Wisconsin Estate Planning and Tax Law Blog

IRS Wins S-Corp Compensation Case

The case, Watson, P.C. v. U.S., was decided by an Iowa district court in December 2010.  In short, the court concluded that the S-Corporation shareholder-employee's salary of $24,000 in 2002 and 2003 was unreasonably low, and the IRS was allowed to reclassify a large amount of dividend payments made to the shareholder-employee as salary.  Thus, the reclassified dividend payments would now be subject to employment taxes, penalties and interest.  The Wall Street Journal offers a summary of the Watson case in the article, The IRS Targets Income Tricks. 

So what is the lesson to be learned from the Watson S-Corp comensation case?  First, the saying used in the first paragraph of WSJ article sums it up very well, Pigs get fed, Hogs get slaughtered.  The motiviation for business owners to classify distributions as dividends versus salary is clear.  A business owner-employee's salary is subject to both sides of Medicare and Social Security Tax.  This equates to 2.9% for Medicare and 12.4% for Social Security (Social Security tax is levied on the first $106,800 of salary) for a a total of 15.3%.  Dividends distributions are not subject to those employment taxes.  It comes as no surprise then that the IRS has taken and will continue to take a hard look at reasonable compensation for shareholder-employees.  

To adhere to the rules business owners must pay themselves a reasonable salary.  But how are we to determine was is a reasonable salary?  The IRS has provided Fact Sheet 2008-25 to assist us with this determination.  The IRS admits that there is no specific guidance provided in the Code or in the Regulations as to what is considered reasonable compensation.  Fact Sheet 2008-25 goes on to list some of the factors that courts have considered when determining whether compensation was reasonable:   

• Training and experience;
• Duties and responsibilities;
• Time and effort devoted to the business;
• Dividend history;
• Payments to non-shareholder employees;
• Timing and manner of paying bonuses to key people;
• What comparable businesses pay for similar services;
• Compensation agreements; and
• Use of a formula to determine compensation.

While the Watson ruling originates in Iowa it is noteworthy for Wisconsin business owners since it involves an interpretation of the Internal Revenue Code and the application of Federal case law.  It also clearly shows the Service's desire to eliminate the tax avoidance caused by characterizing distributions as dividends versus compensation. 

  

Two New Estate Tax Bills Introduced

The week before Thanksgiving 2009 was a busy one for some legislators with an eye on our country's estate tax system.  Through November 20, 2009 the tally of estate tax related bills has reached 20, including the two newest bills discussed below.  The eleventh month does not translate into the eleventh hour, but we are quickly approaching what we would naturally think is the last possible time to act since the estate tax as we know it is set to change dramatically on January 1, 2010.  I do not believe that the December 31, 2009 "deadline" is as much of a call to action as I once did.  In fact, it would not surprise me to see little or no action by Congress prior to the end of 2009.  If that is the case, I would not be surprised to see Congress address the estate tax issue with retroactive legislation.  I have hoped for years that our lawmakers would take a more proactive approach, but I have grown less and less confident as each month and year has passed.

With that, let's turn our attention to the latest round of entrants (bills) in the estate tax lottery.  The first bill, S. 2784, A bill to amend the Internal Revenue Code of 1986 to permanently extend the estate tax as in effect in 2009, and for other purposes, was introduced on November 17, 2009 by Sen. Thomas R. Carper (D-DE) and Sen. George V. Voinovich (R-OH).  The highlights are as follows:

• Making the $3.5 million estate tax exemption permanent and indexing it for inflation starting in 2011;
• Tax rate of 45%;
• Unification of the gift and estate tax exemptions; and
• Portability of the exemption between spouses.

Late last week Rep. Earl Pomeroy (D-ND) introduced his second estate tax related bill this year.  The most recent, H.R. 4154, Permanent Estate Tax Relief for Families, Farmers, and Small Businesses Act of 2009, was introduced on November 19, 2009.  Rep. Pomeroy's earlier bill, H.R. 436, Certain Estate Tax Relief Act of 2009, was introduced in January and has received a fair amount of attention, mostly attributable to the restrictions it places on valuation discounts.  The highlights of H.R. 4154 are as follows:

• Repeal of EGTRRA (a/k/a the 2001 Bush tax cuts)
• Making the $3.5 million estate tax exemption permanent;
• Freezing gift tax and estate tax rates at 45%
• Repeal of carryover basis rules

This is admittedly a very brief summary of the two estate tax related bills.  As always there is much more than meets the eye with new legislation.  What I take from last week's activity is that at least a few lawmakers have this issue on their radar as we near the end of November.  With the amount of time and attention that the health care bill is garnering it would be a major surprise to see any substantive movement on any estate tax bill for the foreseeable future. 

Widespread Fraud and Abuse of First Time Home Buyer Tax Credit

This item can probably best be filed under the category, "News We Expected."  As reported by the Wall Street Journal online in "Tax Credit Abuse and the Four-Year-Old Home Buyer" the Inspector General for Tax Administration, Russell George, testified before Congress today in regards to fraud and potential abuse of the home buyer tax credit.  Mr. George testimony comes at a time when the current home buyer tax credit is set to expire in less than 6 six at the end of November and with the real estate lobby pushing for an extension.

It would be fairly naive in my opinion to not anticipate that some individuals would commit tax fraud or intentional abuse the system.  I am certainly not condoning the illegal activity better known as tax fraud or tax evasion.  Reading articles highlighting fraud and abuse such as this reinforces in my mind the truism, "One bad apple spoils the barrel," except that a number of the apples in this barrel are bad, which will only hasten the spoilage of the first time home buyer tax credit.

U.S. News and World Report also published an online article titled "First-Time Home Buyer Tax Credit: All Sorts of Sketchy Claims" that discusses the fraud and abuse news as well as five things to know about the development.

Cost of Government Day - 2009

For that last couple of years I have kept an eye out for the Cost of Government Day as calculated by the Americans for Tax Reform Foundation and the Center for Fiscal Accountability.  The Cost of Government Day 2009 Report is now available.  Today, August 12, 2009, is this years Cost of Government Day.  This is 26 days later than 2008.

I am sharing this report and link because it is an interesting look at the current tax and government landscape in the U.S.  The overall views expressed in the report of on the websites above are those of the Americans for Tax Reform Foundation and the Center for Fiscal Accountability and are not necessarily my views or the firm's view.  

Wall Street Executive Bonuses: The Firestorm Rages On

I have not had the opportunity to fully research and review all of the material involved with the executive bonuses saga that has engulfed all of us in recent weeks, but I wanted to provide some brief commentary on the topic.  It is relevant to this blog because the most popular ideas currently discussed by the government involve the enactment of an excise tax on executive bonuses received after January 1, 2009.  In fact a Bill was introduced by the Rep. Charles B. Rengel (D-NY) today.  The legislation is referred to as H.R. 1586 and the full text can be found at the House Ways and Means Committee website in pdf here.  The Taxgirl has a great discussion of this bill in her post, Legislation Introduced to Tax Bonuses at 90%.

According to Reuters.com, House votes to recoup bonuses from bailed-out firms, the House overwhelming passed the Bill by a 328-93 split.  An article, House Opens Debate on Bill to Tax Wall Street Bonuses, by Martin Vaughan on CNNMoney.com , discusses some of the partisan debate on the topic including the argument from some Republicans that the Bill is unconstitutional and that more effective alternatives are available.  This article by David Stout on NYTimes.com, House Passes Heavy Tax on Bonuses for Rescued Firms, also provided a nice overview of today's events and the debates that will no doubt linger for at least a bit longer.

As I read through the New York Times article I was struck by a number of things but nothing drew my attention quick as much as the comments made by Rep. Earl Pomeroy (D-ND).  Rep. Pomeroy was as saying, “The people have said ‘no.'  In fact, they said ‘hell no, and give us our money back.’”  I am not intending to take sides in today's great debate, but I am intrigued by Pomeroy's comments for three reasons.  First, I was born and raised in North Dakota so I always get a kick out of seeing the state's long Representative in the news.  Second, until recently I have heard virtually nothing about or from Pomeroy.  Now I see his name in regards to the Wall Street Bonuses topic and he has one of the most popular proposals regarding Federal Estate Tax in H.R. 436: Certain Estate Tax Relief Act of 2009.  Third, I'm completely convinced that Pomeroy's "hell no" clearly eliminates any ambiguity as to his true feelings on the matter.  That direct, no-nonsense delivery is what I attribute to the stereotypical North Dakotan.

One other quote that I thought was noteworthy is from the Bill's sponsor Rep. Rangel.  According to FoxNews.com, Rangel said, "We figured that the local and state governments would take care of the other 10 percent."  So let there be no confusion as to the government's intentions.  While the bonus recipients may face a 90% tax at the Federal level they should also expect the states to gobble up the remaining 10%.  That's one way to recoup the TARP money I guess.