David E. Watson, PC v. United States

David Watson worked as an accountant for 10 years, after which he obtained a 25-percent interest in Larson, Watson, Bartling & Juffer (LWBJ). Thereafter, Watson incorporated David E. Watson, P.C. (DEWPC) (plaintiff), which elected to be taxed as an S corporation. Watson transferred his interest in LWBJ to DEWPC, with DEWPC then replacing Watson as a LWBJ partner. Watson served as DEWPC’s only officer, shareholder, and employee. Watson was a DEWPC employee but provided accounting services exclusively to LWBJ for approximately 35–45 hours per week. In 2002 and 2003, DEWPC distributed $24,000 to Watson as employment compensation, which it reported to the IRS as taxable wages. Watson also received $203,651 as profit distributions for 2002, and $175,470 for 2003. Following an investigation, the Internal Revenue Service (IRS) concluded that DEWPC had underpaid employment taxes required by the Federal Insurance Contribution Act (FICA). DEWPC paid the past-due tax and penalties, but sought a refund, which the IRS denied. DEWPC sued the United States (defendant). The U.S. counterclaimed to recover the employment taxes and penalties. At trial, the U.S.’s expert testified that the market value of Watson’s accounting services was equal to $91,044 per year. The expert determined that, because Watson was, in effect, a LWBJ partner, the value of his compensation would be 33 percent more than that of a director in a firm of that size. The district court adopted the expert’s opinion and concluded that the amount of taxable wages DEWPC paid to Watson was underreported to the IRS by $67,044. The court rendered a tax deficiency judgment against DEWPC. DEWPC appealed.