IRS targets S corporation tax savings

The Wall Street Journal reports on a recent court case, David E. Watson P.C. v. U.S., in which the IRS took on an accountant-taxpayer for not paying himself enough salary as an employee of the subchapter S corporation he co-owned:

For Sub-S owners, this issue isn't going away. Last year it even turned up in legislation, when the House passed a provision that would have subjected all profits of shareholder/employees of personal-service firms—such as accounting, law and consulting firms—to payroll taxes. The measure died in the Senate, but the IRS would likely welcome its return. Cases like Mr. Watson's are expensive for the agency to litigate because each turns on individual circumstances.

Recent IRS statistics suggest why the agency might focus on Sub-S pay. Over the past decade and a half, when executive paychecks exploded, the salaries of Sub-S owners declined as a percentage of total income, from 52% in 1995 to 39% in 2007, according to the latest data available. (The remaining income is taxable to the owners as well, but doesn't incur payroll taxes.) During the same 12-year period, Sub-S income doubled, while salaries increased only 26%. The average pay for a Sub-S owner was recently was $38,400, according to Martin Sullivan, an expert with Tax Analysts, a nonprofit publisher near Washington.

Tom Ochsenschlager, former head of tax for the American Institute of CPAs, says pay and payroll tax issues are a frequent source of friction with clients: "Sometimes you have to take them to the woodshed and say, 'You need to report more income as pay for personal services."'

What is a fair ratio of profits to pay? There isn't one answer, experts say. A company with substantial capital or assets, such as a manufacturer, often is able to justify lower pay than one selling personal services like a law or accounting firm. Says Mr. Willens: "I would tell a client that for personal services, 70% would be the absolute floor and might not get the job done," he says.

Read more about S corporation tax savings.

Social Security Payroll Tax Holiday 2011

For 2011 only, there is a minor payroll tax holiday, where the employee half of Social Security tax will be paid out of the U.S. federal government's general fund, instead of deducted from employees' paychecks. This is part of the overall tax compromise bill, which Congress passed, extending the Bush tax cuts for two years, as well as adding this tax cut.

Employees will pay 4.2% of their wage earnings up to the $106,800 cap, instead of the normal 6.2% rate. Employers still pay their full half (6.2%). The self-employed, who normally pay both halves of the Social Security tax through the self-employment tax, will pay a combined rate of 10.4% (the employer's 6.2%, plus the employee's 4.2% rates).

To a minor extent, this limited payroll tax holiday - which is designed to spur consumer spending - will ameliorate some of the benefits of S corporation payroll tax savings.

Tax Increases Expected by 2011

Higher Taxes Are Coming. Are You Prepared? Wall Street Journal, September 13, 2009:

As the recession and bailout have pushed this year's federal budget deficit to an unheard-of $1.6 trillion, an unpleasant reality has dawned: Taxes are going up. The only questions are when, how much, and for whom?

The answers depend on the shifting sands of wealth politics and the scope of health-care revision. "But everybody thinks that by 2011 tax rates will be higher, at least for those with higher incomes," says Thomas Ochsenschlager, a tax official at the American Institute of Certified Public Accountants.

This certainty turns traditional tax-planning logic upside-down. Taxpayers have long been advised to defer taxes as long as possible, especially by making contributions to tax-sheltered IRAs and 401(k)s or holding assets for years in order to postpone realizing gains.

Now taxpayers should reconsider this rule. The current top capital-gains rate of 15% on most assets is the lowest in living memory and the Obama administration has proposed raising it to 20%. Another proposal might tack on a 4.5% surtax for the wealthiest taxpayers. So it may make sense to realize long-term gains now, says Robert Gordon, who advises clients on sophisticated tax matters at Twenty-First Securities in New York....

See also: Barack Obama's Tax Policies

How to Avoid an IRS Tax Audit: Incorporate Your Small Business

One tip for Dodging a Tax Audit, per the Wall Street Journal's reporting: Incorporate. The WSJ reports that the IRS continues to target Schedule C filers for tax audits and additionally notes that the IRS will sometimes act on an anoymous tip regarding a taxpayer's non-compliance with U.S. tax law.

[T]he overall audit rate this year is likely to remain about the same as last year, says Linda Stiff, IRS deputy commissioner for services and enforcement. But officials are likely to continue their emphasis on high-income taxpayers. Your chances of getting audited are especially high if you work for yourself, file what's known as a Schedule C form for sole proprietors and deal in large amounts of cash. IRS research has shown especially large amounts of noncompliance among this group.

"Like Willie Sutton said about banks, the IRS is looking at high-income, self-employed Schedule C filers because that's where the money is," says Martin Laffer, a certified public accountant at Laffer & Gottlieb in Beverly Hills, Calif. For example, he says one of his clients being audited owns several retail stores and also is a consultant.

See also:

Time to Incorporate?
California incorporation

IRS Increases Standard Mileage Rate

The IRS has announced that, effective July 1, 2008, the standard mileage rate will increase from 50.5 cents per business mile to 58.5 per business mile. The change is in recognition of higher gasoline costs.

The medical and moving rate also increases, from 19 to 20c per mile, but the charitable purposes rate of 14c remains unchanged.

The 2009 mileage rate has yet to be determined and announced.

To those Californians that wonder, if - given the higher gas costs here - the rate varies state by state, the answer is no, although, for some taxpayers in certain instances, using actual automobile operating expenses rather than the standard mileage rate is an option that should be discussed with their accountant. Employers typically reimburse employees for business miles at the IRS standard rate.

Self-Directed IRAs and Real Estate Investing

Self-directed IRAs, for real estate investing and for other purposes, are gaining in popularity. One company that offers self-directed IRA services, Pensco Trust, has put together a plain-English overview that is recommended background reading for anyone who is interested in learning more about self-directed retirement account investing options:

Pensco Trust Self-Directed IRA Top 50 FAQs [Link opens a PDF document.]