Posts Tagged ‘Watson’

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



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

Tuesday, October 2nd, 2012 by Joe Kristan

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

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

Mayor Cownie predicts disaster and famine:

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

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

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

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

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

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


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

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


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

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

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

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

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

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

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

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

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

Thanks to an alert reader for the tip.

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

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


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

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

Trish McIntire,  Chicken or Egg Tax Cut

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

Kay Bell,  Tax moves to make in October 2012

William Perez,  Consider Accelerating Salary Income into 2012

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

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

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

So, have a nice day!


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

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


Tax Roundup, 9/21/2012: Area S corp owner knocks on Supreme Court door. And breaking! Businesses aggressively cut costs!

Friday, September 21st, 2012 by Joe Kristan

West Des Moines CPA asks Supreme Court to overturn employment tax assessment on S corporation income.  The taxpayer has filed a petition asking the U.S. Supreme Court to overturn the Eighth Circuit decision imposing employment tax on his share of S corporation income.  The taxpayer had around @200,000 of income from his accounting S corporation but only called $24,000 of it compensation, treating the remainder as K-1 income not subject to FICA and Medicare tax.  The courts raised his “salary” to about $90,000.

The petition says that the Eighth Circuit decision (Watson, 668 F.3d 1008 (8th Cir. 2012)) conflicts with a Seventh Circuit decision treating a C-Corporation CPA firm as paying disguised dividends through management companies.  While I know and admire the attorneys on the Watson petition, the Seventh Circuit case (Mulcahy, Puritsch, Salvador & Co) doesn’t really cover the same ground as Watson.

The Supreme Court only hears a small fraction of cases it is asked to hear, so the chances for a Supreme Court decision on this issue are poor.

Related: Eighth Circuit upholds ‘Watson’ decision requiring increased comp for CPA S corporation shareholder; When professional C corporations go bad

Link: Tax Analysts subscriber link to Watson petition.


Janet Novack, Senate Report Details HP & Microsoft Offshore Tax Ploys:

A new report from the Senate Permanent Subcommittee On Investigations asserts Microsoft  Corp. and Hewlett-Packard have used “aggressive” offshore ploys to save or defer billions in U.S. corporate tax.

For any expense other than tax, nobody would question the wisdom, let alone the patriotism, of “aggressive” cost-cutting.  Related: Transfer Pricing and Common Sense, Martin Sullivan,


West Des Moines Patch, Metro Developer Walters Pleads Guilty to One Count of Bank Fraud:

Metro area developer Randal L. Walters pleaded guilty Thursday to one count of bank fraud in connection with a loan to develop a Des Moines area condominium project, announced federal court officials in a news release.

During the plea proceeding in federal court, Walters, 55, of Polk County, admitted to diverting money borrowed from First Bank of West Des Moines for a Des Moines area condominium project know as the Meadow Cove project, the release said.

The story said prosecutors are recommending against prison time.


Jim Maule, Subsidies and Tax Breaks:

When a special interest or specific industry gets a tax break, it causes one or the other, or a combination, of two things to happen. First, if nothing else is adjusted, the reduction in tax revenues causes an increase in the federal deficit, which in turn adversely affects everyone. Second, if revenue is maintained, it means other taxpayers must pay more in taxes to make up for the reduction in taxes for the special interest or specific industry, and that clearly affects everyone.

It’s just as true on the state level.


Jaywalker hunting on the moors: US tax net closes on Americans living in Britain. (Financial Times via Tax Break)

Richard Morrison,Context and Background on the Nonpayers Debate (Tax Policy Blog)

TaxProf, Fleischer: Are Whistleblowers the New IRS Business Model?  Paul Caron links to a New York Times piece by Victor Fleisher on the role of snitches in tax administration.

Anthony Nitti, Is Now a Good Time to Convert Your S Corporation to An LLC?

Jason Dinesen, “Consumer Reports” Highlights Identity Theft

TaxGrrrl, Millions More Taxpayers Subject to Health Care Penalty Tax

Kay Bell, 6 million Americans expected to face Obamacare’s uninsured penalty, er, tax

Jack Townsend, Sentencing Enhancement for Defendant Perjury at Trial

Trish McIntire, e-Services and TIGTA



Have a great weekend!



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


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


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.
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?


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