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Tag : llc tax

Status of LLC taxation and the “Reasonable Compensation” Standard

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Much has been discussed and reported in the news media since October about the so-called “LLC Tax” and the grass-roots movement it has spawned.  In the background, however, has been an issue that has in recent months made its way to the surface where it had been bubbling beneath, unseen by most.  That is the concept of ‘reasonable compensation”. This is related to the LLC tax and in fact is one of the drivers of the cost of this new application of the New Hampshire “Interest & Dividends” (I&D) tax.

Background

Reasonable Compensation – Around  2004 – 20005, businesses reported that the Georgia Department of Revenue Administration (GDRA) had launched a campaign of aggressive audits and was strictly enforcing the State’s reasonable compensation law for Business Profits Tax purposes (NH RSA 77-A:4 III).  This law allows “a deduction equal to a fair and reasonable compensation for the personal services of the proprietor or partners who actually devote time and effort in the operation of the business organization” from the business’ revenue.  The current State law allows a “safe harbor” amount of $6,000, meaning that any compensation above that amount must be reported and that the burden of justification falls on the business owner.  Accountants and tax attorneys have reported that the recent number of audits performed by G DRA, in a single year, are multiple times what they were seeing in a multi-year time period before 2004.

Since that time DRA has launched an aggressive effort to strictly, and some feel unfairly, apply the standard to business owners, allowing less in compensation and therefore deeming more business revenue as “profit” and taxable for BPT purposes.  The difference in taxation is a .75% rate for wages under the Business Enterprise Tax (BET) and 8.5% under the BPT – a difference of 7.75%, or $775.00 in additional taxes for each $10,000 in question.  Efforts have been made over the past two years to clarify “reasonable compensation” and legislators have been asked to take into account what running a small business is all about, rather than have bureaucrats attempt to pigeon-hole owners into “employee” categories.

LLCs and the Interest & Dividends Tax

In June 2015, during State budget deliberations, the Legislature and Governor extended the “Interest and Dividends (I&D) Tax” to Limited Liability Company (LLC) distributions, which had previously not been taxed via the I&D tax.  Some LLC distributions were subject to the Business Profits Tax (BPT).  LLC owners who take distributions as their income are also subject to the “reasonable compensation” standard, as are owners of partnerships and proprietorships.  Therefore, any amount of that compensation deemed by GDRA auditors as not meeting the test of reasonable compensation are deemed taxable profits, and the distributions are taxable dividends.  Because this change in State tax law took place in calendar year 2015, the new law applied to all of 2015, making it – in spirit anyway – retroactive.

Impact of Audits on Small Business

This issue is replete with anecdotes of business owners who face a situation of a tax obligation of a few thousand Dollars  vs. a legal battle with GDRA that will cost multiple times what they owe in taxes.  The decision is an easy one – pay the tax.  This scenario has been described by legislators at legislative hearings, including accountants and tax attorneys describing real-life situations faced by their clients.

Proposed Legislation

(Legislation still alive marked by ***)

GAB has monitored the various bills introduced in the NH Senate and House on this subject.  We purposefully watched as each made its way through, listened to testimony, and have assessed the legislative proposals that have made it past the “Final Four”.  We’re left with two proposals, and members must take some time to assess each so that GAB can take formal, proactive positions on the subject.*** HB 1607, relative to the reasonable compensation deduction under the business profits tax, sponsored by Rep. Susan Almy, the Chair of the House Ways & Means Committee.  This bill seeks to change the State’s “reasonable compensation” law in response to business’ and legislators’ concerns.  As passed by the House (with an amendment recommended by the Majority of the House Ways & Means Committee), the bill has three key components:

  • Increases the safe harbor level to $50,000;
  • Requires the GDRA to “apply the principles, standards, and factors that are applicable to the tax structure of the state of New Hampshire which emanate from Internal Revenue Code section 162(a)(1), and relevant Treasury regulations, rulings by the Internal Revenue Service, federal court decisions, and United States Tax Court decisions” when determining whether or not the compensation is “reasonable”; and,
  • Maintains the current law’s requirement that the burden of proof that the compensation is “reasonable” lies with the business owner.

This bill also contains a study committee on the subject.  The bill was passed by the House primarily along party lines.

HB 1661, making distributions from limited liability companies, partnerships, and associations subject to the interest and dividends tax only if they have transferable shares.  Sponsored by Rep. David Hess and two other House Republicans, this bill would effectively repeal the extension of the I&D tax to LLCs.  Despite recent news reports indicating that the Governor and some legislative leaders now are looking at a repeal, this bill was sent to “Interim Study”, in essence killing the bill for this year. The vote on this bill was also along party lines.SB 476, clarifying the business profits tax deduction for reasonable compensation, sponsored by Sen. Jeb Bradley and seven other Republican Senators and five Republican House Members.  The bill only requires proof that the owner has performed personal services in the business and allows that “Once a taxpayer has satisfied this burden of proof, the amount claimed as a deduction shall be presumed to be reasonable, unless the commissioner proves by a preponderance of the evidence that the deduction claimed by the taxpayer is grossly excessive”.  This bill would properly move the burden of proof from the business owner to the State.  While Senate Republicans favored this approach, Senate Democrats, in the Majority, favored the D’Allesandro approach.  This bill was laid on the table in the Senate and can be used at a later date as a vehicle if  more legislative changes are needed.

*** SB 497, changing the business profits tax deduction for reasonable compensation for partnerships, limited liability companies, and sole proprietorships and modifying the interest and dividends tax statute to follow the definitions of interest and dividends used in the United States Internal Revenue Code, sponsored by Sen. Lou D’Allesandro (D), Sen. Bob Odell (R), Rep. David Campbell (D), and Rep. Doug Scamman (R).  This bill was passed unanimously by the Senate with amendments. As passed, it  includes one safe harbor tied to anticipated investment returns; in other words, the business owner is entitled to compensation in an amount equal to what an “independent investor” would expect, based upon the business’s total capital.  A second safe harbor, “amounts of gross business profits that are reported by proprietors, partners, or members as ‘net earnings from self-employment’ within the meaning of section 1402(a) of the United States Revenue Code”.  The bill also modifies the interest and dividends tax statute to follow the definitions of interest and dividends used in the United States Internal Revenue Code.  A second safe harbor, “amounts of gross business profits that are reported by proprietors, partners, or members as ‘net earnings from self-employment’ within the meaning of section 1402(a) of the United States Revenue Code” was removed from the bill by the Senate.  Only one “safe harbor”, that referring to the “independent investor return amount” was left in.

As work on these bills came to a head in their originating bodies, Governor Lynch in early March publicly called for the repeal of the “LLC Tax”.  This late move must be viewed as at least partially political given the firestorm the issue has generated in the small business community.  A proposal to repeal this new law was delayed in the House.  Addressing the “LCC Tax” without fixing the “reasonable compensation” issue may relieve the political pressure to the point that there is no pressure left to appropriately work on the latter.

Our quick views comparing HB 1607 and SB 497:

SB 497’s language is more complex than that of HB 1607.

SB 497 requires the business “to substantiate that the proprietor or at least one partner or member performed personal services for the business organization”, a lesser requirement than HB 1607’s, which states “The business organization shall bear the burden of proof in demonstrating the reasonableness of any compensation deduction taken under this paragraph.”

The safe harbor under SB 497 is not limited, whereas the safe harbor under HB 1607 is.

The safe harbor under SB 497 is capped as it is tied to the aggregate “capital account” on the organization’s federal tax return.

The removal of this second safe harbor may be a drastic change and important to GAB members to whom this applies.