Today’s column is dedicated to answering questions that readers frequently ask. I’ve also included an interesting thought or two about future federal tax legislation.
- Reasonable compensation
I am often asked if a corporation can pay any amount it chooses to an executive and still get the tax deduction. The answer comes in two parts–the answer is “yes” it can overpay an executive, but “no” it cannot deduct compensation which is not reasonable. The Internal Revenue Service frequently analyzes the amount of compensation paid to shareholders who are also employees to determine whether or not that amount is reasonable. If it is not reasonable, then it is disallowed to the corporation as a deduction. In addition, it is taxed again as a dividend distribution to the shareholder.
Let me say that again. If a corporation pays too much money to a shareholder-employee, called unreasonable compensation, then the IRS will tax the excess amount twice. The first tax is by disallowing the deduction to the corporation. The second tax is by treating it as a dividend distribution to the shareholder. These rules are especially scrutinized when a shareholder owns a corporation that elects to pass through its earnings to the individual shareholders. Doing so allows the shareholder to avoid certain Social Security taxes which can generate a significant tax savings.
So the point is if you are paying yourself more than what is customary in your particular industry, you have a risk that on audit the IRS will disallow the deduction for the excess and treat the excess as a constructive dividend, thereby imposing a double tax. If you are in this situation, I urge you to consult your accountant or tax advisor and address the issue in advance. With proper advice, there are several strategies which can be implemented.
- Accumulated earnings
I am also asked frequently about taxes associated with accumulating earnings in closely held corporations. As people age, they sometimes have a tendency to hang on to the earnings in their corporations and try to avoid distributions to shareholders. I often see very successful corporations with large amounts of cash in stocks and other liquid investments. For a variety of reasons, many of which are associated with retirement, the shareholders don’t want to distributed earnings.
Be aware that the Internal Revenue Code imposes a tax on excess earnings that are kept in a corporation. That’s right, if you keep too much cash in a corporation, the IRS can and will tax the earnings a second time.
Proper planning can resolve the specter of this additional tax. The lesson here is that if you own a corporation with significant amounts of cash in stocks, bonds or other investments which are not being used in its active business, I urge you to meet with your accountant or tax advisor and plan for a defense should the IRS audit the company and raise this issue.
Finally, here’s a brief comment about Obamacare. When the Affordable Care Act was passed by Congress, President Obama argued that this law was not a tax but was permissible under the Interstate Commerce Clause of the U. S. Constitution. In an unusual ruling, the Supreme Court ruled to the contrary, finding that it was NOT constitutional under the Interstate Commerce Clause. However, the Supreme Court DID find that it was constitutional as a tax.
Now that the Congress seems prepared to repeal Obamacare, the question is whether that Supreme Court ruling will continue to have any vitality in future years. I would submit to you that it has and will continue to have great significance. Here’s why.
Whenever Congress passes a law that affects all of us, it does so under what was previously considered a grant of basically unlimited authority of the Interstate Commerce Clause. When the Supreme Court ruled that Obama had overstepped that authority and that the provision was limited in scope, the Supreme Court permanently restricted the power of Congress. I think this is a very significant limitation on the power of Congress and that it will survive the repeal of Obamacare. In future legislation, Congress will be forced to consider whether or not it has the authority to pass a new law and whether or not the new law will survive judicial scrutiny. Government laws that require affirmative conduct on our part will be especially restricted.
So, it appears to me that President Obama has lost on two counts: Obamacare is being seriously challenged with a threat of repeal or will at least be the subject of serious overhaul. Plus, the power of the federal government to control our behavior has now been permanently restricted by the Supreme Court. Watch for future challenges to federal laws under the Interstate Commerce Clause.
With all the changes in Washington as a result of the 2016 elections, this will no doubt be a busy year for those of us involved in federal taxation. Keep your questions coming, remember to talk to your tax advisors and keep yourself informed about what politicians are planning next to do with our tax dollars!