FOR TAX PROFESSIONALS
With income tax rates fluctuating between 15 to 40 percent, the self-employment or F.I.C.A. tax at a combined 15.3 percent rate may be significant enough to affect long-term planning for some clients. A variety of techniques have evolved to ease the impact of this tax. This newsletter highlights some specific aspects of this issue which have been of interest to tax practitioners calling the Tax Answer Hotline.
Choice of Entity / S Corporation::
Some principal cases and editorial commentary: Radtke, (7th Cir 1990); Spicer Accounting, Inc. 66 AFTR2d 90-5806 (9th Cir 1990); Spradling, 71 JTAX 104 (8/89); Gendreau 8-95 T.T.A. 478 (8/95) - re: unpublished case: Davis d/b/a Mile High Calcium, Inc., (1994); Raby, Shareholder Compensation: How Low Can You Go? 96 TNT 116-62 (6/17/96)
A frequently cited reason for choosing S Corp instead of LLC form of entity is the opportunity to reduce employment taxes. The principal risk is the challenge from the government that distributions to shareholders represented to be other than salaries represent additional compensation, thus are subject to employment taxes. The cases rely on a "facts and circumstances" approach and should be read to assist in planning for your client. That being said, perhaps the best "highlights" to assist in planning for this area would be the following two points.
First, avoid extremes of any type - e.g., avoid very low salaries compared to earnings, particularly if the earnings are more attributable to the personal efforts of the employee-shareholder than to capital investment; avoid significant decrease in salaries without a corresponding decrease in corporate earnings.
Second, carefully document "intent" (1) that certain distributions represent the complete amount intended as compensation for services (through advance salary arrangements, corporate minutes, etc., in addition to reporting on payroll tax returns and W-2s) and (2) that other distributions represent return on shareholder investment.
An additional benefit of S Corp instead of partnership form of entity is the treatment of self-employment health insurance premiums paid on behalf of 2%+ shareholders - the benefit added to the W-2 will not be subject to F.I.C.A. if the payment is made under "a plan for all employees" (see Rev Rul 91-26 & Ann 92-16).
The history of attempts to integrate treatment of LLC members with self-employment income rules applicable to other taxpayers may well be described as leading taxpayers and their advisors in a circle: two sets of proposed regulations - the first withdrawn, the second "frozen", adaption by commentators of statutes and regulations written for limited partners, temporary prohibition against issuing further regulatory guidance, etc., etc.
The "circle" analogy, apart from the dizzying path practitioners have attempted to follow, may be appropriate in another respect. One group of tax attorneys specializing in pass thru entities appeared to take no issue with one response when the group was asked (upon Congress prohibiting further guidance by the Treasury): "Where are we now?" The response: "We are back where we were before the proposed regulations - deciding just how aggressive the taxpayers and their advisors wish to be in characterizing the income from business activities flowing through the LLC" ("aggressive" to be translated as "subject to 20% accuracy penalty").
At one state-level liaison meeting between a State Society of CPAs tax committee and IRS representatives held late in the year 2000, a written question and answer - though informal and unofficial - may give some insight into IRS thinking. The question was asked by members of the tax committee what the IRS current position is. The response was that, while the second set of proposed regulations are not effective, the IRS "is still raising the issue" based on those regulations. They summarize the tests as treating an LLC member as a limited partner (thus, not self-employment income) unless they: 1) have personal liability for the debts of the partnership, 2) have authority to contract on behalf of the partnership, OR, 3) participate (over) 500 hours during the tax year. Not mentioned are the consequences to LLC members of certain service type entities (the designated QPSC activities affecting certain corporations).
Another relatively recent discussion of relevance is an excerpt from the opinion in a tax case: Gregg (2001 TNT 3-11, D.C. Oregon, 11/29/00). The case deals with the regulations under the passive limitations (IRC Sec. 469), not self-employment income, but is informative nonetheless: "... the limited partnership test, as set forth in (the temporary regulations) is obsolete when applied to LLCs and their members, because the limited liability statutes create a new type of business entity that is materially distinguishable from a limited partnership".
One major editorial service conjectures that the Treasury Department will not issue any regulations in this area until Congress addresses the issue. This could leave us hanging for a long time. Another writer (in April 2000) concludes: "We suspect that whatever solution is adopted, the new provision will not disturb current filings using almost any of the practices being followed [previously listed and varying from extremely aggressive to ultra-conservative], but will be effective prospectively". [italicized text added by yours truly] Contrasting this view to the possible risk of an accuracy penalty produces some level of tension in proper planning.
Selected cases and rulings: Barrett, 58 T.C. 284 (1972); Barnett, 69 T.C. 609 (1978); Grosswald, 653 F. 2d 58 (CA2 1981); Steffens, 707 F. 2d 478 (CA11 1983); Rev Rul 82-210
The 1972 "Barrett" case appeared very pro-taxpayer. The facts indicate that Barrett was "clearly not engaged in offering his services as an adviser or consultant to others" (thus the covenant payments did not constitute self-employment income). In contrast, Barnett was not prohibited from holding himself out to others as a consultant - the fact that he never did do so was not part of the evidence presented to the Court (thus self-employment income).
This distinction between Barrett and Barnett becomes more than blurred by Grosswald: "... in our view Barrett was erroneously decided. It makes little sense to distinguish between a person who 'holds himself out' to only one employer (and agrees to work for no one else) and a person who 'holds himself out' to more than one employer ... While we cannot say that the theory of Barrett is 'as thin as the homoeopathic soup that was made by boiling the shadow of a pigeon that had been starved to death' ... we have to say that we find it unpalatable ..." (thus self-employment income).
It is this writer's recollection that a search of cases in the 1990s revealed a handful of cases still citing the favorable Barrett case as precedent, notwithstanding the prose expressed by the Court in Grosswald.
Except for the treatment of S Corp medical insurance premiums, each of the three scenarios above will require comparing the client's facts to existing case law (or contemplating future case law in the case of LLC members) and establishing a comfort zone somewhere between extremely conservative and highly aggressive. The usual factors include exposure of other items or positions on the taxpayer's return, the client's distaste for penalties or controversy with the government, and perhaps even the practitioner's own boundaries or comfort zones.
RICHARD A. LAVINE, CPA You DO have aemail:lavine@taxacte.com "tax department"
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