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'JOHN EDWARDS SHELTER' TARGETED BY IRS

March 12, 2005

Tax Analysts doesn't publish a weekend edition, but they have a little "Stories we're working on for the next edition" section. One of the stories apparently reports on an interview with John Tuzynsky, chief of employment tax oprations for the IRS Small/Business/Self-Employed division.

He says the division's chief priority is non-filers. That makes sense; you don't collect a lot of self-employment tax from people who don't report their income.

THE EDWARDS ISSUE

edwards.jpgHe also said the IRS is going after what we call the "John Edwards shelter." Mr. Edwards, John Kerry's running mate last year, ran into criticism for taking "only" $360,000 of salary from his S corporation law practice, talking the remaining $26 million or so as S corporation distributions. S corporation distributions are not subject to the federal FICA and Medicare tax, so Mr. Edwards saved about $738,000 on the 2.9% medicare tax.

While Mr. Edwards came under fire for this, his position probably isn't abusive under current practice. The only cases on this issue deal with professionals who take little or no salary from their S corporation to avoid both the 12.4% FICA tax and the 2.9% Medicare tax.

Tax Analysts reports the IRS is paying more attention to this issue:

The compensation of corporate officers is also receiving increased scrutiny. Tuzynski said that his office was ramping up audits of S corporations to ensure that officers were being paid appropriate salaries. For example, Tuzynski said, it would be unreasonable for a doctor involved with an S corporation who reports hundreds of thousands of dollars in distributions to report a minimum wage-level salary.

We have seen no cases where IRS has challenged taxpayers drawing at least the FICA base (currently $90,000), though that shouldn't be treated as any sort of safe harbor. Obviously the current $5.25 minimum wage (about $10,500 per year) is not enough to avoid scrutiny.

Other circumstances might come into play. If you have a retired S corporation shareholder who still serves as chairman of the board, the IRS presumably will not require a "full" salary. One hopes the IRS won't force a start-up S corporation to pay its employee-owner an "adequate" salary while the company is struggling to get off the ground. S corporation professional practices will have to pay more of their earnings as salaries than other businesses because so much of their income is attributable to their owners' personal efforts.

We doubt that an S corporation owner is ever obliged to take a Kenneth Lay-sized salary, regardless of how profitable the business is. We can't say Mr. Edwards $360,000 salary is entirely safe, but it's not clear a $70,000 IRS attorney can argue that a $360,000 legal salary is inadequate without his head exploding.

The real threat to the "Edwards shelter" is the current social security reform debate. Higher payroll taxes are a likely result of the process, and S corporation professionals will be a tempting target.

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