Many partnerships and LLCs elect for S-Corporation status. S-Corp taxation is beneficial in that income is only taxed once — at the partner or member level — and doesn't involve any of that horrible self-employment tax on all the profits. The problem is that S-Corps are legally required to file Schedule K-1 (which is essentially a 1099 for partners or members), where the partner or member is left to pay the taxes. It's all simple enough in theory, but nothing with the IRS ever is when it comes to practical applications! Through some dodge S-Corp tactics, we've seen many unscrupulous partners use this dynamic to screw over another partner.
A common pattern of partnership tax problems
Let's say that the Happy Acres Medical Group of Flatbush Avenue LLP is a rather successful medical practice. It has been around since 2005, and its three partners have enjoyed great success. But two of the partners, Dr. Love and Dr. Dre, are getting tired of a third, Dr. Phil, who they find pedantic and a chore to be around. They want to get rid of him, but because the practice has been so successful, Dr. Love and Dr. Dre would have to come up with two million dollars in order to buy him out at a fair market price. And they really don't want to do that.
So what is a feasible way to get him out for less than fair market value? Well, the straightforward answer is to be very unfair. Weaken Dr. Phil with a tax problem until he becomes desperate, depressed, and downtrodden, so Dr. Love and Dr. Dre are able to buy his interest for far less than Dr. Phil would be able to sell it for if he wasn't such a motivated seller.
The following are some of the (dastardly) ways Dr. Love and Dr. Dre could try to weaken Dr. Phil.
Step One: Keep Dr. Phil in the dark
One can extend the due date for K-1 filing until September 15th of the following year. This means that Dr. Phil may not know the amount that he'll owe the IRS for the previous year until the current year is 75% over.
No big deal, you might say. Well if Dr. Phil has a big tax bill for the previous year, he must have received a lot of money, right? He should have no problem paying the taxes, as taxes are based on income and if his taxes are high then surely his income must have also been high?
Unfortunately, the answer is a resounding no! One of the things about S-Corp taxation is that your taxes are based upon your share of the profits. And get this, your share of the profits is not necessarily distributed to you.
Step Two: Release the distributions
For instance, Dr. Love and Dr. Dre, as majority members (seeing as there is two of them against Dr. Phil), could elect to have profits used to purchase capital goods. And what might surprise a lot of people is learning that capital goods are not expensable, but rather merely depreciable; for every capital expenditure, it's like you're taking cash even though you have no cash with which to pay your taxes. Is this grounds for panic? It definitely can feel that way.
While this phantom income increases a partner's capital account — which is a good thing — it can also leave them penniless to pay taxes on that phantom income. And, if you're thinking to yourself that would be devastating, you are absolutely correct.
Of course the other partners will have to pay taxes on the phantom income as well, but when you know you will have a tax bill coming up, you will be in a much better position to pay for it if you can plan ahead, rather than being surprised by an overwhelming bill at the very last minute.
At this point you might be thinking to yourself, "What a terrible thing to do to another person," and you'd be absolutely right. The fight against the IRS is not an easy one, and it seems particularly wrong to throw your partners under the bus. But, in order to stay aware of other possible ways — aside from capital expenditures — that a partner's cash flow can be decreased while maintaining a sizable tax burden, it's important that you read on:
Dirty Trick #1: Estimated taxes paid to jurisdictions where a partner does not have a taxing liability
Let us suppose that Happy Acres is a New York LLP. Dr. Phil lives in Connecticut, while Dr. Love and Dr. Dre live in New Jersey. Every quarter, the partnership overpays their estimated taxes to the State of New jersey. The thing is, Dr. Phil owes no taxes to New Jersey. So, in order to get his money back from the state of New Jersey, Dr Phil has to wait until his federal and state returns are completed before he can file a state-specific tax return to claim his refund from the State of New Jersey.
Now suppose for 2015, the partners overpaid the State of New Jersey. It would be sometime in October 2016 when Dr. Phil would have his New Jersey return filed, and sometime in December when the State of New Jersey processes his return and sends him his refund check. So, we have a year of delay in having the cash actually available to pay taxes. And really, it's more than a year, as some of that income was made in the first quarter of 2015. So in reality, a portion of that income has almost a two-year delay between earning and access. That is a brilliant and devious way to screw a partner. Of course, Dr. Dre and Dr. Love don't mind as they actually owe the State of New Jersey the money. They're just paying the taxes that they already owe.
Dirty Trick #2: Mandatory retirement contributions
Another way to hurt a partner is to force mandatory retirement contributions. While forcing a partner to make this contribution defers taxes on that income, it also reduces the amount of cash available for the taxes that are due (and pulling the money out of the retirement account will inevitably cause some harsh penalties).
Why using dirty tricks to give a partner a tax problem may not work the way you intend
Of course, if a partner takes these dirty tricks laying down or settles on some low-rent representative, it's an unfortunate possibility that these dirty tricks may work. But, if your partner hires a a competent tax firm, you might have a bit of a battle on your hands.
First, intentionally causing a partner a tax problem can be an actionable tort (meaning that if your partner sues you, they can recover money from you for what you put them through). And, if you think the problem will weaken your partner so much that they won't be able to put up a fight, think again. Why? The IRS knows about these tricks.
Well, maybe not everyone at the IRS, but IRS Appeals is loaded with officers who understand how partners can use the tax code to get rid of another partner. And second, because they know about this, we are often able to secure our clients some breathing room so that they can get on solid ground. Once that base has been established, we can help them unleash a little bit of hell back on the partners who have had no intention of acting fairly. Finally, if you're able to get a very helpful IRS employee on your side, the IRS itself could actually pursue the partners for some of their misdeeds.
So, if you're part of an S-Corp and you see any of these warning signs in the actions of your partners, proceed with caution. I'm not one for cliche phrases, but even I'll admit that an ounce of prevention is worth a pound of solution. By hiring a competent firm that can help you stop your partners' devious ways in their tracks, you can get a leg up and maybe even show them what it feels like to be on the wrong side of the law.
If you're concered about a tax issue with your business, contact us. We can help.