Washington State: Lowest Marginal Tax Rates for Pass-Through Businesses

According to the Tax Foundation, Washington State has the lowest marginal tax rate for "pass-through businesses." A "pass-through" business includes sole proprietors, S Corporations, limited liability companies (LLCs) and partnerships.

The Tax Foundation calculates Washington State's "Top Marginal Tax Rate" for Sole Proprietorships and Partnerships (including LLC's which have no made an "S election") at 42.6%. It calculates the "Top Marginal Rate" for S-Corporations at 39.6%.

The rates calculated for Idaho are 48.2% for Sole Proprietorships and Partnerships and 45.3% for S-Corporations. The rates calculated for Oregon are 49.8% for Sole Proprietorships and Partnerships and 46.8% for S-Corporations. 

The reason that Washington rate is lower than other states is because Washington State does not have an income tax.

Additionally, the Tax Foundation reports that 95% of businesses nationwide are "pass-through" entities. This means that Washington State has a significant edge over other states. 

The Tax Foundation's report can be found here.

S-Corporation shareholder basis of indebtedness: new proposed regulation.

The IRS has today issued proposed regulations that clarify the requirements for a shareholder to obtain "basis indebtedness" for the purposes of increases losses, or deductions.

Background: Generally, deductions and losses of an S-Corporation are passed through to its shareholders to the extent of each shareholder's adjusted basis in his stock. § 1366(d)(1) provides that a shareholder can take losses and deductions to the extent of the adjusted basis of the shareholder's stock and adjusted basis of any indebtedness (basis of indebtedness) of the S-Corporation to the shareholder. Court cases have interpreted these provisions of § 1366 as requiring the investment be "an actual economic outlay" by the shareholder to the S-Corporation in order for the shareholder to qualify the loan for "basis of indebtedness." E.g. Maloof v. Comm'r, 456 F.3d 645, 649-650 (6th Cir. 2006); Spencer v. Comm'r, 110 T.C. 62, 78-79 (1998), aff'd without published opinion, 194 F.3d 1324 (11th Cir. 1999); Hitchins v. Comm'r, 103 T.C. 711, 715 (1994); Perry v. Comm'r, 54 T.C. 1293, 1296 (1970). Due to ongoing disputes on what qualifies for basis of indebtedness, the IRS is proposing this regulation that will provide greater certainty to taxpayers.

Proposed Reg: The proposed regulation requires that the loan transaction in question must represent "bona fide" indebtedness of the S-Corporation to the shareholder. This means, that the shareholder would not need to otherwise satisfy the "actual economic outlay" doctrine for purposes of § 1366(d)(1)(B). The IRS will look to general Federal tax principles (many of which were developed outside of § 1366) to determine whether or not the indebtedness is "bona fide." The proposed regulation also confirms that shareholder guarantees of S-Corporation debt do not result in basis of indebtedness.

Effective Date: The regulation (as proposed) will only apply to loan transactions made after final regulations are adopted.

S-Corporation Payroll Tax Dodge

The Eighth Circuit held yesterday that an experienced accountant must treat $91,044 as wages rather than the $24,000 that he claimed. In 2002, the accountant wage income of $24,000 but took home $203,651 in Subchapter S Dividends.

By setting his "wage" compensation, he only paid FICA employment taxes (combined rate of 15.3%) on the $24,000 wage and not on any of the additional $203,651 he took home as a "dividend." He was the corporation's sole shareholder/director/employee.

The court held that the $24,000 wage was exceedingly low and imputed to him a reasonable wage of $91,044 for the years in question.

Wages, to which FICA is applicable, are defined as "all remuneration for employment" IRC § 3121(a). The Court stated that special scrutiny is given to salaries paid to employees that control a corporation. The Court applied a substance over form analysis and determined that the taxpayer's experience, education and business revenue necessitated at least a $91,044 reasonable wage. Courts look beyond a business's tax reporting and looks at the entirety of the business's transaction with that employee to determine whether or not dividend income should be recharacterized as wage and FICA applied to it.

Conclusion: At the end of the day, a corporation should its service employees wage income that is reasonable remuneration for services performed. A service Corporation that has only one shareholder/director/employee cannot get away with paying its sole employee a wage that is far below reasonable.