Court Gives IRS Rare Win in 'John Edwards Sub S Tax Shelter' Case

Wall Street Journal, The IRS Targets Income Tricks, by Laura Saunders:

[A] recent U.S. district court case [was] won by the IRS against David Watson, a CPA in West Des Moines, Iowa. At issue: a common tax-cutting maneuver available to the owners of millions of closely held businesses.

The case, David E. Watson P.C. v. United States [No. 4:08-cv-442 (S.D. Iowa  Dec. 23, 2010)], revolved around Mr. Watson's low pay as the sole owner and shareholder of a so-called S Corporation. ... According to the decision, the firm made profit distributions of $203,651 and $175,470 to Mr. Watson through his Sub-S for 2002 and 2003, respectively, the years in question.

Mr. Watson, who had a graduate degree in tax and 20 years' experience, received only $24,000 of salary for each of those years, far less than the $40,000 a year earned by recent graduates in accounting with no experience, according to one expert for the IRS.

The agency cried foul, saying his pay was far too low. Why object? Unlike profit distributions, all salary is subject to a 2.9% Medicare tax and some is subject to a 12.4% Social Security, or FICA, tax. ... By reporting low pay Mr. Watson didn't save any income taxes, but he did save nearly $20,000 in payroll taxes for the two years, the IRS said, pegging Mr. Watson's true pay at $91,044 for each year.

Judge Robert W. Pratt agreed, ruling that the CPA owed the extra tax plus interest and penalties.

Mr. Watson plans to appeal the decision. "The IRS can disallow a tax deduction for unreasonably high compensation, but the law doesn't give it the authority to raise pay in order to collect extra payroll taxes," he says. Independent tax expert Robert Willens in New York says this will be a hard argument to win. ...

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.

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.

In Mr. Watson's case, his revised compensation came to only about 40% of his total return from the company. The upshot: Pay can vary—but it can't be too low.

• Tax Update Blog, WSJ Spotlights Area CPA S Corp Court Loss (Jan. 22, 2011)
• Tax Update Blog, Court Sets 'Reasonable' Comp for CPA S Corp Shareholder (Dec. 30, 2010)
• Tax Lawyer's Blog, S Corp Wages and Distributions: Basic Tax Planning (May 5, 2009)
• Tax Update Blog, John Edwards Shelter Targeted by IRS (Mar. 12, 2005)
• TaxProf Blog, WSJ Charges Kerry-Edwards with Tax Hypocrisy (July 14, 2004)
• Thinking Like, S Corps Help Owners Save on Taxes: John Edwards Saved $600k With His S Corp