Double Taxation: A Take On All Things Taxes

While Mitt Romney’s 13.7% effective tax rate finds itself squarely in the crosshairs of both the Republican and Democratic parties, Janet Novack over at Forbes correctly points out that Newt Gingrich used some savvy tax planning of his own to minimize his overall tax liability. Gingrich owns two S corporations, and he leveraged a fifty-year old Revenue Ruling to his advantage by taking “only” $450,000 of compensation from the corporations, while allowing the net profits of $2.4 million to flow through to his individual tax return free from payroll taxes.

In this article published in the Tax Adviser, a certain Aspen-based author takes a thorough look at the issue of S corporation reasonable compensation and explains in detail the mechanism by which Gingrich — and many wealthy business owners like him — are able to save on payroll taxes by minimizing salary in favor of distributions. The article also examines the substantial case history surrounding S corporation compensation, and offers guidance on how to minimize the risk of a successful IRS attack. Fortunately for all, the Tax Adviser article is devoid of the low-brow humor, grammatical errors, and misspellings that have come to define the author’s mildly popular blog:

This S corporation flow-through income has long enjoyed an employment tax advantage over that of sole proprietorships, partnerships and LLCs. This advantage finds its genesis in Revenue Ruling 59-221,[i] which held that a shareholder’s undistributed share of S corporation income is not treated as self-employment income. In contrast, earnings attributed to a sole proprietor, general partner or many LLC members are subject to self-employment taxes.[ii]

As these employment tax obligations have climbed, the advantage of operating as an S corporation has become magnified. Since S corporation income is not subject to self-employment tax, there is tremendous motivation for shareholder-employees to minimize their salary in favor of distributions, which are also not subject to payroll or self-employment tax. Consider the following example:

Example 1: A owns 100% of the stock of S Co., an S corporation. A is also S Co.’s president and only employee. S Co. generates $100,000 of taxable income in 2011, before considering A’s compensation. If A draws a $100,000 salary, S Co.’s taxable income will be reduced to zero. A will report $100,000 of wage income on his individual income tax return, and S Co. and A will be liable for the necessary payroll taxes. S Co. will be required to pay $7,650 (7.65% of $100,000) as its share of payroll tax, and S Co. will withhold $5,650 (5.65% of $100,000) from A’s salary towards A’s payroll obligation, resulting in a total payroll tax bill of $13,300.  

Example 2: Alternatively, A may choose to withdraw $100,000 from S Co. as a distribution rather than a salary. S Co.’s taxable income will remain at $100,000 and will be passed through to A and reported on his individual income tax return, where it is not subject to self-employment tax. The $100,000 distribution is also not taxable to A, as it represents a return of basis.[iii]  By choosing to take a $100,000 distribution rather than a $100,000 salary, S Co. and A have saved a combined $13,300 in payroll taxes.

Now, let it be said, while some may paint Gingrich’s $450,000 salary as unreasonably low — particularly in light of the fact that majority of the earnings of the S corporations appear to be attributable solely to services provided by Gingrich and his wife — there is no precedent in which the courts have held a salary of this magnitude to be unreasonable low.* To the contrary, the majority of IRS challenges have come when shareholders pay themselves less than the social security wage base, thereby avoiding the 12.4% (10.4% in 2011) social security tax on wages below $106,800 in addition to the 2.9% Medicare tax on all foregone wages.

Once a shareholder has paid himself  — at minimum — the social security wage base as compensation, the avoided payroll tax becomes limited to the 2.9% Medicare piece, and the risk of an IRS challenge appears to become significantly reduced. In Gingrich’s case, taking a salary of $450,000 allowed him to avoid only the 2.9% Medicare tax on the additional profits of $2.4 million; and while $70,000 is not a paltry sum by any means, it will certainly not go down among the great tax avoidance strategies of all time.

 Hat Tip: Tax Prof

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Ed note: This post has absolutely nothing to do with tax, but if you’ll humor me I suspect there’s something to be learned that’s far more important than anything found in the Internal Revenue Code.

On Saturday morning, I stood atop the 12,400 foot summit of Highland Peak, my lungs searing and legs shaking from the final push to the top. Among a handful of skiers sharing the summit that day was an Aspen Highlands patroller, who after offering a friendly “hello,” removed his helmet to reveal a partially shaved head and an ominous, angry-looking scar running from his widow’s peak to his ear.

I responded with a hello of my own before quickly asking about the origin of the scar, internally justifying my rude, overly personal inquiry with the belief that my breach of etiquette would soon be forgiven, for I was certain — even before hearing his answer — that we were members of the same exclusive club.

You see, in the spring of 2008, I underwent a nine-hour craniotomy to repair an aneurysm in my brain. As a result, I’m keenly aware of the trademark signs of brain surgery, most notably the telltale half-moon shaped scar sported by the patroller, an exact replica of which could be found under my own helmet and hairline.  

The patroller introduced himself as Steven[i] before explaining that in late October, he had undergone his third craniotomy to remove a relentless tumor. After divulging my story, Steven and I shared a quick laugh at the unlikeliness of the moment; the two of us taking a minute to appreciate the long climb — both figuratively and literally — we had endured to return to this summit.

As we talked, I realized that in Steven presence on that summit, I was bearing witness to an accomplishment nothing short of superhuman. Understand this: a craniotomy is a horribly invasive and violent procedure; one that leaves those fortunate enough to survive remarkably weakened for the better part of a year. From my own experience, it was five weeks before I could walk across a room unassisted, three months before I could travel from one lifeguard stand to the next in soft sand, and nearly five months before I was able to put together what only the most polite among us would call a jog. As daunting as that may sound, however, I assure you that the physical recovery pales in comparison to the ensuing emotional one. 

For as your legs and lungs regain strength, the temptation to return to your pre-surgery life becomes overpowering, as your subconscious seeks to allay the fear that things will never be the way they once were. But as your heart rate rises and that familiar burn permeates your muscles, the self-assurance you seek remains elusive, replaced instead by a silent war that wages within your brain. For every moment spent celebrating, “I’m doing it again!” there is exponentially more time spent questioning, “Should I be doing it again? Will I get another aneurysm? Will I get another tumor?” It is a cruel and tortuous dichotomy of emotions.

And yet here was Steven, only ten weeks removed from surgery, thriving in the harshest of settings without a hint of the self-doubt that defined my recovery. As a ski patroller, he works nine-hour days, six days a week, all of it spent on his feet in the unforgiving environment of the high alpine. Unlike my coddled life as a CPA, Steven returned to a job where hurricane force winds, blizzard conditions and bitter cold are the norm, and where mitigating the threat of a deadly avalanche on the slopes of Highland Bowl depends largely on the physical strength and keen focus of the ski patrol. Mere months after a life-altering event, Steven had rushed to return to a position where he was responsible for the safety of the thousands of skiers that visit Aspen Highlands each winter day.

It goes without saying, such a career allows for no “mail-it-in efforts.” Steven was required to be in peak condition, both physically and mentally. Given that he was less than three months out from having his skull opened and his brain fiddled with for the third time, I had to know: how had he returned so quickly? Steven’s response:

“I just decided I wasn’t going to let anything keep me from living.”

And that is precisely why I felt the need to share Steven’s story. At the risk of infringing on the copyright of a Ray Lamontagne tune, I’ve met far too many people who’ve never truly appreciated that their life was theirs for making. I’ve witnessed what adversity, what fear of death, can do to a person. How visions of a foreshortened future can elevate one’s instinct for self-preservation above all others, tempting a person once brimming with life to spend his remaining days in a self-imposed protective bubble. To die without dying.

And then there was Steven, a man with every reason to live out his days from the safety of his couch, seeking pity for the bad hand he was dealt while wondering what could have been had life been a little more kind. But instead, Steven refused to allow his bad moments to become the defining ones of his life; he willed himself to return to the mountains we share a passion for. Steven understands what so many of us don’t: there’s little point in being alive if you can’t — or won’t — pursue the things that make life worth living.  

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