The IRS Targets Income Tricks
online.wsj.com
online.wsj.com
This is complicated by the fact that, if the tax code were a spec, it would have some requirements which were contradictory and very many interactions whose behavior was totally undefined.
For example, BCC has a fairly similar issue: if the profits are earned income received for the value of my services as an engineer/etc, then they're subject to a generous exclusion since I was physically in Japan when I earned them (foreign earned income exemption, form 2555). If they're unearned income -- that is, if the business is generating profits above the fair market value of the time I am investing -- then they are not subject to that exclusion and I owe the IRS a few thousand extra. On a separate axis, they may not be attributable to the business at all, but as a result of sale of real property, depending on whether the computer software counts as personal property or not, which apparently turns on the degree of support/customization I offer and the mood of the examining IRS clerk. If they aren't attributable to the business and are a sale of real property, then they are excludable, as long as the transaction is not sourced to the United States. Sales of real property are sourced where the transaction physically takes place... but the IRS literally has no opinion on where that is for sales of downloadable software. (I asked. They said "Write up your reasoning with your tax form. If we don't bill you, you're good.") If they are not real property, they may be a sale of computer licenses, which are arguably a source of royalties, which could be subject to a US/Japan tax treaty provision which overrides some of these rules but not others.
The above is not tax advice. Don't even ask about the Japanese side -- I have a few more weeks to figure that mind-meltingness yet.
I'm both licensed and experienced in the tax field.
This is a very clear issue actually and I'm not sure why there is so much confusion and I'd disagree with calling this tax plan a "trick."
It is a legally sound tax plan with a justified theory. You are allowed to exempt a portion of your income from payroll taxes because they are "corporation distributions." Corporate distributions or dividends are not taxed as earned income because they are considered passive investment income. An S-Corp is a corporation that abides under a specific subset of rules within the IRC's Corporation Regulations, thus it is for all legal purposes a regular corporation with certain special rules.
A reasonable salary is a fairly straight forward question. The IRS won't nitpick with you on silly numbers as long as you fit within the range. Obviously, for every position there is a high and low salary range, so as long as you fit within that range the IRS will leave you alone.
The CPA is an idiot because he underpaid himself below market rates to the point where he couldn't justify his position under any reasonable defense.
If you were developer, then you would be paid anywhere from 40k to 250k+ depending on your company, position and experience. Thus, you could potentially pay yourself 40k in reasonable salaries if you owned an S-Corp and take the rest as a dividend. As long as you are able to provide "comps or comparable salaries" to positions with equitable responsibilities and experience in your local region.
The important thing to remember is to be reasonable.
I'm a full-time tax accountant, so this is coming from years of experience in the field with direct contact with auditors from the federal and state levels. They won't come knocking unless you were being a greedy idiot because like the article states it's expensive for the government to audit someone, so when they do audit you it has to be a profitable venture (thus, they usually audit the sure-thing losers).
If you want to reinvest into the company, then you'd have to pay taxes on the distributed income and then put the after tax money back into the business, which would increase your tax basis in the company. This would allow you to take net operating losses in the future as well as help you if you ever sell the company.
Hope that helps. Keeping money in the bank won't help you in this situation.
If an S-Corp makes money, it is assumed that the earnings are distributed and thus both personal income tax (on the entire earnings amount) as well as payroll taxes (on the reasonable wage) have to be paid.
Or:
If an S-Corp makes money, it is assumed that the earnings are distributed and the personal income tax has to be paid (on the entire earnings amount), but payroll taxes don't need to be paid.
Reasonable wages are NOT corporate distributions, they're simply wages paid by the corporation and deducted as an expense. The payroll taxes would be paid on the amount that you deem wages through the corporation. Please note, payroll taxes are also deductible. hope this helps
So how does someone like Steve Jobs get away with making a $1 annual salary without being charged with tax evasion? It seems like he's found a way to avoid paying into the social security and workmen's comp system.
What am I missing? Is it only legal to dodge withholdings in a c-corp?
The IRS does not give out much guidance on the definition of "reasonable salary" but has provided guidance on what is /not/ reasonable.
In this case the IRS evaluated the company's return and decided that his salary was less that reasonable and as such they went after him and got him to pay more tax.
This rule does not apply to C Corporations.
The C corp cost me a little more in terms of the deductions, but was a big win because when I set it up many years ago I put in the bylaws a medical provision such that any full-time employee would have health coverage (up to a limit) including health insurance premiums. This, due to the very high cost of health insurance, was a big win, as these are a business expense.
Were I to do it again, I would probably do LLC with the new way that health care is taken care of.
Thus, there is no issue like there is with the S-corp, because any money taken out of the corporation is done through payroll.
In other words, trying to skirt payroll taxes with a C-corp is going to end up with you paying more taxes than doing no hack. Hence, why the IRS rule only applies to S-corps which pass on their income and are not subject to corporate taxes.
Steve jobs effectively pays a 45% federal tax rate on income (35% corp on apple's income and then 15% long term cap gains on any shares he sells) -- so the IRS really doesn't care.
What would bother the IRS is that capital gains distributions are taxed at a different, lower rate than standard income, so taking distributions instead of income could reduce the total amount owed to the IRS.
(I'm not an accountant - if someone could verify or refute this, that would be nice)
His $1 salary is exactly that. A token amount paid by Apple for his work. It cannot be $0, otherwise he wouldn't be considered an employee and wouldn't be entitled to bonuses, stock options, insurance, etc. The fact that he is taking a $1 and tying all of his income to options, bonuses, perks means that he firmly believes his impact to the company will be rewarded - and it has, rightfully so. By taking a $1 salary, you are saying to the shareholders (world) that you believe so firmly in the company, that, you'll earn your income the same way a shareholder would - through the growth in stock price, etc. He does have to pay taxes on personal use of the corporate jets, and other benefits. I can't really imagine his situation being so dire that any social security income he could get would have any material impact on his life. We also don't know what the nature of his contributions were years ago.
Paying too little and taking out too much profit is actually tied to a separate issue. If one runs an S-Corp and is in the typical feast and famine cycle, i.e lots of work, bill lots of money, work slows down, time for lots of sales because there is no work, here comes work again, then, the IRS could say that you took $x+y during the time when you were cash-flush, and $x when you were in your income slump, making $y a dividend and taxed as such. In many cases, dividend income is taxed at a higher rate than personal income until you hit a certain income (I believe $373k/year or so and in 2013, $171k or so). If you earn less than those amounts, dividends are taxed more heavily than normal income.
A C-corp is its own financial entity. It pays its own taxes, has a separate tax structure. If you wanted to pay yourself a $1 salary, you could. Then, any money you take out of the company could be taxed as a dividend, you would have to assume 100% control of your retirement, probably wouldn't be eligible for Medicare after you retire, but, there isn't anything illegal there.
http://www.irs.gov/businesses/small/article/0,,id=101038,00....
Publication 535, mentioned further down under reasonable compensation talks further about how income is qualified.
Basically, if you pay yourself $8k/month, and in July have a really great month and pay yourself $40k, the IRS could determine that the $32k you gave yourself is a distribution of profit, and therefore a dividend. Even paying your taxes as if that was taken as a wage could end up being scrutinized by the IRS. If the IRS determines that your wage fluctuates as much as your profit does, and you're audited, you could have an issue.
Lets say you run a consulting company, pay yourself $5k/month, write an IPhone app, sell $200k, hand yourself $200k right there, it is possible that the IRS could take that view. The difference in taxes on $200k of income versus a dividend is 2% or $4000. If that is greater than 10% of the amount you owe at the end of the year, you could be subject to underpayment penalties of another few hundred. In the fictional $32k, the underpayment of tax would be $3200.
I'm not an accountant, but, if you run into any of these situations, you need to know when to talk with an accountant. Even thinking that you paid the proper tax is something best left to someone that does that for a living. And if you're going to find an accountant, do it in October.. give them your numbers for the current year and what you're projecting for the rest of the year and give them time. You still have room to maneuver a bit more than talking to him on March 14th when the forms are due March 15th. Tax planning is almost as important as tax filing.
Note: yes, I was audited due to the above situation - prior to having an accountant. Ironically, it was a contract with the Navy that did it - I thought, finally, I made this money, I am going to pay myself for all of the hard work I put into this and reward myself for the last two years of subsistance living. After all was said and done, the penalties and accountant fees were grossly disproportionate to the $2100 in underpaid taxes.
It was my understanding, confirmed by your link, that dividends are either taxed as ordinary income or at a maximum of 15% in case of qualified dividends.
You seem like you know what you're talking about so am I missing something?
If you are given shares in a company after the initial date, I don't know if that resets the calendar, prorates it, etc.
In my case, as the sole shareholder of a closely held Maryland S-Corp, the IRS deemed the cash payment to be a qualified dividend from a company that was 7 months old, therefore, 35%. Overall, it took roughly 2.5 years and about $7k in accountant fees to reconstruct my bad bookkeeping and deal with the IRS, $1.5k in interest and penalties for an unpaid $2100 tax liability.
Again, if your income ever goes crazy for whatever reason, talk with an accountant.
In the USA, even if you get a private ruling, the IRS can decide to renege on their advice at any time, and investigate you and charge you, making you pay penalties and fines for following their own advice.
These ambiguities and "tricks" could be cleared up with simple guidelines backed up by such private rulings; however that would not be in the best interest of our "gotcha now!" system of taxation.
You're supposed to pay "use tax" on those, which for some reason is always equal to the sales tax you think you avoided. So it's still evasion rather than gaming.
Here's my favoured solution: the US Government spent $3.6 trillion this year. There are 280 million people living there. Therefore, Federal tax should be a flat $12,857 per person.
For the average income earner, this is about the same as they're already paying. For those earning more, they find they're incentivised to work harder, since every dollar they earn beyond that point is entirely their own. And for those earning less... well, it's the kick in the butt that they need to start working harder too.
Not too easy to game that system, is it?
I'm all for the idea of simplifying tax systems, but your idea doesn't remotely work.
Ex: Have you ever wondered why supermarkets are designed the way they are? Tax is the reason why every major supermarket redesigned their layout years ago. There is a landmark case that argues whether a snickers bar is considered food or candy. Two categories with different tax rates. In the end the judge stated that candy is anything sold at the register counter and food is anything held within the isles.'
Simplification is an ideal that never pans out because we're always going to look for the loophole and its our own ingenuity that made the current IRC so complicated. Everything starts out simple until life gets a hold of it.
S-Corps work under the general premise that it's just like you, if you were a corporation. So if you don't spend all the income in your business in the year, you owe income tax on what remains. If you have plenty of profits, you write yourself a regular W-2 paycheck. At the end of the year, whatever you don't spend as a legitimate business expense -- even if it's exclusively for business purposes -- is taxed at the same rate as if you had spent the money on whiskey and hookers.
Case in point: there is a huge difference between a high-income wage earner who uses S-Corp status for maximum flexibility and the local beautician or mechanic who does the same thing. Lots of independents who are S-Corps have highly volatile income: if you get a client that writes you a check for 50K in January that might be the last income those guys see for that year. So those guys have to make a difficult business decision as to what to do with the money, and the most logical thing to do is to pay business expenses as needed and withdraw the rest as cash disbursements only as a last result. Writing yourself a W-2 paycheck when you're not sure of future income is basically taking away spending money from the business for no logical reason. As I understand it, the system is designed this way on purpose: tough times allow S-Corps to ride on profits and re-tool for the good times. Good times S-Corps work just like "regular" businesses.
So for small folks with highly-volatile income, being able to move funds around is the only thing sometimes that keeps them afloat. Unfortunately, there are a lot of guys making 400K a year or more who pay themselves a salary of $20K and take the rest as cash disbursements (thereby avoiding paying themselves as W-2 employees mostly altogether)
The reason the tax code is such a mess is that folks get mad at one bunch or another that they think are not acting fairly, so they punish them -- usually punishing many more than the original target. Or politicians want extra votes, so they make an exception for certain people -- usually providing exceptions to hidden interests and creating perverse incentives. 60 years of this and you have a complete disaster.
So yes, by all means make folks pay their share, just be aware that the guy you read about in the paper isn't necessarily the average guy. It's not an "income trick" if it helps the economy grow.
If he had just paid himself fair market he would still have come out ahead and not had to deal with the IRS.
If you'd like to know why it's "fair" for people to be allowed to pay income tax and not FICA tax on profit, then you need to look at the C corporation code. Under this system, the corporation pays a corporate income tax, and then can pay profits to its shareholders as dividends, which are then also subject to a second tax. You'll note that there is no payroll tax in this system. The purpose of an S-corporation is to avoid this "double taxation" for very small companies and instead use the personal income tax code, which may be (but is not necessarily) cheaper for the shareholder. This is not a loophole: it is by design.
It is also worth noting that just because the taxes are paid through the personal income tax code, that doesn't mean that person received that profit as a cash distribution. That money may very well be put to a different purpose, e.g. investing in the business in some way which is not yet tax deductible (like a large capital purchase), in the bank as float, or invested in some way.
In the case mentioned in the article, I certainly agree the owner was not paying himself enough by W-2 for his services, particularly if he was the sole employee and otherwise received that income as a cash distribution. He is obviously an experienced CPA who would be paid much more on the open market, and as a CPA, he should have known better.
The prevailing market wages for beauticians and mechanics are so low that that benefit of evading FICA is marginal. S-Corp owners are rarely audited period, but here you ask us to consider that enforcement of the tax code might focus on them. Of course it doesn't.
Moreover, you've conjured up this issue of income flexibility, the idea that feast-or-famine will cause people to need irregular salaries. But that's not an issue at all. You can pay yourself an irregular salary. Just make sure your quarterly estimated tax payments treat most of it as payroll. The only time this S-Corp rule becomes an issue is when you explicitly invoke it to avoid FICA. Don't do that.
It is not difficult to avoid the problem this article talks about: unless your salary approaches the FICA cap (last year it was just shy of 100k), don't pay yourself a significant fraction of your total income in distros. What makes this a particularly easy rule of thumb to follow is that it's exactly what you would do anyways if you didn't know about the S-Corp loophole.
So if everyone is supposed to pretend it doesn't exist, why does it exist?
Is the US the only country in the world where 2 to 3 percent of our GDP goes into tax preparation?
(Outsourced PAYE administration costs about £20 per month for a very small company.)
It gets more complicated when you can't do taxes through PAYE for any reason - unearned income, dividends, directorships etc.
My own taxes as a director of two firms subject partially to mandatory PAYE on some of my income are a US-level nightmare and once you are out of the 'simple system' getting back into it takes years.
That said, the government is talking about moving to a model whereby you don't have to submit a return unless you specifically want to claim some deductions. This is more like the UK model.
As for the US being the laughing stock - I don't know if I would choose those words, but I do think the IRS needs its wings clipped by foreign governments. The whole W8BEN form thing is ridiculous (so tempted to put F.YOU IRS as my contact details) as is the mind-boggling fact that the only way to not file a return in the USA is to renounce your citizenship (and good luck visiting your relatives after that!).
The myriad of local, state and federal taxes, forms, rulings and corporate structures - well, I do wonder how much GDP is lost in paper shuffling. It can't be insignificant.
Personally, I would have the tax laws in most countries scrapped and replaced with flat-banded taxes with zero exemptions. The tax rates would be lower to make up for the lost deductions, but in general, if you earnt X, you'd be up for taxes of Y. Corporations would be kept for their original purpose of limited liability rather than taxation structures. As noted above, it's all the special interests that get in, and, well, anyone who was tried to selectively reward children will know the impossobility of 'fair' once selective rewards and exemptions are introduced.
I wouldn't consider myself the most knowledgeable on this issue but I think there's an argument for a system that doesn't tax certain basis necessities and offers compensation to the poor to allow for more than just an existence.
S corps (and AFAIK LLCs) are supposed to have "pass through" taxation. I think it's fair that all income (whether salary or profit distributions) from S Corp is treated as regular W-2 income.
If you don't care about the simplicity that "pass through" offers, register a C-corp.
In the end, the payroll tax savings are not that great for a small Sub-S. And as you get older, toward retirement, if you pay yourself too low, you take a big hit on SSA benefit payments (which are based on your latest 40 qtrs).
The biggest bang for the PIA effort is if to can write off a vehicle purchase through a Section 179 deduction, and various other hardware purchases.
The fact of the matter is, as a member of the workforce, you owe FICA on your compensation. This isn't a subject of dispute. The IRS says you do, the courts say you do, your accountants will say you do. This issue comes up on HN roughly once a year, and the story has never changed.
Again, payroll tax savings (on the income/distribution differential) does not usually add up to that much money.
I could only find this worksheet online: http://ssa.gov/pubs/10070.html
And under "Estimating your Social Security retirement benefit" your payments appears to be based on your highest index earnings over 35 years.
If the benefits are provided by the S-corp to employees (i.e., to you), I don't think the question arises. The money used to buy the employees' insurance is removed from the profits, so it won't be part of distributed profits. Since tax is only on income, you won't pay taxes on insurance.
> The federal government does not recognize an LLC as a classification for federal tax purposes. An LLC business entity must file as a corporation, partnership or sole proprietorship tax return.
As for your suggestion that all pass-through income is W-2 income - that would never work. It implies that all business "profits" were paid to its shareholders (that's what payroll / W-2 income is). A cash distribution to its owner is not the only thing a company chooses to do with its profits!
Opting to be taxed as a coporation (or C-corp) avoids all these problems (at the expense of "double taxation").