Tax Avoidance Gone Too Far

The author of this report has been asked to review a situation where a corporation has received unwanted attention from the Internal Revenue Service (IRS) for a few reasons. Among those reasons are income that is deigned to be a de facto dividend, stock redemptions that are improper and a rental loss situation. The goal across the board is to devise a compensation and tax approach that will prevent the IRS from claiming tax avoidance or other such things as well as a plan that limits tax implications and higher costs for the firm. While it is sometimes rankling and maddening when the IRS makes such moves, their reaction is a little predictable given the facts involved.

The IRS taking issue with the compensation is a little predictable, and for a few reasons. First, it is presumed by the author of this response that the company involved is a C-Corporation and not an S-Corporation. This is assumed because the IRS is usually paying attention to limited compensation with S-Corporations and higher compensation with C-Corporations. In the case of S-Corporations, compensation is typically kept low because it limits the amount of income that is subject to FICA taxes. As such, it is much more common for such firms to "low-ball" on salaries so as to keep FICA expenses low and maximize what is seen in the form of S-Corporation distributions, which are exempt from FICA. ON the other hand, C-Corporations tend to maximize salaries and minimize dividends because the former is deductible but the latter is not. Beyond that, the IRS is clearly not a fan of the five percent of gross receipts aspect of the construction business in this case. It is clearly a thinly veiled dividend because it goes up and down (scales) with the revenue of the firm, much like a dividend (Kirkland, 2013). The solutions to this challenge is to either classify the upper half of the income as regular income that is fixed in nature or reclassify the salary above the first five million as a dividend. If minimizing tax impacts is the goal, then paying all of the President's salary as straight salary is probably the goal. However, adjusting it to keep up with revenue would be a bad idea. If the revenue fluctuates a lot, a dividend would be the wise course. If business is good and steady, a fixed salary should work fine. What must be avoided, however, is any appearance of manipulation and such to avoid taxes. It would be much like doing a massive purchase of inventory right before the end of a year . . . the purpose is obvious and illegal (Tax Analysts, 2017).

The distribution/redemption of stock is pretty clear as well. Per 26 USC 302, the rule says "if a corporation redeems its stock (within the meaning of section 317(b), and if paragraph 1, 2, 3, 4 or 5 applies, such redemption will be treated as a distribution in part or full payment in exchange for the stock" (Cornell, 2017). Further, section 317(b) says that "for the purposes of this part, stock shall be treated as redeemed by a corporation if the corporation acquires its stock from a shareholder in exchange for property, whether or not the stock so acquired is cancelled, retired, or held as treasury stock" (Cornell, 2017). Whether this becomes a dividend depends on what happens to the shareholders. If the share of ownership stays the same (which it did here), it is treated as a dividend. If not, it is treated as a capital sale and there will be a capital gain or less, just like if the stock was sold on the open market. As such, if this company wanted to reduce taxes, they would want to have it treated as capital gains or losses (Spaulding, 2017). As for the rental situation, this would be a self-rental situation and thus the loss of passive income is not deductible. The firm will have to choose between being able to claim a loss and keeping the property under the control of the company . . . it cannot be both (Constantine, 2008).

The company in question for this report was clearly trying to limit the taxes they paid. There are very legal and obvious ways to do so. However, there are methods and means to do so that are not looked upon kindly by the IRS and thus they should be avoided entirely. That being said, the firm can make fairly small changes and still achieve a limitation of taxes paid. At the same time, being too aggressive in limiting taxes just leads to audits and negative attention from the IRS that could absolutely outweigh the potential benefits of avoiding detection.

References

Constantine, A. (2017). Avoiding the Self-Rental Trap. The Tax Adviser. Retrieved 29 April 2017, from http://www.thetaxadviser.com/issues/2008/aug/avoidingtheself-rentaltrap.html

Cornell. (2017). 26 U.S. Code § 302 - Distributions in redemption of stock. LII / Legal Information Institute. Retrieved 29 April 2017, from https://www.law.cornell.edu/uscode/text/26/302

Kirkland, S. (2017). Preventing a challenge to (un)reasonable compensation. Journal of Accountancy. Retrieved 29 April 2017, from http://www.journalofaccountancy.com/issues/2013/sep/20137412.html

Spaulding, W. (2017). Stock Redemptions. Thismatter.com. Retrieved 29 April 2017, from http://thismatter.com/money/tax/stock-redemptions.htm

Tax Analysts. (2017). Is It Time to Liquidate LIFO?. Tax Analysts. Retrieved 29 April 2017, from http://www.taxanalysts.org/content/it-time-liquidate-lifo