The unwritten rules of tax

Avoid errors on your return

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Donna H. Laubscher, CPA

While there may not be as many unwritten rules in tax as there are in baseball, and tax rules definitely aren’t as fun, there are some that create a conundrum when working in the tax compliance and consultation field.

Reasonable compensation

Heading the list is the concept of reasonable compensation. Reasonable compensation is critical in a couple of different ways. One is that in an S Corporation, your reasonable compensation needs to be high enough so that the corporation is paying payroll taxes on the shareholders. Additionally, the reasonable compensation should be higher than any distributions of earnings of the S Corporation. For example, if the distributions to a shareholder are $100,000, then that shareholder’s wages should also, as a general rule, be at least $100,000.

But, it could be similar to a double switch when it’s reasonable compensation regarding a C Corporation. A C Corporation is not so much about the payroll taxes but trying to avoid the double taxation of the dividends coming out of the C Corporation.

So, you may ponder – what exactly is reasonable compensation? Well, it’s not defined. There are no regulations, there’s no code, there’s nothing that says your reasonable compensation should be X. It’s a completely facts and circumstances based test.

Double dipping

Double dipping is great when you’re having an ice cream cone in the stands watching the baseball game, but double dipping is not allowed for taxes. Examples of questions we receive that could be considered to be double dipping would be as follows:

  • You have a rental house and you give a certificate to a charity to raffle off a week in your prime location. Taxpayers want to be able to take a charitable deduction for that donation of the week in the super cool Spring Training location. But they are already taking all the expenses, such as HOA fees, mortgage interest and real estate taxes, on their Schedule E page 1; therefore, no double dipping allowed.
  • Another example is a donation of your time. A donation of time is not something that can be quantified; therefore, you are not allowed to take a charitable deduction for that.
  • One final example of double dipping that’s not allowed is if you are a restaurant owner and you give a gift certificate to an organization who’s asking for donations. There’s no deduction for the gift certificate. The reason for this is when the gift certificate is redeemed, the cost of your items at that point will be excluded, as part of cost of goods sold, so you don’t get to double dip on this.

If you REALLY want to see the effects of double dipping in your tax return in any of the above examples, you can include the same amount as revenue and then take the deduction against it. Not usually your desired effect, but that’s the only way it can work.

Cash basis of accounting

This final item of unwritten tax rules isn’t technically unwritten, but it’s one that we need to explain a lot. Individuals in many small businesses are on the cash basis of accounting. This means that revenue is not recognized on your tax return until the cash is received. This also means if you have a bad debt, you don’t get to take the bad debt expense. Bad debts can only be recognized against accrual income, which means that you are recognizing income on your accounts receivable.

So again, the unwritten rules of tax aren’t as exciting as some of the unwritten rules of baseball such as stealing second base when your team is already ahead by a bajillion trillion runs. But numerically, these rules can have a longer lasting effect on your finances than the outcome of a single baseball game in a 162 game season.

Donna H. Laubscher, CPA, Partner, specializes in tax planning and compliance for closely held businesses. She can be reached at DonnaL@hhcpa.com or (480) 483-1170.