Schwidetzky: Musings on Watson and the John Edwards Sub S Tax Shelter

Walter D. Schwidetzky (Baltimore), Musings on Watson and the John Edwards Sub S Tax Shelter:

Last December, an Iowa federal district court came out with a decision on the “John Edwards gambit” (Watson v. United States, 107 A.F.T.R.2d 311 (IA D.C. 2010))  TaxProf blog coverage here and here.] Some musings:

In Watson, the taxpayer formed an S corporation of which he was the sole shareholder.  The S corporation was a partner in an accounting firm partnership.  The other partners were also one-person S corporations.  In 2002, Watson’s S corporation received profit distributions of $203,651 from the the partnership.  In 2003, it received $175,470 in profit distributions.  In each of those years, the S corporation paid Watson a  salary of $24,000 per year, let the balance of the income “flow through” as nonwage income, and paid it to Watson as a dividend.  The court concluded that Watson’s salary and dividend payments were an effort to avoid federal employment taxes, and that the dividends paid to Watson were remuneration for services performed.  Interestingly, the court did not conclude, at it might have, that the dividends paid were income for services and subject to federal employment taxes.  As expert witness testified that fair market value of Watson’s services for the years in question was about $91,044 per year, and only the difference between that amount and $24,000 was held to be subject to federal employment taxes, interest, and penalties.

Watson does not sound the death knell to the John Edwards technique. Iowa federal district courts are not the last word on tax matters.  The salary the taxpayer took, while not de minimis, was quite small.  Finally, and most importantly, the court looked not to the income generated by the taxpayer’s services in calculating his employment income, but rather what a third-party expert said the value of his services were worth.  A significant amount of income generated by the taxpayer’s services, about $110,000 in 2002 and about $85,000 in 2003 still avoided employment taxes.

In some ways, the court’s holding provides an additional incentive to use the technique.  The court’s holding permits significant amounts of income earned through services to avoid federal employment taxes, taxpayers just cannot be too greedy.  Query whether it would be worth it to the Service to litigate a case where salaries equal to the social security tax maximum were paid, since it is more likely that the fair market value of services will be relatively close to such a number.  Note that under the Court’s reasoning in Watson at issue is not the fair market value of the taxpayer’s own services, but those of an average, similarly situated taxpayer, whose services might be worth less than that of a given taxpayer’s.  Indeed, that allegedly is what John Edwards did. According to the New York Times, he took a salary of $360,000 per year on income over 4 years of  $27 million.  The salary was supposedly based  on what the average personal injury lawyer earned in North Carolina.  Under the Iowa court’s reasoning, his approach would have survived challenge.

At this point, the future of the technique is uncertain.  The Iowa court keeps the door open, indeed may open it wider, for those taking substantial salaries.  However, another court might conclude that all the income is federal employment income, which would disallow the technique entirely.  Further, there is a bill pending in Congress which would largely also shut this technique down. 

The Health Care and Education Affordability Reconciliation Act of 2010, starting on January 1, 2013, applies an additional .9% Medicare tax on earned income exceeding certain thresholds (generally these thresholds are $250,000 if married, filing jointly, and $200,000 for single taxpayers).  (The Act’s 3.8% tax  on net investment income should not apply to “dividends” as S corporation shareholder receives.)  The .9% tax should provide an additional incentive to use the technique.