Employment Tax Audit

[LCP]

Large Schedule C is undergoing an audit of his 2010 Form 941...that's exactly what the Letter 3850 says even though he didn't file Form 941. He has employees paid thru a reputable employee leasing company.

Auditor also requested 1099 info.

For obvious but no particular reason, we want to avoid a full audit of his Schedule C as well as his 1040. He uses a Quickbooks file for all business and personal activity. It is well done and the categories clearly reflect the dictinctions between the two.

Any suggestions?

[JohnH]

Print out whatever supporting documentation you need by exporting the relevant transactions to Excel. Then tweak the Excel spreadsheet to give them only what they request - nothing more/nothing less.

Is your client showing mhimself as one of the employees paid through the Employee Leasing Company? Never thought about this type of situation before, but that could be a problem.

[LCP]

He is....good catch.

[Koss]

Wages vs. Schedule C

It is definitely incorrect for a sole proprietor to pay wages to himself.

But if you correct the problem, the result should be a wash.

You would have to unwind all of the withholding, including the employer's share of FICA, and put the income back on Schedule C. It would increase his self-employment tax, but he would get a refund of the tax withheld.

Okay... now that I'm thinking about it...

You're pulling one brick out of the wall, and it could cause part of the wall to collapse. Backing out the improper wages might have some indirect consequences because it will increase his AGI. So it could impact things like the child tax credit, IRA deduction, retirement savings credit, education credits... theoretically, anything that is reduced or phased out based on AGI.

It could go either way. Correcting the error might actually reduce his tax liability. For example, under the right conditions, an increase in AGI will increase the amount of EIC.

Or it could be a disaster. Might trigger AMT...

BMK

[JohnH]

It's hard to visualize all the potential fallout from this. Maybe everything's close to a wash with SE Tax vs SocSec/Medicare being deducted/matched on his wages.

If he has Medical Insurance on his employees and if the premiums are high, that could be significant. If there's a retirement plan through the Employee leasing company and he participates, things could get much more problematic. (taxes and penalties on unauthorized contributions, etc ?)

How about state unemployment tax? If he reclassifies, he might not be able to claim a refund of SUTA paid on his earnings.

The major factor might be how large his salary & benefits especially salary-based benefits) are in comparison to other employees. If he's the chief beneficiary of the perks, he probably has a bigger problem.

On the other hand, he might be able to pressure the Employee Leasing Company to help out with his tax problems. After all, they should at least have procedures in place to obtain the info necessary to avoid this situation - unless he mislead them in some way.

[LCP]

I hear you but I wonder if there might be a distinction between being an employee of your own sole proprietorship and leasing yourself.

I'll have him contact them.

[JohnH]

I haven't run across this before, but I woudl be VERY surprised to learn that a sole proprietor can be an employee of a leasing company which leases his services back to his company. Otherwise, all leasing companies would be touting this as an advantage because it could be a huge benefit for some sole proprietors.

You haven't mentioned whether there are other employees, or how his pay & benefits stack up against the other employees, if there are any. But if he is the only employee (or the only significant employee), I can see this turning into a big mess.

Possibly it's the reason for the audit in the first place. If that's the case, you should be aware of it because it could have a significant impact on how much you decide to participate in the audit.

[Lion]

One of my clients received that letter a few weeks ago. It's a trust filing Form 1041 with no employees ever. Grandparents set up some investments in a trust when grandsons were born. Now boys are in college and drawing down the investments. Over the years, Form 1041 reported interest and dividends and some capital gains, mostly losses, but never wages. Only one of the two trusts (two boys in the family) received the letter. I called the IRS Payroll Division listed on the letter and was told to respond with never having and not having employees and never filed Form 941. I had trustee/mom do that, and we haven't had any further correspondence.

[Koss]

Sole Proprietor

LCP wrote:

hear you but I wonder if there might be a distinction between being an employee of your own sole proprietorship and leasing yourself.

I'll have him contact them.

And JohnH wrote:

I haven't run across this before, but I would be VERY surprised to learn that a sole proprietor can be an employee of a leasing company which leases his services back to his company. Otherwise, all leasing companies would be touting this as an advantage because it could be a huge benefit for some sole proprietors.

IRS Publication 334 says:

You cannot deduct your own salary or any personal withdrawals you make from your business. As a sole proprietor, you are not an employee of the business.

That's not an authoritative source, but the IRS position is pretty clear.

Assuming that this is an accurate interpretation the law, employee leasing would not be a viable "workaround." It's a classic case of form over substance.

BMK

[LCP]

It's a classic case of form vs substance I will give you that.

If it was so clear cut then maybe the IRS would advise us that we should enter/deduct the substance of the transaction (payroll, taxes and benefits) rather than the form (leased employees). Heck....maybe they have.

[BHoffman]

In "Masat v. Commissioner":

http://scholar.google.com/scholar_case?case=7930142239146728023&q=t.c.m.+1956-281&hl=en&as_sdt=2,3&as_vis=1

"...the Commissioner cites a Memorandum Opinion of this Court, Estate of Nottingham v. Commissioner [Dec. 22,090(M)], T.C. Memo. 1956-281, for the proposition that a sole proprietor cannot deduct amounts paid to himself as compensation for labor unless such amount is restored into income by reporting the compensation. While acknowledging that the petitioners did report the $250 as income on their Schedule C for Minute Man, the Commissioner argues that no income was in effect reported since Minute Man reported a loss in 1976 and section 183(b) allows the petitioners to deduct the losses of Minute Man to the extent of gross receipts reported by Minute Man. The Commissioner contends that allowing the labor deduction would produce a result not contemplated by the Court in Estate of Nottingham. We do not agree. We believe that the $250 was actually paid for services rendered. Such amount was properly reported by the petitioners on the Schedule C for Minute Man. Our holding that Minute Man was an activity not engaged in for the purpose of making a profit means that the petitioners may only deduct the losses of Minute Man to the extent of gross receipts. The Commissioner has cited no authority which supports his contention that the result he advocates is required by statute or case law. The petitioners have carried their burden of proof and established that the $250 was paid for services rendered. Accordingly, we allow them a $250 labor deduction for Patchwork Place in 1976."

Here is a link to Nottingham v. Commission:

http://scholar.google.com/scholar_case?case=4289862976275346347&q=t.c.m.+1956-281&hl=en&as_sdt=2,3&as_vis=1

Under IRC 414, leased employees are treated as employees of the leasing company for everything except retirement and fringe benefits.

I've read some discussions that suggest reporting Leased Employee Expense as a misc. deduction on Sch C. Probably not a bad idea. Perhaps showing an amount as "Wages" and no 941 could ring a bell.

I'm wondering if the IRS will drop the audit if they are informed that a leasing company was used. I'd include a letter from the leasing company (on their letterhead) stating their dates of service to the client.

[Koss]

Masat v. Commissioner

This is an interesting case, but I don't think it's on point.

The case does not involve employee leasing.

The case has a bizarre fact pattern. Husband and wife filed a joint return. Husband has a Schedule C for his business; wife has a Schedule C for her business. Wife paid husband for services he provided to her business. She took an expense on her Schedule C, and he reported the income on his Schedule C.

Although the opinion does not explicitly say this, it does not appear that the amount was paid as wages. She took it as a contract labor deduction, and he reported it as self-employment income.

The amount in question was only $250.00.

I don't think this case even remotely touches on the question of whether a business that is a sole proprietorship can pay wages to the individual who is the owner of the sole proprietorship. It addresses the rather narrow question of whether a sole prop owned by one spouse can pay the other spouse for labor, in a context where the other spouse is arguably operating their own business.

With all that being said, BHoffman does make an interesting point about the obvious red flag that goes up if you report wages on Schedule C, but do not file a 941. If you're really lucky, that may in fact be the only issue the IRS is looking at.

BMK

[BHoffman]

Hi Koss - I think the relevant thing about the court case was especially

"...a sole proprietor cannot deduct amounts paid to himself as compensation for labor unless such amount is restored into income by reporting the compensation."

We've seen posts here regarding improper W2 wages issued to sole proprietors and partners. What to do after the fact? Maybe nothing is OK and advise the client to correct that going forward. Maybe leave it alone if the client just cannot or will not make estimated payments and a payroll check is the only way he's going to get it done. Seems like the tax court is happy as long as the income (and FICA/SE tax) is reported. Bad form (and I'm not advocating it), but if the taxes are paid I think the substance argument is pretty strong.

Retirement and/or fringe benefits are a different story. I think mixing that into the W2 bad form would cause trouble.

Sec 414 allows the sole proprietor to be treated as the employee of an employee leasing company for WAGES, but not for retirement and/or fringe benefits.

I'm still hoping the OP can resolve his client's audit with a phone call and a letter from the leasing company. Good luck!