Paul L. Caron

Friday, September 6, 2013

Is the IRS Really Losing the S Corp Compensation War?

Following up on this morning's post, Schwidetzky: The 'John Edwards S Corp Tax Shelter': Is the IRS Winning the Battles But Losing the War?:  Tax Update Blog:  The IRS is Losing the S Corporation Comp War?, by Joe Kristan:

Mr. Schwidetzky, an academic, seems to think taxpayers are just having their way with the poor IRS, but for those of us in the wild trying to keep our clients out of trouble without wasting their money on excessive taxes, it hardly looks like the IRS is losing.

First, the IRS is auditing S corporations aggressively — way too aggressively. Mr. Schidetzky fails to bring up the recent Glass Blocks case, where the Tax Court ruled that a struggling one-man S corporation had to pay a “reasonable salary” even [if] doing so throws the corporation into a loss. That’s a result far worse than the poor guy would have had filing as a Schedule C taxpayer. It’s hard to see how such pointless and harsh treatment is good policy.

Second, there is still no clear statutory or regulatory guidance to determine minimum “reasonable” salaries.  ...

Third, why is this just an S corporation issue? The same thing can come up in C corporations. Think of Warren Buffett’s famous $100,000 annual salary — one that is arguably tens of millions “too low.” Why not hit him for more payroll taxes? The same problem can also arise in an LLC with multiple classes of ownership interests in a partnership return.

The “problem,” such as it is, comes from the tax statutes that exempt some business income from self-employment tax, and from the IRS failure to provide clear guidance to either examiners or taxpayers — not from the courts’ attempts to prevent taxpayer abuse.

Update:  Walter Schwidetzky responds:

Mr Kristan’s response mostly misses the point of my op-ed. Payroll taxes should be due on the entire amount earned from services. The answer should not vary based on the business form used (as it is currently argued it does). There is no statute that requires that result; the cases I discussed could have, and in my view should have, been decided differently. While the John Edwards technique is never used with C corps to my knowledge, I have no problem concluding that Mr. Buffet’s formal salary is less than his actual earnings. There is one item on which Mr. Kristan and I agree. The IRS has failed to provide clear guidance, a failure I find inexplicable.

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I found a history of this tax issue at
which shows, I think, that an old IRS revenue ruling is the source of the problem, by saying that “reasonable compensation” had to be paid by the corporation rather than trying to define which part of a corporation’s profit was return to labor rather than return to capital. Another way to put this is that the IRS didn’t require that *capital* was limited to a “reasonable return”. Of course, using words like “reasonable” gives wiggle room so that a taxpayer could say that of his corporation’s $500,000 profit, $100,000 was a reasonable salary, $50,000 was a reasonable return to capital, and the rest was a gift from heaven and shouldn’t be taxed at all.
I didn’t look at the Glass Blocks case at , but it seems the IRS has accomplished the Immigration feat of being both incredibly lax with most people and incredibly picky with a few. The poor taxpayer’s labor income was clearly negative, but the IRS “reasonable compensation” method doesn’t let people have negative labor income. The simple method of saying everything is labor income except for an estimated return to capital would have avoided making him pay.
(One caveat is that this involves Medicare and Social Security. It seems to me that a negative-income taxpayer should be treated as making no dollar contributions to the funds for purposes of his later eligibility, but as having put in those quarters of work,which was the way charitable work was treated, It hink, back when my mother kept track of her hours as secretary of the civic symphony).

Posted by: Eric Rasmusen | Sep 6, 2013 11:01:13 AM