SOME BREAKING NEWS FOR S CORPORATIONS-> “What, a Potential 15% Tax Increase?”

There were a bunch of rumors spread among the accounting community recently that the IRS has eliminated the capability for execs who operate their business as an S Co. to get distributions from their corporations instead of a wage or income.

On May 28th, 2010, The House passed the North American Roles and Closing Tax Loopholes Act of 2010 which has a provision that proposes to raise over $11 billion by tacking on payroll taxes to certain service pros who now split earnings as salary and draws (Ihope this is you!).  And by certain service pros, Congress particularly means those in “health, law, lobbying, engineering, design, accounting, actuarial science, performing humanities, consulting, athletics, investment recommendation or management, or brokerage” services.  If this change becomes law, it can add a 15.3% surcharge to the distribution portion of the earnings that S Corp Firm owners pay themselves. The Senate has taken this issue up in its June session.

S Corp Firms are entities where the net revenue from the company passes to the investors and gets taxed at the stockholders questionable rate of taxation.  S Enterprise owners typically receive revenue from their enterprises in 2 forms:. * An income or wage (W-2) and * A distribution (K-1).

The income/wage revenue element is subject to social security tax, medicare tax and unemployment taxes.

The distribution element none-the-less isn’t subject to these payroll taxes, which in several cases permits the entrepreneur to avoid 15% or even more in payroll taxes.  The govt wants the payroll tax bucks linked with an income and the pro wants to maximize the distribution portion of their revenue from the S Corporation to save payroll tax dollars.  Though used widely in tax planning, this tactic has lately been dubbed the “John Edwards loophole” as the previous presidential contender used it to pay himself millions from his S firm.

Edwards paid himself a $360,000 income from his S corporation, but then took a further $26 million from the firm that was subjected to revenue taxes, although not work taxes.  The loophole which is totally legal likely saved Edwards at least $500,000 in taxes. (I hope you read that example again if you are not grasping this strategy)

So what should execs do today who are probably impacted by this change?  At that point it is a ‘wait and see ‘ issue on the law. S Enterprise owners must nevertheless, take fast steps to get in accordance with the present laws relative to the compensation they receive from their enterprises. The IRS needs S Enterprise owners to pay themselves a fair income from their business.  Sadly, there is not any clear standard from the IRS the entrepreneur can rely on to make this determination.

The IRS does offer some steering in its audit manual that covers this issue and they have listed these factors the auditor should gauge when deciding the reasonableness of an employee’s compensation:

The employee’s contribution to the profit making of the business.

The time gave by the worker to the business.

The business conditions generally and regionally.

The personality and quantity of responsibility of the employee.

The time of the year when compensation is determined.

The relationship of the stockholder/officer’s compensation to stock holdings (ratio).

The amount paid by similar enterprises in similar areas to similarly qualified workers for similar services.

You could be asking why it is so crucial to address this compensation issue today outside the contemporary House legislation that just passed.  The rationale is that the IRS has identified this issue as an important area for increased enforcement which interprets into higher probabilities of audit.  The Service has upgraded its PC selection technique where it can electronically compare the quantity of officer compensation reported on the tax estimate with the quantity of distributions the stockholder receives.  Pros with S Corporations that pay themselves an insignificant income are going to get selected for audit.  Additionally, the IRS in March of this year began a 3 year work tax audit program where six thousand companies will be at random selected for audit particularly targeting work tax issues.

We haven’t seen these sorts of audits in nearly twenty years.  Reasonable compensation issues have been in public identified as one of the key areas of audit stress by the Service in this program.  And eventually, there are many tax court cases matriculating thru the system where the IRS is making an attempt to re-characterize distributions as wage compensation.

So far, they’ve been successful in these legal efforts.

Due to the increased stress on work tax issues by the Service, firms must take the following speedy steps to guarantee their compensation formulas are in compliance:

(a) Document the compensation schedule in your company records

(b) S Companies should hold a board meeting at the start of the year with resolutions prepared that approve the compensatory plan for the officials

(c) Pros should pay themselves a fair income on the same cycle that their staff employees are paid on

(d) No more grossing up the salary at year end (which I have regularly seen happen in medical care practices)

Executives ought to have a compensation study performed that identifies what other similar professionals are being paid with consideration given to all of these factors.

Amount to time the pro devotes to the practice.

Whether the pro acts in a handling capacity or actually performs the work.

The final analysis is that across all levels of govt we are in an environment of increased regulation and enforcement.

For the pro that suggests higher revenue taxes, increased probabilities of audit and higher degrees of scrutiny in all areas of business.

With proper planning, many of the issues we face can be controlled or mitigated.  Please feel free to call my office at 502-713-6232 for a complementary consultation of how your particular compensation package fits into the various rules and guidelines.  Further examination of your business not only may help your business better sustain its compensation plan; it may also help you take advantage of other compensation arrangements and opportunities.

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