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How Much of S-Corp Income is Labor Income and Hence Subject to Medicare Taxes?

September 7th, 2013 Leave a comment Go to comments

Here are a couple of comments I posted at Taxprof:

T.C. Summary Opinion 2013-62 (McAlary, http://www.ustaxcourt.gov/InOpHistoric/McAlary.SUM.WPD.pdf) is amazing. Professor Schwidetzky has it absolutely right. Suppose Dr. Roe earns high labor income some years, low in others. He becomes an S-corporation, with zero capital. That’s not supposed to change his tax situation, right? But in deciding his S-corporation labor income for tax purposes, the court didn’t use that tax principle, even though it’s Tax Court. Instead, it used the corporation law principle of something like the business judgement rule— how low a salary wouldn’t be ridiculous for that industry? So it calls for expert witnesses to tell the court how much other doctors make in labor income, even though it knows exactly how much *this* doctor made.
If Dr. Roe puts in some capital for office expenses, that only makes things a little harder. It’s actually far far easier for an expert witness to accurately estimate a cost of capital than someone’s market wage. But we can put in a simple safe harbor for tax purposes. Just require the taxpayer to keep track of how much capital he puts in and give it a return of 5% over the IRS late-payment rate each year.
For a safe harbor, we need a notice-and-comment regulation or an IRS declaration of enforcement policy. Otherwise, even just a court ruling would be OK. This decision is a S(mall) one though, so it can’t be appealed. Even if it could be, the taxpayer would be well advised not to appeal it, because the IRS was extremely modest in its tax demand, and amici following the ideas here would ask the court to more than double it. (Can a court do that in a tax case?)

I found a history of this tax issue at

http://www.aicpa.org/publications/taxadviser/2011/august/pages/nitti_aug2011.aspx

which shows, I think, that an old IRS revenue ruling is the source of the problem, by saying that “reasonable compensation” had to be paid by the corporation rather than trying to define which part of a corporation’s profit was return to labor rather than return to capital. Another way to put this is that the IRS didn’t require that *capital* was limited to a “reasonable return”. Of course, using words like “reasonable” gives wiggle room so that a taxpayer could say that of his corporation’s $500,000 profit, $100,000 was a reasonable salary, $50,000 was a reasonable return to capital, and the rest was a gift from heaven and shouldn’t be taxed at all.
I didn’t look at the Glass Blocks case at http://rothcpa.com/2013/08/tax-court-even-if-you-lose-money-your-s-corporation-needs-to-pay-reasonable-compensation/ , but it seems the IRS has accomplished the Immigration feat of being both incredibly lax with most people and incredibly picky with a few. The poor taxpayer’s labor income was clearly negative, but the IRS “reasonable compensation” method doesn’t let people have negative labor income. The simple method of saying everything is labor income except for an estimated return to capital would have avoided making him pay.
(One caveat is that this involves Medicare and Social Security. It seems to me that a negative-income taxpayer should be treated as making no dollar contributions to the funds for purposes of his later eligibility, but as having put in those quarters of work,which was the way charitable work was treated, It hink, back when my mother kept track of her hours as secretary of the civic symphony).

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