Posts Tagged ‘S corporations’

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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Winter Sunday tax tip: loans for S corporation basis.

Sunday, December 22nd, 2013 by Joe Kristan

S-SidewalkYesterday we talked about making capital contributions to an S corporation before year-end to restore basis for deducting K-1 losses.  While that works well if you own all of the corporation stock, it gets difficult when there are other shareholders.  If they aren’t pro-rata, capital contributions will change the ownership percentages.  The other shareholders may not want to issue you more stock, and they may not want to make additional capital contributions themselves.

Fortunately, S corporation owners can also deduct losses based on loans they make to the corporation.  As the loans don’t need to be pro-rata, it’s easier to do.  But you need to do it right, as S corporation loans have some potential tax traps.

First, the shareholder has to make the loan directly.  A guarantee of a third-party loan to the S corporation doesn’t work.  Second, don’t borrow the money you wish to lend from another owner; we’ll explain why tomorrow.

Third, plan to leave the cash in the corporation until you have earned back any losses you take.  If you take losses against an S corporation loan, you reduce your basis in the loan itself, so a repayment can result in a taxable gain.  Subsequent K-1 income will first restore the basis of the loan before going against stock basis, but until that happens, a repayment of a loan used to deduct S corporation losses is a taxable event.

Finally, how you do the loan matters.  It is wise to document the loan with a note at the current Applicable Federal Rate with a definite repayment term.  Making the loan as just “open account debt” can be treacherous, as any time the balance exceeds $25,000, the tax law considers there to be a new separate loan.  An example shows how this works:

Joe owns all of Joe Inc., an S corporation. He is out of stock basis at the end of 2013 so he loans the company $30,000 at the end of 2013 to enable him to deduct $25,000 of corporate losses on his 1040. That leaves him a $5,000 basis is his open account loan.

In January 2014 a customer pays an overdue bill, enabling Joe to pay back his $30,000 advance. The company breaks even in 2014, and Joe loans the $30,000 back on open account in December 2014.

Unfortunately for Joe, he has $25,000 gain on the repayment in January 2014; because the corporation had no taxable income, Joe’s basis wasn’t restored before repayment. The 2014 year-end advance is considered a different loan.

Stop by tomorrow for a new tax tip – one daily through December 31!

 

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2013 Winter Solstice Tax Tip: S corporation basis

Saturday, December 21st, 2013 by Joe Kristan

20091210-1.JPGJust because today is the shortest day of the year doesn’t mean you can’t do some year-end tax planning.  Today is a good day for S corporation owners with losses to ponder whether they can use those losses on their 2013 return.

An S corporation owner needs to jump three hurdles to deduct losses passing through on the K-1.

There needs to be basis.

The basis needs to be “at-risk.”

The losses either need to be “non-passive,” or you need other “passive income” to enable you to deduct a passive loss.

We’ll just talk about basis today.

A taxpayer’s initial basis in an S corporation is the amount paid for the stock. It is increased by capital contributions and by undistributed income of the S corporation. It is reduced by distributions of S corporation earnings and by S corporation losses and expenses.

Your basis is determined on the last day of the tax year, so if you are short right now, a capital contribution made by December 31 can get you where you need to be.  So look at your S corporation income, losses and distributions for this year so far, and see if you need to put some more cash in the company before year-end.  If you own all of the company, that can be just a matter of writing a check.  Don’t try to be cute and take the money back out on January 1, either.

If you have other owners, it gets more complicated.  In that case, a loan to the S corporation might be the way to get you the basis you need.  We’ll talk about that tomorrow.

Check the Tax Update for a new year-end tip daily through December 31!

 

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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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Trusts and material participation: the IRS is just making it up.

Tuesday, April 30th, 2013 by Joe Kristan

20130430-1The Obamacare “Net Investment Income” tax hammers trusts.  The new 3.8% tax affects trusts with taxable income as low as xxx in 2013.  In contrast, it only affects single individuals with Adjusted Gross Income of at least $200,000, and joint filers starting at AGI of $250,000.

“Passive income” is one item subject to the tax.  This means most rental income and business income from pass-through entities, unless the trustee “materially participates” in the business.

The new tax piggybacks off of the old “passive loss” rules for determining whether income is passive.  If a taxpayer has business income or loss, it is passive unless the taxpayer “materially participates” in an activity.   When losses are “passive,” they are only deductible when there is other passive income to offset it, or when the passive business is sold.

So how does a trust participate?  A trust can’t punch a time clock, after all.  The IRS says in newly-released  TAM 201317010 that a trustee’s participation counts as the trust’s participation — and then only if the trustee participates as a trustee.

The TAM involves trusts that own an interest in an S corporation.  The trusts each had a main trustee and a “special trustee” who also happened to be president of the S corporation.  A corporate president normally has no trouble materially participating in corporate business, but the IRS said that wasn’t good enough (my emphasis):

As Special Trustee, A lacked the power to commit Trust A and Trust B to any course of action or control trust property beyond selling or voting the stock of Company X or Company Y. The work performed by A was as an employee of Company Y and not in A‘s role as a fiduciary of Trust A or Trust B and, therefore, does not count for purposes of determining whether Trust A and Trust B materially participated in the trade or business activities of Company X and Company Y under § 469(h).

I think the IRS is wrong here.  They are just making up this requirement that the trustee participate “as a fiduciary.”  If somebody is both a trustee and a corporate employee, how are they to divide the time?  This IRS requirement should be rejected, but it poses a compliance problem until and unless it is overturned.  It creates uncertainty and makes it more difficult for trust businesses to avoid the 3.8% tax.

The TAM also rejects one district court case that allows trustees to count participation of the “employees and agents” as trust participation.  I believe the IRS is correct on that point.

More coverage from Peter Reilly:  Tough IRS Position Means More Trusts Will Get Hit With New ObamaCare 3.8% Tax.    He says “I really have a hard time seeing how you will ever be able to get a trust to be considered to be materially participating in an S
corporation, if this is the logic that is followed.”

A summary of material participation requirements is below the fold.

(more…)

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Tax Roundup, 2/22/2013: Why California refugees might not choose Iowa. And: to C or not to C?

Friday, February 22nd, 2013 by Joe Kristan

 

Enjoying a short Des Moines winter commute.

Enjoying a short winter commute in bicycle-friendly Des Moines.

We aren’t scaring them.  Governor Branstad is making a trip to California to poach some businesses from the failing Golden State.  He’s not scaring one Californian:

Iowa’s top state personal income tax rate is 8.98 percent, compared to 13.3 percent in California. Probably not enough of an improvement to lure millionaires from Pacific Palisades to Dubuque. By contrast, Texas offers zero percent.

The top state corporate income tax rate is 12.5 percent in Iowa, 8.84 percent in California and zero percent in Texas.

Earlier this year, Branstad said he would no longer pursue getting rid of Iowa’s corporate and personal income taxes. Instead, he’s going to focus on cutting property taxes.

Well, California’s property taxes already are fairly low thanks to Proposition 13. Although property prices here are triple those in Iowa and most other states because of our severe restrictions on building.

Bottom line: Iowa doesn’t offer enough incentives to attract many businesses and people to leave California. The Hawkeye State is the Golden State with bad weather.

Ouch.  Well, Iowa’s solvent, too, unlike California, which is a fiscal disaster.  We also have short commutes.  Still, he makes a valid point: it’s not enough to compete with a basket case like California.  Golden State refugees have plenty of places to choose from, many of which have better taxes, better weather, or both.  I have no thoughts on fixing the weather, but The Quick and Dirty Iowa Tax Reform Plan would take care of the tax problems.  With no corporate tax and a 4% individual rate, combined with good employees, education and quality of life, we’d see some Californians.

 

To C or not to C?  The Wall Street Journal reports that taxpayers are revisiting whether to operate businesses as C corporations or pass-through entities.  C corporations face a top rate of 35%, where individuals have top rates over 42% as a result of the ill-concieved fiscal cliff and Obamacare tax increases.  From the article:

“Even though on the surface you’re looking at 35% versus 39.6%, it’s a deceptive comparison,” says Robert W. Wood, a tax lawyer with Wood LLP in San Francisco. “There may be a slight short-term advantage in C-Corporations, but there are a number of negative long-term implications that would outweigh short-term benefit.”

For example, C-Corporation profits can be double-taxed. In addition to the corporate tax on profits, owners also would owe personal taxes on any money they take out of the company as dividends. The double tax kicks in when a business is sold, too.

Another potential problem is that a firm that switches from an S-Corporation generally has to remain a C-Corporation for at least five years. 

At current rates, a switch to C corporation format is probably still unwise, if tempting, because of the double tax issue.  You might have lower tax up front, but getting the money out involves either paying a second tax on the dividends or expensive tax gymnastics, often involving renting to a corporation or potentially “excessive” compensation.  C corporations are the Roach Motels of the tax world: they’re a lot easier to check into than check out of.  But if there is a significant reduction in corporation rates, the current tax savings will be enough to tip the balance for many taxpayers to C corporation status, double tax or no.

Hat tip: TaxProf Blog.

 

When Will Tax Complexity Cause a Collapse? (Jason Dinesen). 

The tax code, as most everyone knows and acknowledges, is ridiculously complex and getting more complex all the time.

When will the complexity cause the system to collapse? And what, exactly, will collapse?

I think it would require a combination of things to “collapse” the tax law.  If the perception becomes widespread that it is impossible to comply with the tax law without unreasonable effort, or the rates get intolerably high, and technical advances allow for cash transfers and banking that the government can’t trace, then the game is over.

Tax Analysts is having a conference today on whether, after 100 years, the income tax has run its race.

Elizabeth Malm, Holy Smokes! Washington Loses $376 Million to Cigarette Tax Evasion in 2012.  Many states have raised tobacco taxes to a point where smuggling becomes attractive.

 

Howard Gleckman, Congress May Not Rewrite the Tax Code in 2013, But It Could Make It Simpler (TaxVox).  If you can’t do everything, you might still do something.

Kay Bell, Education tax credit form, already pushed into February, now causing filer confusion and more delays in processing

Peter Reilly,  Bill Romanowski’s Tax Court Loss Not A Typical Horse Case.  We covered it here yesterday.

TaxGrrrl, About Those Leaked Wal-Mart Emails… Is IRS To Blame For Sluggish Sales?  Are tax refund delays stopping consumer spending?

Teaching by bad example, Nebraska-style.  I examine the tax troubles of a prairie-town lawyer.

 

Jim Maule, How Tax Falsehoods Get Fertilized.  That “70,000-page tax code” really bugs him.

Want to raise the minimum wage?  Then apply it to your interns, Congresscritters. (Donald Boudreaux).

Don’t bug Robert D. Flach with requests for free tax help.

 

It’s probably how he meets girls too.  Berlusconi & The Lure of Tax Refunds (Robert Goulder, Tax.com).

CPA exam tip: Calm Down, This CPA Exam Practice Question Isn’t as Dirty as You Think (Going Concern)

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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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Tax Roundup, 9/14/2012: Jenkens partner pleads guilty ahead of re-trial. And a David Cay Johnston – Tax Policy Blog cage match!

Friday, September 14th, 2012 by Joe Kristan

After winning a new trial, Jenkens partner pleads guilty in tax shelter case, one of the Jenkens & Gilchrist attorneys accused of crimes in connection with the tax shelter frenzy of the late ’90s and early ’00s gave up the fight yesterday.  The Wall Street Journal reports:

Donna M. Guerin, 52 years old, admitted she wrote false opinion letters designed to justify complex financial transactions that reduced the potential taxes to be paid by the firm’s clients. The overall scheme created more than $400 million in false tax losses, she said.

“I knew in my heart then, and I acknowledge to Your Honor today, many of our clients were only interested in reducing their tax liabilities,” Ms. Guerin said.

At a hearing in Manhattan federal court on Thursday, Ms. Guerin pleaded guilty to conspiracy to defraud the U.S. and tax evasion. She faces up to five years in prison on each charge. Sentencing is set for Jan. 11.

Ms. Guerin had been convicted of the charges last year, but the verdict was thrown out because of a juror’s misconduct, and a new trial was set.  Two of her partners still face charges, including the prosecutor’s biggest target, Paul Daugerdas, who was the mastermind of tax shelters that created hundreds of millions of dollars of tax losses.  Many of these shelters failed in court.

The TaxProf has a roundup.

 

How good is your state’s credit rating (Tax Policy Blog)

Anthony Nitti,  Can An S Corporation Make Disproportionate Distributions?

This is a commonly misunderstood area of tax law. In short, S corporations have more flexibility than you realize to make distributions that are not perfectly pro-rata to its shareholders. That being said, I wouldn’t tempt fate.

S corporations can only have one class of stock, which means that all distributions must be equal among shares (though differences in voting rights are allowed).  The hair-trigger proposed rules that would have terminated S elections for trivial  violations of the one-class-of-stock rule were never enacted, thank goodness.  But disproportionate distributions should be avoided, and if they happen, they should be corrected with make-up distributions or reimbursements.

 

Howard Gleckman,  Who Pays the Corporate Income Tax? (TaxVox).  Mr. Gleckman is with the Tax Policy Center, an influential center-left think tank.  Their conclusion is important:

The bottom line: For the first time, TPC assumes that workers bear some of the corporate tax burden.

In newly-published assumptions, TPC figures 20 percent of the corporate income tax is borne by labor and 80 percent by capital. TPC further refines the capital share by dividing it into two chunks.  Twenty percent of the levy is reflected in normal returns (essentially, equal to the return from low-risk bonds) and 60 percent in any additional returns received by shareholders.

The revision, similar to adjustments made recently by the Treasury Department and the Congressional Budget Office, will be important as TPC analyzes tax reform plans that reduce corporate rates.

That’s because, until now, TPC assumed investors ultimately paid the entire corporate tax in the form of lower returns to capital. Now, TPC concludes that labor also pays through lower wages. As a result, workers, as well as shareholders and other owners of capital, would benefit from any cut in the corporate tax. Similarly, both would take a hit if corporate taxes are hiked.

So corporations are people, too.  No, corporations don’t bleed, but corporations are ultimately voluntary organizations of cooperating individuals.  If you take money from a big evil corporation, you don’t hurt some insensate Balrog.  You hurt shareholders, retirement investors and employees.

 

Jim Maule,  Building It With Publicly-Funded Tax Breaks:

It amuses me to listen to the private sector claim that “we built it.” Surely the private sector has built things, but the public funding of sports arenas and other private enterprise facilities, such as warehouses, factories, and office buildings, makes it impossible to consider the private sector claim as anything other than, at best, a gross exaggeration, and at worst, a calculated lie.

When the well-connected pull strings to get government money to build stadiums, they are using the power of the state to take money from the rest of us for themselves.  That’s an argument agains the power of the state, and its bureaucrats and elected officials who facilitate the looting, not against the unsubsidized who get up early, stay late and grow their businesses without special favors.

 

Paul Neiffer,  Mistakes to Avoid In Lifetime Giving – Part 1

Trish McIntire,  Gift Tax

TaxProf,  NY Times: A Tax Tactic That’s Open to Question.  Shockingly, the Times has problems with Mitt Romney.

Kay Bell,  California shoppers, tax offices stocking up in advance of Amazon tax collection

They can be, but they don’t have to be.  Pennsylvania Supreme Court Finds H&R Block Customers Not Necessarily Gullible (Peter Reilly)

 

Cage Match!  In this corner with the neck beard, David Cay Johnston,  Which tax cuts stimulate the economy?:

Studies examining the impact of cutting personal income tax rates on job growth or economic activity generally have been inconclusive, said Will McBride, chief economist for the Tax Foundation.

 William McBride demurs in Journalists Too Quick to Conclude There is No Tradeoff between Taxes and Growth:

It is true there are a lot of studies that find only a weak statistical connection between personal income taxes and economic growth, including my own regression analysis of OECD countries.  However, in the same study which will be published shortly, I find a strong statistical connection between corporate income taxes and economic growth.   This is in line with other research, such as that by Gordon and Lee

Pass the popcorn.

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“Self-Rental rule” trips up trucking company

Thursday, August 9th, 2012 by Joe Kristan

http://www.rothcpa.com/misc/20090115-1.JPGThe perennial tax problem for owners of “C corporations” is getting cash out of the corporation without it being taxed twice.  Unlike “S corporation” income, C corporation income is taxed twice: first under the corporate income tax rules when it is earned, and again as taxable dividend income when distributed to the shareholders.

A common tactic to extract C corporation income without a second tax is to rent property to the corporation.   While the owner has to report the rental payments as income, the corporation gets a rental expense deduction, netting to only one tax.  But this plan has its own risks, as a C corporation owner learned yesterday in Tax Court.  The Tax Court held that the “self-rental” rule kept the taxpayer from deducting rental losses from leases of equipment to his corporation.

Tax Court Judge Wells sets the stage (my emphasis):

Mr. Veriha is the sole owner of John Veriha Trucking, Inc. (JVT), a corporation with its principal place of business in Wisconsin. JVT was a C corporation during 2005 but has since elected S corporation status. Petitioners were both employed by JVT during 2005, and Mr. Veriha materially participated in JVT’s business. JVT is a trucking company that leases its trucking equipment from two different entities, Transportation Resources, Inc. (TRI), and JRV Leasing, LLC (JRV). The trucking equipment JVT leases consists of two parts: a motorized vehicle (tractor) and a towed storage trailer (trailer).

     TRI is an S corporation in which Mr. Veriha owns 99% of the stock; his father owns the remaining 1%. TRI is an equipment leasing company with its principal place of business in Wisconsin. TRI owns only the tractors and trailers that it leases to JVT. During 2005, TRI and JVT entered into 125 separate lease agreements, one for each tractor or trailer leased. TRI’s only source of income during 2005 was the leasing agreements with JVT.

     JRV is a single-member limited liability company, and Mr. Veriha is its sole member. JRV is an equipment leasing company that owns only the tractors and trailers that it leases to JVT. During 2005, JRV and JVT entered into 66 separate lease agreements, one for each tractor or trailer leased. JRV’s only source of income during 2005 was the leasing agreements with JVT.

In 2005 TRI had income from its rental, but JRV, the single member LLC, reported a loss.  Rental income and loss is normally “passive,” and passive losses are only deductible to the extent of passive income.

When the passive loss rules were enacted, the IRS feared that business owners would set up deals with their businesses to generate passive income, enabling them to deduct otherwise deferred passive losses.  To combat this, the IRS issued regulations holding that net income from renting to your own business would not be passive if the income from the business isn’t itself passive.  The IRS used these regulations to keep Mr. Veriha from deducting his rental losses against his rental income.  The taxpayer argued the losses of JVT should be lumped together with the income from TRI, with only the net income of the two treated as non-passive.

The Tax Court sided with the IRS:

Section 1.469-2(f)(6), Income Tax Regs., explicitly recharacterizes as nonpassive net rental activity income from an “item of property” rather than net income from the entire rental “activity”. Section 469 and the regulations thereunder distinguish between net income from an “item of property” and net income from the entire “activity”, which might include rental income from multiple items of property.

we conclude that each individual tractor and each trailer was a separate “item of property” within the meaning of section 1.469-2(f)(6), Income Tax Regs. However, because respondent has not contested petitioners’ netting of gains and losses within TRI, only TRI’s net income is recharacterized as nonpassive income.2

That last sentence has to be scary to anybody renting multiple properties, like a trucking fleet, to a controlled business.  The Tax Court is saying that the IRS could have required the taxpayer to determine the income from each truck and tractor leased to the business, with all income leases non-passive and all losses passive.  The Tax Court in its footnote spells it out:

We note that this result is necessarily more favorable to petitioners than the result would have been had respondent contended that it was necessary for the income from each tractor or trailer within TRI and JRV to be recharacterized as nonpassive.

That implies that the IRS was just being “nice” this time, and another taxpayer with similar facts could do much worse.

The moral: Taxpayers who rent to their own businesses — at least those in which they “materially participate” —  need to remember that they can’t offset passive losses with that rental income.  If they rent many items to their business, they need to make sure that every lease generates a profit, or the IRS might split them out and disallow all the losses.

Cite: Veriha, 139 T.C. No. 3.

More on the passive loss rules here.

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Tax Roundup, 7/12/2012: S corporation distributions aren’t fraudulent conveyance. Also: why Amazon will pay sales taxes; Daffy Chuck

Thursday, July 12th, 2012 by Joe Kristan

Bankruptcy court rules that S corporation payment of shareholder taxes not a fraudulent conveyance.   S corporations don’t pay taxes; their income is taxed on shareholder returns.  Shareholders rely on distributions from the corporations to enable them to pay the taxes. 

A Virginia S corporation paid shareholder taxes attributable to the S election, and not long afterwards ended up in bankruptcy.  The bankruptcy trustee sued to recover the the taxes from IRS, saying they were “fraudulent conveyances” made without consideration. 

Fortunately, the bankruptcy judge was sensible:

Broadly stated, “as long as the unsecured creditors are no worse off because the debtor, and consequently the estate, has received an amount reasonably equivalent to what it paid, no fraudulent transfer has occurred.”

In this instance, it is clear that there is a benefit derived by the corporation from this arrangement. The summary judgment record shows a taxable income of $1,559,954, which was passed through to the shareholders. The IRS calculated the tax that would have been paid by the corporation had it been a chapter C corporation and not a chapter S corporation. The benefit to the corporation of the election was significant.

It would be a planning nightmare if taxpayers who thought they had paid their taxes had them pulled back from the IRS in bankruptcy.  Cite: In Re Kenrob Information Technology Solutions, Inc., Bankruptcy Court, ED-VA

Will the push to make Amazon pay local sales taxes destroy local retail? Slate reports:

In response to pressure from local businesses, many states have passed laws that aim to force Amazon to collect sales taxes (the laws do so by broadening what it means for a company to have a physical presence in the state)… But suddenly, Amazon has stopped fighting the sales-tax war.

Why?

 Now that it has agreed to collect sales taxes, the company can legally set up warehouses right inside some of the largest metropolitan areas in the nation. Why would it want to do that? Because Amazon’s new goal is to get stuff to you immediately—as soon as a few hours after you hit Buy… It’s hard to overstate how thoroughly this move will shake up the retail industry.

Be careful what you lobby for.  (Via Megan McArdle’s twitter feed)

Roger McEowen: Court Says IRS Position Wrong on Tax Impact of Insurance Company Demutualization.  But as we noted yesterday, it didn’t care for the taxpayer’s position either

Anthony Nitti also weighs in with  District Court Refuses to Apply Open Transaction Doctrine to Insurance Company Demutualization

Kay Bell, Home sale profits usually don’t create any tax bills for residential sellers

David Brunori:  Free the Puppies, Tax a Millionaire (Tax.com)

In Defense of Lindsey Graham—and (Legal) Tax Evasion (David A. Graham, The Atlandtic)

Really?  Fight Over Tax Rates Is Meaningless, Really (TaxGrrrl)

Jason Dinesen allitetively addresses Deducing Whether Deductibles are Deductible

Because it’s the biggest issue facing the country, right? Essential reading: Attacks on Romney for offshore assets, taxes heat up, and more (Nanette Byrnes) 

News you can use: Julian Block Explains How To Save Taxes While Being Kind To Animals (Peter Reilly)

Schumer would know despicable. From Phil Hodgen:

I was interviewed today for the NBC Nightly News. They did a story about expatriation (focusing on Denise Rich). The best feature — Charles “Despicable” Schumer’s usual ad hominem attacks. He labels people who expatriate of being “despicable” (watch the video). Senator Schumer’s remark so reminded me of Daffy Duck. (YouTube).

How dare the jaywalkers not stand still while we shoot at them!

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Tax Roundup, 4/26/2012

Thursday, April 26th, 2012 by Joe Kristan

Overstating basis isn’t understating gross income, rules the Supreme Court.  This means that the statute of limitations for many turn-of-the-20th Century-era tax shelters is three years, rather than the six year statute for substantial understatements of gross income.  More from Going Concern, Peter ReillyJack Townsend and the Wall Street Journal.  The TaxProf has a roundup.  (U.S. V. Home Concrete & Supply, LLC)

Since their original proposal isn’t going anywhere anyway.  Tax Analysts reports ($link) that Tom Harkin is “open to considering alternative ways to pay for a student loan interest bill other than taxing subchapter S corporations.”  The proposal we covered yesterday would only reduce student loan rates for one year.  It’s never a good idea to enact a permanent tax to cover an expense temporarily.

Tax Court behind the times?Powerful but obscure Tax Court lags on access” (Reuters)

Jason Dinesen ponders “What to Do About Student Loan Debt?”  My advice: don’t incur it, especially to earn a major that won’t help you pay it back.  Don’t expect those of us who have saved for our own kids to graduate debt-free to want to help you pay your loans.  And allow student debt to be discharged in bankruptcy, but only if the colleges themselves have to pay part of the defaulted amount.  State 29 has some pungent thoughts.

Kay Bell: Made a tax mistake?  Make amends!

Paul Neiffer asks out loud a question usually only whispered: What is the Right Equipment Size?

World’s least-promising crime strategy: impersonating an internal auditor (Going Concern)

Senator Cardin unnecessary because we have smart phones. “Senator Cardin: Tax Simplification Unnecessary Because We Have Computers” (Tax Policy Blog)

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What do I do with that partnership K-1?

Monday, April 2nd, 2012 by Joe Kristan

2011 1065 K-1, Part III

April is here, and it’s time to get serious about wrapping up your tax return.  So you’ve got this K-1 thing from an S corporation or a partnership.  What are you supposed to do with the thing?  We’ll talk about partnership K-1s now, saving the special quirks of S corporations for later.

It helps to remember that you got the K-1 because the outfit that issued it doesn’t pay tax on its income; its owners do.  The K-1 gives the owners the information they need to report their share of the entity’s operations on their 1040.  That means you’ll find income, deduction and credit items, and even items that go into your alternative minimum tax computation. 

Part III of the K-1, reproduced to the right, has all the information most taxpayers need.  It can be confusing, though, because it is a very abbreviated format.  Often the numbers included in the box have letters to their left.  These letters are important.  The instructions for the K-1 tell you what the letters mean.  For example, a letter “A” on the left of a number for box 13, “Other deductions,” tells you that the number is a cash charitable contribution that you can deduct on Schedule A if you itemize. 

 Some key items on the partnership K-1 that confuse many taxpayers:

Guaranteed payments are where partners who work for a partnership find the their earnings — what they may think of as their salary — reported.  While it is often done wrong, partners in a partnership aren’t supposed to get a W-2 from the partnership.  Their compensation should show up on box 4 of the K-1, and probably also on Box 14, self-employment earnings, for computing Social Security and Medicare self-employment tax.

Distributions from a partnership reported in box 20 normally aren’t taxable until the year a partner leaves the partnership. 

You can incur tax from items on your partnership K-1 even if you received no distributions.  While you hope that the partnership distributed at least enough to you to cover your taxes, they don’t have to.

If the partnership reported losses, things can get complicated in a hurry.  We’ll talk about that tomorrow.

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No, your Roth IRA can’t own an S corporation

Thursday, March 29th, 2012 by Joe Kristan

The Ninth Circuit upholds a Tax Court ruling that Roth IRAs aren’t eligible shareholders.  No big surprise there. More coverage from Roger McEowen, Kaye Thomas and Peter Reilly.

Prior Tax Update coverage: Tax Court: Roth IRA can’t own S corporation stock

Cite: Taproot Administrative Services, Inc., CA-9, No. 70-70892

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S corporation losses: you snooze, you lose.

Thursday, March 22nd, 2012 by Joe Kristan

Losing money stinks, but it can have its consolations at tax time.  That’s one reason S corporations are popular.  S corporation shareholders can, under the right circumstances, deduct corporate losses on their 1040s.  But one of the “right circumstances” is that the shareholder has to have “basis” in their S corporation stock.  Basis starts with your investment in the corporation, and  it is increased by capital contributions and your share of S corporation income.  It is reduced by losses and distributions — even if you don’t bother to deduct them on your 1040.

A couple, the Barnses, learned that lesson the hard way in Tax Court yesterday.  Their business, Whitney Restaurants, Inc., struggled over a period of years, with recurring losses and continuing capital contributions.  The Tax Court summarizes their K-1 loss and capital contribution history:

For reasons not clear in the case, the sharholders didn’t deduct any of the 1996 loss of $136,228.50 on their 1997 1040, even though they had made a big capital contribution; they instead reported income of $22,283.  The taxpayers thought that meant they had an extra basis of $158,511.50 to enable them to deduct losses in 2003.  The IRS thought otherwise and disallowed the $123,006.07 in losses (they used pennies on their returns?).

The Tax Court sided with the IRS, ruling that with S corporation losses, it’s use them or lose them.  First, the court ruled that reporting S corporation income you didn’t earn doesn’t increase your basis:

The IRS takes the position that the Barneses’ basis in the Whitney stock did not increase by $22,282 in 1996. It contends that, under section 1367, there is no upward basis adjustment for amounts that are erroneously reported by the shareholder as passthrough income but that do not correspond to the shareholder’s actual pro rata share of passthrough income. The Barneses seem to argue, without citation of authority, that the upward basis adjustment was appropriate because they reported $22,282 in passthrough income on their 1996 return. We agree with the position of the IRS.

What about the loss they didn’t use?

Basis is reduced, the IRS contends, even if the shareholder does not actually claim the passthrough losses on his or her return. Therefore, the IRS argues, the Barneses’ basis was reduced by $136,228.50 for 1997 because of the $136,228.50 loss suspended in 1996 that the Barneses were required to take into account as a deduction for 1997.27 The Barneses’ basis calculations did not incorporate this reduction. Therefore, says the IRS, their basis calculations for subsequent years were inaccurate.

The Barneses offer a different interpretation of the applicable statutes. Section 1367(a)(2)(B), they argue, requires basis reduction only for losses that the S corporation shareholder reports on his or her tax return and claims as a deduction when calculating tax liability. …

The plain language of sections 1366 and 1367 supports the IRS’s interpretation.

The moral?  Somebody – either the taxpayers or their preparers — dropped the ball in 1996 and 1997.  Maybe they thought that they couldn’t use the losses then so they would “save” them until they were needed.  It doesn’t work that way.  If you can deduct your K-1 losses in the year they happen, that’s when you have to deduct them.

Cite: Barnes, T.C. Memo. 2012-80

UPDATE: Anthony Nitti has more.

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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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More on Newt’s S corporation

Tuesday, January 24th, 2012 by Joe Kristan

Newt Gingrich’s S corporation paid him a salary of “only” $250,000 in 2010. It had over $2 million of other income that appeared on his K-1, which some commentators say is an abusive way of avoiding payroll taxes. Peter Reilly has some thoughts at Forbes:

There is one case where a $24,000 salary was held to be too low, but I have not found a case where someone who took a salary over the social security maximum has had S corporation distributions recharacterized. That does not mean that it has not happened in audits, but there are no guidelines there. It is true that the salary of $252,500 is low relative to the profits, but it is still substantial. If he were my client, I probably would have told Newt to consider taking a larger salary, but it is really a judgment call, not a Geithner situation.

Prior coverage: 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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IRS withdraws proposed regulation hitting S corporation banks

Wednesday, October 26th, 2011 by Joe Kristan

The IRS has pulled the proposed regulation that would have applied the “TEFRA” rules disallowing interest expense on “bank qualified” municipal bonds to S corporations. The rule would have disregarded the language of Section 291 that ends the interest disallowance after a bank has been an S corporation for three years.
The withdrawal follows an IRS defeat in the Seventh Circuit when it disallowed interest on examination for an S corporation bank in Wisconsin. The IRS gave no reason for the withdrawal; it is possible that they have concluded that the IRS isn’t supposed to overrule Congress.
Related: IRS gives up on S-corporation bank ‘TEFRA’ disallowance

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Why would you be a C corporation?

Wednesday, September 28th, 2011 by Joe Kristan

While most new businesses are set up as pass-throughs nowadays, C corporations still have a following. Martin Sullivan ponders why taxpayers voluntarily run a business in a way that they know will be subject to two taxes:

Graduated corporate rates, the low rate on corporate dividends, and an exemption from payroll taxes combine to make subchapter C the most advantageous choice for a lot of small business profits. If a business owner can afford to leave profits inside the corporation, the resulting deferral of individual tax only makes subchapter C more attractive.

Pass-throughs — S corporations and partnerships — don’t pay taxes on their income. It instead “passes through” to the personal returns of the owners. The top individual and corporate rates are both 35%, but C corporations are taxed at a 15% rate on their first $50,000 of income. If you are in a 35% personal bracket, having additional income taxed at 15% is attractive, even if you have to pay a second 15% tax to withdraw the earnings as as a dividend. C corporations also provide some fringe benefits unavailable to pass-through owners.
So what’s not to like about the C corporation?
- Your corporation can’t grow very big and still use the low rates. Once corporation taxable income exceeds $100,000, a “phase-out” rate of 39% starts to recapture the benefit of the lower brackets. Once taxable income hits $335,000, a flat 35% rate applies to all corporation income.
- You can only get that corporate 15% bracket once. You can’t set up multiple corporations to get multiple 15% brackets.
- Using the 15% rate requires an ability to monitor and control corporate taxable income. That requires time, effort and expense.
-“Personal service corporations,” including law, medical, accounting and consulting practices, don’t get the lower brackets. They pay a 35% rate starting with the first dollar of taxable income.
-Assets inside the corporation are trapped there. The tax law treats distributions of appreciated property as taxable sales, but losses on distributions are normally not allowed.
- If you sell the business, the C corporation can get very expensive. There is no capital gain break in computing C corporation taxes. Most business buyers prefer not to buy stock because they don’t want to inherit any unconfessed sins of the old corporation. If the assets have gone up in value, you probably have a 35% tax on the asset sale, and a 15% capital gain on the liquidation on top of that. In a pass-through, you will have just one tax, and likely it will mostly be at the 15% capital gain rate.
As long as there is a 15% corporate rate bracket and a 15% dividend rate, C corporations will remain tempting. Still, it is wise to ponder the words of tax sages Bittker and Eustice:

Decisions to embrace the corporate form of organization should be carefully considered, since a corporation is like a lobster pot: easy to enter, difficult to live in, and painful to get out of.


Flickr image of lobster pots courtesy easylocum under Creative Commons license
Related: Corporations: yea or nay?

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Failed tax shelter wrecks S corporation election

Tuesday, September 27th, 2011 by Joe Kristan

One of the products marketed by a national accounting firm in the turn-of-the-century tax shelter frenzy turns out to have cost a taxpayer a lot more than back taxes. The shelter turns out to have blown the taxpayer’s S corporation election.
KPMG marketed the “SC2″ tax shelter to enable S corporation owners to have their cake and eat it too. The shelter had S corporation shareholders donate shares to a tax-exempt entity. Where the income was interest and dividends, it didn’t subject to “unrelated business income tax” and was therefore tax free. A federal judge explains what happens next:

During this period, the S corporation’s income accumulates in the corporation; distributions are minimized or avoided. After the pre-determined period of time has elapsed, the charity sells the “donated” shares back to the original shareholders. Tax has been avoided for the period of time that the shares were “parked” in the charity, and the accumulated income of the S corporation may be distributed to the original shareholders either tax-free or at the favorable long-term capital gains rate.

But what if the charity doesn’t want to sell?

The original shareholders retain control over the S corporation by donating only non-voting stock while retaining all shares of voting stock. Moreover, to protect against the possibility that the donee charity might refuse to sell its majority stock back to the original shareholders after the agreed-upon length of time, warrants are issued to the original shareholders prior to the “donation.” The warrants enable the original shareholders to purchase a large number of new shares in the corporation; if exercised, the warrants would dilute the stock held by the charity to such an extent that the original shareholders would end up owning approximately ninety percent of the outstanding shares. Thus the warrants allow the original shareholders to retain their equity interest in the corporation even though the charity nominally is the majority shareholder.

So if the charity doesn’t want to sell, the taxpayer can dilute them to insignificance.
The problem?

(more…)

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