In the city of London there lives a man who often travels by the Clapham bus, sitting in the back. He is reasonably educated and intelligent, but nondescript. He is not in legal trouble, but his actions are discussed endlessly in courtrooms throughout the English-speaking world. The “man on the Clapham omnibus” is not in fact a real person, but a legal fiction first devised in Victorian England. He is the apocryphal “reasonable person” against whom anyone else’s actions can be judged.
“Reasonable” may be the most argued-over word in the English language. Whether it appears in a contract, a law, or in a legal precedent, it gives lawyers room to dispute exactly what is reasonable and what is unreasonable. One standard of judgment: What would the man on the Clapham Omnibus do?
Now the Reasonable Man is about to become of great importance to business owners. Tax experts see a potential loophole in the tax code changes that take effect this year, and the hole is the size of a Clapham Omnibus.
Accountant Douglas Smith of Axiom CPAs at 103 Carnegie Center will speak on several notable provisions of the Trump tax cuts at the next meeting of the Gotham City Networking Group on Friday, February 23, at 12:30 p.m. at Agricola restaurant at 11 Witherspoon Street. Tickets are $38. For more information, visit www.gothamnetworking.com.
The potential loophole hinges on a provision that allows owners of certain types of companies — S-corporations, sole proprietorships, and partnerships — to deduct up to 20 percent of their company’s net profits from their income from that year before calculating their tax liability. Small businesses are often organized as these kinds of companies, which are also known as pass-through entities. In these entities the income (or losses) from the business are passed through to the proprietors or individual partners, who are then responsible for reporting that income (or loss) on their individual tax returns
But certain forms of business entities cannot deduct this deduction off their entire profits, however — they must first subtract “reasonable compensation” for the business owner. This provision keeps business owners from avoiding payroll taxes by paying themselves a pittance and taking their profit in some other form.
Smith says the vague phrase “reasonable compensation” is sure to become a point of contention. He predicts many business owners will give themselves a tiny “salary” while pocketing their businesses’ profits, thereby applying the 20 percent deduction to as large a portion of their income as possible. Will this be allowed, or will the IRS frown upon it as tax-avoiding trickery? Is it “reasonable” for a business owner to pay himself a $25,000 salary if his business made $150,000 in net profits?
“There is a lot of room for interpretation in this area,” Smith says. “This is a gray area that is not yet defined, so there are opportunities for taxpayers to push the limits. It will be interesting to see how the IRS and future legislation attempt to address this.”
Smith says it will apply additional penalties to owners who fail to compute “reasonable compensation” to themselves, but since the law does not define what reasonable compensation is, no one knows what that amount is. Further, different types of businesses might have different standards for what is reasonable. “The owner could be the chief cook and bottle washer, or he could be a CEO sitting at a desk, or he could be a little of both. I think it’s going to be really interesting to see how this plays out,” Smith says.
Another quirk is that sole proprietorships can take the deduction on their entire qualified business income without having to subtract wages for themselves, while the other types of businesses do. “That doesn’t seem fair,” Smith says.
While waiting to see how the IRS enforces the new law, companies can get a bit of advice from consulting firms who specialize in determining reasonable compensation, which is already a concept in other kinds of business disputes. “It is certainly an area that business owners can exploit,” Smith says.
Another significant change in the tax law is that business meetings at sports games are no longer tax deductible. Under the new law, only the food portion of wining and dining clients will be tax deductible, not the entertainment. In a visit to the ballpark, the hot dogs will be tax deductible, but not the ticket.
“I’m a little surprised that we didn’t hear more from the owners of stadiums and their lobby when all this happened,” Smith says. “I suspect they have a lot of smart people working for them and they’re going to find ways to get around it. Maybe they’ll sell a box and call it advertising instead of calling it a box.”
Smith has been a public accountant since 1994. He grew up in Massachusetts, where his parents owned a Servicemaster franchise. He went to Bentley University in Waltham, and there discovered he had a talent and affinity for accounting. “I appreciated the opportunity to be your own boss and an entrepreneur,” he says. Before co-founding Axiom in 2011, he had worked at the Lawrence-based firm, Bartolomei Pucciarelli.
Throughout Smith’s career, he has worked mostly with small business owners. He founded his own firm about seven years ago. “We consider ourselves a boutique firm for small business owners,” he says. The company does everything from tax accounting to strategic consulting to CFO service.
Smith says that among his client base, the tax bill will most benefit business owners who make between $100,000 and $200,000 a year, with diminishing returns for service professionals who make $400,000 or more. He says the bill might also cause some wealthier residents to leave New Jersey because of its individual tax provisions that punish people who live in high tax states.
His view: “It’s going to be a mixed bag.”