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What do Newt and John Edwards have in common?

January 23, 2012

Besides being model husbands? They both have S corporation income that exceeds their salary -- the so-called "John Edwards Shelter."

Now that it seems that Newt Gingrich might somehow be the Republican nominee for president, his tax return has come under scrutiny. The biggest income item on the return is from an S corporation, Gingrich Holdings. His Schedule E shows top-line K-1 income of $2,478,539, offset by a $25,130 Section 179 deduction. Meanwhile, he took "only" $252,500 in salary from the corporation. His wife took another $191, 827 in W-2 wages from Gingrich Productions, Inc., which is apparently a C corporation.

That leads to this comment reported by Janet Novack:

"It appears that he is not paying his fair share of Medicare tax," Robert E. McKenzie, a partner in the Chicago law firm of Arnstein & Lehr LLP concluded, in an email to Forbes, after reviewing Gingrich’s 2010 tax return. McKenzie, a past chairman of the Employment Tax Committee of the American Bar Association Tax Section and a member of the IRS’ Advisory Council, added: "There are a multitude of cases where the IRS has successfully challenged the improper tax strategy of this candidate and his accountants. Service businesses are only allowed to distribute a fair return on investment from an S corp. as profits exempt from Medicare taxes. The remainder of profits must be paid as salary subject to a 2.9% Medicare tax levy."

A multitude?

While there are plenty of cases where taxpayers have been called to account for taking no salary or nominal salary out of their S corporations, avoiding FICA and Medicare tax, there is no "multitude" of published cases where employee-owners who took salary of at least the FICA base ($106,800 in 2010) have had to take additional salary. In fact, there are none.

The closest case I can see to the Gingrich fact pattern is Watson, a district court case right here in metro Des Moines -- and the facts aren't very close. Watson involves an accountant whose practice generated around $200,000 in income, but for which he took only $24,000 in annual salary. Even in that case, the judge only boosted his annual salary to about $91,000. An appeal of the case by the taxpayer is currently before the Eighth Circuit.

So what is the "fair share" of Medicare taxes? Warren Buffett famously takes only $100,000 salary from Berkshire Hathaway, when comparable executives draw salaries in the millions. Should he be forced to take additional salary just to pay a "fair share" of Medicare tax?

"Reasonable compensation" is a notoriously difficult area of the tax law. Traditionally the IRS has tried to go the other way, trying to reduce W-2 compensation -- reclassifying it as dividends to make the payments non-deductible to C corporations. The incentive to do so was reduced when the salary cap was removed from the 2.9% medicare tax, but I know of no case where the IRS has tried to force a C corporation to pay more compensation to collect more Medicare tax.

You can accurately say that the tax law doesn't support an employee-owner taking no salary, or a token salary, out of an S corporation. You cannot say that the FICA base is a safe harbor "minimum wage" for an S corporation shareholder, but the IRS has won no court decisions involving such taxpayers. There is a huge gray area between token salaries for S corporation employee-owners and Ken Lay-sized salaries that hasn't been litigated.

While I may like Gingrich and Edwards only a little more than a bitter ex-spouse might, the existing case law simply does not support a claim that they failed to pay their "fair share" of Medicare taxes.

The TaxProf has more.

Related: Court sets 'reasonable' comp for Iowa CPA S corporation shareholder

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Warren Buffett doesn't own all of Berkshire Hathaway, and it is a C corporation. Berkshire Hathaway is a real business enterprise, with its own capital at risk and its own activities. It does not depend exclusively on the services of its sole shareholder.

I don't think that situation is comparable to the former Speaker's.

Gingrich Holdings IS the former Speaker. Its activities are his, and its income is his. Maybe there is some income at the margin that is not related to his personal services.

Tom Daschle is reported to have been given $2 million by Alston & Bird in 2008 as a "consultant", and that sounds about right. $250,000 is laughable as "reasonable compensation" to the former Speaker.

David, it is laughable. I wouldn't give him a dime.

The case law doesn't support broad assertions that he isn't paying his "fair share." You can argue all you want that it should be more, but there is no case where the IRS has prevailed when more than a token salary is involved.

The case law stands for the proposition that compensation paid to shareholder/employees of S corporations must be reasonable, and comparable to that paid to employees of corporations in which those employees are not shareholders. That is all it stands for.

It is a factual question.

It is true that the cases decided to date have involved egregious fact patterns, with no or very minimal compensation. That is not what they are based on, however. They are based on the compensation being unreasonably low.

To my mind, this is an equally egregious case, bordering on outright evasion, and if it were anybody else, it would be treated that way.

The Speaker is the corporation. Its income is his income. Those are the facts, and this is after all a factual question.

It is not like it is a real business, with real capital, and real other employees making real other money for its shareholders.

Seriously, who is kidding whom here?

"To my mind" is your key observation. While you can argue that the reasoning of the S corporation cases support you, there are no cases that directly face the hard issue of whether and when a $250K salary can be inadequate for these purposes.

Whether a $60K IRS agent -- or a judge -- would conclude a $250,000 salary is inadequate remains in doubt.

Are you suggesting that the issue is not whether Gingrich's salary was arm's length -- that that is irrelevant? And that the real issue, the "hard" issue is what fixed number of dollars is never "inadequate for these purposes"?

Because that is not true. The question is whether, in all the facts and circumstances of the case, the Gingrich salary was reasonably arm's length.

I think it was Upton Sinclair who said that it is hard to get a man to understand something when his salary depends on him not understanding it.

It was repugnant when Edwards did it, and it is here, too.

Joe gets it right. The allegations that Gingrich is abusing the S corporation form are inflammatory and do not ring true. It's hard to imagine the IRS would litigate the supposed insufficiency of a $250K salary to an S corporation owner.

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