Practice & Procedures

New IRS Approach to Research Program • Advantages of a C Corporation • Installment Agreements: An Alternative to Offers in Compromise

Editor:
John L. Miller, CPA
Faculty Instructor
Metropolitan Community College
Omaha, NE

Mr. Miller is a member of the AICPA Tax Division’s IRS Practice and Procedures Committee. Messrs. Carlton, Starkman, and Zwick are also members of that committee. For further information about this column, contact Mr. Miller at johnmillercpa@cox.net.

IRS Announces New Approach to the National Research Program

Following public Senate hearings focused on IRS tactics, Congress enacted the IRS Restructuring and Reform Act of 1998, P.L. 105-206. With the adoption of the act and the public outrage created by the Senate hearings, a “gentler, kinder,” more service-oriented IRS was created. This resulted in a restructuring that saw more budget dollars ramping up service-related activities and a decrease in compliance efforts, especially taxpayer audits.

Commissioner Mark W. Everson took office at a time of growing budget deficits and a public perception of poor voluntary tax compliance among taxpayers. Too little emphasis was placed on compliance, and too many audits resulted in no changes. Understanding that a smarter and more effective approach toward auditing taxpayer compliance was needed, Everson instituted the National Research Program (NRP). The original approach was to run audits in repeating cycles of Form 1040, U.S. Individual Income Tax Return, Form 1120S, U.S. Income Tax Return for an S Corporation, Form 1065, U.S. Return of Partnership Income, and Form 1120, U.S. Corporation Income Tax Return.

The initial cycle saw fewer than 50,000 individual returns for tax year 2001 selected on a statistical basis for examination. The selected returns were stratified and organized at the Austin Service Center and assigned to the field or campus for examination. The results were startling: They quantified the tax gap at $348 billion, of which the greatest piece resulted from unreported and underreported income. The program provided the Service with details on the composition of the tax gap and led to a more focused approach to compliance examinations.

The second cycle focused on S corporation tax returns. Approximately 5,000 returns for 2003 and 2004 were statistically selected and assigned to the field for examination. This cycle will be completed in 2007.

Based on the results of the initial NRP, Acting Commissioner Kevin Brown has announced a new NRP reporting compliance study to begin in October 2007 that will use a multiyear rolling methodology (Internal Revenue News Release IR-2007-113). The old approach will be halted after the completion of the S corporation cycle. In the new study, the IRS will select approximately 13,000 individual income tax returns (Forms 1040) each year. The sample will include all ranges of income groups, as well as farms and sole proprietors. Returns will be selected based on criteria established from the initial NRP results, which will enable the IRS to reduce the number of audits of compliant taxpayers.

This program will continue on an annual basis, with approximately 13,000 new returns selected each year. The intention is to look at three-year cycle results on a rolling basis. As patterns of noncompliance change over time, the criteria for examination selection will change accordingly. This approach will allow the Service to maintain the most current selection criteria to attack the tax gap.

Programs will continue to focus on flowthrough entities. Since the results of these entities are reported on individual returns, the NRP results will enable the IRS to concentrate on those flowthrough entities causing the greatest noncompliance problems.

The fact remains that the federal budget will remain tight, and additional dollars for enforcement will be difficult to obtain. This new study will provide the Service with information that will help it use its compliance enforcement personnel most efficiently.

From Lawrence H. Carlton, CPA, MST, Carlton & Duran, CPAs, P.C., Bedford, MA

Advantages of a C Corporation

In deciding which form of entity to use for a new small business venture, the potential benefits of a C corporation should be considered. A C corporation may have relative advantages and benefits over other entity forms.

The significant disadvantages of a C corporation are well known:

Double taxation of appreciated assets on sale or dissolution;
High corporate income tax rates on annual income in excess of $75,000; and
Tax traps for accumulated earnings and personal holding companies.

However, there are also significant advantages, especially for non-personal service corporations (non-PSCs):

Low tax rates on the first $75,000 of annual income for non-PSCs;
Availability of a fiscal year for non-PSCs;
Superior fringe benefits for owner-employees;
Different audit potential than passthrough entities;
Sec. 1202 reduced rate of capital gains taxation on the sale of qualified small business stock; and
Sec. 1244 ordinary loss deduction for a failed small business C corporation.

Low tax rates: The C corporation is a niche choice for small business. It allows a non-PSC business to accumulate capital at low tax rates for funding accounts receivable, inventory, and fixed assets. In an S corporation, limited liability company (LLC), partnership, or proprietorship, capital is taxed at the individual’s marginal tax rate, often with FICA liability. If the C corporation’s taxable income can be managed so it does not exceed $75,000, it can achieve significant front-end tax savings, which can greatly reduce the cost of acquiring capital to use in a business.

Fiscal year: Non-PSCs are permitted to use a fiscal year. (PSCs can use a fiscal year with a Sec. 444 election, but there is no benefit to this complex procedure.) A fiscal year spans two calendar years, allowing an owner-employee some leeway to control the calendar year in which he or she will recognize salary income and when the C corporation will realize a deduction.

Fringe benefits: When most of the owners of a C corporation are also employees, a self-insured medical reimbursement plan under Sec. 105(b) is a viable option. It allows the C corporation to pay all medical expenses not reimbursed by insurance, including some over-the-counter medications (Rev. Rul. 2003-102). The corporation can also deduct disability insurance for owner-employees.

Audit potential and tax liability: The audit potential for C corporations and their owners is different than it is for other entities and their owners. There is no income or loss passthrough from a C corporation to raise the owners’ individual audit potential. An audit of a C corporation may lead to adjustments that result in taxation at unplanned high corporate income tax rates—or worse, as a dividend to shareholders, resulting in double taxation. However, the owners of a C corporation generally will not be liable for any additional taxes assessed to the C corporation due to an audit. If a tax assessment exceeds the value of the business, the owners may be able to simply abandon the bankrupt C corporation and walk away from tax debt. In a passthrough or disregarded entity, the tax liability of the business falls directly on the owners.

Sec. 1202: When a shareholder sells or redeems shares, Sec. 1202 benefits may be available. Sec. 1202 allows 50% of the gain on qualified small business stock to be excluded from income, with the balance taxed at 28%—an effective rate of 14%. If a taxpayer is subject to the alternative minimum tax (AMT), the AMT adjustment for gain from the sale of qualified small business stock creates an effective 15% capital gains tax rate. However, the additional 1% AMT is a credit that may be claimed in subsequent years on Form 8801, Credit for Prior Year Minimum Tax—Individuals, Estates, and Trusts, until fully used (which might take decades). The real advantage in Sec. 1202 is that, in states that allow this exclusion, state capital gains taxation can be cut in half.

To qualify for Sec. 1202, the shares must be held for at least five years, at least 80% of the assets must be used in a trade or business, and the business must not be a personal service provider (such as an accountant, actuary, attorney, architect, or other business in which the product is the employees’ knowledge), among other technical requirements.

Sec. 1244: If the corporation fails, Sec. 1244 allows a full deduction, up to $100,000 for joint taxpayers ($50,000 for single taxpayers), as an ordinary loss. Dissolution of the cor-poration in recognition of the loss may be planned for a year in which the owners will have sufficient income to offset the loss. For example, the owner might be able to realize these losses as an offset to salary after arranging for new full-time employment. In addition, should the loss be claimed in the wrong year, Sec. 6511(d)(1) provides a seven-year statute of limitation for a taxpayer to take corrective action to claim the loss in the proper year. In contrast, with a passthrough or disregarded entity, unless the owner has income from other sources, he or she may be unable to use losses in the year incurred.

Other Considerations

The current 15% tax rate on qualified dividend income allows distribution of corporate income at low rates. While this is in effect, the total corporate income tax plus individual dividend tax may be less than the total tax on salary with FICA. The C corporation need not be exclusive; it can be an operating entity combined with non-C entities. The other entities can hold real, personal, or intangible property that may appreciate in value and cause tax problems if held in a C corporation. However, care should be taken to avoid a tainted PSC under Sec. 269A, which performs services for one other entity in which a principal purpose is to avoid, evade, or reduce taxes. If a PSC is subject to Sec. 269A, the IRS may allocate income, credits, deductions, exclusions, and other allowances between the corporation and its employee-owners in order to prevent the evasion or avoidance of tax.

Once the C corporation is successful, having accumulated all its capital needs, it might elect and maintain S status for the requisite 10 years and avoid the Sec. 1374 tax on built-in gain, thereby avoiding the double tax on appreciated assets on sale or dissolution. Meanwhile, as a C corporation it can accumulate capital at lower income tax rates.

Renting property to one’s C corporation is another way to extract earnings without incurring FICA. Under Regs. Sec. 1.469-2(f)(6), net rental income from certain C corporations is treated as nonpassive income, while net rental losses are treated as passive.

When multiple entities are used, care must be taken to properly elect and allocate the deduction and credit limits allowed to controlled groups. Multiple payroll filings need not pose a problem, nor should excess payroll taxes, when the entities take advantage of the “common paymaster” pro visions of Secs. 3121(s) and 3306(p).

Few PSC Advantages

There are few advantages in using a C corporation for a PSC because of the required calendar year and the 35% flat income tax (Sec. 11(b)(2)). A PSC is defined in Sec. 448(d)(2) as any corporation that performs substantially all of its activities in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting and is owned by its employees or assigns.

PSC advantages include the ability to use a medical reimbursement plan and some limited flexibility to manage income for owner-employees. Income could be planned to show a profit and owe corporate income tax in year 1, while generating a net operating loss (NOL) in year 2 for a carryback refund; or an NOL can be created in year 1 for carryforward to year 2. Timing of owner-employee salaries can help generate the desired result. This option can be especially useful to smooth out salary variations for maximizing retirement plan contributions or to take advantage of changing tax rates.

Conclusion

When faced with a choice of entity, the benefits of a C corporation (or combination with a passthrough entity) should not be ignored. A C corporation will be an infrequent choice, but it can be the right choice in certain situations. A C corporation is not limited to entities incorporated under state law; an LLC or partnership can elect under Regs. Sec. 301.7701-3(c) to be treated as an association taxed as a corporation by filing Form 8832, Entity Classification Election.

From Jay Starkman, CPA, Sole Practitioner, Atlanta, GA

Installment Agreements: An Alternative to Offers in Compromise

The IRS expects income taxes to be paid in a timely manner, but a taxpayer may be unable to make full payment of a tax liability when it is due. While offers in compromise are extremely complex and are often rejected by the Service, Sec. 6159 provides taxpayers that cannot pay their prior tax liabilities in full an option to enter into an installment agreement and pay off those liabilities over a period of time. The IRS is authorized to enter into a written agreement with the taxpayer that will require installment payments based on the amount the taxpayer owes and his or her ability to pay that amount within the time the Service can legally collect payment. While the program provides a taxpayer with additional time to pay the tax, interest and penalties continue to accrue while the payments are being made. The IRS may also file tax liens on the taxpayer’s assets until the taxes are paid. Depending on the amount of tax due, there are different options available under the program.

Application Process

To apply for an installment agreement, the taxpayer must file Form 9465, Installment Agreement Request. If the total amount owed is more than $25,000 (including amounts owed for prior years), the taxpayer must complete Form 433-F, Collection Information Statement, and attach it to Form 9465. On acceptance of the agreement, the taxpayer will be charged a fee of $105 ($52 if the taxpayer agrees to make the payments by electronic funds withdrawal) for a new agreement or $45 for a reinstated agreement. Low-income taxpayers may qualify for a reduced fee of $43 for new agreements but must pay the full amount for a reinstated agreement. Based on the information provided to the Service in these forms, an installment amount will be calculated, and the taxpayer will make monthly payments.

If the IRS accepts the agreement but the installment payments will not result in full payment of the tax due, the Service is required to review the agreement at least once every two years. If the taxpayer’s financial situation changes, the amount of each monthly installment is subject to change as well. Unlike an offer in compromise, the installment agreement gives the Service the option of increasing the monthly payments if the taxpayer’s financial status improves. As a result, it is more likely to approve an installment agreement than an offer in compromise.

Streamlined and Guaranteed Installment Agreements

For taxpayers who owe less than $25,000 (including interest and penalties), the IRS has created the streamlined installment agreement (SIA). To qualify, the installment agreement must provide for the full payment of all taxes, penalties, and interest due within five years of the date of the application for the agreement, or the expiration of the statute of limitation, whichever is earlier. The taxpayer must have filed all prior years’ tax returns before the agreement will be accepted. The advantage of an SIA for the taxpayer is that it does not require the same in-depth financial verification that a normal installment agreement requires.

While the general provisions of the installment agreement rules provide the Service with discretion as to the terms of the agreement, the Code also provides a scenario in which the IRS is required to accept a guaranteed installment agreement offered by a taxpayer. Under Sec. 6159(c), if a taxpayer owes less than $10,000 (exclusive of interest and penalties), the Service must accept the agreement if the taxpayer meets the following requirements:

1. During the previous five years, the taxpayer (and spouse, if filing a joint return) has timely filed all income tax returns and paid any tax due and has not entered into another installment agreement;
2. The taxpayer demonstrates an inability to pay the tax in full;
3. The agreement provides for the full payment of the liability within three years; and
4. The taxpayer agrees to remain in full compliance with the tax laws and the terms of the agreement for the duration of the agreement.

As with any other agreement that binds a taxpayer for the near future, an agreement that resolves current problems should not create future disasters. There is no point in entering into an installment agreement with the Service to pay this year’s tax liability if the agreement will guarantee an inability to pay next year’s liability. The goal is to resolve all issues with the IRS, not just postpone them to a later date.

From Marc Zwick, CPA, J.D., LL.M., Zwick & Steinberger, PLLC, Southfield, MI