The Unforeseen Risks of Underplaying Your Income

The most recent Tax Report, on executive pay and payroll taxes, sparked a flood of letters and emails from readers, including lots of questions. Here are answers, plus more about important payroll tax changes set for 2013.

Brief recap: The column was about a court case, David E. Watson, P.C. v. USA. Mr. Watson is an Iowa CPA with decades of experience, and the Internal Revenue Service challenged his $24,000-a-year salaries for 2002 and 2003 as too low. The judge agreed with the IRS and raised it to $90,044.

Mark Matcho

Payroll taxes, not income taxes, were at issue. The IRS said that by keeping his salary artificially low, Mr. Watson was minimizing the 12.4% FICA tax (up to a cap) and the 2.9% Medicare tax (unlimited), saving about $20,000. Other accountants said clients often hope to cut payroll taxes by low-balling pay.

Several readers asked whether the issue in Watson is what caused controversy for John Edwards, the former senator and vice-presidential candidate. The short answer is yes. Sen. Edwards was unavailable for comment for this story, but asserted during the 2004 campaign that he had done nothing improper.

Other readers wondered what happens when Steve Jobs or Vikram Pandit takes a token $1 a year in pay. Does the IRS challenge that salary for being too low as well?

The answer is no, but explaining why involves a short detour into the metaphysical world of corporate taxes. Mr. Jobs's $1-a-year pay doesn't pose a problem for the IRS because Apple is a "C" corporation, not a "Subchapter S" corporation, as Mr. Watson's was.

There are important differences between these two corporate formats, and many are best left to experts. Suffice it to say that large, public companies have to be C corporations, but small or closely held companies can choose among several entities, including both C and S, with advantages and disadvantages for each.

With C corporations, the compensation issue is actually the opposite of Mr. Watson's: The IRS gets upset when pay is too high rather than too low. That is because C corps get an important tax deduction for executive pay. If it is too high, a firm may be disguising a nondeductible dividend payout as tax-deductible compensation—especially if the firm has an owner who is a large shareholder.

Given the explosion in executive compensation in recent years, it has gotten harder for the agency to argue that pay is too high. The IRS actually lost a case on this issue involving a private C corporation, Menard v. Commissioner, in 2009.

So the IRS doesn't mind $1-a-year pay at a Citigroup or Apple. Of course, executives don't work for free. They often get cash payments, "nonqualified" stock options, or restricted stock in return. What happens here?

The executive owes both ordinary income tax and payroll taxes on cash payments when received, on stock options upon exercise, and on restricted stock when it vests.

Here is an example from Eddie Adkins, a benefits expert at Grant Thornton in Washington: A CEO is granted an option at $20 a share that he later exercises at $30 a share. (This means he pays $20 for a share worth $30.) The $10 of appreciation is taxed as ordinary income, with 12.4% FICA tax due on income up to $106,800 and the 2.9% Medicare tax on all income. If the executive holds the shares after exercising, future growth can be taxed at favorable capital-gain rates with no payroll taxes due.

Things are very different for workers whose pay comes from "carried interest," i.e. profit participations that are common at hedge funds, private-equity firms, and real-estate firms. In that case the pay can qualify as a capital gain—taxed at current top rates of 15% instead of 35% for most pay—and also isn't subject to payroll taxes, says Mr. Adkins. This treatment has been a sore subject with some in Congress recently, but the law hasn't changed.

A final note: Last year's health-care changes are up in the air, but taxpayers should know they contain a Medicare tax increase of 0.9% on wages above $250,000 for married couples and $200,000 for singles for 2013 and after. That brings the total Medicare tax to 3.8%.

People who try to lower pay and raise dividends to escape Medicare tax should be aware that the law also imposes a 3.8% tax on investment income. The tax applies at the same $250,000/$200,000 level, and it applies to dividends, possibly erasing any tax saving.

Write to Laura Saunders at taxreport@wsj.com