Not Susie (your bookkeeper’s first name), you say with the certainty you would give your own sister. Only Susie isn’t your sister. She is (fill in the blank i.e. John’s) sister. John and his wife have lost their jobs – both of them have been out of work for six months with no prospects of employment and unemployment insurance about to run out. John desperately comes to his sister and asks for a loan. She doesn’t have it but she knows where she can get it – your organization’s checking account is about to make an unauthorized “loan” but only until John gets back on his feet, so Susie swears to herself. Is there a scintilla of a doubt that she means it – not one! She sincerely means to return the unapproved “loan” ASAP.
This scenario should sound familiar. We can tell you about numerous executive directors that have called Auditors Inc. with the oft used phrase, “if only I had known about you before this happened”. What they don’t want to admit is that they would have behaved exactly the same way because bottom line, NO ONE wants to seriously entertain the thought that their bookkeeper – their right hand person (especially in the case of a small nonprofit) would steal. How can she come into the office every day, look you straight in the face with that smile and ask how your kids are and then stick the financial knife into your innards.
This is how. Her loyalty is to her family – not the nonprofit. She psychologically separates her daily work from her deception. She convinces herself that it is only temporary. What you need to know is that she is not a demonic thief. She is a human being that has made a stupid long term decision to a short term need. Only the definition of short term keeps changing and as time goes by, she looses track of how much she has stolen. Most embezzlers, when caught, are truly shocked when they hear the final tally.
How to increase your revenue is someone else’s expertise.
Our expertise – making sure that you hold on to the revenue that has been raised/earned by the “sweat of your brow” – making sure that Susie doesn’t steal you into bankruptcy (30% of all bankruptcy is due to embezzlement). And if you catch the embezzlement, you’re lucky – most embezzlement -an act of concealment goes undiscovered – after all, the embezzler isn’t out to kill the cow – just milk it.
So how do you deal with this reality. The answer is obvious – defined as something that goes unseen until someone expresses it simply. The next 10 procedures illustrate this axiom. They involve little more than common sense. They are the opposite of those procedures recommended by most CPAs – the ones that can not be implemented by the small nonprofit for the lack of the resources required for implementation.
1) Perform a credit check. This type of check as opposed to a civil/criminal background check is much more reliable. Someone experiencing a cash crunch runs a higher embezzlement risk. Admittedly, bad credit does not guarantee that they will embezzle and some may say this is not a fair assessment, but for people charged with the responsibility of handling the company’s assets, we think it is fair and reasonable. On the other hand, we must also allow for the possibility that the individual has a “squeaky clean” credit record because of a previous embezzlement?
2) Only another designated person can add/delete/edit a new customer/vendor in the accounting program. A common embezzlement technique is to set up dummy vendors and customers. So, you may consider this a pain in the butt, but for the few moments it takes, it is time well spent.
3) The authorized check signers should make a list of every check that they sign and turn their monthly lists over to a designed person who will review the bank statement for checks that clear the account. You are not relying on your memory to catch checks that were not legitimately signed.
4) All client invoices must be sequentially numbered and you want to review every invoice that goes out preventing your bookkeeper from double billing or overbilling your clients. Again make a list of the invoice numbers and as they are paid, check them off.
5) Either you or your outside professional should review all adjusting journal entries. These entries are the customary place to hide a lot of unauthorized activity.
6) You can skip items 2 thru 4 with the following procedure. Once a year, you or someone else should print out the activity ledger sheet for every customer and vendor. Spend the required time (generally no more than 1 day) to call each customer and each vendor to “confirm” all payments either to or from your organization. This insures that your bookkeeper is not issuing unauthorized checks and invoices.
CPA firms used to “confirm” accounts receivable and payable balances (a 2nd cousin to this practice) before they went high tech. This is still an extremely effective procedure to confirm that your cash expended was in fact received properly and all receipts your customers paid were received by your organization.
7) If your organization handles a lot of cash – it is imperative that you have at least 2 people working together. You can not afford to have less than 2; otherwise, embezzlement is almost a forgone conclusion. The incidence of embezzlement collusion is rare.
8) Perform a physical asset check at least once a year. You want to make sure that your computers and other physical assets don’t sprout wings.
9) Should you suspect a problem, call the Secret Service – don’t call the local police (whose white collar crimes division is already inundated). Believe it or not, corporate theft falls under the jurisdiction of the Secret Service.
10) And lastly – forgive our shameless plug – if you simply don’t have the time or the inclination for the above procedures . We know what we are doing, we are affordable and your time is best spent in growing your organization.
You lock the doors to your car and house because you don’t want to fall victim to robbery. The difference between robbery and embezzlement is obvious. You generally don’t know the robber but you do know the embezzler. Don’t be surprised, when in court, face-to-face with your embezzler, if the embezzler’s attorney turns the tables on you, the executive direct and refers to your shared culpability due to your lack of oversight. Increasingly, Boards of Directors are beginning to hold management responsible for lack of oversight when embezzlement is discovered in the organization. The overwhelming majority of embezzlement can easily be deterred following the above procedures. Your bookkeeper will thank you. If s(he) is embezzling, most likely, s(he) is feeling caught between a rock and a hard place.
This is your responsibility – take care of it or accept the consequences just as the Madoff victims had to accept their responsibility in blindly turning over their money with virtually no oversight!
Additional Information
Two well known organizations in this country, the SBA charged with assisting small business growth and the ACFE, charged with detecting/preventing fraud – by their own admission ignore the most vulnerable sector to fraud. Neither of these organizations deal with fraud in the small organization sector (defined as any organization with less than 100 employees).
The ACFE was founded in 1988 because it was about that time that the AICPA began to water down audit standards (our explanation – not theirs).
As per the ACFE 2008 Report to the Nation:
“Small businesses are especially vulnerable and suffer the largest losses. Median loss suffered with less than 100 employees is $200,000. On page 36 of this report it states “70% of victims they examined had external audits that did NOT catch fraud”. Our question to the AICPA and other professional accounting organizations – how do you justify what you do in the cold light of these numbers??
The Association of Certified Fraud Examiners said it best:
“10% of all people will never steal. 10% of all people will always steal. 80% of all people will steal given the right motivation.”
The economy or addiction or fill in the blank provides the motivation.The organization’s lack of oversight provides the opportunity.
Tuesday, August 27, 2013
Monday, August 26, 2013
S Corporation Self-Employment tax Avoidance Still A Solid Strategy
FROM FORBES.COM -
Even though Sean P. McAlary lost in Tax Court, the decision in his case shows that S Corporations are still a valid self-employment tax avoidance strategy. If you operate as a sole-proprietorship, all of its income will be subject to self-employment tax. If you put the business into an S Corporation, none of the income will be subject to self-employment tax. Entrepreneurs will be inclined to heavily discount any decrease in future social security benefits as a trade-off, so organizing as an S Corporation and avoiding self-employment tax seems like a no-brainer for a sole proprietor.
The Exposure
There is a catch. In the C corporation arena, the IRS is wont to argue that very high salaries are disguised dividends. With S Corporations, the Service may take the position that corporate distributions are actually disguised salary. That can be pretty ugly, since the penalties for being late with payroll taxes are fairly stiff. When Sean McAlary Ltd got hit for just over $10,000 in FICA and Medicare tax, that did not really prove that the S Corporation low or no payroll strategy is a bad idea. I mean, nothing ventured, nothing gained. What is nasty is the $6,000 or so in penalties.
Win, Loss or Draw ?
So would Mr. McAlary have been better off for 2006 if he had run his business as a proprietorship and paid self-employment tax on the entire profit. Forgive me for not doing the precise computation, but it is actually close to a push. Mr. McAlary had his corporation pay him no salary at all. There was an agreement in place for his salary to be $24,000. The IRS expert argued that his salary should have been $100,755. The Tax Court determined that $83,200 was actually the right number. According to the discussion in the case the net income of the S Corporation was $231,454 and the total on page 2 of his Schedule E was $200,877. His distributions from the S corporation were $240,000. I can’t tell why there is a difference. Perhaps he or his wife has another S Corporation that lost money. Regardless, by running as an S Corporation, he avoided the effect of Self-employment tax on between roughly $120,000 and $150,000 of income, even after getting audited.
That nasty $6,000 in penalties probably puts him a bit behind particularly when you throw in the tsoris of going all the way to Tax Court. Mr. McAlary represented himself, though, and did win a small concession, so you can’t rule out that he may have enjoyed the fight. When you consider other years, where he did not get audited, he came out way ahead using the strategy.
How To Win Almost For Sure ?
Explaining things like this throws me back to the early days of my career. My elaborate analysis would need to be translated into terms that the client would understand. After absorbing as much of the analysis as he thought relevant, Herb Cohan would then say to the client – “Don’t be chazzer !” The more elaborate version of that caution on the limits of aggressiveness in tax planning was “Pigs get fed. Hogs get slaughtered.”.
What the McAlary case teaches us is not that you can’t use an S Corporation to avoid SE/payroll taxes. It teaches us that you really should not use the strategy to avoid SE/payroll taxes entirely.
The case also shows us where to go for guidance. The IRS expert cited Risk Management Association Annual Statement Studies. RMA, as we used to call it, is a great reference tool. I used to use it a lot, before I became overspecialized. It provides averages of financial statements submitted to banks by businesses applying for loans and the like. Apparently being an expert for the IRS on reasonable compensation is not exactly rocket science. You can do it for yourself and come up with a reasonable percentage of profit to take as salary. There is actually a wealth of other potentially useful data in RMA which might give you a sense of how well you are doing on things like inventory turnover and collections.
Don’t Be A Chazzer
The AICPA standards of tax practice prohibit me from giving clients audit lottery type advice, but you and I are just pals, so I think I am in ethical bounds when I tell you this.
If your business is reasonably profitable, don’t even think about taking less than whatever the unemployment wage base is in your state is. That varies substantially by state ranging from $7,000 in Arizona to $39,800 in Washington. By going below that limit you end up with another group of enforcers being interested in you. My limited experience with them is that they are very stubborn and since there are not many dollars at stake the temptation will be to just pay it. There is then the potential that they will rat you out to the IRS.
If your business is quite profitable, be a sport and take something over the FICA maximum. The savings can still be quire substantial. Newt Ginrgrich took about $250,000 in salary with profits over $2,500,000 in his S corporation. That got him some bad press, of course, but you are probably not going to be running for President. It is worth noting that the President, himself, did not play this particular game and paid SE tax on all the net income from his book royalties.
Policy Question
With the new Obamacare Net Investment Income Tax, almost all income that individuals get from businesses is potentially subject to a medicare levy of one sort or the other. An exception is business flow-through income from businesses in which the taxpayer materially participates. Were it not for that exception, the Obamacare tax would have taken the fun out of the S Corp SE game for fellows like Newt Gingrich. I worked briefly (17 months) for a national firm and got to rub elbows a bit with one of the national guys who would talk to congressional staffers. I asked him if there was any policy justification for this odd loophole and he knew of none.
Is The Game Worth The Candle ?
If you convert a proprietorship to an S Corporation, there are some costs to weigh. If you are going to take salary below the FICA max, there may be an effect on future social security benefits. Actually quantifying that is challenging, but you can give it a shot with some of the calculator programs. I have never gone through that exercise and my experience is that most business owners are dismissive of it. So you can take that factor as a “just saying” if you want.
Operating as an S Corporation will require another tax return to be filed, which might cost something. In principle, your individual return should be somewhat easier, since a Schedule C is no longer required. You may need to “remind” your tax preparer of that in order to realize that saving on the individual return that might offset some of the cost of the S Corporation return. If you are a brown paper bag type of client with a masochistic CPA, the realization on doing your return might be so lousy that even without your Schedule C, standard charges might come out higher than what you paid in the previous year. On the other hand if you are a mensch with a CPA who “knows how to bill” your fee will never go down from one year to the next if you don’t ask.
Although there is a good chance that the potential for your individual return being audited will go down, the S Corporation return will be another return that potentially could be audited. I don’t know how that balances out and I suspect that nobody knows, although you will find plenty of people who will tell you they know.
If your business involves significant debt and has irregular income, there are a lot of tax traps in operating as an S Corporation. It gets really complicated if you have multiple businesses and real estate ownership is somehow involved. If you are the type of person inclined to pay the bills out of whatever account happens to have sufficient cash and let your accountant sort it out with journal entries, you may be setting yourself up for an income tax nightmare in your quest to save a few thousand dollars in SE tax. I have known partners in professional practices who contributed their partnership interests into S Corporations and encouraged me to do the same. I never regretted not doing it and they came to regret having done it, except the one who died. I’m pretty sure his executor really regretted it.
Finally, don’t ignore state and local income taxes in planning this move. There can be pluses and minuses depending on which state or states you are dealing with. New Hampshire is a particularly nasty place to fool with S Corporations and don’t get me started on New York City. Regardless, you need to consider state and local taxes carefully, particularly since you are not really saving a very high percentage federally from making this move.
Conclusion
Despite court losses and the lack of any discernible policy justification, it appears that the S Corporation SE tax avoidance strategy is still solid. Small business owners should examine the implication carefully, though, before jumping into it.
Even though Sean P. McAlary lost in Tax Court, the decision in his case shows that S Corporations are still a valid self-employment tax avoidance strategy. If you operate as a sole-proprietorship, all of its income will be subject to self-employment tax. If you put the business into an S Corporation, none of the income will be subject to self-employment tax. Entrepreneurs will be inclined to heavily discount any decrease in future social security benefits as a trade-off, so organizing as an S Corporation and avoiding self-employment tax seems like a no-brainer for a sole proprietor.
The Exposure
There is a catch. In the C corporation arena, the IRS is wont to argue that very high salaries are disguised dividends. With S Corporations, the Service may take the position that corporate distributions are actually disguised salary. That can be pretty ugly, since the penalties for being late with payroll taxes are fairly stiff. When Sean McAlary Ltd got hit for just over $10,000 in FICA and Medicare tax, that did not really prove that the S Corporation low or no payroll strategy is a bad idea. I mean, nothing ventured, nothing gained. What is nasty is the $6,000 or so in penalties.
Win, Loss or Draw ?
So would Mr. McAlary have been better off for 2006 if he had run his business as a proprietorship and paid self-employment tax on the entire profit. Forgive me for not doing the precise computation, but it is actually close to a push. Mr. McAlary had his corporation pay him no salary at all. There was an agreement in place for his salary to be $24,000. The IRS expert argued that his salary should have been $100,755. The Tax Court determined that $83,200 was actually the right number. According to the discussion in the case the net income of the S Corporation was $231,454 and the total on page 2 of his Schedule E was $200,877. His distributions from the S corporation were $240,000. I can’t tell why there is a difference. Perhaps he or his wife has another S Corporation that lost money. Regardless, by running as an S Corporation, he avoided the effect of Self-employment tax on between roughly $120,000 and $150,000 of income, even after getting audited.
That nasty $6,000 in penalties probably puts him a bit behind particularly when you throw in the tsoris of going all the way to Tax Court. Mr. McAlary represented himself, though, and did win a small concession, so you can’t rule out that he may have enjoyed the fight. When you consider other years, where he did not get audited, he came out way ahead using the strategy.
How To Win Almost For Sure ?
Explaining things like this throws me back to the early days of my career. My elaborate analysis would need to be translated into terms that the client would understand. After absorbing as much of the analysis as he thought relevant, Herb Cohan would then say to the client – “Don’t be chazzer !” The more elaborate version of that caution on the limits of aggressiveness in tax planning was “Pigs get fed. Hogs get slaughtered.”.
What the McAlary case teaches us is not that you can’t use an S Corporation to avoid SE/payroll taxes. It teaches us that you really should not use the strategy to avoid SE/payroll taxes entirely.
The case also shows us where to go for guidance. The IRS expert cited Risk Management Association Annual Statement Studies. RMA, as we used to call it, is a great reference tool. I used to use it a lot, before I became overspecialized. It provides averages of financial statements submitted to banks by businesses applying for loans and the like. Apparently being an expert for the IRS on reasonable compensation is not exactly rocket science. You can do it for yourself and come up with a reasonable percentage of profit to take as salary. There is actually a wealth of other potentially useful data in RMA which might give you a sense of how well you are doing on things like inventory turnover and collections.
Don’t Be A Chazzer
The AICPA standards of tax practice prohibit me from giving clients audit lottery type advice, but you and I are just pals, so I think I am in ethical bounds when I tell you this.
If your business is reasonably profitable, don’t even think about taking less than whatever the unemployment wage base is in your state is. That varies substantially by state ranging from $7,000 in Arizona to $39,800 in Washington. By going below that limit you end up with another group of enforcers being interested in you. My limited experience with them is that they are very stubborn and since there are not many dollars at stake the temptation will be to just pay it. There is then the potential that they will rat you out to the IRS.
If your business is quite profitable, be a sport and take something over the FICA maximum. The savings can still be quire substantial. Newt Ginrgrich took about $250,000 in salary with profits over $2,500,000 in his S corporation. That got him some bad press, of course, but you are probably not going to be running for President. It is worth noting that the President, himself, did not play this particular game and paid SE tax on all the net income from his book royalties.
Policy Question
With the new Obamacare Net Investment Income Tax, almost all income that individuals get from businesses is potentially subject to a medicare levy of one sort or the other. An exception is business flow-through income from businesses in which the taxpayer materially participates. Were it not for that exception, the Obamacare tax would have taken the fun out of the S Corp SE game for fellows like Newt Gingrich. I worked briefly (17 months) for a national firm and got to rub elbows a bit with one of the national guys who would talk to congressional staffers. I asked him if there was any policy justification for this odd loophole and he knew of none.
Is The Game Worth The Candle ?
If you convert a proprietorship to an S Corporation, there are some costs to weigh. If you are going to take salary below the FICA max, there may be an effect on future social security benefits. Actually quantifying that is challenging, but you can give it a shot with some of the calculator programs. I have never gone through that exercise and my experience is that most business owners are dismissive of it. So you can take that factor as a “just saying” if you want.
Operating as an S Corporation will require another tax return to be filed, which might cost something. In principle, your individual return should be somewhat easier, since a Schedule C is no longer required. You may need to “remind” your tax preparer of that in order to realize that saving on the individual return that might offset some of the cost of the S Corporation return. If you are a brown paper bag type of client with a masochistic CPA, the realization on doing your return might be so lousy that even without your Schedule C, standard charges might come out higher than what you paid in the previous year. On the other hand if you are a mensch with a CPA who “knows how to bill” your fee will never go down from one year to the next if you don’t ask.
Although there is a good chance that the potential for your individual return being audited will go down, the S Corporation return will be another return that potentially could be audited. I don’t know how that balances out and I suspect that nobody knows, although you will find plenty of people who will tell you they know.
If your business involves significant debt and has irregular income, there are a lot of tax traps in operating as an S Corporation. It gets really complicated if you have multiple businesses and real estate ownership is somehow involved. If you are the type of person inclined to pay the bills out of whatever account happens to have sufficient cash and let your accountant sort it out with journal entries, you may be setting yourself up for an income tax nightmare in your quest to save a few thousand dollars in SE tax. I have known partners in professional practices who contributed their partnership interests into S Corporations and encouraged me to do the same. I never regretted not doing it and they came to regret having done it, except the one who died. I’m pretty sure his executor really regretted it.
Finally, don’t ignore state and local income taxes in planning this move. There can be pluses and minuses depending on which state or states you are dealing with. New Hampshire is a particularly nasty place to fool with S Corporations and don’t get me started on New York City. Regardless, you need to consider state and local taxes carefully, particularly since you are not really saving a very high percentage federally from making this move.
Conclusion
Despite court losses and the lack of any discernible policy justification, it appears that the S Corporation SE tax avoidance strategy is still solid. Small business owners should examine the implication carefully, though, before jumping into it.
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