The Internal Revenue Service recently issued an alert for schemes in which federal employment taxes are not properly withheld or paid. Some of the more common schemes are as follows.

 

 

This scheme adds a fraudulent twist to the legal business practice of employee leasing. For example, you may have a doctor who works in the U.S. as self employed, has an LLC, and earns $500,000. A combination of Federal income tax, State income tax, and the self-employed Social Security and Medicare tax could result in a tax burden of $275,000. Instead, the doctor will sign an employment contract with an offshore company. The offshore company will then lease the doctor to a U.S. employee leasing company, who will in turn lease the doctor back to his U.S. company. The doctors U.S. company will pay $500,000 to lease the doctor. The domestic leasing company pays the doctor a salary of $200,000, and the remaining $300,000 goes to the offshore leasing company. This money is considered deferred compensation, or goes into a pension fund.

 

This is where fraud comes into play. The offshore leasing company now loans the doctor $300,000 at no interest or at a low interest. So the doctor still has his $500,000, less a few thousand to the promoter of the scheme, and only pays tax on $200,000.

 

The IRS has designated this as a Listed Transaction, and failure to disclose such a scheme in the tax return could lead to civil and criminal penalties.

 

 

For years promoters have been arguing that Internal Revenue Code Section 861, which deals with the allocation of income and expenses between foreign and U.S. sources exempts income earned in the U.S. from income tax. This argument has been refuted numerous times in Court, but the gullible still try. A refinement of this argument is for the employer to collect and pay to the IRS withholding and social taxes during the year, as required. After year end, the employer files Form 941C to “correct” their annual filings and ask for a 100% refund. Recent court cases have resulted in criminal prosecution of promoters of this scheme.

 

 

An argument that continues to rage is whether a person is a self employed contractor, or an employee. If the person is an employee, the employer needs to withhold and pay social security and medicare taxes, unemployment taxes, and Federal and State income taxes. Additionally, the employee may be entitled to certain benefits such as life insurance, a pension, etc. So from an employer standpoint, if you say the person is a self employed contractor, you can save a lot of money.

 

Many times the individual likes the fact that their pay is gross, and that there is no withholding. Usually the person does not make estimated tax payments. However at tax time, the individual learns that they are now liable not only for Federal and State individual income taxes, but also for the 15.3% Social Security and Medicare tax.

 

If the IRS ultimately gets their money, one could ask why they are pursuing the employer. There are two reasons. One, the IRS would get their money much sooner if it is withheld, and two, if the individual is an undocumented alien, the IRS will never get their money. The IRS also has one other bonus if they can prove that the individual is an employee and not a contractor. The law requires the employer to pay all back taxes that should have been withheld, and allows the IRS to assess a 100% penalty for failure to withhold.

 

 

Many businesses utilize a third party to provide administrative, personnel, and payroll accounting functions for their employees. This sub-contracting frees up business owners from a function that either detracts from their operations, or is an aspect of U.S. taxation that they do not want to deal with. Today, very few companies, large or small, handle their payroll in house, and outsource this function to giant payroll providers such as Automatic Data Processing and Paychex.

 

Unfortunately, this business has also attracted the unscrupulous. Small payroll processing companies are being set up with fees that are lower than the giant payroll processing companies, making them quite attractive to a business owner looking to minimize costs. How can these small payroll companies compete? They do so by not turning over the funds that they withhold from their customers to the Internal Revenue Service. They then close down after a year and start up again in a different part of the U.S. under a new name.

 

 

Self employed individuals who are looking for protection of their personal assets usually form a Limited Liability Company (LLC). There is no tax at the LLC level and the earnings are taxed directly to the individual. However, the income tax paid by a self employed individual is quite high. If the individual makes $100,000, they would typically pay Federal income tax at 25%, State income tax at 5%, and Social Security/Medicare tax at 15.3%, thus dividing their profits at $45,000 to the government and $55,000 to themselves.

 

An increasing popular scheme is to form an S Corporation and pay a salary of $50,000, and then declare a dividend of $50,000.  Taxes of $22,500 are paid on the salary, but the dividend is treated as a “qualifying dividend” and taxed for Federal purposes at 15%, and is not subject to the Social Security/Medicare tax at 15.3%. The net result is that the total tax is now $32,500 instead of $45,000.

 

The Internal Revenue Service is attacking this scheme by arguing that the compensation received by the owner is artificially low for the services that they are performing, and the sole purpose of the low salary is to avoid payroll tax.

 

 

If you are a resident of Bermuda on April 15, 2006, you have an automatic extension of time until June 15, 2006 in which to file your 2005 U.S. Federal individual tax return. Be aware, that the extension of time to file does not extend the time when your 2005 tax is due. Any tax due must be paid by April 17, 2006, or you will incur interest for late payment of tax.

 

The tax advice given by this column is, by necessity, general in nature. You should, of course, check with your own U.S. tax consultant as to how specific transactions affect you since tax advice varies with individual circumstances.