Reasonable Compensation-Why it Matters

February 21st, 2012 admin

There has been a lot of talk lately about compensation. Executive bonuses, compensations limitations, disparity of compensation. Often it is in the context of political ideology, or basic fairness. But if you ask ten people what is a reasonable compensation for a given job, chances are you will get ten different answers.

Most of the issues you hear being discussed lately concern an unreasonably high compensation, but if you are a business owner and you are actively involved in your business, a compensation that is unreasonably low can have special significance under scrutiny of an IRS auditor.

Let’s look at a very common scenario. A bright, entrepreneurially minded person decides to start a business. Upon advice from that person’s attorney and CPA, the business is set up as a Sub-chapter “S” corporation, (usually referred to as an “S-Corp”). As a start up, the business owner decides not to take a salary, or decides to take only a small token salary until the business becomes profitable and begins generating cash.

This new business owner works countless hours, and after a lot of hard work, begins to see the fruits of his/her labor in the form of profits. Since the company is an S-Corp, these profits can be taken from the business without paying taxes on the distributions (in contrast to a C-Corp where dividends would be taxable). And these distributions, unlike wages and compensation, avoid FICA, Medicare, and in some cases local occupational taxes, so the owner sees no need in increasing his/her salary.

Seems like a no-brainer, doesn’t it? Instead of increasing the salary, just take the earnings out as distributions and avoid 15.3% in payroll taxes (7.65% paid by employee matched by employer, subject to a ceiling).

Not so fast…here’s where the IRS becomes interested in reasonable compensation.

You see, you have to pay yourself a reasonable compensation, or else the IRS can deem a portion of the distributions you take from your company wages, subject to FICA/Medicare taxes. And to make things worse, you will be levied for fines and penalties on unpaid payroll taxes, these fines and penalties being among the most punitive in the tax code.

Unfortunately, there is no safe harbor, nor is there a table where you can look up an amount which would be considered reasonable compensation. Just like the current debates about executive pay, there is an element of subjectivity in what is considered reasonable by the IRS. I always tell my clients to at least try to come up with an objective basis in determining what there salary is. There are online sites which can provide guidance, not to mention wage and salary surveys in certain geographical areas. I cannot emphasize too much the value of documentation. Formulate an objective basis of your salary (and bonus if applicable), keep written documentation on how you arrived at your salary, and be consistent. Avoid “changing the rules” from one year to the next due to business conditions, and if you feel justified in making changes in the rationale behind your salary, document it!

Note, this article deals with the reasonableness of salaries or owners in S-Corps where generally smaller is better. C-Corps have a different set if circumstances which I will be taking a look at in future articles.

Written by Steve A. Porter, CPA, CMA

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Are you an innocent spouse?

February 19th, 2012 admin

By: Steve A. Porter, CPA, CMA

As any married person can tell you, marriage can lead to certain complications in life. And when you mix taxes and marriage, it is inevitable that problems arise from time to time.

Most married people filing US tax returns do so jointly. And checking that little box on your 1040 return that says “married, filing jointly” not only saves you a bundle in taxes, it creates a special kind of liability called “joint and several” liability. I am not an attorney, so I will let you ask your lawyer to explain what that means, but it is important that you know the IRS may look to both you and your spouse, or either one of you separately, to satisfy a tax liability.

Here’s a little true story illustrating what can happen when a person files jointly, and the marriage has, let’s just say, “communication issues.”

A lady called me, almost sobbing, telling me she received a notice from the IRS who wanted a very significant sum in back taxes, penalties, and interest. The lady had divorced a couple of years prior, and it seems her husband (ex-husband now) had been quite a gambler. So good, in fact, he had gambling winnings of $100,000.00. He had somehow kept this a secret from her, and to make matters worse, had tried to keep it a secret from the IRS. He had not reported this income.

Since she had filed jointly with her husband, the IRS came looking for the tax to both parties. They were unable to collect from the ex-husband, but the lady had a nice job, and a little savings which she wanted desperately to protect.

Not fair? No, it is not. But the good news is that the IRS does have a sense of fairness in this type of situation, and actually offers a way around the joint liability created when you sign a joint return.

It is called “innocent spouse relief”, and you can read all about it in IRS Publication 971.

To actually be an innocent spouse, you have to meet the criteria outlined in Publication 971. You must:

  • Have signed and filed a joint return with your spouse (or ex-spouse) which contained “erroneous items” which resulted in an understatement of tax liability
  • You had no knowledge or (and this is important) reason to know the item in question was erroneous
  • Taking into account all the facts and circumstances, it would be unfair to hold you liable
  • There must not have been a property transfer as part of a fraudulent scheme which defrauds either the IRS or a third party such as a creditor.

Note that you must have all four. If you meet the requirement for numbers 1 and 2, yet fail to meet number 4, you will not be eligible.

Now, things like “erroneous items” and “reason to know” are explained in further detail in Publication 971. Let’s take a look at some examples of what is considered meeting the criteria as defined by the tax code.

Erroneous Item: Broadly, these are income items which go unreported or under-reported, or deductions, tax credits, or basis calculations that are improper and result in an understated tax liability. The gambling winnings in my example above would be an example of unreported income. A deduction for a dependant that did not meet the requirements for a dependant deduction would be another example.

Actual Knowledge or Reason to Know: Actual knowledge is pretty straightforward, but “reason to know” can be subjective. In the gambling example above, let’s assume the wife often accompanied the husband to the horse track or gambling casinos, and the year in question the husband purchased an expensive vehicle with cash, would it have been reasonable to expect the wife to inquire about where the money came from? If so, there might have been a reason to know making innocent spouse relief unavailable.

Indications of unfairness: In the above example, the husband deserted the wife shortly after the gambling winnings. The wife received no benefit from the income, so it would not be fair to require her to pay taxes. But let’s say, for example, a new house was purchased with the winnings, and the wife got to live in the house, and later received proceeds from the sale of the house. In that case, there was no indication of unfairness, and the relief from tax liability would probably not be granted.

The innocent spouse relief is all about fairness. The strict letter of the “joint and several” liability created when you sign a joint tax return would otherwise punish an innocent party for something done by a spouse.

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Tips to increase the value of your business

February 10th, 2012 admin

Most business owners come to a time in their life when they think about selling. Some have very specific plans, such as when they reach a certain age, or when their business reaches a certain level of profitability. Others think about selling, but really have not formulated anything specific.

Whatever category you fall into, it is a good idea to make your business valuable to buyers. That’s because building value takes time, and the best time to do it is now so that you will be ready when you are actively exiting your business. Also, many of the things mentioned below are just good business practices, and well worth developing for now and the future.

Obviously, having a history of profitability and a clean balance sheet are essential in getting a good price for your business, but there are some other non-financial items that you might think about as well.

Diversity
Look at your customer base. Does one large customer account for 50% or more of your sales? If so, attracting a buyer willing to pay a good price is going to be more difficult. The concern is that after the deal is done, that customer might be lost. A buyer does not know what relationships you have with your current customers, so that buyer has no idea if he/she can maintain it.

There are certain exceptions of course, but many small customers are almost always advantageous to a few large ones.

Employees
Many companies live up to the ‘our employees are our most valuable asset’ slogan. After all, attracting and retaining good employees is a key ingredient to success even in these economic times of high employment. But be aware that a potential buyer might be a little apprehensive toward a business that relies too heavily on one or two key people.

Beware of “The Fiefdom Syndrome.” Some managers hoard knowledge in an attempt to give themselves job security. A buyer is buying a business, and while management expertise is important, portability of that expertise is a key factor for someone looking to buy your business.

With employees, as with customers, all your eggs should not be in one basket. If you have one key employee, who if not retained would cause the business to suffer greatly, you really should consider some way of reducing that risk.

Recurring sales and revenues
Not all sales are created equal. Someone looking to buy a software development company will be much more interested in service contract revenue than new license sales. Contract revenue is a sure thing. Even if your business revenue is not typically driven by contracts, you might consider generating more contract revenue by selling service and/or warranty contracts. This might create a liability, but the security of contractual revenue will make your business much less risky, and much more appealing to a potential buyer.

A Unique Core Differentiator (UDF)
This is a fancy way of saying you need to stand out from the crowd. Someone looking to buy as business is probably looking at several prospects. And in this economy, it has become a buyer’s market. So what sets you apart? For some businesses it might be as simple as product packaging. For other businesses, it is good old fashioned reputation. And for some, it might be a unique website or blog that gets a lot of traffic.

And speaking of websites, a dull template design will work against you if you are striving to develop a UDF. In this day and age, your website might be the first contact your business has with potential buyers. Why not show them you are not run of the mill?

Borrowing Potential
I am surprised by how many small businesses operate debt free. There is something to be said about not owing anything to a financial institution, but you should maintain a good relationship with your bank, and your bank should be eager to lend you money if you need it. Note that it is usually in the bank’s best interest to retain the relationship with the new owners, so an ability to borrow money can often easily be transferred from seller to buyer.

But even if third party financing is not part of the equation, a potential to borrow easily means your business is less risky.

Bottom line, it’s not always about the bottom line. You can probably calculate discounted cash flows and times earnings to ballpark a selling price, but if you want to get the true value from your business, try focusing on things that do not necessarily show up in the financial statements and analysis.

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Alternatives to 401K retirement plans

February 8th, 2012 admin

By: Steve A Porter, CPA, CMA

If you have looked at retirement plans for you and your employees, it’s a sure bet that you are familiar with 401K plans. Chances are you already have one. Since they were introduced in the 80’s, there has been a literal explosion of these type plans.

Although they are very popular, they are heavily regulated by the DOL, and sometimes the rules as mandated by the government do not allow you the flexibility you want in rewarding your top performers. The problem usually arises when the plan becomes ‘top heavy’, ie: highly compensated employees receive a greater share of benefit than allowed by the regulations.

Fortunately there are other options available, and one of the most common involves ‘carving out’ highly compensated employees and allowing them to participate in a ‘non-qualified’ style plan.

Other Options: Non-Qualified Plans

A non-qualified plan can replace the existing plan, or exist alongside it. Employees can participate in both plans if the employer allows it. In reviewing what’s out there for these type plans, I found they have increased in popularity in recent years, and they also are very varied and come in many forms. Note that the general recommendation (not necessarily a requirement) is that 15% of the employees be in this plan. It is not meant to be a general retirement fund for all employees. It is a special plan for management and/or upper-tier executives.

The two broad categories are Supplemental Executive Retirement Plans (SERPS) and Non Qualified Deferred Compensation (NQDC).

SERPS are usually in the form of defined benefit plans where the employer foots the bill for a retirement/life insurance payout. NQDCs are contribution plans where employees defer a portion of their salary, and employers provide matching contributions.

Top Hat Plans is the common term for these NQDC style plans. They are very popular because they can be designed and set up to look and feel like (to the participant, at least) a 401K plan. However, there are no testing requirements, no non-discrimination rules, no fiduciary responsibility on administrators, no annual filing, no audits, and they are very flexible as far as pre-funding and payouts are concerned. Also, there are no limits on contributions. Most employers do set limits, but the limit is determined by the employer, not the government.

The structure of the plan is very different from a 401K plan, however. The plan is “unfunded.” This term is misleading because it does not mean the plan has no funds, only that the participant has no specific claim to the fund assets other than that of a general creditor. The assets in the funds are essentially arrangements made by the employer to finance the payout. There is no requirement for this financing (pre-funding), but that lack of financial security adds significant risk to participants. Administrative fees are very high if you do not provide financing for the payout.

Essentially, the participant has a legally binding contract with the employer that he/she will be paid “X” amount of money on a certain date depending on certain events. The payout can be tied to contributions made by employer and employee and/or fund earnings. You can even have a vesting schedule as long as the employee understands he/she does not own anything other than promise by the employer backed up by a contractual obligation. Note that this contract is not administered or regulated by the DOL as in the case of a 401K plan. It is simply a standard contractual obligation bound by standard contract law.

The assets of the fund are owned by the employer. As such, they are vulnerable if the company files bankruptcy. Also, any earnings on the funds are taxable to the company. That’s why most companies use Company Owned Life Insurance (COLIs) as the pre-funding asset. Of course mutual funds and similar investments can be used.

To give employees a little more security, most of these plans use a “Rabbi Trust.” which acts to set aside the fund assets in a special type of trust. These trusts offer no protection from involuntary liquidations such as bankruptcy, however. Also, Rabbi Trusts are required if participants make pre-tax deferrals.

Probably the biggest negative aspect of these type funds is that the employer does not get a tax deduction for contributions to the fund since the company retains ownership and control of the contributions. These tax savings over the years are VERY significant. Forfeiting that tax deduction is costly, however, you do get to deduct employer contributions it when they become taxable to the employee, usually through payout.

These type funds do provide a very good tax shelter for participants, however. And a C-Corp actually has a small advantage over pass though entities since any earnings on the plan are not passed directly to the owner.

If you are interested in these style plans, I would recommend getting proposals from several companies. The big players like Principal or Fidelity can help you learn about these type plans, and offer you quotes and advice on getting set up.

Although these plans have very relaxed rules and are very flexible, they are complicated financial arrangements, and there are several “gotchas” if not done correctly.

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