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  Copyright© 2005 Colin M. Cody, CPA and TraderStatus.com, LLC, All Rights Reserved.
 


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

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, 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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