Ed. note: We’re happy to welcome tax sage Joe Kristan back to a regular posting spot in these pages. This is his first effort for us but insists that he won’t feel as though he’s truly returned until he’s trolled by Adrienne.
Megan McArdle ponders one of life’s great questions:
One of the main “real world” elements of the case for the corporate income tax, as I understand it, is that failure to impose such a tax would simply create an inviting method for evasion of individual income taxes.
The question I always have about this is: “Well, why don’t more people do this now?”
The biggest reason we don’t all corporations to dodge taxes is that it is unnecessary. People looking to nickel and dime their way to deductions long ago learned that all you need is a Schedule C to have a place to hide a deduction for your dog (“security expense”) or your girlfriend (“theft loss”). This idea is one of the foundations of the multi-level marketing industry, and was carried to spectacular lengths by a recently closed Iowa tax preparer. Megan senses the limits to this approach:
And the reason that it’s mostly pretty minor is that if you are obviously using a corporation to fund your lifestyle, then the IRS will descend upon you like a plague of deranged cicadas.
There’s something to that, even though the cicada analogy implies a nimbleness unlikely in the IRS; a herd of flesh-eating slugs would be more apt.
Still, a corporation does offer some tax-sheltering possibilities. One is that C corporations can normally use any fiscal year. By shuffling income between an individual and a corporation with a November tax year, you can, in theory, get 11 months deferral of income — at least until you are caught. Corporations have a 15% tax rate on their first $50,000 of taxable income, giving higher-bracket individuals possibilities of shifting income to a lower bracket. And C corporation shareholder-employees get some benefits unavailable elsewhere.
Yet these chiseling possibilities have serious limits. The fiscal year games require you to have real live business expenses. A Kansas City attorney who marketed such deals crashed against this requirement. Income of “personal service corporations” like law and accounting firms are taxed at a flat 35%, making them useless as a tax shelter. The personal holding company rules impose a special tax on corporations used to shelter income from investments.
Then there is what I call “friction” — the time and effort required to play the games necessary to juggle income between a corporation and an individual. You have to file a corporation tax return and keep corporate records. You have to compute both personal and corporate income accurately during the year to know how much income to juggle. Unless you have a lot of time on your hands, the effort may well be better spent actually making money.
Finally, C corporations have one overwhelming problem: the double-tax dilemma. Unlike S corporations, which report their income on shareholder tax returns, C corporations have their income taxed twice — first when earned, and again when distributed or recovered on a stock sale. There are games you can play to get it out as a deduction to the corporation, but these have their problems. Take cash out as compensation and you incur payroll taxes; take it out as rent and you actually need something you can lease to the corporation with a straight face. Distribute an appreciated asset to yourself and the corporation is taxed on the gain. The Bittker and Eustice tax treatise has a classic summary of the problem:
Decisions to embrace the corporate form of organization should be carefully considered, since a corporation is like a lobster pot: easy to enter, difficult to live in, and painful to get out of.
These problems could be solved by taxing individuals and corporations at the same rates and allowing a deduction for dividends paid. Unfortunately, the chances of that are as likely as the chances of your brother-in-law making good pre-tax money from his Amway operation.
The top individual tax rate is scheduled to jump to 39.6% on January 1, 2011. To those of us who do private business tax returns for a living, one effect is obvious: this will raise the tax rate on LLC and S corporation income.
But now Treasury Secretary Tim Geithner says that all my small business clients thy rich law partners and CEOs (my emphasis):
Ninety-seven percent of small businesses in this country would not pay a penny more due to letting these upper-income tax rates expire.
Now some have argued that even if only a few percent of small business owners make over $250,000, these few make up a vast amount of supposedly small business income.
This argument apparently counts anyone who receives any type of partnership or business income as if they were a small business.
By this standard, every partner in a major law firm and every principal in a major financial institution would count as a separate small business. A CEO who has board fees or speech fees would also count as a small business owner under this overly broad definition.
Well yes, Timmy, “some” have argued for that “overly broad definition” — your friends who say 97% of small businesses won’t be affected by the scheduled tax increase. A 2009 report by the Center on Budget and Policy Priorities is a source of the talking point that only a tiny fraction of businesses will be affected by the expiration of the tax increase. They define a small business 1040 as:
…any tax unit that receives any income (or loss) from a sole proprietorship, farm proprietorship, partnership, S corporation, or rental income.
So while a CEO who has board fees will count as a separate small business — as will President Obama, for that matter — so will every taxpayer that has a schedule C, schedule E or Schedule F. Your office Mary Kay girl or Shacklee dealer counts as a small business. Everybody who moonlights and reports their income is a small business. Everybody who rents out a duplex or vacation home counts, as does every taxpayer who holds, even briefly, an interest in a publicly-traded oil and gas partnership.
So how much small business economic activity will be hit by the increase in the top rate? A lot more than 3%. The center-left Tax Policy Center estimates that 44.3% of taxable income of these “small businesses” will be hit with next year’s scheduled tax increase (hat tip: Howard Gleckman). That seems low, if anything, based on what I see in practice.
It’s the successful, growing and profitable S corporations and partnerships that push their owners into the top tax brackets. Growing businesses typically distribute only enough income to owners to cover taxes — either by inclination or by agreements with lenders. Their remaining earnings go into growing the business or paying off the bank. If you increase their taxes, it either reduces growth and hiring or their ability to service their debt — neither of which does much for the economy.
When Tim Geithner says that the only people who will get hit by his tax increase are rich lawyers and director fee millionaires, it may tell us something about his social world. It tells us nothing about how the tax increase will hit business owners.
When somebody repays a loan, that’s not income to the lender, is it? It can be when a shareholder loans money to an S corporation. New York businessmen Ira and Sheldon Nathel learned that the hard way in court this week. Ira and Sheldon each owned shares in food distributors that were set up as S corporations. When you own an S corporation you may deduct corporate losses on your 1040, but only if you have basis in your S corporation stock or in loans you have made to the corporation (guarantees of corporate debt don’t work).
Yes, there’s a catch. When you take S corporation losses, they reduce your basis — first in your stock, then in your loans. Subsequent income, including tax-exempt income, restores your basis in your debt and r. If you repay a loan with reduced basis, you have taxable income to the extent the repayment exceeds your basis.
At the end of 2000, IRA and Sheldon each loaned $649,775 to one of their S corporations. That enabled them to take losses of $537,228 or so, leaving them with $112,547 in remaining loan basis. That would have been fine if they had waited patiently until S corporation income had restored their basis. Their patience ran out in February 2001, when they repaid the loan in full.
They may have had second thoughts. In August 2001 Ira and Sheldon each made a capital contribution to the S corporation — $537,228, coincidentally. They then took a novel position on their 2001 tax returns. The Second Circuit Court of Appeals takes up the story:
In calculating their 2001 taxes, the Nathels treated their capital contributions… as constituting “tax-exempt income” to the corporations for the purposes of § 1366(a)(1)(A). Therefore, because the Nathels’ bases in their stock previously had been reduced to zero and because their bases in the loans they made to the corporations were also reduced, the Nathels used their capital contributions to restore their bases in the loans pursuant to § 1367(b)(2)(B). Without such an increase in their bases, the petitioners would have been taxed on the ordinary income that would have resulted from the corporations’ repayment of the petitioners’ loans in amounts above the petitioners’ previously reduced bases.
The IRS didn’t buy the idea that a capital contribution was some sort of income. They said a capital contribution increases capital, not debt, and is allocable to stock basis. That meant $537,228 in ordinary taxable income. Unfortunately for Ira and Sheldon, the Tax Court, and now the Second Circuit, continue to recognize the capital/income distinction that has been around for approximately forever.
The economy being what it is (still crappy), lots of S corporation shareholder are going to have basis problems at year end. They should keep a few points in mind:
• Use caution when repaying loans – When you make a year-end loan to your S corporation to enable you to deduct losses, repaying the loan will trigger taxable income until the loan basis is restored by subsequent S corporation income.
• “Open account” loans can be tricky – Regulations split “open account” debt into separate “loans” when the loan amounts exceed $25,000. That means fluctuating open account balances during the tax year can lead to taxable income, even if the balance ends up higher at year end than it was at the start of the year.
• Related party issues – It’s dangerous to borrow from one S corporation you control and loan the funds to another one. The IRS likes to attack such loans as lacking substance.
So Ira and Sheldon get to write some big checks to the IRS. They have the consolation of having $537,228 more basis in their stock, to offset other income somewhere, somehow, someday.
Long before John Edwards became known as a well-coiffed skirt-chasing weasel, he was a well-coiffed successful trial lawyer. He was successful enough to afford good tax advice, so he conducted his law practice in an S corporation.
Back in the old days, professional practices were conducted as sole proprietorships or general partnerships, reportable as self-employment income, subject to the 15.3% self-employment tax up to the FICA base (currently $106,800), and to the 2.9% Medicare portion of the tax to infinity.
When state laws allowed professionals to incorporate, attorneys and accountants quickly noticed that income on S corporation K-1s is not subject to self-employment tax. This makes S corporations a popular way to run a professional practice. The professionals take a “reasonable” salary out of the business (subject to employer and employee FICA and Medicare tax) – enough to not raise IRS eyebrows – and take the rest out as S corporation distributions with no employment tax.
John Edwards did well by this. His law practice generated millions dollars of K-1 earnings in excess of his salary, saving him hundreds of thousands of dollars in payroll and self-employment tax.
Now that he has been reduced to a wealthy target of mockery, Congress is ready to crack down on the John Edwards S corporation tax shelter. The annual “extenders” bill has a provision – almost as absurd as Edwards love life – that will hit professional S corporation K-1 income with self-employment tax. The SE tax will apply when the “principal asset” of the S corporation is the “reputation and skill” of three or fewer professionals – defined for this purpose as “services in the fields of health, law, lobbying, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, investment advice or management, or brokerage services.”
Congress doesn’t muss its hair worrying about how taxpayers in multi-owner S corporations are supposed to figure out whether its “principal asset” is the “reputation and skill” of three or fewer owners. However it works, this provision is too late to hurt John Edwards — his reputation isn’t much of an asset anymore.
When the “Government Accountability Office” reported that 68 percent of S corporation returns had errors, a few people who don’t prepare returns for a living were astonished:
By the way, these S Corporation shareholders are mostly comprised of the “small businessmen” that the right-wing anti-tax crowd constantly claims is overtaxed. Hmmmm. Looks like the bigger issue with this group is noncompliance, not overtaxation. We need to increase enforcement efforts, especially focused on the particular items that have tended to be misreported in S corporation returns.
The reaction from tax pros is more like, “you mean 32% of S corporation returns have no activity?”
Breaking news: this stuff is hard. The tax return for an S corporation of any size starts with thousands of transactions that have to be properly recorded – thousands of opportunities for mistakes. Then you start to apply the tax law. You have to find all of the meals and entertainment expenses, and you have to see which ones fail to qualify. Did the S corporation properly include health insurance on the W-2s (probably not)? What about for the owner’s nephew who has a job at the loading dock? Did every fixed asset get capitalized properly? What about the expenses of acquiring it? Can Section 179 apply? Is it new equipment that qualifies for the bonus depreciation rules? Oh, did they apply the Section 263A inventory capitalization rules properly? Did the Section 199 information get properly recorded for all of the shareholders? Interest? Dividends? Are they qualifying dividends? Are there Capital gains? Section 1231 gains – and what about unrecognized Section 1250 gain? Oh, don’t double them up – that Section 1250 number is part of that 1231 number, not an addition to it!
You get the picture. And if you have a multistate return, your fun is just beginning.
Once you think you have taxable income right, then you have to apply it correctly to the K-1 for the shareholders. Then the shareholders have to apply it correctly to their own tax return, even though the IRS-designed K-1 omits crucial information that the taxpayer or his preparer needs – the shareholder’s basis in the tax return, whether the taxpayer is “at-risk” for basis, and the level of the taxpayers involvement in the business.
If 32% of the returns are reported correctly, it’s shocking all right – it’s amazing that so many are
correct. I’d like to see some law professor, or Congresscritter, try do a tough 1120-S perfectly on a deadline and a budget.
Anybody who has prepared returns for very long has had a “doh!” moment along the way – “holy crap, I’ve been doing that wrong!” It’s not because tax preparers or taxpayers are lazy or evil. It’s just hard.
Joe Kristan is a tax shareholder for Roth & Company, a Des Moines, Iowa CPA firm, where he works with closely-held businesses and their owners. Prior to helping start Roth & Company, he worked for two of what are now the Final Four CPA firms. He writes the Tax Update Blog and is available for seminars, first communions, Bar Mitzvahs, etc. You can see his previous posts for GC here.