Posts Tagged ‘reasonable compensation’

Tax Roundup, 2/4/14: Sometimes the tax crime isn’t the worst crime. And the Carnival moves on.

Tuesday, February 4th, 2014 by Joe Kristan

WashingtonRule 23 of George Washington’s Rules of Civility has a lot going for it:

When you see a Crime punished, you may be inwardly Pleased; but always show Pity to the Suffering Offender.

Yet even the Father of His Country might have had a hard time suppressing a smile over a federal tax sentencing in California yesterday.  From the Contra Costa Times:

A former San Ramon family law attorney was sentenced to two years in prison Monday for evading taxes and illegally eavesdropping on a client’s estranged spouse with the help of a now-incarcerated private investigator who set up divorcing men for drunken-driving arrests.

Mary Nolan, 62, of Oakland, already relinquished her law license and paid $469,000 in back taxes Sept. 27 after she pleaded guilty to four counts of tax evasion and one count of illegal eavesdropping.

Nolan represented the ex-wives of two men who were arrested after [the private investigator's] attractive female employees lured them into drinking and driving. Those convictions were expunged after the scheme became known in 2011, when Butler and jailed former Contra Costa Narcotics Enforcement Team Commander Norman Wielsch were caught selling drug evidence and admitted to pimping and robbery, among other crimes.

Oddly, the sentencing judge not only failed to impose the 33-month sentence requested by the prosecution, but he also seemed to think the tax charge was more serious than the honey-trap thing, reports Concord Patch:

Breyer told Nolan during the sentencing today, “To eavesdrop on conversations that clearly weren’t intended for an adversary to hear is a
very unfair thing to do.”

But he said he was especially concerned about the failure of Nolan, as a lawyer, to pay the taxes due.

“What I find most troubling is the fact that you were a lawyer. Lawyers have that special responsibility not just to know the law but to follow it,” he told Nolan.

Yes, evading $400,000 of taxes is a bad thing, whether or not you are a lawyer.  Still, ruining lives setting up and framing people to win divorce cases strikes me as worse than making the IRS work hard for its money.   Maybe when you’re a federal judge, things start to look a bit funny.

 

 

Lois Lerner, ex-IRS, ex-FEC

Lois Lerner, ex-IRS, ex-FEC

Well, technically “a bunch” isn’t “a smidgeon.”   ‘Not Even a Smidgeon of Corruption’ at IRS, Obama Says.  (Tax Analysts, $link).   If so, it sure is funny how Lois Lerner was so quick to invoke her 5th amendment right against self-incrimination.  

Clint Stretch, Dumb Mistakes Aren’t Crimes.  (Tax Analysts Blog)  He says “IRS employees will not knowingly do someone’s political bidding.”  History shows otherwise.

 

 

TaxProf, OMB: EITC Is 4th Most Error-Prone Federal Program, With 22.7% Error Rate.  If it makes you feel better, the three worse ones are all Medicaid or Medicare.  Makes you want the government and IRS to pay in a bigger role in health care, for sure.

 

Minnesota:  Come for lovely winter weather, and stay for the annual tax hit!  The Minnesota Center for Fiscal Excellence has computed the annual cost for a high-earning individual of life in the tundra.  It’s not cheap:

MNvIA

Of course, beautiful Iowa doesn’t have a lot to crow about, as it looks good only by comparison with Minnesota.  While the hypothetical taxpayer could only buy a nice new sedan annually for the savings of moving from Minnesota to Des Moines, she could buy some really nice wheels every year with a move to Sioux Falls.

 

Tony Nitti, Tax Geek Tuesday: Reasonable Compensation In The S Corporation Arena:

The IRS Fact Sheet provides “The amount of the compensation will never exceed the amount received by the shareholder either directly or indirectly. However, if cash or property…did go to the shareholder…the level of salary must be reasonable and appropriate.”  This language would seem to indicate that there is no requirement that compensation be paid to a shareholder-employee provided the shareholder also foregoes distributions. Even with that bit of guidance from the IRS, it is prudent advice to encourage a profitable S corporation to start making reasonable salary payments to its shareholder-employees as soon as it has the means to do so.

Unfortunately, the IRS has shown that it will attempt to force a salary even when the means are lacking.

Paul Neiffer, You Can File Income Tax Returns Now (Maybe)

 

Jeremy Scott, Making Tax Reform a Partisan Issue (Tax Analysts Blog):

And it isn’t hard to see why. Linking tax reform to the debt ceiling risks making it a partisan issue. Forcing Congress to take up reform is a GOP victory, because it causes Democrats to give up on a clean bill. So Democrats, many of whom are sympathetic to the tax reform process, will have to oppose tax changes because Republicans have politicized the debate, defining tax reform as a win for their side.

Ah, the majesty of government.

 

Lyman Stone, New Study: High Excise Taxes Drive Cigarette Smuggling in Boston, New York, Providence (Tax Policy Blog).  That has to be the most predictable news of the day.

Sad news from Kay Bell “The time has come, however, to put the Tax Carnival on hiatus.”  It’s a lot of work to put one together.  Thanks, Kay, for all of the help you’ve given tax bloggers over the years with the Carnival of Taxes.  So until she feels like reopening the Carnival, let’s have one last ride on the Midway.

20120829-1

 

Going Concern, Here Is a Short List of People Less Deserving of Bonuses Than IRS Employees.  Hard to argue with the list, especially the first two, but I would throw in the other branches as well.

 

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Tax Court: even if you lose money, your S corporation needs to pay “reasonable” compensation.

Thursday, August 8th, 2013 by Joe Kristan

20120801-2One thing I like about S corporations is that while corporation income is taxed on shareholder’s 1040s, income on the K-1 isn’t subject to payroll or self-employment tax.

Except when it is.

Mr. Blodgett had an S corporation called Glass Blocks Unlimited, which “sold and distributed ‘glass blocks’ for the real estate market in North America.”  He was the sole shareholder and president of the company.

The Tax Court lays out some key facts (my emphasis, footnotes omitted):

 He worked full time for petitioner, which had no other full-time employees. He was responsible for all operational and financial decisions of the company, and he performed nearly all of the work necessary to run the business. Petitioner additionally used an unspecified number of day laborers, whom it paid totals of $39,733 and $41,453 in 2007 and 2008, respectively.

Petitioner did not on its 2007 and 2008 Forms 1120S report paying Mr. Blodgett a salary or wages. It did, however, distribute money to him as cash was available and he asked for it. Petitioner distributed not less than $30,844 to Mr. Blodgett over the course of 2007. During 2008, petitioner made distributions to Mr. Blodgett totaling not less than $31,644.

The IRS treated the distributions as taxable wages to the taxpayer and assessed FICA and Medicare taxes.  The taxpayer disagreed, saying that the his “reasonable” compensation was lower than that assessed by the IRS.  The judge sided with the IRS:

As president of the company, Mr. Blodgett was petitioner’s only officer. Mr. Blodgett was also petitioner’s sole full-time worker in 2007 and 2008. He performed substantially all of the work necessary to operate the business, including processing orders, collecting payments, arranging shipment of goods, managing inventory, and handling customer relations. His services generated all of petitioner’s income.

     Because Mr. Blodgett was petitioner’s employee for the periods at issue and performed substantial services for it yet it did not pay him a salary, its distributions to him are deemed wages and thus are subject to Federal employment taxes.

The taxpayer also said some of the distributions were repayment of loans to the company.  Here the taxpayer was the victim of informal bookkeeping:

There were no written agreements or promissory notes supporting Mr. Blodgett’s testimony that the transfers were loans. While it is true that a portion of the transfers was reported as loans from shareholders on petitioner’s Forms 1120S, that entry is of little value without the support of other objective criteria. Indeed, petitioner did not even report the $10,000 transfer as a shareholder loan on its 2008 return. The absence of notes or other instruments, plus petitioner’s failure to treat the $10,000 transfer as a loan at all, indicates that the transfers were not loans.

To make things worse, the court upheld late payment penalties on the payroll taxes.

I think the taxpayer gets a raw deal here.  The IRS imposed $30,844 of wages on the taxpayer in 2007, even though the corporation’s net taxable income for the year was only $877, not counting the “wages.”  It hit him with another $31,644 if wages for 2008, when pre-wage income was only $8,950.  In other words, the Tax Court expected the corporation to incur a taxable loss just to generate some payroll taxes for the IRS.  That’s ridiculous, and a worse result than the same taxpayer would have had running the business on a Schedule C.

Furthermore, the Tax Court was too cavalier in disregarding the loans and repayments.  It’s wrong to expect a one-man corporation to generate prissy paperwork when the shareholder advances funds.   Yet because he didn’t have pieces of paper with the magic words, he got stuck with payroll taxes — and penalties.

The Moral?  When advancing and withdrawing funds from an S corporation, be sure to generate the appropriate prissy paperwork.  And if a wholly-owned S corporation generates enough cash to distribute to an owner working in the business, set a salary and pay the payroll taxes on at least a “reasonable” amount, or the IRS might impose payroll taxes on all of it.  You have to protect yourself from an unreasonable IRS assessment, because it looks like the Tax Court won’t.

Cite: Glass Blocks Unlimited, T.C. Memo. 2013-180

 

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Bad records help stick struggling S corporation owner with extra salary

Thursday, December 27th, 2012 by Joe Kristan

S corporation K-1 income isn’t subject to self-employment or payroll taxes.  This tempts S corporation owners to take minimal salary and take earnings out as S corporation distributions instead.   Former vice-presidential nominee and model husband John Edwards famously used an S corporation to minimize his payroll taxes.

20121227-1The IRS has had success in imposing additional payroll taxes when owners of profitable S corporations take little or no salary.  Yesterday the Tax Court also imposed payroll taxes on the owner of a struggling S corporation.

The owner of a small Twin Cities courier business reported wages of $24,452 to $28,452 in 2004-2006.  He took only $2,400 in salary in 2007.  The IRS found that $55,000 was transferred from the S corporation to the owner’s bank accounts in 2007 and imposed payroll taxes on that amount of salary.

How do we know the business struggled?  The Tax Court explains:

During petitioners’ operation of H&H up to some point in 2009, H&H either lost money every year or earned little income. In 2009 petitioners finally closed the business down, after losing their home on  account of losses incurred in the business and their inability to make payments on a home equity loan obtained in 2004 to finance their purchase of the business.

This wasn’t like the CPA who earned around $200,000 from his busienss and reported salary of only $24,000.  Yet the IRS didn’t let the taxpayer’s financial ruin stand in the way of an assessment of additonal payroll taxes.  The Tax Court upheld part of the assesment:

     We believe and accept petitioner’s testimony that he in fact paid significant H&H expenses with cash using funds received from H&H. For example, petitioner credibly testified that after finishing deliveries, truck drivers often would assist with repairs on the trucks and that he would pay the drivers cash for their assistance. No evidence indicates any unusual personal use by petitioners of the funds in question received from H&H.

     In spite of the limited evidence before us, we believe it improper and excessive to charge petitioner with receipt from H&H in 2007 of $52,600 in additional wages. However, we also believe petitioner’s reported H&H wages of $2,400 are unreasonably low.

Unfortunately, as you might have guessed from this, the taxpayer’s records were a mess.  The Tax Court used a very rough estimate:

To estimate what portion of the funds petitioner received from H&H in 2007 is to be treated as wages, we believe it appropriate to average petitioner’s wages for 2002 through 2006 and to use the average wage amount as the total for petitioner’s 2007 H&H wages subject to employment taxes — namely, $30,445.

I think the result would have been better if the taxpayer had kept better records.  If the taxpayer had kept personal and company spending separate and could account for all expenses, the Tax Court might have left him alone.

Still, I think the IRS and the Tax Court did the taxpayer a disservice.  Lee Iacocca famously took a $1 salary when he was in charge of struggling Chrysler.  If Warren Buffett can hold his salary to $100,000 in a fabulously profitable company, it’s plain mean to stick a struggling owner with additional salary just to collect more payroll taxes.

Fortunately this is a “summary opinion,” which isn’t supposed to serve as precedent.  A better-represented and better-organized taxpayer might well do better.

Cite:  Herbert, T.C. Summary Opinion 2012-124

 

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So is Newt really vindicated?

Thursday, March 1st, 2012 by Joe Kristan

While his presidential campaign seems to be fading, Peter Reilly at Forbes says that at least Newt’s tax return filings are looking better after last week’s decision on S corporation compensation by the Eighth Circuit in the Watson case:

I think Newt is being more than generous to Medicare compared to what the IRS has let Mr. Watson get away with. Of course, the other side of the argument is that the IRS made Mr. Watson pay payroll tax on almost half his total compensation while Newt is at less than 10%. So it depends on whether you want to focus on the percentage or the absolute number.

I don’t think you can focus on either exclusively. You have to look at comparable employees in the business, if any, and what they are paid, as well as the role of capital in the business.
Prior coverage: Eighth Circuit upholds ‘Watson’ decision requiring increased comp for CPA S corporation shareholder

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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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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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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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