Successful folks are always in demand, which is why they often pick up board seats, consulting assignments and speaking fees. On top of that, there is the condo in, say, Aspen or Miami that is rented out half the year, producing yet more income. And so, without thinking about it, a problem of success arrives—a much higher tax bill.
Take "self-employment" gigs like consulting. On top of federal and state income taxes and a 0.9% Medicare tax, income may also be subject to the 15.3% self-employment tax, which includes FICA's Social Security and Medicare taxes. When it comes to self-employment income, you're responsible for all the FICA taxes that are normally split by employer and salaried employee.
So what's the most tax-efficient way to receive secondary income? Consider a seat on a company's board, a stimulating part-time job, particularly during semiretirement. Board members are usually paid with cash and shares in the company, typically restricted stock that vests after a few years.
You can reduce the tax impact by deferring the cash portion of your board fee through the company's deferred-compensation plan. Most companies have "nonqualified" plans that allow directors to funnel fees to 401(k)-like plans without contribution limits. The funds aren't tax-deductible, but they grow tax-deferred until retirement.
"If a member of the board who lives in New York moves to another state with no or low income taxes in retirement, they're going to pay a lot less tax," says Mitch Drossman, national director of the Wealth Planning Strategies Group at U.S. Trust. To avoid paying income tax in the original state, you must put the money in a 401(k) and take the income over at least a 10-year period in your new state.
Directors receiving restricted stock that vests over a number of years can accelerate rather than defer the taxes. Usually taxes are owed after stock is vested, based on the value of the stock at that point, but a director can opt to be taxed on its value when first received. This is a bet the stock is going to appreciate in excess of what you're paying in taxes now, usually in cases where "the company is going public or it's a good candidate to be acquired," says Drossman.
If you are generating a substantial self-employed income stream, consider creating your own "defined-contribution plan," similar to a 401(k). They're known as a Keogh or a SEP IRA, and they allow you to sock away 25% of your earnings, either pre-tax or tax deductible, up to $52,000.
A defined-benefit plan, meanwhile, works more like a pension plan, but is more complicated and currently limits maximum retirement payouts to $210,000 a year. But contributions are tax deductible in the year they're made, and that can go a long way toward blunting your current tax blow.
If your extracurricular business generates a profit, structure your windfall for a tax advantage. A limited liability company, or LLC, protects your assets outside the vehicle from lawsuits filed against the LLC, but S corporations can be sweeter for tax purposes. The S corporation owner is usually paid a salary and takes profit distributions. The owner pays taxes on the salary as is normal—including the self-employment FICA charge totaling 15.3%—but the profit distributions aren't subject to the self-employment tax.
But make sure to strike the right balance between salary and profit distributions. "The IRS' position is that the owner must receive reasonable compensation in the form of income. A tax return that shows zero cash income is an automatic red flag for an audit," says Stephen Kirkland, a tax specialist at Atlantic Executive Consulting Group in Columbia, S.C. Furthermore, to legitimately claim S corporation profits, the company must either have equipment, merchandise, or one or more employees.
What that means is, if your extra income is generated by personal services that can't arguably generate profits, such as board membership fees, you can't benefit from an S corporation. And here's another caveat: The IRS keeps a close, skeptical eye on S corporations after a U.S. Government Accountability Office report estimated that these entities, some four million in 2006, underpaid taxes by $23.6 billion in the 2003 and 2004 tax years.
So if you go down the S corporation path, make sure you keep detailed records of your journey.
Showing posts with label S corporation. Show all posts
Showing posts with label S corporation. Show all posts
Tuesday, September 30, 2014
Sunday, September 21, 2014
Weighing tax benefits of S corporations
Factors to consider in deciding which type of incorporation is best for you
AS TAX LAWS continue to evolve, so do choices of entity. Being mindful of the alternatives is critical to achieving tax benefits. Both S corporations and Limited Liability Companies (LLC's) are flow-throughs, which have long been a desirable alternative to regular C corporations.
Unlike in C corporations, the incomes of flow-throughs are taxed directly to their individual owners, largely independent of distributions. C corporations, on the other hand, are double-taxed, incurring their own tax first, without any long-term capital gains break. Then, as money is distributed to owners, it is taxed again at the individual level, without a deduction to the corporation. The law enforces the double tax by limiting owner salaries to reasonable levels, and by preventing corporations from accumulating excess earnings.
However, S corporations have a newly enhanced tax advantage over LLC's. Only active shareholders of S corporations are exempt from the Affordable Care Act's new 3.8% tax on unearned investment income of joint filers making over $250,000. While inactive owners of both entities incur the new tax, highincome active members in LLC's do also, in that a 3.8% Medicare tax applies to their flow-through income.
There are several benefits and risks of becoming and operating as an S corporation. LLC's, on the other hand, feature absence of corporate formalities, unrestricted owner types, flexibility of income allocation and distributions, ability to distribute appreciated assets, and more immediate tax benefits of losses if incurred.
Ultimately, the choice of entity depends heavily on the direction of future tax legislation. The year 2013 saw increases in maximum tax rates for individuals to 43.4% for ordinary income and 23.8% for long-term capital gains and qualifying dividends. Meanwhile, maximum rates for C corporations held firm at 35% on all income. If C corporation rates decline to be more competitive globally, as many in the federal government advocate, flowthrough entities may lose their current appeal. Companies must work with their tax advisors to assure adequate consideration of the unique facts of their situations.
Election and ownership
Switching from a regular C corporation to an S involves a special election, which may have tax costs. Electing S status causes the loss of any credits or carryovers from previous years, and subjects the corporation to "built-in gains" tax at the time of the election, which includes adjustments of property to market value. If sold within a period of ten years after the election, S corporations may be open to double taxation.
The advantages of S corporations in taxes come with many restrictions, violation of which can result in termination of S status and loss of its tax benefits. The number of shareholders is limited to 100. Ownership is restricted to individuals, estates, certain trusts, and certain exempt organizations.
Corporations, partnerships, and nonresident aliens are ineligible. An S corporation cannot be an owned subsidiary of a C corporation or a multiple member LLC, but can be a 100%-owned subsidiary of another S corporation.
Transfer or sale of stock can have severe consequences. If a shareholder is an LLC with more than a single member, the S election terminates. It is advisable to have a shareholder agreement in place to provide a right of first refusal, in the event that stock is offered for sale to nonqualifying shareholders.
Moreover, only a single class of stock is allowed. For example, preferred shares may not be issued. A potential problem arises with undocumented shareholder debt. If upon audit, the Internal Revenue Service interprets the debt as a second class of stock, the S election terminates. On another note, voting right differences do not constitute separate classes of stock.
Choice of tax year-end is restricted. The concern is that shareholders could otherwise benefit from cash-basis timing differences. Selecting a year-end other than Dec. 31 requires that sufficient funds be kept on deposit with the U.S. Treasury to offset any timing benefit.
Taxation and compliance
Once operating as an S corporation, taxation takes place at the owner level from amounts reported on the schedule K-l from the form 1120-S. Unlike C corporations, dividend distributions are not taxed unless they exceed the shareholder's cumulative basis. The basis is the amount paid for the stock plus amounts lent to the company plus the pro rata share of the accumulated adjustments account, which is basically the equivalent of retained earnings while the entity is an S corporation. A shareholder's guarantee of debt does not constitute basis.
Additionally, unlike C corporations, losses may provide tax benefits for owners. The deductibility of losses for active shareholders, however, is limited to the basis in the stock. Losses in excess of basis must be carried forward.
Compensation of stockholders who are active in the business must not be unreasonably low or distributions unreasonably high. The reason is that these shareholders might evade payroll taxes by making non-taxable distributions instead. Some tax practitioners advise clients to apply a minimum benchmark of the FICA base, which is $117,000 in 2014.
Distributions are heavily restricted. In accordance with the formalities of having a single class of stock, distributions must be paid in proportion to ownership. Also, distributions must be made to the actual shareholders. For example, if a trust owns the stock and distributions are paid directly to beneficiaries, it might cause the Internal Revenue Service not to respect the existence of the trusts.
Moreover, distributions in excess of basis are taxed as capital gains. S corporations having C corporation earnings and profits face additional potential taxes. If paid out of C corporation earnings and profits, excess distributions are taxed at ordinary dividend rates. Passive investment income in excess of 25% of gross receipts is taxed at the highest C corporation tax rate. Continuing the excess for three years can cause the S election to terminate.
Fringe benefits
While shareholders of regular C corporations participate in tax-favored fringe benefits alongside their employees, their counterparts in S corporations are limited. Shareholders owning more than two percent of an S corporation are considered to be self-employed for purposes of many of the rules. They may not participate in certain programs, including cafeteria plans and flexible spending accounts. Other financial benefits, such as medical or education, are deducted by the company and taxed to the shareholder in year-end payroll reporting. The medical insurance portion of compensation is exempt from social security, Medicare, or unemployment taxes. Medical insurance premiums are deductible by shareholders as selfemployed medical expense on their personal income tax returns.
On the other hand, life insurance premiums are fully taxable to shareholders, without a personal tax deduction. There may be good reasons to carry life insurance outside of the business. If it is used to fund corporate buy-sell agreements among shareholders, proceeds from policies that are normally exempt from taxes for beneficiaries may be taxed at maximum rates under transfer of value rules. A separate partnership might be preferred to avoid the issue, while also retaining the benefit of increased equity interest basis brought about by individual surviving owners doing a cross-purchase.
S corporation considerations
Summarized here are the critical aspects of S corporations. Failure to comply with restrictions on ownership, distributions, or passive investment income could result in termination of S status. This means the S corporation reverts to a C corporation, and the benefits, including the single level of taxation, are immediately lost.
Election and ownership
* Electing S status may cause loss of certain tax benefits, including credits and carryovers from previous years.
* A sale may be double-taxed within ten years of making the S election.
* Number of shareholders may not exceed 100.
* Shareholders must be individuals, estates, certain trusts, or certain exempt organizations.
* Shareholders may not be corporations, partnerships, or non-resident aliens. The only exception is 100% ownership by another S corporation.
* Only a single class of stock is allowed, although voting right differences do not constitute separate classes of stock.
Taxation and compliance
* S corporation income flows through to its shareholders, who report their share on their individual income tax returns.
* S corporation losses are deductible only up to the basis in the stock.
* Distributions up to basis are not taxed.
* Shareholder compensation must not be unreasonably low, or distributions unreasonably high.
* Distributions must be proportioned to ownership.
* If entities are shareholders, distributions must be to those entities, not direct to beneficiaries.
* Distributions become taxable if paid in excess of cumulative undistributed income or out of prior C corporation accumulated earnings.
* Passive income must be within limits or risk termination.
2% shareholder fringe benefits
* Shareholders may not participate in certain programs, such as cafeteria plans and flexible spending accounts.
* Medical insurance and most other benefits are deducted by the S corporation as compensation and taxed to shareholders.
* Life insurance premiums are taxed to shareholders without an S corporation deduction.
* Life insurance proceeds from policies held within the S corporation risk taxation at maximum rates under transfer of value rules.
AS TAX LAWS continue to evolve, so do choices of entity. Being mindful of the alternatives is critical to achieving tax benefits. Both S corporations and Limited Liability Companies (LLC's) are flow-throughs, which have long been a desirable alternative to regular C corporations.
Unlike in C corporations, the incomes of flow-throughs are taxed directly to their individual owners, largely independent of distributions. C corporations, on the other hand, are double-taxed, incurring their own tax first, without any long-term capital gains break. Then, as money is distributed to owners, it is taxed again at the individual level, without a deduction to the corporation. The law enforces the double tax by limiting owner salaries to reasonable levels, and by preventing corporations from accumulating excess earnings.
However, S corporations have a newly enhanced tax advantage over LLC's. Only active shareholders of S corporations are exempt from the Affordable Care Act's new 3.8% tax on unearned investment income of joint filers making over $250,000. While inactive owners of both entities incur the new tax, highincome active members in LLC's do also, in that a 3.8% Medicare tax applies to their flow-through income.
There are several benefits and risks of becoming and operating as an S corporation. LLC's, on the other hand, feature absence of corporate formalities, unrestricted owner types, flexibility of income allocation and distributions, ability to distribute appreciated assets, and more immediate tax benefits of losses if incurred.
Ultimately, the choice of entity depends heavily on the direction of future tax legislation. The year 2013 saw increases in maximum tax rates for individuals to 43.4% for ordinary income and 23.8% for long-term capital gains and qualifying dividends. Meanwhile, maximum rates for C corporations held firm at 35% on all income. If C corporation rates decline to be more competitive globally, as many in the federal government advocate, flowthrough entities may lose their current appeal. Companies must work with their tax advisors to assure adequate consideration of the unique facts of their situations.
Election and ownership
Switching from a regular C corporation to an S involves a special election, which may have tax costs. Electing S status causes the loss of any credits or carryovers from previous years, and subjects the corporation to "built-in gains" tax at the time of the election, which includes adjustments of property to market value. If sold within a period of ten years after the election, S corporations may be open to double taxation.
The advantages of S corporations in taxes come with many restrictions, violation of which can result in termination of S status and loss of its tax benefits. The number of shareholders is limited to 100. Ownership is restricted to individuals, estates, certain trusts, and certain exempt organizations.
Corporations, partnerships, and nonresident aliens are ineligible. An S corporation cannot be an owned subsidiary of a C corporation or a multiple member LLC, but can be a 100%-owned subsidiary of another S corporation.
Transfer or sale of stock can have severe consequences. If a shareholder is an LLC with more than a single member, the S election terminates. It is advisable to have a shareholder agreement in place to provide a right of first refusal, in the event that stock is offered for sale to nonqualifying shareholders.
Moreover, only a single class of stock is allowed. For example, preferred shares may not be issued. A potential problem arises with undocumented shareholder debt. If upon audit, the Internal Revenue Service interprets the debt as a second class of stock, the S election terminates. On another note, voting right differences do not constitute separate classes of stock.
Choice of tax year-end is restricted. The concern is that shareholders could otherwise benefit from cash-basis timing differences. Selecting a year-end other than Dec. 31 requires that sufficient funds be kept on deposit with the U.S. Treasury to offset any timing benefit.
Taxation and compliance
Once operating as an S corporation, taxation takes place at the owner level from amounts reported on the schedule K-l from the form 1120-S. Unlike C corporations, dividend distributions are not taxed unless they exceed the shareholder's cumulative basis. The basis is the amount paid for the stock plus amounts lent to the company plus the pro rata share of the accumulated adjustments account, which is basically the equivalent of retained earnings while the entity is an S corporation. A shareholder's guarantee of debt does not constitute basis.
Additionally, unlike C corporations, losses may provide tax benefits for owners. The deductibility of losses for active shareholders, however, is limited to the basis in the stock. Losses in excess of basis must be carried forward.
Compensation of stockholders who are active in the business must not be unreasonably low or distributions unreasonably high. The reason is that these shareholders might evade payroll taxes by making non-taxable distributions instead. Some tax practitioners advise clients to apply a minimum benchmark of the FICA base, which is $117,000 in 2014.
Distributions are heavily restricted. In accordance with the formalities of having a single class of stock, distributions must be paid in proportion to ownership. Also, distributions must be made to the actual shareholders. For example, if a trust owns the stock and distributions are paid directly to beneficiaries, it might cause the Internal Revenue Service not to respect the existence of the trusts.
Moreover, distributions in excess of basis are taxed as capital gains. S corporations having C corporation earnings and profits face additional potential taxes. If paid out of C corporation earnings and profits, excess distributions are taxed at ordinary dividend rates. Passive investment income in excess of 25% of gross receipts is taxed at the highest C corporation tax rate. Continuing the excess for three years can cause the S election to terminate.
Fringe benefits
While shareholders of regular C corporations participate in tax-favored fringe benefits alongside their employees, their counterparts in S corporations are limited. Shareholders owning more than two percent of an S corporation are considered to be self-employed for purposes of many of the rules. They may not participate in certain programs, including cafeteria plans and flexible spending accounts. Other financial benefits, such as medical or education, are deducted by the company and taxed to the shareholder in year-end payroll reporting. The medical insurance portion of compensation is exempt from social security, Medicare, or unemployment taxes. Medical insurance premiums are deductible by shareholders as selfemployed medical expense on their personal income tax returns.
On the other hand, life insurance premiums are fully taxable to shareholders, without a personal tax deduction. There may be good reasons to carry life insurance outside of the business. If it is used to fund corporate buy-sell agreements among shareholders, proceeds from policies that are normally exempt from taxes for beneficiaries may be taxed at maximum rates under transfer of value rules. A separate partnership might be preferred to avoid the issue, while also retaining the benefit of increased equity interest basis brought about by individual surviving owners doing a cross-purchase.
S corporation considerations
Summarized here are the critical aspects of S corporations. Failure to comply with restrictions on ownership, distributions, or passive investment income could result in termination of S status. This means the S corporation reverts to a C corporation, and the benefits, including the single level of taxation, are immediately lost.
Election and ownership
* Electing S status may cause loss of certain tax benefits, including credits and carryovers from previous years.
* A sale may be double-taxed within ten years of making the S election.
* Number of shareholders may not exceed 100.
* Shareholders must be individuals, estates, certain trusts, or certain exempt organizations.
* Shareholders may not be corporations, partnerships, or non-resident aliens. The only exception is 100% ownership by another S corporation.
* Only a single class of stock is allowed, although voting right differences do not constitute separate classes of stock.
Taxation and compliance
* S corporation income flows through to its shareholders, who report their share on their individual income tax returns.
* S corporation losses are deductible only up to the basis in the stock.
* Distributions up to basis are not taxed.
* Shareholder compensation must not be unreasonably low, or distributions unreasonably high.
* Distributions must be proportioned to ownership.
* If entities are shareholders, distributions must be to those entities, not direct to beneficiaries.
* Distributions become taxable if paid in excess of cumulative undistributed income or out of prior C corporation accumulated earnings.
* Passive income must be within limits or risk termination.
2% shareholder fringe benefits
* Shareholders may not participate in certain programs, such as cafeteria plans and flexible spending accounts.
* Medical insurance and most other benefits are deducted by the S corporation as compensation and taxed to shareholders.
* Life insurance premiums are taxed to shareholders without an S corporation deduction.
* Life insurance proceeds from policies held within the S corporation risk taxation at maximum rates under transfer of value rules.
Monday, March 17, 2014
401(k) Moves to Ease Your Tax Time Blues
FROM HUFFINGTONPOST.COM
It's been a rough winter for most of the country. And, if you think Mother Nature hits hard, just wait a few weeks until Uncle Sam gets a crack at us. Millions will owe money to the government, but there's still time to help reduce your tax burden for this year and beyond. A good place to start is with your workplace 401(k) plan. While the 401(k) is designed to help you save more for retirement, it can also lessen your tax blow for 2014. Here's a look at what you need to know:
- Try to increase or max out your contributions. Traditional 401(k) plans are funded with pre-tax dollars, which means your current taxable income is lowered. Making a significant contribution could bump you down into a lower tax bracket entirely, allowing you to keep even more of your pay. An Employee Benefit Research Institute report found that only 10% of participants were maxing out their contributions, so there is room to get more aggressive with your savings rate. *
- Get extra credit. Based on your income and filing status, contributions to a qualified 401(k) plan may even further lower your tax bill through the saver's credit or retirement savings contributions credit. The credit was established in 2002 and directly reduces your taxable income by a percentage of the amount you put into your 401(k) plan. According to the IRS, those who meet eligibility requirements can take a credit of up to2,000, so it's definitely worth investigating.
- Consider a Roth 401(k). A Roth 401(k) can offer a different kind of strategic tax planning opportunity. In a traditional 401(k) plan, contributions are made on a pre-tax basis and taxes are paid when you take distributions from the plan. In a Roth 401(k), contributions are made on an after-tax basis and distributions of any investment earnings are tax-free after you meet certain requirements.
- Withdrawals are tax burdens. Any withdrawal from a 401(k) plan can carry significant tax consequences. How significant? If you take money out of your employer-sponsored retirement plan before the age of 59½, you'll likely face a 10% federal penalty. What's more, the government will take 20% of your withdrawal as an advance on your tax bill. Plus, some plans may freeze employees who have taken a withdrawal from contributing for the next six months, hurting retirement savings even further.
- Avoid the loan. Borrowing from your 401(k) should be an absolute last resort. Loans from a 401(k) plan must be repaid with after-tax dollars, negating much of the tax benefits of a 401(k). And if you leave your job and are unable to repay the loan in full, the outstanding balance is treated like a withdrawal, triggering a tax bill and possibly a 10% penalty on top of the tax.
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.
Friday, July 26, 2013
IRS eyes payroll tax avoidance tactics via S corporations
Payroll tax collection continues to vex the Internal Revenue Service despite several court cases that have resulted in rulings favorable for the IRS regarding unreasonably low compensation. A recent high profile case was David E. Watson, P.C. v. United States on which the Eighth Circuit ruled in 2012. Watson was an indirect partner in a CPA firm, practicing through an S corporation that paid him $24,000 of salary per year and between $175,000 and $203,000 in profit distributions. The court adjusted his compensation to $93,000.
It isn’t hard to see why shareholders of S corporations attempt to justify wage levels below what the IRS considers “reasonable compensation” (assuming the understated compensation is below the FICA wage base). Both the S corporation and employee save the 7.65% FICA and Medicare taxes on the wages not reported.
Another recent case is Herbert v. Commissioner. Herbert received between $24,000 and $29,000 of wages for the years 2004 through 2006. In 2007, he received $2,400 of wages. Although the Tax Court noted that the corporation lost money or earned very little income in each of the years, and the corporation closed down in 2009, the Court increased the taxable compensation for 2007. The IRS wanted to reclassify all of the draws from the S corporation for 2007 as additional wages (i.e., an additional $52,600). Ultimately, the judge averaged the petitioner’s wages for 2002 through 2006 to arrive at $30,445 as a reasonable wage. (The business was owned by someone else in 2002 and 2003.)
It didn’t help matters that Mr. Herbert used the draws to pay corporate expenses personally. He lost, misplaced or never kept receipts for many corporate expenses he paid with cash. The Court accepted Herbert’s testimony that he in fact paid significant corporate expenses with cash using funds received from the corporation. Nonetheless, the judge also believed that the wages of $2,400 were too low.
The result? Herbert was found to have under-reported his wages, even though the amount of cash drawn out of the corporation covered corporate expenses. If he had maintained a better set of books, paid all of the corporate expenses with corporate (rather than what became to be personal) funds, he wouldn’t have had distributions from the corporation to himself.
Although the wages were quite low, the fact of the matter is the business was failing. There wasn’t an adequate cash flow to pay wages and expenses. By shuffling funds and taking money personally, Mr. Herbert created a payroll tax liability where such liability shouldn’t have existed.
Payroll tax reduction or avoidance is, perhaps, a major reason for the popularity of S corporation status for an operating entity, even though the formation of an LLC under state law provides similar liability protection for the sole proprietor. The IRS projects that 4.6 million Forms 1120-S will be filed for 2012, compared to 3.6 million Forms 1065 (partnership).
As part of its tax reform efforts, Congress is evaluating the continuing treatment of the bottom-line S corporation as not subject to payroll taxes or self-employment tax. The AICPA will be closely monitoring any developments and keeping you up to date through its tax reform page and other communications.
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