If You Have K1 Income, Then You Need to Know This!

Posted on December 6, 2012 by Bill Faiferlick

Bill Faiferlick Reduce Taxes Hybrid Pension PlanDays of Excessive K1 versus W2 income is successfully being recharacterized by the IRS and is being upheld by the courts.

For decades business owners have handsomely benefited from lower tax rates by shifting most of their income to K1 income. Today, most business owners will discover all too late that this technique is now the past if your CPA hasn’t already mentioned this (I’m finding most haven’t).

The IRS in the last few years have had their position upheld by the courts when they’ve forced business owners to recharacterize their W2 – K1 incomes requiring in most cases that the split at maximum be 45 to 55 percent K1 of all income the owner received.

For owners who work or perform duties for the business, the IRS is looking at the total income you’re receiving and is successfully making the call that up to 50% of all income derived is earned income or W2. This is just one of the many changes and financial challenges owners face along with huge tax increases at every level.

If you believe your tax bill was high in the past you don’t get caught at the end of 2013 with a whopping tax bill you hadn’t planned for. Your CPA will say there’s little opportunity to offset these higher taxes and frankly that isn’t true. What is true is the strategies I’ve used for well more than a decade were designed to conservatively address these very issues. Below is just one of the recent cases where the owner is now facing massive fines, penalties, interest and of course back taxes due to recharacterization of his K1 income and for the record, he is a CPA.

“On or about February 5, 2007, the United States of America recharacterized dividend and loan payments from David E. Watson, P.C. to its sole shareholder and employee, David E. Watson a wages….. In light of this recharacterization, Defendant assessed additional employment taxes, interest and penalties against Plaintiff for each of the eight calendar quarters in 2002 and 2003.” – Watson v United States of America Case 4:08-cv-00442-RP -CFB Document 35

Business owners who fail to have ‘reasonable compensation’ proportionally between K1 and W2 risk audits from the IRS and fines and penalties for underpayment of FICA and FUTA taxes. Court cases are now supporting the requirement for business owners to have reasonable incomes and the days of being able to have $150,000 in W2 and $850,000 K1 to reduce taxes are becoming history as have other tax opportunities which have been scratched from the history books.

To significantly lower tax obligations, it’s been customary for S Corporation owners to escape the imposition or reduction of both FICA and FUTA taxes by simply reporting a larger portion of their income as a K-1 allocation. This has been the strategy recommended by CPAs for years as a viable tax reduction strategy. Today the government as evidenced by recent court cases is successfully challenging the large disparity between W2 versus K1 income and what constitutes “reasonable compensation” all without having to define what is reasonable income which we all know is impossible to do as since there are too many variables between businesses.

There are conservative solutions but first you have to know they exist.