Posts Tagged ‘John Edwards Shelter’

Tax Roundup, 11/8/13: Kyle Orton gets the bad news about the Tax Fairy. And: how many Lithuanians can you fit into a mailbox?

Friday, November 8th, 2013 by Joe Kristan

tax fairyKyle Orton’s old lawyer fails to find the Tax Fairy, departs the tax business.  From a Department of Justice press release:

A federal court has permanently barred Gary J. Stern from promoting tax fraud schemes and from preparing related tax returns, the Justice Department announced today.  The civil injunction order, to which Stern consented without admitting the allegations against him, was entered by Judge Robert Gettleman of the U.S. District Court for the Northern District of Illinois.  The order permanently bars Stern from preparing various types of tax returns for individuals, estates and trusts, partnerships or corporations (IRS Forms 1040, 1041, 1065, and 1120), among others. 

According to the complaint, Stern designed at least three tax-fraud schemes that helped hundreds of customers falsely claim over $16 million in improper tax credits and avoid paying income tax on at least $3.4 million.  Stern allegedly promoted the schemes to customers, colleagues, and business associates.  The complaint alleges that his customers included lawyers, entrepreneurs and professional football players, and some of the latter, including NFL quarterback Kyle Orton, have sued Stern in connection with the tax scheme, alleging fraud, breach of fiduciary duty and professional malpractice. 

Mr. Stern seems to have led his clients on a merry chase after the Tax Fairy, the legendary sprite who can wave her wand and make your taxes disappear.  Kyle Orton is a graduate of Southeast Polk High School near Des Moines, where the truth about the Tax Fairy apparently was not in the syllabus.

Related: Jack Townsend, Chicago Lawyer Enjoined From Promoting Fraudulent Tax Schemes 

 

20131108-1Maybe Lithuanian apartments are crowded?  USA Today reports:

The Internal Revenue Service sent 655 tax refunds to a single address in Kaunas, Lithuania — failing to recognize that the refunds were likely part of an identity theft scheme. Another 343 tax refunds went to a single address in Shanghai, China.

Thousands more potentially fraudulent refunds — totaling millions of dollars — went to places in Bulgaria, Ireland and Canada in 2011.

In all, a report from the Treasury Inspector General for Tax Administration today found 1.5 million potentially fraudulent tax returns that went undetected by the IRS, costing taxpayers $3.2 billion.

When your controls don’t notice something like that, you have a lot more urgent problems than regulating preparers.   Yet Congress and the Administration think the IRS is ready to take on overseeing your health insurance purchases.  What could go wrong?

Tony Nitti is moved to offer the IRS a proposition:

MR. IRS,

REQUEST FOR URGENT BUSINESS RELATIONSHIP

FIRST, I MUST SOLICIT YOUR STRICTEST CONFIDENCE IN THIS TRANSACTION. THIS IS BY VIRTUE OF ITS NATURE AS BEING UTTERLY CONFIDENTIAL AND ‘TOP SECRET’.

Heh.

 

 

S-SidewalkCosting taxpayers by not taking their money.  Tax Analysts reports ($link):

Democrats seeking to raise revenue in ongoing budget talks have circulated a list of tax preferences they would like to see eliminated, including a provision that allows some wealthy individuals to avoid large payroll taxes, the carried interest preference, and the tax break for expenses businesses incur when moving operations overseas. 

The “provision that allows some wealthy individuals to avoid large payroll taxes” is called Subchapter S.  Form 1120-S K-1 income has never been subject to payroll or self-employment tax.  This bothers the congresscritters (my emphasis):

Commonly known as the “Newt Gingrich/John Edwards” loophole, it is most often used by owners of Subchapter S corporations to avoid the 3.9% Medicare tax on earnings, which costs taxpayers hundreds of millions of dollars every year.  Many S corporation shareholders receive both wages from the S corporation and a share of the S corporation’s profits, but they pay payroll tax only on their wages.

“Costs” taxpayers?  From my point of view, and from that of my S corporation clients, it saves taxpayers hundreds of millions of dollars every year — but keeps it out of the hands of grasping politicians, so it’s perceived as a bad thing, by grasping politicians.

The versions of this “loophole closer” proposed in the past have been lame.  When all they have to offer on tax policy is warmed over lameness like these, they aren’t serious.

 

 

TaxProf, Brunson: Preventing IRS Abuse of the Tax System.  The TaxProf quotes a new article by Samuel D. Brunson:

The IRS can act in ways that violate both the letter and the intent of the tax law. Where such violations either provide benefits to select groups of taxpayers without directly harming others, or where the harm to taxpayers is de minimis, nobody has the ability or incentive to challenge the IRS and require it to enforce the tax law as written.

Congress could control the IRS’s abuse of the tax law. Using insights from the literature of administrative oversight, this Article proposes that Congress provide standing on third parties to challenge IRS actions. If properly designed and implemented, such “fire-alarm oversight” would permit oversight at a significantly lower cost than creating another oversight board. At the same time, it would be more effective at finding and responding to IRS abuse of the tax system and would generally preserve the IRS’s administrative discretion in deciding how to enforce the tax law.

Right now the IRS — and by extension the administration in power — can pick and choose what parts of the law it wants to apply.  For example, the current administration has chosen to allow tax credits for participants in federal insurance exchanges, which the law does not authorize, while unilaterally delaying the employer insurance mandate but not the individual mandate.  Somebody should be able to challenge this sort of fiat government.

 

More on the shutdown of Instant Tax Service, a story we covered yesterday:Irwin

Department of Justice press release: Federal Court in Ohio Shuts Down Nation’s Fourth-Largest Tax-Preparation Firm and Bars CEO from Tax-Preparation Business

 

Irwinirwin.jpgPeter Reilly, Ninth Circuit Rules Against Irwin Schiff Sentence Appeal:

Irwin Schiff is probably one of the more famous alternate tax thinkers.  His seminal work “How Anyone Can Stop Paying Income Taxes” is available in hardcover on Amazon for one cent.

Mr. Schiff appealed his sentence on tax crimes on the basis that his attorney failed to raise a “bipolar disorder” defense and what an attorney I know calls the “good faith fraud” defense — the Cheek argument that you really thought the wacky stuff you were saying is true.  Peter wisely notes:

The problem with the Cheek defense is that you have to be smart to raise it, but if you show that you are too smart, then it does not work.

Its a fine line — smart enough to spend “thousands of hours” researching the tax law, but not smart enough to avoid a massive misunderstanding of it.

 

Jana Luttenegger,  IRS Change to Use-Or-Lose Rule for FSA Accounts (Davis Brown Tax Law Blog): “New IRS rules permit employers to allow participants in a health Flexible Spending Arrangement (FSA) to carry over unused amounts up to $500 from one plan year to the next.”

 

Paul Neiffer, Trusts Get Hit with New 3.8% Tax too. And hard.

Kay Bell, It could be time to harvest capital gains and future tax savings

Rush Nigut,  Careful Planning Necessary When Using Retirement Monies to Fund Startup Business

Brian Strahle, IGNORANCE MAY NOT BE BLISS WHEN IT COMES TO ‘ZAPPERS’  These are software apps designed to hide point-of-sale receipts from the taxman.

Phil Hodgen’s Exit Tax Book: Chapter 9 – Estate and Gift Tax for the Covered Expatriate

Catch your Friday Buzz with Robert D. Flach!

TaxGrrrl,  Former NFL Star Cites Concussions, Receives Prison Sentence For Role In Tax Fraud 

Leslie Book,  TIGTA Report on VITA Errors (Procedurally Taxing)

 

Howard Gleckman,  Can Expiring Tax Provisions Save the Budget Talks? (TaxVox).  “Sadly, it is hard to see how.”

 

Not strictly tax-related, but good reading anyway:  How to Put the Brakes on Consumers’ Debt(Megan McArdle).  Megan points out the wisdom of spending less than you take in, in preference to trying to get the government to cover your shortfalls.

 

News you can use: 3 ways to screw up your next website (Josh Larson at IowaBiz.com)

News from the Profession: Failed PwC Auditor Finds Success in Burning Bridges With This Ridiculous Farewell Email (Going Concern)

 

Quick thinking.  From The Des Moines Register:

A Des Moines man awoke to find a stranger in his living room Thursday afternoon, police said. When the victim confronted the burglar, the suspect reportedly offered to mow the victim’s lawn for $5.

Guy needs to work on his pricing model.

 

 

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Tax Roundup, 9/6/2013: The IRS is losing the S corporation comp war? And Tax Analysts has a history video!

Friday, September 6th, 2013 by Joe Kristan

S-SidewalkIf they’re losing the war, I’d hate to see how they’d act if they won. The TaxProf today offers Schwidetzky: The ‘John Edwards S Corp Tax Shelter': Is the IRS Winning the Battles But Losing the War? :

 Arguably, that case has yet to be litigated. But there are two cases where the taxpayer either paid or was supposed to have paid a modest salary, curiously the same amount in both cases, $24,000 per year. The two cases are Watson v. Unied States, 107 AFTR2d 311 (IA DC 2010), aff’d 668 F.3d 1008 (8th Cir. 2012) and McAlary v. Commissioner, T.C. Summ. Op. 2013-62. Both cases rejected the $24,000 salary as too small. But neither case concluded that that the net income of the S corporation was wages. Instead, following John Edwards’ lead, the courts looked to what, essentially, the average similarly situated taxpayer earned instead of what the taxpayer earned from his services…

It is common for tax advisors to suggest that the taxpayer take a salary equal to the social security tax cap. Until the courts come to their senses, there is no reason for tax advisors not to continue to give that advice.

The tax law does not impose self-employment or employment taxes on S corporation K-1 income.  Most (but not necessarily all!) partnership income of active partners, and all Schedule C income, is subject to self-employment tax.  This encourages S corporation shareholders to take less in salary and more on their K-1s.

Mr. Schwidetzky, an academic, seems to think taxpayers are just having their way with the poor IRS, but for those of us in the wild trying to keep our clients out of trouble without wasting their money on excessive taxes, it hardly looks like the IRS is losing.

First, the IRS is auditing S corporations aggressively — way too aggressively.  Mr. Schidetzky fails to bring up the recent Glass Blocks case, where the Tax Court ruled that a struggling one-man S corporation had to pay a “reasonable salary” even doing so throws the corporation into a loss.  That’s a result far worse than the poor guy would have had filing as a Schedule C taxpayer.  It’s hard to see how such pointless and harsh treatment is good policy.

Second, there is still no clear statutory or regulatory guidance to determine minimum “reasonable” salaries.  There are many taxpayers who have interests in multiple businesses, and whose time spent in one of them may be very high early, or when the business may be struggling, but devoted to other businesses in other years.  The taxpayer may take all of his salary from one of his companies, inviting the IRS to say that he should be taking it from other companies instead.  Whatever you do, the IRS can second-guess it, while giving the taxpayer no guidance on what it should be doing.

Third, why is this just an S corporation issue?  The same thing can come up in C corporations.  Think of Warren Buffett’s famous $100,000 annual salary — one that is arguably tens of millions “too low.”  Why not hit him for more payroll taxes?  The same problem can also arise in an LLC with multiple classes of ownership interests in a partnership return.

The “problem,” such as it is, comes from the tax statutes that exempt some business income from self-employment tax, and from the IRS failure to provide clear guidance to either examiners or taxpayers — not from the courts’ attempts to prevent taxpayer abuse.

Related:

 ‘JOHN EDWARDS SHELTER’ TARGETED BY IRS

Eighth Circuit upholds ‘Watson’ decision requiring increased comp for CPA S corporation shareholder

Update: Don’t miss Tony Nitti’s long-form analysis, S Corporation Shareholder Compensation: How Much Is Enough?

 

Lois Lerner, IRS, FEC

Lois Lerner, IRS, FEC

This is why the IRS political scandal is such a big deal.  Who Will Audit the Auditors(Steven Malanga):

The Internal Revenue Service’s targeting of conservative groups has revived old fears about the agency’s vast taxing and auditing powers, so easy to abuse. But the IRS isn’t alone in holding those powers. Across the country, states and municipalities have endowed thousands of revenue and audit bureaucracies with similar capabilities. Critics complain that officials use these entities to harass enemies and help allies. The evidence makes clear just how well-founded those concerns are—especially since these agencies typically receive far less scrutiny than the IRS does.

Using tax laws to silence opposition is a standard part of the Russia and Ukraine dictator toolkit.  And it has happened here, too.   That’s why talk over whether one organization might have had it coming misses the point.  It’s clear that only the Administrations political opponents are getting that sort of examination.  And the IRS can make life difficult even if you are squeaky clean.

TaxProf, The IRS Scandal, Day 120

 

Wall Street Journal,  IRS Rule Leads Restaurants to Rethink Automatic Tips; Gratuities Added for Large Groups Will Be Taxed as Service Charges

 

Starting in January, the Internal Revenue Service will begin classifying those automatic gratuities as service charges—which it treats as regular wages, subject to payroll tax withholding—instead of tips, which restaurants leave up to the employees to report as income.

The change would mean more paperwork and added costs for the restaurants—and a potential financial hit for waiters and waitresses who live on their tips but don’t always report them fully.

Some big restaurants are reconsidering automatic tips on large parties.

 

Answer: the cost, especially when you are young and healthy.  What’s up with Insurance Premiums under Obamacare?  (Kyle Pomerleau, Tax Policy Blog)

 

Roberton Williams, A Closing Window for Some Same-Sex Couples to File 2012 Tax Returns:

But most reports on the ruling have missed an important detail: the IRS will begin applying the new rule on September 16. That gives same-sex couples who haven’t yet filed their 2012 tax returns just a few more days to file as individuals if they choose to do so.

Multiple-sex couples are unaffected.

 

TaxGrrrl, Back To School: Teacher & Educator Expenses 

Russ Fox,  IRS Interest Rates Unchanged for the Fourth Quarter

Kay Bell,  State taxes take a big bite out of most NFL players’ incomes

Paul Neiffer,  Notice to Employees of Coverage Options Due October 1st  More pointless government-mandated busywork for you!

Peter Reilly, Parent Booster Clubs – Raising Money For Your Own Kid Is Not Charity

Steven Olsen,  Tax Court Holds IRS Must Follow Corporation’s Designation on Tax Payment. (Procedurally Taxing):

To pay the restitution for their individual income tax, the Dixons paid the funds to Tryco, and then had Tryco submit payment with Form 941 and a cover letter stating the payment was “to be applied to the withheld income taxes of [the Dixons]” for the applicable years. Initially, the Service followed those directions, and then reversed course and applied the funds to the unpaid employment taxes.

The court held for the taxpayers.

 

Jack Townsend,  Outlier Foreign Investment Conviction

Robert D. Flach has his Friday Buzz on!

 

It’s comical.  Exclusive: Vintage Tax Reform Comic Book Now Online! (Tax Justice Blog)

Christopher Bergin, The Story of Tax AnalystsA little video that tells how this little non-profit has done so much to make the tax law less of an insider’s game.

It’s a little over three minutes, and it would be worth watching just for the old office technology pictured — but it’s especially valuable to see just how far back the IRS desire to hide what it does goes.

Accounting career news. Accounting Career Conundrums: How Soon Is Too Soon to Quit?   Anytime before tax season, if you work for me.  Otherwise, suit yourself.  (Going Concern)

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Tax Roundup, 10/2/2012: Des Moines has to repay $40 million in illegally-collected taxes. Also: Kansas City tax shelter figure arrested.

Tuesday, October 2nd, 2012 by Joe Kristan

The City of Des Moines will finally do the right thing, having exhausted all venues to do otherwise.  The Supreme Court yesterday ruled that the city must repay $40 million of an illegally-imposed franchise fee on utility bills.  The Des Moines Register reports:

The high court’s ruling centers on franchise fees that are added to customers’ gas and electricity bills. A lower court ruled that the city charged excessive fees for a period of years, in essence an illegal tax. The high court declined to review the lower court’s order requiring the city to repay roughly $40 million to residents who paid the illegal tax.

Mayor Cownie predicts disaster and famine:

City lawyers have fought the case for years by arguing, in part, that any refunds would lead inevitably to higher property taxes — in essence taking money out of one pocket of city residents to place cash in another.

Cownie said the city would pursue options fairest to citizens while balancing the long-term realities of a beleaguered city budget. Any franchise fee repayment from the city would likely come from a mixture of property tax increases and cuts to city services, he said.

“We’re not just cutting away fat. We’re cutting away muscle and bone and tendons,” he said.

It’s useful to imagine how much sympathy the city would offer a taxpayer who had illegally collected money from the city.  “I’m not just cutting away fat.  I’m cutting away essential services for myself and my family, like my house and my car.”  Of course, the city has compounded its own problems by litigating all the way to the U.S. Supreme Court, piling up legal fees and interest on top of the refunds.

The city now has to pay up, though the Register story makes it look like the city isn’t exactly racing to cut the refund checks.

The Moral?  Next time, don’t collect an illegal tax, and if you do, repay it. 

 

Supreme Court declines to review West Des Moines S corporation compensation case.  In addition to denying Des Moines’ franchise tax appeal, the Supreme Court yesterday denied a hearing in an important case involving the so-called “John Edwards Shelter,” named after the former vice-presidential nominee and model husband who ran his law practice in an S corporation.

A U.S. district court held that an area CPA who reported $24,000 of wage income and around $200,000 of K-1 income from his S corporation had to report as compensation around $90,000 of the income; the Eighth Circuit upheld the ruling in February (David E. Watson, P.C. v. U.S).   The tax law imposes payroll taxes on compensation, but not S corporation K-1 income, so the taxpayer must pay payroll taxes on the additional compensation.    The denial is reported on page 50 here.

 

Being enjoined is bad.  Being indicted is worse.  An attorney who was enjoined from promoting some extremely aggressive tax shelters in the Kansas City area now has worse problems, as outlined in a press release from the California Franchise Tax Board:  Los Angeles Tax Professionals Arrested for Illegal Tax Schemes Costing State $7.6 Million:

A Cerritos CPA and Los Angeles attorney were  arrested today on felony charges of conspiracy and tax evasion, the Franchise  Tax Board announced.

Victor George Kawana, 53, and Blair Stover,  51, each own one-third of Kruse Mennillo, LLP. According to FTB special agents,  Kawana and Stover allegedly promoted an abusive tax avoidance transaction  (ATAT) to more than 100 clients during the years 2002-2005. The fraudulent  activity cost the state more than $7.6 million in tax liability.

They each face three felony counts of aiding  in the preparation of false state income tax returns and one felony count of conspiracy.  Each tax count carries a maximum sentence of three years in state prison.

The charges appear to arise from the same sorts of shelters Mr. Stover was enjoined from promoting:

They instructed their clients to utilize an  ATAT involving the creation of Nevada corporations and Roth IRA or Employee  Stock Option Plans (ESOP) as the sole shareholders. The ATAT was formed with a  series of related transactions with no valid business purpose other than tax  evasion.

Kawana and Stover were recently arrested and  both pleaded not guilty at their arraignments.

Mr. Stover got his start at national firm Coopers and Lybrand in St. Louis, later moving to their Kansas City office.  He joined the Grant Thornton office there before going to Kruse Menillo, LLP.

While a number of the tax shelters involved did poorly in court, that doesn’t make it a crime to promote them; the defendants are innocent until proven guilty.  Whatever the outcome of the trial, we can safely assume that the shelters relied on taxpayers’ eternal pursuit of the tax fairy, that mythical creature who can magically make income taxes go away without pain and without risk.  There is no tax fairy. 

Thanks to an alert reader for the tip.

 
Martin Sullivan,  Romney Advisor Advocates Tax Hikes (Tax.com): “He proposes putting a cap on everyone’s tax benefits from deductions and credits equal to some percentage (perhaps 2 or 3 percent) of adjusted gross income and using the revenue gained for both rate cuts and deficit reduction”

Richard Morrison,  Chart of the Day: The Average Tax Rate for the Rich (Tax Policy Blog):

 

Patrick Temple-West,  Essential reading: Payroll tax cut is unlikely to survive into next year, and more

TaxGrrrl,  Comment for the Cure: Cancer, Comments, Cures and Yeah, Taxes

Trish McIntire,  Chicken or Egg Tax Cut

Jack Townsend has two more posts on the affirmation of sentences for figures in the “Aegis” tax shelter case:  Aegis Convictions Affirmed Installment #4 – the Conspiracy Conviction and  Aegis Convictions Affirmed Installment #5 – IRS Notices and Harmless Error

Kay Bell,  Tax moves to make in October 2012

William Perez,  Consider Accelerating Salary Income into 2012

Howard Gleckman,  If Congress Goes Over the Fiscal Cliff Your Taxes Will Likely Go Up (TaxVox):

If Congressional gridlock sends the U.S. government tumbling over the fiscal cliff later this year, Americans could face an average tax hike of almost $3,500 in 2013. Nearly 9 of every 10 households would pay higher taxes. Every income group would see their taxes rise by at least 3.5 percent, but high-income households would suffer the biggest hit by far, according to a new Tax Policy Center analysis.

TPC found that if the tax hikes last the entire year—a big ”if”–those in the top 0.1 percent would pay an average $633,000 more than if today’s tax rules were extended. However, even middle income households would take a hit: they’d pay an average of almost $2,000 more, and see their after-tax income fall by more than 4 percent. Such tax hikes would be “unprecedented,” said the paper’s authors, Bob Williams, Eric Toder, Donald Marron, and Hang Nguyen.

So, have a nice day!

 

Kaye A. Thomas, Roth Conversions Ahead of 2013 Tax Increases.

The Critical Question: What is this “Fiscal Cliff,” and why are we in this handbasket?  My new post at IowaBiz.com, the Des Moines Business Record blog for entrepreneurs.

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Tax Roundup, 9/26/12: Romney vs. John Edwards; Also: low taxes, if you don’t count some taxes.

Wednesday, September 26th, 2012 by Joe Kristan

Not every S corporation is a “John Edwards” shelter.  The TaxProf highlights a New York Times piece by Colorado Tax Professor Victor Fleischer, who says that Mitt Romney may be using the “John Edwards Tax Shelter” to avoid Medicare taxes.

The “John Edwards shelter” got its name from the model husband and former Democratic vice-presidential nominee.  He ran his law practice in an S corporation, so much of his multi-million dollar income came to him on the K-1.  Unlike wage income or law partnership K-1 income, S corporation K-1 income is not subject to self-employment, Social Security or Medicare taxes.

Mr. Fleischer says:

Mr. Romney continues to receive cash payments from the companies that manage Bain Capital’s funds. A couple of weeks ago in this column, I described how private equity firms like Bain Capital convert management fees, which would normally generate ordinary income, into investments that yield capital gain.

R. Bradford Malt, the trustee who manages Mr. Romney’s Bain holdings, has stated that Mr. Romney did not participate in the fee conversion program. One might have logically inferred, then, that Mr. Romney’s share of the management fee income would be reported as wage income on Mr. Romney’s tax return.

Not so. Instead, the payments are reported on Schedule E of the return as distributions from S corporations — the largest being $1,961,325 from Bain Capital Inc. The distinction between wage income and an S corporation distribution is meaningless from a business standpoint, but it’s important for tax purposes.

Current law imposes a 2.9% Medicare tax on all wages and self-employment income. To avoid this tax, taxpayers have an incentive to characterize as much labor income as they can as investment income (like carried interest) or as a distribution from an S corporation.

Mr. Fleischer gets this badly wrong.  Wage income and S corporation income can be hugely different from a business standpoint.   For an obvious example, consider a second-generation family business S corporation — say, a farm.  One member of the second generation may continue the business, while the others may go do other things but remain owners.   As S corporation earnings must be allocated straight-up based on share ownership, the only way to compensate the sibling who runs the business is through additional salary.  The working sibling gets the only salary in the family, while all siblings get K-1 income.

While much is uncertain about how much S corporation income should go between K-1 income and W-2 income, it is certain that it usually isn’t all compensation when capital investments are involved.  To the extent that that Bain Capital Inc. owns passive interests in Bain Group investments, it certainly isn’t disguised wages.  As his termination deal largely involved receiving passive investment interests, it’s a stretch to say that this translates into an Edwards Shelter.

 Update: Victor Fleischer replies in the comments:

Hi Joe.  Thanks for the thoughtful post.  I’ve replied here: http://victorfleischer.com/archives/365

Bain Capital Inc. is the management company, and as far as I can tell receives nothing but fee income.  No passive investments, which are instead held by the GP.  You are right that I overstated the general point about S Corps, but in this particular case it’s hard to see how the S Corp income is related to passive investments or investment income of any kind.

 

Is Romney really paying the “lowest rate”?  From Joseph Thorndike at Tax Analysts (Subscriber link):

     So applying the Romney method to his actual returns, we get an average rate of 14.02 percent in 2010 and 2011. As many commentators have noted, that’s a lot lower than President Obama’s average effective tax rate of 26.45 percent during his presidency. (It’s also lower than the average rate Obama paid in the same two years covered by the Romney release: 23.4 percent.)

     But Romney’s rate isn’t low just by comparison with our current president. It’s also low compared with every president of the last 40 years.

That 14.02% rate is because of several factors.

  • Lots of dividend income, taxed at 15%.
  • Lots of capital gain deductions, taxed at 15%.
  • Huge itemized deductions for charitable gifts and state taxes.

Of course, this also ignores how dividends come from corporations, which pay their own 35% federal tax.  Capital gains are from the sale of corporate stock, which means accumulated and anticipated corporate earnings taxed at 35%.  Romney is only paying the second tax on that income.

Mr. Thorndike acts like Romney has done something shady:

If he wins his race for the White House — and continues to file tax returns that look like the ones released during the campaign — President Romney will have only Richard Nixon to keep him company at the bottom of the rate roster. Generally speaking, Nixon is not a happy point of comparison for presidents, and this is true for taxes as well as break-ins and cover-ups.

Joseph Thorndike, what is Romney supposed to do?  Dump his dividend paying investments and buy bonds so he only earns interest, taxable at the top rate?  Stop earning long-term capital gains?  Stop deducting his charitable contributions?  Oh, wait, he’s already done that.

 

Trish McIntire,  Shorting Deductions

Dear Client – I know what you’re thinking. Since Gov. Romney didn’t claim all his charitable deductions so that he could hit his target tax rate, you’re thinking about not taking all your business (farm) deductions so that you can manipulate your income tax. I’m sorry to break the news to you but you can’t do that. Business deductions are not the same as charitable deductions.

 

Daniel Shaviro,  Should Romney pay a lower tax rate than the rest of us?

Howard Gleckman,  Will Romney Scale Back Rate Cuts If Congress Won’t Curb Tax Breaks? (TaxVox)

TaxGrrrl,  The Most Tax Friendly Country In The World Is…. (Spoiler Alert: It’s Not the U.S.)

Paul Neiffer,  IRS Extends Drought Replacement Period for Ranchers

Joseph Henchman, D.C. Judge Rules Online Travel Companies Must Pay Hotel Tax on Their Services (Tax Policy Blog)

Jim Maule, Biting the Hand that Feeds the Tax Critic.

Peter Reilly weighs in on the Iowan who claimed to be a South Dakotan while sporting Iowa vanity plates:   State Residence For Income Tax – Pay Attention To The Basics

Martin Sullivan,  Capital Gains: The Missing Link toTax Reform?

Dan Meyer,  “Going Concern” Explanatory Does Not Always Mean that the Sky is Falling

Robert D. Flach has posted his Wednesday Buzz.

The Critical Question:  Who — Aside From the Rap Community — Doesn’t Pay Any Income Tax? (Anthony Nitti)

 

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So what is the right S corporation salary?

Wednesday, February 22nd, 2012 by Joe Kristan

By affirming yesterday that a West Des Moines CPA had to pay FICA taxes on about $91,000 of his earnings from his professional S corporation — instead of the $24,000 he put on his W-2 — the Eighth Circuit helped make the first marks in the big unmapped area of how much compensation S corporations must pay their employee owners.
Income reported on an S corporation K-1 isn’t subject to FICA and Medicare taxes. This tempts S corporation owner-employees to skip the W-2 and take out all of their earnings as S corporation distributions. The IRS naturally doesn’t like that, and they have been successful for some time in attacking S corporations paying zero salary.
The case decided yesterday made a bold challenge to the IRS position. Rather than taking a zero salary, the S corporation shareholder took a $24,000 salary, with the rest of his $200,000 or so earnings from his practice coming out as S corporation distributions. This avoided the 12.4% combined FICA tax and the 2.9% Medicare tax on the difference. The taxpayer argued the $24,000 was all the salary he intended to pay, and that the IRS had no authority in the tax law to upset this intent.
The appeals court declined to accept the taxpayer’s stated intent as decisive:

However, even if intent does control, after evaluating all the evidence, the district court specifically found “Watson’s assertion that DEWPC ‘intended’ to pay Watson a mere $24,000 in compensation for the tax years 2002 and 2003 to be less than credible.” We will not disturb this finding on appeal.

So $24,000 compensation for a CPA whose practice earns $200,000 isn’t “reasonable,” but, at least in this case, $91,000 is. What does that tell an S corporation owner trying to set his compensation?
Colorado CPA Anthony Nitti draws this conclusion:

The IRS is taking a formal, quantitative approach towards determining reasonable compensation, so to adequately advise our clients, we must be prepared to do the same thing.

Roger McEowen adds:

The bottom line is that S corporation salaries must not be set too low in an attempt to avoid payroll taxes. The good news, however, is that

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Eighth Circuit upholds ‘Watson’ decision requiring increased comp for CPA S corporation shareholder

Tuesday, February 21st, 2012 by Joe Kristan

The Eighth Circuit Court of Appeals has upheld the widely-discussed Iowa District Court opinion in Watson. The district court required an one-shareholder S corporation owning an interest in a CPA practice to pay employment taxes on about $90,000 of compensation, even though the S corporation issued the shareholder a W-2 for only $24,000. The partnership reported around $200,000 of K-1 income to the S corporation.
This is an extreme example of the so-called “John Edwards Shelter,” where an owner pays less employment tax by earning income through an S corporation than might be paid if the business were reported through a partnership or a Schedule C. It shows that there are limits to how low courts will allow S corporation shareholders to set their compensation; it also stands for the case that a professional business doesn’t have to pay 100% of its earnings as taxable compensation subject to FICA.
I’m tied up with work today, so I will follow up later when I can.
Links:
Eighth Circuit Decision
District Court Decision
Related Tax Update Coverage:
Court sets ‘reasonable’ comp for Iowa CPA S corporation shareholder
What do Newt and John Edwards have in common?

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Legislating to the headlines: S corporations and stock options

Wednesday, February 8th, 2012 by Joe Kristan

There are many reasons the tax law is as awful as it is, but one reason is too often overlooked: the way Congress writes laws to respond to headlines. Two current examples show how this works.
S corporation compensation. Lots of congresscritters remember Newt Gingrich unfondly. When it came out that he used an S corporation, and therefore paid less employment tax than the critters in their infinite wisdom thought appropriate in hindsight, they proposed a new bill, reports Linda Beale. Actually, they’ve repropoposed an old bill — the worst of two bills proposed in 2010 to fight the same “abuse.” The bill would treat S corporation distributions as subject to payroll taxes if 50% or more of a firm’s value was due to the “reputation and skill” of three or fewer owners. As we noted the first time this came around, this bill would punish the smallest service providers (not me! We have ten shareholders) and create horrendous valuation problems. Let’s hope it dies again.
Stock Options. The second example is a new proposal to limit the deduction for stock option compensation expense (via Going Concern). When an employee exercises a typical stock option, the employee has taxable income to the extent the value of the option exceeds the option price; the corporation has a deduction for the same amount. Because the Facebook IPO will reportedly wipe out the company’s taxable income, congresscritters want to delay such deductions. Never mind that the deduction on one side triggers just as much income on the employee side, plus payroll taxes. Never mind that it creates complexity and disturbs a useful simplicity and symmetry. Something must be done!
While the current legislative gridlock may mercifully stop these bad ideas for now, some of the most dreadful parts of the tax law came about as responses to headlines. Examples that come to mind:
– Section 409A deferred compensation rules. These brutal and horrendously complex rules make deferred compensation plans difficult, dangerous and expensive for everyone because Congress thought Ken Lay did bad things.
– The $1 million limit on executive cash compensation — which did much to encourage the option-based compensation plans that the critters suddenly find distasteful.
– The disastrous, fraud-ridden and futile First-time Homebuyers Credit was a headline-driven response to the collapse in housing prices.
– The absurd alternative minimum tax itself was born in response to headlines about rich people avoiding taxes.
Not every problem is a tax problem. Not every result a congresscritter dislikes is a problem. And when there is a tax problem, not every bill is the solution.

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What do Newt and John Edwards have in common?

Monday, January 23rd, 2012 by Joe Kristan

Besides being model husbands? They both have S corporation income that exceeds their salary — the so-called “John Edwards Shelter.”
Now that it seems that Newt Gingrich might somehow be the Republican nominee for president, his tax return has come under scrutiny. The biggest income item on the return is from an S corporation, Gingrich Holdings. His Schedule E shows top-line K-1 income of $2,478,539, offset by a $25,130 Section 179 deduction. Meanwhile, he took “only” $252,500 in salary from the corporation. His wife took another $191, 827 in W-2 wages from Gingrich Productions, Inc., which is apparently a C corporation.
That leads to this comment reported by Janet Novack:

“It appears that he is not paying his fair share of Medicare tax,” Robert E. McKenzie, a partner in the Chicago law firm of Arnstein & Lehr LLP concluded, in an email to Forbes, after reviewing Gingrich

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When professional C corporations go bad

Friday, April 1st, 2011 by Joe Kristan

You can operate a professional corporation as a C corporation and get tax-free fringe benefits unavailable to partnerships or S corporations. Sure, C corporations are subject to a flat 35% tax on every dollar of taxable income left at year end, but you just suck out all the earnings as salary at the end of the year. Right?
For an Orland Park, Illinois CPA firm, that failed spectacularly yesterday in Tax Court, and those fringe benefit tax savings are turning out to be quite expensive.
Like many professional C corporations, the firm sucked out all the cash as (purportedly) deductible expenses at year-end to take its taxes down to zero. The Illinois firm did this by paying “consulting fees” to entities controlled by the firm’s owners. Tax Court Judge Morrison explains:

The firm made a number of payments to the related entities that it designated as “consulting fees”. It now claims that these payments were compensation for the services of the founders. It paid PEM, as “consulting fees”, $136,570 in 2001, $147,837 in 2002, and $81,467 in 2003. It paid Financial Alternatives, as “consulting fees”, $755,000 in 2001, $468,306 in 2002, and $610,524 in 2003. And it paid MPS Ltd., as “consulting fees”, zero in 2001, $250,000 in 2002, and $301,537 in 2003.

The IRS took exception:

In a notice dated December 5, 2007, the IRS determined the following deficiencies in tax: $317,729 for 2001, $284,505 for 2002, and $377,247 for 2003. The deficiencies primarily resulted from disallowance of the deductions for “consulting fees”. The IRS also determined that the firm was not entitled to the $34,421 interest expense deduction in 2003. And, as a result of its disallowance of the “consulting fee” deductions for 2001 and 2003, the IRS determined that for 2003 the firm was entitled to neither the credit for prior-year minimum tax nor the deduction for the net operating loss carry forward.
The IRS also determined that the firm was liable for accuracy-related penalties under section 6662 in the following amounts: $63,546 in 2001, $56,901 in 2002, and $73,238 in 2003.

That’s real money. Naturally the firm defended the deductibility of the payments, saying that they were intended to be compensation to firm owners for services, and the compensation amounts were reasonable.
The judge found otherwise. He said even if the payments were intended to be compensation, they were too high. He also said found that they weren’t really intended as compensation:

We find that the firm intended for the payments to the related entities to distribute profits, not to compensate for services. As discussed above, [one of the owners] chose the amount to pay each year so that the payments distributed all (or nearly all) accumulated profit for the year. He did this for tax planning purposes. Each founder’s percentage of the payments to the related entities was tied to hours worked, but the firm’s intent in making the payments was to eliminate all taxable income. The firm did not intend to compensate for services.

This sounds a lot like business as usual for many professional C corporations. This case should put many C corporation law, medical and accounting firms on notice that they need to do more than just suck out their cash at the end of the year; they need to document that they are making reasonable salary payments. That could be a tough circle to square.
Not only were the expenses non-deductible to the corporation, the distributions were presumably taxable as dividends to the owners also. That’s why the IRS likes to win excess compensation cases — the owners still get taxed, but the corporation gets no deduction.
On the other hand, this case could be useful to S corporations. The IRS has an incentive to try to jack up the salaries of S corporation owner, which is the opposite of their goal for C corporation owners. S corporation earnings left in the company pass through without self-employment tax on a K-1; IRS likes to reclass such earnings as salary and subject them to employment taxes. This case makes a good argument that you don’t have to treat all of the earnings of a professional practice as salary.
Cite: Mulcahy, Pauritsch, Salvador & Co. Ltd., T.C. Memo 2011-74

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S corporation law firm has to pay FICA taxes on owner, associates

Thursday, March 3rd, 2011 by Joe Kristan

20110303-1.jpgA little Louisiana Hot Sauce can make your scrambled eggs great, but the whole bottle probably ruins them. Using S corporations to reduce employment taxes works something like Louisiana sauce — you can overdo it.
That’s the lesson we learn from a Louisiana law firm’s Tax Court case this week. The Donald G Cave law firm was an S corporation. It filed returns on the basis of having full-time attorney employees, as Tax Court Judge Marvel explains:

Donald Cave considered petitioner an “attorney incubator” because he generally hired recent law school graduates with little prior professional experience.

Donald Cave believed it was appropriate for petitioner to treat the associate attorneys and Mr. Matthews as independent contractors because he did not have sufficient control over their work. The record does not disclose, however, the basis on which Donald Cave determined it was appropriate for petitioner to treat the associate attorneys, Mr. Matthews, and himself as independent contractors.

The Tax Court opinion goes through each person that the IRS wanted to treat as an employee, starting with Mr. Cave, the owner:

An officer of a corporation who performs substantial services for the corporation and receives remuneration for such services is an employee for employment tax purposes…
In 2003 and 2004 Donald Cave was petitioner’s president, made virtually all corporate decisions with respect to petitioner, received a percentage of the legal fees recovered in cases he handled, and received draws from petitioner of $48,000 and $360,000 in 2003 and 2004, respectively. These facts tend to establish that Donald Cave was petitioner’s employee within the meaning of section 3121(d)(1).

The case doesn’t indicate whether any earnings passed through on Mr. Cave’s K-1; to the extend they did, he was able to avoid Medicare taxes on that amount.
The judge also decided the associate attorneys were under sufficient control by Mr. Cave that they should be treated as employees.
The Moral? S corporations can reduce professional employment taxes under current law, but don’t overdo it. If you pay yourself no salary, or a token one, you are looking for trouble with the IRS.
Cite: Donald G. Cave a Professional Law Corp, T.C. Memo 2011-48
Related: Court sets ‘reasonable’ comp for Iowa CPA S corporation shareholder
Flickr image courtesy Trucknroll under Creative Commons license

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Tax Court: partnership agreements matter; Kansas LLP members owe self-employment tax

Thursday, February 10th, 2011 by Joe Kristan

The Tax Court yesterday addressed two important tax planning issues:
– How much flexibility to partners have in allocating taxable income; and
– Are limited liability partners (and by extension LLC members) automatically “limited partners” for self-employment tax purposes.
One of the benefits of operating as a partnership is that the tax law gives you flexibility in allocating income. That contrasts with S corporations, which must allocate all items pro-rata by shareholdings. Multi-owner limited liability entities, like LLCs and LLPs, are normally taxed as partnerships. But partnership flexibility is limited under the tax law, as members of a Kansas law firm found out yesterday.
The law firm used a fancy structure where its three owners held LLP interests personally. They also set up an S corporation to own an LLP interest, and they set up an employee stock ownership plan to own the S corporation. When an ESOP owns an S corporation, the S corporation income is not currently taxed — a huge tax break.
While the S corporation nominally held only 10% of the LLP, the attorneys filed tax returns allocating 87.5% of the LLP income to the S corporation — making the law firm operations 87.5% tax-free.
The IRS challenged this, saying that the allocation failed to meet the tax law standards for allocations of partnership income. The partnership regulations have an elaborate standard for determining whether such allocations are valid; if the partnership agreement fails to meet the “Sec. 704(b)” standards, the income is to be allocated “in accordance with the partners interests in the partnership,” whatever that means
The judge said that the law firm failed to produce a partnership agreement for the first year at issue, 2004, and that the 2005 agreement produced in court failed to support the allocations. The court looked at four items in determining the lawyers’ “interests in the partnership”: Capital contributions, interests in profits and losses, interests in cash flow and distributions, and liquidation rights. The judge found that the three attorneys held 1/3 capital interests and 30% profits interests based on the documents available; he reallocated the income accordingly
Self-employment tax
The issue of LLP, LLCs and self-employment tax has been uncertain for years. Back before LLCs and LLPs were invented, the tax law was written to treat general partners as subject to self-employment tax and limited partners as exempt. If limited partners were active in the business, they could lose their protection from partnership liabilities, so that operated as a check against abuse.
LLCs and LLPs muddied this issue. Their members can be active in the business without losing their personal immunity from partnership debts. The IRS tried to regulate this issue, but it became a political football and final regulations were never issued. But that didn’t prevent the tax law from finding that the lawyers were subject to self-employment tax on their income, including the income reallocated away from the ESOP:

Aside from a nominal amount of income arising from recognition of certain pass-through income from RCGW, all of the law firm’s revenues were derived from legal services performed by petitioner and Messrs. Campbell, and Weaver in their capacities as partners. Petitioner and Messrs. Campbell, and Weaver each contributed a nominal amount ($110) for their respective partnership units. Thus it is clear that the partners’ distributive shares of the law firm’s income did not arise as a return on the partners’ investment and were not “earnings which are basically of an investment nature.” Instead, the attorney partners’ distributive shares arose from legal services they performed on behalf of the law firm.
To conclude, we hold that the respective distributive shares of petitioner and Messrs. Campbell, and Weaver arising from the legal services they performed in their capacity as partners in the law firm are subject to self-employment taxes for the 2004 and 2005 tax years.

This conclusion is unsurprising. I’ve always assumed this result in the case of a professional LLP, especially one with only one class of interest. This helps explain why S corporations are popular with professional firms — if they pay a reasonable salary, they can usually get at least some of their income free of self-employment and FICA taxes.
The case leaves unanswered some interesting issues relating to the S corporation ESOP. There are severe taxes that can apply to closely-held S corporation ESOPs, as well as strict drafting and operational compliance rules that must be met. The case doesn’t address these issues, but anybody who uses an S corporation ESOP must watch them carefully.
Cite: RENKEMEYER, CAMPBELL & WEAVER, LLP, 136 T.C. No. 7.

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More on the ‘John Edwards Shelter’

Wednesday, January 26th, 2011 by Joe Kristan

The Smartmoney tax blog has a bit of history on the use of S corporations to reduce employment taxes — the issue in a recent case involving a Des Moines-area CPA.

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Wall Street Journal spotlights area CPA S corporation court loss

Saturday, January 22nd, 2011 by Joe Kristan

Today’s Weekend Wall Street Journal picks up on the case of the local CPA who only paid himself a $24,000 salary on around $200,000 in income from his S corporation. He took the rest through his K-1, avoiding FICA tax on the K-1 amount. The U.S. District Court in Des Moines last month ruled that the CPA had to pay employment taxes on an additional $67,000 for two tax years.
The article says the CPA plans to appeal the decision. It quotes him as saying “The IRS can disallow a tax deduction for unreasonably high compensation, but the law doesn’t give it the authority to raise pay in order to collect extra payroll taxes.” The article adds:

Independent tax expert Robert Willens in New York says this will be a hard argument to win.

The article then goes on to discuss the problems of determining S corporation owner compensation:

What is a fair ratio of profits to pay? There isn’t one answer, experts say. A company with substantial capital or assets, such as a manufacturer, often is able to justify lower pay than one selling personal services like a law or accounting firm. Says Mr. Willens: “I would tell a client that for personal services, 70% would be the absolute floor and might not get the job done,” he says.

I don’t think percentage estimates are that useful. There are many factors that come into play. The argument for paying high compensation would normally be stronger in a professional firm than in a manufacturing or distributive business, because more of the profit would be due to the owners’ work. I don’t think the IRS can force a struggling business to give its owner a raise to make the salary “reasonable.” If you have an absentee owner, or minor children owning interests in a family business, zero can be a reasonable number.
In a professional practice, the place to start is probably the compensation of non-owner professionals. A full-time attorney or CPA owner who gets paid less than the hired help is asking for trouble.
UPDATE, 1/24: The TaxProf has more. The Iowa LLC blog also weighs in.

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Court sets ‘reasonable’ comp for Iowa CPA S corporation shareholder

Thursday, December 30th, 2010 by Joe Kristan

The IRS last week won a battle in the war against S corporation owners who pay less salary — and less FICA and Medicare tax — than the government would wish. A U.S. District Court in Des Moines ruled against a Des Moines-area CPA who took only $24,000 annual salary of his approximately $200,000 in earnings for 2002 and 2003 from his CPA business. The court reclassed $67,044 of his S corporation distributions as salary for each year, giving him FICA/Medicare wages of $91,044.
The IRS hates the use of S corporations to minimize FICA taxes — the so-called “John Edwards Shelter.” S corporations are not taxed on their own income; instead the income is taxed directly on the tax returns of their owners via a K-1 information return. Unlike partnership income, S corporation K-1 earnings are not subject to the 12.4% combined employer-employee FICA tax and the 2.9% Medicare tax, S corporation shareholders try to get away with as low a salary as possible. That’s why every IRS letter accepting an S election includes a stern warning to take an appropriate salary.
This case involved a CPA firm that was apparently set up as a partnership of S corporations, with a separate S corporation for each partner. Each S corporation would pay salary to its shareholder. The judge decided that $24,000 just wasn’t enough (emphasis added):

A reasonable person in [the Taxpayer

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Ways and Means extender bill hits carried interests, professional S corporations

Thursday, May 20th, 2010 by Joe Kristan

A summary of newest version of the annual lobbyist shakedown, a/k/a the expiring tax provision extension, has been released by the House Ways and Means Committee. To pay for a one-year renewal of the usual expiring corporate welfare provisions (Biodiesel!), the bill would impose permanent tax increases on some professional s corporations. It would also turn much capital gain to hedge fund and private equity partners into ordinary income.
The S corporation tax imposes self-employment tax on S corporation professional activity K-1 income. Under current law K-1 income from professional practices is not subject to self-employment tax, but the IRS often moves K-1 income to owner W-2s and then assesses FICA and Medicare taxes. The attacks the “John Edwards Shelter,” but not in all cases. From the Ways and Means summary:

The bill would address this abuse in situations where (1) an S corporation is engaged in a professional service business that is principally based on the reputation and skill of 3 or fewer individuals or (2) an S corporation that is a partner in a professional service business.

We’ll have to see the bill language to see what “based on the reputation and skill of 3 or fewer individuals” means. As a shareholder in a nine-shareholder CPA firm, I am suddenly moved to be modest about my own role, at least until bonus time.
The bill zaps hedge funds as follows:
Taxation of carried interest. The bill would prevent investment fund managers from paying taxes at capital gains rates on investment management services income received as carried interest in an investment fund. To the extent that carried interest reflects a return on invested capital, the bill would continue to tax carried interest at capital gain tax rates. However, to the extent that carried interest does not reflect a return on invested capital, the bill would require investment fund managers to treat seventy-five percent (75%) of the remaining carried interest as ordinary income. A transition rule would apply prior to January 1, 2013. This proposal is currently being estimated by the Joint Committee on Taxation.

Presumably this will be based on the carried interest provisions in Sec. 602 of HR 4213, as passed by the House earlier this year, which does little to grandfather existing hedge funds and private equity funds.
I hope to see statutory language by tomorrow.
Kay Bell has more on the extender bill.
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Will tax on S corporation professional practices be part of ‘extender’ bill?

Friday, April 30th, 2010 by Joe Kristan

Of all of the disgusting and dishonest Congressional habits, passing tax laws for a year or two at a time is among the worst. They pass provisions — many of them corporate welfare giveaways — temporarily to hide their true costs, and then offset the cost of a temporary extension with a permanent tax increase on less-favored taxpayers.
Both houses have passed versions of HR 4213 to extend a raft of breaks through 2010, including the biodiesel giveaway and the research credit. Now the new Chairman of the House Ways and Means Committee is threatening to permanently increase taxes on S corporation service businesses to pay for the temporary giveaways. Tax Analysts reports ($link)

Levin also said members are considering a plan to impose payroll taxes on some S corporation income as one possible offset for the package but said the details have not been worked out.
In 2007 then-Ways and Means Chair Charles B. Rangel, D-N.Y., proposed applying payroll taxes to service-sector S corporation income as part of his trial-balloon “mother of all tax reforms” bill, the Tax Reduction and Reform Act of 2007 (H.R. 3970). At the time, the Joint Committee on Taxation estimated that the provision would raise $9.4 billion over 10 years.

This would likely apply self-employment taxes to K-1 income from businesses that would be “personal service corporations” if they were C corporations — closing the so-called John Edwards Tax Shelter. That tax increase, if enacted, will stay forever, while next year the Congresscritters will look for somebody else to mug to pay for the next “temporary” extension of the giveaways.
Kay Bell has more.
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