S Corporations- How do you get paid?
August 31, 2011 | 
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Executive Summary:
S Corporation shareholders generally prefer to take dividend distributions from their profits as opposed to compensation payments. Compensation payments are subject to employment taxes, where as distribution payments are not. This gives S Corporation shareholders a distinct tax advantage over that of LLs, partnerships and sole proprietorships as these types of entities cannot take profit distributions.
The IRS does require S Corporations to pay “reasonable compensation” to shareholders to prevent these corporations from avoiding employment taxes.
If you are an S Corporation shareholder, particularly of a professional services firm, take note of the three qualifying factors for determining reasonable compensation:
- Employee performance
- Salary comparisons
- Company conditions
Background:
S Corporations have long enjoyed a tax advantage over that of sole proprietorships, partnerships, and LLCs. As the tax burdens on businesses grown, this advantage has become more pronounced. However, the IRS is taking aim at the S Corp distribution payments v. compensation payments debate.
Until recently, the IRS offered very little guidance to S Corporation shareholders and their tax advisors on defining and computing “reasonable compensation,” leaving the window open to a wide range of interpretation.
Determining an analytical approach to computing “Reasonable Compensation”:
Two recent district court cases (David E. Watson, P.C., 714 F. Supp. 2d 954 (S.D. Iowa 2010) and JD & Assocs., Ltd., 3:04-cv-59(D.N.D. 2006)) have finally shed some light on the methodology the IRS uses to determine reasonable compensation for S Corporations.
Both of these cases involve a shareholder in a professional services firm with a broad spectrum of responsibilities drawing what the IRS believed to be unreasonably low salaries. The District Court developed three groupings of factors to determine reasonable compensation:
- Employee performance
- Salary comparisons
- Company conditions
Regarding employee performance, the shareholders in question were leading profitable firms, and leveraging advanced degrees and decades of experience. The IRS ruled that they were underpaid for their services.
To determine comparative salaries, the IRS engaged a certified valuation engineer to make a determination of reasonable compensation. The expert compared various ratios, including the firm’s profitability in relation to peers and shareholder in question’s salary as a percentage of net sales in relation to peers. Whereas the firms in question were more profitable than peers, the Shareholders in question were making markedly less in compensation compared to peers (in some cases, over 250% less!).
Regarding company conditions, the court determined that a small yet profitable enterprise with few requirements in terms of reinvestment should have excess capital for reasonable employee compensation.
In other words, in both these cases, the Courts ruled in favor of the IRS.
It is not a coincidence that both these cases involved professional services firms (law, accounting, consulting). In the view of the IRS, these businesses generate profits primarily through personal efforts of their employees, as opposed to other types of businesses where revenue is driven more through a corporation’s capital and assets. In the case of professional services firms, profits should be paid out in compensation.
How can I determine reasonable compensation?
Use basic benchmarking tools, like monster.com, salary.com, Robert Half and the Bureau of Labor Statistics data to determine the reasonableness of shareholder compensation in relation to industry norms.
Questions?
Selling Your Home? Here are 10 Tax Tips:
August 25, 2011 | Subscribe to our RSS Feed
If you are selling your home right now, and actually stand to make a gain from the sale, you may qualify to exclude all or part of that gain from your income. Here are 10 tips to keep in mind:
- Generally, you are eligible to exclude the gain from income if you have owned and used the home as your MAIN RESIDENCE for two out of the last five years prior to the date of its sale.
- If you have a gain from the sales of your main home, you may be able to exclude up to $250,000 of the gain from your income ($500,000 on a joint return).
- You are not eligible for the exclusion if you excluded the gain from the sale of another home during the 2 year period prior the sale.
- If you can exclude the gain, you do not need to report the sale on your tax return.
- If the gain cannot be excluded and is taxable, you must report it on Form 1040.
- You cannot deduct a loss from the sale of your main home.
- Use the worksheets included in IRS Publication 523 to help you calculate what can be excluded.
- You can only exclude the gain from the sale of your main home. If you have two homes and live in both of them, your main home is ordinarily the one you live in most of the time.
- If you received the fist-time homebuyer credit and within36 months of the date of purchase, the property is no longer used as your principal residence, you must repay the credit.
- Always update your address with the IRS and US Postal Service when you move.
Questions?
9 Tips for Tax Payers Making Charitable Donations
August 22, 2011 | Subscribe to our RSS Feed
If you make a donation to charity this year, you may be able to take a deduction on your 2011 tax return. Here are 9 things you should know:
- Make sure the organization qualifies. You can find a full list of qualifying organizations at www.irs.gov. Check IRS Publication 78.
- You must itemize.
- Deduction value. You can generally deduct your cash contributions and the fair market value of most property you donate. Special rules apply to several types of donated property, including clothing, household items, cars and boats.
- Receiving gifts or services in return. When your contribution entitles you to receive merchandise, services or goods- like admission to a charity banquet- you can deduct only the amount that exceeds fair market value of the benefit received.
- Recordkeeping. Keep good records of any contribution you make, regardless of the amount.
- Pledges and payments. Only contributions actually made during the tax year are deductible. If you pledge an amount to a charitable organization in 2010, but do not pay the full amount by 12/31, you can only deduct the amount paid.
- Donations made near the end of the year. Include credit card payments and payments by check in the year you gave them to the charity, even though you may not pay the credit card bill or have your checking account debited until the following year.
- Large donations. For any contribution $250 or more, you need to have more than a bank record. You must have written acknowledgement from the organization. For items valued at more than $500 you must complete IRS Form 8283. For a contribution of noncash property valued at more than $5000, you generally must obtain an appraisal.
- Tax exemption revoked. Approximately 275,000 organizations lost their tax-exempt status recently because they did not file required reports in a timely manner, as required by law. Donations made to one of these organizations prior to the organization’s status revocation remain tax-deductible.
Questions?
Market Observations- The Perceived Instability of Markets
August 16, 2011 | Subscribe to our RSS Feed
| Market/Index | 2010 Close | Prior Week | As of 8/12 | Week Change | YTD Change |
| DJIA | 11577.51 | 11444.61 | 11269.02 | -1.53% | -2.66% |
| NASDAQ | 2652.87 | 2532.41 | 2507.98 | -.96% | -5.46% |
| S&P 500 | 1257.64 | 1199.38 | 1178.81 | -1.72% | -6.27% |
| Russell 2000 | 783.65 | 714.63 | 697.50 | -2.40% | -10.99% |
| Global Dow | 2087.44 | 1906.46 | 1861.30 | -2.37% | -10.83% |
| Fed. Funds | .25% | .25% | .25% | 0 bps | 0 bps |
| 10-year Treasuries | 3.30% | 2.58% | 2.24% | -34 bps | -106 bps |
Volatility was the name of the game last week, marked by the Dow’s history-making 400-point daily swings over a four-day period, driven primarily by the S&P’s downgrade of the U.S. credit rating and the European debt crisis.
Recent weeks have seen investors lowering their growth expectations on a worldwide basis. Their wide-ranging worries concerning the strength of the world markets are very reasonable, given that available fiscal and monetary policies designed to stimulate have already been set in motion in numerous areas globally.
The Federal Reserve announced at its regular policy meeting last week that it intends to maintain the Fed Funds rate at its current level (0% to 0.25%) through mid-2013. This is the first time the Fed has ever provided a set timeframe on a rate decision. In its commentary, the Fed indicated that first-half growth in 2011 was “significantly lower” and consequently lowered its future expectations.
While the Fed may be right in its belief that the U.S. economy’s growth will be weak, we maintain our view that fundamentals will be enough to keep us on the path to recovery. Nonetheless, given the worsening financial conditions, it is becoming apparent that, if central banks were to intercede, it may improve confidence and ease the pressure on the economy. Currently, the Bank of England and the Fed are considering more asset purchases and the ECB may be getting ready to expand its bond-purchase program.
On a positive note, initial jobless claims for the week ended August 6 came in under the 400,000 mark. This supports our expectation that the labor market continues to slowly strengthen. Also of note, June retail sales figures were revised upward, and July’s retail sales increased.
It is clear to us that a double-dip recession in the United States is weighing on our clients minds. We ask that clients consider that market behavior is an unreliable gauge of recessions and company fundamentals continue to be robust. Companies are holding cash on their books at a level not seen in over 60 years. Cash on the books of non-financial corporations is running around 11%. Additionally, earnings results in the second-quarter reflect an 18% year-over-year increase in conjunction with an approximate 10% climb in revenues. While stock prices are hovering around 35% below where they were four years ago, corporate earnings are on a path this year to outdo the highs they set back then. This setting further highlights how incredibly cheap stocks are right now. So, while the market may be choppy in the near-term due to the current economic issues and debt concerns, our long-term attitude towards equities remains optimistic.
Questions?
vanessa.duchman@glassjacobsonia.com
Glass Jacobson Investment Advisors, LLC (GJIA) provides investment and wealth management. Securities products and brokerage services are offered through Triad Advisors, Schwab Institutional, and/or Fidelity Registered Investment Advisory Group, registered broker-dealers and members of FINRA and SIPC. Insurance products and advice may be provided by licensed insurance agencies that are not affiliated with GJIA. A licensed insurance agent will receive compensation if you choose to purchase insurance through GJIA. A decision to purchase insurance will not affect the cost or availability of other products or services from GJIA. GJIA does not provide legal, tax, or accounting advice. Investments and Insurance: Not FDIC Insured. No Bank or Federal Government Guarantee. May Lose Value.