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IRS: Sub-S owner didn't pay himself enough

Agency wins court case after arguing that CPA used ploy to avoid payroll taxes.

By Teresa Mears Jan 25, 2011 5:07PM

This post is by Laura Saunders of The Wall Street Journal.


There's a saying: Pigs get fed and hogs get slaughtered. The Internal Revenue Service surely hopes that includes tax hogs.


That is the message of a recent U.S. district court case won by the IRS against David Watson, a CPA in West Des Moines, Iowa. At issue: a common tax-cutting maneuver available to the owners of millions of closely held businesses.


The case, David E. Watson P.C. v. U.S., revolved around Watson's low pay as the sole owner and shareholder of a so-called S Corporation. Such companies, often called "Sub-Ss" after the subchapter of the tax code governing them, is a popular choice of entity for private firms. Unlike C corporations, Sub-Ss have no more than 100 shareholders, and they pass profits to owners without an extra layer of tax. There are nearly 4 million Sub-Ss in the U.S. today.


Watson's Sub-S was, in turn, one of four principals in LWBJ, an accounting firm.


According to the decision, the firm made profit distributions of $203,651 and $175,470 to Watson through his Sub-S for 2002 and 2003, respectively, the years in question.

Mr. Watson, who had a graduate degree in tax and 20 years' experience, received only $24,000 of salary for each of those years, far less than the $40,000 a year earned by recent graduates in accounting with no experience, according to one expert for the IRS.


The agency cried foul, saying his pay was far too low. Why object? Unlike profit distributions, all salary is subject to a 2.9% Medicare tax and some is subject to a 12.4% Social Security, or FICA, tax. (The FICA income cap, $84,900 in 2002, is now $106,800.) By reporting low pay Watson didn't save any income taxes, but he did save nearly $20,000 in payroll taxes for the two years, the IRS said, pegging Watson's true pay at $91,044 for each year.


Judge Robert W. Pratt agreed, ruling that the CPA owed the extra tax plus interest and penalties.


Watson plans to appeal the decision. "The IRS can disallow a tax deduction for unreasonably high compensation, but the law doesn't give it the authority to raise pay in order to collect extra payroll taxes," he says. Independent tax expert Robert Willens in New York says this will be a hard argument to win.


For Sub-S owners, this issue isn't going away. Last year it even turned up in legislation, when the House passed a provision that would have subjected all profits of shareholder/employees of personal-service firms -- such as accounting, law and consulting firms -- to payroll taxes. The measure died in the Senate, but the IRS would likely welcome its return. Cases like Watson's are expensive for the agency to litigate because each turns on individual circumstances.


Recent IRS statistics suggest why the agency might focus on Sub-S pay. Over the past decade and a half, when executive paychecks exploded, the salaries of Sub-S owners declined as a percentage of total income, from 52% in 1995 to 39% in 2007, according to the latest data available. (The remaining income is taxable to the owners as well, but doesn't incur payroll taxes.) During the same 12-year period, Sub-S income doubled, while salaries increased only 26%. The average pay for a Sub-S owner was recently was $38,400, according to Martin Sullivan, an expert with Tax Analysts, a nonprofit publisher near Washington.


Tom Ochsenschlager, former head of tax for the American Institute of CPAs, says pay and payroll tax issues are a frequent source of friction with clients: "Sometimes you have to take them to the woodshed and say, 'You need to report more income as pay for personal services."'


What is a fair ratio of profits to pay? There isn't one answer, experts say. A company with substantial capital or assets, such as a manufacturer, often is able to justify lower pay than one selling personal services like a law or accounting firm. Says Willens: "I would tell a client that for personal services, 70% would be the absolute floor and might not get the job done," he says.


In Watson's case, his revised compensation came to only about 40% of his total return from the company. The upshot: Pay can vary -- but it can't be too low.


More from The Wall Street Journal and MSN Money:


Jan 26, 2011 6:06PM
The law is clear and the IRS is not following the law. The legislators even know that the law gives this benefit  and attempted to change it or pretended to. It's not a fair law and should be changed but judges are not supposed to do that. I don't ever want  the IRS to be able to change the laws to their liking. Feel free to bother your legislator to get this fixed.
Feb 1, 2011 11:52AM

I am sorry but I have to side with the accountant on this one.  Are they going to come into where I work and say.  Hey he has this degree and he should be making this much so he should pay this much tax?


I am sorry but it seems we are moving away from the land of the free to the land of the taxed!


A long time ago didn't we separate from another nation because of this stuff?  I was not around but there were a few people... Washington was the name of one of them?


Jan 31, 2011 3:09PM
I hope you all remember this and when the IRS come after you don,t gag and say  butttttttt i did nothing. 

 Yea it sounds fishy , but you don,t know anything about the man. 

Jan 27, 2011 9:48PM
The cap on payroll taxes should be removed. All income should be taxed the same way.
Feb 2, 2011 2:53PM
Read the writings of our Founding Fathers.  Read French history from Louis XIV to Louis XVI.  America, as we know it, is repeating history and those we have put in power can't see the forest for the trees.  What you see in Egypt will be coming to our shores soon...sooner when you read stories like this!
Feb 3, 2011 1:26AM
John Edwards did this for years and got away with it.

I guess it really is who you know.

Jan 31, 2011 3:57PM



How does the kool-aid taste?  You are such a whiny, cry in your beer man that it is just sickening.  Step up and be responsible for your own money and if you don't earn enough, work on earning more.


The so called "Bush Tax Curts for the Wealthy" were tax cuts for everyone.  The top 1% richest americans pay around 40% of all income tax collected.  You can search for it.  When Reagan took over and the highest tax rate was 70% or 90%, the top 1% only paid 19% of all income tax collected. 


Many people who make in the bottom 50% virtually pay no tax and get money back through credits.  In essence, 50% of Americans are riding on the backs of the top 10% taxpayers in this country.


You must be a Keith Olbermann, Maddow, Chris Matthews, Randi Rhodes listerner and losing the ability to think for yourself.


A month ago I had a client in my office, who by his own admission, is in the top 1%.  He attended a dinner the night before with some really rich people.  About 70 people there who employeed about 30,000 employees between them.  Most of those 70 could shut their businesses down and live a comfortable life until they die, leaving 29,930 people unemployeed.  Thanks to people like you who constantly complain about rich people and the taxes that they pay.  Let all rich people take their money, close down their businesses and see where we are at as a country.

Jan 29, 2011 10:51PM

IRS got it right. Earned income is subject to payroll taxes. All the income generated by the CPA's personal services is taxable. Any income generated by other employees should be considered a return on capital and not be subject to payroll taxes.  

Jan 26, 2011 1:11PM
It sounds pretty fishy to me. Once again the rich trying to beat the system, while the rest of us pay our dues.
Jan 26, 2011 8:25PM

Allen Dore said, "Feel free to bother your legislator to get this fixed."


Translation: Feel free to bribe your legislature, I mean feel free to give to his/her campaign a donation to prevent Sub-S's from paying anything. Down with the Bush rich people tax cuts.

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