Tax Guru – Ker$tetter Letter

Q:

Subject: Subchapter S Corp vs Sole Proprietorship

Hello,

I read information on your website showing the advantages/disadvantages between C and S Corporations. But I could not find any literature from you on S Corps vs Sole Proprietorships. I have been looking to go from a Sole Proprietorship  (Sched C) to Incorporating and Filing for Subchapter S status.  The reason I am contemplating this is that I was told I can avoid paying social security and medicare taxes on my income.  I know the shareholders of a C Corporation can take dividend distributions. Is this true of S Corporations?  And is this the means to avoid paying ss and medicare taxes.

I would appreciate your input.

Thanks.

A:

Using a corporate structure instead of sole proprietorship is one of the easiest ways to drastically reduce your tax burden, as well as give you additional personal liability protection.  I discuss many of these points on my main website, as well as  in several blog postings.

Before you do anything, you should work with a professional tax advisor who understands how small corporations work, to see how your particular circumstances can most efficiently utilize a C or S corporation.

To save time and money with the tax pro, it would be a good idea to get a copy of one of the basic books on incorporating to familiarize yourself with the fundamentals of how corporations work.  Two of the best are from:

          Nolo Press – printed book    

          Corporate Publishing – free online virtual book

Good luck.

Kerry Kerstetter
 

Q:

Subject: Social Security early-retirement rip-off? + C-CPI-U: Escher staircase?

Approaching 62 years old, I have discovered that – should I take the early, reduced Social Security retirement benefit – and then go on working normal hours — my benefits may be reduced to zero until my full retirement date — thought I will be locked into the reduced benefit for life. 

Before your full retirement year, Social Security reduces benefits $1 for every $2 earned above $12,000 a year.  For the tax year in which you retire the formula changes to $1 out of $3 above $31,800 until you reach the magic month.  [http://www.ssa.gov/pubs/10069.html#howmuch]

 

Most people opt to begin benefits at 62.  I wonder how many are blind sided by this upside-down reduction?  Social Security should at least make this benefits sink hole extremely clear to would be early retirees (perhaps even getting them to sign a form stating they understand before jumping in)?

 

If the majority of the citizenry were informed of this Pearl Harbor short-change, change would be forced overnight.  The motivation to discourage work – or whatever the intention – is a miniscule social goal next to the need to provide our elders (hey; that’s me!) with sufficient money to survive. 

 

At the very least, early-retirement benefits lost in one year should upgrade benefits later.  In the age of computers this would entail almost no administrative effort at all.

***********************************

The new inflation measure that Bush’s BLS is trying to foist (C-CPI-U; the extra “C” stands for “chained”) to reduce Social Security cost-of-living adjustments takes into account consumer substitutions when the prices of one commodity rise faster than another’s.

 

Depending on how computed, C-CPI-U may be an Escher staircase.  For instance, inflation will be lower if we substitute chicken for pork if the price of pork goes up faster this year – but, what happens when we switch back for the same reason next year: does C-CPI-U reflect the CONTINUING price of chicken or just the current year’s change (the latter practice sounds like some formulas labeled “chained”)?

 

If C-CPI-U is not an Escher staircase, then C-CPI-U may not result in much more than one-time – even temporary reductions — in the inflation rate and benefits  (doesn’t sound like a Republican style set-up to me – better watch out!).

 A:

I understand your disgust with the benefit reduction scheme used for SS recipients under a certain age.  However, this is not in any way a new development and should not have been a surprise to you.  It has been the policy for as long as I have been in the tax business.  In fact, it used to apply to all ages.  Over the years, the penalty on excess earned income had no maximum age applicability.  It was later changed so as to only apply to recipients under 70, and then a few years back was changed again to only apply to those under 65.  It now applies to anyone under the age of eligibility for full benefits, which is 65 and four months for those starting to draw benefits in 2005.  This will be increasing every year, as the SSA continues to raise the retirement age and hope that more people pass away before starting to claim any benefits. 

Depending on how you earn your income, avoiding this penalty may or may not be an easy task.  The earnings limit only applies to compensation for services, most often in the form of W-2 gross wages and 1099-MISC non-employee compensation (NEC) as reported after expenses on Schedule C.

A common strategy to avoid this limit is to change your income from “earned” to “unearned.”  Examples of unearned income include payments reported on Schedule E (rents and royalties) and Schedule B (interest and dividends).  If you own your own business, it’s a simple task to set up a corporation and use it to convert earned income into unearned.  I actually learned this technique from one of the first CPAs I worked for, back in the 1970s.  He was in his 60s and had his accounting practice incorporated so that it could pay him rents instead of professional fees.  He was thus able to continue receiving full SS benefits because the rents weren’t counted against his earned income limit.  That loophole is still available today.

If you work for someone else, you will need to negotiate ways to convert salary to other kinds of income, such as leases or royalties or even 1099 NEC that you can run through a corporation.  A competent tax professional who understands how this strategy works can help you properly arrange things.

Expecting our rulers in DC to remove this unfair penalty is almost hopeless.  The financial “solvency” of the SS system depends heavily on people not being able to draw out all of the benefits they have paid in.  Not having a penalty for opting to receive early benefits would go completely against this requirement that as many people as possible die before recouping their payments in and thus forfeit them to the system. 

It is the case that I normally advise clients to choose the earliest pay-out from SS; but that is always partnered with a strategy to avoid hitting the limit on earned income and being subject to the benefit reduction penalty. 

  
I have to admit that I haven’t studied the new CPI formula.  However, your description of it does fit the standard MO of our rulers; to fiddle with formulas to give the false impression of improving accuracy, while actually just sweeping the real problem under the rug.  It is how our rulers, who have no regard for any time beyond the next election, prefer to pull the wool over our eyes rather than actually do anything bold to tackle the underlying problem.

Thanks for writing and sharing your thoughts.

Kerry Kerstetter

 Follow-Up:

Thanks much for the helpful tax info.

 

I should have included: I wonder what C-CPI-U’s take is when you switch from gassing up the SUV to taking the subway or to less pork and more rice?  On the flip side, C-CPI-U wants to fully assess the performance improvement my modern Timex makes over an ancient Rolex.  C-CPI-U seems to want to include as much value change or exclude as much as needed to lower the inflation rate!  🙂

 

Thanks again.

 

Untangling Tax Reform – From the Wall Street Journal

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Warning of e-Mail Scam about Tax Refunds

The Income Tax and How it Undermines the U.S. Economy

Music to Song-writers Ears: Lower Taxes – Possible lower rates for song-writers’ royalties?  If this special deal passes, the flood-gates will open as other professions lobby for similar tax treatment.

Q:

Subject: Inherited IRA 50% Penalty

 

Dear Kerry Kerstetter,

Your web page and blog are great!

I have searched the web high and low for an answer to my question about Inherited IRAs, and can’t find the answer anywhere. Maybe it’s appropriate for your blog, as many people are probably in the same situation:

I inherited an IRA from my mother, who died in 1996.  Web pages tell me I should have begun taking out yearly minimum distributions in 1997, or I should have cashed out the whole account by the end of 2001.  If not, there is a 50% penalty on what I should have taken out.

The problem is, I didn’t know any of this until now.

So what to do now in 2005?  No web page anywhere has the answer!

I guess the strictly correct answer according to the IRS is that I must file amended returns for every year from 1997 to 2004 and report the under-withdrawal and pay the 50% penalty, and calculate interest, and late payment fees.  But amending 8 years of tax returns would drive me crazy, and I would prefer to just forfeit the whole account instead!

So should I just start taking minimum distributions in 2005 and hope the past returns don’t get audited?  Or is there another solution?

Thanks for any help, and if there is a fee for your answer, I would be glad to pay.

A:

You do really need to work with a qualified tax pro to handle the several issues that this situation raises for you.

Going back and amending most of those older years’ tax returns isn’t even a valid option because of the three year statute of limitations barring any changes to any 1040 that has been filed more than three years ago.  Even filing 1040Xs for the three open years would be dangerous for you.  If you’ve been reading my blog, you know that the coast still isn’t clear from the risk of IRS initiating full-blown audits of taxpayers who file amended returns.

The old adage that “ignorance of the law is no excuse” is least appropriate in the area of tax law.  Our convoluted mish-mash of a tax system is so confusing to absolutely everybody that penalties are routinely waived by IRS for those persons who can make the case that the oversight was unintentional. 

Technically, somebody involved with the transfer of the IRA to your name (such as the account custodian or probate attorney) should have notified you of the requirement to start withdrawals from the account by the end of 1997, as should have your personal tax preparer, if you had told him/her about the inheritance.  Since nobody obviously told you about that requirement, you would probably be best off starting the withdrawal plan in 2005.  You should attach an explanation of the circumstances creating the delay to your 1040.

This obviously isn’t the only way in which to handle this situation for you.  As I said earlier, you should consult with a tax pro, who may either endorse this strategy or advise another option, especially if there are other pertinent details that you didn’t mention in your email to me.

Good luck.  I hope this helps.

Kerry Kerstetter

Follow-up:

Dear Kerry,

Thank you very much for your informative answer.

The only thing I didn’t mention was that on the Form 5498 I receive each year from Fidelity, it is always written in Bold print in Box 11:

“Required Minimum Distribution for 2004 – NO”.

This should certainly help my case for pleading ignorance of the required distribution for previous years.  I will attach a copy of Form 5498 and an explanation to my 2005 return (and do the required distribution for 2005).

I also noticed that on Form 5329 for reporting excess accumulations, you can only pay a penalty for 2005.  The IRS doesn’t make it easy to pay the 50% penalty for previous years.

Just curious why there is a lower audit rate for returns with lots of explanatory attachments, as you say on your web page.  Off hand you would think extra attachments would draw more attention to a return.  Maybe it makes the IRS think you are not hiding anything if you explain everything?

Reply:

While the lack of a check mark or a YES in Box 11 on the 5498 will help you defend against any IRS penalties, it is not by itself a 100% guarantee as the instructions for that box say on the back of the 5498 form. 

Box 11. If the box is checked, you must take a required minimum distribution (RMD) for 2006. An RMD may be required even if the box is not checked. The amount, or offer to compute the amount, and date of the RMD will be furnished to you by January 31 either on Form 5498 (in the blank box to the left of box 10) or in a separate statement. If you do not take the RMD for 2006, you are subject to a 50% excise tax on the amount not distributed. See Pub. 590 for details.

In regard to attaching explanatory documents to tax returns, it helps to understand how IRS processes the returns.  They enter the information from the returns into their computers and then run several tests on the data to check the accuracy.  They match against third party information documents, such as W-2s, 1099s and 1098s and kick the return out if there is a discrepancy. 

They also match up dependent info to ensure that they are valid SSNs and haven’t been claimed on another tax return.  Again, discrepancies cause the return to be kicked out.

The tax return data are run through the basic audit selection process which uses the super top secret DIF (discriminant index function) score, which measures such things as expenses in relation to income and occupation.        If the DIF Score comes out high, the return is kicked out.

Here is the critical point.  When a tax return is kicked out by the IRS computer, a human IRS employee will look at the actual paper return if one is available (not e-filed) and go through it to see if there is an explanation for the discrepancy or other abnormality.  If the explanation appears to be valid, the return is processed as filed and the taxpayer never has a problem. 

On the other hand, if there is not adequate explanatory info attached, the item in question is automatically disallowed or the return is sent out to the field for a full blown examination.  While one item may have triggered the selection for audit, the actual exam will cover many more things on the return while they are at it.  It opens a can of worms that cannot be closed.

This is not just a theory.  Because of my very high billing rate and very exclusive clientele, a high percentage of the tax returns I prepare have the kinds of unusual things that would automatically trigger IRS audits if there weren’t explanatory information attached.  Many of the tax returns we assemble are an inch thick, even when printing on both sides of the paper.  That extra info has kept the number of returns chosen for audit at a small fraction of the
national average.

I have had arguments over this issue with other tax preparers for decades.  I still firmly believe that any preparer who refuses to attach the additional explanatory information to tax returns is intentionally trying to drum up additional off-season billable work by implicitly asking for an audit.  Any preparer who doesn’t have the experience to know what kinds of things would require this additional explanation is probably too green to be trusted.

I hope this clarifies this point for you.

Kerry Kerstetter

 

With this kind of attitude, as portrayed by Scott Stantis, there’s no hope of ever reducing the size or scope of government and taxes.

I’m not sure about the drug issue; but I am confident based on my interactions with fellow boomers that we don’t support the current Social Security Ponzi Scheme and would very much prefer the right to own and control our own retirement funds. The big opposition to this is still coming from the AARP and the blatant lies it is spewing to its members, claiming that their benefits will be discontinued if any change is made to the current system.

Taking Cash Out: How a Business Can Help Pay an Owner’s Estate Tax Bill – Some ideas courtesy of the latest Intuit ProConnection newsletter.

IRS to Increase Audits Next Year – Individuals with income over $100,000 are dead center in the IRS’s cross-hairs, making the use of corporations to smooth out income flow even more important.