In our research for the upcoming Lunch and Learn, we discovered something quite interesting. I thought I would work through it here and try to figure out how to help small businesses plan effectively.
As part of the potential for tax reduction is an attempt to deal with flow-through entities; that is sole proprietorships, S Corporations and LLC’s. Currently, with flow-through entities, the tax on profits is paid by the owners. The problem becomes defining profits. Let’s look at 3 companies A, B and C.
Profits and Compensation
All 3 companies make $100,000 before owner compensation. A decides to pay herself $50,000 of wages, B decides not to pay any and C pays almost all in the form of wages. The tax consequences are remarkably different.
| A | B | C | ||||
| Taxable Income Before Owner Compensation | 100,000 | 100,000 | 100,000 | |||
| Owner Compensation | 50,000 | – | 92,500 | |||
| Company Payroll Taxes | 8.0% | 4,000 | – | 7,400 | ||
| Taxable Income Passed Through | 46,000 | 100,000 | 100 | |||
| Income Tax for Owner | ||||||
| Wages | 50,000 | – | 92,500 | |||
| Taxable Income Passed Through | 46,000 | 100,000 | 100 | |||
| Taxable Income for Owner | 96,000 | 100,000 | 92,600 | |||
| Tax Liabilities | 25.0% | 24,000 | 25,000 | 23,150 | ||
| Total Taxes Paid | ||||||
| Company Payroll Taxes | 4,000 | – | 7,400 | |||
| Owner Payroll Taxes | 4,000 | – | 7,400 | |||
| Income Taxes | 24,000 | 25,000 | 23,150 | |||
| Total Taxes | 32,000 | 25,000 | 37,950 | |||
| Taxes as a Percent of Income Before Comp | 32.0% | 25.0% | 38.0% | |||
The difference between the results is the payroll taxes which every employee pays and which every employer matches. The problem is that the only statutory requirement is that “Compensation must be Reasonable”. And this has been an audit headache as the term “Reasonable Compensation” is based upon the facts and circumstances of the particular taxpayer and Company.
This difference in the tax law has been around for decades and has been left to auditors and taxpayers to argue about the term “Reasonable Compensation”. In this case, we have argued on all sides – that A’s and C’s compensation is reasonable and so is B’s. Most professionals would worry about losing in B’s position but clearly any compensation less than the amount of taxable income before owner compensation is a win for the taxpayer by reducing employment taxes.
Given that there is already this disparity and given that Congress knows about it and has elected not to touch it yet should give us all pause for concern as Congress looks at passing a substantial rewrite of the tax law to both reduce rates as well as treat Business earnings with a different tax rate.
Deemed Wages
To address this issue Congress will need to figure out a way to address owner compensation. So far, in all the proposals they use a phrase “Deemed Wages” to account for owner compensation. Randy and I have debated this and we are of the opinion that what is likely to happen is that the IRS will publish a table of expected compensation for various businesses and the owner’s compensation should be close to that in order to be considered reasonable. If an owner wants to pay differently, there should be some written justification for the position, such as minutes to the board of directors or a memo from a meeting between the owners and their representatives.
Keep in mind though, that this is one areas where is almost no guidance as it hasn’t been touched before.
This change to how small business reflects taxable income will be major. By addressing the disparity shown above, Congress will potentially eliminate an audit headache and improve compliance. It may mean that some pay more and some pay less, but it could also help give taxpayers peace of mind by addressing the unknown of “Reasonable Compensation” and reducing the risk of money spent on litigating this issue.
Accounting Clarity 