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Archive for Audits

Increase Your Tax Deductions—Switching from the IRS Mileage Rate to Actual Expenses

By Kim M. Larsen EA CTFS
Friday, February 27th, 2015

Do you feel like you’re not getting as much as you should from your business vehicle mileage deductions? For some business owners, gas and maintenance for a vehicle can be significant business expenses. If you’re not already using the actual expense method to calculate your mileage deduction, that may be your ticket to getting more from your vehicle expenses.

Usually, you’ll make a decision once regarding whether to use the IRS mileage rate for your deductions or to use the actual-expense method. If you choose the IRS mileage rate, you also lose out on MACRS depreciation.[1] However, you’re not locked into your choice forever. You have two different options for switching to claiming actual expenses.

Option 1: Amending Your Tax Return

If you realize fairly quickly that you’ve made the wrong decision in choosing to use the IRS mileage rate, you can act quickly and change your decision. That means you’ll have to file an amendment to your tax return before its original due date (if you filed extensions, the deadline includes the extensions).[2]

This option is fairly easy to enact. You’ll file the amendment, electing actual mileage expenses, Section 179 deductions, and MACRS depreciation. But, you have to act fast. This method essentially replaces the election on your original tax return.

Option 2: Straight-Line Depreciation

If you’ve already missed out on your chance to amend your return, you do have other options. You could still switch to the actual-expense method with MACRS depreciation, but you’ll have to get permission from the IRS commissioner . . . if you enjoy wasting time and money with the possibility of rejection.[3] Let’s be smart here; the commissioner is not a good option.

Instead, you can opt for straight-line depreciation for the remainder of your vehicle’s useful life.[4] This allows you to make the actual expense deductions. For calculating the straight-line depreciation, you’ll need the following information on your vehicle:[5]

  • Its Adjusted Basis—This is typically the original cost of the vehicle minus depreciation. When you use the IRS mileage rate, depreciation is included in it (22 cents per mile in 2014 and 24 cents per mile in 2015).[6] If you pay $30,000 for your car and drive it 5,000 miles for business (with no personal miles), you would calculate your depreciation at 5,000 miles x $0.22, which equals $1,100. Your adjusted basis is $28,900 ($30,000 – $1,100).
  • Its Estimated Remaining Useful Life—You don’t need to think too hard about this. It’s simply how long you expect to keep the vehicle.[7] We’ll call it 5 years for our example.
  • An Estimate of Its Salvage Value when the Useful Life Ends—To get a salvage value, you should use a respected pricing source, such as Kelly Blue Book. In our example, the value is what you estimate you could sell the vehicle for in 5 years (the remaining useful life). Let’s say this number is $4,000. Don’t forget to document where you get this number from!

Now, when you switch to actual mileage expenses, the IRS gives you a bonus on the salvage value if you plan to keep the vehicle for more than three years. Our example vehicle meets that requirement, which means you can reduce the salvage value by $3,000 (10 percent of the basis). If 10 percent of the basis exceeds the salvage value, that’s no problem. You’ll simply claim a salvage value of zero.

An Additional Consideration

When claiming actual expenses, you’ll have to pay attention to the luxury vehicle depreciation limits. These apply to passenger vehicles, and the limits differ between cars, vans, and trucks. You’ll need to find the amounts for the year you placed your vehicle in service.

For 2014 the limits for cars placed in service that year are:

The limits for vans and trucks are:

Note: These are amounts for used vehicles only. If your leased or purchased a new vehicle, use the tables in Rev. Proc. 2014-21 . Regardless of the type of vehicle or whether it is new or used, you must reduce the limit by your personal use. So, if you use your car for 80 percent business and 20 percent personal purposes, your first year limit is $2,528. If these limits affect your depreciation, you can simply claim the rest of the depreciation in a later year—you do not lose it.

Some vehicles are exempt from the luxury limits. Your truck, van, crossover, or SUV may be exempt if it 1) is classified as a truck by the Department of Transportation, and 2) has a gross vehicle weight rating over 6,000 pounds. Note that some passenger trucks are not classified as a “truck” by this definition.

If you don’t like the choice you made for your mileage deductions, you can fix it. If you catch it early, you’ll still get all the additional benefits that come with the actual-expense method (Section 179 expensing and bonus depreciation). However, if you make the switch later, you can still get some benefit from actual expense deductions with straight-line depreciation. What you need to know is that the choice to switch is available to you.

  1. Rev. Proc. 2010-51; IRC Section 168(f)(1) ↑
  2. Reg. Section 301.9100-2(d) ↑
  3. Rev. Proc. 2011-14, Appendix 6.02 ↑
  4. Rev. Proc. 2010-51 ↑
  5. IRS Pub. 534, Depreciating Property Placed in Service Before 1987, (Rev. Nov. 1995), p. 7 ↑
  6. Notice 2014-79; http://www.irs.gov/2014-Standard-Mileage-Rates-for-Business,-Medical-and-Moving-Announced ↑
  7. IRS Pub. 534, Depreciating Property Placed in Service Before 1987, (Rev. Nov. 1995), p. 7 ↑
Categories : Audits, Business Expenses, Cars, Trucks & SUVs, Depreciation, Listed Property, Tax Planning

Do You Own Multiple Businesses? Consider this Tax Advice for Passive Losses

By Kim M. Larsen EA CTFS
Friday, February 27th, 2015

Any time one of your businesses experiences a loss, you want to be able to claim those losses on your tax return. Unfortunately, the passive loss rules can stand in the way of these deductions, unless you plan ahead. In case you don’t already know the passive loss rules, here’s a breakdown of the requirements for deducting passive losses:

  1. You must participate materially in the business that has losses in order to deduct those losses (or if you group the business with another, you must actually participate in the group); or
  2. If you do not participate materially in the business, you must have other sources of passive income that you can deduct the losses against.

Grouping to Claim Passive Losses

Here’s a likely scenario. A medical doctor owns a medical practice, and she would like to open a physical therapy business, but she does not plan to actually work at the new business. Someone else will handle management of this business, and employees will provide the services. The doctor understands that the business will likely lose money for the first couple of years.

However, the doctor does not have any other source of passive income; her only other business is the medical practice in which she actively participates. Therefore, she has to figure out some other way to avoid passive loss rules and claim her deductions. Aside from deducting the losses from other passive income, she could also wait to deduct the losses in total when she gets rid of her entire interest in this passive business.[1] But, she doesn’t want to do that—she wants the deductions now because she doesn’t plan on selling this business for quite some time.

As you can see from the above points, one option for getting around passive loss rules is to form a group from the multiple businesses you own. So, in order to deduct those losses, she groups her new physical therapy business with her medical practice. “Wait a minute,” you may say. Even if she groups these two businesses together, doesn’t the physical therapy business still have only passive income?

It turns out that in order to meet the material participation requirements, you can group your business together to form suitable economic units.[2] That means the businesses and business activities within the grouping must make sense together based on these factors (quoted from IRS Publication 925):[3]

  1. The similarities and differences in the types of trades or businesses,
  2. The extent of common control,
  3. The extent of common ownership,
  4. The geographical location, and
  5. The interdependencies between or among activities.

Note that each business may conduct multiple sets of activities, and any entity structure may group its businesses or activities into one.[4] Even if you are the sole owner of three business that conduct four separate business activities, you can group all of these into one. Your material participation in the grouping then allows passive loss deductions for any of the business activities.

If you want to take advantage of such a common ownership grouping, you’ll need to make the election on your tax return and attach a disclosure statement.[5] Additionally, you’ll need to attach a statement with your tax return for any year that you add another activity to an existing group or regroup a grouping that was inappropriate. If you group inappropriately and don’t follow the requirements, you could end up losing your deductions because the activities will be treated separately.

Your disclosure statements should include the names, addresses, and employer identification numbers for each of the businesses being grouped together. Once you’ve made the election to group, you’re good to go with claiming deductions on an activity’s passive losses, so long as you meet the material participation requirements for the group. What that typically means is you have to participate in the combined businesses for at least 500 hours per year. Going back to our doctor, if she works at the medical practice for 1,968 hours in the course of a year and never does any work at the physical therapy business, she has met the 500-hour test for the entire group.

Not everyone has two business interests that make sense together as an economic unit. If you, like the doctor, are considering opening a second business, but your second business operates in a completely different way from the first, you may not be able to take advantage of grouping. When that’s the case, you should ask yourself, “Is it even worth it to start a business I cannot deduct losses for?” Remember, your tax deductions can make a big difference in your yearly profit.

Basically, you want to make sure the plans you make for your business ventures are the best choices for your bottom-line. Grouping elections are easy to make for the single-owner business, and the rules apply to real estate rentals, as well. So, if you have taxable income you’d like to offset, grouping may be a solution for your business.

  1. IRC Section 469 ↑
  2. Reg. Sections 1.469-4(a); 1.469-5T(a)(1) ↑
  3. Reg. Section 1.469-4(c)(2). ↑
  4. Passive Activity Loss Audit Technique Guide (ATG), Training 3149-115 (02-2005), Catalog Number 83479V, p. 4-2. ↑
  5. Rev. Proc. 2010-13 ↑
Categories : Audits, Business Expenses, Passive Income & Losses, Receipts, Records, Tax Planning

When Investments Go Wrong: IRS Safe Harbors for Ponzi Scheme Losses

By Kim M. Larsen EA CTFS
Friday, February 27th, 2015

It’s been several years since Bernie Madoff confessed to taking billions of dollars from investors in his fake asset management division. But, Ponzi schemes existed well before Madoff pulled off his extravagant plot, and you will always come across people who think they can skirt the law (and ethics in general). Sometimes, these “opportunities” seem like legitimate investments until you start looking at the statements. So, what do you do if you’ve been caught in a Ponzi scheme?

First, know that you do have some protection. You “invested” your money, so you can’t just get it all back unfortunately. You live and you learn. However, you are eligible to claim tax-deductible losses on that money. The problem is that you’ll have a heck of a time proving your Ponzi scheme losses in the year of the loss, which could really hurt your finances.[1] Luckily, the safe harbor laws grant additional protection. Legislation passed in 2009 allows losses from a Ponzi scheme to be carried back 5 years on your taxes, as long as you are eligible[2].

So, what do you do when you find yourself victim to investment fraud?

Using Tax Law Safe Harbors

First, you should know that you are not required to use the Ponzi scheme tax relief safe harbor. But, you’d be silly not to. If you don’t invoke the safe harbor rules, your losses will be deducted using the general rules for theft loss, which means jumping through more hoops and possibly being audited. Yes, you read that correctly. Regarding taxpayers who choose not to use the safe harbor, the IRS has stated:

Returns claiming theft-loss deductions from fraudulent investment arrangements are subject to examination by the [IRS].[3]

That means being audited.

When the IRS actually threatens you with an audit, you should probably take it seriously. And, what about those general theft rules? If you forego the safe harbors, you’ll be required to prove:[4]

  • The loss actually was theft;
  • You claimed this loss on your taxes the year you found out about it (which can be difficult to prove);
  • You have the exact dollar amounts lost, with documentation; and
  • You cannot reasonably expect to recover the loss through reimbursements in the year you found out about the theft and claimed the deductions.

All in all, it’s just easier to follow the safe harbor rules. In fact, you’ll have a much nicer time of it with the IRS if you do.[5] Here’s how it will work when you use the Ponzi scheme tax relief safe harbor laws:

  • You will be able to deduct the fraudulent scheme as a theft loss.
  • You will be able to deduct the loss the year the scheme was found out (i.e. when the perpetrator was indicted, or when the perpetrator either admits guilt or has their assets frozen following a federal or state criminal complaint).
  • Your losses will be calculated with the safe-harbor formula.

Using the safe harbor rules, you have less evidence to provide, and the deduction process is simpler for you to complete. You should know that the IRS often disagrees with deductions for theft loss. Safe harbor rules prevent that.

How Safe Harbor Amounts are Calculated

Before you can take advantage of the safe harbor, you’ll need to show that you are in compliance with its requirements by providing statements of the following (under penalty of perjury):[6]

  • The name of the Ponzi scheme perpetrator;
  • Confirmation that you have written documentation to back up your deduction amounts;
  • Your declaration of status as a Ponzi scheme victim and qualified defrauded investor; and
  • Confirmation that you will abide by all terms of declaration.

This information will need to be attached to your tax return.[7] Also, in this statement, you will show your loss deduction calculations for the discovery year, as follows:[8]

  1. The starting number is your original investment.
  2. Add all of your subsequent investment amounts.
  3. Add any money that was supposedly reinvested on your behalf and that you claimed on your tax returns as income (but for which you received no cash payments from the perpetrator).
  4. Subtract any withdrawals you made from the investment fund. The resultant number is your qualified investment.
  5. Next, determine whether you are a Ponzi victim with possible third-party recovery.
  6. Determine your net qualified investment. If you do have possible third-party recovery, you will multiple the qualified investment amount from step 4 by 75 percent. If you do not have possible third-party recovery, multiply the qualified investment amount by 95 percent.
  7. List any money you actually recovered from the Ponzi scheme (through any source) in the year you are making a deduction.
  8. List the totals for any agreements that protect you from the loss, including insurance policies, contracts, and amounts you are entitled to by the Securities Investor Protection Corporation (SIPC).
  9. Add together your total recoveries from step 7 and step 8.
  10. Finally, you will subtract the answer in step 9 from the answer in step 6 in order to get your gross theft-loss deduction.

It’s all pretty straightforward. As long as you kept all of your statements, and financial and insurance documents, you’ll have everything you need. In subsequent years, you’ll make adjustments for an additional recovery income or for increased losses in the case that your reasonably estimated recovery claims were too low.[9]

Typically, personal theft is subject to certain reductions before it can be claimed as a tax deduction.[10] First, the amount is reduced by a flat $100. Then, you reduce the remaining amount by 10 percent of your AGI. Fortunately, Ponzi scheme victims are not subject to these reductions; individuals can claim the full deductible amount, and businesses can claim the full business casualty loss amount.

Why the IRS Wants You to Follow Safe Harbor Rules

Do you really benefit from using the safe harbor calculations for your deductions? Let’s look at what you agree to give the IRS:

  • You will only deduct the amounts calculated in their formula (in the year the scheme was discovered);
  • For taxable years that precede the year of discovery, you will not amend or file tax returns that re-characterize or exclude income;
  • You will not claim Section 1341 benefits for your Ponzi scheme loss (restoration of an amount under the claim of right doctrine); and
  • You will not use the mitigation provisions of Sections 1311–1314 or the doctrine of equitable recoupment.

The IRS has made a strong statement against claiming the rights and provisions in that last bullet point.[11] It’s always a gamble going against the IRS in a situation that will likely end up in court. You could win the case, but will it be worth the time, money, and effort to challenge it?

Prevention

By being educated in financial matters and paying attention to your personal and business finances, you can avoid Ponzi schemes. For one thing, you should never, ever give someone else complete control of your money. The best advice is to always know exactly what you are investing in and not making financial decisions that you don’t understand—even if everyone else is doing it. The government also has some guarantees set up to help people avoid losses: Federal Deposit Insurance Corporation (FDIC) and the Securities Investor Protection Corporation (SIPC).

Aside from avoiding fraudulent investments and being aware of government protections, you have a couple of other options for reducing your risk. One way is to have insurance on your investments. Making the investments yourself (rather than having someone else handle it) is the another way to avoid investment fraud losses. If you feel nervous about making these decisions on your own, know that you have resources from the Internet, news publications, financial magazines, and television, and just because someone says they are a financial expert doesn’t necessarily mean they know more than you do.

Even if you do hire an investment advisor to help you make decisions, you should always maintain control of your funds yourself. Never let an advisor have direct access to your money. You can reduce your chances of needing these safe harbor rules in the future if you ask questions about your portfolio and always know what is happening with your money.

  1. Rev. Proc. 2009-20, Section 2.03 ↑
  2. IRC Section 172(b)(1)(H) ↑
  3. Rev. Proc. 2009-20, Section 8.03 ↑
  4. Rev. Proc. 2009-20, Section 8.01 ↑
  5. Rev. Proc. 2009-20, Section 5.01 ↑
  6. Rev. Proc. 2009-20, Appendix A, Part III ↑
  7. Rev. Proc. 2009-20, Section 6.01 ↑
  8. Rev. Proc. 2009-20, Appendix A, Part II ↑
  9. Rev. Proc. 2009-20, Section 5.03; Rev. Rul. 2009-9, Law and Analysis, Issue 3, Year of Deduction ↑
  10. http://www.irs.gov/pub/irs-pdf/p547.pdf ↑
  11. Rev. Rul. 2009-9 ↑
Categories : Audits, Casualty Losses, Investments, Records, Tax Planning

Make Your Records Rock Solid to Avoid Audit

By Kim M. Larsen EA CTFS
Sunday, February 8th, 2015

This article isn’t about any particular way to save money on your taxes. However, it will make a huge difference in your taxes no matter what strategy you use for your tax return. Even the absolute best tax methods can leave you at the mercy of an auditor when you don’t properly document and keep records. Sure, you may think it’s a hassle, but is putting in a few hours up-front on an organized record-keeping system worth thousands, even tens of thousands, of dollars in tax savings? You bet!

The Rules of Record Keeping

Here’s the fact—the IRS is never just going to take your word for it that you spent X number of dollars on justifiable and legal business expenses that are now tax-deductible on your return. Sorry, no documentation, no deduction.

So, with that in mind, here’s the first rule you need to know.

Rule #1 Always keep your accounts separate. In fact, you should have separate checking accounts for:

  • Each spouse,
  • Each corporation,
  • Each Schedule C business you report, and
  • Your rental properties (you may even want a few separate accounts for these if they are very different kinds of rentals).

How about an example of why this is so important. Let’s say you own a sole proprietorship, and you cover your spouse under a Section 105 medical reimbursement plan. If you’re using one checking account jointly for your household and your business, you would have to write the reimbursement check to yourself—and that negates your Section 105 plan.

That’s exactly how Darwin Albers lost out on deductions for his 105 plan.[1] Keep your business and personal accounts separate—just do it.

Rule #2 Earnings go to the account belonging to the business that earns the money. Do not take payments in your personal name. If you do, they cannot be assigned to your corporation. The person or entity that earns any given income is taxed for said income.[2] If you follow the rule above, then it’s easy not to mix personal receipts into your business account and vice versa. Although it’s possible to argue with the IRS that some receipts in a given account are not taxable, it’s not worth the frustration and wasted time.

Rule #3 Keep track of your deductible expenses each day. Don’t wait until two weeks from the purchase to write down your expenses (or save them in your file). For one thing, it increases the chance that you may miss something. For another, the IRS requires that deductible expenses are recorded within one week. The idea of doing daily record keeping may make you want to just toss your files over your shoulder (don’t—you’ll hate reorganizing them up later), but it really is good practice. After all, how hard is it to save a receipt and make a note about why you spent the amount?

Rule #4 Keep a log for each set of expenses. For most deductions, you need evidence that proves your business use or business purpose for the expense. Want to deduct vehicle expenses? Keep a log to track daily mileage. Want to deductions on your rental properties? You’d better keep track of how you materially participate in your real estate or how you qualify for status as a real estate professional. Planning to make deductions for your home office? Again, you need a log, this time to keep track of how many hours you spend working in that office. You’ll have to consistently spend more than 10 hours per week working from your home office in order to claim it on your tax return.[3] By keeping track on a daily basis, you can take advantage of the sampling method of calculating your deductions in some cases (such as vehicle mileage); this method allows you to take a sample from a three month period rather than calculating the exact sums.[4]

Rule #5 Keep track of travel and entertainment costs. For travel expenses, you have to prove (with documentation) where you were each day and why. Your business entertainment costs also need proper documentation, including what you spent money on, how much, when, and where the expense occurred. Your receipt will cover all of those, but you’ll additionally need to note who you entertained and why (i.e. the benefit to your business).

In the case that you operate your business as a corporation, you’ll have to turn the expenses in to your company. You can do this by paying with a corporate credit card, or you can have the corporation reimburse you for the expenses. Making sure the company pays is important; otherwise you’ll only get employee-business deductions for those expenses.

What to Remember

No matter what kind of business costs you incur, you need to remember these two primary pieces of information: 1) prove what you bought and 2) prove that you, in fact, paid for it. As mentioned above, a receipt or paid invoice covers the first part of this. In order to prove payment, you can use a credit card receipt or statement, canceled check, or bank statement (for electronic transfers). Note: An item is considered paid for when you charge it to your credit card, regardless of when you pay the amount to your card.[5]

Don’t pay with cash. It makes things more difficult for you. If you pay with cash, an auditor will want to know where the cash came from, how you can show cash trail and tie it to the payment, whether you can prove an ATM withdrawal, and most importantly, did you really pay for something in cash or are you just making up a deduction? Paying with pretty much any other method is much less of a hassle.

A Note on Petty Cash

Petty cash works for some small businesses. If it’s what you’re accustomed to and you haven’t had any problems, then by all means continue using the system. However, many small business owners end up kicking themselves in the pants with a petty cash system. You’ll likely find it easier to use a reimbursement system.

With the reimbursement system, your company simply writes you a check for the expense when you provide documentation for it (a receipt or expense report, for instance). Because you have to present documentation for reimbursement, you’re less likely to get caught without evidence for your spending, as you could with petty cash.

Statutes of Limitations and How Long to Keep Records

The IRS has statutes of limitations on when either you or it can make changes to a tax return (this is not just the period during which they can audit you). Here are the time frames given in IRS publications:[6]

  • No limit if you did not file a return
  • No limit if you filed a fraudulent return
  • Three years after filing if you filed on time (or with extensions), you did not understate your income by 25 percent or greater, and you did not file fraudulently
  • Six years after filing if you filed on time (or with extensions) but you understated your income by greater than 25 percent
  • If you filed an amended return or already made changes to the original return (like a quick refund claim), either three years after filing or two years after paying the tax
  • Seven years from filing for a claim filed for a bad-debt deduction or loss from worthless securities

If you have employees, you need to save your employment tax records for four years after whichever date comes later, the date payroll taxes were paid or the date they were due.

Because these statutes of limitations also indicate how long the IRS can audit your return, you need to ensure that you hang on to all of your records until the risk of audit has passed. This could mean keeping records for a period of multiple years. In the case of assets, like office equipment and office buildings, the records are relevant throughout the asset’s entire depreciable class life. As long as you are still depreciating an asset, it will be in that year’s tax return. When using Section 179 to expense an asset, you also have a potential recapture throughout the depreciable class life.

Here’s an example. You buy a desk for $1,500 and depreciate it over the MACRS life of seven years. This depreciation actually takes eight years, so you need the original purchase receipt in year eight in order to prove your deduction. Additionally, you will need to retain that purchase record for three years after that when the statute of limitations expires (for a total of eleven years). It works the same with Section 179, except that you also have recapture exposure during those eight years of depreciation.

Would you like an easy way to keep track of this? Just make a permanent file for any assets with a life greater than one year. This way, you don’t need to keep track of class lives or time frames on the statutes of limitations.

And, here’s another quick tip for keeping those records organized:

Simplify your file system by devoting separate drawers for each tax year. In those drawers, you’ll put any information on assets, income, and other information applicable to your return. This method is for assets other than those you keep in your permanent file. The first drawer will be where you put all documents as you acquire them throughout the year. The next drawer is last year’s tax documents. The drawer after that contains documents from three years ago, and so on until you reach the year at which your statute of limitations expires. Each year, you move the drawers down one level and dump the one at the bottom of the line. You can also use this method for any employee tax files.

You see? It really isn’t all that difficult to keep your records straight. You’ll be thankful you did when it comes time to prepare your return.

  1. Darwin J. Albers v Commr., TC Memo 2007-144. ↑
  2. United States v Basye, 410 U.S. 441, 449, 451 (1973); Lucas v Earl, 281 U.S. 111 (1930). ↑
  3. John W. and Regina R. Z. Green v Commr., 78 TC 428 (1982), reversed on other grounds, 707 F2d 404 (CA9, 1983). ↑
  4. IRS Reg. Section 1.274-5T(c)(3)(ii)(C), Example 1. ↑
  5. E.g., Rev. Rul. 78-38; Rev. Rul. 78-39. ↑
  6. IRS Pub., 583, Starting a Business and Keeping Records (Rev. January 2007), Record Keeping. ↑
Categories : Audits, Business Expenses, Cars, Trucks & SUVs, Depreciation, Entertainment, Receipts, Records, Tax Planning, Travel

The Relationship between Your Salary and Your Taxes

By Kim M. Larsen EA CTFS
Tuesday, February 3rd, 2015

It’s no secret that the more money you earn from your S corporation, the higher your tax bracket. But, have you actually run the numbers to see what damage—if any—your current salary is actually doing? If not, it’s time you did. As a business owner, you can’t leave financial matters to chance.

A big, fat salary may look nice, but it could actually be losing you money. By capping your own income at the proper amount, you can save yourself thousands of dollars in taxes. The old adage, “A penny saved, a penny earned” certainly applies when it comes to dealing with tax brackets.

Calculating the Right Number

Some may think the solution is to dramatically reduce your salary, but watch out for that tactic! If you set your salary too low, this can also arouse the suspicion of the IRS and elicit an audit. Did you know that if you set your salary unusually low, you could end up paying not only back taxes, but also penalties and interest? Luckily, this article is your guide to getting the amount right—for the most advantage and least audit risk.

The IRS actually has guidelines to setting reasonable salaries for S corporation owners. Keep in mind these are just guidelines created by the IRS—not tax law—but playing by IRS rules goes a long way towards reducing your chances of audit. The good news for you is that a few recent court cases help taxpayers like you to understand how these guidelines are held up (and how you can justify your salary).

Salary Case Examples

First, let’s look at how reducing your salary lowers your payroll taxes. For a sole proprietor earning $100,000 in business income for the year, $14,130 will be paid in self-employment taxes.[1] However, if you form an S corporation and give yourself a salary of $50,000, you pay only $7,650 of payroll taxes between yourself and your corporation combined.[2] That’s nearly $6,500 in tax savings! The remaining $50,000 can be considered a distribution, and those are not subject to payroll taxes.[3]

To see how all this is viewed by the IRS, let’s examine the results of precedent cases:

  • The S Corporation Accountant—David Watson operated his accounting business as an S corporation.[4] His corporation also happened to be a 25 percent partner in an accounting firm. For several years, the firm paid Watson’s corporation more than $200,000. Watson’s self-appointed salary, however, was only $24,000. As you can guess, this is far below the average salary for an accountant.

In fact, the IRS determined that for the area of the country where Watson did business, a reasonable salary was more like $91,044. They came to this conclusion using the Management of Accounting Practice survey conducted by the American Institute of Certified Public Accountants, which listed compensation. For an accountant with no investment interest, average salary was $70,000.

However, Watson did have investment interest. Considering that owners billed at rates 33% higher than directors, the IRS’s valuation expert then increased the reasonable amount by 33% and decreased that amount to reflect fringe benefits that were not taxed—coming up with the $91,044.

In the end, the court sided with the IRS expert and Watson’s salary was adjusted to the more reasonable number. He still took the majority of his income payroll tax-free as distributions (giving him bigger savings than he would have as a sole proprietor), but he got hit with $23,431.23 in payroll taxes owed, penalties, and interest.

  • The Real Estate Professional—Sean McAlary entered the real estate business before the housing crash.[5] His success allowed him $240,000 in distributions from his S corporation in 2006. The mistake he made was taking absolutely no salary—$0—despite being entitled to $24,000, according to corporate minutes.

Using methods similar to those above, the IRS valuation expert determined a reasonable salary of $100,755. Using the California Occupational Employment Statistics Survey, the expert found real estate brokers’ median wage to be $48.44 per hour. That wage was then multiplied by a 40-hour work week and again by 52 weeks. This was despite evidence that McAlary actually worked longer hours and rarely took days off. The court adjusted this finding slightly, and McAlary’s salary for tax purposes was considered to be $83,200, still making distributions a majority of his income.

  • The Glass Blocks Manufacturer—Frederick Blodgett produced glass blocks to be used in homes and other real estate. Unfortunately, the construction industry in his area had a bad year in 2006, and his company felt the fall.[6] So, in the following two years, he ended up loaning his S corporation $55,000. The corporation’s net income for each of the two years was $877 and $8,950.

For 2007 and 2008, Blodgett drew no salary from his corporation. Instead, he took what he described as a mix of distributions and loan repayment, in a total of $30,000 per year. His plan was not viewed his way by the court. The “loans” were deemed capital contributions, making 100 percent of his corporation’s payments to him distributions.

It was decided by the IRS, and held up by the court, that the $30,000 per year distributions would be assigned as Blodgett’s salary. Rather than doing calculations like those in the above cases, the IRS simply stated that someone in Blodgett’s field would make at least that much. The decision gave Blodgett’s business a net loss for the year.

Applying the Lessons

You can see a few tips from these examples. First of all, when setting your salary, consider what other professionals in your field make in your area. Being self-employed, you may not always be able to match yourself to a single profession with compensation statistics. In that case, choose a best match that you can reasonably back up.

Of course, you are also a business owner, so after comparing wages, you’ll need to adjust for several factors. Decrease your wage to account for:

  • Your business’s profit relative to similar businesses in your area (if your profits are smaller);
  • The number of hours you work (if you work less than full-time); and
  • Factors that contribute to your corporation’s success outside of your own personal efforts (for instance, unusually good market conditions for a particular year).

If you’re able to reduce your salary by a reasonable amount because of one of these circumstances, be sure to document your reasoning in the corporate minutes. The lower salary will give you big savings on payroll taxes, as long as it remains reasonable.

As a final note, you do not have to take a salary if your S corporation is not making a profit.[7] Just be prepared by understanding that taking distributions in a year you don’t take a salary is a major red flag to the IRS. If you don’t take a salary in a particular year, try to eliminate or at least minimize the distributions you take.

Reducing your salary is a legal tax strategy for S corporation owners. As long as you don’t take it to the extreme, the technique is an easy way to keep more of your cash. So, research comparable salaries in your area, adjust it downward if you can do so justifiably, and always document your strategy.

  1. Assuming a 15.3 percent self-employment tax rate is applied to 92.35 percent of the income. See Schedule SE for rate details. ↑
  2. $50,000 x 15.3 percent. ↑
  3. Rev. Rul. 59-221. ↑
  4. Watson v US, 668 F.3d 1008 (8th Cir.). ↑
  5. Sean McAlary Ltd, Inc., TC Summary Opinion 2013-62. ↑
  6. Glass Blocks Unlimited, TC Memo 2013-180. ↑
  7. See Davis, d/b/a Mile High Calcium, Inc. v US, 74 AFTR 2d 94-5618. ↑
Categories : Audits, Corporations, Payroll, Tax Planning

What the Statute of Limitations Means for Your Tax Records

By Kim M. Larsen EA CTFS
Monday, January 26th, 2015

When you went into business, chances are you weren’t imagining grand evenings filled with paperwork. Maybe you thought tax records were a thing you would think about once a year and have your accountant deal with. But, the truth is, as you progress in business, you come to realize that record-keeping for your taxes needs regular maintenance. In fact, even after you breathe a sigh of relief once that return has been double-checked and sent off to the IRS, you may need to make a change to the document.

That’s where the statute of limitations comes in. It refers to the periods of time during which both you and the IRS may make changes to your tax return (not just audits). Those time frames are clearly delineated in IRS publications[1].

Here they are:

  • No limit if you did not file a return
  • No limit if you filed a fraudulent return
  • Three years after filing if you filed on time (or with extensions), you did not understate your income by 25 percent or greater, and you did not file fraudulently
  • Six years after filing if you filed on time (or with extensions) but you understated your income by greater than 25 percent
  • If you filed an amended return or already made changes to the original return (like a quick refund claim), either three years after filing or two years after paying the tax
  • Seven years from filing for a claim filed for a bad-debt deduction or loss from worthless securities

Keeping Appropriate Records

Aside from letting you know how long you have to make changes to a return, the statute of limitations also lets you know how long the IRS has to audit your return. If an audit occurs, you are going to need all of your tax records to prove your deductions. What does this mean for your record keeping habits? Hang on to those records until any chance of audit has passed.

The following are a few guidelines for making sure you hold on to the appropriate records long enough:

  • Employment Tax Records—If you have employees, you need to save your employment tax records for four years after whichever date comes later, the date payroll taxes were paid or the date they were due. An easy way to do this is simply to keep six separate drawers in your filing cabinet for each tax year. Every year, discard the sixth drawer when it’s statute of limitations expires.
  • Records for Assets—You have certain assets that are pertinent to your tax return for as long as they remain in the depreciable category. Examples of such assets include your office building, computers, desks, and even your car. If you are depreciating those assets, they will be on your tax return. Otherwise, if you are using Section 179 to expense the assets, you may be able to recapture the depreciable class life.

For example, let’s say you purchased a desk for $1,500 and depreciate it over the seven year Modified Accelerated Cost Recovery System (MACRS) life, which takes eight years. You’ll still have to prove depreciation in the eighth year. So, you need the record of the original purchase in the eighth year and through the eleventh year to meet the three year statute of limitations (the time during which this purchase is subject to auditing). The example works the same if you used Section 179. Any assets with more than a one year class life should be kept in a separate, permanent file so they don’t get tossed out with files whose statutes of limitations have expired.

Record Keeping Tips

As mentioned in the section on employment tax records, you can simplify your file system by devoting separate drawers for each tax year. In those drawers, you’ll put any information on assets, income, and other information applicable to your return. The first drawer will be where you put all documents as you acquire them throughout the year. The next drawer is last year’s tax documents. The drawer after that contains documents from three years ago, and so on until you reach the year at which your statute of limitations expires.

In order to use this method, it’s important that you file your taxes on time or file an extension so you know for sure your specific time frames. At the end of each year, the last drawer gets dumped and you move the other drawers down, starting a new drawer for the current year. It’s really simple once you put the system in place. Record-keeping may seem tedious, but remember, it shows you where your business has been and where it’s going, like a runner trying to improve their time. You can’t improve the numbers if you don’t know what they are.

  1. IRS Pub. 583, Starting a Business and Keeping Records (Rev. December 2011), Dated Feb. 17, 2012, p 12. ↑
Categories : Audits, Business Expenses, Capital Gains, Payroll, Receipts, Records, Tax Planning

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