Category Archives: S Corporation

Tax Audit Red Flags

by Michael W. Blitstein, CPA
The IRS audits only slightly more than 1% of all individual tax returns annually. So why do they pick some returns to investigate and ignore others?  Although there’s no sure way to avoid an IRS audit, you should be aware of the following red flags that could increase your chances of drawing unwanted attention from the IRS.

You Have Foreign Assets…

Stashing money overseas? Then you’re probably well aware that the IRS has been ramping up its efforts to rein in offshore accounts.  Launched in 2009, the agency’s voluntary disclosure program has already raked in more than $5 billion in back taxes, interest and penalties for illegally hiding assets in offshore accounts.

Taxpayers are asked to check a box on Schedule B if they have an ownership interest in foreign accounts. If they then fail to provide information about those assets, it will undoubtedly trigger an audit.

Indicating on your return that you do business in foreign countries or take many trips abroad for work could also raise eyebrows if no foreign assets are reported.

Your Return Has Too Many Zeroes…

While rounding numbers on your tax return to the nearest dollar is okay, rounding to the nearest thousand is not – especially when itemizing deductions like business expenses, unreimbursed employee expenses and job hunting costs.  If you submit figures like $5,000 in auto costs, $2,000 in gas mileage and $4,000 in lodging, it may look like you pulled those numbers out of thin air or inflated them by rounding – since it’s unlikely that every single expense was a perfect multiple of $1,000.

You Have a Home Office…

Just because you do some work on your couch while watching TV doesn’t mean it counts as a home office.

After years of watching people abuse the home office deduction, the IRS is on the look out. In order to avoid being scrutinized, make sure you only claim reasonable expenses – and only those that directly apply to the part of the home used as an office.  Remember, the credit can only be claimed if the home office is your primary place of business and is used exclusively for work. People get into trouble when the IRS suspects they are mixing personal costs with their business costs.

You Forgot Some Income…

For people who earn money from various places, remembering to report every single cent can be difficult. But ‘I forgot’ isn’t a good enough excuse for the IRS.  For any miscellaneous income over $600 you received throughout the year, the company you worked for should send you a Form 1099. If you don’t receive it for some reason – it was mistakenly sent to a previous address, for instance – you can be sure that the IRS will still get it.  You can either request the missing form from the employer or simply report the income without the form. This is why it helps to track your income throughout the year.

Of course, some people earn money that may not get reported on.  Even if the IRS doesn’t know about it, you must report this income as well or you risk the agency finding out.

You Exaggerate Donations…

Even good deeds can spark suspicion at the IRS.  If you report extremely high charitable contributions – especially relative to your income – make sure you have the proof to back it up.  Receipts for cash donations of more than $250 are required in the event the IRS comes knocking.  Donating items gets a little trickier, because it’s common for people to think the items are worth a lot more than someone will actually pay for them. So it’s important to be reasonable with your valuations.

You Own a Money Losing Business…

If you own a business that is reporting losses year after year, the IRS may grow suspicious that it’s actually a hobby.  There’s a rule-of-thumb saying you must have a profit in two [out] of five years – if you don’t have a profit they’re going to look at it as a hobby.  To fend off the IRS, make sure to keep diligent financial records and do little things like have business cards and company letterhead.

You Have a Shady Tax Preparer...

If your tax preparer tries to convince you to claim deductions that sound too good to be true or to report income that doesn’t line up with what you would have reported, watch out.  You want a preparer that will get you the best refund possible – but not if it means breaking the law.

CJBS, LLC is a Chicago based firm that assists its clients with a wide range of accounting and financial issues, protecting and expanding the value of mid-size companies. E-mail me at michael@cjbs.com if you have any questions about this posting or if I may be of assistance in any way.

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IRS Increases Audit Examinations

by Michael W. Blitstein, CPA 

The Internal Revenue Service has stepped up its examinations in the past year of taxpayers with high adjusted gross income.

The IRS released its 2012 IRS Data Book on March 25th, providing a snapshot of agency activities for the fiscal year. The report describes activities conducted by the IRS between October 1, 2011 and September 30, 2012, and includes information about returns filed, taxes collected, enforcement, taxpayer assistance and the IRS budget and workforce, among others.

The IRS said it examined just under 1 percent of all tax returns filed and about 1 percent of all individual income tax returns during fiscal year 2012.  Overall, in fiscal year 2012, individual income tax returns in higher adjusted gross income (“AGI”) classes were more likely to be examined than returns in lower AGI classes.

The IRS examined about 12.1 percent of the 337,477 tax returns reporting income of $1 million or more, compared to 2.8 percent of those reporting at least $200,000 and under $1 million, and 0.4 percent of those reporting income under $200,000 who didn’t file a Schedule C, E, F or Schedule 2106, and 1.1 percent of those with income under $200,000 and filing Schedule E or Form 2106. Of the 1.5 million individual tax returns examined, nearly 54,000 resulted in additional refunds. In addition, the IRS examined 1.6 percent of corporation income tax returns, excluding S corporation returns, in fiscal 2012.

During fiscal year 2012, the IRS collected almost $2.5 trillion in Federal revenue and processed 237 million returns, of which almost 145 million were filed electronically. Out of the 146 million individual income tax returns filed, almost 81 percent were e-filed. More than 120 million individual income tax return filers received a tax refund, which totaled almost $322.7 billion.

IRS acknowledged that one of the biggest challenges confronting the IRS today is tax refund fraud caused by identity theft. The IRS has more than doubled the number of staff dedicated to preventing refund fraud and assisting taxpayers victimized by identity theft, with more than 3,000 employees working in this area. As a result of these increased efforts, the IRS during fiscal year 2012 was able to prevent the issuance of more than 3 million fraudulent refunds worth more than $20 billion. Despite these efforts, much more work remains on identity theft as well as on overall refund fraud.

The IRS made significant progress last year on international enforcement, specifically in its efforts to combat the practice of illegally hiding assets and income in offshore accounts. They have continued a two-pronged approach: offering a voluntary disclosure program for those who want to come in and get right with the government, while at the same time pursuing tax evaders and the promoters and banks assisting them.

CJBS, LLC is a Chicago based firm that assists its clients with a wide range of accounting and financial issues, protecting and expanding the value of mid-size companies. E-mail me at michael@cjbs.com if you have any questions about this posting or if I may be of assistance in any way.

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Tax Policies of the Major Presidential Candidates

by Michael W. Blitstein, CPA 

On November 6, 2012, Americans will elect the occupant of the White House for the next four years. As President of the United States, the winner will play a major role shaping tax policy and possibly reforming the entire Tax Code. This briefing describes the tax policies of President Obama and former Governor Mitt Romney, with analysis of the potential impact of their tax positions both for the immediate future and for 2014 and beyond.

Impact

Under current law, the Bush-era tax cuts (reduced income tax rates, reduced capital gains/dividends tax rates, and much more) are scheduled to expire after December 31, 2012. Effective January 1, 2013, sequestration under the Budget Control Act of 2011 is scheduled to take effect, with the goal of reducing the Federal budget deficit by nearly $1 trillion over 10 years. In addition, after 2011, a host of so-called tax extenders expired, and after 2012, numerous additional temporary incentives are scheduled to sunset. Moreover, the 2012 payroll tax holiday, which reduced the employee-share of OASDI taxes by two percentage points, is also slated to expire after December 31, 2012. The combination of all these events has many commentators referring to 2013 as “taxmageddon” or the “fiscal cliff.”

The balance between Democrats and Republicans in the House and the Senate may also change on election day. However, whether either party acquires sufficient political capital, let alone a mandate, on taxes to address short-term issues such as sunsetting provisions and long-term issues like tax reform, remains to be seen.

Caution

Between the date of publication and election day, the positions of the candidates may change. CJBS has based this briefing on what we consider accurate, nonpartisan and unbiased information at the time of publication.

SELECTED POSITIONS
Obama —Individual taxes Romney – Individual taxes
2013 rates higher for higher-income taxpayers only 2013 rates same as 2012 for all taxpayers
Unspecified future date: lower rates for middle/lower income brackets Unspecified future date: 20% income tax rate reduction for all taxpayers
Higher capital gains/dividend rate for higher-income taxpayers Eliminate tax on investment income for AGI below $200,000
$3.5 million estate tax exemption/45% rate Abolish the estate tax
Replace AMT with “Buffett rule” Repeal the AMT
Obama – Corporate Taxes Romney—Corporate Taxes
Reduce maximum corporate tax rate to 28% (25% for manufacturing) Reduce maximum corporate rate to 25%
Maintain worldwide system but with reforms Implement territorial system of international tax
 SELECTED CHANGES IN FEDERAL TAXES: 2012-2013 IF CONGRESS FAILS TO ACT
2012 2013
Top individual tax rate 35% 39.6%
Capital Gains 15%* 20%
Dividends 15%* Taxed at ordinary income rates
Top estate tax rate 35% 55%
Child tax credit $1,000 $500
AOTC Up to $2,500 Unavailable
Code Sec. 179 dollar limit $139,000** $25,000
WOTC for veterans Up to $9,600 Unavailable
Research tax credit Unavailable Unavailable
Wind energy PTC Available Unavailable
*Zero percent for taxpayers in the 10 and 15 percent brackets
**As adjusted for inflation

Individuals: 2014 and Beyond

The basic goal for tax reform on the individual tax level expressed by both candidates is to broaden the tax base and lower tax rates. The candidates agree that tax reform should be revenue neutral. Each candidate also forecasts an improved economy from the savings of a simplified tax system and lower overall rates.

Businesses: 2014 and Beyond

Corporate tax reform, and business tax reform in general, has been raised by several Congressional committees and both candidates over the past year as a necessary long range step in making businesses more innovative and competitive. Based upon the multilayered considerations involved, however, concrete changes are not anticipated until 2014 or later.  Specific issues include:

  • Corporate Tax Rates
  • International Proposals
  • Other Business Reforms

Note: A more comprehensive PDF version of this brief can be seen on the CJBS website at: http://www.cjbs.com/Email/October2012/CJBS_long.pdf

CJBS, LLC is a Chicago based firm that assists its clients with a wide range of accounting and financial issues, protecting and expanding the value of mid-size companies. E-mail me at michael@cjbs.com if you have any questions about this posting or if I may be of assistance in any way.

www.cjbs.com

Court Upholds Treatment of S Corporation Dividends as Compensation

by Michael W. Blitstein, CPA 

The Eighth Circuit Court of Appeals has affirmed a Federal district court decision holding that a portion of the dividends paid to an employee-owner of professional services firm was compensation for services. As a result, the taxpayer earned additional wages and owed additional Social Security taxes.

Taxpayers and the IRS frequently spar over the amount of compensation, and, subsequently, the amount of FICA (Social Security) taxes owed, by a closely-held corporation where the same person owns the company and is its employee. Unlike a partnership, where a general partner’s share of profits is subject to self-employment taxes, distributions to an S corporation stockholder are not subject to FICA taxes.

Background

The taxpayer was working for his own professional corporation (“P.C.”). The P.C. owned 25 percent of a professional services firm that was an S corporation. His P.C. entered into an employment agreement with the S corporation, and he exclusively worked for the firm.

The P.C. paid the taxpayer $24,000 a year as compensation and paid Social Security taxes on that amount. The P.C. received substantial distributions from the firm, which had gross earnings of $2–3 million each year. After the P.C. paid the taxpayer’s salary and other expenses, it distributed the remaining cash to the taxpayer as dividends, amounting to $203,000 in year one and $175,000 in year two.

The IRS determined that the P.C. underpaid employment taxes. A Federal district court agreed, determining (based on the testimony of IRS’s expert) that the taxpayer’s compensation should have been $91,000 a year.

Substance Over Form

To determine the appropriate amount of FICA taxes, the court found that the inquiry was whether payments at issue were remuneration for services performed. Because the corporation was controlled by the employees to whom the compensation was paid, the court gave special scrutiny to the salary amount, since there was a lack of arm’s-length bargaining.

A reasonable compensation determination is usually appropriate to determine the amount of an income tax deduction, but it also applies to FICA tax cases. In an old regulation ruling, the IRS concluded that it could recharacterize S corporation dividend payments because the dividends were paid to stockholders in lieu of reasonable compensation. Courts looking at the FICA issue have also evaluated the economic substance of a transaction.

Reasonable Compensation

The Eighth Circuit agreed with the district court’s conclusion that the value of the taxpayer’s services was $91,000 and that the P.C. owed additional FICA taxes. The P.C.’s purported intent to pay $24,000 as compensation was not relevant, the court concluded. Even if intent mattered, it was not credible that the P.C. intended to pay a mere $24,000 in compensation.

The appeals court said that it was appropriate to determine whether the taxpayer’s compensation was reasonable. Based on the following factors, the appeals court concluded that the district court properly determined the fair market value of the taxpayer’s services: the taxpayer was a qualified professional; the taxpayer worked 35 to 45 hours per week as a primary earner of the firm; the $24,000 supposedly paid was unreasonably low compared to similar professionals; the firm had substantial gross earnings; and the firm made substantial distributions to the taxpayer, especially when compared to the claimed salary.

CJBS, LLC is a Chicago based firm that assists its clients with a wide range of accounting and financial issues, protecting and expanding the value of mid-size companies. E-mail me at michael@cjbs.com if you have any questions about this posting or if I may be of assistance in any way.

www.cjbs.com

Winning The Lottery Is Just The Beginning…

by Michael W. Blitstein, CPA 

Many individuals play the lottery every week with the fantasy of having that winning ticket. Oh, all the things the prize would provide if we just had the lucky numbers.  However, most do not think of the necessary tax planning that surrounds acquiring the wealth.

A recent Tax Court case summarizes the experience of one family. The taxpayer learned she held a winning lottery ticket. The taxpayer’s father contacted an attorney who prepared incorporation papers for an S corporation. The taxpayer and several family members were the stockholders. The taxpayer subsequently transferred the ticket to the S corporation.

Before the taxpayer could claim her winnings, she had to defend her prize against a competing claim by her co-workers. A state trial court sided with the co-workers but the state highest court reversed that decision.

The IRS determined that the taxpayer had made a gift as a result of her transfer of the ticket to the S corporation. The IRS issued a deficiency notice for $771,000 for gift tax owed (income tax liability was not a part of this case). The taxpayer appealed to the Tax Court for relief.

The court first found that the Code generally imposes a tax irrespective of whether the gift is direct or indirect. Under regulations, a transfer of property to a corporation for less than adequate consideration represents gifts to the other individual stockholders of the corporation to the extent of their proportionate interests.

The court rejected the taxpayer’s argument that there was no gift because a family contract required transfer of the ticket. The court found that there was no pooling of money. There were no predetermined sharing percentages. At most, the family had an unenforceable “agreement to agree.”

The court further found that no partnership existed among the taxpayer and her family members. All of the decisions about the ticket were made by the taxpayer’s father; not jointly by all the family members as had been argued. The court concluded that the transfer was a gift, discounted only to account for the competing claims by co-workers at the time of the gift.

So… what’s the moral of this story? As you daydream about what winning the lottery can mean to you, you may want to include getting some real tax advice before you cash in the ticket as part of your fantasy.

CJBS, LLC is a Chicago based firm that assists its clients with a wide range of accounting and financial issues, protecting and expanding the value of mid-size companies. E-mail me at michael@cjbs.com if you have any questions about this posting or if I may be of assistance in any way.

www.cjbs.com

S Corporation Stockholder-Employee Compensation

by Michael W. Blitstein, CPA 

S corporation stockholder-employees and their tax advisers often find themselves with conflicting goals when setting the stockholder-employee’s compensation. Typically, the stockholder-employee prefers to minimize compensation in favor of distributions to reduce payroll taxes. Tax advisers, however, are faced with a body of governing authority providing that the stockholder-employee cannot avoid the imposition of payroll taxes by forgoing reasonable compensation. Unfortunately, until recently this governing authority had offered little in terms of how to actually compute reasonable compensation, leaving tax advisers with sparse guidance upon which to rely when recommending salary amounts to their clients.

In late 2010, an Iowa district court decided Watson, a reasonable compensation case that, together with the North Dakota District Court’s 2006 decision in JD & Associates, provides the direction tax advisers have been seeking. These two cases shed much needed light on the methodology the IRS and the courts use to determine reasonable compensation in the S corporation arena.

S Corporations and Employment Taxes

As passthrough entities, S corporations generally do not pay entity level tax on their taxable income. Instead, taxable income and other attributes are allocated among the stockholders, who report the items and pay the corresponding tax on their personal income tax returns.

This S corporation flowthrough income has long enjoyed an employment tax advantage over that of sole proprietorships, partnerships, and LLCs. The advantage finds its genesis in that a stockholder’s undistributed share of S corporation income is not treated as self-employment income. In contrast, earnings attributed to a sole proprietor, a general partner, or many LLC members are subject to self-employment taxes.

As the need to fund Social Security and Medicare payments has risen, the employment tax burden on employers, employees, and the self-employed has increased dramatically. In 2011, employers will pay 6.2% of the first $106,800 of an employee’s wages toward the Social Security tax, with employees paying an additional 4.2% through wage withholding. Employers and employees will split the 2.9% Medicare tax on all wages, without limitation.

Self-employed individuals will be responsible for the entire 10.4% Social Security tax—again limited to the first $106,800 of self-employment income—and the 2.9% Medicare tax on all self-employment income.

As these employment tax obligations have climbed, the advantage of operating as an S corporation has become magnified. Since S corporation income is not subject to self-employment tax, there is tremendous motivation for stockholder-employees to minimize their salary in favor of distributions, which are not subject to payroll or self-employment tax. Consider the following examples.

Example 1: John owns 100% of the stock of S Corporation, an S corporation. John is also S’s president and only employee. S generates $100,000 of taxable income in 2011, before considering John’s compensation. If John draws a $100,000 salary, S’s taxable income will be reduced to zero. John reports $100,000 of wage income on his individual income tax return, and S and John are liable for the necessary payroll taxes. S is required to pay $7,650 (7.65% of $100,000) as its share of payroll tax, and S withholds $5,650 (5.65% of $100,000) from John’s salary toward John’s payroll obligation, resulting in a total payroll tax bill of $13,300.

Example 2: Alternatively, John withdraws $100,000 from S as a distribution rather than a salary. S’s taxable income will remain at $100,000 and will be passed through to John and reported on his individual income tax return, where it is not subject to self-employment tax. The $100,000 distribution is also not taxable to John, as it represents a return of basis. By choosing to take a $100,000 distribution rather than a $100,000 salary, S and John have saved a combined $13,300 in payroll taxes.

Reasonable Compensation History: No Salary Taken

In light of these potential employment tax savings, the IRS has long challenged attempts by stockholder-employees to minimize compensation in favor of distributions. IRS opened its attack on these perceived abuses in Revenue Ruling 74-44. In the ruling, the IRS imputed the payment of reasonable salaries to an S corporation that paid distributions but no compensation to two stockholders who provided services to the corporation.

Fifteen years later, an oft-cited decision further clarified the IRS’s position on reasonable compensation. In Radtke, the taxpayer was the sole stockholder and director of a law firm established as an S corporation. Although the taxpayer devoted all his working time to the law firm, he took no compensation for the year at issue, opting instead to withdraw $18,225 in distributions.  The IRS argued, and the district court agreed, that the distributions represented wages subject to payroll taxes, with the court adding, “where the corporation’s only director had the corporation pay himself, the only significant employee, no salary for substantial services . . . [h]is ‘distributions’ functioned as remuneration for employment.”

Soon after, the Ninth Circuit Court of Appeals expanded on this line of reasoning with its decision in Spicer.  In that case, the taxpayer was Spicer Accounting Inc. (SAI), an accounting firm established as an S corporation. SAI was owned by Spicer, who was a CPA, and his spouse. Spicer also served as president, director, and treasurer. As SAI’s lone accountant, Spicer performed substantial services, working approximately 36 hours per week.

Spicer had an arrangement with his corporation whereby he donated his services to the corporation in exchange for no compensation, and as a stockholder he withdrew his earnings as distributions. Accordingly, Spicer did not pay payroll taxes on the amounts he received.

The Ninth Circuit, in analyzing the nature of the payments made to Spicer, stated that “salary arrangements between closely held corporations and [their] stockholders warrant close scrutiny.”  In an effort to determine if the distributions truly represented remuneration for services, the Ninth Circuit established a line of analysis that would be followed repeatedly in the years to follow.

The Ninth Circuit first looked to Sec. 3121(d), which defines an employee for payroll tax purposes in part as “any officer of a corporation.”  Because Spicer was the president of SAI, this requirement was easily met. The Ninth Circuit then turned its attention to Regulations Section 31.3121(d)-1(b), which provides an exception to employee status for some officers, but only to an officer who “does not perform any services or performs only minor services.”

In arriving at its decision, the Ninth Circuit held that Spicer’s services were substantial. As the firm’s lone CPA, Spicer was the only person capable of signing tax returns, performing audits, and preparing opinion letters. The Ninth Circuit concluded that distributions paid to Spicer were classified properly as compensation subject to payroll taxes because “a corporation’s sole full-time worker must be treated as an employee.”

A line of nearly identical rulings followed, with one Pennsylvania CPA at the heart of many of the decisions. In Grey, the sole stockholder of an accounting firm took no salary despite rendering significant services, opting instead to withdraw amounts as independent contractor fees. The Tax Court, using the line of reasoning established in Spicer, held that the stockholder was an employee and the accounting firm was liable for payroll taxes on the independent contractor fees.

After its victory in Grey, the IRS zeroed in on the accounting firm’s client list. In all, six of those clients found themselves in front of the Tax Court, defending the reasonableness of their compensation.  In each case, stockholder-employees who provided significant services to their S corporation withdrew the entire taxable income of their corporation as distributions, neglecting to take any salary. The Tax Court held that the stockholders were employees and recharacterized the distributions as compensation.

The abuses evidenced in these decisions did not go unnoticed. In 2005, the Treasury Inspector General for Tax Administration (TIGTA) issued a report examining the payroll tax advantage that S corporations enjoyed over sole proprietorships. The report, which analyzed S corporation tax returns filed in 2000, revealed the following:

  • Approximately 80% of all S corporations were more than 50% owned by one stockholder, giving that stockholder control in setting his or her compensation.
  • Owners of single-stockholder S corporations paid themselves salaries equaling only 41.5% of the corporation’s profits, down from 47.1% in 1994.
  • There were 36,000 situations in which the sole owners of S corporations generating over $100,000 of income took no salaries. These corporations passed through $13.2 billion to their owners free from payroll tax.
  • In total, the payroll taxes paid by single-stockholder S corporations were $5.7 billion less than the self-employment taxes that would have been imposed if the taxpayers were sole proprietors.

In 2009, a U.S. Government Accountability Office (GAO) report to the Senate Committee on Finance echoed the concerns expressed in the TIGTA findings. The GAO report noted that in 2003 and 2004 combined, S corporations had underreported their stockholder compensation by $24.6 billion, with corporations with fewer than three stockholders responsible for nearly all the underreporting.

A Rare Defeat for the IRS

Although a stockholder faces a heavy burden in proving that services provided to a corporation are not substantial, it can be accomplished. For example, in Davis, a district court held that the stockholder had proved this point and rejected the IRS’s attempt to recharacterize distributions made to a stockholder of an S corporation as “arbitrary and capricious.”

Davis was the president of the corporation but did not actively participate in its activities. The court, citing Spicer, found that based on the uncontroverted evidence of the stockholder, she did not provide substantial services to the corporation and met the exception from employee treatment provided for in the Section 3121 regulations. While this decision remains an anomaly in the relevant case history, it confirms that stockholders need not draw a salary provided they render only minimal services to the corporation.