IRS targets S corporation tax savings

The Wall Street Journal reports on a recent court case, David E. Watson P.C. v. U.S., in which the IRS took on an accountant-taxpayer for not paying himself enough salary as an employee of the subchapter S corporation he co-owned:

For Sub-S owners, this issue isn't going away. Last year it even turned up in legislation, when the House passed a provision that would have subjected all profits of shareholder/employees of personal-service firms—such as accounting, law and consulting firms—to payroll taxes. The measure died in the Senate, but the IRS would likely welcome its return. Cases like Mr. Watson's are expensive for the agency to litigate because each turns on individual circumstances.

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.

Tom Ochsenschlager, former head of tax for the American Institute of CPAs, says pay and payroll tax issues are a frequent source of friction with clients: "Sometimes you have to take them to the woodshed and say, 'You need to report more income as pay for personal services."'

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.

Read more about S corporation tax savings.

Tax Increases Expected by 2011

Higher Taxes Are Coming. Are You Prepared? Wall Street Journal, September 13, 2009:

As the recession and bailout have pushed this year's federal budget deficit to an unheard-of $1.6 trillion, an unpleasant reality has dawned: Taxes are going up. The only questions are when, how much, and for whom?

The answers depend on the shifting sands of wealth politics and the scope of health-care revision. "But everybody thinks that by 2011 tax rates will be higher, at least for those with higher incomes," says Thomas Ochsenschlager, a tax official at the American Institute of Certified Public Accountants.

This certainty turns traditional tax-planning logic upside-down. Taxpayers have long been advised to defer taxes as long as possible, especially by making contributions to tax-sheltered IRAs and 401(k)s or holding assets for years in order to postpone realizing gains.

Now taxpayers should reconsider this rule. The current top capital-gains rate of 15% on most assets is the lowest in living memory and the Obama administration has proposed raising it to 20%. Another proposal might tack on a 4.5% surtax for the wealthiest taxpayers. So it may make sense to realize long-term gains now, says Robert Gordon, who advises clients on sophisticated tax matters at Twenty-First Securities in New York....

See also: Barack Obama's Tax Policies