Tax Guru – Ker$tetter Letter

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Archive for November 30th, 2007

Shifting Corp Income?

Posted by taxguru on November 30, 2007

Q-1:

Subject: RE: Fiscal Year

Kerry,

I read your online article I have a question with respect to the following paragraph:

Fiscal Year
One of the most useful tools in the tax game arsenal is the ability to shift income between taxable years.  Individuals report their taxable income based on the January 1 to December 31 calendar year.  S corporations are required to also use the calendar fiscal year, allowing no opportunity to shift income between years.  C corporations, however, can end their fiscal year at the end of any month.  The first tax return will almost always be less than a full 12 months, so don’t worry about coordinating it with the incorporation date.  How this saves on taxes is pretty straight forward.  Toward the end of your personal fiscal year (12/31), you bleed off some of your taxable income to your C corp by paying it for something like rent or marketing services.  In January, your corporation can pay it back to you.  Near the end of the corp’s fiscal year, bleed its net profits out by paying yourself This back and forth income shifting can go on for a long time.  Sometimes income is never taxed; or if it is, we make sure that it is taxed at the lowest rate possible (15%).

Specifically,
  
I am a physician, a radiologist to be exact.  I am currently in the military, and I owe 2.5 more years.  In addition to my “day job”, I do moonlighting for various local locum tenens agencies.  I followed the pattern of some other people here, and got hooked up with an accountant here who got me set up in some entities.  I do not know if this is the right way to go for my particular situation.  I am in essence a “sole proprietor” in that it is just me, as a physician, doing this work.  My goals were to provide a liability shield, and tax advantage.

How this is set up is: I have a S-type professional corporation under the auspices of which I take on these local jobs, either on a daily or a weekly basis.  This is strictly a fee-for-service type arrangement.  The accountant also had me set up a traditional C-Corporation as a management entity. His plan is that the money I earn from my moonlighting each month (in the professional S-corp) is paid to the management C-corp.  He made the tax year-end dates for the S-corp 31Dec, but gave the C-corp a 31 Jan end, ostensibly putting the taxes on those earnings off a year.

My question boils down to the legitimacy of shifting my S-corp income to the C-corp to avoid the taxes; doesn’t the IRS flag this arrangement, which I believe is what you are refering to in your article?

Thanks,

 

A-1:

It sounds like you are working with a good tax advisor, if you believe in using legal means to minimize your tax bites.  That sounds exactly like scenarios I have set up for clients, which I learned from other tax pros before me.  Shifting income in this way isn’t avoiding taxes.  It allows you to control the timing and rate at which you pay taxes on your income. 

As long as all of the transfers and shifting are done properly and consistently, you are not breaking the laws.  IRS would obviously prefer that people just bend over, grab their ankles, and not do such things and just continue to pay them higher and higher taxes every year; but if you do take proper steps, under the guidance of an experienced tax pro, that is your right to do.

Whether taking legal steps to reduce your taxes is an unpatriotic thing to do is something I have been accused of my entire career. 

My guiding philosophy has always been the following 1934 quote from Judge Learned Hand:

“Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.”

Good luck.  I hope this helps.

Kerry Kerstetter


Q-2:

Thanks, Kerry, for the quick reply.  I guess what I really meant to ask you is about the part where you say “…In January, your corporation can pay it back to you.  Near the end of the corp’s fiscal year, bleed its net profits out by paying yourself…”

I get the point about bleeding the money out of the S-corp to the C-corp as a “management” fee, but not about how to legally get that money back to the S in January, so that the “shift” can go on. 

One last thing,  is it legitimate in your opinion for me to in fact “shift” 100% of my profits in the S corp to the C corp?  That is what my current CPA is having me do.  I have taken no salary nor distributions from either account.  I have however, repayed to myself the original money I put in to both entities from my personal account to open the business accounts.  I have heard some sources say that this is a no-no, as the IRS my somehow consider this a “second class of stock” and revoke your S-status?

I may be looking for a new CPA… any interest? You obviously know this game quite well.

Thanks,

 

A-2:

The shifting of income back and forth is a very common technique.  Various methods can be used, such as leases and royalties, or a catch-all category of Business Services, to accomplish full deductibility on the return from which it was paid. 

Having just a one month overlap in the tax year-ends makes it a little tighter time-wise to plan the amounts needed to shift, but it is entirely possible to do.

It’s not always necessary to bleed out 100% of the net profit; but that’s a judgment call made with the assistance of your professional tax advisor, who will need to work with up to date accounting info.  The weak link in this game plan is almost always out of date bookkeeping, making it a shot in the dark in regard to determining how much income needs to be shifted.  The more up to date the books are for all of the entities involved (1040, 1120 and 1120S in your case), the more effective the income shifting will be.

I wish I could be more help; but I already have too many clients to take care of properly; so we are still trimming back on the difficult clients and are not accepting any new ones at this time. 

Unfortunately, we don’t have anyone specific to whom we could refer you. I did recently post some names and links for some like-minded tax pros around the country. 

If you haven’t already done so, you should check out my tips on how to select the right tax preparer for you. 

I wish I could be of more assistance; and I wish you the best of luck.  

Kerry Kerstetter

 

  

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