November Bar Bulletin

1) A Fair Tax System?

2) S Corps and Low Wages

3) Borrowers Bonanza

1). Okay, I'll confess I did watch some of the debates, but honestly, who in their right mind could possibly sit through such a silly exchange. There was the President trying to act very much presidential and the contender often times whining and stuttering like the new kid on the block at a local basketball pickup game when no one seems to want to let him play. Perhaps the best choice in this election would be to elect any one of the Moderators. But it looks pretty clear to me who the winners and losers were. The President has created all the problems, and Romney has all the answers. Such is politics. But both candidates have been treading very carefully about future tax increases. Believe me even if the federal government was disbanded under a Romney administration and every irresponsible Social Security recipient were to be denied another dime, taxes would still have to be increased. The only question which remains is whether or not it is time to actually make the tax system fair. Individual taxpayers who are wage earners have no play in the current system. Their taxes are simply yanked from their paychecks by withholding.  Business owners, large corporations and self-employeds hold all the cards and can choose when concocting their income tax returns what tax they will pay with the odds of audit being about 1% for some of them. Romney learned early how to make the tax system work for him and it is no accident that part of his education was the value of off shore accounts in saving tax dollars. All legal of course.  So, let's face a fact. Neither candidate will create a tax system that is fair. The working folks that plug away at their jobs are simply too busy to spend any time studying the tax code to learn the advantages that are being used by a class the President so often refers to as the “rich”. So there will be plenty of lip service paid to tax reform no matter who gets to sit in the Oval Office. Itemized deductions will likely be reduced, tax rates and the tax base will be played with and bones will be tossed to the middle class. But when all is said and done the rich will still get richer and the poor will have children and four years from now we will have to again listen to the tax reform nonsense from whoever is looking to hang his or her hat in the White House as to how they will make the tax system fair.

2). If you have ever wondered why the guy who delivers your paper to your house in the morning has created an S. Corp. let me explain. Without a doubt, the abuse in the S. Corp. has become widespread. In casual conversation, taxpayers may comment that they have not paid social security tax in years. Can this be true? How does the S. Corp. become a tax evading legal entity? It's really rather simple. If you are receiving a wage from your employer and you don’t own the company, your objective in working is simple. Get your employer to increase your wages. But you must of course realize when that is done you will pay both income tax, as well as Social Security and Medicare tax on the increase. That is not to say that you should stop trying to get your wages increased. But you should understand the S. corporation rules as not everyone is facing the same issue. If instead of being an employee of a company you don’t own you instead started an S corp, it may be possible for you to receive a dividend from the profit from your own little business rather than wages. Now both profit from  S corp companies and wages are income taxable. But that is where the similarity ends. A distribution of the profit from an S. corporation is not subject to the Social Security and Medicare tax. This can result in a savings of 15% annually on your earnings. Now add to the mix that the IRS audit rate of these corporations is ridiculously low you can understand that there is a virtual free for all when it comes time for the filing of an S. corporation tax return and the individual tax returns of their owners. The game is played by those who know the rules by having wages as low as possible. It is the savings in the Social Security tax and Medicare tax, which is the plum for this type of tax dodge. For a particularly bad example of this kind of planning gone bad, see Watson, vs. US, 108AFTR2d 2012-1059. In that case, the shareholder owner claimed a $24,000 salary and a $67,000 dividend payment from his S. corporation. As to the owner both amounts were taxable, but once IRS got done with the corporation it assessed $48,519 in additional employment taxes, penalties and interest. The Supreme Court recently denied Cert in this case.

3). Oh, the magic of borrowing. The Internal Revenue Code is kind to debtors. What I mean to say is when you borrow money the cash you receive is not considered gross income for purposes of the tax system. The law does provide that gross income includes income from whatever source derived. This includes, by the way, both legal and illegal sources. Everyone knows the story of gangster Al Capone and his trip to Alcatraz for tax evasion. But the profit from borrowing is excluded from gross income by a specific code section. The reason this is the case, perhaps, can be found in accounting logic. That is to say, while borrowing results in an increase in wealth and therefore income under the tax law, there is an immediate offsetting increase in liability as the borrower has promised to repay the funds. Now for ordinary working people who borrow from a bank or their credit cards the promise to repay is real and the interest they pay goes to banks and other lenders.  Now consider the business owner. By applying this same accounting logic to them, business owners are able to remove vast sums of profit without paying any tax at all. This can be done by simply signing a promissory note agreeing to pay the loan back to their own companies. With current interest rates being held artificially low as part of the country's economic stimulus, business owners are having a field day as they need promise to repay their own companies at extremely low interest rates. Any interest they do pay goes right back into their own pockets. In truly egregious situations owners take no wages at all and float their lives through borrowing from their own companies. Many never repay the principle or pay any interest at all. Nice deal. The IRS takes a very dim view of these situations and has no problem recharacterizing the loan as income which is taxable.