Wednesday, August 31, 2011

Natural Disasters and Your Taxes

Hit by Irene? You might have a tax deduction or an unexpected tax gain.


While Hurricane Irene turned out to be milder than expected, it still caused deaths, injuries and an estimated $5 billion to $7 billion in property damage. And Irene was not the only big problem this year. In the spring we had devastating tornadoes in Missouri and widespread flooding in the Midwest. The sad truth: natural disasters occur every year in the U.S. because this is a big country. If you're unlucky enough to suffer a disaster-related casualty, here's what you need to know about the federal income tax implications.

Deductions for Personal Casualty Losses

Theoretically, our beloved Internal Revenue Code allows you to claim an itemized deduction on your Form 1040 -- for personal casualty losses that are not covered by insurance. Exactly what is a casualty loss? It's when the fair market value of your property or asset is reduced or wiped out by a hurricane, flood, storm, fire, earthquake or volcanic eruption (not to mention sonic boom, theft, or vandalism).

In reality, however, many disaster victims won't qualify for any personal casualty loss write-offs because of the following two rules. First you must reduce your loss by $100. Then you must further reduce the loss by an amount equal to 10% of your adjusted gross income (AGI) for the year. Say you incur a $10,000 personal casualty loss this year and have AGI of $80,000. Your write-off is a puny $1,900 ($10,000 - $100 - $8,000). You get absolutely no tax break if your loss is $8,100 or less, and you have no chance at all if you don't itemize.

But let's assume you do have a 2011 deductible personal casualty loss after the two reductions. If the loss was caused by a disaster in a federally declared disaster area (more on that later), a special rule allows you to claim your rightful deduction either this year or last year. For example, victims of Hurricane Irene can file amended 2010 returns and claim their losses last year. And if you extended your 2010 return to October 17, 2011, you can claim the loss on your original return for last year filed by that date. This rule allows you to get some immediate tax savings instead of having to wait until 2012 when you finally get around to filing your 2011 return. Remember: this special rule is only available for losses in federally declared disaster areas. You can find a by-state listing of these areas on the Federal Emergency Management Agency (FEMA) website at .

Deductions for Business Casualty Losses

If you have disaster-related losses to business assets, you don't have to worry about the $100 reduction rule or the 10%-of-AGI reduction rule. Instead, you can deduct the full amount of your uninsured loss as a business expense. As with personal casualty losses, you have the option of claiming 2010 deductions for 2011 losses that occur in a federally declared disaster area.

Watch Out: You Might Have a Taxable Gain

When you have insurance coverage for disaster-related property damage (such as under a homeowners, renters, or business policy), you're almost as likely to have a taxable gain as a deductible casualty loss. Why? Because if the insurance proceeds exceed the tax basis of the damaged or destroyed property, you have a taxable profit as far as the Internal Revenue Service is concerned. This is the case even when the insurance doesn't compensate you for the full pre-casualty value of the property or asset. These insurance-caused gains are called involuntary conversion gains (because your asset is suddenly converted into cash insurance proceeds without you having any say about it).

If you do turn out to have an involuntary conversion gain, it must be reported on your tax return unless you: (1) make sufficient expenditures to repair or replace the property and (2) make a special tax election to defer the gain. If you make the election (you generally should), you have a taxable gain only to the extent the insurance proceeds exceed what you spend to repair or replace the property. The expenditures for repairs or replacement generally must occur within the period beginning on the date the property was damaged or destroyed and ending two years after the close of the tax year in which you have the involuntary conversion gain.

Special favorable rules apply to involuntary conversion gains resulting from casualties in presidentially declared disaster areas (the rules are way too complicated to adequately explain here).

For more details on disaster-related casualties and your taxes, see IRS Publication 547 (Casualties, Disasters, and Thefts) at If you have big losses or big insurance payments, consider hiring a tax pro (like me) to deal with the complicated rules and prepare your return. It could be money well-spent.

Friday, August 26, 2011

Keep Good Records Now to Reduce Tax-Time Stress

You may not be thinking about your tax return right now, but summer is a great time to start planning for next year. Organized records not only make preparing your return easier, but may also remind you of relevant transactions, help you prepare a response if you receive an IRS notice, or substantiate items on your return if you are selected for an audit.

Here are a few things the IRS wants you to know about recordkeeping.

1. In most cases, the IRS does not require you to keep records in any special manner. Generally, you should keep any and all documents that may have an impact on your federal tax return. It’s a good idea to have a designated place for tax documents and receipts.

2. Individual taxpayers should usually keep the following records supporting items on their tax returns for at least three years:

• Bills;

• Credit card and other receipts;

• Invoices;

• Mileage logs;

• Canceled, imaged or substitute checks or any other proof of payment;

• Any other records to support deductions or credits you claim on your return.

You should normally keep records relating to property until at least three years after you sell or otherwise dispose of the property. Examples include:

• A home purchase or improvement;

• Stocks and other investments;

• Individual Retirement Arrangement transactions;

• Rental property records.

3. If you are a small business owner, you must keep all your employment tax records for at least four years after the tax becomes due or is paid, whichever is later. Examples of important documents business owners should keep include:

Gross receipts: Cash register tapes, bank deposit slips, receipt books, invoices, credit card charge slips and Forms 1099-MISC;

Proof of purchases: Canceled checks, cash register tape receipts, credit card sales slips and invoices;

Expense documents: Canceled checks, cash register tapes, account statements, credit card sales slips, invoices and petty cash slips for small cash payments;

Documents to verify your assets: Purchase and sales invoices, real estate closing statements and canceled checks.

For more information about recordkeeping, check out IRS Publication 552, Recordkeeping for Individuals, Publication 583, Starting a Business and Keeping Records, and Publication 463, Travel, Entertainment, Gift, and Car Expenses. These publications are available at or by calling 800-TAX-FORM (800-829-3676).

If you need help with your recordkeeping (bookkeeping and accounting services), please contact me (Ken Reid) directly at 773-792-1910 or by email at

Thursday, August 25, 2011

Higher Business Taxes May Follow Treasury’s Definition of Small

By Andrew Zajac

Aug. 18 (Bloomberg) -- A new definition of what constitutes a small business being considered by the Treasury Department is raising concerns among some closely held companies that it’s a step toward requiring them to pay corporate taxes.

The proposed definition, included in an Aug. 9 Treasury report, places the upper limit for a small business at $10 million in annual gross income or deductions. Currently, there is no size limit on what constitutes a small business for purposes of tax policy discussions.

The parameters could affect larger, closely held businesses, including those organized as partnerships, S corporations and limited liability companies. Such firms are called flow-through entities because profits flow directly to their owners, who pay personal income tax without first being subject to corporate tax. Large investment firms, including D.E. Shaw LP of New York and Renaissance Technologies Corp. of East Setauket, New York, and major law firms such as Los Angeles- based Latham & Watkins LLP are organized as flow-through companies.

The announcement of the proposed definition, coming as congressional lawmakers consider rewriting the U.S. tax code, heightens concerns of larger flow-through businesses that they are being targeted for a tax increase, said Brian Reardon, a lobbyist for the S Corporation Association of America, which advocates on behalf of family- and closely held businesses.

“The administration has made it clear that it’s interested in drawing an arbitrary line and taxing firms above it,” Reardon told Bloomberg Government.

Corporate Taxation

Reardon said his members were concerned earlier this year that Treasury was developing a proposal that would levy corporate taxes on flow-through businesses with more than $50 million in annual revenue as part of an effort to lower U.S. corporate tax rates by broadening the base.

“It’s obviously something that they’ve been looking at,” Reardon said.

The proposed definition is designed for tax policy discussion and has no effect on government contracting or other government agencies with their own definitions of small businesses.

A Treasury official familiar with the crafting of the definition said that it isn’t intended to lead to a tax increase and is an attempt to address a widely acknowledged information gap resulting from difficulty matching tax returns of flow- through businesses with their owners’ returns.

‘Big Step Forward’

As a result of the difficulty matching returns, taxpayers reporting flow-through income typically have been counted as small business owners, even if they are large companies.

“This is a really big step forward,” said Edward Kleinbard, a former staff director of the Joint Committee on Taxation, who is now a law professor at the University of Southern California. “Before this, you had the largest law firms in America, with revenues over $1 billion, and they were being treated as small businesses. That’s just preposterous on its face,”

More than 90 percent of businesses are structured as flow- through entities and their owners pay about 43 percent of all U.S. business taxes on their individual tax returns, according to a study by Robert Carroll, a former Treasury official, for the S Corporation trade group.

Reardon said subjecting flow-through profits to corporate taxes would amount to double taxation because owners of such companies already pay personal income tax on their earnings.

Small Business Cutoff

Using $10 million as the cutoff for a small business is arbitrary, though it does have some basis in tax administration, according to the Treasury official. For example, the Internal Revenue Service uses $10 million in assets as the administrative dividing line between large and small businesses.

Under the proposed definition, there would be significantly fewer small businesses and fewer owners of such businesses would be included in top income brackets.

Democrats could use the proposed definition to argue for tax increases, said Payson Peabody, a former tax counsel to former Republican Senator Jim Bunning.

“In the short term, this report is aimed at Republicans in Congress who say that raising top rates would impact small business,” said Peabody, who represents the Angel Capital Association, a trade group of private early-stage investors. “The White House always has said the impact on small business would be smaller, and, by narrowing the definition of small business, this report attempts to back that claim,”

Using the proposed definition, 20 million small business owners reported $376 billion in net business income for 2007, according to a Treasury analysis of returns that year.

Under a second, narrower definition in which profit or loss from a business represented at least 25 percent of a filer’s income, researchers estimated there were 9.4 million small business owners with $335 billion in reported income for 2007.

The previous methodology counted 34.7 million filers reporting $662 billion in income in 2007.

Under the new definitions, the share of small-business income subject to the top two tax rates dropped to 32 percent under the broad definition and to 29 percent under the narrower one. By comparison, under the previous methodology, 50 percent of small- business income was taxed at the top two rates.

Was Buffett Right? Do Workers Pay More Tax than Their Bosses?

By Roberton Williams

When Warren Buffett called for higher taxes on the wealthy in a New York Times op-ed last week, the billionaire investor argued that he and wealthy people like him face lower federal rates than the rest of us. Low rates on long-term capital gains and qualified dividends and limited exposure to payroll taxes mean low taxes for the rich, he asserted, while more typical workers don’t get those breaks. He’s right on many of his points but not about the rich paying less tax (relative to income) than average—or even well off—taxpayers.

First, what did Buffett get right? Taxpayers who get lots of income from capital gains and dividends pay less tax than those who earn most of their income from wages. People who get all of their income from long-term capital gains and qualified dividends will never pay a combined federal individual income and payroll tax rate of even 15 percent, no matter how much they make. That’s because the maximum tax on their investment income is 15 percent and they don’t face payroll taxes. (See graph. Note that the graph shows the highest possible tax rate by assuming the taxpayer 1) claims only the standard deduction and personal exemptions; 2) gets no benefit from other deductions, exemptions, exclusions, or tax credits; and 3) bears the cost of both the employer and employee shares of payroll taxes.)

In contrast, single people who get all their income from wages always pay more than 15 percent once their income hits about $12,500. When their income reaches about $500,000, their combined tax approaches 38 percent. The same story applies to married couples, although their effective tax rate is always less than that for singles if only one spouse works. At any total income level, you will always pay a higher tax rate if your income comes in the form of wages than if it is from investments only.

The tax differential between earnings and investment income may be tempered somewhat, if corporate taxes reduce investment returns. Economists disagree about who actually bears the burden of the corporate income tax but some of it likely falls on investors and thus boosts their effective tax rate. Of course, if some falls on workers, it also raises the effective tax rate on their earnings.

Overall, Buffett’s story is correct, but he did get a couple of things wrong.

First, the 41 percent top tax rate he ascribed to his fellow workers appears to be a marginal rather than an average rate. That is, it’s the tax on an additional dollar of income rather than total tax measured as a percentage of total income. A single worker’s earnings must approach $500,000 before his combined income and payroll tax hits even 35 percent and the effective tax rate never tops 38 percent. For a married couple, total earnings have to near $1 million to hit those levels. Those are still very high rates, well above Buffett’s 17.4 percent, but they’re not as high as he asserted.

More importantly, because of progressive tax brackets and the many exclusions, exemptions, deductions, and tax credits, typical taxpayers actually pay effective tax rates well below the levels Buffett cites. And high-income taxpayers usually pay a higher effective rate than he does. The average household in the middle 20 percent of the income distribution (income between about $34,000 and $65,000) will pay combined income and payroll taxes equal to 12.0 percent of total income this year, compared with 19.6 percent for those in the top 20 percent (income over about $104,000) and 20.2 percent for those in the top 1 percent (income over roughly $533,000).

Warren Buffett may be right when he says that high-income taxpayers could pay more, especially given the extremely rapid rate of income growth at the top of the distribution. And he’s certainly correct when he says that the low tax rate on investment income cuts his tax bill well below that of many Americans. But he’s off base when he suggests that all high-income taxpayers pay a smaller share of their income in taxes than their middle-income coworkers.

Saturday, August 20, 2011

Interest Rates Decrease for the Fourth Quarter of 2011

IR-2011-85, Aug. 18, 2011

WASHINGTON — The Internal Revenue Service today announced that interest rates will decrease for the calendar quarter beginning Oct. 1, 2011. The rates will be:

* three (3) percent for overpayments [two (2) percent in the case of a corporation];

* three (3) percent for underpayments;

* five (5) percent for large corporate underpayments; and

* zero and one-half (0.5) percent for the portion of a corporate overpayment exceeding $10,000.

Under the Internal Revenue Code, the rate of interest is determined on a quarterly basis. For taxpayers other than corporations, the overpayment and underpayment rate is the federal short-term rate plus 3 percentage points. Generally, in the case of a corporation, the underpayment rate is the federal short-term rate plus 3 percentage points and the overpayment rate is the federal short-term rate plus 2 percentage points.

The rate for large corporate underpayments is the federal short-term rate plus 5 percentage points. The rate on the portion of a corporate overpayment of tax exceeding $10,000 for a taxable period is the federal short-term rate plus one-half (0.5) of a percentage point.

The interest rates announced today are computed from the federal short-term rate during July 2011 to take effect Aug. 1, 2011, based on daily compounding.

Revenue Ruling 2011-18, announces the rates of interest and will appear in Internal Revenue Bulletin No. 2011-39, dated Sept. 26, 2011.

U.S. needs to reform corporate tax, GE CEO says

By Scott Malone

HANOVER, New Hampshire (Reuters) - The United States needs to reform its corporate tax code and should consider eliminating all loopholes that allow companies to pay less than the statutory rate, General Electric Co 's chief said.

The largest U.S. conglomerate would accept the elimination of loopholes "in a heartbeat" if it was coupled with a lowering of the statutory 35 percent rate, Jeff Immelt told a group of students on Thursday.

"Corporate tax in this country needs to be reformed," Immelt said at Dartmouth College, in Hanover, New Hampshire. "Stuff that the deficit commission came up with, which was a lower corporate tax rate ending every loophole, is what we would take, with a territorial system, we would take in a heartbeat. The fact is I'd take Germany's or Japan's or the U.K.'s corporate tax policy today, sight unseen, without any dispute, I would take any of those tax policies today."

A so-called Congressional "super committee" is working on a way to find another $1.2 trillion in cuts from the nation's budget over the next decade, terms that were part of the recent deal to raise the U.S. debt limit and avoid a default. Existing tax breaks for businesses and individuals cost the government some $1 trillion per year, but Republicans may agree to cutting those if the move is coupled with a reduction in the top tax rates for companies and people.

Immelt also acknowledged the criticism the world's largest maker of jet engines and electric turbines came under this year for its recent low tax rate. A study released in June by the left-leaning research group Citizens for Tax Justice found that GE had an effective tax rate of negative 61.3 percent in 2010, making it one of at least eight big U.S. companies to record a tax benefit rather than a bill for the year.

"GE has paid tens of billions of dollars in taxes over the last decade," he told the crowd at the Ivy League university where he played football as an undergraduate. "Our technique for paying low taxes in 2009 and 2010 was writing off $32 billion (in losses) at our financial service business. I don't recommend it."

Troubles at the GE Capital arm contributed significantly to the company's woes during the financial crisis that sent its shares to 18-year lows in early 2009. They have since rebounded to almost three times their crisis level and closed at $15.34 on Thursday, down 5.5 percent on a day the U.S. stock market dropped sharply.


Immelt, who leads a panel advising the Obama administration on job creation, said he puts little stock in talk that the government could do more to encourage companies to invest and lower the nation's persistently high unemployment rate.

"A lot has been said that business isn't investing because of uncertainty. I think that's rubbish," the 55-year-old CEO said. "The government couldn't do anything to make me invest and believe me the rest of the world isn't that stable either. We've made our own choices that we're going to keep investing regardless of what happens in Washington."

But in an uncharacteristically animated moment, he blasted critics who contend that companies like GE that do much of their sales outside the United States are hurting the economy. He noted that GE sells 90 percent of its jet engines abroad but manufacturers all of them in U.S. factories.

More Tax Trouble for Small Firms

By Arden Dale

Lots of small companies are skipping their federal payroll taxes in this wobbly economy, and tax lawyers say the Internal Revenue Service has gotten more aggressive about penalizing executives, accountants or other individuals for the lapses.

Among the IRS’s tough tactics: freezing a company’s accounts receivable, seizing assets and garnishing wages of responsible employees. It can assess substantial penalties and apply tax liens.

Payroll tax debt can “bring a company to its knees,” says Caroline D. Ciraolo, a partner at Rosenberg Martin Greenberg LLP in Baltimore, Md. She sees cases more frequently now, citing the example of a tool company that suffered a fire and, struggling in the rocky economy, used money it should have spent on payroll tax as an emergency slush fund.

Other clients with payroll tax problems included a medical services company and a group of charter schools for at-risk children. Closely-held businesses like these may have revenue of several millions of dollars and may be owned by four or five people.

A government watchdog in July estimated that some $54 billion in employment taxes go underreported every year. The report by Treasury Inspector General for Tax Administration described a study the IRS has under way, in which it plans to audit payroll-tax compliance by some 6,600 randomly picked employers for recent years.

Chicago tax lawyer Robert E. McKenzie, a partner at Arnstein & Lehr LLP, describes the IRS’s tactics as “harsh.” In singling out people to penalize, it seems “more likely to shoot at the person on the sidelines” instead of those genuinely responsible for the arrears.

The tax code gives leeway to hold the company itself liable for employment tax errors, or to lay responsibility with a range of individuals or entities, from officers, owners, bookkeepers and treasurers to lenders that prevent companies from paying employment tax by seizing control of company accounts and dictating what debts can be paid.

Once the IRS adds its penalties, the debt can snowball. Companies can be fined for outright failure to pay or to report on the tax, and also for paying late — that is, if it misses by more than two-and-a-half days the deadline for depositing the funds with a bank or other authorized institution, which then forwards them to the IRS. Fines for late payment can go as high as 25% of the tax due. Sometimes employers hesitate to file a tax report when they have fallen behind on payments, and that just compounds their problems and triggers more penalties.

Typically, tax attorneys like Ciraolo and McKenzie get involved after a business has run into trouble. Often their help is sought by an individual whom the IRS has held personally liable.

Tom Nichols, a tax attorney in Milwaukee, Wis., advises new businesses on how to avoid trouble in the first place. The best plan: Meet the deadlines, he says. Short of that, pay taxes the IRS could make a personal liability for the person it targets.

The Federal Insurance Contribution Act (FICA) tax is equal to 15.3% of an employee’s gross wages up to the FICA wage base of about $110,000, and consists of Social Security (12.4%) and Medicare taxes (2.9%). Half of the FICA tax is paid through an employee contribution (7.65%) and the other half is paid by the employer (7.65%); the latter can’t trigger personal liability.

In hard times, businesses tend to look at payroll tax as their own money, and hang onto it or use it to pay “the squeakiest wheels first,” Nichols says. Often, this is a supplier or someone else key to keeping the business running.

In the end, the IRS, not employees, stands to lose. Even employers who do not pay payroll tax report it on Forms W2 issued to employees, which keeps workers right with the IRS.

IRS Issues Benefits Summary Rule; Insurers Must Offer Consumer Details

The Internal Revenue Service, the Employee Benefits Security Administration, and the Centers for Medicare and Medicaid Services Aug. 17 released a proposed rule (Reg-140038-10) that would require insurers to make available to consumers a standardized summary of the benefits and coverage for each plan they offer.

The goal of the proposed rule is to increase transparency in the insurance market so that consumers can compare plans on an apples-to-apples basis and make an informed choice about which to purchase. Insurers and group health plans will be required to provide the information.

The standard summary, which can be no more than four double-sided pages, would have to include information about the policy a consumer is considering, such as its premium and deductible costs, covered benefits, and coverage limitations and exceptions. In addition, the summary would have to include coverage examples that show how much a consumer would pay in three common scenarios: having a baby, treating breast cancer, and managing diabetes.

Insurers also would have to provide consumers with a separate glossary that defines insurance terms such as co-payment and deductible.

Under the proposed rule, health insurance issuers and group health plans would be required to provide either online or in print the summary and the glossary to consumers before they purchase or enroll in a plan, including before a plan is reissued or renewed. Insurers also would have to notify beneficiaries of any significant changes to the terms of coverage at least 60 days before the change takes effect.

In addition, a potential consumer or a person enrolled in a plan could request a copy of the summary and must receive it within seven days.

The departments of Health and Human Services, Treasury, and Labor issued the proposed rule, which implements part of the Patient Protection and Affordable Care Act.

Providing Consumers More ‘Access to Information'

“Today, many consumers don't have easy access to information in plain English to help them understand the differences in the coverage and benefits provided by different health plans,” HHS Secretary Kathleen Sebelius said in a statement. “Thanks to the Affordable Care Act, that will change.”

The proposed rule is scheduled for publication in the Aug. 22 Federal Register, and comments are due 60 days later.

Consumer, Insurer Reactions

Consumer groups such as Consumers Union and Families USA lauded the release of the proposed rule, saying it would make navigating the insurance marketplace much easier.

Ron Pollack, executive director of Families USA, called the proposal a “triumph of common sense.”

The complete text of this article can be found in the BNA Daily Tax Report, August 18, 2011.

Health Care Premium Credit Rules Proposed

The IRS released proposed regulations on August 12 implementing the health insurance premium tax credit, which was enacted last year by the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act and is effective starting in 2014 (REG-131491-10).

The proposed regulations are part of a “next step” announced August 12 by the Treasury Department and the Department of Health and Human Services (HHS) to establish “affordable insurance exchanges” that under the health care acts will allow individuals and small businesses to purchase private health insurance coverage, also starting in 2014.

Together, the IRS and HHS released three sets of proposed rules. The proposed IRS regulations provide guidance to the insurance exchanges—and to individuals who enroll in the exchanges’ health plans—in claiming the premium tax credit, including an advance credit. The other proposed rules, released by HHS, provide guidance on eligibility determination for enrollment in a qualified health plan or insurance affordability program and address coordination of exchange coverage with Medicaid and the Children’s Health Insurance Program.

To be eligible for a premium tax credit (Sec. 36B(c)(1)), a taxpayer must be an applicable taxpayer. To be an applicable taxpayer, the taxpayer must (1) have household income between 100% and 400% of the federal poverty line (FPL) amount for his or her family size, (2) not be claimed as a dependent by another taxpayer, and (3) if married, file a joint return. The credit amount is the sum of “premium assistance amounts” for each month the taxpayer or any family member is covered by a qualified health plan through an exchange. The assistance amount is the lesser of (1) the premium amount or (2) the result of a formula based on a “benchmark plan” and the taxpayer’s household income (Sec. 36B(b)).

The IRS proposed regulations:

Address the eligibility criteria for the credit for a taxable year, including:

* Who is an applicable taxpayer; and

* The minimum essential coverage rules for government-sponsored coverage and employer-sponsored coverage.

* Provide guidance on the computation of the premium tax credit.

* Describe the requirements for reconciling the advance payments of the credit with the actual credit amount and determining the amount of any additional credit or additional income tax liability.

The IRS invites written comments on the proposed regulations, which must be received by October 31. They may be sent via or in writing as directed in the regulations’ summary. A public hearing is scheduled in the IRS building in Washington, D.C., on November 17.

Final Regulations Simplify Reduced Research Credit Election

The IRS released final regulations on July 26 (T.D. 9539) further simplifying an election method by which taxpayers may use a standard rate to reduce a research credit under Sec. 41 in lieu of reducing their research expense deductions. The final regulations also clarify how members of a controlled group may make the election. The final regulations adopt with some modification proposed regulations issued in 2009 (REG-130200-08).

Under Sec. 280C(c), a deduction in a tax year for qualified research expenses under Sec. 41(b) or basic research expenses under Sec. 41(e)(2) must be reduced by the credit amount for that tax year. Similarly, where those expenses are capitalized, the amount capitalized in that tax year must be reduced by the excess, if any, of the amount of the credit over the amount of such expenses otherwise allowable as a deduction. However, instead of either of those limitations, taxpayers may elect under Sec. 280C(c)(3) to reduce their Sec. 41 credit. The amount of the reduction equals the excess of the amount of the Sec. 41 credit over the credit amount multiplied by the maximum corporate tax rate.

The statute provides that the election is irrevocable for the tax year in which it is made and may be made anytime up to the return filing deadline, including extensions. Until now, the regulations (Regs. Sec. 1.280C-4(a)) had provided that the election was made by claiming the reduced credit on an original return for the tax year.

The new final regulations specify that the election must be made on Form 6765, Credit for Increasing Research Activities, filed with the original return.

Controlled Groups

Under Regs. Sec. 1.41-6, all members of a controlled group of corporations (or trades or businesses under common control) are treated as a single taxpayer, and the credit amount is allocated to each member in proportion to its share of qualified research and other expenses for which the credit is claimed.

The final regulations provide that each member of a controlled group may make the election after the group credit is computed and allocated. One commentator was concerned about the administrative complexity of having each member of a controlled group making the election. Accordingly, the final rules clarify that a common parent of a consolidated group filing a consolidated return may make the election on behalf of all members of the group. The common parent must adequately identify the group members for which the election is being made on an attachment to its Form 6765.

The final regulations also add an example clarifying that a member of a controlled group may make the election on its original return even if it does not claim the credit. Otherwise, the member could be barred from making the election later if another member of the group determines that it had understated its qualified research expenses for the tax year, resulting in an increased group credit with a portion allocable to the nonelecting member.

The final regulations amend Regs. Sec. 1.280C-4 and apply to tax years ending on or after July 27, 2011.

Final Regulations Simplify Accounting Rules in Corporate Reorganizations

The IRS issued final regulations (T.D. 9534) intended to clarify and simplify rules concerning continuity of accounting methods and inventory methods in certain tax-free corporate reorganizations and liquidations.

The regulations revise regulations under Secs. 381(c)(4) and 381(c)(5) and adopt with nonsubstantive modifications proposed regulations issued in 2007 (REG-151884-03). They are intended to provide greater clarity and certainty to rules by which a corporation acquiring the assets of another corporation in a Sec. 381(a) transaction—a distribution under Sec. 332 (liquidation of a subsidiary) or transfer under Sec. 361 (reorganization solely for stock or securities)—determines the method of accounting and inventory it will use.

Under Sec. 381(a), the acquiring corporation succeeds to and takes into account specified items of the distributor or transferor corporation, including its method of accounting and inventory method. Under Regs. Sec. 1.381(c)(4)-1, if the trades or businesses of the parties to a Sec. 381(a) transaction are operated as separate trades or businesses after the transaction, an otherwise permissible accounting method used by the parties is carried over and used by each trade or business of the acquiring corporation (“carryover method”). If, on the other hand, an integrated trade or business results, the acquiring corporation must determine and use a “principal method.”

The principal method generally is that used by the acquiring corporation before the transaction. However, if the distributor or transferor corporation is larger than the acquiring corporation, the principal method is that of the distributor or transferor corporation immediately before the transaction.

Similar rules under Regs. Sec, 1.381(c)(5)-1 apply to inventories.

To determine which party to the transaction is larger, for accounting methods, the adjusted bases of the assets and gross receipts are compared to determine the accounting method. For inventories, the fair market value of the parties’ inventories are compared. The final regulations modify this test to specify that the attributes of only the trades or businesses that will be integrated after the transaction are compared, rather than those of the entire entities.

The final regulations also provide rules for identifying a principal method where either of the parties operates more than one separate and distinct trade or business for which it uses more than one method of accounting on the date of the distribution or transfer, and those trades or businesses are combined after the transaction. In addition, the final regulations also clarify the definition of “cut-off basis.”

The final regulations are effective August 31, 2011.

Election to Deduct Business Startup Expenses Gets Final Rules

The IRS on August 16 issued final regulations (T.D. 9542) governing elections by individual taxpayers, corporations and partnerships to deduct startup expenses or organizational expenditures. The regulations adopt with a slight change temporary regulations the Service issued in 2008 (T.D. 9411).

The rules provide guidance on the application of section 902 of the American Jobs Creation Act of 2004 (AJCA, P.L. 108-357), which amended Secs. 195(b), 248(a) and 709(b) to allow electing individual taxpayers (in the tax year they begin an active trade or business) and corporations and partnerships (in the tax year they begin business) to deduct up to $5,000 of startup expenses (individuals) or organizational expenditures (corporations and partnerships). The remainder of the start-up or organizational expenses can be amortized over the 180-month period beginning with the month in which the active trade or business begins.

The deductible amount is reduced by the amount by which startup or organizational expenditures exceed $50,000; in other words, no first-year deduction (beyond the amount of amortization for the first year) is allowed if startup expenses equal or exceed $55,000. (For tax years beginning in 2010 only, the Small Business Jobs Act of 2010 (P.L. 111-240) increased the maximum first-year deduction for individual taxpayers (but not corporations or partnerships) to $10,000 and the phaseout threshold to $60,000.)

Except under provisions of the three sections, taxpayers cannot take a deduction for startup or organizational expenditures.

The final regulations provide the time and manner of making the election. The election is automatic: An individual taxpayer, corporation or partnership is deemed to have made an election to deduct startup expenditures in the year in which it begins an active trade or business (individual taxpayers) or begins business (corporations and partnerships). The entity may forgo the deemed election by “affirmatively electing” (rather than “clearly electing” as the temporary regulations had stated) to capitalize its startup expenses on a timely filed federal income tax return (including extensions) for the tax year in which the active trade or business begins or it begins business. The election is irrevocable and applies to all startup expenditures.

The regulations also provide guidance on the meaning of “begins business” as applied to corporations: If activities “have advanced to the extent necessary to establish the nature of its business operations,” the entity is deemed to have begun business.

The final rules are effective August 16, 2011, and apply to expenditures paid or incurred after that date. Taxpayers may also apply them to expenditures paid or incurred after October 22, 2004, to the extent not barred by the limitation period for assessment of tax.

Separately Identifiable Intangible Assets: Tax Opportunities and Traps

by Nick Gruidl, CPA, MBT

In Letter Ruling 201016053,1 the IRS ruled that where a taxpayer could separately identify and distinguish acquired customer-based intangibles from self-created customer-based intangibles, the taxpayer could separately calculate gains on the sale of each, thereby avoiding Sec. 1245 ordinary income recapture on the sale of the self-created customer-based intangibles. The ruling is consistent with a recent Chief Counsel Advice (CCA)2 holding that customer-based intangibles (among others) “can be separately described and valued apart from goodwill” and thus qualify as like-kind property under Sec. 1031. The underlying technical analysis of the ruling, albeit not groundbreaking, is significant to taxpayers in a variety of transactions outside of Sec. 1245 recapture, such as the application of the Sec. 197 antichurning provisions and the Sec. 1374 built-in gain (BIG) tax.

Simplified Ruling and Fact Pattern

The ruling appears to involve the sale of certain partnership interests held by an S corporation following the implementation of an Up-C3 initial public offering (IPO) transaction. Simplifying the facts in the ruling, shareholder SH owns S, a subchapter S corporation, which in turn owns an interest in the operating LLC (taxed as a partnership for federal tax purposes). The remainder of the LLC interest is owned by P, which prior to the IPO was controlled by SH. Following the IPO, P acquired LLC interests from S. The acquisition by P was presumably eligible for an election under Sec. 754 and asset basis adjustments under Sec. 743. The exhibit shows a simplified structure that differs from the actual structure in the ruling.

The LLC owned both self-created and acquired customer-based intangibles. The acquired intangibles were customer relationships with terminable-at-will written service contracts. The LLC acquired the intangibles while it was primarily engaged in the provision of Service A. The LLC took a cost basis in the assets and began amortizing them over 15 years. Following the acquisition, the LLC expended significant capital to expand its service offerings to include Service B and develop the capability to service customers it previously was unable to serve. The LLC operates in a competitive industry that requires continued capital investment, which the taxpayer (P) claimed was necessary to keep customers from choosing competitors. As a result, the LLC held x number of acquired customer relationships that were different from y number of self-created customer relationships.

Gain on the sale of the customer-based intangibles, presumably as a result of the application of Sec. 751, would generate ordinary income recapture under Sec. 1245 up to the amount of amortization deductions claimed on the intangibles. However, if the LLC could establish that rather than being a single intangible asset, the self-created customer-based intangibles were separate from the acquired customer-based intangibles, ordinary income recapture on the sale would be limited to gain on the acquired intangibles.4

Example: LLC pays $45 million for customer-based intangibles and also creates customer-based intangibles in the ordinary course of business. LLC disposes of the business assets in a taxable transaction. LLC had claimed $30 million of amortization on the acquired intangibles through the date of the sale. The total purchase price allocated to customer-based intangibles is $60 million. If the intangibles are looked at as a single asset, $30 million of the $45 million gain will represent Sec. 1245 gain. However, assuming that LLC is able to distinguish between the two and determines that the value of the acquired intangibles is $15 million and the self-created intangibles have a value of $45 million, none of the gain will be recaptured as ordinary (i.e., the tax basis of the acquired intangibles equals the value ($45 million – $30 million depreciation = $15 million), so there is no gain on the sale of these assets).

While the concept seems quite simple (i.e., segregate intangible assets as if they were pieces of equipment and allocate purchase price accordingly), it is often difficult to determine and substantiate that customer-based intangibles (e.g., customer lists) are both distinguishable from goodwill and separable from each other. In fact, the taxpayer in Letter Ruling 201016053 was required to make significant representations to the IRS, all of which were subject to challenge under exam, in order to get the ruling. In short, the representations were as follows:

* The taxpayer represented that it had sufficient records and information to identify which of its current customers represent the acquired customer relationships (ACR) and which represent the self-created customer relationships (SCR).

* It also represented that each of the identified types of customer relationship that are ACRs and SCRs has a reasonably ascertainable value and a reasonably determinable life.

* Further, it represented that it has expended significant amounts of capital to solicit and service new customers.

Thus, by analogy, these representations—that the taxpayer can separately identify, value, and determine the life of the ACRs and the SCRs—support treating the SCRs as being a separate and distinct asset from the ACRs.

Given these facts and representations, the IRS ruled that the self-created customer relationships were separate and distinct from the acquired customer relationships, and as such the sale of the self-created customer-based intangibles was not subject to Sec. 1245 recapture. The IRS based its determination primarily on case law holding that, under pre–Sec. 197 rules, intangible assets with an ascertainable value and reasonably determinable limited useful life were amortizable.5 The ruling also addressed the fact that the mass-asset rule does not affect a taxpayer’s ability to achieve this favorable tax treatment as long as the taxpayer is able to satisfy the dual burden of establishing an ascertainable value separate from goodwill and a limited useful life.6

Separately Identifiable Intangibles

To meet the dual burden required to establish the existence of a separately identifiable asset, a valuation is likely required. As a result of changes in financial reporting with the issuance by the Financial Accounting Standards Board (FASB) of Statement of Financial Accounting Standards (FAS) 141R, Business Combinations, applicable to business acquisitions occurring in fiscal years beginning on or after December 15, 2008,7 additional attention is being paid to the identification of specific intangibles separate from goodwill for financial statement purposes. Taxpayers, however, should proceed with caution when relying on FAS 141R appraisals. Unless the taxpayer specifically directs the appraiser to do so, the appraiser does not perform a FAS 141R appraisal with the tax provisions in mind. As a result, such an appraisal may not provide the required analysis pertaining to distinct value apart from goodwill and a useful life.

While not a result of the implementation of FAS 141R, the Third Circuit decision in Technicolor USA Holdings8 provides a good reminder that not all valuations are created equal. In that case, the Third Circuit upheld the Tax Court’s decision finding that the intangible assets acquired by a taxpayer, which were supported by a valuation from a large national accounting firm, did not have a readily ascertainable useful life. Therefore the assets were not separate assets and their basis was attributed to goodwill and going concern value.

Even in giving the taxpayer the favorable ruling in Letter Ruling 201016053, the IRS made it clear that meeting this two-part test is no simple task. In its analysis of the law, the IRS cited Newark Morning Ledger,9 where the Court stated that the burden of proof is often too difficult for taxpayers to satisfy the two-part test. In the following paragraph, the IRS cited the Citizens and Southern Corp. decision, where the Tax Court stated that satisfying the two-part test is a “perhaps extremely difficult burden.”10

As a result, it is very important that taxpayers and their advisers closely review any appraisal to verify that any separately identifiable intangible has both a reasonably ascertainable value and a reasonably determinable life.

Additional Applications of the Underpinnings of Letter Ruling 201016053

While the ruling addressed only Sec. 1245 recapture, the identification of intangible assets separate from goodwill could play an important role in a number of areas. In particular, separate identification could be useful in the area of the Sec. 197 antichurning rules and the Sec. 1374 BIG tax.

Antichurning Rules

Prior to the enactment of Sec. 197, taxpayers could not amortize goodwill and similar intangible assets. Sec. 197 granted a 15-year amortizable life to intangible assets acquired after the enactment of the statute. Included in the enactment of Sec. 197 were the antichurning provisions, which disallow the amortization of intangibles subject to the rules.11 Assets subject to the antichurning provisions include goodwill and similar intangible assets held by the seller that were not amortizable prior to the enactment of Sec. 197 and that were acquired from a related person (as defined in Secs. 267(b) and 707(b), except substituting “more than 50 percent” for “more than 20 percent”) who continues to use the intangible.12 The relationship is tested immediately before and after the sale of the intangible13 and applies whether the continuing shareholders took part in a fully taxable transaction or received a tax-deferred rollover.14

The antichurning provisions apply only to goodwill and similar intangible assets held by the seller that were not amortizable prior to the enactment of Sec. 197. If the taxpayer can identify assets that would have been amortizable pre–Sec. 197, such assets are not subject to the antichurning rules.

To establish that an intangible asset would have been amortizable pre–Sec. 197, the taxpayer must show that the asset has both a readily ascertainable value separate and distinct from goodwill and a useful life.15 This is the same analysis performed and represented to by the taxpayer in Letter Ruling 201016053. A similar analysis was performed in CCA 200911006, addressing the segregation of intangibles for purposes of the Sec. 1031 like-kind exchange rules, where the IRS adopted the Newark Morning Ledger analysis, stating, “[i]n our opinion, except in rare and unusual situations, intangibles such as trademarks, trade names, mastheads, and customer-based intangibles can be separately described and valued apart from goodwill.” While neither the letter ruling nor the CCA directly applies to the antichurning provisions, they nonetheless are an indication of the IRS’s acceptance of separate identification of intangibles apart from goodwill. However, the language of the CCA in no way lessens the taxpayer’s burden of establishing that the intangible asset in question has both a readily ascertainable value separate and distinct from goodwill and a useful life.

Sec. 1374 BIG Tax

In general, when a subchapter C corporation elects subchapter S status, net recognized BIGs during the applicable recognition period (five, seven, or ten years following the subchapter S election depending on the years of election and gain) are subject to tax at the highest corporate tax rate (the Sec. 1374 BIG tax).16 The same rules generally apply to any asset transferred to an S corporation by a C corporation in a tax-deferred transaction.17

Recognized BIGs include any gain recognized during the recognition period, with two exceptions. The gain will not be taxed if the corporation establishes that it did not hold the asset as of the beginning of the first S corporation tax year (or it did not receive the asset from a C corporation in a tax-deferred transaction). In addition, the tax does not apply to the extent of the gain that exceeds the difference between the fair market value and the tax basis of the asset as of the beginning of the first S corporation tax year.18

As a result, BIGs attributable to goodwill and similar intangibles are subject to the Sec. 1374 BIG tax. However, if the S corporation can establish that an intangible is both separate from goodwill and was acquired or created after the subchapter S corporation election, any gain recognized on the disposition of the asset would avoid the Sec. 1374 BIG tax.

While Letter Ruling 201016053 addresses Sec. 1245, not Sec. 1374, the correlation between the two is clear. Just as with the customer-based intangibles in the ruling, if an S corporation can establish that a customer-based intangible (or any intangible for that matter) has a readily ascertainable value separate and distinct from goodwill and a useful life, the determination of whether a gain is subject to the Sec. 1374 BIG tax is made on an asset-by-asset basis. If the asset was acquired or created after the S corporation election, any gain on the sale of the intangible would avoid tax under Sec. 1374. As discussed above, this should be the case even where the intangible may be part of a mass asset such as a customer list.


When acquiring or disposing of intangible assets, such as customer-based intangibles, understanding the impact of an intangible’s distinction from goodwill and other similar intangibles may be critical. As addressed above, such a determination could provide tax advantages when dealing with the recapture provisions of Sec. 1245, avoidance of Sec. 197 antichurning limitations, and application of the Sec. 1374 BIG tax.

However, it is important to remember that the taxpayer carries the significant burden of establishing, and defending under exam, that the intangibles in question have a readily ascertainable value separate and distinct from goodwill and a useful life. Reliance on valuations prepared for financial statements or other nontax purposes should be carefully reviewed to determine if they truly meet both requirements to establish separateness. The more advisable route would be to engage an appraiser to specifically identify and value intangible assets that are both separate from goodwill and have a reasonable ascertainable useful life.


1 IRS Letter Ruling 201016053 (4/23/10).

2 CCA 200911006 (3/13/09).

3 An Up-C or umbrella partnership C corporation structure allows the business to acquire assets by issuing operating partnership units.

4 See, e.g., IRS Letter Ruling 200243002 (10/25/02), which ruled that self-created intangibles generally constitute capital assets.

5 Newark Morning Ledger Co., 507 U.S. 546 (1993); and Citizens and Southern Corp., 91 T.C. 463 (1988), aff’d, 919 F.2d 1492 (11th Cir. 1990).

6 Houston Chronicle Pub. Co., 481 F.2d 1240 (5th Cir. 1973), cert. denied, 414 U.S. 1129 (1974).

7 Codified at FASB Accounting Standards Codification (ASC) Topic 805, Business Combinations.

8 Technicolor USA Holdings Inc., 288 Fed. Appx. 15 (3d Cir. 2008), aff’g Claymont Investments, Inc., T.C. Memo. 2005-254.

9 Newark Morning Ledger Co., 507 U.S. at 566.

10 Citizens and Southern Corp., 91 T.C. at 482.

11 Sec. 197(f)(9).

12 Sec. 197(f)(9)(C).

13 Sec. 197(f)(9)(C)(ii).

14 See Regs. Sec. 1.197-2(h).

15 Id.

16 See Secs. 1374(a), (b), and (d)(7).

17 Sec. 1374(d)(8).

18 Sec. 1374(d)(3).

Nick Gruidl is a partner and managing director in the M&A tax practice of RSM McGladrey in Minneapolis, MN. He is the chair of the AICPA’ s Corporations and Shareholders Technical Resource Panel.

S Corporation Shareholder Compensation: How Much Is Enough?

by Tony Nitti, CPA, MST

Executive Summary

* S corporation shareholders generally prefer dividend distributions of their S corporations’ profits over compensation payments from the S corporations because the compensation payments are subject to payroll taxes and dividend distributions are not.

* To prevent S corporations and their shareholders from avoiding payroll taxes by maximizing distributions and minimizing compensation payments, the IRS requires S corporations to pay shareholders who provide substantial services reasonable compensation.

* Disputes between the IRS and taxpayers have required courts to determine on a regular basis whether an S corporation has paid reasonable compensation to its shareholder(s). Two recent district court cases provide a framework that advisers can use to determine whether the IRS and the courts will consider a shareholder’s compensation reasonable.

S corporation shareholder-employees and their tax advisers often find themselves with differing goals when setting the shareholder-employee’s compensation. Typically, the shareholder-employee prefers to minimize compensation in favor of distributions to reduce payroll taxes. Tax advisers, however, are faced with a body of governing authority providing that the shareholder-employee cannot avoid the imposition of payroll taxes by forgoing reasonable compensation. Unfortunately, until recently this governing authority had offered little in terms of how to actually compute reasonable compensation, leaving tax advisers with sparse guidance upon which to rely when recommending salary amounts to their clients.

In late 2010, an Iowa district court decided Watson,1 a reasonable compensation case that, together with the North Dakota District Court’s 2006 decision in JD & Associates,2 provides the direction tax advisers have been seeking. Watson and JD & Associates shed much-needed light on the methodology the IRS and the courts use to determine reasonable compensation in the S corporation arena, providing an analytical approach tax advisers can follow when guiding their clients.

S Corporations and Employment Taxes

As passthrough entities, S corporations generally do not pay entity-level tax on their taxable income.3 Instead, taxable income and other attributes are allocated among the shareholders, who report the items and pay the corresponding tax on their personal income tax returns.4

This S corporation flowthrough income has long enjoyed an employment tax advantage over that of sole proprietorships, partnerships, and LLCs. The advantage finds its genesis in Rev. Rul. 59-221,5 which held that a shareholder’s undistributed share of S corporation income is not treated as self-employment income. In contrast, earnings attributed to a sole proprietor, a general partner, or many LLC members are subject to self-employment taxes.6

As the need to fund Social Security and Medicare payments has risen, the employment tax burden on employers, employees, and the self-employed has increased dramatically. In 2011, employers will pay 6.2% of the first $106,800 of an employee’s wages toward the Social Security tax, with employees paying an additional 4.2% through wage withholding. Employers and employees will split the 2.9% Medicare tax on all wages, without limitation.

Self-employed individuals will be responsible for the entire 10.4% Social Security tax—again limited to the first $106,800 of self-employment income—and the 2.9% Medicare tax on all self-employment income.

As these employment tax obligations have climbed, the advantage of operating as an S corporation has become magnified. Since S corporation income is not subject to self-employment tax, there is tremendous motivation for shareholder-employees to minimize their salary in favor of distributions, which are not subject to payroll or self-employment tax. Consider the following examples.

Example 1: A owns 100% of the stock of S Corp., an S corporation. A is also S’s president and only employee. S generates $100,000 of taxable income in 2011, before considering A’s compensation. If A draws a $100,000 salary, S’s taxable income will be reduced to zero. A reports $100,000 of wage income on his individual income tax return, and S and A are liable for the necessary payroll taxes. S is required to pay $7,650 (7.65% of $100,000) as its share of payroll tax, and S withholds $5,650 (5.65% of $100,000) from A’s salary toward A’s payroll obligation, resulting in a total payroll tax bill of $13,300.

Example 2: Alternatively, A withdraws $100,000 from S as a distribution rather than a salary. S’s taxable income will remain at $100,000 and will be passed through to A and reported on his individual income tax return, where it is not subject to self-employment tax. The $100,000 distribution is also not taxable to A, as it represents a return of basis.7 By choosing to take a $100,000 distribution rather than a $100,000 salary, S and A have saved a combined $13,300 in payroll taxes.

Reasonable Compensation History: No Salary Taken

In light of these potential employment tax savings, the IRS has long challenged attempts by shareholder-employees to minimize compensation in favor of distributions. The IRS opened its attack on these perceived abuses in Rev. Rul. 74-44.8 In the ruling, the IRS imputed the payment of reasonable salaries to an S corporation that paid dividends but no compensation to two shareholders who provided services to the corporation.

Fifteen years later, an oft-cited decision further clarified the IRS’s position on reasonable compensation. In Radtke,9 the taxpayer was the sole shareholder and director of a law firm established as an S corporation. Although the taxpayer devoted all his working time to the law firm, he took no compensation for the year at issue, opting instead to withdraw $18,225 in dividends.

The IRS argued, and the district court agreed, that the dividends represented wages subject to payroll taxes, with the court adding, “where the corporation’s only director had the corporation pay himself, the only significant employee, no salary for substantial services . . . [h]is ‘dividends’ functioned as remuneration for employment.”

Soon after, the Ninth Circuit Court of Appeals expanded on this line of reasoning with its decision in Spicer.10 In that case, the taxpayer was Spicer Accounting Inc. (SAI), an accounting firm established as an S corporation. SAI was owned by Spicer, who was a CPA, and his spouse. Spicer also served as president, director, and treasurer. As SAI’s lone accountant, Spicer performed substantial services, working approximately 36 hours per week.

Spicer had an arrangement with his corporation whereby he donated his services to the corporation in exchange for no compensation, and as a stockholder he withdrew his earnings as distributions. Accordingly, Spicer did not pay payroll taxes on the amounts he received.

The Ninth Circuit, in analyzing the nature of the payments made to Spicer, stated that “salary arrangements between closely held corporations and [their] shareholders warrant close scrutiny.”11 In an effort to determine if the distributions truly represented remuneration for services, the Ninth Circuit established a line of analysis that would be followed repeatedly in the years to follow.

The Ninth Circuit first looked to Sec. 3121(d), which defines an employee for payroll tax purposes in part as “any officer of a corporation.”12 Because Spicer was the president of SAI, this requirement was easily met. The Ninth Circuit then turned its attention to Regs. Sec. 31.3121(d)-1(b), which provides an exception to employee status for some officers, but only to an officer who “does not perform any services or performs only minor services.”

In arriving at its decision, the Ninth Circuit held that Spicer’s services were substantial. As the firm’s lone CPA, Spicer was the only person capable of signing tax returns, performing audits, and preparing opinion letters. The Ninth Circuit concluded that distributions paid to Spicer were classified properly as compensation subject to payroll taxes because “a corporation’s sole full-time worker must be treated as an employee.”13

A line of nearly identical rulings followed, with one Pennsylvania CPA at the heart of many of the decisions. In Grey,14 the sole shareholder of an accounting firm took no salary despite rendering significant services, opting instead to withdraw amounts as independent contractor fees. The Tax Court, using the line of reasoning established in Spicer, held that the shareholder was an employee and the accounting firm was liable for payroll taxes on the independent contractor fees.

After its victory in Grey, the IRS zeroed in on the accounting firm’s client list. In all, six of those clients found themselves in front of the Tax Court, defending the reasonableness of their compensation.15 In each case, shareholder-employees who provided significant services to their S corporation withdrew the entire taxable income of their corporation as distributions, neglecting to take any salary. The Tax Court held that the shareholders were employees and recharacterized the distributions as compensation.

The abuses evidenced in these decisions did not go unnoticed. In 2005, the Treasury Inspector General for Tax Administration (TIGTA)16 issued a report examining the payroll tax advantage that S corporations enjoyed over sole proprietorships. The report, which analyzed S corporation tax returns filed in 2000, revealed the following:

* Approximately 80% of all S corporations were more than 50% owned by one shareholder, giving that shareholder control in setting his or her compensation.

* Owners of single-shareholder S corporations paid themselves salaries equaling only 41.5% of the corporation’s profits, down from 47.1% in 1994.

* There were 36,000 situations in which the sole owners of S corporations generating over $100,000 of income took no salaries. These corporations passed through $13.2 billion to their owners free from payroll tax.

* In total, the payroll taxes paid by single-shareholder S corporations were $5.7 billion less than the self-employment taxes that would have been imposed if the taxpayers were sole proprietors.

In 2009, a U.S. Government Accountability Office (GAO) report to the Senate Committee on Finance17 echoed the concerns expressed in the TIGTA findings. The GAO report noted that in 2003 and 2004 combined, S corporations had underreported their shareholder compensation by $24.6 billion, with corporations with fewer than three shareholders responsible for nearly all the underreporting.

A Rare Defeat for the IRS

Although a shareholder faces a heavy burden in proving that services provided to a corporation are not substantial, it can be accomplished. For example, in Davis,18 a district court held that the shareholder had proved this point and rejected the IRS’s attempt to recharacterize distributions made to a shareholder of an S corporation as “arbitrary and capricious.”

Davis was the president of the corporation but did not actively participate in its activities. The court, citing Spicer, found that based on the uncontroverted evidence of the shareholder, she did not provide substantial services to the corporation and met the exception from employee treatment provided for in the Sec. 3121 regulations. While this decision remains an anomaly in the relevant case history, it confirms that shareholders need not draw a salary provided they render only minimal services to the corporation.

JD & Associates and Watson: How Much Is Enough?

Unlike the cases discussed above, in JD & Associates and Watson, the S corporation shareholder-employees involved drew both salaries and distributions. As a result, the courts no longer had to determine that the shareholder was an employee; instead, they only had to decide whether the compensation paid was reasonable given the services provided. The opinions in these decisions give a much-needed road map for tax advisers to follow when recommending compensation amounts for S corporation shareholder-employees.

JD & Associates

In JD & Associates,19 Jeffrey Dahl was the sole shareholder of JDA, an accounting firm taxed as an S corporation. Dahl was a CPA with over 20 years of experience, and he ran a very successful firm. He was responsible for making all the firm’s hiring decisions, paying its bills, maintaining its books and records, preparing its tax returns, and preparing and reviewing tax returns for the firm’s clients.

Despite this laundry list of responsibilities, Dahl drew a salary of only $19,000 in 1997, $30,000 in 1998, and $30,000 in 1999, opting instead to take distributions from the S corporation totaling $47,000 in 1997 and $50,000 in both 1998 and 1999.

The IRS asserted that Dahl’s compensation was unreasonably low, citing his responsibilities as managing partner of the firm. Engaging the services of a certified valuation engineer (the IRS expert), the IRS made its own determination of reasonable compensation for Dahl’s services.

The IRS expert, using a national survey of financial ratios conducted by Risk Management Association (RMA), compared the following financial ratios of JDA and Dahl to those of accounting firms with comparable asset levels:

* JDA’s after-tax profit as a percentage of net sales. The resulting ratio confirmed that JDA was 200%–300% more profitable than its peers.20

* Dahl’s salary as a percentage of net sales. The resulting ratio confirmed that Dahl’s compensation was 166%–266% less than that of his peers.21

The IRS expert then normalized Dahl’s compensation by the average officers’ compensation percentages found in the RMA survey and determined his reasonable compensation to be $69,584 in 1997, $79,823 in 1998, and $79,711 in 1999.22

In reaching its decision in favor of the IRS, the North Dakota District Court condensed nine factors previously used by the Eighth Circuit23 to determine reasonable compensation in the C corporation arena into the following three groupings:24

* Employee performance;
* Salary comparisons; and
* Company conditions.

In examining the first factor, the court cited JDA’s after-tax profit as a percentage of sales and concluded that Dahl’s performance as head of JDA was exemplary. Thus, the court stated that Dahl’s compensation was “not congruent to his performance.”25

The comparison of salaries also evidenced that Dahl’s salary was unreasonable. The court noted that Dahl took a salary barely in excess of his subordinate employees and failed to receive a raise in 1998 and 1999 despite JDA’s increase in gross receipts during those years.26

Finally, the conditions of the company dictated higher pay for Dahl. As a small enterprise with few requirements in terms of reinvestment, the court believed there was excess capital for employee compensation, which would allow for a higher salary than Dahl received.27

Having found that all three factors of its test weighed against Dahl, the court concluded that Dahl’s compensation was unreasonably low and upheld the IRS’s recharacterization of distributions to wages of $42,817 in 1997, $33,072 in 1998, and $35,582 in 1999.28

IRS Fact Sheet 2008-25

After the district court’s decision in JD & Associates, the IRS issued a fact sheet29 to remind S corporations of the importance of paying reasonable compensation to their shareholder-employees. To aid shareholders in determining a reasonable salary, the IRS summarized the factors considered by the courts in making this determination and advised shareholders to give them careful consideration in establishing their compensation.30


At the end of 2010, an Iowa district court decided Watson, offering another detailed look at the methodology employed by the IRS and the courts in determining reasonable compensation.

David Watson, like Jeffrey Dahl, was a CPA. He was also the sole shareholder and employee of DEWPC, an S corporation, which in turn was a 25% shareholder in LWBJ, a successful accounting firm. During 2002 and 2003, LWBJ exceeded $2 million in gross revenues. Watson typically worked 35–40 hours a week providing tax services to the firm’s clients.

As the sole shareholder of DEWPC, Watson set his annual compensation at $24,000 for both 2002 and 2003. Watson received distributions from DEWPC of $203,651 and $175,470, respectively, in those years.

The IRS maintained that Watson’s compensation was unreasonably low based on the services he provided to DEWPC. The IRS engaged the services of the same general engineer used in JD & Associates to determine an amount of reasonable compensation.

In doing so, the IRS again sought to determine the health of DEWPC and Watson’s compensation relative to his peers and subordinates. The IRS expert used the RMA annual statement studies to determine that DEWPC was at least three times more profitable than comparably sized firms in the accounting field. Using data from Robert Half, a large international specialized staffing services firm, and a University of Iowa survey, the IRS expert found that individuals in positions subordinate to Watson were paid significantly more in compensation.

To quantify the amount of reasonable compensation, the IRS expert turned to the Management of an Accounting Practice (MAP) survey conducted by the AICPA specific to the Iowa Society of CPAs. The MAP indicated that an average director (defined as solely an employee with no shareholder interest) in a firm the size of DEWPC would realize approximately $70,000 in compensation annually. The IRS expert then determined that, on average, owners (defined as both a shareholder and an employee in a firm) such as Watson billed at a rate approximately 33% higher than did a director. The IRS expert grossed up the $70,000 in director compensation by 33% to reflect Watson’s ownership interest, resulting in reasonable annual compensation of $93,000.31

The district court held in favor of the IRS. The court, citing Watson’s 20 years of experience, advanced degree, and the hours per week he spent as one of the primary earners at a well-established firm, concluded that any reasonable person in Watson’s position at such a profitable firm would be expected to earn far more than a $24,000 salary. The court agreed with the IRS that a reasonable salary in both 2002 and 2003 would be $91,044; correspondingly, it reclassified $67,044 of Watson’s distributions in each of those years as compensation, holding DEWPC liable for payroll taxes on the reclassified amounts.

Lessons from JD & Associates and Watson

An S corporation should treat a shareholder who provides substantial services to the S corporation as an employee and compensate him or her accordingly. In computing a reasonable salary, tax advisers should take a lesson from JD & Associates and Watson and perform an analysis using the factors provided by the Eighth Circuit32 and the IRS Fact Sheet.33 In particular, advisers should give several of the factors careful consideration.

Nature of the S Corporation’s Business

It is no coincidence that each case cited in this discussion involves a professional services corporation, such as law, accounting, or consulting firms. It is the IRS’s view that in these businesses, profits are generated primarily by the personal efforts of the employees; as a result, a significant portion of the profits should be paid out in compensation rather than distributions.

To the contrary, in other types of businesses the revenue is typically driven less by a shareholder’s personal efforts and more by the corporation’s capital and assets. In these businesses, a lower salary for the shareholder-employees may be justified.

Employee Qualifications, Responsibilities, and Time and Effort Devoted to Business

A full understanding of the nature, extent, and scope of the shareholder-employee’s services is essential in determining reasonable compensation. As seen in Davis, a shareholder who provides limited services need not draw any salary. In addition, a reduced role for a once full-time shareholder-employee may justify a decrease in salary or compensation to less than industry norms. Conversely, the greater the experience, responsibilities, and effort of the shareholder-employee, the larger the salary that will be required.

Compensation Compared with Nonshareholder Employees or Amounts Paid in Prior Years

Here, common sense rules. In both JD & Associates and Watson, CPAs with significant experience and expertise were paid a smaller salary than recent college graduates. Clearly, this is not advisable. Similarly, if a shareholder-employee has more responsibilities than the highest paid nonshareholder, the shareholder’s wage should logically be higher than the nonshareholder’s wage.

Comparisons with prior years are also relevant. If the corporation has enjoyed rising revenues but the shareholder-employee’s salary has not increased, this may be an indication that compensation is unreasonably low. In addition, if the corporation recently elected S status and correspondingly reduced its amount of shareholder compensation, this will raise questions about whether the motivation behind the salary reduction was to avoid payroll taxes.

What Comparable Businesses Pay for Similar Services

Tax advisers should review basic benchmarking tools from sources such as,, Robert Half, and Bureau of Labor Statistics wage data to determine the relative reasonableness of the shareholder-employee’s compensation when compared with industry norms.

Compensation as a Percentage of Corporate Sales or Profits

As another vital step in their analyses, tax advisers should use the financial ratios published in the RMA and industry-specific publications such as the MAP to determine the corporation’s overall profitability and the shareholder-employee’s compensation as a percentage of sales or profits. Whenever possible, advisers should make these comparisons with similarly sized companies within the same geographic region.

The RMA and the MAP are particularly useful in that they compare a shareholder-employee’s compensation with the corporation’s profitability and not with other shareholder-employees. Therefore, a CPA in Montana will not have his or her salary compared with a CPA in Manhattan, where the amount of reasonable compensation may well be materially different.

If the resulting ratios indicate that the S corporation is more profitable than its peers but is paying less salary to the shareholder-employee, tax advisers should determine if there are any differentiating factors that would justify this lower salary, such as the shareholder’s reduced role or the corporation’s need to retain capital for expansion. If these factors are not present, an increase in compensation to the industry and geographic norms provided for in the publications likely will be necessary.

Compensation Compared with Distributions

While large distributions coupled with a small salary may increase the likelihood of IRS scrutiny, there is no requirement that an S corporation pay out all profits as compensation. Though the district court in Watson recharacterized significant distributions as salary, it permitted Watson to withdraw over $110,000 as distributions in 2002 and nearly $85,000 in 2003. While the opinion did not discuss it, the court may have been content to recharacterize just enough distributions to ensure that Watson’s compensation exceeded the Social Security wage base in place for the years at issue.34 In doing so, the payroll tax savings on Watson’s remaining distributions amounted only to the 2.9% Medicare tax.

If a careful analysis of the factors supports compensation equal to or above the Social Security wage base, setting a shareholder’s compensation below that amount likely leaves a greater likelihood of IRS scrutiny. Conversely, as the salary amounts equal or exceed that wage base, the tax savings of the salary-for-distribution trade diminish greatly, and this may reduce the risk of an IRS challenge.

Can a Shareholder Forgo Both Salary and Distributions?

The IRS fact sheet provides that “[t]he amount of the compensation will never exceed the amount received by the shareholder either directly or indirectly. However, if cash or property . . . did go to the shareholder . . . the level of salary must be reasonable and appropriate.” This language would seem to indicate that there is no requirement that an S corporation pay compensation to a shareholder-employee provided that he or she also forgoes distributions. Even with that bit of guidance from the IRS, it is prudent advice to encourage a profitable S corporation to start making reasonable salary payments to its shareholder-employees as soon as it has the means to do so.

What Does the Future Hold?

S corporation reasonable compensation is a hot issue. The 2005 TIGTA report recommended imposing self-employment tax on the undistributed income of all shareholders owning more than 50% of an S corporation’s stock. Similarly, the GAO report posed several alternatives for S corporation reform, including imposing self-employment tax on the undistributed income of all shareholders. Most recently, in 2010 the House of Representatives passed proposed legislation that would have subjected all undistributed income of professional service S corporations to self-employment tax.35 The measure died in the Senate, but if a similar law were to be passed, the inherent employment tax advantage these corporations have long enjoyed would disappear.

It is likely that the limitation on the amount of Social Security wages subject to payroll tax will continue to increase, with some suggesting that Congress might remove it entirely. If this were to occur, the likelihood of abuse would only increase. Suffice it to say that Watson will not be the last we hear regarding S corporation reasonable compensation.


1 David E. Watson, P.C., 714 F. Supp. 2d 954 (S.D. Iowa 2010).

2 JD & Assocs., Ltd., 3:04-cv-59 (D.N.D. 2006).

3 S corporations may pay corporate-level tax under Sec. 1374 (tax imposed on certain built-in gains) or Sec. 1375 (tax on excess net passive income). In those circumstances, there is motivation for an S corporation to zero out taxable income through the payment of salaries to avoid the imposition of corporate-level tax. As a result, these S corporations may find the compensation of their shareholder-employees challenged as being unreasonably high.

4 Sec. 1366.

5 Rev. Rul. 59-221, 1959-1 C.B. 225.

6 Sec. 1402(a).

7 Sec. 1368.

8 Rev. Rul. 74-44, 1974-1 C.B. 287.

9 Joseph Radtke, S.C., 712 F. Supp. 143 (E.D. Wis. 1989).

10 Spicer Accounting, Inc., 918 F.2d 90 (9th Cir. 1990).

11 Id.

12 Sec. 3121(d)(1).

13 Spicer Accounting, Inc., note 10 above.

14 Joseph M. Grey Public Accountant, P.C., 119 T.C. 121 (2002).

15 See Veterinary Surgical Consultants, P.C., 117 T.C. 141 (2001); Mike J. Graham Trucking, Inc., T.C. Memo. 2003-49; Superior Proside, Inc., T.C. Memo. 2003-50; Specialty Transport & Delivery Services, Inc., T.C. Memo. 2003-51; Nu-Look Design, Inc., T.C. Memo. 2003-52, aff’d, 356 F.3d 290 (3d Cir. 2004); Water-Pure Systems, Inc., T.C. Memo. 2003-53.

16 TIGTA, Actions Are Needed to Eliminate Inequities in the Employment Tax Liabilities of Sole Proprietorships and Single-Shareholder S Corporations (2005-30-080) (May 2005).

17 U.S. GAO, Tax Gap: Actions Needed to Address Noncompliance with S Corporation Tax Rules (GAO-10-195) (December 2009).

18 Davis, No. 93-C-1173 (D. Colo. 1994).

19 JD & Assocs., Ltd., note 2 above.

20 Id.

21 Id.

22 Id.

23 See Charles Schneider & Co., 500 F.2d 148 (8th Cir. 1974). The JD & Associates court characterized these nine factors as: (1) employee qualifications; (2) the nature, extent, and scope of the employee’s work; (3) the size and complexity of the business; (4) prevailing general economic conditions; (5) the employee’s compensation as a percentage of gross and net income; (6) the employee-shareholder’s compensation compared with distributions to shareholders; (7) the employee-shareholder’s compensation compared with nonshareholder employees or amounts paid in prior years; (8) prevailing rates of compensation for comparable positions in comparable concerns; and (9) comparison of compensation paid to a particular shareholder-employee in previous years where the corporation has a limited number of officers.

24 JD & Assocs., Ltd., note 2 above.

25 Id.

26 Id.

27 Id.

28 The court agreed with the IRS expert’s computation of reasonable compensation of $69,584, $79,823, and $79,711 in 1997, 1998, and 1999, respectively. However, the IRS had originally assessed these reduced amounts, which the court accepted as reasonable.

29 FS-2008-25, Wage Compensation for S Corporation Officers (August 2008).

30 The factors are as follows: (1) training and experience, (2) duties and responsibilities, (3) time and effort devoted to business, (4) dividend history, (5) payments to nonshareholder employees, (6) timing and manner of paying bonuses to key people, (7) what comparable businesses pay for similar services, (8) compensation agreements, and (9) the use of a formula to determine compensation.

31 After reduction for nontaxable fringe benefits, reasonable compensation was held to be $91,044 in both 2002 and 2003.

32 See note 23 above.

33 See note 30 above.

34 $84,900 in 2002 and $87,000 in 2003 (Publication 15-A, Employer’s Supplemental Tax Guide 14 (rev. 2002 and rev. 2003)).

35 American Jobs and Closing Tax Loopholes Act of 2010, H.R. 4231, §413.

Tony Nitti is a partner with WithumSmith+Brown, PC, in Aspen, CO.

Carrying Back Net Operating Losses

By Alistair M. Nevius

One of the biggest questions surrounding net operating losses (NOLs) is when to use this potentially significant tax attribute. Once a decision is made about when an NOL will be used, it is important that it be carried back and/or forward properly. Under IRC § 172(b)(1), an NOL (in general) can be carried back two years and forward 20 years (certain special rules exist for NOLs for specified losses, resulting in NOLs that may be carried back more than two years). The general rule under section 172(b)(2) is that an NOL is used in the following order until exhausted:

* Carried back to the second preceding tax year;

* Carried back to the first preceding tax year; and

* Carried forward to the following 20 tax years.

Carrying an NOL back to the two preceding tax years may not result in its best utilization, even if the taxpayer had significant income in those years, because the income could have been taxed at lower rates due to capital gain or qualified dividends. The taxpayer may benefit in these circumstances by electing to waive the carryback period. This is an all-or-nothing election, so the taxpayer is electing either affirmatively to waive the entire carryback period or by default to use the entire carryback period. In addition, this election must be “made by the due date (including extensions of time) for filing the taxpayer’s return” and “shall be irrevocable” (IRC § 172(b)(3)). Therefore, this election should be made after weighing the benefits of carrying the NOL back to the two preceding tax years versus the expected benefits of carrying the NOL forward.


Individual taxpayers can carry an NOL back to the two preceding years in one of two ways. The first is by filing Form 1045, Application for Tentative Refund, within one year from the end of the year in which the NOL occurred. The taxpayer could also file Form 1040X, Amended U.S. Individual Income Tax Return.

The Form 1040X filing period is governed by section 6511. A claim for credit or refund must generally be “filed by the taxpayer within 3 years from the time the return was filed or 2 years from the time the tax was paid, whichever of such periods expires later” (section 6511(a)). However, this period is modified in the case of a claim for credit or refund attributable to an NOL carryback; the limitation period ends three years after the due date for filing the return (including extensions) for the tax year of the NOL that results in the carryback.

Making the election under section 172(b)(3) to waive the carryback period on a timely filed return is critical. If the election is not made and the claims for credit or refund are not filed for the preceding two years within the limitation period discussed above, the taxpayer may lose out on its ability to use all or a portion of its NOL.

For a detailed discussion of the issues in this area, see “Mitigating the Results of a Failure to Carry Back an NOL,” by Robert L. Venables III, CPA, J.D., LL.M., in the August 2011 issue of The Tax Adviser.

Thursday, August 18, 2011

Accounting Board to Seek Comments on Rotating Auditors


WASHINGTON — An accounting oversight board agreed on Tuesday to seek public comment on whether companies should be required to change their auditors every few years, a move that supporters say they believe would strengthen the independence and objectivity of accountants that inspect corporate ledgers for accuracy.

The regulatory body, the Public Company Accounting Oversight Board, voted unanimously to seek comment over the next four months on a concept known as mandatory audit firm rotation. The practice would limit the number of consecutive years that an accounting firm could audit the books of a publicly traded company.

The proposal is the third significant measure that the accounting board, created in 2002 as part of the Sarbanes-Oxley Act, has begun to examine in an effort to give investors greater certainty that auditors are in fact doing their job — something that was not always clear after the 2008 financial crisis, the Enron collapse and other recent accounting failures.

“The reason to consider auditor term limits is that they may reduce the pressure auditors face to develop and protect long-term client relationships to the detriment of investors and our capital markets,” said James R. Doty, the chairman of accounting oversight board and an advocate of the idea.

In part, he said, those pressures exist because of “the fundamental conflict of the audit client paying the auditor,” which could create incentives for the auditor to render a favorable, yet misleading, opinion.

Some other members of the five-person board voiced doubts about the concept, however, saying that the cost of getting new auditors up to speed on large companies every few years would burden both the company being audited and the accounting firms.

“I have serious doubts that mandatory rotation is a practical or cost-effective way of strengthening independence,” said Daniel L. Goelzer, who is one of the board’s two certified public accountants. While he recognizes the potential for auditor bias in favor of a client, Mr. Goelzer said, “there are already powerful forces built into public company auditing to foster and maintain independence.”

The board has asked for comments on how to improve auditor independence to be submitted by Dec. 14. It also plans a public meeting to discuss the proposal in March. Any rule approved by the board also has to be approved by the Securities and Exchange Commission to take effect.

Mandatory audit firm rotation has been considered at various times since the 1970s. Most recently, in 2002, Congress considered including it in the Sarbanes-Oxley legislation, but decided instead to require a report on the topic by the General Accounting Office (now called the Government Accountability Office). The act did require auditors to rotate the partner in charge of a company’s audit every five years.

The G.A.O. report, issued in 2003, found that “mandatory audit firm rotation may not be the most efficient way to enhance auditor independence and audit quality.” Firms also estimated that first-year auditing costs would rise by 20 percent as a new auditor got up to speed on a company.

But the report also said that the board would need to consider the results of its reviews of audits and auditing firms to determine whether more needed to be done, particularly in cases where a company had used the same auditor for decades.

Steven B. Harris, a member of the accounting oversight board, said the evidence showed that the Sarbanes-Oxley measures had failed to eliminate “the strong incentives that lead some auditors to serve the interests of the company paying the bills rather than those of investors.”

Eight years of those reviews have revealed “several hundred cases” where “the firm failed to fulfill its fundamental responsibility in the audit — to obtain reasonable assurance about whether the financial statements are free of material misstatement,” according to the board’s release.

In the most recent reporting cycle, ended last year, the board’s inspectors “have also identified more issues than in prior years.”

The board is seeking comments on whether mandatory audit rotation would enhance objectivity among auditors and make them better able to resist management pressure, and if so, what would be an appropriate term length.

Also of interest to the board is whether it might require rotation only for a subset of publicly traded companies, like the largest companies; whether there are enough qualified auditors to permit giant multinational companies to change regularly; and whether the practice would lead to opinion shopping.

Considering mandatory audit rotation is one of three changes in auditing practice that the board is considering. The other proposals also are still in the early stages. One of those, which has already finished its comment period, would require accounting firms to have the partner in charge of an audit sign the firm’s report, much as a company’s executives have to attest to its financial statements.

Another, on which comments are due Sept. 30, would expand the scope of the auditor’s report, which now is little more than a boilerplate statement that the financial information fairly reflects the company’s economic condition.

Workers' comp systems getting stricter

By Melissa Maynard, Stateline Staff Writer

Montana has long had a workers’ comp problem. Its labor force is injured far more frequently and at greater expense to employers than is typical around the country. Part of that stems from the jobs people do in Montana — drilling for oil and working in mines. But part of it has been the system itself. A prominent national study, released last fall, singled out Montana’s as the most expensive workers’ compensation system in the United States — with premiums 163 percent higher than the national median.

“We had businesses just up and walking across the border to Idaho and North Dakota,” says state Representative Scott Reichner, the sponsor of an overhaul package that was signed into law in April. “It was killing us. Lawyers push the envelope and make the system looser and looser and next thing you know we’re covering everybody for everything."

In March, the Montana Supreme Court upheld a Workers’ Compensation Court award involving a man who smoked marijuana on the job at a tourist attraction before feeding — and subsequently being mauled by — a grizzly bear. The state is footing approximately $35,000 in medical bills because, in the words of the court, bears are “equal opportunity maulers,” even though the decision to smoke pot around them was “ill-advised to say the least and mind-bogglingly stupid to say the most.”

Since the Montana system was revised in April, however, the effects have been dramatic. Insurers in the state have lowered premiums by 20 percent, and a further reduction of 10 to 15 percent is expected within the next five years. The new law shortens the period in which workers can receive medical benefits, and specifies which doctors they can see and how well those doctors are compensated. If an employee is injured on a break while away from the workplace, the employer is no longer likely to be on the hook for lost wages and medical expenses.

Unique programs

State workers’ comp systems in America have little in common. “Workers’ compensation is a state-run program with no federal standards and almost no federal involvement,” says John Burton, a professor emeritus at Rutgers University who has studied the subject for more than 40 years. “There’s an enormous amount of variation in who is eligible and the level and type of health care that must be provided.”

Burton chaired the National Commission on State Workmen’s Compensation Laws in the early 1970s, which concluded that federal standards might be necessary. Many states increased benefits for injured workers in the years that followed in the hopes of fending off federal intervention.

But since the 1990s, states have been moving in the other direction — tightening eligibility in response to rising medical costs. This year, legislatures in Illinois, North Carolina, Oklahoma, Kansas and Washington State, like the one in Montana, made significant changes aimed at cutting costs and demonstrating a more business-friendly climate. “It’s not that if you’re in the system, you’ve seen a weekly benefit cut,” Burton says. “It’s that many states have made it harder to get any benefits at all.”

Every state but Texas requires employers to provide some workers’ comp insurance for their employees, and many large companies self-insure, paying injured workers themselves according to the standards in state law. In Ohio, North Dakota, Washington and Wyoming, the only alternative to self-insurance is to enroll in a state-run plan. About 20 other states allow employers to either enroll in a state plan or carry private insurance. In the remaining states, purchasing insurance through a private carrier is the only option other than self-insurance.

Medical benefits reviewed

Montana’s legislation was widely supported but involved significant compromise from labor, doctors, lawyers, business groups and insurance companies. “When you bring a consensus team together, if at the end of the day all sides are squealing like they’ve been bit by a dog, then you know you’ve got it just about right,” Governor Brian Schweitzer said in an interview with Stateline.

The governor was himself among the squealers. Schweitzer, a Democrat, was never fully comfortable with eliminating ongoing “permanent partial” benefits for workers with certain minor injuries. He vetoed a provision that would have excluded tips from workers’ income calculations for wage replacement. Still, when all was said and done, Schweitzer reports, “I said ‘Eureka!’ We’ve got it.”

Some of Montana’s most significant and controversial changes pertain to the way medicine is practiced. Medical benefits are now capped at five years except when extensions are granted by a review panel of doctors. The idea is that 90 percent of injured workers reach “maximum medical improvement” within five years and shouldn’t be able to rely on workers’ comp as their primary form of medical care indefinitely. The 10 percent who require ongoing care related to their injuries may go before a medical review board to argue for two-year extensions.

Doctors and hospitals are seeing their medical fee schedules frozen, and are being asked to follow uniform treatment guidelines and file additional paperwork. Injured workers are limited in their choice of physician; insurance companies can refer them to a doctor of the company’s choosing if they disapprove of the original selection.

Some doctors say they felt they were being attacked by legislators during the process. “I am personally offended by the concept that we somehow drive this,” Chris Mack, a neurosurgeon from Missoula, told legislators in one heated exchange. The impression is that “we order inappropriate tests, we ask patients to come and see us, and we schedule them for routine visits so that we can bill.” Mack says none of this was the case.

Injured in Illinois

While Montana was changing its law, Illinois was reducing medical fee schedules for doctors and hospitals and changing a number of standards and processes after a bizarre set of scandals and circumstance gave the issue a boost in political momentum.

The CEO of industrial manufacturer Caterpillar, a major Illinois employer, cited high workers’ comp costs in a widely publicized letter to the governor in which he threatened to take his firm out of the state. National rankings called out the Illinois system as the third most expensive in the country. And then a scandal broke at Menard Correctional Facility, where more than half of all workers have claimed an on-the-job injury, costing the state almost $10 million in payouts over the last three years.

Many of the workers in question have said that repeatedly unlocking cell doors has caused carpal tunnel syndrome, a claim that arbitrators have often rewarded with large payouts. Capping awards for carpal tunnel was among the changes in this year’s legislation. “That scandal kept bubbling in the papers for months and months, and ultimately succeeded in moving workers’ compensation from the back burner to the front burner and keeping it there,” says Peter Burton, of the National Council on Compensation Insurance.

Oklahoma completely rewrote its workers’ comp law this legislative session, in part to the benefit of workers. Changes were geared toward lowering costs but also toward getting legitimate medical claims approved more quickly, says state Representative Daniel Sullivan, the bill’s sponsor. Medical care that follows treatment guidelines can move forward now with less of a hassle for injured workers. In the past, an employer or insurance carrier in Oklahoma could delay access to any medical procedure by challenging the need for care in Workers’ Compensation Court. “We’re trying to eliminate some of the unnecessary aggravation in the system for everyone involved,” Sullivan says.

Other changes relate to the qualifications of independent medical examiners, whose determinations are used by the Workers’ Compensation Court to make decisions about contested claims. Those examiners are now required to be medical doctors or doctors of osteopathy, and to specialize in the injuries they are diagnosing. Before, says Sullivan, “We had chiropractors writing reports on psychological overlay and opining on things they knew nothing about.”