http://www.traderstatus.com/IRSsloppy.htm
about Case: Montagne v. Commissioner, 04-4137
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Jan. 2003
Every year or so there seems to be some hot issues the IRS is looking
at. This year the amount of *salary* taken by shareholder-employees is
on the IRS hot list. This issue is not new, but seems to be one of the
items that will be looked at closer by the IRS in 2003. Not knowing how
to play the game can lead to an audit. Even knowing how to play the game
may not prevent an audit, but will go a long way to avoid additional
taxes and penalties.
Background
The issue of double taxation has long been a concern of taxpayers.
Dividends paid to shareholders of a closely held business are includible
in the shareholder's gross income and are not tax deductible. This issue
is relevant if your PR firm operates as a C corporation. The IRS loves
dividends and tries to inflict this pain on C corporations either
voluntarily or involuntarily. For many PR firms, operating as an *S*
corporation or LLC is the medicine to cure the double taxation issue.
Nevertheless, switching to an *S* corporation or LLC can be expensive
and may not be the best business model for all PR firms. In this case,
the treatment of choice is to "clean" out taxable income by paying a
bonus to the shareholder-employee(*s*).
PR firms operating as a S corporation also have compensation issues. *S*
corporations try to implement a tax-savings strategy of limiting
compensation payments to shareholder-employees. Smaller compensation
payments mean reduced liabilities for federal Social Security and
Medicare taxes. Distributions passed through to shareholder-employees
are not subject to the federal self-employment tax. Additionally, since
*S* corporation taxable income passed through to shareholder-employees
increases the tax basis of stock, distributions of corporate cash flow
can usually be received income taxfree by shareholder employees.
Reasonable compensation
The IRS will be reviewing C corporation business tax returns to assess
whether the compensation issue will reap tax dollars. Tax returns
showing high officer compensation will be targeted. The IRS will attempt
to argue that the *salary* paid was unreasonable for the services
rendered and includes a dividend element. For example, assume a
shareholder-employee's *salary* for 2002 is $800,000. The IRS could
argue that a portion of the $800,000 is a disguised dividend. If
$100,000 is considered a dividend, the shareholder-employee will still
pay tax on $800,000, but the PR firm will lose the $100,000 deduction.
How much is reasonable?
How much can be paid as *salary* without raising the IRS' eyebrows? The
position of the IRS is generally that "reasonable" compensation is equal
to the amount paid by similar employers for similar services. The IRS
has only to look at the various PR industry *salary* surveys to compile
this information.
For some closely held firms, the "eat what you can kill" theory will be
the answer. If you were a sole proprietor and earned $800,000, operating
as a C corporation and paying an $800,000 *salary* will work no matter
how much the IRS complains. Any *salary* paid should qualify as
"reasonable" as long as it does not exceed net corporate profits from
the services personally rendered.
Larger agencies
Let's say you are the CEO of a 20-person PR firm and earn $800,000. Will
this *salary* be reasonable? It may very well be; however, what if the
O'Dwyer or Council *salary* surveys indicate CEO's salaries for this
size agency are $300,000? In this case, the IRS will argue that your
*salary* was actually derived in part from the labor of other PR
professionals. In other words, you are no longer rendering all the
services yourself. The IRS, with the help of the Tax Court, is now
holding much better cards. Your chances of winning are no longer as solid.
The new medicine
The case is not as easy to cure, but certainly an ounce of prevention
can go a long way to making sure the disease does not spread. You need
to understand the questions the IRS will ask in order to arrive at what
they consider to be a reasonable *salary*. These include:
1) Your duties;
2) The amount of time required to perform those duties;
3) Your ability and accomplishments;
4) The complexity of the business;
5) The gross and net income of the bus business;
6) Your compensation history, and
7) The firm's *salary* policy for all its employees.
There are a number of steps you can take to make it more likely that the
compensation you earn will be considered "reasonable" and therefore
deductible by your corporation. For example, you can:
Use the minutes to contemporaneously document the reasons for the
amount of compensation paid. For example, if compensation is being
paid in the current year to make up for a year in which it was too
low, be sure that the minutes reflect this.
Avoid paying compensation in direct proportion to the stock owned by
the shareholders. This looks too much like a disguised dividend, and
will be treated as such by the IRS.
Keep compensation in line with what similar PR firms are paying-
e.g., *salary* offers to your executives from comparable companies-
to support what you pay if you are later questioned.
Some tax professionals' advise to pay some dividends if the business
is profitable. This avoids giving the impression that the
corporation is trying to pay out all of its profits as compensation.
Next month the issue of *S* corporations and LLCs will be discussed.
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Before you consult experts to help with your decision about which
entity is best, remember that you may get conflicting counsel
depending on whom you ask. Attorneys will often recommend the LLC,
while accountants tend to favor the S corp. "Accountants just know S
corps better and don't know LLCs as well," says Larry Ribstein, a
law professor at the University of Illinois. Attorneys, on the other
hand, are much more familiar with LLCs, he adds.
To get the most beneficial advice, recruit an attorney /and/ an
accountant, and make sure both specialize in closely held businesses
and both have experience with multiple business structures. "You
need both the legal side and the tax side," says Timen, who adds
that accountants can help with business structure but not with
liability, and vice versa for attorneys. And, of course, do your own
research–the more you know, the better you can evaluate the advice
you receive.
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The FICA tax </wiki/FICA_tax> need only be paid on employee wages
and not on distributive shares. Because FICA tax </wiki/FICA_tax> is
avoided on distributive shares, the IRS and equivalent state revenue
agencies may recategorize distributions paid to
shareholder-employees as wages if shareholder-employees are not paid
a reasonable wage for their position within the company.
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