

The IRS Targets Income Tricks - wglb
http://online.wsj.com/article/SB10001424052748703951704576092371207903438.html

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patio11
Small businesses are somewhat notorious for aggressively interpreting the tax
code in one's favor, largely because they have a variety of options for doing
so not available to the W-2 employee. The game theory sort of incentivizes it,
too: heads you save 100% of the taxes at issue, tails you have to pay the
taxes at issue and (if you had any sort of a good faith case) only interest at
a below-market rate on them... and the coin is known to flip tails only a few
percentage points of the time, due to how infrequent audits are.

This is complicated by the fact that, if the tax code were a spec, it would
have some requirements which were contradictory and very many interactions
whose behavior was totally undefined.

For example, BCC has a fairly similar issue: if the profits are earned income
received for the value of my services as an engineer/etc, then they're subject
to a generous exclusion since I was physically in Japan when I earned them
(foreign earned income exemption, form 2555). If they're unearned income --
that is, if the business is generating profits above the fair market value of
the time I am investing -- then they are not subject to that exclusion and I
owe the IRS a few thousand extra. On a separate axis, they may not be
attributable to the business at all, but as a result of sale of real property,
depending on whether the computer software counts as personal property or not,
which apparently turns on the degree of support/customization I offer and the
mood of the examining IRS clerk. If they aren't attributable to the business
and are a sale of real property, then they are excludable, as long as the
transaction is not sourced to the United States. Sales of real property are
sourced where the transaction physically takes place... but the IRS literally
has no opinion on where that is for sales of downloadable software. (I asked.
They said "Write up your reasoning with your tax form. If we don't bill you,
you're good.") If they are not real property, they may be a sale of computer
licenses, which are arguably a source of royalties, which could be subject to
a US/Japan tax treaty provision which overrides some of these rules but not
others.

The above is not tax advice. Don't even ask about the Japanese side -- I have
a few more weeks to figure that mind-meltingness yet.

~~~
rubyrescue
i just realized the both of us need to start an american-expat-tech-
entrepreneur-tax forum. a few other people are in the same boat and email me
based on my profile from time to time. I find i know much more about IRS tax
code regarding form 2555 than most US accountants because they just don't deal
with it much, OR, the ones that have charge way more than I can afford to help
me with my questions - but i haven't found a place to discuss these type of
issues online. perhaps a google group?

~~~
camz
I'd be willing to help with my experience with these tax issues. =)

I'm both licensed and experienced in the tax field.

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camz
I'd like to clarify the issue. Personally, I think that the CPA in question in
the article is an idiot for a number for reasons. (1) He's an accountant so he
should've known that playing this game with the IRS as a CPA is begging the
IRS to slam you. (2) Litigating a losing position like this so publicly is
going to kill your reputation and put you on the IRS' top 10 favs list for
life.

This is a very clear issue actually and I'm not sure why there is so much
confusion and I'd disagree with calling this tax plan a "trick."

It is a legally sound tax plan with a justified theory. You are allowed to
exempt a portion of your income from payroll taxes because they are
"corporation distributions." Corporate distributions or dividends are not
taxed as earned income because they are considered passive investment income.
An S-Corp is a corporation that abides under a specific subset of rules within
the IRC's Corporation Regulations, thus it is for all legal purposes a regular
corporation with certain special rules.

A reasonable salary is a fairly straight forward question. The IRS won't
nitpick with you on silly numbers as long as you fit within the range.
Obviously, for every position there is a high and low salary range, so as long
as you fit within that range the IRS will leave you alone.

The CPA is an idiot because he underpaid himself below market rates to the
point where he couldn't justify his position under any reasonable defense.

If you were developer, then you would be paid anywhere from 40k to 250k+
depending on your company, position and experience. Thus, you could
potentially pay yourself 40k in reasonable salaries if you owned an S-Corp and
take the rest as a dividend. As long as you are able to provide "comps or
comparable salaries" to positions with equitable responsibilities and
experience in your local region.

The important thing to remember is to be reasonable.

I'm a full-time tax accountant, so this is coming from years of experience in
the field with direct contact with auditors from the federal and state levels.
They won't come knocking unless you were being a greedy idiot because like the
article states it's expensive for the government to audit someone, so when
they do audit you it has to be a profitable venture (thus, they usually audit
the sure-thing losers).

~~~
DenisM
Does any of this apply if you're not distributing the cash _at all_? Say, I am
making money in my S-Corp, but I keep all of it in the bank (minus the
expenses) and instead live off my savings. The plan is to save enough to
expand the business, but for now the money is just sitting there, doing
nothing.

~~~
camz
No that is not going to work. Keeping money in the business is called
"retained earnings." Only C corporations or regular corporations are allowed
to retain earnings. Pass-through entities such as partnerships and
S-corporations are required to pass any income to the owners regardless of
whether cash or any other form of income is distributed.

If you want to reinvest into the company, then you'd have to pay taxes on the
distributed income and then put the after tax money back into the business,
which would increase your tax basis in the company. This would allow you to
take net operating losses in the future as well as help you if you ever sell
the company.

Hope that helps. Keeping money in the bank won't help you in this situation.

~~~
DenisM
Thanks for your reply. Just to be sure I understand you correctly, which one
(if any) is true:

If an S-Corp makes money, it is assumed that the earnings are distributed and
thus both personal income tax (on the entire earnings amount) as well as
payroll taxes (on the reasonable wage) have to be paid.

Or:

If an S-Corp makes money, it is assumed that the earnings are distributed and
the personal income tax has to be paid (on the entire earnings amount), but
payroll taxes don't need to be paid.

~~~
camz
Option 1 sounds about right. All distributions are going to be tax on your
personal income tax and exempt from payroll taxes.

Reasonable wages are NOT corporate distributions, they're simply wages paid by
the corporation and deducted as an expense. The payroll taxes would be paid on
the amount that you deem wages through the corporation. Please note, payroll
taxes are also deductible. hope this helps

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joe_bleau
See, this points out something I've never understood. If you own an s-corp,
you have to be careful about paying yourself too little and taking out too
much profit, presumably due to the reduction in FICA withholdings.

So how does someone like Steve Jobs get away with making a $1 annual salary
without being charged with tax evasion? It seems like he's found a way to
avoid paying into the social security and workmen's comp system.

What am I missing? Is it only legal to dodge withholdings in a c-corp?

~~~
ayb
A S-corp owner must take what the IRS deems to be a "reasonable salary" based
on the overall profit of the company, and must pay self employment taxes
(FICA, Medicare, etc.) on that amount.

The IRS does not give out much guidance on the definition of "reasonable
salary" but has provided guidance on what is /not/ reasonable.

In this case the IRS evaluated the company's return and decided that his
salary was less that reasonable and as such they went after him and got him to
pay more tax.

This rule does not apply to C Corporations.

~~~
tptacek
To be clear: the rule doesn't apply to C Corporations because they are taxed
differently; it's not an oversight. It's the pass-through taxation structure
of S Corporations that make this an issue.

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patrickgzill
Aside (but relevant): some countries have as an explicit rule, that if you get
a letter from the IRS on an issue, both you (as someone who has to comply with
the law) and the IRS itself, is bound by the interpretation that is given.

In the USA, even if you get a private ruling, the IRS can decide to renege on
their advice at any time, and investigate you and charge you, making you pay
penalties and fines for following their own advice.

These ambiguities and "tricks" could be cleared up with simple guidelines
backed up by such private rulings; however that would not be in the best
interest of our "gotcha now!" system of taxation.

------
ams6110
There is so much "waste motion" expended in trying to game the tax code in so
many situations... what could creative people achieve in that time if they
didn't spend it that way. We need a vastly simplified income tax code... I'm
talking throw it all out and start from scratch. Or replace it with a national
sales tax, rebating some amount to make it less regressive.

~~~
tptacek
This implies that if you simplified the tax code, people would stop gaming it.
The opposite is probably true; the simpler you made the tax code, the more
accessible tax games would be to average taxpayers.

~~~
JeffL
I don't agree. In order to game, there has to be different rules to take
advantage of. The fewer and simpler the rules, the less you can manipulate it.
Take sales taxes, for example. You can't really game them. You can evade them,
but not really game them, although I suppose mail ordering things from another
state could qualify, but that's an issue of jurisdiction.

~~~
tbrownaw
> I suppose mail ordering things from another state could qualify

You're supposed to pay "use tax" on those, which for some reason is always
equal to the sales tax you think you avoided. So it's still evasion rather
than gaming.

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DanielBMarkham
I hope I don't get slammed for this, but the tax code is a large pile of
stinking dung, and good luck trying to do the right thing.

S-Corps work under the general premise that it's just like you, if you were a
corporation. So if you don't spend all the income in your business in the
year, you owe income tax on what remains. If you have plenty of profits, you
write yourself a regular W-2 paycheck. At the end of the year, whatever you
don't spend as a legitimate business expense -- even if it's exclusively for
business purposes -- is taxed at the same rate as if you had spent the money
on whiskey and hookers.

Case in point: there is a _huge_ difference between a high-income wage earner
who uses S-Corp status for maximum flexibility and the local beautician or
mechanic who does the same thing. Lots of independents who are S-Corps have
highly volatile income: if you get a client that writes you a check for 50K in
January that might be the last income those guys see for that year. So those
guys have to make a difficult business decision as to what to do with the
money, and the most logical thing to do is to pay business expenses as needed
and withdraw the rest as cash disbursements only as a last result. Writing
yourself a W-2 paycheck when you're not sure of future income is basically
taking away spending money from the business for no logical reason. As I
understand it, the system is designed this way on purpose: tough times allow
S-Corps to ride on profits and re-tool for the good times. Good times S-Corps
work just like "regular" businesses.

So for small folks with highly-volatile income, being able to move funds
around is the only thing sometimes that keeps them afloat. Unfortunately,
there are a lot of guys making 400K a year or more who pay themselves a salary
of $20K and take the rest as cash disbursements (thereby avoiding paying
themselves as W-2 employees mostly altogether)

The reason the tax code is such a mess is that folks get mad at one bunch or
another that they think are not acting fairly, so they punish them -- usually
punishing many more than the original target. Or politicians want extra votes,
so they make an exception for certain people -- usually providing exceptions
to hidden interests and creating perverse incentives. 60 years of this and you
have a complete disaster.

So yes, by all means make folks pay their share, just be aware that the guy
you read about in the paper isn't necessarily the average guy. It's not an
"income trick" if it helps the economy grow.

~~~
tptacek
Respectfully --- I like you and your comments, even though our politics
couldn't be more different --- you should get slammed for this analysis.
You're muddying the waters and you know it.

The prevailing market wages for beauticians and mechanics are so low that that
benefit of evading FICA is marginal. S-Corp owners are rarely audited _period_
, but here you ask us to consider that enforcement of the tax code might focus
on them. Of course it doesn't.

Moreover, you've conjured up this issue of income flexibility, the idea that
feast-or-famine will cause people to need irregular salaries. But that's not
an issue at all. You can pay yourself an irregular salary. Just make sure your
quarterly estimated tax payments treat most of it as payroll. The only time
this S-Corp rule becomes an issue is when you _explicitly invoke it to avoid
FICA_. Don't do that.

It is not difficult to avoid the problem this article talks about: unless your
salary approaches the FICA cap (last year it was just shy of 100k), don't pay
yourself a significant fraction of your total income in distros. What makes
this a particularly easy rule of thumb to follow is that it's exactly what you
would do anyways if you didn't know about the S-Corp loophole.

~~~
tbrownaw
> What makes this a particularly easy rule of thumb to follow is that it's
> exactly what you would do anyways if you didn't know about the S-Corp
> loophole.

So if everyone is supposed to pretend it doesn't exist, why _does_ it exist?

~~~
tptacek
The tax structure S-Corp owners are taking advantage of is the one that
governs investment income. These people are deliberately reclassifying their
compensation as return on the investment of having started a business.

~~~
abalashov
Thanks, that clears it up. I was reading the article wondering since when
these people don't have to pay SEP taxes.

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johnwatson11218
Can anyone comment on how personal income tax is handled in other countries? I
don't mind paying tax but I hate the fact that I can take my paper work to
several different tax preparation services and get different tax bills. In
some cases I have heard of people owning the IRS thousands, going somewhere
else and claiming a refund.

Is the US the only country in the world where 2 to 3 percent of our GDP goes
into tax preparation?

~~~
notauser
In the UK personal taxes are generally automatically handled by the employer.
You just get the post-tax income transferred into your bank every month, and a
payslip showing the deductions that were made.

(Outsourced PAYE administration costs about £20 per month for a very small
company.)

It gets more complicated when you can't do taxes through PAYE for any reason -
unearned income, dividends, directorships etc.

My own taxes as a director of two firms subject partially to mandatory PAYE on
some of my income are a US-level nightmare and once you are out of the 'simple
system' getting back into it takes years.

~~~
johnwatson11218
I read a book by Jim Rogers, I think it was "Investment Biker" and he said
that the US is the laughing stock of the developed world because of the way
our incomes taxes work. He said that in Australia you have one form the size
of a postcard that everybody mails in once a year.

~~~
brc
While I agree with you, it's not entirely true that you have one form that you
post in once a year. While your 'group certificate' is postcard size, I
_think_ it's somewhat like a W2 (been a while since I received either), you
still have to submit a personal tax return. For most people, it's just a case
of reporting the information on the Group Certificate(s) (depending on how
many jobs you had) and perhaps claiming on some deductions like uniforms or
(new) secondary school expenses for dependent children.

That said, the government is talking about moving to a model whereby you don't
have to submit a return unless you specifically want to claim some deductions.
This is more like the UK model.

As for the US being the laughing stock - I don't know if I would choose those
words, but I do think the IRS needs its wings clipped by foreign governments.
The whole W8BEN form thing is ridiculous (so tempted to put F.YOU IRS as my
contact details) as is the mind-boggling fact that the only way to not file a
return in the USA is to renounce your citizenship (and good luck visiting your
relatives after that!).

The myriad of local, state and federal taxes, forms, rulings and corporate
structures - well, I do wonder how much GDP is lost in paper shuffling. It
can't be insignificant.

Personally, I would have the tax laws in most countries scrapped and replaced
with flat-banded taxes with zero exemptions. The tax rates would be lower to
make up for the lost deductions, but in general, if you earnt X, you'd be up
for taxes of Y. Corporations would be kept for their original purpose of
limited liability rather than taxation structures. As noted above, it's all
the special interests that get in, and, well, anyone who was tried to
selectively reward children will know the impossobility of 'fair' once
selective rewards and exemptions are introduced.

------
JeffL
Seems like if we just had a large sales tax, rather than income taxes, none of
these things would be so complicated, and we'd save so much money on the cost
of compliance.

~~~
jrockway
A large sales tax is an unfair tax on the poor. Why should people making
$20,000 a year pay the same tax on their groceries as someone making
$1,000,000 a year?

~~~
detst
Don't tax groceries as is already the case in many states.

~~~
jrockway
So all poor people are allowed to do is eat? That's worked really so far...

~~~
detst
I'm not advocating replacement of income tax with higher sales tax; just
answering your question.

I wouldn't consider myself the most knowledgeable on this issue but I think
there's an argument for a system that doesn't tax certain basis necessities
and offers compensation to the poor to allow for more than just an existence.

------
jrockway
Wow, a mandatory minimum wage for professionals. I estimate that this will
last for about ten more minutes.

~~~
tptacek
It's not a "mandatory minimum wage". Stop trolling. You can pay yourself
$0.50/yr if you'd like; you just can't do it will paying yourself tens of
thousands in distributions.

~~~
DenisM
So if I am not distributing anything, I don't need to worry about the
"reasonable wage" rule, right?

~~~
tptacek
I think it's safe to say that if you don't know about the S-Corp FICA tax
dodge, you're not going to run afoul of the IRS over it.

------
anonymous246
This is one of those few instances where I actually support the IRS and also
support the law that's being contemplated.

S corps (and AFAIK LLCs) are supposed to have "pass through" taxation. I think
it's fair that all income (whether salary or profit distributions) from S Corp
is treated as regular W-2 income.

If you don't care about the simplicity that "pass through" offers, register a
C-corp.

~~~
jabits
So then as a small Sub-S owner (wife and me), I would have to pay FICA and
Medicare on the money spent on health care insurance, disability insurance,
etc., which you as a W-2 employee do _not_ pay payroll taxes on.

In the end, the payroll tax savings are not that great for a small Sub-S. And
as you get older, toward retirement, if you pay yourself too low, you take a
big hit on SSA benefit payments (which are based on your latest 40 qtrs).

The biggest bang for the PIA effort is if to can write off a vehicle purchase
through a Section 179 deduction, and various other hardware purchases.

~~~
tptacek
The tax code already goes way, way out of its way to make it easy to pay for
health insurance; get a high-deductable plan and build an HSA. It's what you
should be doing anyways, even if you don't care about taxes.

The fact of the matter is, as a member of the workforce, you owe FICA on your
compensation. This isn't a subject of dispute. The IRS says you do, the courts
say you do, your accountants will say you do. This issue comes up on HN
roughly once a year, and the story has never changed.

~~~
jabits
"...you owe FICA on your compensation". Exactly. I want to be taxed (and get
the same breaks) as my corporate client employees. Business writes off all
possibly related equipment, as do I. I try to write off everything a C-corp
would for employees, but it is much more difficult for us (and very time-
consuming even trying to be IRS-compliant).

Again, payroll tax savings (on the income/distribution differential) does not
usually add up to that much money.

