Paul L. Caron

Sunday, February 6, 2011

More on the 'John Edwards Sub S Tax Shelter'

Following up on my prior post, Court Gives IRS Rare Win in 'John Edwards Sub S Tax Shelter' Case (Jan. 24, 2011):  Weekend Wall Street Journal, The Unforeseen Risks of Underplaying Your Income, by Laura Saunders:

The most recent Tax Report, on executive pay and payroll taxes, ... was about a court case, David E. Watson, P.C. v. USA. Mr. Watson is an Iowa CPA with decades of experience, and the IRS challenged his $24,000-a-year salaries for 2002 and 2003 as too low. The judge agreed with the IRS and raised it to $90,044.

Payroll taxes, not income taxes, were at issue. The IRS said that by keeping his salary artificially low, Mr. Watson was minimizing the 12.4% FICA tax (up to a cap) and the 2.9% Medicare tax (unlimited), saving about $20,000. Other accountants said clients often hope to cut payroll taxes by low-balling pay.

Several readers asked whether the issue in Watson is what caused controversy for John Edwards, the former senator and vice-presidential candidate. The short answer is yes. Sen. Edwards was unavailable for comment for this story, but asserted during the 2004 campaign that he had done nothing improper.

Other readers wondered what happens when Steve Jobs or Vikram Pandit takes a token $1 a year in pay. Does the IRS challenge that salary for being too low as well?

The answer is no. ...Mr. Jobs's $1-a-year pay doesn't pose a problem for the IRS because Apple is a "C" corporation, not a "Subchapter S" corporation, as Mr. Watson's was. ... With C corporations, the compensation issue is actually the opposite of Mr. Watson's: The IRS gets upset when pay is too high rather than too low. That is because C corps get an important tax deduction for executive pay. If it is too high, a firm may be disguising a nondeductible dividend payout as tax-deductible compensation—especially if the firm has an owner who is a large shareholder. ....

Things are very different for workers whose pay comes from "carried interest," i.e. profit participations that are common at hedge funds, private-equity firms, and real-estate firms. In that case the pay can qualify as a capital gain—taxed at current top rates of 15% instead of 35% for most pay—and also isn't subject to payroll taxes ... This treatment has been a sore subject with some in Congress recently, but the law hasn't changed.

A final note: Last year's health-care changes are up in the air, but taxpayers should know they contain a Medicare tax increase of 0.9% on wages above $250,000 for married couples and $200,000 for singles for 2013 and after. That brings the total Medicare tax to 3.8%.

People who try to lower pay and raise dividends to escape Medicare tax should be aware that the law also imposes a 3.8% tax on investment income. The tax applies at the same $250,000/$200,000 level, and it applies to dividends, possibly erasing any tax saving.

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This is favorable news for those who keep their S Corp compensation to around 40% of total company income, as the IRS allowed. Pigs get fat, hogs get slaughtered.

Articles about this case neglect another reason for limiting compensation: For younger Social Security recipients, lower salaries allow full benefits. Wages must be less than $14,160 for those under "full retirement age;" less than $37,680 annually for the months in the final year before that age is reached.

Posted by: Bob | Feb 6, 2011 6:45:06 AM

Don't forget that CEOs that declare a $1 salary may be still be taxed on whatever fair market value their salary should be, through the concept of constructive receipt.

They are CHOOSING to pay themselves $1 a year (coupled with fat stock options), which therefore creates the potential for deferred compensation, which is only allowed under some retirement plans. If the IRS was smart, they'd go after these self-aggrandizing CEOs.

Posted by: Aaron | Feb 6, 2011 10:03:03 AM