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SomewhereupinMichigan · 01-10-2004, 12:46 PM

Likely not the same Charlotte O'Dell, but it certainly would make for an interesting extension of our story line:

Rent & Royalties - A Good Plan Gone Bad

Charlotte Odell operated a small office supply business providing primarily staplers, staple removers and letter openers to the U.S. Post Office. She operated the business as a sole proprietorship until 1995 at which time she incorporated as a C corporation. She transferred in money and a small amount of inventory to the corporation in exchange for stock. So far so good. She kept the customer list separate and did not transfer this in (a good plan for when she sells the business). She then paid herself a small salary ($400 per month for 2 hours of work each day, not unreasonable per se). She also paid herself rent (presumably for use of her home or garage) and a royalty for her technical know-how and use of the customer list. The rents and royalties averaged around $44,000 per year.

The IRS conducted an employment tax audit claiming all the royalty and rent payments were really wages and were subject to payroll taxes. The court agreed. The rationale was that you could not convert what was self-employment income (income from the know-how and personal efforts) into income not subject to self-employment taxes (in this case payroll taxes).

The lessons to be learned are that aggressive converting of what was once self-employment income into income not considered wages won't work. Why the court did not pull out the rent is a puzzle unless Charlotte was not taking a home office deduction. If she had been the issue of rent should have been moot. Had Charlotte had other employees who did the actual work that also would have helped her cause. As it was, she and her husband (not on the payroll) did all the real work. The plan would have worked better had she been retired or nearly so.

Since the examination had to involve two entities (corporation and personal) it is possible that the IRS became suspicious of the reduced compensation income and the new royalty income. Since this was an employment tax audit, the IRS was clearly focused on the payments to Charlotte, not unsubstantiated deductions.

If you are thinking of incorporating and believe that this might apply to you, please talk with your tax advisor first. The case to refer to is Charlotte's Office Boutique, Inc. (2003) 121 TC No. 6.

01-10-2004, 12:46 PM	#17
SomewhereupinMichigan Senior Member Join Date: Sep 2002 Location: Owosso and Houghton Lake, MI Posts: 403	Likely not the same Charlotte O'Dell, but it certainly would make for an interesting extension of our story line: Rent & Royalties - A Good Plan Gone Bad Charlotte Odell operated a small office supply business providing primarily staplers, staple removers and letter openers to the U.S. Post Office. She operated the business as a sole proprietorship until 1995 at which time she incorporated as a C corporation. She transferred in money and a small amount of inventory to the corporation in exchange for stock. So far so good. She kept the customer list separate and did not transfer this in (a good plan for when she sells the business). She then paid herself a small salary ($400 per month for 2 hours of work each day, not unreasonable per se). She also paid herself rent (presumably for use of her home or garage) and a royalty for her technical know-how and use of the customer list. The rents and royalties averaged around $44,000 per year. The IRS conducted an employment tax audit claiming all the royalty and rent payments were really wages and were subject to payroll taxes. The court agreed. The rationale was that you could not convert what was self-employment income (income from the know-how and personal efforts) into income not subject to self-employment taxes (in this case payroll taxes). The lessons to be learned are that aggressive converting of what was once self-employment income into income not considered wages won't work. Why the court did not pull out the rent is a puzzle unless Charlotte was not taking a home office deduction. If she had been the issue of rent should have been moot. Had Charlotte had other employees who did the actual work that also would have helped her cause. As it was, she and her husband (not on the payroll) did all the real work. The plan would have worked better had she been retired or nearly so. Since the examination had to involve two entities (corporation and personal) it is possible that the IRS became suspicious of the reduced compensation income and the new royalty income. Since this was an employment tax audit, the IRS was clearly focused on the payments to Charlotte, not unsubstantiated deductions. If you are thinking of incorporating and believe that this might apply to you, please talk with your tax advisor first. The case to refer to is Charlotte's Office Boutique, Inc. (2003) 121 TC No. 6.