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.

Has Maryland Been Caught Reaching Into The Tax Cookie Jar?

There are several states that impose a county tax in addition to a state income tax. Maryland is one of those states, and it has attracted attention to itself with the Maryland v Wynne. This case will soon go before the Supreme Court, which will decide whether Maryland has run afoul of the Commerce Clause of the Constitution.

That sounds esoteric.

It is not that bad, though, as long as we stay out of the weeds.

Let’s start this tax tale with an S corporation shareholder. His name shall be Clark. You may remember that “S” corporations do not pay tax (except in rare circumstances). Instead the corporation “passes through” its income to its shareholders, who in turn report their proportionate share of the corporate income on their individual tax returns.

Let’s say that Clark and his wife live in Maryland.

Let’s say that the S corporation does business both inside and outside Maryland. This means that Clark gets to pay income tax to all the states where the S corporation does business. This happens all the time, much to the chagrin of the tax professional who gets to prepare the paperwork.

Clark's corporation does business in North Carolina,. Clark pays tax to North Carolina (remember: the shareholder pays the income tax for an S corporation). Clark then takes a tax credit on his Maryland income tax for the taxes paid North Carolina. As long as North Carolina is not more expensive than Maryland, there is no-harm-no-foul, except for the professional fees to sort all this out.

And there we encounter the rub.

You see, Maryland divides its tax between a “state” tax and a “county” tax. And it makes a difference.

Enter Brian and Karen Wynne (the Wynnes). They are shareholders in Maxim Healthcare Services, Inc., an S corporation that files returns in 39 states. They themselves live in Howard County, Maryland. When they filed their 2006 Maryland tax return, they claimed taxes that they paid the other 38 states as a credit against their Maryland tax.

And the Maryland State Comptroller changed their numbers and sent them a bill. This lead to Appeals, then Maryland Tax Court, followed by the Circuit Court and – now - the Supreme Court.

The Comptroller’s argument? The Wynnes could not claim a credit for taxes paid other states against the county portion of the Maryland tax. Maryland changed its law in 1975, which was like … a really, really long time ago. Why are we even going there? How can one reasonably offset a state tax against a county tax?

I have to disagree.

Take two people living in Maryland. Have one invest in an S corporation that does all its business inside Maryland. Have the other invest in an S that does all its business in Maine. Unless the other state’s income tax rate is less that the Maryland state income tax rate, the first investor will pay less tax than the second investor. Tell me, how is that fair? Is the state not burdening interstate commerce by taxing the second investor (who invested outside Maryland) more than the first (who invested exclusively within Maryland)? And there you have the core of the challenge under the Commerce Clause.

Let’s use some numbers to make this concrete.

Say that the S corporation income allocable to Maine is $1,000,000. 

(1) The top Maine income tax is 7.95%, so let’s say the Maine income tax will be $79,500.

(2) The top Maryland state income tax rate is 5.75%, so the state income tax will be $57,500.

(3) The Maryland county tax rate is 3.2%, so the county income tax will be $32,000.

(4) This makes the total tax to Maryland $89,500. This exceeds the Maine tax by $10,000.

One offsets the $79,500 paid Maine against the $89,500 otherwise paid Maryland, and it all works out, right?

This is where you get hosed. According to Maryland, you cannot take the excess $22,000 (that is, $79,500 – 57,500) and claim it against the county tax. After all, it is a …. county tax. It does not make sense to offset Maine’s state tax against Maryland’s county tax.

Uhhh, yes it does.

Let us play games with this, shall we? I live in Kentucky, for example. Kentucky has 120 counties. Only Texas and Georgia have more counties, and I wonder why anybody would want more. I understand this goes back to rural times, when travel was more arduous. Nowadays it doesn't make much sense. How much money is wasted on duplication of facilities, county commissions, staff and services that accompanies all these counties?

Let’s say that Frankfort finds itself in a financial bind. Some hotshot realizes that disallowing a resident credit to Kentuckians with income outside the state would help to bridge that financial bind. Said hotshot proposes to carve the Kentucky state income tax into two parts: the state part and the county part. When the county part arrives, Frankfort will just pass it along to the appropriate county. Considering that Frankfort is shuttling monies to the counties already, all one has done is rearrange the furniture.

Except that Frankfort now keeps more money by disallowing a resident credit against all those county taxes. After all, it does not make sense to allow a state tax credit against county tax, right? Pay no attention that Frankfort itself would have created the distinction between state and county income tax. Why that was ... a really, really long time ago. Why are we even going there?

Could Maryland possibly, just possibly, be cynical enough to be playing out my scenario?

I’ll bet you a box of donuts that they are.

So Maryland v Wynne is before the Supreme Court, which will review whether Maryland has violated the “dormant” Commerce Clause. The Maryland Association of Counties has joined in (I will let you guess on which side), and the case has attracted considerable attention from tax practitioners and government policy wonks. There is, for example, some interesting tension in there between the Due Process and Commerce Clauses, for those who follow such things.

The case is scheduled for hearing the second week of November.

What New Paperwork Does An Employer Have Under ObamaCare?

You are an employer. You are a bit unclear on the new paperwork you need to file to comply with the Affordable Care Act (ACA), also known as Obamacare.  As we go into the fourth quarter of 2014, this issue is taking on greater urgency.

You are completely normal. Many companies, including their advisors, are in the same situation. The rules are new, complicated and – and in some cases – repetitively postponed. Are you supposed to do anything different when you send out the 2014 Forms W-2 in early 2015, for example?

The easiest way to make sense of this is to divide employers into three categories. Why? Because each employer category has its own rules.

The first category is an employer with less than 50 employees (technically, “full-time equivalents”). The Government is quick to point out that this encompasses 96% of all employers, although of course it encompasses a much smaller percentage of employees.

If this is you:

·        You do not have to do anything different with your 2014 W-2s.

·        You are not required to provide health insurance coverage to your full-time employees.

·        You are not required to pay an employer penalty.

·        This is true for 2014, 2015 and all years thereafter.

So, if you are an employer in this category you may or may not offer health insurance to your employees, but this remains a business decision. You are not required to do anything – including filing any new paperwork – to be in compliance with the ACA.

Let’s make our second category employers with 100 or more employees. Why? Technically the original ACA divided employers into two groups: under 50 employees and 50 employees and over. There have been numerous regulatory changes to the law, and one change divided employers further into 50-but-99-and-under employees and 100-employees-and-over.

If this is you… you need to get ready to make changes. 

·         You do not have to do anything different with your 2014 W-2s (fortunately). However, see below for your 2015 W-2s, which you will file in 2016.

·        You will have to provide health insurance to your employees starting January 1, 2015.

o   The ACA itself defines what is acceptable insurance, referred to as “minimum essential coverage.”

§  It also has to be “affordable.”

§  These are areas you want to review with your insurance agent or benefits consultant.

o   There is a sub-rule in here that may or may not impact you. The ACA originally required employers to cover 95% of their full-time employees in 2015. That rule has been changed. You are now required to cover 70% of your full-time employees in 2015 and then 95% for 2016 and later years.

·        You will be required to pay an employer penalty if you don’t provide minimum essential and affordable health insurance.

o   Interestingly enough, this penalty will not appear on your business income tax return. The IRS has to wait until your employees have filed their individual tax returns, then match any information provided to the IRS by the health-care exchanges and by you as the employer.

o   This is expected to be in the form of an IRS notice. You will be given time to respond, after which the IRS will issue another notice and demand for payment.

o   You can therefore expect that this notice will not go out until the end of 2016 or more likely in 2017. This is approximately one-year after you paid the underlying payroll itself.

§  We should expect that this penalty will also eventually be required to be paid via estimated tax payments.

·        You will have new paperwork when you file your 2015 year-end payroll tax returns in 2016. These are known as the “Section 6056 rules” and are in place to provide employees the information they need to calculate their ACA penalty, if any, on their individual tax returns.

o   You will file Form 1095-C Employer-Provided Health Insurance Offer and Coverage. A copy of this goes to your employee. It will also go to the IRS with its transmittal – Form 1094-C Transmittal of Employer-Provided Health Insurance Offer and Coverage Information Returns.

§  It is therefore similar to sending the W-2s with their transmittal Form W-3.

o   By the way, filing Forms 1095-C and 1094-C are optional for 2014 (to be filed in 2015). The IRS has said it would like you to file and consider them a “trial run,” but you do not have to.

o   But they are mandatory for 2015 (to be filed in 2016).

Finally, our third category: employers with 50 to 99 employees.

This category is different because in February, 2014 the IRS segregated what it called “midsized employers” (that is 50 to 99 employees). These employers received a one-year delay before facing ACA penalties – until January 1, 2016.

The “large employers” (100-or-more employees) received no such break and have to comply starting January 1, 2015.

If this is you… you need to get ready to make changes. 

·        You do not have to do anything different with your 2014 W-2s (fortunately). However, see below for your 2015 W-2s, which you will file in 2016.

·        You will have to provide health insurance to your employees starting January 1, 2016 (not 2015).

o   There is an interesting requirement, though.

§  You will have to certify – for 2015 - that…

·        You have not reduced your workforce to qualify for this relief; and

·        You have not materially reduced or eliminated any health coverage.

§  This certification is on Form 1094-C, which you will be filing anyway.

o   Otherwise, the requirements are the same as 100-and-more employers, as discussed above.

·        You will have an employer penalty for not complying, but you do not have to comply until January 1, 2016. That is, you have one additional year to comply (as compared to 100-and-more employers).

o   Otherwise, the requirements are the same as for 100-and-more employers, as discussed above.

·        You will have new paperwork when you file your 2015 year-end payroll tax returns in 2016. These are known as the “Section 6056 rules” and are in place to provide employees the information they need to calculate their ACA penalty, if any, on their personal tax returns.

o   You will file Form 1095-C Employer-Provided Health Insurance Offer and Coverage. A copy of this goes to your employee. It will go to the IRS with its transmittal – Form 1094-C Transmittal of Employer-Provided Health Insurance Offer and Coverage Information Returns.

§  It is therefore similar to sending the W-2s with their transmittal Form W-3.

o   By the way, filing Forms 1095-C and 1094-C are optional for 2014 (to be filed in 2015). The IRS has said it would like you to file and consider them a “trial run,” but you do not have to.

o   But they are mandatory for 2015 (to be filed in 2016).

You now have a high-altitude view of what you, as an employer, are to do to comply with the ACA filing requirements. Unless you are a less-than-50 employer, you will have additional reporting requirements. Please consider that some of this information is not presently collected as part of your routine accounting process. Both 50-to-99 and more-than-100 employers should review that new procedures will be in place to collect the information needed to complete these new ACA tax forms. Whereas these forms will not be filed until early 2016, they will contain information going back to January, 2015.