My friends at Crawford Ellenbogen LLC  know a lot about taxes. One of their principals, Victor Dozzi CPA, recently sent me a great tip about kids who are earning income from summer jobs, and I asked him if I could share it with you. He agreed, so here it is:

Are your children working at summer jobs this year?  If so, here are some tax reminders.

* If a child did not owe any income tax last year and doesn’t expect to owe any this year, the child can claim “exempt” when completing the federal withholding allowance form (Form W-4). This will eliminate having federal income tax withheld from his or her paychecks.

* For 2010, your child can earn as much as $5,700 without owing federal income tax. There will still be withholding from your child’s paycheck for a number of other taxes, including: social security, Medicare, PA, PA UC & perhaps local.

* As long as you provide more than half of your child’s support, you can still claim the child as an exemption on your 2010 tax return.

* Earnings from a summer job will qualify a child to contribute to an IRA – up to $5,000 or the child’s 2010 earnings, whichever is less. If your child would rather spend his earnings than save for retirement, you could gift all the cash, or agree to match what your child saves. As long as the amount put into the IRA doesn’t exceed the child’s wages (or the $5,000 limit), it doesn’t matter where the cash comes from.

The principals of Crawford Ellenbogen (Joan, Victor, and Barb) can provide great advice and personalized service – it’s just a phone call away.

Department of the Treasury Required Disclosure

In accordance with IRS’ Circular 230 we are required to advise you that any written advice we provide to you cannot be used for the purpose of avoiding penalties under the Internal Revenue Code.

The U.S. Court of Appeals for the Seventh Circuit recently took up the case of Menard v. Commissioner, 560 F.3d 620 (2009), considering whether the CEO of a privately-held company was receiving a dividend disguised as salary from the business he controlled. The CEO whose salary was questioned was John Menard, founder and controlling shareholder of Menards, a chain of retail hardware and building supply stores. The Tax Court took the position that John Menard’s $20 million salary was really a disguised dividend because it was much greater than the salaries of the Home Depot and Lowe’s CEOs, who earned $2.8 million and $6.1 million respectively.

The appellate court’s opinion in this case is so well-researched that I cannot help but include large blocks of text, starting with its introduction to the subject:

The Internal Revenue Code allows a business to deduct from its taxable income a “reasonable allowance for salaries or other compensation for personal services actually rendered,”[or] “payments purely for services.” Occasionally the Internal Revenue Service challenges the deduction of a corporate salary on the ground that it’s really a dividend. A dividend, like salary, is taxable to the recipient, but unlike salary is not deductible from the corporation’s taxable income. So by treating a dividend as salary, a corporation can reduce its income tax liability without increasing the income tax of the recipient. . . As a result of a change in law in 2003, dividends are now taxed at a lower maximum rate than salaries—15 percent, versus 35 percent for salary. 26 U.S.C. § 1(h)(11). This makes the tradeoff more complex; although the corporation avoids tax by treating the dividend as a salary, which is deductible, the employee pays a higher tax. But depending on its tax bracket, the corporation may still save more in tax than the employee pays, and in that event, if the employee owns stock in the corporation, he may, depending on how much of the stock he owns, prefer dividends to be treated as salary. . . . Even before the change in the Internal Revenue Code, treating a dividend as salary was less likely to be attempted in a publicly held corporation, because if the CEO or other officers or employees receive dividends called salary beyond what they are entitled to by virtue of owning stock in the corporation, the other shareholders suffer. But in a closely held corporation, the owners might decide to take their dividends in the form of salary in order to beat the corporate income tax, and there would be no one to complain—except the Internal Revenue Service.

The usual case for forbidding the reclassification (for tax purposes) of dividends as salary is thus that “of a corporation having few shareholders, practically all of whom draw salaries,” Treas. Reg. § 1.162-7(b)(1), especially if the corporation does not pay dividends (as such) and some of the shareholders do no work for the corporation but merely cash a “salary” check. A difficult case—which is this case—is thus that of a corporation that pays a high salary to its CEO who works full time but is also the controlling shareholder. The Treasury regulation defines a “reasonable” salary as the amount that “would ordinarily be paid for like services by like enterprises under like circumstances,” § 1.162-7(b)(3), but that is not an operational standard. No two enterprises are alike and no two chief executive officers are alike, and anyway the comparison should be between the total compensation package of the CEOs being compared, and that requires consideration of deferred compensation, including severance packages, the amount of risk in the executives’ compensation, and perks.

Courts have attempted to operationalize the Treasury’s standard by considering multiple factors that relate to optimal compensation. [Citations omitted.] We reviewed a number of these attempts in Exacto Spring Corp. v. Commissioner, 196 F.3d 833 (7th Cir.1999), and concluded that they were too vague, and too difficult to operationalize, to be of much utility. Multifactor tests with no weight assigned to any factor are bad enough from the standpoint of providing an objective basis for a judicial decision [citations omitted]; multifactor tests when none of the factors is concrete are worse, and that is the character of most of the multifactor tests of excessive compensation. . . . All businesses are different, all CEOs are different, and all compensation packages for CEOs are different.

In Exacto, in an effort to bring a modicum of objectivity to the determination of whether a corporate owner/employee’s compensation is “reasonable,” we created the presumption that “when . . . the investors in his company are obtaining a far higher return than they had any reason to expect, [the owner/employee’s] salary is presumptively reasonable.” But we added that the presumption could be rebutted by evidence that the company’s success was the result of extraneous factors, such as an unexpected discovery of oil under the company’s land, or that the company intended to pay the owner/employee a disguised dividend rather than salary. 196 F.3d at 839.

The strongest ground for rebuttal, which brings us back to the basic purpose of disallowing “unreasonable” compensation, is that the employee does no work for the corporation; he is merely a shareholder. [Citations omitted.] Comparison with the compensation of executives of other companies can be helpful if—but it is a big if—the comparison takes into account the details of the compensation package of each of the compared executives, and not just the bottom-line salary. This qualification will turn out to be critical in this case.

Having explained the context of this case, the Circuit Court next explained why the Tax Court’s analysis was wrong, especially its comparison of John Menard’s salary to the salaries earned by the Home Depot and Lowe’s CEOs in that year. The appellate court first rejected the notion that the taxpayer’s $17 million bonus, which was equal to 5% of the company’s net income before taxes, was more likely to be a dividend than salary because it was paid at year’s end; was approved by a board that the CEO controlled without outside directors; must be returned if the IRS should disallow the company’s tax deduction as salary; and exceeded the salaries earned by the CEOs of publicly-traded competitors (Home Depot and Lowe’s). The appellate court noted that the managers of privately-held companies often face greater risk than public companies, warranting greater reward for success:

Of particular importance to this case is the amount of risk in the compensation structure. Risk in corporate compensation is significant in two respects. First, most people are risk averse, and the scholarly literature on corporate compensation suggests that risk aversion is actually an obstacle to efficient corporate management because managers tend to be more risk averse than shareholders. Shareholders can diversify the risk of a particular company by owning a diversified portfolio, but a manager tends to have most of his financial, reputational, and “specific human” capital tied up in his job. [Citations omitted.] So the riskier the compensation structure, other things being equal, the higher the executive’s salary must be to compensate him for bearing the additional risk.

That is not a critical consideration in this case because, as we said, management and ownership in Menards are not divorced. But a second significance of risk in a compensation structure is fully applicable to this case. A risky compensation structure implies that the executive’s salary is likely to vary substantially from year to year—high when the company has a good year, low when it has a bad one. Mr. Menard’s average annual income may thus have been considerably less than $20 million—a possibility the Tax Court ignored. Had the corporation lost money in 1998, Menard’s total compensation would have been only $157,500—less than the salary of a federal judge—even if the loss had not been his fault. The 5 percent bonus plan was in effect for a quarter of a century before the IRS pounced; was it just waiting for Menard to have such a great year that the IRS would
have a great-looking case?

The appellate court also noted that the Tax Court had not considered the total compensation packages of the CEOs from the public companies, such as equity compensation, severance packages, retirement plans, and perks. The appellate court noted that the CEO of Home Depot, whose salary was used as a benchmark, actually earned $124 million over six years, and a $210 million severance package when he was forced out. The Court of Appeals also noted that the Tax Court had not considered the salaries of other senior managers, both of Menards and of the benchmark public companies, which may have indicated that this CEO was more productive and delegated less than average. The Court observed that John Menard worked 14 to 16 hours per day, six to seven days per week.

The Seventh Circuit adopted a skeptical, even sarcastic, tone toward the Tax Court’s remark that the owner of a business has no need for incentive compensation because ownership is incentive enough. The Court of Appeals held that owners should not be treated differently from other managers.

Having concluded that John Menard’s $20 million salary was not excessive, the Court of Appeals reversed.

The 9th Circuit Court of Appeals recently issued a decision (highlighted by Carsten Hoffman’s FMVOpinions) affirming a tiny fractional interest discount applied to a jointly-owned collection of paintings. In Stone vs. U.S. (2009), the district court rejected the opinion of the estate’s expert, who testified in favor of a 44% fractional interest discount, citing the expert’s “total lack of experience with the art market; the dissimilar motives driving purchasers to acquire art, on one hand, and real estate or limited partnership shares, on the other; and the unreasonably low appreciation rate and unreasonably high present-value discount rates Hoffmann used in his cost-of-partition analysis.” The district court refused, on the other hand, to apply no discount, as urged by the government. Instead, the district court settled upon a 5% fractional interest discount, the percentage that was conceded by the IRS. The 9th Circuit affirmed.

On appeal, the estate argued that the lack of data regarding real-world  sales of fractional interests in art justified its use of discounts derived from sales of fractional interests in real estate and limited partnerships. The estate also argued that the district court had erroneously assumed that the estate’s 50% interest in the art collection would be sold together with the other 50% interest. The appellate court dismissed both arguments under an abuse of discretion standard.

In his post-mortem analysis, Carsten Hoffman (who was the estate’s expert in Stone) speculated that fractional interest discounts in art should actually be higher than, not lower than, discounts in real estate and partnerships.

To begin with, empirical data regarding discounts for lack of marketability as it relates to restricted stock, demonstrates that the magnitude of the discount is directly related to the degree of volatility. This is logical, as an investor would rather surrender liquidity for low volatility assets compared to high volatility assets. For example, the FMV Restricted Stock Study shows that the discount for lack of marketability is approximately 300 percent higher for stocks in the top 10 percent, measured by volatility, compared to those in the bottom 10 percent (approximately 45 percent vs. 11 percent). This is significant, as art has provided the least attractive risk and return potential of any asset class as reported by Merrill Lynch. The report also indicates that over a 5-year investment horizon, the risk of loss in art ownership is 70 percent higher than the risk of loss in the S&P 500 Index. Further, the standard deviation (a measure of volatility) for art is 44 percent higher, on average, than for the S&P 500.

Hoffman noted that data did not exist in 1982 when the courts first confronted the challenge of applying a fractional interest discount to real estate and partnership interests. The data that supports such discounts has been developed over the intervening years. Similarly, the scholars will have to compile data for the art market.

The forensic accounting firm of Stout Risius Ross Advisors LLC has published an excellent guide to year-end tax questions that separated and divorcing spouses may have:

1.) What is my filing status for 2008? Your filing status is determined as of the last day of the calendar year. You are considered unmarried for the whole year if, on the last day of your tax year, you are unmarried or legally separated from your spouse under a divorce or separate maintenance decree. Your filing status will be either single or head of household.

2.) How can I qualify to file as head of household? In general, you must meet the following requirements to file as head of household.

1. You are unmarried or “considered unmarried” on the last day of the year.

2. You paid more than half the cost of keeping up a home for the year.

3. Your home was the main home of your child for more than half the year.

4. You must be able to claim an exemption for the child. However, you meet this test if you cannot claim the exemption only because you waived the right to claim the child pursuant to your divorce decree.

3.) What if my ex and I have the child an equal amount of time?
If the child lived with each parent the same amount of time during the year, the parent with the higher adjusted gross income has the right to the head of household filing status.

4.) Who claims the exemptions for our children? In most cases, a child of divorced or separated parents will qualify as a dependent of the custodial parent under the rules for a qualifying child. However, the noncustodial parent may be able to claim the exemption for the child if the special rule (discussed next) applies. Special rule for divorced or separated parents. A child will be treated as the qualifying child or qualifying relative of his or her noncustodial parent if all of the following apply.

1. The parents: a. Are divorced or legally separated under a decree of divorce or separate maintenance, b. Are separated under a written separation agreement, or c. Lived apart at all times during the last 6 months of the year.

2. The child received over half of his or her support for the year from the parents.

3. The child is in the custody of one or both parents for more than half of the year.

4. The custodial parent signs a written declaration, discussed later, that he or she will not claim the child as a dependent for the year, and the noncustodial parent attaches this written declaration to his or her return.

If the parents divorced or separated during the year and the child lived with both parents before the separation, the custodial parent is the one with whom the child lived for the greater part of the rest of the year.

More answers are available at SRR’s website.

Chris Mercer’s Value Matters newsletter offered a succinct summary of the Eleventh Circuit’s recent decision in Jelke v. Com., an important decision dealing with built-in capital gains (BIG) tax liability of Subchapter C corporations. The subject company in the case was a C corporation established 80 years ago, whose principal asset was an investment portfolio managed for long-term capital growth. The company was valued for estate tax purposes, and the decedent’s expert discounted the net asset value by $51.6 million tax liability, assuming liquidation of the investment portfolio. The IRS took the position that liquidation was not imminent, and spread out the tax liability over 16.8 years (which was consistent with the slow rate of asset turnover). Discounting the future tax liability back to its net present value, the IRS estimated the tax liability at $21.0 million. The Tax Court adopted the IRS position, and the taxpayer appealed.

The Eleventh Circuit Court of Appeals employed the principal of substitution in its analysis, wondering why a hypothetical buyer would choose to purchase an interest in a corporation with BIG tax liabilities when the buyer could simply buy the underlying stocks in the market. The Eleventh Circuit court held that liquidation was the proper assumption when determining net asset value, and sided with the taxpayer by discounting the corporation’s value for the entire tax liability.

This decision might be persuasive in the divorce courts of Pennsylvania, where hypothetical tax consequences may be considered in determining the value of marital assets. Were the divorce court faced with the valuation of a C corporation having BIG tax liability, it might be appropriate to subtract the tax liability from the company’s net asset value. The market alternative for an interest in a corporation having BIG tax would be the underlying assets themselves without tax liability, according to Jelke.