Alan Zipp, Speaker Bio COMPENSATION ISSUES UNDER THE TAX LAW. Alan Zipp, Speaker Bio WHO IS AN EMPLOYEE. A Presentation By Alan Zipp CPA-Attorney

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1 Alan Zipp, Speaker Bio COMPENSATION ISSUES UNDER THE TAX LAW A Presentation By Alan Zipp CPA-Attorney Certified Public Accountant Attorney at Law AICPA Accredited in Business Valuation Certified Business Appraiser Certified Fraud Examiner Author, Lecturer, AICPA Discussion Leader Member, AICPA Steering Committee on Small Business Practitioners Tax Conference 1 2 Alan Zipp, Speaker Bio Masters Degree in Taxation Author of RIA s Divorce: Valuation, Tax, and Financial Strategies Bar Association of Montgomery County, Maryland, served as: Treasurer, Executive Committee member, and Chair of the Taxation Section. WHO IS AN EMPLOYEE Any Officer of a Corporation Any Common Law Employee Anyone Else Who Performs Services for Remuneration 3 4 1

2 WHAT ARE WAGES DIVIDENDS All Remuneration for Services of Whatever Nature [IRC 3121(b) and 3306(c)] Taxed As Ordinary Income Ordinary Rates 15% Tax Rate Not Subject to Payroll Tax Not Deductible By the Corporation Not Taxable to Shareholder Unless Paid from Earnings & Profits 5 6 REASONABLE COMPENSATION Tax Deductible if Reasonable 162(a) Excess is Not Deductible (b)(1) Excess is Taxed as a Dividend Facts and Circumstances Test TOP ENFORCEMENT ISSUE Beginning in February 2010, IRS will Audit 2,000 Companies Each Year, for 3 Years for: Worker Classification Fringe Benefits Officer Compensation Reimbursed Expenses Non-Filers 7 8 2

3 INTENSE SCRUTINY Government Accountability Office (Report 12/15/09) Treasury Inspector General for Tax Administration (Report 2/4/09) IRS Advisory Council (Report 1/18/08) Government Accountability Office (Report 7/06) Government Accountability Office December 15, 2009 S-Corporations failed to pay adequate wages to shareholder-employees Resulting in billions in underpaid employment taxes annually Recommended treating S-Corporation net income as self-employment taxable for professional service businesses 9 10 Bill To Make Certain S-Corp Net Income Self-Employment Taxable American Jobs and Closing Tax Loopholes Act, (H.R. 4213), introduced May 20, 2010 Special rule for Professional Service Businesses The shareholder s pro rata share of all items of income attributable to professional service activities will be included in determining the shareholder s net earnings from selfemployment. (Amend IRC section 1402) Treasury Inspector General February 4, 2009 IRS actions needed to address the misclassification of employees as independent contractors The misclassification of employees as independent contractors continues to grow and contribute to the tax gap

4 IRS Advisory Council Recommended that IRS embark on a National Research Program on employment tax issues IRS announced an Employment Tax National Research Program in early 2008 Government Accountability Office Report July % of employers misclassified 3.4 million workers as independent contractors, causing an estimated total tax loss of $1.6 billion Independent Contractors numbered over 10 million or 7.4% of the U.S. workforce Independent contractors accounted for 24% of the total contingent workforce of 42.6 million SPECIFIC IRS ACTIONS Electronic matching of Forms 1099 of $25,000 to each of five or more workers who have no other income sources Collaboration with state agencies to exchange employment tax audit information FORM 8919 Required to be filed by workers who have no withholding and who believe they are improperly classified Used to calculate and report uncollected social security and Medicare taxes

5 EMPLOYEE or CONTRACTOR? Common Law Test of Employee When the person for whom the services are being performed has the RIGHT to CONTROL and direct the individual performing the services not only as to the result to be accomplished but also the details and means to be employed. IRS GUIDANCE Anyone who performs services for you is your employee if you can control what will be done and how it will be done. IRS Pub Employer s Tax Guide STATUTORY EMPLOYEES A commissioned driver who delivers food, beverages, laundry, or dry cleaning Life insurance salesperson STATUTORY NON-EMPLOYEE Direct Sellers Real Estate Agents Homeworker using furnished materials Traveling salesperson

6 INDEPENDENT CONTRACTOR Not defined in the Code or Regs IRS is Prohibited from issuing guidelines or rulings on employee classification by Section 530 of the Revenue Act of 1978 IRS STANDARDS FOR WORKER CLASSIFICATION Behavioral: Right to control worker? Financial: How is the worker paid and who provides tools/supplies etc.? Relationship: Written contract or employee-type benefits? Is work a key aspect of the business? IRS 20 FACTORS Rev. Rul , C.B. 296 Sets forth 20 factors from court cases identifying elements of the common law employee relationship Any one factor COULD indicate an employee/employer relationship KEY COMMON LAW FACTORS Must comply with employer s instructions Is personally required to render services Maintains continuing working relationship Works full time for employer Is subject to employer s control Is reimbursed for business & travel costs Can be fired at any time by employer Can quit at any time without liability

7 SECTION 530 DEFENSE AGAINST RECLASSIFICATION If ALL factors met the worker is NOT an employee: Consistently treated as a contractor Forms 1099 properly filed Reasonable basis to classify as contractor REASONABLE BASIS Judicial precedent, IRS ruling, IRS advice Prior IRS payroll tax audit re: classification Long-standing industry practice BILLS TO AMEND SECTION 530 Bills in Congress will modify and codify section 530. (S. 2882, 12/15/09) and (H.R. 3408, 7/30/09) Reasonable basis provision limited to written IRS determination or prior IRS employment tax audit Eliminate long-standing industry practice OTHER PROPOSED REVISIONS Senate Bill S.2044, introduced by Senators Barack Obama, Richard Durbin, Edward Kennedy, (9/12/07) Bill to amend Section 530 to remove all prohibitions against IRS issuing rulings on worker classification and to eliminate industry practice as a reasonable basis

8 NEW LAW: FORMS 1099 TO CORPORATIONS Section 6041(h) requires the issuance of Forms 1099 to corporations for payments of $600 or more, after 12/31/2011 Patient Protection and Affordable Care Act (March 23, 2010) BLACKWATER CASE Blackwater Security Consulting provides security services to the U.S. Government in Iraq So do two other companies: DynCorp and Triple Canopy Blackwater classifies its workers as independent contractors. The other two do not LIABILITY FOR EMPLOYEES BUT NOT FOR CONTRACTORS CONGRESSIONAL INVESTIGATION In September 2007, 17 Iraqi civilians were killed in Baghdad, allegedly by Blackwater contractors Blackwater denied responsibility for its independent contractors IRS had previously ruled on Form SS-8 that a worker of Blackwater was an employee 31 House Oversight Committee investigates millions of dollars of payroll taxes not paid by Blackwater Senate Finance Committee looks into proper classification of workers Senate Bill S.2044 Introduced 32 8

9 BLACKWATER ARGUED SECTION 530 DEFENSE Advice of a tax professional is basis of Blackwater s reasonable basis argument Blackwater argued that Form SS-8 determination by IRS had little legal effect 2010 Blackwater Update May 2009 Blackwater ceased operations in Baghdad, Iraq May 16, 2009, Associated Press reported that four Blackwater contractors were being held for a deadly shooting in Kabul, Afghanistan. January 2010, Federal judge dismissed charges against five Blackwater security guards accused of killing Iraqi civilians in September 2007 due to prosecutorial misuse of guard s statements Blackwater is Now XE Blackwater changed its name to Xe Its base of operations is located in Moyock, North Carolina Controversy continues over the use of private security companies in Afghanistan and elsewhere 35 State Law May Differ From Federal Some States may treat certain workers differently from Federal law. For purposes of: Unemployment taxes, Minimum wages, Workplace safety, and Labor laws. 36 9

10 Example of State Law Classification Maryland Presumes Workers In Two Industries Are Employees: Construction Services Landscaping Services [Labor & Employment, sec , Md.Code Ann] PENALTIES FOR MISCLASSIFICATION Employee income tax 25% Employee FICA withholding 7.65% Employer FICA withholding 7.65% Employer FUTA appropriate rate MORE PENALTIES Understatement of Reported Tax Failure to Pay Tax When Due Failure to Make Payroll Tax Deposits Failure to File Information Returns Negligence Fraud Interest REDUCED PENALTIES If Form 1099 Was Filed, then: Income tax 1.5% FICA withholding 1.53% Employer FICA 7.65% IRC

11 REDUCED PENALTIES EVEN WITHOUT 1099 No 1099s Filed, but have a good excuse Income tax 3.0% FICA withholding 3.06% Employer FICA 7.65% IRC 3509 WILLFUL DISREGARD Willful Disregard of Withholding Rules: No reduced penalties Subject to all IRS penalties IRC 3509(c) TAX COURT HAS LIMITED JURISDICTION There must be an actual controversy with regard to worker classification The IRS must have made a determination in the course of an audit that a worker is an employee and that relief under Section 530 is not available Independent Contractor Cases Dancers at Adult Clubs Truck Owner-Operators Automobile Body Repairmen Barber or Beautician Who Rents Chair Carpenter Drywall Construction Workers Exterminators Home Carpeting Installers Nurses Taxicab Drivers

12 OWNER BENEFITS AS A FORM OF COMPENSATION Health and Accident Insurance Company Car Used for Personal Purposes House Provided for Personal Purposes Health Flexible Spending Arrangements Life Insurance Working Condition Fringe Benefits DIVIDENDS Not subject to payroll taxes $100,000 of Dividends saves $15,356 in payroll taxes W-2 WAGES TO OWNERS C-Corporation S-Corporation Partnership [IRC 707(a)] Limited Liability Company [IRC 707(a)] ADVANTAGES OF W-2 WAGES TO PARTNERS Facilitate the owner s payment of income and social security taxes through withholdings rather than burdensome quarterly estimated tax payments. Provide a convenient mechanism for the company to issue payments for compensation to the owners, separately from distributions of profits, in the same manner as it does for other employees, i.e., payrollservice company. Facilitate the admission of an employee as a partner on an administrative level by continuing him or her on the payroll system

13 ADVANTAGES OF W-2 WAGES TO PARTNERS Treat owners of partnerships and LLCs similarly to S-Corp and C- Corp owners who are treated as employees for payroll tax purposes. Permit ease of payroll administration when LLC or partnership checks the box to be taxed as a corporation where the owners are continued as employees of the business, subject to withholding and payroll taxes, without change. Provide for calendar year wage recognition for owner-employee regardless of the fiscal year of the partnership or LLC, similar to S-Corps or C-Corps. Treat owner wages as payment for services on a uniform basis, subject to reasonable compensation standards, regardless of the legal form of business entity organization DISADVANTAGES OF W-2 WAGES TO PARTNERS The partnership or LLC will be subject to $56 Federal Unemployment Tax and related State Unemployment Tax on each owner receiving Form W-2. The IRS will collect tax payments on partner wages without effort and can hold responsible people at the partnership or LLC personally liable for the payment of withholding taxes on partner wages AUTHORITY FOR ISSUING PARTNER W-2 WAGES 26 U.S.C. 707(a) Engaging in a transaction with the partnership other than in his capacity as a member of such partnership 26 C.F.R Such transactions include the rendering of services by the partner to the partnership AUTHORITY FOR ISSUING PARTNER W-2 WAGES Rev. Rul , C.B. 144 The payments made for these services is not part of the partner s distributive share of partnership income; is a payment that is subject to code section 707(a) and is not a guaranteed payment; is taxable to the partner as compensation for services and is deductible by the partnership

14 AUTHORITY FOR ISSUING PARTNER W-2 WAGES Armstrong v. Phinney, 394 F.2d 661 (5 th Cir. 1968) A person could occupy the dual status of a partner and employee with respect to distinct services provided to the partnership. As a matter of law, it was possible for a partner to stand in an employer-employee relationship with respect to a partnership. AUTHORITY FOR ISSUING PARTNER W-2 WAGES 26 C.F.R (b)(2) For purposes of section 132(a)(3) (relating to working condition fringes), the term employee means any partner who performs services for the partnership DIVIDENDS AVOID PAYROLL TAXES Use an S-Corporation to avoid payroll taxes by distributing dividends No double taxation BUT, IRS can reclassify dividends as compensation if reasonable compensation is not paid for services rendered 55 GAO REPORTED THAT SOME S-CORPS FAILED TO PAY ADEQUATE COMPENSATION 94% of S-Corporations are held by three or fewer shareholders 68% of S-Corporations misreported at least one item affecting net income Of the S-Corporations that misreported shareholder compensation, 93% understated it 56 14

15 GAO REPORT (12/15/09) Net S-Corporation shareholder-employee compensation underreporting is about $23.6 billion annually Annual employment tax revenue losses due to noncompliance with tax rules is estimated at $15 billion for all types of entities, including S-Corporations GAO REPORT (12/15/09) 13% of S-Corporations paid inadequate wage compensation to their shareholders, resulting in $23.6 billion underpaid wages About $3 billion in annual employment taxes are lost from S-Corporations IRS employment tax audits are inadequate GAO REPORT (12/15/09) Inadequate shareholder compensation was one of the biggest compliance problems Federal law and IRS guidance is too vague on determining adequate wage compensation for shareholders GAO RECOMMENDATIONS TO IRS Improve guidance to auditors and require documented analysis of reasonableness Improve guidance to tax preparers, such as that provided to IRS examiners, on determining adequate shareholder compensation Provide specific guidance to shareholders

16 GAO RECOMMENDATIONS TO CONGRESS Create a new standard of employment taxation of S-Corporations to eliminate problem of underpaying wages to shareholder-employees Subject S-Corporation net income to employment tax for service sector businesses CONGRESS INTRODUCES LEGISLATION (May 20, 2010) Special rule for Professional Service Businesses in the fields of health, law, lobbying, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, investment advice or management, or brokerage services The shareholder s pro rata share of all items of income attributable to professional service activities will be included in determining the shareholder s net earnings from selfemployment. (Amend IRC section 1402) CONGRESS INTRODUCES LEGISLATION Law applies to S-Corporations engaged in a professional service business that is principally based on the reputation and skill of 3 or fewer individuals. Law also applies to any S-Corp that is a partner in a professional service business organized as a partnership if substantially all of the activities of such S-Corporation are performed in connection with such partnership. And to limited partners on their share of partnership income if they provide substantial professional services to the partnership. S-CORPORATION MUST PAY REASONABLE WAGES IRS Position is Long-Standing Rev. Rul , C.B. 287 Where two shareholders took zero wages and 100% dividends, IRS reclassified distributions as wages, and applied penalties

17 COURTS REQUIRE REASONABLE COMPENSATION Radke v. United States, 895 F.2d 1196 (7 th Cir. 1990) Sole shareholder of S-Corporation took zero wages and 100% dividends U.S. District Court ruled all distributions were subject to payroll taxes Appeals Court upheld District Court decision, including penalties OFFICERS ARE EMPLOYEES Dunn & Clark P.A. v. Comm r., 95-2 USTC 50,383 (9 th Cir. 1995) The S-Corporation s only attorneys never received wages; only dividends. IRS imputed payroll taxes. Shareholders argued Section 530 defense. Court reminded these attorneys that the statute defines officers as employees and they had no reasonable basis to ignore the statute S-CORPORATION PRESIDENT IS AN EMPLOYEE Nu-Look Design, Inc. v. Comm r., USTC 50,138 (3 rd Cir. 2004) Corporation President provided more than minor services and was not a common law employee because IRC 3121(d)(1) defined him as an employee under the statute. AUTOMATIC DIVIDEND RULE McCandless v. United States, 422 F.2d 1336 (Ct.Cl. 1970) Court found reasonable compensation But, decided that some must be dividends because of the poor dividend history Court created an Automatic Dividend Rule It took 10 years for IRS to reject this rule

18 IRS REJECTION OF AUTOMATIC DIVIDEND RULE Rev. Rul. 79-8, C.B. 92 IRS will not automatically treat a portion of a shareholder s salary as dividends solely on the ground that the corporation has not paid more than an insubstantial portion of its earnings as dividends. TAX COURT REJECTS AUTOMATIC DIVIDEND RULE Davis & Sons, Inc. v. Comm r., T.C.Memo While the absence of dividends may indicate the presence of disguised dividends, it does not convert compensation determined to be reasonable into dividends TH CIRCUIT REJECTS AUTOMATIC DIVIDEND RULE Charles Schneider & Co. v. Comm r., 500 F.2d 148, 153 (8 th Cir. 1974) An absence of profits paid back to the shareholders as dividends justifies an inference that some of the purported compensation really represents a profit distribution; but not a conclusive presumption. 7 th CIRCUIT REJECTS AUTOMATIC DIVIDEND RULE Edwin s, Inc. v. United States, 501 F.2d 675 (7 th Cir. 1974) While the absence of dividends might be a red flag, it should not deprive compensation demonstrated to be reasonable under all of the circumstances of the status of reasonableness

19 9 th CIRCUIT REJECTS AUTOMATIC DIVIDEND RULE Elliotts, Inc., v. Comm r., 716 F.2d 1241 (9 th Cir. 1983) First, there is no statute requiring profitable corporations to pay dividends. Second, the automatic dividend rule is based on the faulty assumption that shareholders of a profitable corporation will demand dividends. Third, it may well be in the best interests of the corporation to retain and reinvest its earnings. REASONABLE COMPENSATION IRM (3) Nature of Duties Background, Knowledge, & Experience Contribution to Profit Relationship of Wages to Ownership Wages Ordinarily Paid for Like Services Economic Conditions Locally JURY INSTRUCTION INDEPENDENT INVESTOR TEST Palmetto Pump and Irrigation Co., v. Tomlinson, 313 F.2d 220 (5 th Cir. 1963) aff g D.C. Fla USTC 9,369 Comparable Salaries Relationship of Wages to Ownership Relationship of Wages to Net Profits Year-End Bonus Determination Dividend History Compensation of Other Employees Time Devoted to Business Nature of Duties & Services Performed Qualifications of Individuals Receiving Wages 75 Elliotts, Inc. v. Comm r., 716 F.2d 1241 (9 th Cir. 1983) A relevant inquiry is whether an inactive independent investor would be willing to compensate the employee as he was compensated. This generally relates to the rate of return the investor actually receives after the compensation is paid

20 REASONABLENESS FACTORS Elliotts, Inc. v. Comm r., 716 F.2d 1241 (9 th Cir. 1983) Role in Company External Comparison in Industry Character & Condition of Company Relationship of Employee to Corporation Hypothetical Independent Investor Test MODERN VIEW OF INDEPENDENT INVESTOR TEST E.J. Harrison & Son, Inc. v. Comm r., T.C. Memo A hypothetical investor would not look solely at the rate of return and ignore the availability of other executives at less compensation than that actually paid Tax Court Adjusted Income to Create Adequate Rate of Return [Multi-Pak Corp., TC Memo (7/1/10)] Application of Independent Investor Test 2 Years in Issue First Year Approved $2 million in Wages Second Year Reported NOL Tax Court Reduced Wages in Year 2 to Create Profit in Order to Allow $1.2 Million in Deductible Wages TAX COURT REBUTS REASONABLE RATE OF RETURN Menard v. Comm r. T.C. Memo Corporate Rate of Return was 18.8 % Tax Court found rate of return was sufficient to create a rebuttable presumption that Mr. Menard s compensation was reasonable Then denied reasonable compensation on grounds that it exceeded competitors

21 TAX COURT WAS REVERSED Menard, Inc. v. Comm r. 560 F.3d 620 (7 th Cir. 3/10/2009) Appeals Court provides guidance in measuring reasonable compensation in closely held businesses No two enterprises are alike and no two chief executive officers are alike COMPENSATION PACKAGES FOR CEOs ARE DIFFERENT Comparison of executive compensation MUST take into account the details of the entire compensation package, not just the bottom line salary Bonuses based on company profitability cause compensation to be at risk and tied to executive performance SALARY IS JUST THE BEGINNING OF COMPARISON Salary is but one element of the compensation package Risk in corporate compensation is critical in evaluating reasonable compensation A risky compensation structure implies executive compensation is likely to vary substantially from year to year 83 MEASURE SERVICES PROVIDED Where comparisons are made to other CEOs, compare the services rendered and responsibilities assumed Mr. Menard ran the entire company while the comparisons were made to CEOs with large staff and many support personnel 84 21

22 COMPARISONS MUST BE COMPARABLE Menards had only three corporate officers Mr. Menard owned all of the voting stock Mr. Menard ran the company himself Mr. Menard was compared to CEOs at Home Depot and Lowe s EXCESSIVE WAGES BASED ON PRIOR UNDER COMPENSATION There is a line of cases, beginning with the decision of the Supreme Court in Lucas v. Ox Fibre Brush Co., 281 U.S. 115, 119 (1930), holding that current payments for services rendered in prior years may be deductible currently PROOF REQUIRED Pacific Grains, Inc. v. Comm r., 399 F.2d 603, 606 (9 th Cir. 1968) In order to be allowed the deduction, the taxpayer must establish: (1) The amount of the under-compensation for the earlier year s service, and (2) That the payment in the later year is intended as compensation for the earlier years services. TAX COURT PERMITS WAGES FOR EARLIER SERVICES Devine v. Comm r., T.C. Memo The Tax Court held that the compensation paid to a corporation s founder was, in light of the under-compensation in earlier years due to business necessity, reasonable compensation and deductible in full under section

23 FAILURE TO DOCUMENT PRIOR UNDER COMPENSATION BECOMES FATAL Brewer Quality Homes, Inc. v. Comm r., T.C. Memo There were no corporate minutes declaring any part of the compensation as a make up for past performance. There was no evidence that the petitioner was under-compensated in prior years. 89 SECTION 530 DOES NOT APPLY TO SHAREHOLDER-OFFICERS Veterinary Surgical Consultants v. Comm r., T.C. Memo Section 530 does not afford a reasonable basis for disregard of the explicit rules of section 3121(d)(1) and section (d)- 1(b) and (i)-1(e), Employment Tax Regulations. Section 3121(d)(1) defines employee to include any officer of a corporation. 90 INDUSTRY DATA CAN SHOW EXTERNAL COMPARISON Brewer Quality Homes, Inc. v. Comm r., T.C. Memo Robert Morris Associates (RMA) data used as reasonable basis for industry averages of executive compensation as a percentage of sales for companies comparable to petitioner. We do not know exactly how many officers, directors, and affiliates are represented in the total officers compensation in the RMA figures. UNSUPPORTED SALARY COMPARISON NOT ACCEPTED Leonard Pipeline Contractors v. Comm r., T.C. Memo We do not accept Respondent s expert s conclusions because they are not based on data from businesses that are sufficiently similar to petitioner s. Petitioner s experts were also unconvincing because they were not objective and simply promoted petitioner s position

24 IRS INDUSTRY AUDIT GUIDELINES Market Segment Specialization Program Industry Compensation Rates Comparability Studies: Executive Compensation Series, by RIA; Management Compensation Survey, by Medical Group Management Association; Research of Labor Statistics. IRS AUDIT GUIDELINES Size and Complexity of the Business Compensation to Income Ratio & Trend General Economic Conditions Prior Compensation and Dividend History Compensation of Non-Owner Employees Duties and Responsibilities Relationship of Services to Profitability