I've been reading a lot about Obama Care, and thinking about how it will affect small business. Basically, if your business has more than fifty full time employees, it is not good. For the purposes of the Health Care Act, a full time employee is defined as one who works 30 hours per week. And the testing period to determine how many full time employees a business has is the calendar year preceding the year to which the Act applies. Since the insurance portion of the Act (Employer Shared Responsibility) is effective after 12/31/13, the 2013 calendar year is the testing period for 2014. If you plan to rearrange your workforce to fall below the fifty full time employee threshold, you should start working on it now. Since the test is based on annual averages, if you wait until the end of 2013 to address this issue, you will be too late.
The Act contains penalty provisions for businesses that fail to comply with the insurance requirements. For businesses that do not comply, it appears that the penalty is $2,000 per employee, after the first thirty employees. If your business has eighty full time employees who are not covered by health insurance, the penalty will be $100,000 per year. I observe many business owners who say that they will pay the penalty rather than provide health insurance, but I don't know if that is a wise choice. For federal tax purposes, penalties are not deductible expenses. To decide if the penalty less costly than the insurance coverage, one must analyze and compare the after tax cost of each.
For businesses that are labor intensive and low margin, the health insurance requirement will be devastating. It is unfortunate that President Obama has never run a business. Perhaps if he had, he would understand what he has done.
July 14, 2012
February 23, 2012
S Corp Reasonable Comp Part II
In January, I wrote about a Tax Court case (David E. Watson, P.C.) which held that the wages paid to a CPA by his 100% owned S corporation were unreasonably low, and that the difference between these wages and the amount determined by the Tax Court to be reasonable compensation constituted wages subject to FICA tax. In addition to the tax liability, the CPA was assessed penalties and interest. The CPA appealed the Tax Court decision to the US Court of Appeals for the Eight Circuit, which upheld the lower court ruling in favor of the Internal Revenue Service.
In making its ruling, the Court of Appeals found that Mr. Watson was a well qualified and experienced accountant working in a reputable and well-established firm, and that the nominal salary paid to him was unreasonably low in comparison to what a reasonable person in his role would have expected to earn. Further, the Court held that the S corporation "dividend" paid to Mr. Watson was compensation for services paid to him as an employee/shareholder, rather than a distribution of the corporation's earnings and profits. In this case, Mr. Watson received $24,000 of annual wages. During the two years at issue, he received dividend distributions of approximately $203,000 and $175,000.
Many S corporation shareholders employ the same technique, that is, they take relatively low salary and large dividend distributions. In order for this to have any chance of success against an IRS challenge, the wages received must be reasonable in comparison industry standards and services provided, and in relation to the dividends paid. In any event, your case will be strengthened by contemporaneous written documentation of how and why the compensation was determined. In Mr. Watson's case, $91,000 was determined to be reasonable compensation. If his actual salary were not so very low, maybe $52,000 instead of $24,000, perhaps the IRS would not have even made an issue of it. Proper planning and documentation are the key to all successful tax positions.
Please contact me if you would like a copy of the Watson case, or have any comments or questions.
In making its ruling, the Court of Appeals found that Mr. Watson was a well qualified and experienced accountant working in a reputable and well-established firm, and that the nominal salary paid to him was unreasonably low in comparison to what a reasonable person in his role would have expected to earn. Further, the Court held that the S corporation "dividend" paid to Mr. Watson was compensation for services paid to him as an employee/shareholder, rather than a distribution of the corporation's earnings and profits. In this case, Mr. Watson received $24,000 of annual wages. During the two years at issue, he received dividend distributions of approximately $203,000 and $175,000.
Many S corporation shareholders employ the same technique, that is, they take relatively low salary and large dividend distributions. In order for this to have any chance of success against an IRS challenge, the wages received must be reasonable in comparison industry standards and services provided, and in relation to the dividends paid. In any event, your case will be strengthened by contemporaneous written documentation of how and why the compensation was determined. In Mr. Watson's case, $91,000 was determined to be reasonable compensation. If his actual salary were not so very low, maybe $52,000 instead of $24,000, perhaps the IRS would not have even made an issue of it. Proper planning and documentation are the key to all successful tax positions.
Please contact me if you would like a copy of the Watson case, or have any comments or questions.
January 26, 2012
Does Your Business Have an Effective Buy-Sell Agreement?
Buy-sell agreements are among the most important yet most often overlooked business agreements. If you are a business owner or partner and are suddenly unable to work, what would happen to your business? If the business has an effective buy-sell agreement, then you should not have to worry.
What is an effective buy-sell agreement? It is an agreement that is clearly written and yields results that are fair to the buyer and the seller. In working with closely held business owners as an advisor, and in working with attorneys as a business valuation professional and expert witness, I have seen the best and the worst of buy-sell agreements, and the results that they bring.
A bad but all too frequently used buy-sell provision calls for the buyer and seller to each have a valuation of the business interest performed, and if the two valuations do not agree, a third appraiser is agreed upon and hired to perform a binding valuation. Are you surprised to know that the first two valuations never agree, and it is always necessary to have a third one done? And for this process, you have paid for three appraisals, when only one was necessary. Furthermore, if the process is at all contentious, agreement on the third business appraiser is also very difficult. I was involved in a three appraiser dispute, and the legal and professional fees paid were more than two times the amount paid for the retiring partner's interest. What is the solution to these problems? Change the agreement now to require only one appraisal, and specify in the agreement who (or what firm) will perform that appraisal.
Another buy-sell provision that will often produce disastrous results is one that values the business based on a formula, such as a multiple of something such as sales, net income, or book value. Although the formula may have made sense when it was written, business conditions change, and the formula result may no longer be fair.
We recently helped a client where one of the owners became ill and passed away within one year of diagnosis. Although I had tried to get the business owners to address buy-sell issues for a number of years, they refused to focus on it until the illness was diagnosed. In this case, the owners were fair minded and reached an agreement that was equitable to all the parties. But this is the exception rather than the rule. If you wait until a triggering event such as disability or death to start negotiating the buy-sell agreement, it is very difficult to reach an agreement.
A fair buy-sell agreement is one in which no one is overpaid and no one is underpaid, and the payment structure does not place an unfair burden on the business. Although buy-sell agreements are frequently funded with life insurance, what is the funding mechanism if the seller is disabled and does not pass away? Can the business afford to make the required payments without the benefit of life insurance proceeds?
Do yourself a favor. Get out your buy-sell agreement and read it. If the price specified by the agreement is formula based, ask your CPA to use the formula to calculate the price for the business? Keeping in mind that you don't know if you will be a buyer or a seller, are you happy with the result? Is the agreement structured in a way that will minimize income taxes for both parties? If the answer to either question is no, it is time for a new agreement.
As always, we welcome your comments and thoughts, requests for additional information, and suggestions for new topics.
What is an effective buy-sell agreement? It is an agreement that is clearly written and yields results that are fair to the buyer and the seller. In working with closely held business owners as an advisor, and in working with attorneys as a business valuation professional and expert witness, I have seen the best and the worst of buy-sell agreements, and the results that they bring.
A bad but all too frequently used buy-sell provision calls for the buyer and seller to each have a valuation of the business interest performed, and if the two valuations do not agree, a third appraiser is agreed upon and hired to perform a binding valuation. Are you surprised to know that the first two valuations never agree, and it is always necessary to have a third one done? And for this process, you have paid for three appraisals, when only one was necessary. Furthermore, if the process is at all contentious, agreement on the third business appraiser is also very difficult. I was involved in a three appraiser dispute, and the legal and professional fees paid were more than two times the amount paid for the retiring partner's interest. What is the solution to these problems? Change the agreement now to require only one appraisal, and specify in the agreement who (or what firm) will perform that appraisal.
Another buy-sell provision that will often produce disastrous results is one that values the business based on a formula, such as a multiple of something such as sales, net income, or book value. Although the formula may have made sense when it was written, business conditions change, and the formula result may no longer be fair.
We recently helped a client where one of the owners became ill and passed away within one year of diagnosis. Although I had tried to get the business owners to address buy-sell issues for a number of years, they refused to focus on it until the illness was diagnosed. In this case, the owners were fair minded and reached an agreement that was equitable to all the parties. But this is the exception rather than the rule. If you wait until a triggering event such as disability or death to start negotiating the buy-sell agreement, it is very difficult to reach an agreement.
A fair buy-sell agreement is one in which no one is overpaid and no one is underpaid, and the payment structure does not place an unfair burden on the business. Although buy-sell agreements are frequently funded with life insurance, what is the funding mechanism if the seller is disabled and does not pass away? Can the business afford to make the required payments without the benefit of life insurance proceeds?
Do yourself a favor. Get out your buy-sell agreement and read it. If the price specified by the agreement is formula based, ask your CPA to use the formula to calculate the price for the business? Keeping in mind that you don't know if you will be a buyer or a seller, are you happy with the result? Is the agreement structured in a way that will minimize income taxes for both parties? If the answer to either question is no, it is time for a new agreement.
As always, we welcome your comments and thoughts, requests for additional information, and suggestions for new topics.
January 17, 2012
Why the Millionaires' Tax is Unfair
Over the past few months, there has been talk in Congress about increasing federal income taxes on "millionaires." Many people, including members of Congress, are concerned that such an increase will be counterproductive because tax increases will take away the millionaires' incentive to work. In fact, I heard a Congressman make that statement in a recent radio interview. This reason could not be further from the truth.
In 1987, tax laws were changed to encourage businesses operating in the corporate form to elect S corporation status. At that time, most closely held businesses that were not already S corporations elected S status. The main difference between a C corp and an S corp is that a C corp pays tax on its income, and an S corp does not. The S corp passes its income through to its shareholders, who include it on their personal income tax returns and pay personal income tax on the income, whether or not the income is distributed to them.
Why is this important? It is important because a person that has ownership in an S corporation, partnership, or limited liability company may report income high enough to throw them into the "millionaire" tax bracket, when they receive little or none of the income that they are required to report on their tax returns. The problem is compounded by other tax rules, which require many businesses to report taxable income on the accrual basis of accounting, that is, recognizing taxable income when the income is earned rather than when it is received. So now imagine this reality; the S corp shareholder is not only paying tax on income that he has not received, but is paying tax on income not even received by his corporation! And if any tax rate increase is enacted, it may very well be this phantom income that causes the shareholder to be subject to the millionaires' tax.
So if the S corp shareholders must pay tax on income that they have not received, where do they get the money to pay this tax? Sometimes it comes from the shareholders' personal funds, but most often it is distributed to the shareholders from the corporation. The theory is that if the business was a C corp, it would be required to pay its own income taxes, so it distributes an equivalent amount to reimburse the shareholders for the tax liability arising from reporting the S corp income. And if there is a tax increase, it is likely that this policy will continue, but the additional distribution will reduce the amount of money available to the business to create jobs, purchase equipment, and finance growth. This is the reason why business owners object to the proposed milionaires' tax. It is not because it takes away their incentive to work, but because it reduces their ability to reinvest in their business. The most troubling part of this whole story is that members of the United States Congress do not grasp this concept.
Can this problem be solved without upsetting our entire pass through entity tax structure? I think it can, and the solution is relatively simple. If any proposed millionaires' tax is enacted, the only pass through entity income that should be considered in calculating income subject to the tax should be the amount actually distributed by the S corp, partnership, or limited liability company. Furthermore, distributions used to pay federal or state income taxes on the pass through entity income should be excluded from the calculation and the increased tax rates. This will prevent business owners who report phantom income from being subject to increased taxes on income not received.
In 1987, tax laws were changed to encourage businesses operating in the corporate form to elect S corporation status. At that time, most closely held businesses that were not already S corporations elected S status. The main difference between a C corp and an S corp is that a C corp pays tax on its income, and an S corp does not. The S corp passes its income through to its shareholders, who include it on their personal income tax returns and pay personal income tax on the income, whether or not the income is distributed to them.
Why is this important? It is important because a person that has ownership in an S corporation, partnership, or limited liability company may report income high enough to throw them into the "millionaire" tax bracket, when they receive little or none of the income that they are required to report on their tax returns. The problem is compounded by other tax rules, which require many businesses to report taxable income on the accrual basis of accounting, that is, recognizing taxable income when the income is earned rather than when it is received. So now imagine this reality; the S corp shareholder is not only paying tax on income that he has not received, but is paying tax on income not even received by his corporation! And if any tax rate increase is enacted, it may very well be this phantom income that causes the shareholder to be subject to the millionaires' tax.
So if the S corp shareholders must pay tax on income that they have not received, where do they get the money to pay this tax? Sometimes it comes from the shareholders' personal funds, but most often it is distributed to the shareholders from the corporation. The theory is that if the business was a C corp, it would be required to pay its own income taxes, so it distributes an equivalent amount to reimburse the shareholders for the tax liability arising from reporting the S corp income. And if there is a tax increase, it is likely that this policy will continue, but the additional distribution will reduce the amount of money available to the business to create jobs, purchase equipment, and finance growth. This is the reason why business owners object to the proposed milionaires' tax. It is not because it takes away their incentive to work, but because it reduces their ability to reinvest in their business. The most troubling part of this whole story is that members of the United States Congress do not grasp this concept.
Can this problem be solved without upsetting our entire pass through entity tax structure? I think it can, and the solution is relatively simple. If any proposed millionaires' tax is enacted, the only pass through entity income that should be considered in calculating income subject to the tax should be the amount actually distributed by the S corp, partnership, or limited liability company. Furthermore, distributions used to pay federal or state income taxes on the pass through entity income should be excluded from the calculation and the increased tax rates. This will prevent business owners who report phantom income from being subject to increased taxes on income not received.
December 6, 2011
New 2011 Tax Reporting Requirements Place Greater Burden on Taxpayers
The IRS has published many 2011 tax forms on its website, and let me tell you, it is getting ugly. Each year, a greater compliance burden is placed on taxpayers, making tax reporting even more time consuming and complicated. Although I haven't had a chance to review all the form changes, I did look at Schedules C and E, and it is scary.
Schedule C is the form used by individual taxpayers to report the income and expenses of a business operated as a sole proprietorship or a single member LLC. Schedule E the form used to report the income and expenses of operating rental real estate. Each of these forms contains two new questions. The first is "Did you make any payments that would require you to file forms 1099?" The second question is "If yes, did or will you file all required forms 1099?"
Form 1099 is generally required to be issued to report payments made in the course of a trade or business to any individual or unincorporated entity if the total of the payments is $600 or more in a calendar year. This seems simple enough, right? Wrong! Whether you own a two family house or operate a small business on a part time basis, you are subject to the 1099 filing requirements. For you rental property owners, are the landscaper and snow plower corporations? What about the roofer and the plumber? If they are unincorporated, do you have their addresses and federal tax identification numbers? After all, you do need this information to file the 1099 forms with the government by February 15. Do you see where I'm going with this? And by the way, if the 1099's are late filed, you are subject to penalty, so unless you plan to prepare these forms on your own, you can't wait until whenever you get around to it to see your accountant.
Getting back to the two questions, how will you answer them if you are required to but do not file forms 1099? It doesn't take a genius to know that the IRS is not asking these questions for their health. Keep in mind that when you sign your tax return, you are doing it under penalties of perjury, so you do not want to give a false answer. I would love to hear your thoughts on this, so please comment if you have any. I will provide more information as it becomes available. And by the way, these questions also appear on the 2011 partnership tax return form 1065. S Corporation form 1120 S has not yet been released for 2011, but I suspect the question will also appear on it.
Next time, I will discuss the new basis reporting requirements on Schedule D and new form 8949, which requires disclosure of whether or not basis was reported to you on form 1099, and potentially requires the filing of six different forms 8949 to comply with these reporting requirements. Like I said, it is getting really ugly.
Please contact us if you have any questions or we can be of assistance in any way.
Schedule C is the form used by individual taxpayers to report the income and expenses of a business operated as a sole proprietorship or a single member LLC. Schedule E the form used to report the income and expenses of operating rental real estate. Each of these forms contains two new questions. The first is "Did you make any payments that would require you to file forms 1099?" The second question is "If yes, did or will you file all required forms 1099?"
Form 1099 is generally required to be issued to report payments made in the course of a trade or business to any individual or unincorporated entity if the total of the payments is $600 or more in a calendar year. This seems simple enough, right? Wrong! Whether you own a two family house or operate a small business on a part time basis, you are subject to the 1099 filing requirements. For you rental property owners, are the landscaper and snow plower corporations? What about the roofer and the plumber? If they are unincorporated, do you have their addresses and federal tax identification numbers? After all, you do need this information to file the 1099 forms with the government by February 15. Do you see where I'm going with this? And by the way, if the 1099's are late filed, you are subject to penalty, so unless you plan to prepare these forms on your own, you can't wait until whenever you get around to it to see your accountant.
Getting back to the two questions, how will you answer them if you are required to but do not file forms 1099? It doesn't take a genius to know that the IRS is not asking these questions for their health. Keep in mind that when you sign your tax return, you are doing it under penalties of perjury, so you do not want to give a false answer. I would love to hear your thoughts on this, so please comment if you have any. I will provide more information as it becomes available. And by the way, these questions also appear on the 2011 partnership tax return form 1065. S Corporation form 1120 S has not yet been released for 2011, but I suspect the question will also appear on it.
Next time, I will discuss the new basis reporting requirements on Schedule D and new form 8949, which requires disclosure of whether or not basis was reported to you on form 1099, and potentially requires the filing of six different forms 8949 to comply with these reporting requirements. Like I said, it is getting really ugly.
Please contact us if you have any questions or we can be of assistance in any way.
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