Posted: Apr 24, 2005 By: John Baker

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

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.


John R. Baker