Posts Tagged ‘s corporation’

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.


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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Election fatigue is rapidly setting in. Mitt Romney hates half of America. President Obama is a socialist. Kinda’ makes me think of this:


So rather than get immersed in the mudslinging, let’s just stick to good ol’ fashioned tax law talk, shall we?

Fact: Converting from an S corporation to an LLC is generally a painful event. Why? Because in order to convert, regardless of the form the conversion may take, the conversion will generally require a taxable liquidation of the S corporation. And upon liquidation, an S Corporation recognizes gain under Section 336 as if it sold all of its assets, including any intangible assets (i.e., goodwill) for their FMV. This deemed sale usually creates gain at the S corporation level that is prohibitive.

Example: S Co. is owned 100% by A, who has a $300,000 basis in the S Co. stock. S Co. owns hard assets worth $1,000,000 with a $300,000 tax basis. S Co. also has intangible value of $500,000, making the total enterprise value $1,500,000.

If S Co. wishes to convert to an LLC by liquidating and then having its shareholders contribute the assets to the new LLC, S Co. will recognize $1,200,000 of gain under Section 336 ($1,500,000 FMV – $300,000 tax basis) upon distribution of the assets. 

When S Co. then passes out the assets in liquidation, S Co.’s shareholders will treat the $1,500,000 FMV of the distributed assets as the amount realized in exchange for the shareholders’ stock under Section 331. Because the $1,200,000 corporate level gain flows through and increases A’s stock basis under Section 1367, however, A’s basis will be $1,500,000 after adjustment ($300,000 + $1,200,000). Thus, A will recognize no further gain or loss upon liquidation ($1,500,000 amount realized less $1,500,000 stock basis).

Nevertheless, the $1,200,000 of corporate level gain is often reason enough not to pursue the conversion.

But what if you have an S corporation that is in the business of property development or home building? These types of activities have two things going for them that may facilitate a conversion:

1).There is often no goodwill value, as the entities are typically special purpose entities designed for one piece of development, not an ongoing business; and

2) In the current real estate market, many property development or home builder S corporations have mortgages that exceed the FMV of the developed property.

Why is this important? Because given those two facts, now may be the opportune time to convert to an LLC, if so desired:

Assume instead, S Co. owns a property with a FMV and tax basis of $1,000,000. S Co. also owns other assets with a basis and FMV of $500,000. The property is encumbered by a mortgage of $1,500,000. A has a stock basis in the corporation of $0.

If S Co. decides to liquidate and convert to an LLC, Section 336 requires that in computing S Co.’s corporate level gain upon liquidation, the FMV of the property cannot be less than any liability encumbering the asset. As a result, S Co.’s gain will be $500,000 ($1,500,000 debt + $500,000 FMV other assets – total basis of $1,500,000).

This gain then flows through to A, and will increase his stock basis from $0 to $500,000.

Furthermore, when S Co. distributes the assets, the case law (See Ford) dictates that the amount realized on the liquidation is the $1,000,000 FMV of the building  plus the $500,000 FMV of the other assets less the debt distributed along with it of $1,500,000. Thus, S Co. is treated as having received no value for the stock, and will recognize a $500,000 capital loss under Section 331 or Section 165. This loss may offset the $500,000 of gain passed through from the S corporation, resulting in no net gain or loss to A.

What’s the point? With the real estate market still suffering and many properties encumbered by debt in excess of the FMV of the property, now may be the time to correct the “mistake” of placing real estate in an S corporation. Provided intangible value is not a concern, distributing real estate encumbered by debt that exceeds the FMV of the asset may mitigate the normal pain of converting an S corporation into a more tax-friendly LLC.

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Cliché as it may sound, it’s better to be lucky than good. Just ask the shareholders of CMT, the S corporation that conveyed a conservation easement valued at $5.4 million to Wetlands America Trust, Inc. (WAT),  yet very nearly lost its charitable contribution deduction for failure to properly substantiate the contribution.

After the conveyance of the conservation easement, CMT received a letter from WAT acknowledging the $5.4M value of the contribution; however, the letter failed to address whether CMT had received any goods or services from WAT in exchange for the conservation easement.

On the conservation deed that was conveyed from CMT to WAT, however, there was included the following language:

NOW, THEREFORE, the Grantor, in consideration of the foregoing recitations and of the mutual covenants, terms, conditions and restrictions hereinunder set forth and as an absolute and unconditional gift, subject to all matters of record, does hereby freely give, grant, bargain, donate and convey unto the Grantee, and its successors and assigns, the Easement over the Protected Property subject to the covenants, conditions and restrictions hereinafter set forth which will run with the land and burden the Protected Property in perpetuity.

The deed also contained a detailed description of the conservation easement’s restrictions, WAT’s rights pursuant to the easement, and the rights reserved to CMT. Additionally, the conservation deed included a description of the property on which CMT placed the conservation easement and was signed by WAT during 2004. 

On its 2004 tax return, CMT deducted the $5.4M value of the conservation easement as a charitable contribution. The IRS denied the deduction, arguing that CMT had failed to adequately substantiate the contribution pursuant to I.R.C. § 170(f)(8).

As a reminder, a charitable contribution of $250 or more must be substantiated with a contemporaneous written acknowledgment from the donee organization. Section 170(f)(8)(B) provides that the contemporaneous written acknowledgment must include the following information:

(i) The amount of cash and a description (but not value) of any property other than cash contributed 

(ii) Whether the donee organization provided any goods or services in consideration, in whole or in part, for any property described in clause (i)

(iii) A description and good faith estimate of the value of any goods or services referred to in clause (ii) * *  

In its initial argument, CMT maintained that the letter of acknowledgement received from WAT met the substantiation requirements of I.R.C. § 170(f)(8). The Tax Court held otherwise, however, noting that the letter failed to address whether CMT had received any goods or services in exchange for its contribution.

On the verge of losing its $5.4M deduction courtesy of a drafting oversight, CMT was bailed out by the fastidiousness of the transferred deed, as the Tax Court concluded that the deed, while not a formal letter of acknowledgement, contained all of the necessary substantiation information:

The conservation deed was signed by a representative from WAT, provided a detailed description of the property and the conservation easement, and was contemporaneous with the contribution. Additionally, the conservation deed in the instant case states that the conservation easement is an unconditional gift, recites no consideration received in exchange for it, and stipulates that the conservation deed constitutes the entire agreement between the parties with respect to the contribution of the conservation easement. Consequently, we conclude that…the conservation deed in the instant case satisfies the substantiation requirements of section 170(f)(8).


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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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Yesterday, the Senate failed to achieve the 60 votes necessary for Senate bill S. 2343, the “Stop the Student Loan Interest Rate Hike Act of 2012,” to advance. The bill would have paid for the lost revenue caused by keeping the interest rate on subsidized Stafford loans steady at 3.4% for another year by closing a long-standing S corporation “loophole” (their words, not mine).

The loophole in reference is the ability of S corporation shareholder/employees under current law to forego compensation in favor of distributions to reduce their payroll tax obligation. The Senate bill would have taken a hybrid approach to closing the loophole by subjecting the income allocated to shareholders of “professional service” S corporations — law, lobbying, accounting etc… — to self-employment tax only if:

1. the shareholder provides substantial services to the S corporation;

2. 75% or more of the gross income of the business is attributable to 3 or fewer shareholders; and

3. the shareholder has AGI > $250,000 if MFJ and $200,000 if single.

With the Senate bill dead — and with no other bill currently in the pipeline to close the loophole — S corporation shareholder-employees can continue to play the compensation/distribution game, but be warned…the IRS is watching.

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If you went to college and weren’t fortunate enough to either earn a scholarship or pay your way by moonlighting as a pool hustler or exotic dancer, you’re probably still dedicating a portion of your paycheck to whittling away your student loans.  

Unfortunately, you’re fighting an uphill battle, because on July 1, 2012, interest rates on subsidized Stafford loans are set to double from 3.4% to 6.8%.

Congress has your back, however, as proposals have been formulated that would grant a stay of execution to the rate hike.

One such proposal — creatively named the “Stop the Student Loan Interest Rate Hike Act of 2012” —  would postpone the rate increase for one year, and pay for the lost revenue by doing away with the “S corporation loophole” that allows S corporation shareholder-employees to forego compensation in favor of distributions that are not subject to payroll taxes.

For some background, we’ve previously discussed this loophole here and here, but in short, it works like this:  Because S corporation flow-through earnings are not subject to payroll taxes — unlike their partnership counterparts — there is tremendous motivation for S corporation shareholder-employees to limit the compensation they pay themselves. While compensation is subject to payroll taxes, by forgoing salary S corporation owners increase their flow-through income, which can be withdrawn from the corporation as distributions that are also not subject to payroll taxes.

As a result, many S corporation shareholder-employees, including John Edwards and Newt Gingrich — have used this loophole to limit their compensation and take large sums of cash out of closely-held S corporations free from payroll tax.

The IRS routinely attacks such transactions and requires the shareholder-employees to pay themselves a minimum “reasonable” salary. In the fifty year case history of reasonable compensation cases, however, the IRS has never required a salary of more than $95,000, so the opportunity still exists for shareholder-employees to trade compensation above this amount for distributions. (For a detailed history of S corporation reasonable compensation issues and the relevant case history, please see this brilliantly written piece — Tax Adviser – S Corporation Shareholder-Employee Reasonable Compensation) — which, like most great works of art, won’t be fully appreciated until the author is dead and gone.)

Lawmakers have long sought to close the S corporation compensation loophole and put S corporations and partnerships on equal footing. Many different types of proposals have been floated, including:

 1.  subjecting the flow-through income of shareholders owning more than 50% of S corporation stock to self-employment income;

2. subjecting the flow-through income of shareholders in “professional services S corporations” to self-employment tax; and

3. Simply subjecting all S corporation flow-through income to self-employment tax.

The “Stop the Student Loan” Act takes a hybrid approach to closing the loophole. The proposal would subject the income allocated to shareholders of “professional service” S corporations to self-employment tax only if:

 1. the shareholder provides substantial services to the S corporation;

2. 75% or more of the gross income of the business is attributable to 3 or fewer shareholders; and

3. the shareholder has AGI > $250,000 if MFJ and $200,000 if single.

 The proposal would also apply to a S corporation that is a partner in a professional service partnership.

Lastly, “professional service” businesses are defined as any trade or business providing services in the fields of health, law, lobbying, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, investment advice or management, or brokerage services.

Despite being attached to the attractive student loan bill, I wouldn’t expect this to get passed. The bill is too narrow and the law changes too difficult to enforce, and would simply give rise to a new era of loopholes intended to circumvent the 75% rule.  

Joe Kristan has more.

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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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