employment tax assessments.
3. Whether DEWPC was entitled to a refund and whether the United States was entitled to recover unpaid employment taxes, penalties, and interest on its counterclaim.

## Decision

- The court entered judgment for the United States after a bench trial.
- The court held that, in economic reality, the challenged distributions functioned as remuneration for Watson’s services up to the level of reasonable compensation.
- The court found Watson’s reported salary of $24,000 was unreasonably low given his qualifications, role, and the business’s earnings.
- The court credited the government’s expert evidence and concluded the IRS’s recharacterization and employment tax assessments were supported by the record.
- DEWPC’s refund claim was denied, and the United States prevailed on its counterclaim for the remaining unpaid employment taxes, penalties, and interest.

## Legal Principles

- Federal tax classification turns on substance rather than taxpayer labels; courts may recharacterize payments to reflect economic reality.
- An S corporation cannot avoid employment taxes by paying a shareholder-employee a token salary while distributing most earnings as dividends or purported loan repayments.
- When a shareholder-employee provides substantial services, amounts paid in excess of a nominal salary may be treated as wages to the extent necessary to reflect reasonable compensation, and are subject to FICA and related employment taxes.
- Reasonable compensation is a fact-intensive determination; credible market-based expert testimony may support reallocating distributions to wages.

## Conclusion

The court upheld the IRS’s allocation of S-corporation distributions to wages where the shareholder-employee performed the income-producing work but was paid an unreasonably low salary, resulting in valid FICA assessments and judgment for the government on both the refund claim and the counterclaim.


David E. Watson, P.C. v. United States, 757 F. Supp. 2d 877 (S.D. Iowa 2010)