Is that dividend really pay?

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Individuals covered by high-deductible health plans became eligible Jan. 1 for health savings accounts (HSAs), which allow for tax-free savings toward medical expenses. Amounts deposited in HSAs earn interest tax free, and distributions are not taxed if the funds are used to pay qualifying medical expenses. Contributions to HSAs by employers are not taxed to either the employer or employee. For more information, see Notice 2004-2 at www.irs.gov.

Equipment Leasing Association of America says a provision in the U.S. Treasury Department’s proposed budget for fiscal 2005 would adversely affect tax deductions available for various types of property leased by tax-exempt entities, such as schools, transportation authorities or hospitals. Property affected includes vehicles leased to federal, state and local governments and property used to provide transportation services to a tax-exempt entity, ELA says. For more information, visit www.elaonline.com.

The National Accounting and Finance Council of the American Trucking Associations will hold its 2004 meeting June 27-29 at the Adolphus in Dallas. For more information, contact NAFC at nafc@trucking.org or (703) 838-8820.

Small Business Administration said last month that it may be forced to close its 7(a) loan program unless Congress promptly enacts the agency’s fiscal 2004 appropriation.

Owners of S corporations have long known that funds taken out as salary incur payroll taxes but that distributions of profits or dividends do not. But the Internal Revenue Service has recently intensified scrutiny in this area in an effort to minimize perceived abuses. After all, lots of tax funds are at stake for the U.S. Treasury.

The IRS has won a round or two in this fight. In fact, the Tax Court has recently tagged trucking as well as other companies. See, for example, Mike J. Graham Trucking, Inc. v. Commissioner (T.C. Memo 2003-49) or Specialty Transport & Delivery Services, Inc. v. Comm. (T.C. Memo 2003-51).

What’s at stake for the trucking company owner? Assume an annual payout of $100,000 for each owner who also is active in the business. The difference between classifying those funds as dividends as opposed to pay is about $13,700. Multiply that times three or more back years, and add penalties and interest and you could quickly have an audit exposure exceeding $50,000 for each owner active in the business.

But the difference between tax treatment of pay and dividends also shows why it’s so tempting for an owner to declare that they just take profits from the business and not a salary. He takes zero W-2 income and withdraws funds as dividend distributions, thinking he can avoid the payroll taxes. The IRS has had about as much of this as it can stand. With these court victories under its belt, you can bet that agents will scrutinize compensation in any audit.

What accounts for such a large difference between salary and dividends? Suppose an S-corporation shareholder withdraws $100,000 in wages from his company. He would pay about 6.2 percent FICA on a significant portion of that and 1.45 percent Medicare on all of it. As the employer, the S corporation must match these taxes, so the total is doubled. Once the FICA limit is reached, only Medicare taxes apply, but this can still combine to be almost $3,000 per $100,000 of additional salary each year.

If you happen to own a limited liability company, partnership or sole proprietorship, you likely already pay all these taxes. The S corporation is the type of business entity that allows “profit distributions” that are not subject to payroll taxes.

According to a recent Tax Court decision, “Regardless of how an employer chooses to characterize payments made to its employees, the true analysis is whether the payments represent remuneration for services rendered.”

In Graham Trucking, the president, who was also the majority shareholder, was active in the business by driving a truck, soliciting new business, negotiating contracts, overseeing finances and generally running the business. The Tax Court held that this constituted “more than minor services,” so the president was an employee. Therefore, any compensation he received constituted wages and were subject to payroll taxes.

So how do you defend yourself? It is entirely possible that if you are a good entrepreneur, you would realize significant profits from skillful operation of your company. Those profits should not be subject to payroll taxes. But doing nothing is clearly an invitation to disaster. You must carefully document your officer pay by seeking out comparable pay scales, carefully listing duties and hours and keeping current with annual corporate minutes to document officer pay. You may even want to consider an employment contract. At a minimum, your W-2 salary should be in the range of a top comparable manager in a similar business.

Every case stands on its own merits and circumstances, but it’s a hot issue for the feds. If you are shareholder active in the business and taking little or no compensation in the form of salary or wages, consult your CPA or tax adviser immediately.

For more information, see “S Corporation Officers Performing Services Are Employees; Pay Is Wage” from the IRS online publication “The Digital Daily,” August 28, 2003, at this site.