Reasonable Compensation and the Goldilocks Rule. The IRS has been fighting taxpayers over how much compensation is “reasonable” since Great-grandpa realized he could reduce his corporate tax by taking it out as a salary. The agency historically fought this war over whether taxpayers were taking too much compensation. The IRS has since opened a second front, arguing that S corporation owner-employees were improperly reducing their employment taxes by taking too little salary out of the corporation. Employee owners now need to find a comp level that is “just right.”
As in any two-front war, a victory on one front might cause problems on the other. A Tax Court victory yesterday for the IRS over an eye doctor who took “too much” compensation may give ammunition to S corporation professional practices that take corporate earnings out via their K-1s and distributions — free of Medicare taxes — rather than as salary and bonus.
Judge Kerrigan says Dr. Ahmad, the owner and principal employee of Midwest Eye Center, took four $500,000 bonuses in November and Decemeber of 2007. This wiped out corporate income, which would likely have otherwise been taxed at a flat 35% rate under the “professional corporation” tax rules. They even overdid the bonus a little, carrying a net operating loss into 2008.
The taxpayer failed to convince the judge that the bonus was “reasonable”:
Petitioner produced no evidence of comparable salaries. Instead, petitioner argues that there are no “like enterprises” under “like circumstances” from which to draw comparisons. Petitioner argues that Dr. Ahmad’s large bonus was reasonable for several other reasons. Petitioner points to Dr. Ahmad’s increased workload during 2007 and the various roles that Dr. Ahmad performed, such as CEO, CFO, and COO, and the corresponding managerial duties of those positions. However, petitioner did not provide any methodology to show how Dr. Ahmad’s bonus was determined in relation to these responsibilities.
This tells us that when you have a C corporation owned by a single professional, you have to do more to determine how much bonus is “reasonable” than estimate what the pre-bonus taxable income is. If you are going to suck the income out of such a corporation through bonuses, it is wise to have written bonus criteria that make sense when compared to other practices.
It might be even better to make an S corporation election. The medical practice C corporation was hit with over $320,000 in tax on $1 million “excessive” compensation (and some other items), and another $62,000 in penalties — all of which would have been avoided in an S corporation, where all income is taxed on the 1040 regardless of whether it is “excessive.”
In fact, this case helps S corporation professional practices a little, in that it is evidence that it is not “reasonable” to assume that all income of the practice has to come out as compensation subject to employment taxes.
IRS says “Rabbi” had a tax practice that wasn’t entirely orthodox. A Department of Justice Tax Press Release tells a story of a man who sought the Tax Fairy in the Torah:
The lawsuit, filed in the U.S. District Court for the Southern District of California, alleges that Lawrence Preston Siegel, aka Larry Lave, Yehuda Lave and Larry Easy, falsely represented that he is a licensed attorney and CPA in order to solicit business for his tax practice.
According to the civil injunction suit, Siegel pleaded guilty to one count of tax evasion and two counts of subscribing false tax returns in 1994. He subsequently resigned from the California bar in 1994, lost his CPA license in 1997, and never regained either accreditation, according to the suit. The complaint alleges that following his release from federal prison in 2001 for additional convictions, Siegel established a tax practice and stated online that he is an “[i]interesting combination of a Tax Lawyer and CPA who is also a Rabbi trained in Spirituality.” Siegel, the complaint alleges, claimed to others that his “goal as a spiritual Rabbi, Tax Attorney and CPA is to save people money without going to jail … Everybody wants to pay very little tax, I do it legally and morally under the Torah.”
It never occurred to me that a Rabbi would require the qualifier “trained in Spirituality.” Isn’t that the whole idea? In any case, he isn’t well-trained in tax, if the Justice Department press release is to be believed (my emphasis):
According to the complaint, among his tax fraud schemes, Siegel falsely advised his customers, typically high earners who own profitable businesses, that they can establish companies in Nevada and treat their California home as an out-of-state corporate office. Siegel falsely claimed that doing so would transform a vast array of non-deductible personal expenses into tax deductible business expenses, according to the suit. According to the complaint, Siegel boasted about this tax fraud scheme in e-mails, including one where he falsely claimed that his customers are entitled to free housing as tax-free compensation from their out-of-state companies and that “[t]he housing can [b]e luxurious and cost thousands a  month” because “[t]here is an assumption that corporations don’t waste money.”
What’s amazing to me is that (if the allegations are true) he had clients who actually believed this. Religious or secular, reform or orthodox, believer or non-believer, the desire to believe in the Tax Fairy is strong among all races, religions and belief systems. But there is no tax fairy.
On Friday, March 20, CMS announced that it had discovered additional 1095-A errors among those forms issued by both State-run exchanges and the federally-facilitated exchange. CMS is notifying taxpayers impacted by these errors with emails, phone calls, and messages in their Marketplace accounts. Because of these errors, Treasury is expanding the relief it offered in February.
Now, anyone who (1) enrolled in any type of marketplace coverage, (2) received an incorrect Form 1095-A, and (3) filed their return based upon that form, does not need to file an amended tax return. The IRS will not pursue the collection of any additional taxes based on updated information contained in the corrected forms. This relief applies to tax filers who enrolled through either the federally-facilitated marketplace or a state-based marketplace. As provided before, taxpayers who were harmed by the errors may file amended returns to collect the difference.
So the liability of a taxpayer for potentially thousands of dollars in taxes depends on two items:
1. Whether the exchange botched the 1095-A filing, and
2. Whether the taxpayer filed before the 1095-A was corrected.
Chicago Tribune, It’s Obamacare’s first tax season. Can the IRS handle it?. Kristy Maitre of the ISU Center for Agricultural Law and Taxation is quoted: “Overall, I do not believe they’re as prepared as they could have been.”
Hank Stern, The Best Laid Plans [Updated]. “In other words, a lot of folks with even rudimentary math skills have figured out that paying the
fine penalty tax and “going bare” is a much more cost-effective choice than buying coverage.”
Robert Wood, Happy Anniversary Obamacare Taxes, Many Happy Returns.
Norton Francis, Bobby Jindal’s Revenue Enhancements (TaxVox). “His trick: Turn refundable business credits into non-refundable credits.”
Tyler Cowen presents New arguments on a carbon tax, including one that suggests a way in which “…a carbon tax could make global warming worse.”
Martin Sullivan, U.S. Effective CorporateTax Rate Higher Than Foreign Competitors? Not Really (Tax Analysts Blog)
TaxProf, The IRS Scandal, Day 684
News from the Profession. Conducting Tax Return Update Meetings at the Gym Maybe Not the Best Idea (Caleb Newquist, Going Concern). “If a client requests a meeting at a location where heavy objects are laying around, and there’s an off-chance that the news you have may be anything other than positive, may we suggest an alternative venue.”