Tax Court Rejects Small Business Owner's Use of 'John Edwards Sub S Tax Shelter'

Wall Street Journal Tax Report:  Income Tricks Under Fire  by Laura Saunders:

The IRS has won its second clear victory in three years over a tax-cutting maneuver available to—and used by—millions of small-business owners.

In 2010, an Iowa federal court slapped down a popular move in which small-business owners underpay themselves in order to minimize Social Security and Medicare taxes, while taking compensation in other ways [David E. Watson P.C. v. United States, No. 4:08-cv-442 (S.D. Iowa Dec. 23, 2010)]. On appeal, the Eighth Circuit affirmed the decision [David E. Watson, P.C. v. United States, No. 11-1589 (8th Cir. Feb. 21, 2012)].

Earlier this month, the U.S. Tax Court sided with the agency in the case of Sean McAlary Ltd. Inc. v. Commissioner [T.C. Summ. Op. 2013-62 (Aug. 12, 2013)]. It ruled that a Subchapter S firm whose sole owner was Mr. McAlary, a California real-estate broker, should have paid him $83,200 in wages for 2006. Instead, he was paid zero. ...

This issue is a perennial one, although it has become more important as payroll taxes have risen. "There's a constant push and pull between small-business owners wanting their wages to be as low as possible and the IRS wanting them high," says Jeffrey Porter, a certified public accountant in Huntington, W.Va., with many small-business clients The court ruled that the firm owed nearly $13,700 in payroll and unemployment taxes, plus more than $4,300 in penalties, for that year.

Prior TaxProf Blog coverage:

• More on the 'John Edwards Sub S Tax Shelter' (Feb 6, 2011)
• More on the 'John Edwards Sub S Tax Shelter' Case (June 5, 2011)
• Newt Gingrich Used 'John Edwards Sub S Tax Shelter' to Save $50k in Medicare Taxes (Jan. 23, 2012)