Monday, January 25, 2010

S Corporations: A Target of Missed Tax Revenue for the IRS?

S corporations are the fasted growing legal entity choice; there are approximately 4 million nationwide. With that, they have attracted the attention of Congress and the IRS to ensure reporting practices meet applicable standards. The IRS conducted audits on 2003 and 2004 S corporation tax returns as part of a “National Research Program.” The result? An estimated 68% of S corporations misreported their net income understating their combined net profits by $85 billion.

Background - Why are S corporations attractive?
• S corporations do not pay corporate income tax. Instead, the earnings or losses are passed through to its shareholder(s), and the taxes are paid at the individual level.
• Opposed to other “pass-through” entities, such as partnerships, S corporation earnings are not subject to payroll taxes (self-employment tax reported on the individual income tax return). “Reasonable compensation” is required to be paid S corporation owners in lieu of payroll taxes on passed through earnings.

Through the Eyes of the IRS - Missed Tax Revenue
If S corporation net profits are understated as reported in the IRS audit results above, those affected shareholders’ individual income taxes are understated as well. Furthermore, if the reasonable compensation requirement is ignored by setting an unreasonably low salary or even no salary at all, the payroll taxes on that amount are missed. As a result of the same IRS audits discussed above, S corporation owners were underpaid an estimated $24 billion in wages in accordance with the reasonable compensation requirement.

What is Congress going to do about it?
Although nothing has been passed to date, there is much discussion of raising payroll taxes to increase tax revenue. A Medicare tax rate increase and raising the Social Security tax on earnings above $250,000 are just a few ideas being kicked around. If payroll taxes are increased, you can bet the effort to enforce S corporations to pay reasonable compensation will likely increase as well.

Already paying a reasonable salary? Well, you still might not be safe. Other ideas that have made the paper: subjecting S corporation owners who perform services (i.e. doctors, accountants, attorney, etc) to Social Security and Medicare taxes on all of their earnings, and imposing payroll taxes on all earnings of any S corporation owner who owns more than 50% of the corporation.

In summary, there is no reason to shy away from forming or maintaining an S corporation. Rather, S corporation owners should make sure they are in compliance with the taxation rules, consult their tax advisors for guidance, and be prepared for increased IRS audits.

Stay tuned for the latest developments!

Tuesday, January 12, 2010

No Estate Tax for 2010, real or not?

Last week, at lunch with a tax attorney associate, I posed the question, “The phone must be ringing off the wall, from client inquiries, about their respective wills and trust, the attorney replied, not, yet! Adding, if Congress does not amend the estate tax provisions, and retroact the provision to the first of the year, I will be real busy, revising wills and trusts with the AB provision. Hopefully, this will get the pot stirring when you read this article, leading you to contact your estate attorney or our firm, to discuss the following article, and it s implications to your family and you.

A quick history of estate tax:

For 2009, the estate was free from tax for estates 3.5 million, or less. For estates greater than 3.5 million, the tax was 45% of the amount over 3.5 million. For a husband and wife using the standard A B bypass provisions for a will or living trust, the provision enabled 7 million to be passed to the heirs without estate tax, on the death of both husband and wife. Further, on the death of the first spouse, the marital provision of the will or trust , would absorb any amount above the 3.5 million amount, thus no tax was due from the first spouse to die, thus any tax due would be due on the second spouse death. Further, the surviving spouse and heirs enjoyed a step up to fair market values in the assets passing to them thru the marital and bypass trust, or outright to the heirs, in certain instances, ie life insurance proceeds, annuities, joint property , etc. For estates 7 million and less , with a husband wife, no estate would be due, and the value of the estate assets would pass to the heirs, ie children, etc, tax free , with a new fair market value , at the date of death, if the assets were later sold, for income tax purposes. This was a great tax benefit! Think of the estate distribution provisions, if the B bypass trust, is written to receive all the estate tax free assets, which used to be 3.5 million, and is now unlimited, passes to the kids or grandkids, and leaves the surviving spouse out of the distribution, except for the income interest. I am sure on reading this article the spouse who expects to be the survivor will want to do away with the AB trust provision and have all assets left only to the surviving spouse, sounds like a lot of wills and trust amendments to be done, if this law stays in effect for 2010.

In the Fall of 2009, and pondering the estate tax rules for 2010, most tax attorneys working with the Bell firm, thought that the 2009 rules would stay in effect for 2010 and thereafter, following congressional amendment to the existing law. This amendment did not happen, Think of the lawsuits that will be filed if Congress retroacts this bill to January 1, 2010 , and someone has died with a taxable estate over 3.5 million in the interim, and the IRS , does not allow the estate to pass tax free!

The 2001 tax act , which was a 10 year sunset law, remains in effect, thus for 2010 there is no estate tax, I repeat , for 2010 , there is no estate tax.
Further, for grandparents, there is no generation skipping tax, to consider for 2010. The caveat is that the heirs do not have to pay estate tax, but they receive a limited step up basis in the inherited assets of only 1.3 million. Think of the nightmares this will be for accountants and financial advisors in keeping up with the cost basis of assets, passed on from parent to child or grandchild!

Further, for all who plan on making gifts to children, grandchildren, etc, the annual gift exemption amount is $13.000 , for annual amount above the $13,000 amount per person, allows for a life time gift amount of $1 million per person, and the tax rate is 35 percent, for amounts over 1million of cumulative gifts made to all persons. Think of the planning , a parent could gift property at 35% in 2010, and the same property would be taxed at 55% in 2011, when the 2010 law sunsets and the estate rules revert back to 1 million, as noted below.

For 2011, the “no estate tax” for 2010, reverts back to the law for prior 2001 estate tax law, or an estate tax of 55% for estates greater than 1 million, which would be quite onerous, but would allow for step up in estate values. What a swing from a no tax to a burdensome tax only one year later!

I hope I have the pot stirring, what a scenarios of what if and estate planning to be done, contact your attorney, or give me a call if we can help!