S Corporations and Salary Payments to Shareholders - Essay Example

Ten Tax Articles Including Middle Initial School Ten Tax Articles S Corporations and Salary Payments to Shareholders By James A. Fellows and John F. Jewell The Internal Revenue Service has the power to reclassify certain S corporation distributions as wages, an action that profoundly affects on the amount of cash shareholders ultimately receive. The Service scrupulously monitors irregularities in this area, especially salaries that approach zero. Fellows and Jewell discuss how S corporation taxpayers attempt to circumvent employment taxes through the following methods: masking distributions as wages, loans to shareholders, and income distributions to the SE. Another method used was dubbed the 530 plan, in which corporation presidents appointed themselves independent contractors. In the case of shareholder loans, the IRS requires a contract in writing that stipulates a "reasonable" interest rate and stringent terms for repayment. The authors are concerned with the tendency to pay extremely low salaries to shareholder-employees. The IRS sternly educated S corporations on the proper levels of compensation, and the distinguished tax law as applied to S corporations vs. partnerships. The courts tended to rule in favor of raising shareholder-employee wages. When S corporations are found guilty of shirking salary payments, the IRS may subsequently collect recovered FICA and FUTA taxes, interest, failure to file penalties, late deposit penalties, and negligence penalties for failing to try hard enough to adhere to the Tax Code. Among the corporate practices the courts disallowed in this matter were: agreements made in writing between the SE and the S Corporation, erroneous readings of Statute 1366, and Section 530 relief. The point of contention in these cases hinges upon how the term 'wages' is defined. Taxpayers have give themselves too much latitude in this area. When discussing these cases, the courts felt a duty to examine their financial "substancerather than their legal form." Fellows and Jewell emphasized that deviations from equitable salary payments to S corporation shareholder-employees will no longer be tolerated. The Corporate Alternative Minimum Tax in the 1990s By Stephen L. Cash and Thomas L. Dickens Although the Revenue Reconciliation Act provided an amended approach to tax calculation, Cash and Dickens point out that its repercussions are not all favorable to corporations. This tax amendment required that beginning in 1990, the Alternative Minimum Tax (AMT) would be figured from adjusted current earnings, rather than regular taxable income. Further, taxpayers must figure Adjusted Current Earnings (ACE) each year as a prerequisite to applying the AMT. Deductions to Adjusted Current Earnings that decrease profits and earnings, such as federal taxes and dividends, are disallowed because they are not subtracted when AMTI is calculated. An alternative minimum tax depreciation calculation depends on several factors, such as when a particular item was first used. Two methods used are the 150% declining balance technique and the double declining technique. Cash and Dickens emphasize that depreciation is the most important "special rule" in figuring Adjusted Current Earnings. The Alternative Depreciation System (ADS) is used for all three of "regular tax purposes," Adjusted Current Earnings and Alternative minimum Tax. Choosing the Alternative Depreciation System can be a boon to corporations who are required to pay the Alternative Minimum Tax every year. ADS is also helpful to those companies who do not possess the time or money to make complex alternate calculations. Deferring taxes and accelerating deductions are both desirable privileges for corporate taxpayers, for obvious reasons. It seems counterintuitive, but the authors suggest reversing these behaviors. Income should be declared in years qualifying for a 20% tax rate, and deductions put off until the corporation reaches a 38% tax rate. On the whole, the new law handles adjustments more fairly than previous laws in effect. If a corporation's effects were first used beginning on January 1, 1987, their depreciation could affect taxable income either positively or negatively. Corporations must adjust their net minimum tax and subtract prior year credits to arrive at their tax credit. Evaluating Limited Partnership Investment By William Jordan and William Hillison Jordan and Hillison lay out the basics of LPs before editorializing about their relative merits. The authors urge caution when engaging in limited partnership investments. They also compare stocks to limited partnerships, with limited partnerships showing a number of distinct disadvantages: the lack of secondary markets for performance comparison, expense and nuisance value, lack of GAAP earnings performance data, illiquidity, stratospheric fees, negligible tax benefits and income diversion into debt. Further, a large portion of the profits is often drained in the process of fulfilling ERISA requirements. It would not be too much of a stretch to say that Jordan and Hillison feel that some limited partnerships and the brokers who sell them are swindling their investors. Typical claims by salespeople are that they carry little risk, are a viable portfolio substitute to CD's, and that they are a perfect retirement investment. On top of that, general partners often enjoy management control without the risks of the limited partners. Some of the more outrageous scenarios enacted by general partners are: taking ten percent without having invested any of their own capital, skewing limited partner profits lower and losses higher, unconventional accounting methods and dishonest reporting practices. Among the steps the authors suggest to protect oneself from shady limited partnership arrangements are reading the prospectus thoroughly, examining the actual figures in the financial statement and studying the general partner's track record. The reporting practices of general partners can be rife with ambiguities. Potential investors must also determine who is accountable for liabilities and blunders in the day-to-day administration of the partnership. Jordan and Hillison suggest using the Application of Proceeds section to understand the partnership's apportionment of assets. A number of issues must be examined when considering a limited partnership investment, such as their unsuitability for many individual investors. The authors advise giving the downside much greater weight than the upside when making this decision. Master Limited Partnerships by Keith Martin Martin states that Master Limited Partnerships are formed for three basic reasons: to upgrade the value of businesses, to form an "acquisition vehicle" that can outbid rivals for "existing assets," and to limit the number of times the company is taxed. Two of the advantages of a Master Limited Partnership are that its after-tax returns are higher, and its equity capital costs are lower. Master Limited Partnerships are also effective tax shelters. Further, the partnership entity does not pay taxes-its individual partners do. Master Limited Partnerships are parallel entities to the Canadian income trust. Master Limited Partnership interests may not be publicly traded. A Master Limited Partnership must meet an important criterion: its assets must be considered eligible by IRS standards. Many domestic or foreign passive income sources are eligible, such as capital gains, dividends and rents. Further, all but ten percent of gross earned income must be eligible by the standards explained in the article. Losses are simply not a part of the equation in determining eligibility. The 90% figure is all-important, as a miscalculation means permanent Master Limited Partnership disqualification. Master Limited Partnership investments must also meet the IRS' definition of 'exhaustible.' Therefore, water, air, wind, minerals and earth are generally ineligible. However, Congress created a loophole when it ruled that performing actions upon a mineral resource do qualify. So, oil and gas refining is allowable, but refining the first end product (e.g. butane) to manufacture plastic material is not. Aside from the strict eligibility rules, there are several disadvantages to Master Limited Partnerships. In the arena of repurchase and redemption, the Master Limited Partnership operates much like a closed end fund. Secondly, Master Limited Partnerships are not of much interest to institutional investors. As in many limited partnership scenarios, the general partner receives a proportionately larger share of cash as the Master Limited Partnership's cash distributions increase. Alternative Minimum Tax Targeted Democrats Seek Fix for Middle-Class Families By Lori Montgomery At the time this article was written, the author's main point was that the Alternative Minimum Tax (AMT) in effect rescinds Bush's campaign promise that he would slash taxes for the "professional" class, who tend to be married with children. In one place in the article, the author states that by 2010, the Alternative Minimum Tax's reach will increase tenfold, to 30 million households. On another page, the number was 23 million. The original intent of the Alternative Minimum Tax was to prevent extremely wealthy taxpayers from dodging income taxes. Colloquially known as the "Blue State Tax," it has a 26% and a 28% level, and it allows fewer deductions than filing a regular tax return. Rather, there is a single "Alternative Minimum Tax exemption." Taxpayers are required to fill out a regular tax return and the Alternative Minimum Tax, and pay the higher of the two tax amounts. Democrats campaigned hard in 2006 to readjust the AMT, and the White House gave lip service to doing the same. Historically, Congress has simply upped the dollar amount that it would exempt. Fifty billion dollars was the expected price tag of the 2007 "patch." Montgomery states the cost of eliminating the AMT at one trillion dollars through 2016, although she does not reveal her sources. The Alternative Minimum Tax is very political. In effect, Bush is giving certain tax cuts (that carry benefits like credits and deductions), and taking away those benefits by imposing the Alternative Minimum Tax. So while the tax cuts have indeed reduced taxes, the Alternative Minimum Tax rates have remained high enough to negate the cuts. The end result is a worse situation for people who earn between $100,000 and half a million per year. Democrats are very vocal in denouncing the AMT in its current incarnation, stating that Bush's tax priorities are misplaced. The AMT also affects taxpayers below the $100,000 mark. Barack Obama will have a hornet's nest to deal with in the fiscal arena alone, Montgomery predicts, in the forms of Medicaire, Social Security and, of course, fixing the AMT. TEI Opposes Public Disclosure of Corporate Tax Returns By Tax Executives Institute In this 2006 letter to the Senate Finance Committee, the authors set forth various reasons why public disclosure of corporate tax returns is ill conceived. They also rebut several 'pro' arguments, namely the public's need for full corporate disclosure and enhancing taxpayer behavior in terms of obeying tax laws. They hint that the full disclosure the government seeks will actually defeat its own purpose, which is to extend the reach of Sarbanes-Oxley. Prior to 1977, returns were theoretically in the public domain, except that they were never disclosed. In 1976, after Watergate's incursions on the IRS, Congress put Section 6103 in place to reinforce taxpayer privacy. Our country has perpetuated a balancing act, continually questioning the public or an agency's right to know with personal and corporate privacy. The authors contend that no logical and coherent argument has been made in support of Public Disclosure of Corporate Tax Returns, especially none that would outweigh the need for accountant/client confidentiality. They also criticize the judgment of the IRS, stating that following up on "tips" resulting from Public Disclosure of Corporate Tax Returns would detract from more fruitful pursuits. This misuse of IRS employees' time is in direct contradiction to the stated purpose of Public Disclosure of Corporate Tax Returns, which is the prompt and efficient inspection of returns. So, the authors opine, this measure would have no upside. It would potentially cost corporations and the IRS money, time and aggravation. Here are some specific arguments against Public Disclosure of Corporate Tax Returns: 1) corporations would be the target of incompetent analysis; 2) disruption of Congress' authority to establish tax law; 3) unsettle vital corporate endeavors by giving unintentional assistance to competitors; and, 4) potential abuse of proprietary data. The authors offer a possible compromise measure by suggesting that revealing corporate monetary data will serve the twofold purpose of achieving transparency and also preserving taxpayer privacy, which is "at the core of America's tax system." Section 1231 Property: An Alternative Investment By J. Gregory Bushong, Russell H. Hereth and John C. Talbott Section 1231 is a long-standing (dating from 1940) tax law that grants advantageous tax rates for long-term investments. It provided taxpayer relief in the areas of ordinary income and capital gains. Section 1231 is a win-win option for those who wish to comply with its provisions. If one has a gain for the year, one saves on taxes. If one has a loss, one can use it to offset income. The key to understanding Section 1231 is that assets are considered at the net amount, not the gross, and therefore taxed at a lower rate. Investments that qualify for Section 1231 are: 1) any property that depreciates over time; 2) animals bought for hauling, reproduction, hunting or dairy; 3) unsown crops; and 4) competitive and legal intangibles. The holding period is a minimum of one year, and two years in the case of livestock. Interestingly, livestock are considered to be "items used in abusiness," not as assets. Changes to the tax in the late 1990s provided additional assets that qualify for Section 1231 treatment. The sale of land or homes that can be depreciated may qualify for capital gains twice. Clinton's changes abated capital gains taxes for 15% bracket payers. They only pay 10% of sales prior to May 7, 1997. This is in stark contrast to the potential of paying 40% at a particular earnings threshold. Section 1231 deals with losses in an especially advantageous manner. Rather than limiting deductible losses to $3,000, 1231 allows all net losses to be deducted. This is key to understanding the benefit of owning anything that depreciates. Net losses will offset income, thereby easing the tax burden, in some cases tenfold. In effect, according to the authors, the government's share of such losses is more than 33%. Stock losses are compared unfavorably with Section 1231 asset losses. Should the market decline, taxpayers have only the $3,000 deduction as a safety net. The authors tout section 1231 as a favorable route for those willing to engage in the investments listed above. Further, it softens the blow of losses and depreciation from such speculative assets. Their upside potential can also be attractive. Absolute Responsibility and Corporate Tax Governance By Michael D. Rashkin The author feels strongly that when it comes to professional tax preparers, 'the buck stops here.' He explains why he feels that professional ethics are a separate issue from absolute responsibility, which is just as important. He talks about corporate lapses in tax compliance (mostly inadvertent), and offers solutions for poorly organized tax departments. There are two main aspects to tax dynamics. Microtax aspects pertain to corporate projects. Macrotax aspects relate to a company's approach to tax compliance or its tax rate. Among the lapses mentioned above are: inappropriately long depreciation periods, failure to use proper IRS forms, misjudgments that cost the corporation money, and misrepresentation of documents. In some cases, someone else committed these transgressions, but the tax manager is still ultimately responsible for their impacts on the corporation. A direct benefit of the tax manager's willingness to be completely accountable for any lapses in tax compliance is the increased incentive to set up a tax department that is an error-free tax compliance machine. The tax department must undertake a detailed examination of every tax issue relevant to corporate business. The next step is to separate the issues into microtax and macrotax categories, for which specific individuals become responsible. Now more employees are absolutely accountable, and have a stake in day-to-day compliance. Establishing such a system has numerous employee benefits: heightened investment in company success, reduced likelihood of embezzlement, increased stakeholder attitude about their job function, better morale and a general sense of positive self-esteem throughout the corporation. Once the system is in place, each individual in the tax department receives a copy of the game plan. Now the department has a plan of attack to tax problems for ongoing reference. Rashkin also advises forming a committee to keep ethical standards high with respect to tax issues. One huge advantage to Rashkin's approach is an informed staff and the ability to form a united front should an audit occur. Basic Tax Concerns in Operating a Small Business By Steven C. Thompson and Randall K. Serrett This article provides tips for legally establishing a sole proprietorship, with an emphasis on taxes. The author asserts the advantages of a sole proprietorship (user-friendly and easy to establish). Thompson and Serrett elucidate such tasks as obtaining a federal employer identification number and opening a discrete business checking account. The authors emphasize that stringent recordkeeping and adherence to tax law are essential. Travel on a per diem basis (including 50% of meals and entertainment) is deductible. All income is reported on a Form C or C-EZ. Vehicles and equipment must be used half or more of the time for business operations in order to be deductible. In terms of accounting periods, most taxpayers utilize a regular calendar year. If they wish to use a fiscal year, they must justify a business reason for this. The three main methods of accounting are hybrid, accrual and cash. If one wishes to use cash accounting, one declares income as one takes it in, and deducts expenses as they are paid. An accrual technique calls for the declaration of income and expenses at the time that they are earned/billed or incurred, respectfully. This is true no matter when the income or expenses are actually collected or disbursed, in contrast to the cash method. Hybrid accounting is a two in one method, which incorporates aspects of both techniques. Thompson and Serrett stress that business expenses can only be deducted at a "reasonable" level, that hobby expenses are extensively examined by the IRS, and that entertainment and dining must be substantiated as strictly business-related. The home office deduction is a maze of confusion to the novice. If one sets up an office at home, it must be utilized "exclusively and regularly" to see consumers and clients. Starting in 1999, action of running the business also qualifies for the home office deduction, and a satellite location is also deductible. If one incurs transportation, investigative, attorney or accounting costs in researching a potential business venture, they are only deductible only if similar enterprises exist. Guiding Principles for Tax Law Transparency By the American Institute of Certified Public Accountants Today's taxpayers face "a bewildering array of ambiguities" when preparing their taxes. The American Institute of Certified Public Accountants (AICPA) defines transparency as the knowledge that a tax is in effect, its comprehensibility and the circumstances of its imposition. The AICPA feel that the complexity of taxes is unwarranted. The authors consider transparency to be essential to maintaining tax obedience, and bemoan the low priority that legislators have given it. They declare a number of dire consequences to transparency's absence. Increasing tax law simplicity goes hand in hand with enhancing its transparency. When tax laws are too complicated, payers tend to assume that they lack fairness. Citizens also assume that politicos are concealing the true nature of their tax obligations. The end result of this can be tax fraud, either inadvertent or intentional. Obscuring tax law causes other problems, such as: difficulties in tax administration, inequities, setting up roadblocks to compliance and costing everyone too much money. The article outlines four specific actions to improve transparency: 1) do not confuse the issue of payment with varying effective and sunset dates; 2) establish a uniform set of rules governing interactive provisions, and consider eliminating the Alternative Minimum Tax; 3) define terms in the same manner throughout the tax code; and 4) establish congruent exemption and deduction phaseout methods. The AICPA declares that the transparency issue has "reached a critical juncture," stating that tax law is almost impossible to understand. This situation leads to taxes being computed in a myriad of ways, none of them necessarily correct. Often, IRS agents have computation dilemmas as well. Current tax laws should be revised and simplified, and future laws should possess greater transparency. Read More