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The Profit-Instead-of-Income Subchapter S Tax Strategy’s Been Kilt September 1, 2013

Posted by geoff in News.

Many years ago I was discussing the economics of start-ups with an acquaintance, who told me that in his new start-up they were planning to avoid social security and medicare taxes by paying themselves $1 per year (saving 15% in taxes). They would then take the rest of their income as profit from the business.

I’d heard other people talk about the same strategy, but none so aggressive as these guys. I mean, $1? Talk about a red flag for the IRS. But those guys (I never did hear if they pulled it off) had nothing on Mr. Sean McClary:

Earlier this month, the U.S. Tax Court … ruled that a Subchapter S firm whose sole owner was Mr. McAlary, a California real-estate broker, should have paid him $83,200 in wages for 2006. Instead, he was paid zero.

The court ruled that the firm owed nearly $13,700 in payroll and unemployment taxes, plus more than $4,300 in penalties, for that year. Although the case can’t be cited as precedent, experts take such cases seriously.

$0 per year? That’s the equivalent of donning a Star Trek security guard uniform and beaming down to Planet IRS.

Mr. McClary claims that he wasn’t really that stupid:

When challenged by the IRS, he said he meant to claim at least $24,000, but that his tax preparer had made an error.

I’ll bet that if he had originally gone in at $24K (which is still ridiculously low), the IRS would have let it slide. But now that he set up a situation where they pretty much had to do something, it’s set a precedent that will reverberate throughout the Subchapter S community (some 4 million businesses).

As with anything, there will be positive and negative consequences. The government will get a higher share of Subchapter S income, but the economics of some small businesses may change to the point where their viability is threatened. Many small businesses will decide that the 15% pay cut will tip the scales against entrepreneurship, which already comes with a huge downside.

In the end I suspect that the economic damage will exceed the additional revenues to the government. But for now, Subchapter S owners be warned: pay yourself a market wage.


1. red sweater - September 1, 2013

Isn’t this similar to how Hollywood accounting has worked for decades? Except instead of shortchanging taxes, they only shortchange creditors and sometimes actors, so they get away with it.

2. BrewFan - September 2, 2013

How To Become A Millionaire and Pay No Taxes:

First, get a million dollars. Second, when you’re in Tax Court just say “I forgot”.

Name that comedian!

3. Retired Geezer - September 3, 2013

Steve Martin?

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