Reilly: S Corporation Self Employment Tax Avoidance Strategy Still Viable Despite Recent Tax Court Ruling

From Peter J. Reilly's article on forbes.com - S Corporation SE Avoidance Still A Solid Strategy:

Even though Sean P. McAlary lost in Tax Court, the decision in his case shows that S Corporations are still a valid self-employment tax avoidance strategy.  If you operate as a sole-proprietorship, all of its income will be subject to self-employment tax.  If you put the business into an S Corporation, none of the income will be subject to self-employment tax.  Entrepreneurs will be inclined to heavily discount any decrease in future social security benefits as a trade-off, so organizing as an S Corporation and avoiding self-employment tax seems like a no-brainer for a sole proprietor.

The Exposure

There is a catch.  In the C corporation arena, the IRS is wont to argue that very high salaries are disguised dividends.  With S Corporations, the Service may take the position that corporate distributions are actually disguised salary.  That can be pretty ugly, since the penalties for being late with payroll taxes are fairly stiff.  When Sean McAlary Ltd got hit for just over $10,000 in FICA and Medicare tax, that did not really prove that the S Corporation low or no payroll strategy is a bad idea.  I mean, nothing ventured, nothing gained.  What is nasty is the $6,000 or so in penalties. 

Win, Loss or Draw ?

So would Mr. McAlary have been better off for 2006 if he had run his business as a proprietorship and paid self-employment tax on the entire profit.  Forgive me for not doing the precise computation, but it is actually close to a push.  Mr. McAlary had his corporation pay him no salary at all.  There was an agreement in place for his salary to be $24,000.  The IRS expert argued that his salary should have been $100,755.  The Tax Court determined that $83,200 was actually the right number.  According to the discussion in the case the net income of the S Corporation was $231,454 and the total on page 2 of his Schedule E was $200,877.  His distributions from the S corporation were $240,000.  I can’t tell why there is a difference.  Perhaps he or his wife has another S Corporation that lost money.  Regardless, by running as an S Corporation, he avoided the effect of Self-employment tax on between roughly $120,000 and $150,000 of income, even after getting audited.

That nasty $6,000 in penalties probably puts him a bit behind particularly when you throw in thetsoris of going all the way to Tax Court.  Mr. McAlary represented himself, though, and did win a small concession, so you can’t rule out that he may have enjoyed the fight.  When you consider other years, where he did not get audited, he came out way ahead using the strategy.

How To Win Almost For Sure ?

 Explaining things like this throws me back to the early days of my career.  My elaborate analysis would need to be translated into terms that the client would understand.  After absorbing as much of the analysis as he thought relevant, Herb Cohan would then say to the client – “Don’t be chazzer !”  The more elaborate version of that caution on the limits of aggressiveness in tax planning was “Pigs get fed.  Hogs get slaughtered.”.

What the McAlary case teaches us is not that you can’t use an S Corporation to avoid SE/payroll taxes.  It teaches us that you really should not use the strategy to avoid SE/payroll taxes entirely. 

See Peter J. Reilly's full article here.

Williams: Finally, A Permanent Estate Tax, Though Just For Wealthy Few

From Roberton Williams, in his article on Forbes.com, Finally, A Permanent Estate Tax, Though Just For Wealthy Few :

After more than a decade of nearly constant change, the federal estate tax is finally permanent. It’s a bit more onerous than last year’s version but still only a shadow of its former self. New tables from the Tax Policy Center show that in 2013, just 3,800 estates—fewer than one in 700—will owe the tax. And they’ll pay a total of just $14 billion—half the revenue collected five years ago.

With the passage of the American Taxpayer Relief Act of 2012 (ATRA), Congress set the effective exemption for combined bequests and gifts at $5 million, indexed that value for inflation, and allowed surviving spouses to claim any exemption not used by their deceased mates. It also raised the rate to 40 percent, 5 percentage points higher than in 2012.

The estate tax has endured nearly constant change over the past dozen years. The 2001 tax act (EGTRRA) reduced the tax in steps, raising the effective exemption from $675,000 in 2001 to $3.5 million in 2009 and cutting the top rate from 55 percent to 45 percent before repealing the tax entirely in 2010. Because EGTRRA expired entirely in 2011, the repeal lasted only one year. But rather than let the tax return to its pre-EGTRRA status, Congress set new parameters for 2011 and 2012: a $5 million exemption and a 35 percent tax rate. The tax reverted to 2001 law at the stroke of midnight last New Year’s Eve.

See Roberton's full article here .

Schneider: Ways and Means Releases Discussion Draft of Financial Product Tax Reform

Steven R. Schneider, Ways and Means Releases Discussion Draft of Financial Product Tax Reform, January 25th, 2013:

On January 24 the chair of the House Ways & Means Committee released proposals to reform the taxation of financial products.  The reforms include:

• Mark-to-market taxation for speculative financial investments.  Specifically the draft would require taxpayers engaged in speculative financial activity—but not business hedging against common risks—to mark certain financial derivative products to fair market value at the end of each tax year, thus triggering the recognition of gain or loss for tax purposes.  The proposal would apply to property acquired and positions established after December 31, 2013.
• Eliminate the requirement for many common business transactions to separately “identify” hedges for tax purposes.  For taxpayers that are engaged in hedging business risks, the draft would allow transactions that are properly treated as hedges for financial accounting purposes to be treated as hedges for tax purposes.  This taxpayer-favorable proposal would minimize inadvertent failures to identify a transaction as a hedge for tax purposes, even though the transaction satisfies all of the substantive requirements for hedging transaction tax treatment.  The proposal would be effective for hedging transactions entered into after December 31, 2013.
• Eliminate phantom income on non-write-down debt restructurings.  The draft would reform the tax rules that apply to debt restructurings that do not involve a forgiveness of principal. This change would reduce the prevalence of “phantom” cancellation-of-indebtedness income when debt is restructured—a common practice during economic downturns—thereby creating a more taxpayer-favorable rule.  The discussion draft would eliminate the phantom taxable income problem associated with many debt restructurings by generally providing that the issue price of the modified debt instrument cannot be less than the issue price of the debt instrument prior to modification.  The proposal would be effective for debt modifications that occur after December 31, 2013.
• Harmonize the Tax Treatment of Bonds Traded at a Discount or Premium on the Secondary Market. The draft would require the holder of the bond to recognize taxable income on the discount over the remaining life of the bond.  Further the amount of discount to be recognized for tax purposes would be limited to the discount that typically reflects an increase in interest rates that has occurred since the date the bond was originally issued—as opposed to steeper discounts that often reflect deterioration in the creditworthiness of the borrower.  The proposal would be effective for bonds acquired after December 31, 2013.

See full article from taxlawroundup.com here.

Ashleae Beling: Tax Hikes Hit Trusts Hard, Beneficiaries Pull Money Out:

Ashleae Beling, Forbes.com: Tax Hikes Hit Trusts Hard, Beneficiaries Pull Money Out:

Folks with trusts, and that includes widows and the disabled, not just the ultra-wealthy, have been hit with a double tax whammy this year. First the 3.8% Obamacare tax that applies to net investment income kicked in Jan. 1. Then, the American Taxpayer Relief Act was signed into law on Jan. 2, imposing income and capital gains tax hikes on trusts akin to those on the wealthiest taxpayers. The top income tax rate is now 39.6%, up from 35%, and the top capital gains rate is now 20%, up from 15%.
The kicker: these taxes hit a trust on any income it does not distribute over just $11,950, far less than the $400,000/$450,000 ATRA and $200,000/$250,000 Obamacare thresholds for individuals.

“It’s hitting where it really shouldn’t,” says Laurie Hall, an estates lawyer and head of the Wealth Management Group at Edwards Wildman in Boston. “These increases weren’t intended to hit people with income below $200,000, and they will.”

Here’s why. Most trusts (non-grantor trusts) pay tax on capital gains and accumulated income that stays in the trust, while the beneficiaries pay tax on income that is distributed to them. So trusts—even relatively small ones—will be hit with the 23.8% capital gains rate (the 20% rate plus the 3.8% Obamacare tax), even if the beneficiary himself would be squarely in 15% capital gains territory. “Going forward you have to think the trust is going to be hit with the extra 8.8%,” says Hall.

See Ashleae Beling's full article Tax Hikes Hit Trusts Hard, Beneficiaries Pull Money Out,  Forbes.com, January 9, 2013.

What is the Difference Between Forms W-2 and 1099?

With tax season looming around the corner, Robert W. Wood explains the differences between IRS Form 1099 and IRS Form W-2 in his article on Forbes.com: 1099 or W-2? Giving or Receiving, Be Careful:

Both key tax forms arrive in January or February, so watch your snail mail. If you’re an employee, taxes must be withheld. You’ll receive an IRS Form W-2 from your employer in January the following year. If you’re an independent contractor, you are liable for your own taxes. Assuming your total pay was $600 or more, you’ll receive an IRS Form 1099.

But is it that simple? What if you’re the employer rather than the recipient? This key decision is made thousands of times daily all over America, often, it seems, without much thought. Some employers ask “1099 or W-2?” as if they were asking how you take your coffee.

If you’re the worker, you may be tempted to say “1099,” figuring you’ll get a bigger check that way. Of course, you’ll actually owe higher taxes. As an independent contractor, you’ll owe not only income tax, but self-employment tax too.  In contrast, if you’re an employee, you pay only one half the Social Security tax, plus one half the Medicare rate. Your employer pays the other half.

Apart from tax law, employee status carries protection under nondiscrimination laws, pension and benefits laws. Wage and hour protections apply to employees but not to independent contractors. For all of these reasons, employers have considerable incentives to try to pay independent contractors rather than employees. This can often be done in ways that are perfectly proper.

See Robert W. Wood, Forbes.com: 1099 or W-2? Giving or Receiving, Be Careful:, January 25, 2013.

QUICK TIP:  Skillserv.com has a handy online tool, which can be found here, that compares the different effective 'take-home pay' of equally compensated W-2 and 1099 employees.

Bonner & Nevius: Congress Passes Fiscal Cliff Act

Paul Bonner and Alistair M. Nevius, Congress passes the fiscal cliff act, Journal of Accountancy:

Pulling back from the “fiscal cliff” at the 13th hour, Congress on Tuesday preserved most of the George W. Bush-era tax cuts and extended many other lapsed tax provisions.

Shortly before 2 a.m. Tuesday, the Senate passed a bill that had been heralded and, in some quarters, groused about throughout the preceding day. By a vote of 89 to 8, the chamber approved the American Taxpayer Relief Act, H.R. 8, which embodied an agreement that had been hammered out on Sunday and Monday between Vice President Joe Biden and Senate Minority Leader Sen. Mitch McConnell, R-Ky. The House of Representatives approved the bill by a vote of 257–167 late on Tuesday evening, after plans to amend the bill to include spending cuts were abandoned. The bill now goes to President Barack Obama for his signature.

“The AICPA is pleased that Congress has reached an agreement,” said Edward Karl, vice president–Tax for the AICPA. “The uncertainty of the tax law has unnecessarily impeded the long-term tax and cash flow planning for businesses and prevented taxpayers from making informed decisions. The agreement should also allow the IRS and commercial software vendors to revise or issue new tax forms and update software, and allow tax season to begin with minimal delay.”

With some modifications targeting the wealthiest Americans with higher taxes, the act permanently extends provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16 (EGTRRA), and Jobs and Growth Tax Relief Reconciliation Act of 2003, P.L. 108-27 (JGTRRA). It also permanently takes care of Congress’s perennial job of “patching” the alternative minimum tax (AMT). It  temporarily extends many other tax provisions that had lapsed at midnight on Dec. 31 and others that had expired a year earlier.

The act’s nontax features include one-year extensions of emergency unemployment insurance and agricultural programs and yet another “doc fix” postponement of automatic cuts in Medicare payments to physicians. In addition, it delays until March a broad range of automatic federal spending cuts known as sequestration that otherwise would have begun this month.

Among the tax items not addressed by the act was the temporary lower 4.2% rate for employees’ portion of the Social Security payroll tax, which was not extended and has reverted to 6.2%.

See full article by Paul Bonner and Alistair M. Nevius, Congress passes the fiscal cliff act, Journal of Accountancy, January 1, 2013.

ESOPs as a Plan to Help Business Owners Avoid "Taxmageddon"

Jerry L. Ripperger & Brian D. Hector: ESOPs: a plan to help business owners avoid "taxmageddon":

The potential massive tax increases looming in 2013 will be felt by many taxpayers, but they could take an especially hard toll on business owner clients who have plans to sell.  With nearly 80 percent of their net worth tied up in the value of the enterprise¹, such business owners could lose a significant amount of assets which they have spent a lifetime amassing.

On the horizon

If Congress allows the Bush-era tax cuts to expire in 2013, long-term capital gains rates will increase to 20 from 15 percent.  On top of that, the health care reform act will impose a new 3.8 percent tax on capital gains for certain individuals in 2013, bringing the capital gains tax to 23.8 percent.  The jump to 23.8 from 15 percent is a 60 percent increase.

Higher income taxpayers will also experience a reduced benefit from itemized deductions if these tax cuts expire. The net effect could boost their capital gains tax rate to 25 percent from 23.8 percent.  Further, Congress and President Obama are discussing reducing deductions in other ways.

Then there are state taxes. Some, like California or New York, already have high capital gains tax rates, some as much as 8-10 percent, which high income taxpayers would pay in addition to the increased Federal rates.   Consequently, for the business owner who sells his or her business in 2013 as part of a succession plan, the collective tax increases could wipe out as much as 30 to 35 percent of the wealth the owner worked for decades to build up in the business and accumulate for retirement regardless of whether the owner’s stock is redeemed or sold to a third party.

Enter the ESOP Advantage

There is a way to help business owner clients soften (and in some instances completely eliminate) the impending tax blow and unlock substantial assets by using an employee stock ownership plan. Because of their special tax features, ESOPs allow owners to sell their stock and diversify their wealth on a tax-favorable basis, while effectively retaining control of their business.

See full article by Jerry L. Ripperger & Brian D. Hector at ESOPs: A Plan to Help Business Owners Avoid "Taxmageddon", LifeHealthPro, Dec. 10, 2012.

Arkansas Intestate Estate Calculator

Kurt R. Nilson has taken the guesswork out of determining how property will be distributed for those Arkansas residents who do not have a will (also known as passing by intestacy).  His online calculator, which can be found on his website, MyStateWill.com, automatically determines to whom such property will be distributed and calculates the dollar amount given to each such heir.  This tool streamlines the complicated Arkansas intestacy laws, which are some of the most complex of any state.

You can find his Arkansas Intestacy Calculator here.

From his website:

Dying Intestate

Do you really know what happens to your property if you die without a will? (Click here and choose your state for the quick answer) Do you know what happens to a person's debt when they pass away? Learn more bankruptcy information at totalbankruptcy.com.  Some common misconceptions about what happens to your property when you die without a will, or "intestate", include having all of your property being given to charity or to the state.

Another common misconception, with more serious consequences, is the belief that a surviving spouse is always granted all or substantially all of the deceased spouse's intestate estate. (Much about the probate process is also misunderstood.)

Post Presidential Election, Tax Professionals Predict Expiration of Lifetime Gift & Estate Tax Exemption

Now that the dust has settled following the 2012 presidential election, some tax experts are predicting that President Barack Obama's administration and the new Congress may let the current lifetime gift and estate tax exemption expire.  In his article, Grab the $5M Gift and Estate Tax Perk: It's Gone in 2013, Robert W. Wood discusses this important issue:

It’s post-election, nearly year-end, and taxes are on everyone’s mind. You may not be able to do much about the fiscal cliff or other imponderables. But you can fix your will and trust or just make a gift by year-end.

Act now! Think infomercial. This is a special limited time offer! Procrastination is understandable, especially about taxes and mortality. Yet it’s still surprising most people haven’t taken advantage of the incredibly favorable estate and gift tax law expiring in 2012. See It Pays To Plan For Future Estate Tax Changes. 

Congress enacted a $5 million exemption for both gift and estate taxes, but only through 2012. See Making Tax Decisions In Limbo. But wait, there’s more! Indexed for inflation, the exemption is now $5,120,000. It drops to only $1 million January 1, 2013. That’s a free pass to give away up to $5,120,000 without tax. If you are married, that’s up to $10,240,000 for a married couple with no tax.