Laura Saunders for the Wall St Journal writes: Call it a one-two punch.The Internal Revenue Service has won its second clear victory in three years over a tax-cutting maneuver available to—and used by—millions of small-business owners.
In 2010, an Iowa federal court slapped down a popular move in which small-business owners underpay themselves in order to minimize Social Security and Medicare taxes, while taking compensation in other ways. On appeal, the Eighth Circuit affirmed the decision.
Earlier this month, the U.S. Tax Court sided with the agency in the case of Sean McAlary Ltd. Inc. v. Commissioner. It ruled that a Subchapter S firm whose sole owner was Mr. McAlary, a California real-estate broker, should have paid him $83,200 in wages for 2006. Instead, he was paid zero.
The court ruled that the firm owed nearly $13,700 in payroll and unemployment taxes, plus more than $4,300 in penalties, for that year. Although the case can't be cited as precedent, experts take such cases seriously.
Both Mr. McAlary and a spokesman for the IRS declined to comment on the case.
This issue is a perennial one, although it has become more important as payroll taxes have risen.
"There's a constant push and pull between small-business owners wanting their wages to be as low as possible and the IRS wanting them high," says Jeffrey Porter, a certified public accountant in Huntington, W.Va., with many small-business clients.
It is easy to see why the tension exists. Subchapter S is a highly popular format for closely held businesses, with over four million reported in 2010 tax returns, the most recent data available. Often such business owners also are employees—as Mr. McAlary was—and they owe both the employer's and employee's portion of Social Security and Medicare taxes on compensation for their services.
The rate for Social Security taxes is a flat 12.4% up to a preset cap ($113,700 this year, up from $94,200 in 2006). The Medicare tax is 2.9% on all wages, making the total bite as high as 15.3%. Federal unemployment tax adds a bit more.
Lowballing pay can lower these taxes. Many Subchapter S owners appear to do just that: In the 15 years ended in 2010, a period when executive compensation exploded, Subchapter S income increased by two-thirds while salaries rose only 16%, according to Martin Sullivan, chief economist at Tax Analysts, a nonprofit publisher near Washington.
What's more, the salaries of Subchapter S owners declined as a percentage of firm income, from 52% in 1995 to 43% in 2010. The average pay for a Subchapter S owner was $35,700, Mr. Sullivan said.
Subchapter S firms still owe income taxes on their earnings no matter how they are distributed. Every year net income "passes through" to the owners and is taxed on their individual returns, but only compensation is subject to payroll taxes.
So how much pay is enough? Clearly the answer isn't zero, as Mr. McAlary's 2006 tax return claimed. When challenged by the IRS, he said he meant to claim at least $24,000, but that his tax preparer had made an error.
Even that amount was too low, according to the decision. There isn't any strict rule determining proper pay, however, because the law treats each case according to its circumstances, using factors such as the nature of the employee's work, comparable pay elsewhere and prevailing economic conditions.
To prove its case, the IRS produced an expert who had studied compensation for real-estate agents in Southern California, and he said that $100,755 would be appropriate for Mr. McAlary's pay. The judge adjusted that to $83,200.
In practice, Mr. Porter says, the IRS usually doesn't challenge wages that are within shouting distance of the Social Security wage cap, such as the pay the Tax Court judge approved for Mr. McAlary.
Compensation doesn't have to equal net income. In Mr. McAlary's case, the final amount was about 35% of the firm's 2006 net income of $231,454.
Mr. Porter says his clients tend to go along with higher pay when he explains "the downside, which is that the IRS is aggressive on this issue."
Gerard Schreiber, a CPA who practices in Metairie, La., says it often is hard to escape "vicious" penalties in such cases. He also stresses another consequence to clients who want to minimize compensation: "With Social Security, people get payouts based on what they put in. They'll shortchange themselves if they become disabled or die leaving minor children."
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