SMALL BUSINESS BEWARE: THE DEPT. OF LABOR IS COMING AFTER YOU
GEORGE WILSON ADAMS CPA MBA
December 23,2021
Are You At Risk of an Unemployment Tax Audit?
The Maine Department of Labor (“DOL”) routinely audits small businesses as a part of their work. Most small family businesses in Maine consist of an owner-officer and perhaps a few employees. These DOL audits primarily target the compensation paid to the owner-officer of the corporation being audited.
By law, the Maine unemployment tax system taxes compensation up to $12,000 per year per employee. Maine unemployment taxes for an owner-officer of a corporation range from approximately $300 to $600 per year.
The entities targeted for these audits include Subchapter S corporations and some Subchapter C corporations. If you operate your business using these types of corporations be aware that the Maine DOL may be coming after you if your owner-officer compensation is significantly less than $12,000 per year. Auditors will claim you are not paying yourself “reasonable compensation” and will charge your company unemployment taxes on the difference between what you did pay yourself and the $12,000 maximum.
State auditors will want to come to your home if it is also your place of business. They will demand to see all the books and records of the business. If you are uncomfortable with this engage a CPA or tax attorney to represent you and have the meeting occur in their office.
You may appeal the decision of the auditor. But the final verdict must be to the satisfaction of the Commissioner.
What is “Reasonable Compensation”?
The key legal standard which applies to what owner-officers of companies should pay themselves is “reasonable compensation.” IRS Revenue Ruling 74-44 and many, many court cases have ruled on this subject. The truth is that courts have struggled for years to find clarity, without success.
The idea behind this confusing concept is that business owners should be paid a salary which reflects both the amount of time they spend providing services to their company and the value of those services (which depends on what industry or occupation they are in.)
In my opinion the federal court system has failed to impose clarity on this subject, which has remained ambiguous, unclear, and confusing. The best advice that exists on the issue of reasonable compensation is a court-established ”multi-factor model” that considers many elements including the time the owner-officer spends in his business, the ratio of capital to services, comparable pay, and other factors.
The ultimate responsibility for this failure rests with Congress, which has refused, or proven incapable, of establishing clear standards for reasonable compensation for owner- officers of small family business.
I have one further insight to offer on the issue of reasonable compensation which is a story that is easy to understand, unlike so much of the tax law.
One of my favorite TV programs (now cancelled) was “Cops”: a reality-TV show that focused on the real-world experiences of law enforcement officers.
One evening I watched a Cops episode which showed an officer on highway radar-patrol. The police officer was dozing in his patrol car on the side of a highway with his radar gun. All of a sudden the alarm went off, indicating a vehicle speeding along at 90 miles per hour.
The officer started his cruiser and gave pursuit along the highway. The speeding car pulled over to the shoulder and stopped. The officer got out of his police car and approached the driver cautiously. He reached the driver’s window and was astounded to see that no one was in the driver’s seat.
Then, he looked in the back seat of the car and saw three young men sitting there quietly, pretending to be completely innocent. The officer moved to the window by the back seat and knocked on it. The man by the window rolled it down but didn’t look the officer in the eye.
The police officer examined the three young men crowded in the back seat and asked “Where’s the driver?”
The young men remained silent.
At this point the officer became upset and said “Look! If the driver doesn’t identify himself right now I’m going to charge all of you with speeding and I’m going to throw in some extra charges besides.”
At this point the driver finally identified himself, took the speeding ticket, and life went on.
It’s exactly the same for those of you with S corporations. If your S corporation tax return is pulled over by an auditor and if that auditor sees blank white space on line 7 of the company tax return (the line that reports owner-officer compensation) then you will be in a similar position to the car pulled over for speeding where no one was in the driver’s seat.
If you own your S corporation then both the IRS and Maine expect to see a reasonable number on line 7 of page one of the company tax return (Form 1120S). Someone has to be in the driver’s seat of the company. And this person must be paid “reasonable compensation” for running the company and being in charge. Blank white space on line 7 of the company tax return is a large red flag for auditors.
The Maximum has Become the New Minimum
For many years the maximum salary subject to Maine unemployment tax has been $12,000 per employee. The minimum was whatever the facts and circumstances of the case could justify. Things seem to have changed over the years and it appears that the $12,000 maximum salary has become the de facto minimum. Any business owner who pays himself significantly less than $12,000 salary is asking for a Maine unemployment tax audit.
Based on a recent experience I will say that some DOL auditors are more knowledgeable and experienced than others, and therefore more understanding of the realities faced by business owners. What if paying a textbook computed "reasonable compensation" amount generates a large loss for the business and makes the company insolvent?
The Tail That Wags the Dog
Once your DOL audit is over your business will then have to deal with the federal implications of having owner-officer salary adjusted upwards to $12,000. You may need to file amended federal payroll forms to reflect the higher salary imposed by the DOL audit. The Maine and federal payroll tax systems are linked. Whatever salary you report to Maine MUST be consistent with the salary reported to the IRS.
The change in your salary from the DOL audit will be subject to a 15.3% federal social security tax. And so if you originally reported an owner-officer salary of $5,000 and the DOL rejected this amount and taxed your business on a salary of $12,000 your business will owe not only a few hundred dollars of Maine unemployment tax but also $1,071 in social security tax ($7,000 increase in salary times 15.3%).
The Maine DOL is increasing the cost of doing business here in Maine by using $12,000 as the new minimum for state unemployment taxes. The federal impact of this change is far more significant and will further increase business payroll taxes as well as expose business owners to IRS penalties and interest.
Implications
The truth is that business owners wear many hats and perform many different functions. A self-employed carpenter, for example, will perform carpentry as his primary work, but also works as the manager of his own business, the driver who picks up supplies, the clerk who keeps receipts and performs bookkeeping, etc. Every self-employed person knows they are the last to be paid. Bills come first, then payroll for the other employees of the business, then debt service, and then overhead costs.
The owner of a small business may believe he has the authority to set compensation policy for himself based on the actual results of the business, the risks incurred, and available cash flow. Further, many small businesses are self-financed by their owners and it is a legitimate question whether the monies paid to the owner by his or her company should be classified as salary or re-payment of debt.
The Maine DOL may ignore these realities and simplistically impose the same standard on small business that it applies to Cianbro Corporation or L.L. Bean. Unlike the IRS in some limited cases, Maine doesn’t have “safe harbors” that minimize the administrative burdens and costs imposed on small business. The irony is that the IRS is more business friendly than Maine.
Maine has all the rules on its side to get away with declaring that the minimum salary for a business owner is $12,000. DOL auditors may simplistically look at the hours worked per year and say that even using the minimum wage the owner’s salary has to be at least $12,000. Obviously this approach ignores the risks, costs and burdens the owner of a business assumes, and further ignores the fact that it is wrong to classify business owners with all other employees.
Solutions
The first solution that will occur to small business owners beset by these taxes is to consider relocating to a more business friendly state. According to many state rankings, almost every state in the country is more business friendly than Maine.
An alternative to leaving Maine is to change the burdensome tax rules which beset small business here. Maine could create a “safe harbor” for small family business that would stipulate a lower minimum compensation for owner-officers of corporations, say $6,000 (the exact mid-point between zero and $12,000). Small business owners who followed this rule would be exempt from audits, and the Maine Dept. of Labor could re-task its auditors to chase businesses who don’t even file taxes, and make fools of the rest of us. Audit resources are a scarce public resource that should be deployed wisely.
It must be remembered that Maine’s unemployment tax system provides vital benefits to the unemployed, who frequently experience severe financial hardship and other difficulties while trying to find a new job. The wisest public policy approach for Maine’s unemployment system is to take steps that ensure its long-term solvency while creating rules that are friendly to business, easy to comply with, and not a source of fear and frustration to the companies who fund the system with their tax dollars. Employers are ‘customers’ of the system just the same as the unemployed applicant who files for benefits.
“The power to tax is the power to destroy.”
Chief Justice John Marshall, U.S. Supreme Court (1819)
McCulloch v. Maryland
Photo Acknowledgements and Credits: Composition & Modifications by Shawn Hill | VASTmicro
George Adams
Certified Public Accountant Master of Business Administration
Tel: (207) 989-2700 E-Mail: GeorgeAdams@IntelligenceForRent.com
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Brewer, Maine 04412-2339
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