Q:

Subject: SE Tax Avoidance Strategy

Hello, Tax Guru. I'd like to become one myself. Forgive me for the length of this email, but I wanted to present what I think are all the relevant facts so that you could give me your expert opinion. I've really enjoyed reading all the articles you have on your website and I, too, feel that we give too much of our money away to Uncle Sam because of fear. But I must confess, I have a little fear because it's just me and my own little mind. Here goes.My wife and her unrelated partner have two businesses. A lawyer suggested they set one up as an LLC and the other as an S-Corp. Both of these are split 50-50.

The LLC bought a commercial building (28K sqft) and pay a mortgage. The LLC leases this building to the S-Corp. Through an informal "triple-net-lease?", the LLC requires S-Corp to pay the RE taxes and insurance on the building.

The S-Corp is in the Art Business. They rent out space to artists, usually with 6-mos to 1-yr leases. The rent out wall space a month-at-a-time. They rent out floor space for weddings/receptions, corp meetings, karate instructors - you name it. They try to rent the air above the building. The S-Corp also sells art for the artists when they are not there, taking anywhere from a 10-30% commission, plus credit card fees for these sales. Both owners put in at least three days a week into the biz.

In the beginning, Oct 2003, both partners put money in the biz to get rolling. An accountant told me to put $100 each into Quickbooks (QB) equity accounts called Owners Capital. The rest of the money he had me put into accounts called Loans From Owner. I set these up as Equity accounts, but maybe they should be liabilities, short-term or long? I guess you know by now I do the books and taxes for the babes (they don't like to be called ladies because that implies old).

Up until now, the owners have been taking 2K each out of the businesses. I book these by reducing the Loan From Owner accounts. Now, one of the partners has gotten her original investment out, so we're talking about salaries, etc.

The S-Corp, in my mind, is never going to generate enough money to pay wages and dividends. I know from reading your website and others that wages are subject to FICA and dividends not.

Then I had a thought that the S-Corp may be in the rental business and thus the income would not be subject to SE/FICA tax. But I now think that because substantial services are rendered to the artist tenants and the hours the owners put in are relatively substantial, the S-Corp is really an active activity and not a passive rental activity. More like Property Management, I guess, which I read is also an active activity.

Next thought was that LLC is truly a rental, passive activity and that money earned in the LLC is not subject to SE tax. If this is true, then why not reduce S-Corp's income down toward zero by increasing the rent paid to the LLC?

The only potential flaw in this strategy, in my mind, is that the IRS could say this structure is only for the purpose of evading SE taxes because the rent amount is "unreasonable" and exorbitant. To that end, we're going to see what the going commercial lease rate is in this city per square foot.

There you have it. If you haven't yet gone to sleep or deleted the email - what do you think about this?

Just as an aside, I've always done my own taxes and have been aggressive (like hiring my wife in my IT consulting business and deducting all health expenses), borrowing money from my IRA late in the year and having 99% of it withheld to avoid penalties for not paying estimated income tax during the year (is this a cool trick or what?!) and have done lots of reading. I'm a math major and always interested in numbers (and saving taxes). Since I got outsourced to India (I hope those six guys are happy) about the same time as this Art business, I decided to professionally prepare taxes for people last year (actually made a few hundred dollars) and I'm doing it again this year.

Thank you very much for listening and I would appreciate any advice you could give me on anything herein.

Sincerely,


P.S. When the Babes take non-wage money out of the biz and the Loans From Owner account have already been paid back, what is this disbursement called and where do I book the Debit in QB? (Obviously I'm a self-taught bookkeeper, too!).

A:

I don't want to rain on your parade here, but working with LLCs and S corps is not something you can learn as you go on your own without making a lot of costly mistakes. You really need to be working with a competent professional tax advisor who has experience with coordinating these kinds of things. As you pick up on what s/he is advising, you can gradually take on more of the tasks yourself.

If you are serious about becoming a professional tax preparer, you should consider doing some tax season work for an established CPA or other tax prep service, where you can learn how to handle various kinds of tax issues. There is no substitute for real life experience in the tax profession, and most tax services are desperate for busy season help. I used to have several CPAs work for me during tax season back in my offices in the PRC. I taught them how to work with corporations and partnerships, skills they were able to take out on their own.

Good luck.

Kerry Kerstetter

Follow-Up:

I guess I really didn't expect an answer for free. I'm already professionally preparing taxes anyway and have always learned everything I know from doing it myself, whether it's computer programming technology or taxes. You're right that I should be hanging around seasoned pros, which is why I sent the email to you and am constantly seeking other opinions – face-to-face, emails and by researching on the internet.

Anyway, I'm pretty confident in my assessment re: avoiding SE tax in the partnership. I found some more ammunition at the following website.

Thought you might be interested in it.

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 1/29/2006 02:23:00 PM Send this post: