Do You HAVE To Cash That Bonus Check (To Get A Tax Deduction)?

For (very) closely-held service companies, it is common to “bonus” enough profit to bring taxable income down to zero (or very close). There are two reasons for this:

(1)  The company is a personal services company (PSC), meaning that it will face a maximum corporate tax rate on whatever profit is left in the company. This is a tremendous impetus to not leave profit in the company.

(2)   There is one owner (or very few owners) and the majority of the money is going to him/her/them anyway.

In many cases the company is also cash-basis taxpayer, and the accountant normally pays very close attention to cash in-and-out during the last few days of the tax year. With electronic bank transfers becoming more commonplace, I have seen carefully-monitored tax planning destabilized by sizeable electronic customer transfers on the last day or two. It happens, as the customer may be doing cash-basis planning themselves, and payment to my client is a tax deduction to them.

There are limitations on how far this can be pushed, though. It is not acceptable to delay depositing customer checks, for example, in order to avoid income recognition. In addition, one has to be careful about writing so many checks that it creates a bank overdraft. A common way to plan around an overdraft is to have a line of credit available. The bank would then sweep funds from the line as necessary to cover any overdraft. One might also run an overdraft if he/she knows that a deposit will arrive early the following month, as that deposit would occur during the float period of any outstanding checks.  A business owner might “know” that check is coming because said check is already in the owner’s desk drawer, but we will not speak further of such absurd examples. It is not as though I have ever seen such a thing, of course.

Let’s talk about Vanney Associates, Inc. Robert Vanney is an architect with perilously close to 40 years experience. The firm has about 25 employees, and Robert is the sole shareholder. He is – without question – the key man. His wife, Karen, is a CPA with a retired license, and she takes care of the books and records.

In 2008 Mr. Vanney received $240,000 in monthly payroll. At the end of the year, he determined and paid employee bonuses, taking as a personal bonus whatever was left over. The leftover was $815,000. The withholdings on the leftover were approximately $350,000, leaving approximately $464,000 payable to Mr. Vanney.

Problem: there was only $389 thousand in the bank.

There was enough money to pay the withholding taxes, but there wasn’t enough to also pay Mr. Vanney. What to do? The Vanney’s did not need the money, so they decided not to borrow from the bank. Mr. Vanney instead endorsed the check back to the company, and that was the end of the matter.

But it wasn’t. The IRS looked at the business tax return and decided to disallow the $815,000 bonus and almost $12,000 in related employer payroll taxes.

Why? The government got their taxes, so why should they care? 

There is a legal concept when paying with a check. A check is referred to as a “conditional payment,” because writing the check is subject to a condition subsequent. That subsequent condition is the check clearing the bank. We take it for granted, of course, so we overlook that technically there are two steps. When the check clears, the two steps unify and become as one. This is why you can send a check to a charity on December 31 and claim the deduction in the same tax year. There is no chance that the charity is receiving that check and depositing it by December 31. Still, if it clears in the normal course of business, all parties – including the IRS – consider the check as having been written on December 31.

That is not what happened here. The check never cleared the bank.

Which is unfortunate, as the IRS now could argue that the check remained conditional. Being conditional there was never payment in 2008. This was fatal, as Vanney Associates was a cash-basis taxpayer.  

And the Court agreed.

Think about this for a moment. The corporation was disallowed a 2008 deduction for the $815,000. Whereas the Court did not address this point, that bonus was included on Mr. Vanney’s 2008 Form W-2. He would have reported that W-2 on his 2008 individual tax return.

There is something seriously wrong with this picture.

I suppose Vanney Associates could amend its 2008 payroll tax returns. It could reverse that bonus, as well as the related withholding taxes. It would get a refund, but it would be amending multiple federal and state (and possibly local) payroll returns.

Mr. Vanney would then amend his personal 2008 tax return.

But that is assuming we are within the statute of limitations to amend all those returns.

When then would Vanney Associates get its $815,000 bonus deduction?

Your first response might be the following year: in 2009. I believe you would be wrong. Why? Because Mr. Vanney did not cash his check in 2009. The check remained a conditional payment in 2009. Same answer for 2010, 2011, 2012 and 2013. This case was decided September, 2014. Seems to me the first time Mr. Vanney could “cash” his check is this year – 2014.

Let me ask you another question: why didn’t the Court allow the (approximately) $350,000 in withholdings as a tax deduction? That check cashed, right?

I think I know. If the company did not “pay” the $815,000 in 2008, then there is no “bonus” for that withholding to attach to. From a tax perspective, the company overpaid its withholding taxes in 2008. The tax problem is that the overpayment is not a "deduction," as no payroll taxes were actually due. Payroll taxes attach to payroll, and there was no payroll. It was a "prepayment," waiting on Vanney to request a refund.

What is our takeaway?

Over the years I have heard more than one practitioner declare a tax outcome as “making no sense.” An unfortunate consequence is that the practitioner may not pursue a line of reasoning to conclusion. There are reasons for this, of course. First, an accountant has probably been exposed somewhere to generally accepted accounting principles. GAAP is a financial statement concept (think auditors, not tax accountants) and GAAP generally has some symmetry to it. The practitioner forgets that the IRS not bound by GAAP. The purpose of the IRS is to collect and enforce, and it does not consider itself bound by any symmetry should GAAP get in its way. The second is human: we respond to an absurd result by assuming we must have made a mistake in our reasoning. Many times we are right. In Vanney’s case, we were not.

What could Vanney have done?

Simple.

He could have had a line of credit in place. He could have cashed that check.

BTW I almost invariably recommend my cash-basis clients have a line of credit, even if they have no intention of using it. This costs them money, as the bank may charge a flat fee (say $100 or $250) annually for keeping the line of credit available. In addition, many a bank will require at least one draw over a month-end annually in order to keep the line open. This means there will be some interest expense.

Why do I recommend it? It is cheap insurance against nightmares like this.

Why Is The IRS Looking At Restaurant Tips (Again)?

I recently visited one of our clients. He owns a restaurant/bar. That is a tough business under the best of circumstances.  It is a business where almost all your profit comes from paying attention to the nickels and dimes.

Is there anything new out there, he asked?

We talked about the IRS’ recent interest in employee tips and gratuities. What is the difference?

• A tip is an amount determined by the patron

• A service charge is an amount agreed upon by the restaurant and patron

The IRS has long defined a tip as:

1. Paid free from compulsion
2. Determinable by the customer
3. Not dictated by the restaurant/employer
4. The recipient of which is identified by the customer

You may know that restaurant employees are paid a lower minimum wage, as a substantial part of their income is expected to come from tips. The employees are supposed to report their tips to the restaurant, which in turn withholds the employee’s share of the taxes. The restaurant also pays employer FICA on the base wages and tips.

The IRS has long believed that there exists substantial noncompliance with tip reporting by restaurant employees, and it has rolled out a number of “programs” over the years with the intent of increasing compliance. I have been through several of these, and my conclusion is that the IRS just wants money, even if it takes a work of fiction to get there. For example, if the IRS feels that the cash tip rate is too low, they will simply propose a higher rate, and call upon the restaurant (which then means me) to prove otherwise. Failure to do so means the restaurant is writing a tidy check for those actual taxes on proposed tips.

It is unfortunately too common that a server will be under-tipped if he/she is serving a large party. As a defense mechanism, many restaurants have imposed a service charge policy (also known as an auto gratuity or “auto-grat”) on that table or tables. The policy has worked fine for years.

But not for the IRS. They have recently clarified that they don’t believe auto-grats count as a tips, as the customer does not have the option of changing the amount or directing who is to receive it. I have to admit, the IRS has a point. However, are they making things worse by pressing the point? Let’s go through a few issues:

• The auto-grat will be on the server’s paycheck, rather than cashed out at the end of the shift. This is not a big deal in the scheme of things – except perhaps to the server.

• Restaurants are allowed to claim a tax credit for employer FICA paid on tips in excess of the amount necessary to get a server to minimum wage.

a.     Reduce the amount considered to be tips and you reduce the credit available to the restaurant.

b.     Meaning more tax to the restaurant.

• An auto-grat is considered revenue to the restaurant. Tips are not. States with a gross revenue tax – such as Ohio with its CAT – will now tax those auto-grats.

a.     Meaning more tax to the restaurant.

• Following on the same vein as (3), the customer will pay more sales tax, as the auto-grat is included in sales.

a.     Meaning more tax to the customer.

• How does one (I don’t know: say my accounting firm) figure out what rate of pay to use if the employee works overtime?

a.     Remember, service charges are resetting the base rate of pay.

b.     What if they server works tips and auto-grat tables over the course of one shift? Do they have one rate of pay or two? How would you even calculate this?

• Let’s throw a little SALT (State And Local Tax) into the mix: some states do not follow the federal definitions. For example, New York will consider auto-grats to be considered tips if they are separately stated on the receipt or invoice. New Jersey and Connecticut follow this line also.

a.     The good thing is that auto-grats will not be subject to New York sales tax.

b.     The bad thing is the accounting required to figure this out.

How long do you think it will be before the attorneys eviscerate some restaurant chain for violations of FLSA and overtime regulations? Remember, a service charge can change a server’s base pay, something a tip cannot do. On the other hand, the odds of overtime under the current economy are pretty low.

What about discrimination? How long before someone sues for being scheduled insufficient/excessive service -charge/non-service-charge shifts?

You know what I would do? I would do away with service charges altogether. I am not bringing that tiger to the party. Tips only at my restaurant.

Is it good for the servers? Since when does any of this care whether it is good for the employee?

It is about one thing: more money to the IRS. There may have been a time when I would have been sympathetic to the government’s position, but in this day of credit and debit cards, I am cynical about how much “unreported” income there is left to squeeze out of this turnip. I am also concerned that some restaurants may impose a service charge and then keep a portion of it for themselves rather than pass it along in full to the servers and others.  I am unhumored by the IRS, but I would be beyond unhumored by a restaurant that did that to its employees. 

CPAs Blow Their Own Tax Planning

Here is one of my favorite tax quotes thus far in 2012:

                That an accounting firm should so screw up its taxes is the most remarkable feature of the case.”

You can be sure that language isn’t going to make it to the firm’s brochure.

What happened? It started with compensation. There is a CPA firm in Illinois with three senior partners. These partners were making pretty good jack, enough so that they did not want the other partners to know the actual amounts. Considering that they are – you know, a CPA firm – that could be a tall order. So the three senior partners in turn started three other companies.

EXAMPLE: Let’s say you, me, and the guy in the elevator form three companies to hide our good fortunes from our partners. Let’s say company 1 paints and wallpapers CPA offices, company 2 shreds CPA firm files and company 3 provides door-to-door transportation to CPAs during busy season.  We will have our firm “pay” these companies for services and then we will split it up – behind the scenes, of course. Brilliant! What could go wrong?

The firm and tax case is Mulcahy, Pauritsch, Salvador & Co. They had approximately 40 employees and revenues between $5 and $7 million during the years at issue. The firm was organized as a C corporation. This technically made the partners “shareholders,” and the existence of a C corporation allowed for the possibility of dividends. The three shareholders had the following ownership:

                Edward Mulcahy                              26%

                Michael Pauritsch                            26%

                Philip Salvador                                  26%

For the years at issue they received W-2s as follows:

                                               

                                                              2001                       2002                       2003

                Mulcahy                           106,175                 103,156                 102,662                    

                Pauritsch                            99,074                  96,376                   95,048                         

                Salvador                           117,824                 106,376                 112,086

The firm paid consulting fees to the three companies of:

                2001                                   911,570                

                2002                                   866,143

                2003                                   994,028

The three companies then paid the three shareholders according to the hours each worked during the year.

The IRS comes in and asks the obvious question: what consulting services were provided?

Back to our example:

               

                IRS:  Steve, how many paints and wallpapers did you do?

                Me:  Er, none.              

                IRS:  How many files did you shred?

                You: None.

                IRS:  How many transportation clients did you drive?

                Elevator guy: None.

Truly folks, it does not require graduate school and years of study and practice in taxation to guess the IRS’ reaction. They disallowed the deduction and said that it was a disguised dividend to the three shareholders.

MPS is upset. If it is not consulting, they argue, then it is compensation.

The IRS says: please show us the W-2, the 1099, anything which indicates that this is compensation. MPS argues that it is “like” compensation. Heck, at the end-of-the-day the three companies paid the shareholders based on their hours worked. Doesn’t that sound like compensation? “Sounds like” is a childhood game, says the IRS, and is not recognized as sound tax planning. Surely MPS would know this, being a CPA firm and all.

MPS goes to Tax Court. MPS argues that its intent was to compensate, therefore the tax consequence should follow its intent. It brought in experts to prove that the shareholders were undercompensated, malnourished and in need of more sunshine. The Court listened to the argument, gave it weight and said the following:

               

There is no evidence that the ‘consulting fees’ were compensation for the founding shareholders’ accounting and consulting services. If they had been that—rather than appropriations of corporate income—why the need to conceal them?”

There is an important point here. There is a long-standing tax doctrine that you may select any form and structure you wish for a transaction, but once you do you are bound by that form and structure. The CPA firm was a C corporation and was transacting with its shareholders. A C corporation transacts in one of two ways with its shareholders: as compensation or as dividends/distributions. If the compensation was disallowed, you have the possibility of a dividend.

The Court did try to work with MPS. It noted that two tests for compensation are that (1) it must be reasonable and (2) it must be for services performed. This brought in the “independent investor test” of Exacto Spring, which precedent the Tax Court had used in the past. The idea is easy: what return would you need on your investment to pay someone a certain amount of compensation?

EXAMPLE: A hedge fund manager receives 20% of the fund’s capital gains. This is referred to as the “carry.” Why would an investor agree to this? What if the manager was returning 20% to 30% to you annually – even after deducting his/her 20%? Would you agree to this? Uh, yes.

So the Court looks at MPS’ taxable income for the years at issue:

                2001                                    11,249

                2002                                   (53,271)

                2003                                      -0-

The Court observed that the firm had money invested in its offices, technology, furniture, etc. It noted that – according to normal market expectations – that invested capital required a rate of return. It did not think that taxable income of zero was a reasonable rate of return. The Court was aware that the firm was zeroing-out its taxable income by paying consulting fees. This indicated to the Court that the firm was not concerned with a reasonable return on invested capital. MPS could not meet the Exacto standard. Without meeting that standard, the Court could not weave “compensation” out of “consulting fees” whole cloth. This was an unfortunate result because the firm received no deduction for dividends but the shareholders had to pay taxes on them. That is the double taxation trap of a C corporation. It is also a significant reason why many planners – including me – do not often use C corporations.

Let’s go tax nerd for a moment. I believe that MPS would have substantially prevailed had it deducted the payments as compensation (and included on the W-2) and the IRS in turn argued unreasonable compensation. Why? Because I believe the Court might have disallowed some of the compensation but permitted the rest. MPS instead came from the other direction: it had to argue that the payments were compensation rather than something else. This changed the dynamic, and it now became an all-or-nothing argument. MPS lost the argument and got nothing.

MPS appealed the case but with the same result. It is here that the Seventh Circuit Court of Appeals gave us the quote:

                That an accounting firm should so screw up its taxes is the most remarkable feature of the case.”

The taxes were almost $980,000. Remember, the personal service corporation lost its deduction (and paid taxes) and the shareholders received dividends (and paid taxes). The penalties alone exceeded $190,000.

MY TAKE: This tax strategy borders on the unforgivable. There were so many ways to sidestep this result.  One way would have been working with disregarded entities, also known as single-member LLCs. The three shareholders performed services for and received W-2s from the accounting firm. The Court however did not agree that their three companies performed services for the accounting firm. A disregarded entity would have avoided that result by having the member’s activities attributed to the SMLLC.

How could the firm pay entities that provided no services? Was nobody in that tax department paying attention? I presume they were steamrolled by the three senior shareholders.

I was brought up with the technique of draining professional service corporation profit to zero by using year-end bonuses. That technique has frayed over recent years as new doctrines – such as Exacto Spring– have appeared. It is as though these MPS guys were stuck in a time warp.

Another way, and the obvious, would be to have just paid the founding partners more compensation. Yes, that would have given away the amount of actual compensation to the senior partners. Then again, this case has also given away that information.