Consequences

Happy Wednesday.

Prior to my going to work in the private sector as first a business development and marketing director for a startup and then a controller, I worked with lots of small business owners.  Almost all were structured as S Corporations.  And they almost always got in trouble for unreasonable compensation issues.

Unreasonable compensation is an outlier issue.  What I mean is that, compensation is considered reasonable if it is likely someone would take that pay package in the real world.  With C Corporations, the unreasonableness comes when the owners receive W2 income that is not tied to their job performance and where it drives the Company’s profits to zero.  With S Corporations, the unreasonableness comes when owners don’t take wages and instead act as though the business earned all the profit.

An Example:

XYZ Corp. earns $1.0 Million before payroll to Owen, the 100% shareholder.  Owen wants to take all the money out of XYZ, and at the lowest possible tax cost.  This is a fair requirement and depending on C or S status, drives a particular approach and potential audit issue.

As a C Corporation, XYZ would not want to say that Owen didn’t earn a wage and issue a dividend.  First, XYZ would pay about $350,000 of tax on the $1.0 Million in profits (35%).  Then, Owen would receive the $650,000 and pay about $100,000 in personal tax on the distributions (roughly 15%, I rounded up for simplicity sake).  So, Owen would net only $550,000 out of $1.0 Million.

If XYZ paid Owen $900,000 in wages, the tax consequences are more involved but lower.  First would be the payroll taxes, which is equal to l.2% of the first $150,000 of wages for both Owen and XYZ, plus 1.45% each for medicare on all of the wage, roughly $25,000.  Total payroll taxes are $45,000.

Owen hates the idea of writing a check to the IRS in April so he has 35% withheld.  The total withholding is $315,000.

And XYZ earned a profit of about $50,000 (since the company’s payroll taxes and the wages paid are deductions) and owes about $7,500.

Total taxes when paid out in the form of wages and driving XYZ’s profits to near zero?  $370,000 and Owens net cash received is about $570,000 (rounded of course).  And if he took a dividend of the remaining $40,000 net cash in XYZ, he would net almost $600,000, or a total overall tax rate of 40%.

The IRS would prefer that XYZ have much higher profit and taxable dividends to Owen as the combined tax effect is higher.

But what if Owen elected XYZ to be an S Corporation?

Here the consequences are reversed.  If, as an S Corporation, Owen took the $900,000 in wages, the tax effect would be the same.  But, he personally would pay the tax on the $50,000 at his marginal tax rate – 35%.  The total tax bill would be closer to 45% which is not as good as being a C Corporation and paying wages.  But, what if he didn’t take a wage?

XYZ would pass the net income to Owen, $1.0 Million.  Owen would be taxed at 35%, or pay $350,000.  There would be no payroll taxes and there are no corporate taxes so that 35% is all there is.  Net cash to Owen is $650,000.

This is a far superior approach as it drives the lowest overall tax bill.  It is also fraught with serious consequences as it is likely even more “unreasonable” than the C Corporation paying everything out in wages.

Which brings me to a quick story.  A new client came to see us – a dentist.  Not surprisingly he was being audited for unreasonable compensation.  You see, the good doctor decided to pay himself $12,000 a year and claimed that his practice generated profits of almost $500,000.

His case wasn’t helped by the fact that 2 years earlier he was a sole proprietor and earned $300,000.  The year after that he was a C Corporation and paid himself $400,000.

He wanted to know what to do.  I gave him two choices.  Pay the firm $10,000 to fight with the IRS and most likely lose and have 100% of the profits taxed as wages or pay us $2,500 to negotiate a more realistic figure of about $200,000 for wages.

He wisely chose the later option.  We were actually able to make the case that a “reasonable profit” from the business was about $300,000 – taking into consideration the focus on non-dentist services offered and a return on his capital investment.  We also convinced the IRS to waive penalties and interest on the underpayment.

If (and possibly a big IF) the tax law changes for pass-through entities, this type of challenge will become even more prevalent.  So, if you own a pass-through entity, make sure your professional is looking out for your best interest, not just how much tax can be saved.  And if you would like to discuss your tax position with someone, feel free to send me a message.  Remember, pigs get fat and hogs get slaughtered.

Have a great day.

 

The Traveling Salesman

I love telling stories about the good, and not-so-good, things clients have done over the years.  Actually, to be honest, I like the not-so-good stories as they are educational and hopefully stop others from going down a path they might regret.

Part of my role is technical compliance and final reviewer of tax work.  My responsibility is to make sure that any significant tax position taken was backed up by adequate documentation and research.  I couldn’t stop clients from taking risky positions, but I could stop the firm from agreeing to dumb things that we couldn’t defend.

One tax return comes to mind.  It was a new client and I was having trouble getting my head around his small business.  It was on Schedule C and reported a loss of about $100,000.  He had a W2 for about $150,000 so was getting about 30K back in refunds.

What stood out most were two items.  Negative gross profit of $60,000 and an RV on the books which generated about $25,000 of depreciation.

Negative gross profit, by the way, comes from when you sell your product for less than the total cost of those products.  In this case, he had revenues of $12,000 and Cost of Goods sold of $72,000.

I wouldn’t sign off and the partner wanted to know what my concerns were.  I asked him if he talked to the client about his “business” and the answer was, “Not really.”

So, I was indulged and the client came in for a meeting.  I asked him to explain how his business worked.  He bought product, he told us and traveled up and down I-5 stopping at county fairs to sell his product.

Interesting.  We didn’t notice any fees for space rental at any events, though.

That’s because he parked his RV in the lot and sold on the outside.  Ok.

How many customers did the $12,000 represent?  We inquired.

One, he replied.  One client.  So what was the $4,000 of meals and entertainment?

He took this client out to dinner and to various ball games and other events because of their loyalty.

Who is this client? we asked dreading the answer.

His wife.

Yeah.  He and his wife took the summer off to travel and he bought stuff and he “sold” it to her.  Because she was such a loyal customer, he gave her a substantial discount on buying the stuff she “wanted”.  And he rewarded her loyalty with dinners and events.

Now, I know you are thinking BS, I am making this up.  I swear I am not.  Public accountants get some of the most entertaining and too-good-to-be-true stories out there.

Our main problem was that his prior accountant let him get away with it.  We suggested that he face the fact that on audit, the IRS would probably say this was a hobby (we didn’t bother to let him know it was probably outright tax fraud) and to protect the prior losses, he should shut down his business and maybe consider starting it up in 2 or more years after a cooling-down period.

He said no thank you but appreciated our advice.  He paid us for the work we did, took his “records” and went to find another tax preparer who wouldn’t be so nosey.

The moral of the story?  You may have heard the old saying that “Pigs get fat and hogs get slaughtered”.  Sometimes, it doesn’t pay to push the boundaries of acceptability.  He may never have been audited – hell he might have even been turned down by the next dozen tax preparers and decided he wasn’t going to win and dropped it – but it was still an extremely risky position to take and there was no real defense.

There are ways to make a business work while you travel.  But the odds are, the bigger the loss, the greater the risk, so documentation is vital to winning.  So, as you prepare for the end of the year and are looking to work with someone who wants to help you be successful, consider an accountant with integrity and who is willing to help you get everything right to protect you from major risks.  If you need the name of one, feel free to write me and I will send back the contact information for one or two to help you.

Have a great Tuesday.

 

Living Trusts and QSSTs

One of the tax projects that we are working on involves a couple where the husband passed away in 2012 who owned a successful small business.  As we go through the process of trying to make sure all the appropriate steps were taken, my research leads me to potential issues related to S Corporations, Living Trusts and QSST elections.  This is a simple thought experiment but the overall issue is likely to be a potential problem as baby boomer’s age and we find their estates have ownership of S Corporation stock.

Husband (H) was the owner of all the shares and owned the shares prior to his marriage to wife (W).  The S Corporations shares were titled to the living trust of Husband.  The shares, per the will, specified that half of the shares were to go to a marital trust and the other half directly to W.  The marital trust stated that W could not sell the shares and they would all go directly to their 4 children at the time of her death.

Husband passed away in 2012.  The problem beings when the 2012 return reports the S Corporation shares on the joint return which reported H as deceased and W as surviving spouse.  The Company’s tax preparer changes the name and tax id number to W’s on the 1120-s K-1 in accordance to W’s statements and their understanding of the living trust document.  All shares are now in W’s name and reported on her 1040 return as the preparer knew about the living trust arrangement.

This creates lots of problems.  The will stated how the assets were to be divided and from the look of it, it wasn’t handled correctly.  Possibly, the shares transferred directly to W through the living trust would be valid, but what about the shares that were supposed to be transferred to the marital trust?  If the shares are owned by the marital trust, was a Qualified Subchapter S Trust (QSST) election filed with the IRS?  Can the marital trust even qualify as a QSST because of the successor beneficiaries listed in the will?

If the QSST is considered invalid or isn’t made, then the S election is terminated.  Without a valid S election, the income is no longer passed to the shareholders.  Income is first taxed at the corporate level and then the dividends – the S Corporation distributions – are taxed to the shareholder at time of receipt.

The tax consequences can be significant.  Let’s say that the Company made $1.0 Million in taxable income as an S Corporation.  It distributes all $1.0 Million to the shareholders.  The shareholders, W in this case, would pay about $390,000 in tax.  Without a valid S election, the Corporation ends up being taxed on that $1.0 Million, which costs about $350,000 and then W is taxed on the $1.0 Million in dividends, which costs her personally about $200,000.

$550,000 in taxes compared to $390,000.  And worse, the Company owed the tax but it may have distributed all its available cash, leaving W to wonder how she is going to pay the tax bill.  And if she used the remaining $610,000 to pay her living expenses, she can’t even loan the money back to the Company to pay its tax bill.

And remember, this is for the last 5 years, so almost $800,000 in additional taxes could be owed.

If you own S Corporation stock and have it titled to your living trust, you may want to talk with your estate planning attorney or CPA to make sure instructions are available to make sure something like this doesn’t happen.  Make sure your will aligns with your living trust and takes into consideration the fact that some assets have special rules about transfers to trusts.  And if you need the name of a practicing attorney or accountant who specializes in trusts and estates in Oregon or Washington, let me know and I will send you a few contacts you can discuss your concerns with.  Proper planning will make sure your wishes are carried out well and your beneficiaries receive what you planned for them.

Have a great weekend.

Clarity

Where to start.

Depending on which talking head you prefer, the republican control of the legislative, executive and possible the courts will either ruin our great country or propel it into an amazing future.  Just like when the democrats had control, your favorite pundit predicted the death of our great country or the beginning of a new era.

The truth, and clarity, always lies in the middle.

These are trying times for all of us, especially those of us who are not ideological purists.  I personally remain unmoved by the arguments put forth by either side in the current handwringing or jubilant flag waiving of the non-centrist.  But this is a time to take stock and carefully start preparing for things to unravel.

On tax reform.

The real problem is, when the legislative and executive branches change hands, as they inevitably will, do you think that these so-called tax reforms will stand? Will we keep a 20% tax on corporate earnings?  Probably not.  Will we keep the unnecessarily complex “pass-through” tax law?  Probably not. Will individual tax brackets go back to more progressive?  Most likely.

Within 10 years.

When I first started in public accounting a partner took me along to a lunch with a long-time client.  He harvested walnuts.  The most striking thing he said at this lunch was that the crops he is harvesting today comes from trees planted 15 or more years ago.  It takes that long to produce mature enough nuts to take to market.

Consider that.  Someone had to be willing to invest day 1 knowing that there would be no pay back for 15 years.  Believe it or not, that is what strong companies do, they plant, the tend, and then they harvest.  What they need is things to remain somewhat consistent and predictable.  But if tax laws are changing every few years, planning become impossible.  Businesses get whiplash and planning goes out the window.

On our current executive.

He is what we elected.  If you don’t like it, then think about how to address the problem.  But I will be honest, more people voting against him in 2020 in the states of California and New York will not get him voted out of office.  If he really bothers you, then you will need to move you, your family, and the 10,000 close friends you have to the mid-west.  The Elector College matters and yes, sometimes it gives us terrible results, but I think that is why it was put in place.

On jobs and economic growth.

Several years ago I read a paper on the correlation between economic growth and the increase to the labor pool.  Historically, countries tend to grow at the same pace as the participants in the labor force grows, otherwise, countries end up in either inflationary or recessionary cycles.  I believe that our labor force participation rate is growing about 2% a year.  This is the net of new entrants, retirees, immigration and emigration.  Cut immigration and the economy will grow at 1.5%.

This is a huge problem, and not just for meeting the projections in the tax bill.  Japan is a fascinating example of this.

Social security needs a certain minimum number of working adults paying into the system in order for it to receive sufficient funds to pay out claims for retirees.  If I remember my numbers, back in the 1930’s there were 8 working people for every retiree drawing social security.  Today I believe that number is about 3:1.  Again, if the ranks of retirees are growing faster than the ranks of new entrants to the labor market, we have to face the reality that this ratio could drop to 1.5:1.

Oh, and consider that wages are not growing.  That means that social security taxes, which are only on wages, is not growing.

Getting clarity is not hard.  It does, however, require a little effort to look beyond your belief system and ask hard questions.  The most effective answers always lie in the middle.  Let’s see if we can’t start having that conversation there instead of always arguing from the fringes.

Have a great day.