Page 121-144 07 - Related Parties - Compensation and Loans 1
Page 121 I. Owner Compensation Issues in General Some basic facts we know but our clients do not: A. All shareholders MUST take a reasonable salary B. IRS, lacking a reasonable salary, may reallocate, distributions and even loan payments as payroll C. Determination of what is a fair salary is difficult 07 - Related Parties - Compensation and Loans 2
Page 121 I. Owner Compensation Issues in General Courts have said that the following may (but not absolutely) be determinants: 1. Performed Services 2. Received Loans or Distributions 3. Nobody else worked 4. A majority of ownership 5. Loans were made but no documentation 6. Made more in prior unowned company 7. NO Salary Plan 8. Compensation less than prevailing rates 9. Less compensation than employees performing similar duties 07 - Related Parties - Compensation and Loans 3
Page 122 I. Owner Compensation Issues in General Glass Blocks Unlimited, TC Memo 2013-180 Distributions were taxable wages, not loans: No collateral was given. No promissory notes issued Dixie Dairies Corp, (1980) 74 TC 476 Burden of proof of the character of the transfer was that of the taxpayer NO Wages Loan payments made at shareholder request See 13 item list Use them as guide 07 - Related Parties - Compensation and Loans 4
Page 123-135 Owner Compensation Issues Balancing Act of Judgment C-Corp too high S-Corp too low 07 - Related Parties - Compensation and Loans 5
II. Owner Compensation Issues in a C Corporation Page 123 Disputes with the IRS over fair compensation in a C Corporation is always about excessive amounts. 07 - Related Parties - Compensation and Loans 6
II. Owner Compensation Issues in a C Corporation Page 123 The courts repeatedly cite the issue of the reasonable investor test that owes it roots to the Dexsil Case 147 F 3d 96 (2 nd Cir. 1998). (Page 124 Item F In a C Corporation the investor return must be recognized: 07 - Related Parties - Compensation and Loans 7
II. Owner Compensation Issues in a C Corporation Page 124 The arguments are important BUT documentation is a must: 07 - Related Parties - Compensation and Loans 8
II. Owner Compensation Issues in a C Corporation Page 124 Consider the Independent investor test applied by the Dexsil Corp v Comm provides a lens through which the entire analysis should be viewed i.e. Is it to much? WOULD AN OUTSIDE INVESTOR APPROVE AND RECEIVE A REASONABLE RATE OF RETURN? 07 - Related Parties - Compensation and Loans 9
II. Owner Compensation Issues in a C Corporation When is the independent investor test too much? Is there a upper limit for the investor? Page 125 07 - Related Parties - Compensation and Loans 10
II. Owner Compensation Issues in a C Corporation Determination of Reasonable Compensation is always difficult. The H.W. Johnson, Inc., TC Memo 2016-95 was successful because the taxpayer did their paperwork when setting the salary. Page 125 07 - Related Parties - Compensation and Loans 11
II. Owner Compensation Issues in a C Corporation Page 125 Vanney Associates Inc. TC Memo 2014-184 In a case the court determined that the year end bonus paid to the CEO was not deductible because the company did not have the funds to honor the check. Insufficient Funds Total Payroll Management 07 - Related Parties - Compensation and Loans 12 12
II. Owner Compensation Issues in a C Corporation Page 126 The Facts: At year end per past practice the taxpayer wrote a bonus check to the CEO for the amount of the profits of the company in this case $815,000 applied withholding that was timely sent to IRS. However Vanney Associates did not have the necessary funds at the time to cover the check. Total Payroll Management 07 - Related Parties - Compensation and Loans 13 13
II. Owner Compensation Issues in a C Corporation Page 126 What did Mr. Vanney do: Upon the receipt of the check he endorsed the check payable to Vanney Associates Inc. but NEVER attempted to cash the check. Recorded the payment on the books as a loan. Indicated that he believed that the corporation could have obtained a loan to cover the check Total Payroll Management 07 - Related Parties - Compensation and Loans 14 14
II. Owner Compensation Issues in a C Corporation Page 126 The court said: No deduction allowed. The Tax Court concluded that both Mr. and Mrs. Vanney knew or should have known that Vanney Associates didn't have the funds to cover the check, rejecting Vanney Associates argument that the payment was unconditional and that it occurred when Mr. Vanney took possession of the check. Total Payroll Management 07 - Related Parties - Compensation and Loans 15 15
II. Owner Compensation Issues in a C Corporation Page 126 A taxpayer with obvious family issues lost his case even with an IRS expert who made numerous mistakes: The analysis of the compensation by the IRS expert was deficient. The expert never determined exactly the sons role in the business The sons were never interviewed by the IRS expert. But the court found for the IRS, because burden of proof rests with the taxpayer 07 - Related Parties - Compensation and Loans 16
II. Owner Compensation Issues in a C Corporation What needs to be done checklist: Page 127 07 - Related Parties - Compensation and Loans 17
III. Owner Compensation Issues in an S Corporation Other side of the argument, IRS will argue that compensation is too low, based on: Page 127 Services Performed Stock Owned No Basis for Salary Distributions Received Distributions disguised as loans Salary Below Prevailing Rates Other Workers Prior Comparable Salaries Compensation below nonowners 07 - Related Parties - Compensation and Loans 18
III. Owner Compensation Issues in an S Corporation A fair salary for an S Corporation shareholder is: $24,000 lots of cases that is what they took. $91,000 court said okay in Watson case. An expert witness for IRS said whatever the company made. Court on appeal said that a fair wage in California was $83,200. Whatever you can get away with. Newt took $2 mill that should work Let the client decide. Page 127 07 - Related Parties - Compensation and Loans 19
III. Owner Compensation Issues in an S Corporation The Watson Case, the fair compensation for the experienced CPA in Des Moines IA was? - $91,000 + Page 128 07 - Related Parties - Compensation and Loans 20
III. Owner Compensation Issues in an Page 128-129 S Corporation A realtor in California fair compensation was? - $83,200 07 - Related Parties - Compensation and Loans 21
III. Owner Compensation Issues in an S Corporation Other cases that auditors will cite include: So the answer is, i.e. a facts and circumstances test Page 129 07 - Related Parties - Compensation and Loans 22
An individual lends a $100,000,000 to his S Corp. He then takes no salary but has the Corp pay his personal expenses? A. This is a disaster. B. I hope he set it up as a contribution of capital rather than a loan. C. He better have set this up as a loan. D. This guy got lucky. Singer Case 07 - Related Parties - Compensation and Loans 23
III. Owner Compensation Issues in an S Corporation We now have the Singer Installation Inc. v Comm. TC Memo 2016-161. Question before the Court - Determine if the payment of personal expenses by the S Corporation were loan repayments or constituted wages. Facts of the Case Shareholder advanced funds to corporation using various methods from 2006-2011, all these advances were recorded as loans on the books and In 2010-2011 (years of the audit) $181,872 of the shareholder s personal expenses were paid by the corporation directly, oops, no salary either. Page 129 07 - Related Parties - Compensation and Loans 24
III. Owner Compensation Issues in an S Corporation We now have the Singer Installation Inc. v Comm. TC Memo 2016-161. Question before the Court - Determine if the payment of personal expenses by the S Corporation were loan repayments or constituted wages. IRS issued Notice of Determination of Worker Classification to determine employment status of shareholder. IRS determination was that the shareholder was in fact an employee. Page 130 07 - Related Parties - Compensation and Loans 25
III. Owner Compensation Issues in an S Corporation We now have the Singer Installation Inc. v Comm. TC Memo 2016-161. The Court Said: a. Advances 2006-2008 Reasonable as loans Business was growing and likelihood of payment reasonable. b. Advances 2008-2011 Should be capital Business was stressed and repayment no longer seem assured. c. Court did concur that shareholder did in fact have sufficient loan balances payable to him to consider the payments as loan repayments Page 130 07 - Related Parties - Compensation and Loans 26
III. Owner Compensation Issues in an S Corporation We now have the Singer Installation Inc. v Comm. TC Memo 2016-161. But The Court Said: Citing a series of code sections IRC 3121, IRC 3306, and IRC 3401 with their associated regulations the court affirmed, there is no provision in the code or regulations that authorizes an employee to waive his or her right to receive wages. Moral of the Story You got to take a paycheck Page 130 07 - Related Parties - Compensation and Loans 27
III. Owner Compensation Issues in an S Corporation We now have the Singer Installation Inc v Comm TC Memo 2016-161. The IRS response: 5. Does not matter that there were sufficient loan balances for repayment there must be a salary. 6. The IRS will continue in these type of cases to assert: Loan payments must be documented Capital contributions must be reflected in books Any payment of personal expenses is compensation. Page 130 07 - Related Parties - Compensation and Loans 28
III. Owner Compensation Issues in an S Corporation Okay IRS issues Action on Decision 2017-4 where they will not acquiesce to the Singer Decision in its Form: The IRS in the AOD said the following: Loans should be documented, bear adequate interest, and collateralized. The IRS will only respect a loan as such if the taxpayer does as well. and Accordingly, unless a taxpayer objectively substantiates both the existence of a loan and that payments made were in repayment of that loan, the Service will continue to assert that the payment of personal expenses by an S Corporation on behalf of its corporate officer/employee constitute wages subject to Federal employment taxes. Page 130 07 - Related Parties - Compensation and Loans 29
III. Owner Compensation Issues in Bonus an - Page 130 S Corporation Chief Counsel Advice 201735021 Reclassification of Payments not Eligible for Tax Court Review IRS position on exam that did not involve worker classification but dealt with recharacterization of wages. Opinion No Tax Court review is available to taxpayer for the reclassification of: Loan Payments Distributions 07 - Related Parties - Compensation and Loans 30
III. Owner Compensation Issues in Bonus an - Page 130 S Corporation Chief Counsel Advice 201735021 During an exam certain payments that were not classified as wages (reported on payroll returns) Were determined incorrect and were reclassified as payroll. The CCA has concluded that the reclassification of payments was not subject to Tax Court review as it was not an worker classification issue. 07 - Related Parties - Compensation and Loans 31
IV. Determining Reasonable Compensation Page 132-133 What to do when setting salaries: A. Using the thumbnail approach B. Using averages C. Know that the IRS will attack with its experts using multiple analysis theory D. Use tools that will facilitate a defense of the salary decision made. 07 - Related Parties - Compensation and Loans 32
IV. Determining Reasonable Compensation Consider using a Reasonable Compensation Reporting service such as RC Reports. Page 133 07 - Related Parties - Compensation and Loans 33
VI. Compensation Disguised as Loans to Shareholders Page 133 The Issue: IRS has been given the authority under IRC 482 to reclassify loans as compensation for services if: Sufficient documentation of intent to be a loan does not exist, and The loan is not treated as such (See Singer Case) Compensation actually paid does not reflect, reasonable compensation. 07 - Related Parties - Compensation and Loans 34
VI. Compensation Disguised as Loans to Shareholders Example of the Loan Problem: Page 134 07 - Related Parties - Compensation and Loans 35
Page 136 VIII. What Constitutes a Bona Fide Debt? The loan needs to pass the smell test: Does it look like a loan Is it treated like a loan Would an unrelated party advanced the funds Are collection steps taken 07 - Related Parties - Compensation and Loans 37
Page 136 VIII. What Constitutes a Bona Fide Debt? When making, holding and collecting a note from a shareholder: 1. Draft and sign a note, open account debt is more likely subject to challenge. 2. Payments, including interest should be paid on a regular basis, at least annually. 3. Insure the note comes to a term and is rewritten based on current economic info. 07 - Related Parties - Compensation and Loans 38
Page 137 VIII. What Constitutes a Bona Fide Debt? 07 - Related Parties - Compensation and Loans 39
Page 137-138 IX. Bad Debts Was there really a debt? Was there an intent and effort to collect? Legal action? Was it futile? How come? Business debts deductible Probably ordinary loss How related was it to the business? Non business bad debt is S.T. Cap loss 07 - Related Parties - Compensation and Loans 40
Page 138 IX. Bad Debts What proof is there that the debt is no longer collectable? Attempts to collect Including demand notices. Attempt to legally enforce Pursue in the courts. Agreement with debtor What kind of debt work outs were attempted with debtor. 07 - Related Parties - Compensation and Loans 41
XI. Below Market Loan Rules on Corporation Shareholder Loans Page 141 Applies regardless of shareholder s level of ownership Deminimus exception: < $ 10,000 as long as: It never went above that during the year There was no tax avoidance purpose Imputed Interest = a dividend or comp If employee, compensation PR tax applies 07 - Related Parties - Compensation and Loans 42
Page 144 XIII. Additional Resources 07 - Related Parties - Compensation and Loans 43