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Yesterday, the Supreme Court of the United States denied certiorari to a tax case on an issue of first impression from the U.S. Court of Appeals for the Eighth Circuit — David E. Watson P.C. v. U.S., 668 F.3d 1008 (8th Cir., 2012).

You may remember Watson from our previous discussion here, or from this brilliantly written article in the Tax Adviser. Either way, Watson directly impacts tax advisors as it provides a long-awaited roadmap for quantifying a “reasonable compensation” amount for shareholder/employees in personal service S corporations.

Background

In late 2010, an Iowa district court held that David Watson, a partner with a CPA firm who paid himself only $24,000 in annual salary while taking out over $200,000 in annual distributions, had avoided payroll taxes by failing to pay himself reasonable compensation. Because Watson actually reported some compensation, however, the court was facing an issue of first impression: determining just what constituted “reasonable compensation” for Watson’s services. The resulting analysis provided the first court-approved roadmap for tax advisers to use in setting appropriate salary amounts for their S corporation shareholder-employee clients.

In setting Watson’s salary, the IRS engaged the services of a general engineer, who first sought to determine the health of Watson’s CPA firm. By analyzing financial ratios published by the Risk Management Association — particularly profits/sales and compensation/sales — the engineer found that Watson’s firm was very healthy, and that compared to similarly healthy firms, Watson’s compensation was unreasonably low.

The court then looked internally at Watson’s firm, noting that Watson was paid less than those subordinate to him. In fact, Watson’s salary was less than what the firm was paying recent college graduates.

Finally, to quantify the appropriate salary, the engineer utilized MAP surveys conducted by the AICPA, which indicated that the average non-owner director of a CPA firm the size of Watson’s would be paid $70,000. The engineer then grossed up this salary by 33% to account for Watson’s stake as a shareholder, resulting in “reasonable” compensation of $93,000 for each of 2002 and 2003.

The District Court agreed, citing Watson’s experience, expertise, and time devoted to his role as one of the primary earners at a well-established firm.

In February 2012, the Eighth Circuit Court of Appeals affirmed the District Court’s decision. Watson appealed once more to the Supreme Court, but saw that dream die yesterday.

With Watson apparently in the books as concluded tax law, now is an appropriate time to remind ourselves what we can take away from this important decision:

What Can We Learn?

Above all else, Watson established that the IRS is taking a formal, quantitative approach towards determining reasonable compensation, so to adequately advise our clients, we must be prepared to do the same thing. At a minimum, in setting the compensation of our S corporation shareholder-employee clients, we must consider the following:

1. Nature of the S Corporation’s Business. It is no coincidence that the majority of reasonable compensation cases involve a professional services corporation, such as law, accounting, and consulting firms. It is the view of the IRS that in these businesses, profits are generated primarily by the personal efforts of the employees, and as a result, a significant portion of the profits should be paid out in compensation rather than distributions.

2. Employee Qualifications, Training and Experience, Duties and Responsibilities, and Time and Effort Devoted to Business. A full understanding of the nature, extent, and scope of the shareholder-employee’s services is essential in determining reasonable compensation. The greater the experience, responsibilities and effort of the shareholder-employee, the larger the salary that will be required.

3. Compensation Compared to That of Non-shareholder Employees or Amounts Paid in Prior Years.  Here, common sense rules the day. In Watson, a CPA with significant experience and expertise was  paid a smaller salary than recent college graduates. Clearly, this is not advisable.

4. What Comparable Businesses Pay for Similar Services. Tax advisors should review basic benchmarking tools such as monster.com, salary.com, Robert Half, and Bureau of Labor Statistics wage data to determine the relative reasonableness of the shareholder-employee’s compensation when compared to industry norms.

5. Compensation as a Percentage of Corporate Sales or Profits. Tax advisors should utilize industry specific publications such as the MAP to determine the overall profitability of the corporation and the shareholder-employee’s compensation as a percentage of sales or profits. Whenever possible, comparisons should be made to similarly sized companies within the same geographic region. If the resulting ratios indicate that the S corporation is more profitable than its peers but paying less salary to the shareholder-employee, tax advisors should determine if there are any differentiating factors that would justify this lower salary, such as the shareholder’s reduced role or the corporation’s need to retain capital for expansion. If these factors are not present, an increase in compensation to the industry and geographic norm provided for in the publications is likely necessary.

6. Compensation Compared With Distributions. While large distributions coupled with a small salary may increase the likelihood of IRS scrutiny, there is no requirement that all profits be paid out as compensation. Though the District court in Watson recharacterized significant distributions as salary, it permitted Watson to withdraw significant distributions in both 2002 and 2003. Perhaps the court was content to recharacterize just enough distributions to ensure that Watson’s compensation exceeded the Social Security wage base in place for the years at issue. In doing so, the payroll tax savings on Watson’s remaining distributions amounted only to the 2.9% Medicare tax.

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As we’ve discussed previously, a shareholder in an S corporation may only utilize the loss allocated to them on Schedule K-1 to the extent of the shareholder’s basis in the stock and debt of the corporation.

While a shareholder’s stock basis is fairly straightforward, establishing debt basis is another matter entirely; with the vagaries in the Code having been manipulated enough times to foster reams of case law and new proposed regulations that would liberalize, to some extent, what types of transactions give a shareholder debt basis.

And while the IRS appears willing to make some concessions within the proposed regulations, one element of shareholder debt basis remains unchanged: the loan must be made directly from the shareholder to the S corporation, and perhaps just as importantly, the shareholder must be able to prove that this requirement has been met.

To illustrate the importance of attention to detail, the courts have blessed so-called “back to back loans,” whereby a shareholder borrows money and in turn loans it directly to the corporation, provided the shareholder can establish that they, and not the corporation, borrowed the money from the third party, and that they in turn loaned the borrowed amounts to the S corporation. To the contrary, should the same third party loan the amounts directly to the corporation without passing through the shareholder first, the faulty structuring dooms the shareholder’s claimed debt basis.

Late last week, the Tax Court drove this point home once again in Welch v. Commissioner, in which an S corporation shareholders claimed she had debt basis sufficient to allow her to absorb large flow-through losses from her S corporation. Her failure to establish that the purported advances were made directly from her to the corporation, however, convinced the Tax Court to deny the debt basis and the related losses.

In Welch, Ms. Welch owned 80% of the stock of Respira, an S corporation. During 2005 and 2006, Ms. Welch had no stock basis in the S corporation, but she asserted that she had substantial debt basis. Ms. Welch claimed that she had borrowed nearly $600,000 from a Dr. Levenson and lent all these funds to Respira.

These advances, however, were either paid directly by Dr. Levenson to Respira or else represented amounts that he charged to his credit card as payments of Respira’s expenses. Dr. Levenson wrote no checks to Ms. Welch, nor did he otherwise make any payments to her with regard to the alleged loans. Ms. Welch contributed no personal funds to Respira, nor did Respira execute a loan agreement or any notes evidencing any loans from Ms. Welch.

Respira’s trial balance as of December 31, 2005, listed a $60,848 shareholder loan from Ms. Welch. Respira’s balance sheet as of December 31, 2006, listed liabilities of $66,349 “Due to Majority Shareholder”.

When it came time to file the Forms 1120S for 2005 and 2006, Respira reported net operating losses of $50,294 for 2005 and $683,059 for 2006. On her separate individual Federal income tax returns for 2005 and 2006, Ms. Welch deducted her share of the losses — 80% — against her claimed debt basis.

Ms. Welch argued that she made loans to Respira by contributing funds she received as personal loans from Dr. Levenson. She claimed that as of December 31, 2005 and 2006, she had $521,061 and $480,826 of debt basis in Respira, respectively, for amounts personally borrowed from Dr. Levenson and reloaned to the S corporation.

The IRS denied the losses, arguing that the shareholders lacked sufficient basis in either the stock or debt of Respira. The Tax Court agreed, holding that Ms. Welch could not prove that she loaned any amounts directly to the S corporation.

Foremost among the damning evidence against Ms. Welch was that while she claimed to have made loans approximating half a million dollars to Respira, the books and records of the S corporation revealed loan payable balances of only $65,000 for the years at issue, rather than the $500,000 Ms. Welch claimed to have advanced.  This, the court reasoned, was because the amounts used to fund the S corporation were not borrowed directly from Ms. Welch, but rather from Dr. Levenson, and thus were evidenced as normal liabilities on the balance sheet, rather than loans to shareholders.

Because the S corporation’s debt could not be proven to be owed directly to Ms. Welch, the Tax Court denied her claimed debt basis, and more importantly, the utilization of the underlying allocated losses.

The lesson? Even in the face of the proposed regulations, S corporation shareholders must take care in structuring any advances to the corporation. Any amounts borrowed from a third party must follow the proper channels — from the lender to the shareholder then to the corporation — and be properly recorded. In a back-to-back loan situation, each set of loans should be evidenced by formal written documents requiring interest and a stated maturity date.

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Today is March 15th, which means the last thing we should be writing about is a corporate tax issue. But let’s be honest, many of the more complex corporate returns get extended until September 15th, meaning the corporate filing season is really just starting as opposed to coming to an end.  

As tax-paying entities, C corporations present many issues that are unique when compared to the flow-through regimes of Subchapters K (partnerships) and S (S corporations). When these issues are not properly identified and addressed, the result is often real dollars to clients in the form of a tax deficiency assessed by the IRS.

One of the issues that causes confusion among even the most experienced of advisers is the limitation on net operating losses for certain C corporations that have undergone an ownership shift under the meaning of I.R.C. § 382.

Q: Why is Section 382 important?

A: Because over the next six months, it will simply be reflexive to offset any federal corporate taxable income for 2011 with available net operating loss carryforwards. Should a Section 382 change have occurred under your nose, however, those losses may well be limited in their usefulness.

Q: Why does Section 382 exist? What’s the point?

A: Section 382 exists predominately for two reasons.

1. In the context of an outright sale of corporate stock to new owners, Congress believes the new owners should not be able to “traffic” in NOLs and acquire losses that can be used to offset income previously earned by the buyer.

2. In the context of a change in corporate ownership created by the issuance of stock to new investors, Congress believes that new “controlling” owners should not have unfettered access to losses that were generated by the previous controlling shareholders

Q: OK, makes sense. So when does a corporation have a Section 382 change?

A: A Section 382 ownership change occurs when a loss corporation undergoes an ownership shift in which the stock ownership percentage (by value) of 5-percent shareholders has increased by more than 50 percentage points over such shareholders’ lowest ownership percentages within the testing period.

Q: I recognize all the words you just wrote, but I have no idea what that sentence means. Can we approach this differently?

A: Sure. There are a lot of moving parts in that definition, so breaking it down into its components is essential to developing an understanding of the mechanics of Section 382. Fire away.  

Q: What’s a loss corporation?

A: A loss corporation is any corporation entitled to use a NOL or generating an NOL for the tax year in which an ownership shift occurs. If a corporation is currently not generating a NOL and has no NOL carryforwards, then it can have all the ownership turnover in the world and Section 382 is not an issue.

Q: What is an ownership shift?

A:  Ownership shifts can take the form of sales of stock by existing shareholders, or issuances of new stock from the corporation to new or existing shareholders. Without ownership shifts, a corporation can generate unlimited NOLs without risk of Section 382 applying.

Q: Got it. So I need a corporation with losses and changes in the shareholders’ ownership. What if I have a bunch of shareholders with tiny interests?

A: The transfers of stock your concerned with involve 5-percent shareholders. While this definition can become confusing when evaluating public companies, in general a 5% shareholder is any shareholder that owns — directly or indirectly through attribution — 5% of the stock of the loss corporation. All of the shareholders who own less than 5% in a corporation are aggregated together and treated as one 5% shareholder.[i]

Q: Do I have to test every time a 5% shareholder buys, sells, or is issued additional stock?

A: Yes. However, the transfers of stock involving 5% shareholders must only be evaluated throughout a testing period. The testing period is the shorter of 1) three years, 2) the period of time since the corporation became a loss corporation, or 3) the period of time since a previous Section 382 change occurred.

Q: You lost me there. Can you show me what you mean?

A: Example: X Co. generated NOLs from 2003 through 2011. Thus, X Co. is a loss corporation. X Co. previously underwent a Section 382 change on May 3, 2008. On December 1, 2010, A, who owns 70% of X Co.’s stock, sells his stock to B, who was  not  previously a shareholder.

A is a 5-percent shareholder, and his sale of stock to B constitutes an ownership shift. X Co. must test its cumulative changes during the testing period. The testing period ends on December 1, 2010, and begins on the later of 1) December 1, 2007 (three years prior to the ownership shift); 2) January 1, 2003 (the date X Co. became a loss corporation); or 3) May 3, 2008 (the date of X Co.’s most recent Section 382 change resulting in a limitation). Thus, the testing period is from May 3, 2008-December 1, 2010.

Q: OK, but what exactly am I testing for?

A: To have an ownership change that limits your NOLs, there needs to be a cumulative increase in the ownership interest of 5-percent shareholders of at least 50 percent during the testing period. There are three common misconceptions surrounding this requirement that often result in inaccurate Section 382 computations:

  • The 50-percent increase is based on absolute values. If A’s ownership increases from 20% to 40%, even though his ownership interest has increased by 100% over his previous interest, it is not an absolute 50% increase. If ,however, A’s ownership increases from 20% to 75%, then A’s ownership has increased by 55-percent for purposes of Section 382.
  • The measure of the change is based on value, rather than pure percentage of stock held. This complicates matters greatly, as the value of the corporation must be known at each testing date in order to determine each 5-percent shareholder’s share of the total value. For a publicly traded corporation, value can be determined by merely glancing at the stock ticker. But for all other corporations, particularly those that may have multiple classes of stock outstanding with varying liquidation rights, the determination of the total enterprise value — and each 5-percent shareholder’s piece of that value on the testing date — often presents the biggest hurdle in measuring whether a Section 382 change has occurred.
  • The 50-percent increase is measured by comparing the percentage of value held by a 5-percent shareholder on a testing date to the lowest percentage owned by the shareholder throughout the testing period. Thus, if during a testing period A’s ownership of X Co. goes from 20% to 30%, and then from 30% to 45%, A’s increase for the second change is 25% (45% compared to 20%), rather than 15%. Even worse, the cumulative increases of the 5-percent shareholders are not offset by any decreases in interest by a 5-percent shareholder.

Q: Once I’ve confirmed I have a 50-percent change, what do I do next?

A: Once it has been determined that a Section 382 change has in fact occurred, an annual limitation must be determined on the utilization of the pre-change losses against taxable income. The limitation is generally equal to the long-term tax exempt rate in place during the month of change (issued by the IRS every month) multiplied by the value of the corporation immediately prior to the ownership change. The resulting amount represents the maximum amount of taxable income the corporation may offset in a post-change year with pre-change NOLs.

Example: X Co. underwent a Section 382 change on December 31, 2011. The value of the corporation was $1,000,000 prior to the change, and the long-term tax exempt rate was 5%. Thus, X Co.’s Section 382 limitation is $50,000. If X Co. recognizes $200,000 of taxable income in 2012, it may only use $50,000 of its pre-change NOLs to offset the $200,000 of taxable income.

Q: So I pretty much only need to be worried about big stock sales, right?

A: You weren’t listening, were you? A Section 382 change will not always be the result of an obvious 100% sale of a corporation’s stock; rather, they often are the end result of creeping changes over a period of time, or even situations where no new shareholders acquire interests in the corporation, but rather an existing shareholder greatly increases his ownership.

Example: A, B, C, and D each own 25% of X Co., a loss corporation. On January 10, 2009, A buys 10% of X Co. stock from D. On March 4, 2009, A buys all of B’s stock. Finally, on January 20, 2010, X Co. buys 20% of X Co. stock from C. An ownership change has occurred, because during the testing period ending January 20, 2010, A has increased his ownership in X Co. from 25% to 80%, a 55% increase. A’s increase is not offset by B, C, and D’s decrease in stock ownership.  

Q: I think I understand, thanks to your thoughtful explanation. You clearly deserve a large raise.

A: That’s’ really not a question, but thank you, I appreciate that. Truth be told, simply understanding that Section 382 exists is half the battle. Many tax advisers miss the issue entirely and utilize an NOL regardless of an underlying ownership change, inviting scrutiny from the IRS. While the hard part — the calculation — doesn’t begin until you’ve identified that your corporate client may be subject to Section 382, by simply undertaking the calculation, you’ve helped minimize risk for your clients.  


[i] If a 5-percent owner is an entity (i.e., a corporation, partnership or trust), the loss corporation is required to look through the entity (and through any higher-tier entity) in order to determine which owners of the entity are indirectly 5-percent shareholders of the loss corporation. It is the ownership of these ultimate 5-percent shareholders, including public groups, that is considered when determining whether a greater than 50 percentage point increase has occurred.

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Last week we drew your attention to Newt Gingrich’s use of a well-documented nuance in the S corporation law to forego a portion of salary in favor of distributions from his two corporations/employers and avoid $70,000 in payroll taxes.

Over the years, several solutions have been suggested to curb what is seen as abuses of this S corporation payroll advantage, including:

  • Imposing self-employment tax on the flow-through income of all shareholders owning 50% or more of an S corporation’s stock;
  • Imposing self-employment tax on the flow-through income of all shareholders, which would equalize the payroll tax treatment of S corporations and many partnerships.
  • Impose self-employment tax on the flow-through income of all “professional service corporations,” i.e., those S corporations engaged in law, accounting, consulting, etc…

Most recently, in response to the news that Gingrich took only $450,000 of salary from his S corporations while allowing net-profits of $2.4 million to flow through payroll-tax free, U.S. congressman Pete Stark proposed the not-so-subtly-named Narrowing Exceptions for Withholding Tax, or NEWT, Act.

Under Stark’s bill, the flow-through income of an S corporation with three or fewer shareholders would be taxed as compensation, thus requiring both the corporation and the shareholders to pay the necessary payroll taxes, effectively closing this lucrative loophole for closely-held S corporations.

From my perspective, Congress has had 50 years to close this loophole, and if they didn’t feel compelled to do so when former vice president candidate John Edwards took advantage of the same rules in a far more egregious manner, then there’s no reason to believe they will now.

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