Comment: Dear Sir or Madam: In early 2004, I came up with the idea of transforming my small business - a Schedule C sole proprietorship to an LLC and to elect Subchapter S status in order to pay less payroll (self employment) tax by paying myself a "fair" salary and allowing the remainder of my income to flow to the bottom line (which is treated as a distribution for S Corporations and, therefore, not subject to payroll tax. I formed an LLC by the deadline (March 15) for the tax year 2004. I attempted to vet this with the IRS from March 2004 to June 2004 to determine what a "reasonable" amount of compensation would be for a business like mine. To my surprise, there seem to be no hard rules. I spoke with a number of people at the IRS including the tax payers advocate's office. I got varying responses and I was left confused and bewildered. Literally no one could clearly articulate what the rule would be as it applies to a small business owner in my situation. I threw out some amounts for what I would consider a "fair" salary for my type of business and no one would (or could) tell me if that was "reasonable". I was amazed. With a tax code that has millions of tedious little rules, how could something this big be left out? Literally, no one could give me any idea what a "reasonable" salary would be for my type of business. In fact, several (but not all) of the IRS people with whom I spoke warned me against employing this strategy. They indicated that I would be opening myself up for audit and potential interest and penalties. The court cases I could find also provided very little useful guidance on the matter. They obviously are ad hoc case by case rulings each with special circumstances related to a particular case. The only thing I could ascertain from them is that paying oneself no salary is not a good idea - which commonsense had already told me. To make a long story short, I dropped this tax savings idea based on the feedback I got from IRS employees (and cancelled my LLC and subchapter S Corporation) for fear that I might be hit with an audit and end up paying substantial interest and penalties if I adopted this tax saving strategy. In my line of work, I have seen many other small business people endure the wrath of the IRS interest and penalties, and believe me, I have no desire to get into that sort of mess. Fast forward to October 8, 2004. I was watching the Vice Presidential debate on TV. I sat straight up in my chair as Vice President Dick Cheney described that Vice Presidential candidate John Edwards had employed exactly the same type of tax savings strategy for his single member LLC organized as a subchapter S Corporation and had saved approximately $600,000 in payroll taxes in the years prior to entering the U.S. Senate. Needless to say, I was furious with my government for misleading me. My obvious question (still unanswered as of this writing) is why in the IRS eyes is it o.k. for Mr. Edwards to employ such a tax savings strategy and yet I was told by numerous people at the IRS that I would be subjecting myself to potential audit and associated interest and penalties. I printed Mr. Edward's tax returns off the internet and sure enough Dick Cheney was right about how much Mr. Edwards had saved. I don't disparage Mr. Edwards for taking advantage of an apparent loophole in the system but the rules should be the same for me as they are for him. Why was I told otherwise by the IRS employees? I asked my wife "Is this the two Americas that Mr. Edwards so vehemently talked about on the campaign trail - one for the guys who can afford pricey tax advisors and tax attorneys and one for the little guys?" As best I can tell from my research, Mr. Edwards was never audited by the IRS. At his lofty income level I would think that he should have been considered a high probability for an audit if the eyebrows of the IRS would have been raised by his payroll tax treatment on his tax returns. In any event, Mr. Edwards might have been able to withstand an IRS audit and been able to pay for some high priced tax attorneys given he saved $600,000. How many others in his high income status are also receiving the benefit of this tax shelter? For me, it would be $3,000 - $4,000 a year in tax savings at the most. I can't afford to (nor would I want to) get into a legal dispute with the government over such a relatively small amount of money. However, if I could save this amount each year in taxes, it might be enough for me to pay for a vacation or make a down payment on a car. So, it is important to me. In further researching the John Edwards tax strategy on the Internet, I discovered that several tax advisors have evne dubbed the single member LLC/subchapter S combo the "John Edward's tax shelter." When I asked specifically about this, the IRS has completely avoided it in communications back to me. Subsequently, I have sent letters to my Senators and my Congressmen asking them for their help in seeking clarification and clear guidance from the IRS as it relates to my specific situation. While they have attempted to intervene on my behalf, all I have received back is a restatement of my original memos to the IRS outlining my research in the matter and references to court cases which have little relationship to my specific situation. I have received absolutely no specific guidance whatsoever as it relates to my situation. If someone could just give me a dollar amount or % of income that must be reported as a salary for my type of business. This is all I am asking. It seems so simple and straightforward to me. I think the IRS should answer my questions directly and avoid dancing around the issue. The way I look at it is that it is either o.k. for taxpayers in my situation to employ this tax strategy or it is not. If it is o.k., the IRS should tell me what the dollar guidelines are so that I can avoid interest and penalties in the event of an audit. If it is not o.k. for me, I need to know specifically why it is appropriate for some and not others. Frankly, as a taxpayer and a citizen, I believe I have had my intelligence insulted with the responses I have received to date. All the written correspondence I have received has no specifics and all of it seems to have a carefully worded "politically sensitive" tone. I would characterize much of the verbal communication I have had with IRS employees on this matter in much the same light. They have all been very polite but have been extremely guarded and vague in their communications. As a taxpayer, I am not interested in politically correct generalized disertations on this issue. I am only interested in, as John McCain might say "the straight talk express". If there are no real guidelines or the guidelines are inadequate, just say it clearly. Based on my research, conversations and the correspondence received to date, I have already come to conclude that this is in fact the case. The IRS should bluntly tell me as much in a written communication and allow me to file an amended return and recover a portion of the payroll taxes I have overpaid as a result of the misleading guidance I received to date. My conclusion is that there are just no clear rules as it relates to this subchapter S payroll tax issue and a lot of good intentioned IRS employees have been put into an uncomfortable situation by Congress. I suspect that they can't give me the "clear" answer that I seek for fear that their jobs might be at stake if they mis-speak or mis-write. One of them summed it up this way when I pressed him for a clear answer, "We don't make the laws. Congress makes the laws.... and this is an area where there is no clear law." I sensed that many of them were frustrated that they couldn't provide any real guidance on this matter. I ask your panel how such an important tax issue that impacts millions of small businesses each year have been left to such wide interpretation by small business owners and their accountants? One thing I have yet to tell you is that I know something about payroll taxes for S Corporation small business owners. In my business, I operate as a business intermediary. Essentially, I help small business owners (mostly S Corporations) sell their businesses. I have seen hundreds of S Corporation tax returns over the course of my time in this business. I have seen business owners who make $400,000 to $800,000 per year pay themselves little or, in some cases, no salary and, therefore, little or no payroll taxes. I have seen others pay themselves $100,000 or more in salary and pay the resulting payroll taxes. In one case, I saw a minority business owner who was losing money every year (and about to go out of business), paying himself a $60,000 salary and paying the associated payroll taxes. I suspect that he wasn't able to afford a high priced tax adviser and, therefore, was paying more than he should have been paying in payroll taxes...when he could have used the extra cash to help his business stay afloat. There just seems to be no rhythm or reason other than how aggressive a small business owner (and his/her tax advisor) are on this issue. Now, on to the broader issue at hand and the real reason for this correspondence. The federal government is forfeiting huge sums of payroll tax (social security and Medicare taxes) by not closing this payroll tax loophole for small business owners. This whole thing can be simplified. A formula based approach should be employed. Add the sub S Corporation owner's salary to his/her reported bottom line pretax income and arrive at a fair % of that amount that will be subject to the payroll tax. Perhaps you might want to consider different categories such as single member LLC/subchapter S electors at one rate and the owner of a subchapter S business that employs 2-10 employees at another rate, 10 - 100 at another rate, etc. Regardless, putting in place a clear formula will help the government increase its intake of payroll taxes from subchapter S business owners - many of whom I think you will discover are avoiding a good portion of this tax today. Again, I have seen a good number of sub S tax returns over the past several years and I can attest that there are a lot of folks who own small businesses who are not paying much in the way of payroll taxes (and fewer who are). If you are looking for a way to help fund the Social Security and Medicare Trust Funds, I can think of no better loophole to close. A clear formula based tax that is not subject to tax advisor or small business owner interpretation (and aggressiveness) is the answer. To me, this is a better way to increase revenue than to raise payroll tax rates on average employees. Personnally, I would like to see an abolishment of the Federal Income tax and replacement with a progressive national sales tax system that taxes the purchase of luxury items at a higher level than basic items. For example: Lowest sales tax rate to highest tax rate: Federal Sales Tax free: Items that benefit the greater societal good: Such as fuel efficient cars, Medical Care/Medicine. Some of these could be put on and off as necessary to drive behavior (puchase of fuel efficient cars as an example) that is good for all of us. Basics: food (unprepared), clothing (up to a certain $ price level), autos (up to a certain $ price level), houses and rent (up to certain price level), basic communications (internet service, PCs and phones), basic household capital goods (fridge, stove, washer, dryer,etc), auto fuel and basic household utilities. Non-Basic Liesure items that everyone should be able to afford and enjoy at some level: (basic restaurants, travel, hotel, vacation, and other liesure goods and services, cell phones, electronic goods like TVs, DVD players, video games and other liesure goods and services, etc. Luxury items(mostly enjoyed by the wealthy): Expensive cars, boats, homes over certain values, vacation homes (2nd, 3rd, 4th, 5th), Luxury Vacations, Hotels, Liesure activities. Sin Items(Things that tend to be abused by the some citizens and end up costing the greater society in the long run): Alcohol, Cigarettes, High fat/high sugar foods, gambling, prostitution (where it is legal) Good luck with your work and remember that simple clear concise rules are usually better. Sincerely, John R. Baker Taxpayer |