Archive for the ‘Taxes’ Category

S-Corp owners: is your compensation reasonable?

May 9th, 2012 admin

By: Steve A. Porter, CPA, CMA

In a previous article, I discussed reasonable compensation and how it applied to owners of C-Corporations. With those type organizations, the issue is usually an owner compensation that is unreasonably high. In that situation, it could be construed that the compensation was actually a dividend, which would not deductable at the corporate level.

But most businesses, particularly small businesses are ‘pass-through’ type entities. These include S-Corps, LLCs, and sole proprietorships. The problem is not a compensation that is unreasonably high, but one that is unreasonably low.

If you own one of these pass through type entities, you probably are aware that you pay taxes on the businesses earnings even if you take no money from the business. You might pay yourself a salary, on which you pay taxes, or you might take a distribution from equity. This distribution has already been taxed to you since earnings are passed to you personal income tax return via a K1.

So why would the federal, state, and local tax folks care if your compensation was too low? It has to do with payroll taxes, or more specifically FICA, Medicare, FUTA, SUTA, and in some cases local occupational type taxes. These type taxes are levied on compensation, but usually not on distributions.

Let’s say your business earns a half million dollars. And let’s say you are taking an annual salary of $10,000.00. You get a K1 for the $500,000.00, which goes on your income tax return. Since your payroll taxes are applied to the ten grand, an not the $500 grand, you can congratulate yourself for making such a smart business decision, right?

Wrong, and beware! Unless you can show that the relatively low salary of $10K is reasonable, you could be challenged in an audit, and receive a substantial bill for back taxes relating to the payroll taxes mentioned above. Note that these taxes have some very harsh punitive penalties associated with them. OK, so maybe the idea of keeping payroll taxes low by paying your self a salary that is below the market value is not looking like such a good move.

To avoid this situation, the answer is simple: pay yourself a reasonable compensation. That begs the question: “how does one determine what is reasonable?”, a question for which the answer is not so simple.

The answer is not eimple because ‘reasonable’ is subjective. In many areas of tax law, there are specific rules for determining various amounts. There are safe harbors, there are online calculators, and there are schedules. But With ‘reasonableness’ of compensation, you are somewhat on your own.

While this gives the IRS some advantages in that they can challenge you from more than one angle, it actually works to the taxpayer’s advantage, since you can justify your claim of reasonableness using one or more criteria that people in business typically use. You can use simple things like hours worked, average salary for similar jobs in your industry, or you can use a return method such as commission or percent of profits.

It all begins by documenting your formula and criteria for paying yourself. If you do that, you are ahead of many small business owners in justifying your compensation to a tax auditor. You just want to make sure the formula and criteria used is, well, ….reasonable.


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Constructive Dividends: Tax Trap for Small C Corps

April 25th, 2012 admin

If you own a small business, and you started operations in the last 20 years or so, chances are you are an “S Corporation”, or an “LLC” (Limited Liability Company). These forms of entities are popular because they are “pass through” entities, which simply means profits earned by the company are passed to the owners for tax purposes avoiding corporate level taxation altogether. (more…)

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Reasonable Compensation-Why it Matters

April 24th, 2012 admin

There has been a lot of talk lately about compensation. Executive bonuses, compensations limitations, disparity of compensation. Often it is in the context of political ideology, or basic fairness. But if you ask ten people what is a reasonable compensation for a given job, chances are you will get ten different answers.

Most of the issues you hear being discussed lately concern an unreasonably high compensation, but if you are a business owner and you are actively involved in your business, a compensation that is unreasonably low can have special significance under scrutiny of an IRS auditor.

Let’s look at a very common scenario. A bright, entrepreneurially minded person decides to start a business. Upon advice from that person’s attorney and CPA, the business is set up as a Sub-chapter “S” corporation, (usually referred to as an “S-Corp”). As a start up, the business owner decides not to take a salary, or decides to take only a small token salary until the business becomes profitable and begins generating cash.

This new business owner works countless hours, and after a lot of hard work, begins to see the fruits of his/her labor in the form of profits. Since the company is an S-Corp, these profits can be taken from the business without paying taxes on the distributions (in contrast to a C-Corp where dividends would be taxable). And these distributions, unlike wages and compensation, avoid FICA, Medicare, and in some cases local occupational taxes, so the owner sees no need in increasing his/her salary.

Seems like a no-brainer, doesn’t it? Instead of increasing the salary, just take the earnings out as distributions and avoid 15.3% in payroll taxes (7.65% paid by employee matched by employer, subject to a ceiling).

Not so fast…here’s where the IRS becomes interested in reasonable compensation.

You see, you have to pay yourself a reasonable compensation, or else the IRS can deem a portion of the distributions you take from your company wages, subject to FICA/Medicare taxes. And to make things worse, you will be levied for fines and penalties on unpaid payroll taxes, these fines and penalties being among the most punitive in the tax code.

Unfortunately, there is no safe harbor, nor is there a table where you can look up an amount which would be considered reasonable compensation. Just like the current debates about executive pay, there is an element of subjectivity in what is considered reasonable by the IRS. I always tell my clients to at least try to come up with an objective basis in determining what there salary is. There are online sites which can provide guidance, not to mention wage and salary surveys in certain geographical areas. I cannot emphasize too much the value of documentation. Formulate an objective basis of your salary (and bonus if applicable), keep written documentation on how you arrived at your salary, and be consistent. Avoid “changing the rules” from one year to the next due to business conditions, and if you feel justified in making changes in the rationale behind your salary, document it!

Note, this article deals with the reasonableness of salaries or owners in S-Corps where generally smaller is better. C-Corps have a different set if circumstances which I will be taking a look at in future articles.

Written by Steve A. Porter, CPA, CMA

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Are you an innocent spouse?

April 22nd, 2012 admin

By: Steve A. Porter, CPA, CMA

As any married person can tell you, marriage can lead to certain complications in life. And when you mix taxes and marriage, it is inevitable that problems arise from time to time.

Most married people filing US tax returns do so jointly. And checking that little box on your 1040 return that says “married, filing jointly” not only saves you a bundle in taxes, it creates a special kind of liability called “joint and several” liability. I am not an attorney, so I will let you ask your lawyer to explain what that means, but it is important that you know the IRS may look to both you and your spouse, or either one of you separately, to satisfy a tax liability.

Here’s a little true story illustrating what can happen when a person files jointly, and the marriage has, let’s just say, “communication issues.”

A lady called me, almost sobbing, telling me she received a notice from the IRS who wanted a very significant sum in back taxes, penalties, and interest. The lady had divorced a couple of years prior, and it seems her husband (ex-husband now) had been quite a gambler. So good, in fact, he had gambling winnings of $100,000.00. He had somehow kept this a secret from her, and to make matters worse, had tried to keep it a secret from the IRS. He had not reported this income.

Since she had filed jointly with her husband, the IRS came looking for the tax to both parties. They were unable to collect from the ex-husband, but the lady had a nice job, and a little savings which she wanted desperately to protect.

Not fair? No, it is not. But the good news is that the IRS does have a sense of fairness in this type of situation, and actually offers a way around the joint liability created when you sign a joint return.

It is called “innocent spouse relief”, and you can read all about it in IRS Publication 971.

To actually be an innocent spouse, you have to meet the criteria outlined in Publication 971. You must:

  • Have signed and filed a joint return with your spouse (or ex-spouse) which contained “erroneous items” which resulted in an understatement of tax liability
  • You had no knowledge or (and this is important) reason to know the item in question was erroneous
  • Taking into account all the facts and circumstances, it would be unfair to hold you liable
  • There must not have been a property transfer as part of a fraudulent scheme which defrauds either the IRS or a third party such as a creditor.

Note that you must have all four. If you meet the requirement for numbers 1 and 2, yet fail to meet number 4, you will not be eligible.

Now, things like “erroneous items” and “reason to know” are explained in further detail in Publication 971. Let’s take a look at some examples of what is considered meeting the criteria as defined by the tax code.

Erroneous Item: Broadly, these are income items which go unreported or under-reported, or deductions, tax credits, or basis calculations that are improper and result in an understated tax liability. The gambling winnings in my example above would be an example of unreported income. A deduction for a dependant that did not meet the requirements for a dependant deduction would be another example.

Actual Knowledge or Reason to Know: Actual knowledge is pretty straightforward, but “reason to know” can be subjective. In the gambling example above, let’s assume the wife often accompanied the husband to the horse track or gambling casinos, and the year in question the husband purchased an expensive vehicle with cash, would it have been reasonable to expect the wife to inquire about where the money came from? If so, there might have been a reason to know making innocent spouse relief unavailable.

Indications of unfairness: In the above example, the husband deserted the wife shortly after the gambling winnings. The wife received no benefit from the income, so it would not be fair to require her to pay taxes. But let’s say, for example, a new house was purchased with the winnings, and the wife got to live in the house, and later received proceeds from the sale of the house. In that case, there was no indication of unfairness, and the relief from tax liability would probably not be granted.

The innocent spouse relief is all about fairness. The strict letter of the “joint and several” liability created when you sign a joint tax return would otherwise punish an innocent party for something done by a spouse.

For more information, please use the contact form.

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