Fall-out from the over-exposure of a certain s-corporation tax benefit
(or tax loop-hole) during the 2004 Presidential Campaigns has resulted in a broad-based
review by the Congress and the IRS.
update:
As IRS audits of S-corps increase during 2006 there is a defacto
definition of a required reasonable salary paid to working owners.
A minimum of 30% to 40% of net taxable profits (before deducting your
salary) has been deemed reasonable in many cases. The
significance of "salary" rather than "profits distributions" is that
"salary" is subject to Social Security and Unemployment taxes.
Retirement Plan contributions are based on a percentage of your
salary.
http://accounting.smartpros.com/x49128.xml
IRS to Launch Tax
Evasion Study
Washington, July 26, 2005 - The Internal Revenue Service said it will
launch later this year a study to measure tax evasion and compliance
risk. The study will examine 5,000 randomly selected S corporation
returns from tax years 2003 and 2004.
S
corporations are entities whose income and deductions pass through the
corporate structure to the shareholders. S corporations are now the
most common corporate entity. In 2002, the latest year for which data
is available, S corporation returns accounted for 59 to 60 percent of
all corporate returns filed for that tax year.
"The
use of S corporations has exploded," said IRS Commissioner Mark W.
Everson. "The IRS needs a better understanding of what this means for
tax compliance. This research is critical for achieving our strategic
goal of ensuring that corporations and high-income individuals are
paying their fair share."
Numerous restrictions and requirements apply to S corporations. For
example, an S corporation can have no more than 75 shareholders and
none of these can be another corporation or non-resident alien.
The
last reporting compliance study of S corporations involved about
10,000 returns from tax year 1984, prior to the tax law changes that
spurred the growth in S corporations. The results of the study will be
used to more accurately gauge the extent to which the income,
deductions and credits from S corporations are properly reported on
returns filed by the flow through corporations and their shareholders.
"This
research effort provides us the knowledge we need to both improve
compliance and reduce unnecessary taxpayer burden," said Everson.
High on the agenda will be an
analysis of the self-employment tax trick a/k/a the former
vice-presidential candidate "Senator John Edwards Tax Shelter."
http://www.forbes.com/business/forbes/2005/0314/046a.html
March 14, 2005 - If Washington
changes the Social Security payroll tax, it might be time to
incorporate--as the former senator did.
High-earning self-employed
professionals are likely hearing one word from their accountants these
days: incorporate. It might make sense in light of President Bush's
recent comment that he's "open-minded" to an increase in the amount of
salary--now $90,000--that the Social Security payroll tax is levied
on.
The idea is to do what
Democratic vice presidential candidate and former North Carolina
Senator John Edwards did back when he was a trial lawyer: Set up your
practice as an S corporation, pay yourself a reasonable salary as an
employee and then take the rest as S corp profits that are subject to
income but not payroll taxes. (S corp profits aren't subject to
corporate tax but are all passed through to an owner's return and
taxed at ordinary income rates.)
Right now wages of more than
$90,000 a year are subject to the Medicare tax, which amounts to 2.9%
when both the employer and employee contributions are counted, but not
to the combined employer-employee levy of 12.4% for Social Security.
(Here it gets complicated: The self-employed pay both the employer and
employee share but get to deduct the employer share of payroll taxes
when calculating their net earnings for the purposes of both payroll
and income tax.)
If the cap on the Social
Security tax is eliminated, some doctors, lawyers, actors and other
high earners could find the extra payroll tax more than eats up their
savings from the 2001 and 2003 tax cuts.
Earn enough and the numbers get
pretty big. Example: In 1998 Edwards reported a salary of $360,000 and
profits of $5 million from his law practice. Allocating so much to
profits is "somewhat aggressive, but not that unusual,'' says Phoenix
CPA Edward Zollars. Under current law, incorporating and treating $5
million as profits instead of self-employment income saves a taxpayer
$110,500. If the $90,000 cap on Social Security taxes is removed, the
tax savings from incorporation climb to $583,000.
But before you rush to
incorporate, consider this: If Congress raises the ceiling on the
Social Security tax, it's also likely to crack down on the John
Edwards ploy. In a recent report on possible loophole closers the
staff of Congress' Joint Committee on Taxation suggested that partners
and S corp. owners in service businesses like law be subject to
payroll taxes on all of their S corp. or partnership income. Even with
the existing $90,000 cap, this and some less drastic tightening on
other S corp. owners and partners would raise $57 billion over ten
years, the report projects. Get rid of the $90,000 cap and you're
talking real money.
Washington,
July 26, 2005 - Internal Revenue Service officials announced
today the launch of a study to assess the reporting compliance of S
corporations. The study, carried out under the National Research
Program (NRP), will examine 5,000 randomly selected S corporation
returns from tax years 2003 and 2004.
S corporations are entities
whose income and deductions pass through the corporate structure to
the shareholders. Since the mid-1980s, the number of S corporations
has risen rapidly, growing from 724,749 in 1985 to 3,154,377 in 2002.
The growth rate has been even
faster among S corporations with more than $10 million in assets. From
1985 to 2002, the number of these larger S corporations grew more than
ten-fold, from 2,305 to 26,096.
"The use of S corporations has
exploded," said IRS Commissioner Mark W. Everson. "The IRS needs a
better understanding of what this means for tax compliance. This
research is critical for achieving our strategic goal of ensuring that
corporations and high-income individuals are paying their fair share."
S corporations are now the most
common corporate entity. In 2002, the latest year for which data is
available, S corporation returns accounted for 59 percent of all
corporate returns filed for that tax year. Two million S corporations
reported net income of about $248 billion and 1.2 million S
corporations reported net losses of about $63 billion.
Numerous restrictions and
requirements apply to S corporations. For example, an S corporation
can have no more than 75 shareholders and none of these can be another
corporation or non-resident alien.
Program officials expect these
audits to begin later this year. The last reporting compliance study
of S corporations involved about 10,000 returns from tax year 1984,
prior to the tax law changes that spurred the growth in S
corporations. The new NRP initiative will use a study approach
designed to reach statistically valid conclusions regarding compliance
behavior, while using a smaller sample of returns than in the past.
The results of the NRP study
will be used to more accurately gauge the extent to which the income,
deductions and credits from S corporations are properly reported on
returns filed by the flow through corporations and their shareholders.
When completed, this research will assist the IRS in selecting and
auditing S corporation returns with greater compliance risk.
The research program on S
corporations is a complement to the study of individual reporting
compliance completed last year. The preliminary results from that
study, announced in March, indicated that the gross tax gap is more
than $300 billion each year. IRS collection and compliance efforts
reduce this gap by about $50 billion each year.
The NRP, created in 2000, is a
comprehensive effort by the IRS to measure payment, filing and
reporting compliance for different types of taxes and various set of
taxpayers.
Administering a tax system that
serves America’s taxpayers by promoting fairness and operating
efficiency and effectiveness is dependent on the agency’s ability to
measure and distinguish between the many factors that impact
compliance with tax laws.
"This research effort provides
us the knowledge we need to both improve compliance and reduce
unnecessary taxpayer burden," said Everson.
Without reliable measures, the
IRS faces major challenges in enhancing its ability to detect
noncompliance, improve overall compliance and develop methods for
allocating resources more effectively.
IR-2005-38,
New IRS Study Provides Preliminary Tax Gap Estimate
Washington, March 29, 2005 -
The Internal Revenue Service released preliminary results today from a
major research project assessing compliance with the tax laws. The
study reveals the vast majority of American taxpayers pay their taxes
timely and accurately, but the nation still has a significant tax gap.
The preliminary findings show
the gross tax gap - which is the difference between what taxpayers
should pay and what they actually pay on a timely basis - exceeds $300
billion per year. The results indicate the nation’s tax gap increased
slightly to between $312 billion and $353 billion in tax year 2001.
This compares to the old tax gap estimate for 2001 of $311 billion
based on earlier studies.
Net Tax Gap Tops
Quarter-Trillion Dollars
IRS enforcement activities,
coupled with late payments, recover about $55 billion of the tax gap,
leaving a net tax gap of between $257 billion and $298 billion.
"This research confirms that
the vast majority of Americans pay their taxes honestly and
accurately," IRS Commissioner Mark W. Everson said. "Even after IRS
enforcement efforts and late payments, the government is being
shortchanged by over a quarter-trillion dollars by those who pay less
than their fair share. People who aren’t paying their taxes shift the
burden to the rest of us."
Since 2001, the year covered by
the study, the agency has taken a number of steps to bolster
enforcement. The IRS increased its enforcement revenues by nearly 28
percent from $33.8 billion in 2001 to $43.1 billion in 2004. Audits of
high-income taxpayers — those earning $100,000 or more — topped
195,000 in fiscal year 2004, which is more than double those conducted
in 2001. Total audits of all taxpayers topped 1 million last year — a
37 percent jump from 2001.
“We are ramping up our audits
on high-income taxpayers and corporations, focusing more attention on
abusive shelters and launching more criminal investigations,” Everson
said. He noted that the IRS announced last week it had collected $3.2
billion in the settlement initiative for Son of Boss, a particularly
abusive tax shelter.
"Our enforcement efforts are
designed to increase compliance and reduce the tax gap," Everson said.
The initial tax gap findings
come from a three-year study called the National Research Program (NRP),
which audited 46,000 individual income tax returns for 2001. The
preliminary results determined a range for the tax gap, which will be
refined into final, more detailed estimates by year-end 2005. It is
unlikely but possible that the final estimates of the total tax gap
will fall outside the established range.
The tax gap has three
components: underreporting of income, underpayment of taxes and
non-filing of returns.
The new study shows modest
deterioration in tax compliance among individual taxpayers since the
last study was conducted in 1988. Preliminary findings include:
Underreporting noncompliance is
the largest component of the tax gap. Preliminary estimates show
underreporting accounts for more then 80 percent of the total tax gap,
with non-filing and underpayment at about 10 percent each.
Individual income tax is the
single largest source of the annual tax gap, accounting for about
two-thirds of the total.
For individual underreporting,
more than 80 percent comes from understated income, not overstated
deductions.
Most of the understated income
comes from business activities, not wages or investment income.
Compliance rates are highest
where there is third-party reporting or withholding. Preliminary
findings show less than 1.5 percent of wages and salaries are
misreported.
The NRP study includes updated
research only on individuals, not corporations.
Preliminary Findings Support
Enforcement Efforts, Tax Reform
Everson said the study confirms
two key points involving tax enforcement and simplification.
"The IRS needs to enforce the
law so that when Americans pay their taxes, they are confident that
neighbors and business competitors are doing the same," Everson said.
"At the same time, this research underscores the President’s call for
tax reform. Complexity obscures understanding. Complexity in the tax
code compromises both the service and enforcement missions of the IRS.
Those who try to follow the law but cannot understand their tax
obligations may make inadvertent errors or ultimately throw up their
hands and say ‘why bother.’ Meanwhile, individuals who seek to pay
less than what they owe often hide behind the tax code’s complexity in
order to escape detection by the IRS and pay less than their fair
share."
The President has called for a
nearly 8 percent increase for enforcement activities in the
administration’s 2006 IRS budget request. The additional funding will
increase audits of corporations and high-income individuals as well as
expand collection and criminal investigation efforts.
Everson noted that the United
States tax administration system remains one of self-assessment and
has a high compliance rate.
"We’re moving aggressively to
reduce the tax gap," Everson said. "With proper funding, over a number
of years we will be able to close a significant portion of the gap.
But no one should think we can totally eliminate the gap. That would
take Draconian measures and make the government too intrusive. We have
to strike the right balance."
The next stage of the NRP will
be to finish the data analysis and refine the tax gap data in late
2005. The IRS will also use the data to update its statistical tools
used to select individual returns for audit, an important step in
strengthening compliance with the tax system.
The IRS also plans to update
estimates for other areas of the tax gap. The first part of this
process will study reporting compliance of flow-through entities
(S-corporations and partnerships).
Miscellaneous links regarding paying salary to s-corp
stockholders:
http://www.traderstatus.com/IRSsaudits.htm
http://state29.blogspot.com/2004/07/sign-me-up-for-john-edwards-tax.html
http://www.rothcpa.com/archives/000541.php
http://experts.about.com/q/Tax-Law-Questions-932/S-corp-salary-shareholder-3.htm
>>Should a 1 person Sub S corp owner take a salary equal to 100% of
his net
>>profit each year?
http://www.taxalmanac.org/index.php/Discussion:S_Corp_Owner_Salary_vs._Distributions
>>I advise clients of the 60/40 rule, 60 being salary.
http://taxes.about.com/od/scorporations/qt/reasonable_comp.htm
>>The number one audit risk for S-Corporations is salary and wages
paid to
>>officers of the corporation.
http://www.selfemployedweb.com/s-corp-vs-llc.htm
http://tax.cchgroup.com/primesrc/bin/cchmsgboard.dll?Topic=CCH+Tax+Community+Open+Forum&a=m&ThreadChain=0.7631&Site=tax
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