WorldWide Drilling Resource

Drilling Into Money Not Boring by Mark E. Battersby Reasonable Owner Compensation and Unreasonable Tax Changes The owners of drilling businesses operating as S Corporations or other pass-through entities must, according to the tax rules and the courts, be “reasonably compensated” for the services they provide. Un- fortunately, tax law and the Internal Revenue Service (IRS) have failed to provide shareholders and owners with guidance on how exactly to determine the reasonableness of the compensation paid by their busi- nesses. The perennial argument over what is “reasonable” compensation for those operating a drilling business as an S Corporation or other so-called pass-through entities is increasing in complexity thanks to the tax rate proposals of our lawmakers. The majority of tax reform proposals of President Trump and our lawmakers would lower the corporate tax rates - rates which are one of the main attractions of pass-through entities. Lawmakers will soon explore whether to increase or decrease the seven individual tax rates on ordinary income as part of the long-promised tax reform. It is those tax rates which are a major issue in determining how much pass-through entities pay in federal income taxes. Proposals to create a new lower tax rate specifically for pass-through business entities raises the question of why pass- through income should be taxed at a lower rate than income from wages and salaries. Those changes could make the tax code “less neutral”, potentially leading in- dividuals to invest in pass-through busi- nesses based on tax considerations rather than the economic merits. Further- more, a lower rate would benefit owners in the highest tax brackets. A lower tax rate might also be an incentive to label as much income as possible as pass- through income - spurring tax avoidance. As mentioned, the profits of a closely- held drilling business can be distributed as either wages or as dividends. Typi- cally, a closely held, incorporated drilling business avoids double-taxation by paying most of its profits in the form of a bonus, or by leaving profits in the business as accumulated earnings. However, wi th the Accumulated Earnings Tax raised from 15-20% of a drilling operation’s accumulated earnings and the IRS including S Corporations, reasonable compensation which is too high for regular C Corporations, but too low for S Corporations, is rapidly becom- ing an issue. The need for professional assis- tance, not only when determining - and backing up - the owner’s compensation package, but for evaluating the potential impact of the tax reform legislation later this year can’t be emphasized enough. Mark Mark E. Battersby may be contacted via e-mail to michele@ worldwidedrillingresource.com 35 WorldWide Drilling Resource ® MAY 2017