Navigating The Fog

“All the Congress, all the accountants and tax lawyers, all the judges and a convention of wizards cannot tell for sure what the income tax law says”, said Walter B. Wriston, former CEO of Citibank.

Between the two narrow extremes of complete compliance with tax law and outright tax fraud, is a dense fog of uncertainty. Many business owners consistently make key decisions concerning their business and individual taxes in a fog without being aware of the pitfalls or opportunities. Unfortunately, a misstep in one direction can lead to increased risk of audits and penalties. A misstep in the other direction can lead to substantial imposition of unnecessary taxes.

This fog is created by the Internal Revenue Code and Congress’ failure to provide black and white guidance regarding critical tax issues. Instead, the Internal Revenue Code substantially relies on ambiguous terms such as “reasonable compensation,” “business purpose,” “materially involved,” and “ordinary and necessary business expense” (among many others). Many taxpayers are more than willing to take risks, but do so blindly without proper guidance. These taxpayers run substantial risks of audits and penalties. Other taxpayers are unwilling to step into the fog and risk the dangers. However, in many cases these conservative taxpayers incur far more tax than legally necessary.

As an example, the Internal Revenue Code requires an S-corporation shareholder to receive “reasonable compensation” for services performed for the corporation. This requirement is to prevent S-corporation owners from eliminating their wages entirely and receiving distributions in lieu of wages. S-corporation owners have a strong incentive to do this in order to reduce their Social Security and Medicare taxes. Unfortunately, the Code does not provide guidance as to whether $25,000, $60,000 or even $300,000 will be considered reasonable.

Several years ago I met with an electrical contractor in Indiana who was receiving nearly $250,000 of W-2 wages from his S corporation and received no distributions. Upon my question, he simply explained that his CPA said this was necessary to avoid an IRS audit. While the CPA was correct that his client would not be audited for failure to claim a reasonable compensation, he had not explained that he could also have received $70,000 and still be receiving reasonable compensation. Failure to understand reasonable compensation caused the electrical contractor to incur nearly $9,000 of unnecessary taxes.

The same electrical contractor also had purchased a residence for rental purposes, remodeled the home, and eventually decided to sell the home at a substantial profit. As with the issue concerning reasonable compensation, the CPA took a very conservative approach and reported the sale as if the contractor was engaged in the “trade or business” of selling homes, which meant that the profit was taxed at the ordinary tax rates (33% in this case), rather than the capital gains rate of 15%. Moreover, it meant that the profit also was subject to Social Security taxes at 15.3%. Again, the CPA’s unwillingness to enter into the fog of uncertainty and inability to provide clarity for his client caused him to incur nearly $12,000 of unnecessary tax on the transaction.

A large part of tax planning is serving as a guide for business owners and providing a safe path through the fog of uncertain tax principles. Despite the fact that the Internal Revenue Code does not provide black and white guidelines as to many principles, there are quite a few sources, including Tax Court decisions, federal and state court decisions and Internal Revenue Service decisions, that a prudent tax planner can research and rely upon to clarify the ambiguities of the Internal Revenue Code. Upon researching these sources, one could find that the reasonableness of compensation can be determined by analyzing an individual’s salary history, salary levels of other employees, the complexity and time involved in the business, and the cost of living in the locality. Based on these factors, it is possible to recommend a salary that meets the IRS requirements and saves substantial tax savings. While the risks in the fog may be frightening to the uneducated, the due diligence of a prudent tax planner serves as a bright light to illuminate the uncertainty and expose the hidden dangers, ultimately allowing business owners to safely structure their businesses and transactions while realizing substantial tax savings.