S Corporation
Tax Secrets
W. Murray Bradford, CPA
John Myrick, JD, LLM
Proven Tax Strategies to
Help You Turn Your S Corporation into
a Tax-Saving Machine
Bradford and Company, Inc
www.bradfordtaxinstitute.com
Table of Contents
Section 1
What An S Corporation Can
Offer You ............................................... 3
Section 2
Will Your S Corporation Add
to Your Bottom-Line Profits? ............ 10
Section 3
Comparison of Business Entities ..... 15
Section 4
Avoid These Common Mistakes
When Converting to an
S Corporation ...................................... 21
Section 5
S Corporation Tax on Built-In
Gains Is Trouble ................................. 26
Section 6
Audit-Proof Your Salary ..................... 30
Section 7
Obamacare Revives S Corporation
Income Shifting Strategy ................... 37
Section 8
Client Questions on Salary Issues ... 43
Section 9
Tax Tips for the S Corporation’s
Fringe Benefit Realization ................. 47
Section 11
Health Insurance for Your Family ...... 57
Section 12
How You Can Discriminate
with the Health Savings Account ...... 61
Section 13
How to Deduct Car Expenses
When Incorporated ............................. 67
Section 14
Tax Deductions for Personal Car
Used for S Corporation Business ...... 73
Section 15
The Best Way to Claim a Home
Office Tax Deduction for the
Owner of a Corporation ...................... 78
Section 16
Good-bye, S Corporation;
Hello, C Corporation. .......................... 83
Section 17
Don’t Let Losses Disappear When
You Liquidate Your S Corporation .... 90
Section 18
Good Records are the Key to
Your Deductions.................................. 97
Section 10
The S Corporation Path to
Health Insurance Deductions ............ 52
2
Copyright 2014 by Bradford and Company, Inc.
Section 1
Notes
What An S Corporation Can
Offer You
How S corporations reduce your taxes and
protect you from liability
You should approach the tax treatment of your business just like you
would any other business decision.
The right tax treatment for you is the treatment that best suits your bottom
line.
And just like any other business decision, the key to making the right
choice is having the right information. That’s what we are going to do in
this tax guidebook. We are going to tell you what choices you have, give
you the pros and cons of those choices, and show you how to put the data
together to make the right decision for your business.
Four Options
The first major step in choosing your tax treatment is selecting a “business
entity.”
As an individual business owner or husband-and-wife business owner, you
have the following options:
1.
2.
3.
4.
Sole proprietorship
Partnership (if your business has at least two owners)
C corporation
S corporation
This tax guidebook focuses on S corporations, but we are going to explain
the other tax entities as well. In order to determine whether the S
corporation is the right form for you, you have to know how it compares
to your other options.
Copyright 2014 by Bradford and Company, Inc.
3
Notes
Why Aren’t LLCs on the list?
Federal tax law does not have a separate category for LLCs. When you
form an LLC in your state, you select the federal tax treatment you want.
Depending on how many members you have, you could operate your LLC
as any of the four options on the list above.
For example, you could form an LLC in your state and then select S
corporation treatment for federal tax purposes.1 In all areas of the law
outside of tax, you would have an LLC. Only the IRS would see your
business as an S corporation.
You might be asking, why do this? Why set up an LLC only to have it
taxed as an S corporation?
The answer will depend on the specific details of your business. You might
prefer an LLC for non-tax reasons, such as state regulation, and you might
prefer the S corporation for its tax benefits.
LLC taxed a sole proprietorship. In this tax guidebook, we often compare
S corporations to sole proprietorships. If you have a single-member LLC,
you can choose sole proprietorship taxation. So when we mention sole
proprietorships, you can think of two things:
• an individually-owned business not operated in any state business
form, or
• a single-member LLC taxed as a sole proprietorship.
If you incorporate your business under state law, you cannot choose sole
proprietorship taxation.
We go into all of this in much more detail later on, so we’ll save the rest of
the discussion until we get there.
The Three Big S Corporation Benefits
Here are the three main benefits you get from an S corporation:
•
•
•
liability protection,
relief from double taxation, and
savings on employment tax.
Liability Protection
Say the deliveryman slips and falls on a banana peel on the doorstep of
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your business location—which might be your home. Your personal assets
could be at risk when he decides to sue for his disabling back injury.
Notes
How do you protect your personal assets? You could operate your business
as an entity that limits your liability to the assets of your business.
But before you rush off to incorporate, you should know that you have
other options for liability protection.
First, LLCs also offer liability protection. The choice between LLCs and
corporations involve a number of tax and non-tax factors. We will cover
the tax differences in this guidebook, but you should check out your state’s
liability rules before you make your choice.
Second, liability insurance might provide you with all of the protection
you need for your sole proprietorship. You should consider the cost and
risk of the liability insurance in your area that applies to your line of work.
No Liability Protection Here
In general, no liability-limiting entity can protect your personal assets from
your
•
•
professional errors and omissions, or
tortious acts. (Tortious acts are things like reckless operation of a
car resulting in injuries to others and/or property damage).
To protect your assets from exposure to professional and tort liabilities,
you must conduct your business and personal life with due diligence and
buy adequate insurance coverage. No surprises here!
Double Taxation for C Corporations
You no doubt cringe when you see the words “double taxation.”
Here is what it means. If you own a C corporation, the government taxes
both you and your corporation:
•
•
First, the corporation pays income tax at corporate rates.
Second, you as a shareholder pay tax on the dividend you receive
from the corporation.
So before your money gets to you it goes through two layers of taxation.
Copyright 2014 by Bradford and Company, Inc.
5
Notes
Single Taxation for S corporations
With an S corporation, you pay tax only once.
An S corporation is a pass-through entity, which means that the S
corporation does not pay tax. Instead, the income, deductions, and tax
credit items skip the layer of corporate tax and “flow through” to you, right
onto your individual tax return.
Double Taxation for C Corporations
Double taxation may not be so bad as you think, depending on your
income level. The first C corporation tax bracket is the 15 percent bracket
on income of up to $50,000.
If you are not in the highest tax bracket, your dividend tax rate is either 0
percent or 15 percent.
Thus, with C corporation income of $50,000 or less, your combined
corporate and individual tax rate is either 15 percent or 27.75 percent.2
However, once your income and dividends exceed the first corporate tax
bracket of $50,000, the effective tax rate jumps to 36.25 percent.3
Note for professionals. If you are a “professional,” such as a lawyer,
dentist, accountant or engineer, you do not have a 15 percent tax bracket.
You have to pay a flat corporate rate of 35 percent on all of your income.
Then you pay the dividend tax for any transfer from corporate funds to
you.
S Corporations Reduce Your Employment Taxes
Here is the number one reason to have an S corporation—savings on
employment taxes.
When you operate your business as an S corporation, you are both a
corporate employee and a shareholder.
As an employee, you receive a wage or salary to compensate you for the
work you perform.
As a shareholder, you receive distributions (think corporate dividends) for
your ownership stake in your S corporation.
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Only your salary is subject to employment tax. Your shareholder
distributions are not.
Notes
Now think about this: You set your own salary. This means that you
determine how much of your income from the S corporation is subject to
employment tax.
Example. Say that before you consider your salary, your S corporation
earns a net income of $100,000. If you take the $100,000 as salary, you and
your corporation pay $15,300 in employment taxes.4
But let’s say you take $38,000 as salary and the balance as a profit
distribution. Presto! You and the corporation save at least $9,486 in
employment taxes.
Employment Tax Savings Might Not Outweigh the
Cost
There are three parts to employment tax:5
1. You pay 15.3 percent on your first $117,000 of salary or
compensation
2. You pay 2.9 percent on all remaining salary or compensation
3. You pay an additional 0.9 percent on all salary or compensation
above $200,000 ($250,000 if you are married filing jointly).
Consider this: Taxpayer X creates an S corporation which pays him a
salary of $160,000 and gives him pass-through income of $150,000. (Thus,
his total income is $310,000). Because he is already above the FICA limit
with the $160,000 salary, this S corporation saves him Medicare taxes of
$5,007 on the pass-through income of $150,000.6
Now this taxpayer has to consider the state taxes on his S corporation. In
this case, the state tax on his S corporation income adds $9,000 to his tax
bill. His net result: operating as an S corporation costs this taxpayer $3,993
in additional taxes. He also spent money to organize the corporation, file
the separate tax return, and change his letterhead and promotional
materials. This was an expensive mistake.
Take a Reasonable Salary
Many S corporation owners believe they can eliminate their salary
altogether and thereby avoid 100 percent of their employment tax.
Don’t do that.
Copyright 2014 by Bradford and Company, Inc.
7
Notes
Please don’t do that.
Not so many years ago the Treasury inspector general for tax
administration did a study and discovered this no-salary strategy.7 The
inspector general recommended that the IRS audit these entities and take
that easy money for the government.
Although the salary range can be broad, this is certain: You need to take
some salary. Further, you must justify the salary. Ideally, you would have
documentation of why the salary you are taking is reasonable.
The good news when you have a salary is that the IRS has found it difficult
to prove in court that a salary is unreasonable.
But don’t worry about the precise number for your salary just yet. We
devote a section on salaries and distributions later on in this tax guidebook.
We will tell you just what you need to know to audit-proof your salary and
maximize your tax savings.
The Stuff to Know From This Section
As a single-owner business or husband-and-wife operated business, you can
choose any of the following tax treatments for your business:
1.
2.
3.
4.
Sole proprietorship
Partnership (if your business has at least two owners)
C corporation
S corporation
S corporations offer you liability protection, but you can also get liability
protection with an LLC, a C corporation, or even through liability
insurance.
S corporations offer you relief from the double taxation you face as the
owner of a C corporation.
S corporations offer a unique way to reduce your employment taxes. We
will go into this issue in great detail in our section on setting your salary.
Coming Up Next
In the next section, we take a look at the “tax factors” that determine how
well each business entity suits your business and personal needs.
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Endnotes – Section 1
1
Notes
We will show you the mechanics of this process in Section 4.
2
The way this works is that you first pay the income tax and then the dividend tax. For
example, say your C corporation earns $50,000 net and pays taxes of $7,500 at the 15
percent rate. It then pays a dividend to you of $42,500, on which you pay $6,375 in taxes,
leaving you with $36,125. On the $50,000 of income, you and your C corporation paid a
combined corporate and dividend tax of 27.75 percent, or $13,875.
3
Same calculation as above, using the next-higher 25 percent corporate tax rate followed by
the 15 percent personal dividend tax.
4
FICA and Medicare taxes of 15.3 percent.
5
The calculation of employment taxes is different for the self-employed and for owneremployees of S corporations. But for the purposes of this section, the following rates are a
good estimate.
6
2.9% x $150,000 x .9235. + .9% x $110,000.
7
Treasury Inspector General for Tax Administration, Audit # 200130027, Reference #
2002-30-125.
Copyright 2014 by Bradford and Company, Inc.
9
Notes
Section 2
Will Your S Corporation Add to
Your Bottom-Line Profits?
Learn the “tax factors” that affect your choice of
business entity
Every business is different. To maximize your tax deductions, you have to
find the business entity that best fits your business and your personal life.
Did you see the words “personal life” above? That’s right. Your personal
and family lives impact the type of business entity you need. With the right
business form, you get tax breaks for things like:
•
•
•
•
giving money to your parents,
buying health insurance for your family,
saving for your children’s educations,
and much more.
This section gives you an overview of the issues you need to consider
before you choose your business entity. We call these issues “tax factors”
because they determine the tax savings (or costs) each business entity will
offer.
When you read this section, make a note of the tax factors that apply to
you, and in the next section we’ll add these factors together to determine
the entity that is right for your business.
How Does Your State Treat S Corporations?
Depending on where you live, your state may require your S corporation to
file and pay a state income, franchise, or similar tax.
Be particularly alert if you live in a state with no personal income tax.
Those states often charge you a tax on your S corporation income. For
example, in Texas, a state with no personal income tax, the state
corporation tax applies to S corporations.
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Before you decide to form an S corporation, you need to consider whether
your state charges additional taxes or fees. If you live in a state that is not
friendly to S corporations, you need to factor in these additional costs
when you calculate the total tax benefits of the S corporation.
Notes
LLCs face similar treatment. Some states charge fees and taxes for LLCs
too, so be sure to check out your state’s LLC policy as well.
Are You an Employee of Another Business?
The general tax rule is that income is taxed to the person or entity who
earns it.1 If you get checks in your personal name and then endorse those
checks to your corporation, in all probability, neither the IRS nor the
courts will recognize your corporation for tax purposes.
For example, say you work as a 1099 sales agent, but all the commission
checks are paid to you in your personal name. In fact, the company for
which you work as a 1099 agent does not recognize any of its agents as
corporations. Assigning this income to your “corporation” does not make
it a corporation. As you might suspect, this is going to be a big problem for
you in the event of an IRS audit.
This also is true of a medical practice where the doctor accepts the
payments in his personal name and then assigns those payments to his
corporation. The patient was not dealing with the corporation. The patient
was dealing with the doctor, and the doctor earning the income will be
taxed on it. Again, this creates a big mess for the doctor who does not
instruct his patients to deal with his medical corporation.
Do You Help Others Financially?
With an S corporation, you can take advantage of “income splitting” if
you regularly give money to a person who is in a lower tax bracket than
you.
Here’s how this strategy works: Say you are in the 35 percent tax bracket
and you want to give money to your dad, who is in the 10 percent tax
bracket.
If you want your dad to have $10,000 in his pocket, you have to either:
1. Earn $15,385, pay taxes of $5,385 in your 35 percent bracket, and
then gift the remaining $10,000 to your dad, or
2. Give your dad a percentage ownership in your S corporation so the
corporation can distribute $11,111 to him, on which he pays $1,111
in taxes (10 percent times $11,111), leaving him with $10,000.
Copyright 2014 by Bradford and Company, Inc.
11
Notes
Note. You had to earn $4,274 more to make a gift with your after-tax
money compared to gifting a percentage of your S corporation to your
father ($15,385 minus $11,111).
The downside to this strategy is that now your father owns part of your
corporation. Thus, if you use this strategy, you will probably want to create
a separate class of non-voting stock to protect your control over the S
corporation. See more about how to do this in Section 7.
No income splitting for your children. The Kiddie Tax limits the
effectiveness of the income-splitting strategy for children who are under age
19 or who are under age 24 and in college, because for these children, the
law taxes unearned income over $2,000 at the parent’s rate.2
Do You Hire Your Under-Age-18 Children?
If you operate your business as a sole proprietorship, you get a tax benefit
when you hire your under-age-18 children. You deduct your childrens’
wages, and neither you nor your children pay employment taxes.
This doesn’t work for S corporations. When you hire your children through
your S corporation, you still deduct the wages, but you don’t get the break
from employment taxes. You can still benefit from this strategy, but it’s not
as good as what the sole proprietorship can offer.
How Do You Buy Health Insurance?
As an S corporation owner, you are probably at a disadvantage in terms of
tax benefits for healthcare. We say “probably” because the health insurance
issue is complicated, particularly after the Affordable Care Act
(Obamacare), and it’s hard to give a one-size-fits-all answer.
In general, your best strategy as an S corporation owner is to take a selfemployed medical deduction for health insurance on page 1 of your Form
1040 for your health insurance premiums, (this includes premiums of your
spouse and dependents under age 27).
Here again, a sole proprietorship might give you something better. If you
have a sole proprietorship and employ your spouse, you qualify for a
Section 105 medical plan, which allows you to deduct both your health
insurance premiums and your qualified medical expenses.
How Much Do You Put Away for Retirement?
Your solo 401(k) and other defined contribution retirement plan
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contributions are based on salary. If you take a low salary to save on
employment taxes, you will have a low contribution base for your 401(k)
or other retirement plan contribution.
Notes
If you operate as a sole proprietorship, you base your defined contributions
on net income—a higher number, and thus you can make larger
contributions to your retirement plan.
If you find that your S corporation salary is too low to support your
retirement contributions, there’s an easy solution—raise your salary. In
almost all cases, you will still save overall on employment taxes, even with
the salary increase.
What Will Your Family Inherit?
If you own a sole proprietorship when you die, the individual assets of
your business such as real estate, patents, copyrights, and customer lists get
marked up to fair market value for your date of death or alternate date. In
general, the markup means lower taxes for your heirs.3
If you own an S corporation when you die, the value of your S corporation
stock is marked up to fair market value. That value could be far different
from the value of the individual assets within your S corporation. Further,
proving the value of the stock is more difficult and expensive than
identifying only the value of the assets.
Are You Detail-Oriented With Your Paperwork?
The S corporation creates extra tax-related paperwork each time you take
money (or any other asset) out of the corporation, because you must treat
each withdrawal in one of three basic ways:
1. As a salary or bonus paid to you in your capacity as a corporate
employee,
2. As a distribution of corporate earnings paid to you in your capacity
as a corporate shareholder, or
3. As proceeds from a loan made by the corporation to you.
If you treat the withdrawal as salary or bonus money, you’ll have to deal
with employment taxes, employment tax forms, and W-2s.
Distributions create adjustments in the retained earnings section of your
balance sheet.
Loans create a need for loan documents, an interest rate, and (preferably) a
Copyright 2014 by Bradford and Company, Inc.
13
Notes
repayment schedule backed up by actual payments on your part.
Comparatively, you face little extra tax-related paperwork when you run
your business or practice as a sole proprietorship.
Assets. The assets owned by the S corporation are not your assets. They
are S corporation assets. You may not take them from the S corporation
without triggering a taxable action, in most cases adverse to you and/or the
S corporation.
With the sole proprietorship, you have far more ability to take assets
without triggering a taxable action.
Some Other Costs to Think About
With an S corporation, you face the extra cost of tax returns and corporate
compliance.
Unlike the Form 1040 Schedule C of a proprietorship, the S corporation
tax return includes a balance sheet in addition to the required Schedule K-1
pass-through information. To ensure that you get the right numbers in the
right spots of your S corporation tax return, you should use a professional
tax preparer.
Your S corporation is a corporation, and that means you also need
corporate paperwork. To get this right for both tax purposes and legal
protection, you should use a lawyer.
Final Thoughts
Deciding how to run your business is not easy. You have a lot of factors to
consider before you make your determination.
Just keep in mind that as you are running the numbers and figuring these
issues out, you are making money. When you pick the correct form of
entity for your business, you save in taxes, not only for the current year, but
for subsequent years as well.
Endnotes – Section 2
1
United States v Basye, 410 U.S. 441, 449, 451; Lucas v Earl, 281 U.S. 111 (1930).
2
IRC Section 1(g)(4)(A)(ii); Rev. Proc. 2013-35. The $2,000 floor increases if your child has
more than $1,000 of itemized deductions attributable to the unearned income.
3
14
IRC Section 1014(a).
Copyright 2014 by Bradford and Company, Inc.
The Big Picture
Section 3
Section 3
Notes
Comparison of Business Entities
Run the numbers and see if the S corporation is
right for you
The first two sections of this tax guidebook covered the basics of S
corporations. If any of the information in those sections is still fuzzy to
you, don’t worry. We are going to cover all of the issues in more detail
later on in this tax guidebook and in the webinar.
If you want to skip ahead to the other sections to learn more about
individual topics, feel free. But take a look at this section first. We are
going to show you how to run a side-by-side comparison of the different
business entities and determine which of the entities gives you the best
bottom line.
When you go on to the rest of this guidebook, keep this section in mind.
Every business form has its advantages and disadvantages. So never get
bogged down in any one aspect of an entity until you have had a chance to
revisit the big picture and see how all the numbers work together.
If you need to engage your tax advisor to make this comparison for you,
consider that a good investment to ensure that your business operates the
right way. Having read the prior sections in this guidebook, you will be in
a great position to provide your tax advisor the essential information he or
she will need in order to get you to the right answer.
Big-Picture Comparison of Tax Benefits
The following two charts summarize the major income and payroll tax
factors we covered in the prior two sections using the four business options
that you are most likely to choose from.
Copyright 2014 by Bradford and Company, Inc.
15
Choice of Entity—Table 1: Income and Payroll Taxes for the One-Owner Business
Description
Tax on income
Payroll taxes on
owner-employee
Proprietorship
Taxed at the
individual level
Single-Member
LLC Taxed as
Proprietorship
C Corporation
S Corporation
Taxed at the
individual level
(caution: some
states assess a
corporate tax on
the LLC)
Income is taxed at
the corporate
level. Dividends
from the after-tax
profits of the
corporation paid
to the owner are
taxed at the
individual level.
No tax at the S
corporation level.
The income flows
through to the
individual level
(caution: some
states assess a
corporate tax on
the S
corporation).
Corporation pays Corporation pays
FICA, Medicare, FICA, Medicare,
and
and
unemployment
unemployment
Owner pays selfOwner pays selftaxes on wages
taxes on wages
employment taxes employment taxes
paid to the owner. paid to the owner.
on Schedule C
on Schedule C
The ownerThe ownerincome.
income.
employee pays
employee pays
FICA and
FICA and
Medicare on the
Medicare on the
owner’s wages.
owner’s wages.
Payroll taxes on
hiring your underage-18 child
Wages paid by
proprietor-parent
to an under-age18 child are
exempt from
FICA, Medicare,
and
unemployment
taxes.
Wages paid to an
under-age-18
child are subject
to FICA,
Medicare, and
unemployment
taxes.
Section 105
medical
reimbursement
plan
Available by
hiring and
covering the
spouse with
family coverage
Available by
hiring and
covering the
spouse with
family coverage
Section 179
expensing
16
Individual level
Individual level
Wages paid to an
under-age-18
child are subject
to FICA,
Medicare, and
unemployment
taxes.
Wages paid to an
under-age-18
child are subject
to FICA,
Medicare, and
unemployment
taxes.
Available to
owner-employee
Not available to
more-than-2percent-owners or
their spouses
Corporate level
Flows through to
the individual
level
Copyright 2014 by Bradford and Company, Inc.
Choice of Entity—Table 2: Other Considerations for the One-Owner Business
Description
Liability
protection
Paperwork
Income splitting
Net operating
loss (NOL)
Proprietorship
Single-Member
LLC Taxed as
Proprietorship
C Corporation
S Corporation
None
Excellent.
Exposure
generally limited
to assets of the
LLC.
Excellent.
Exposure
generally limited
to assets of the
corporation.
Excellent.
Exposure
generally limited
to assets of the
corporation.
Separate
checkbooks and
bookkeeping,
separate personal
and corporate tax
returns, corporate
minutes, annual
disclosure filings
Separate
checkbooks and
bookkeeping,
separate personal
and corporate tax
returns, corporate
minutes, annual
disclosure filings
Poor
Excellent by
adding
shareholders
No flow-through
to the individual.
Corporation may
carry back the
NOL two years
and forward 20
years. If the
corporation fails,
use Section 1244
stock to write off
your initial
investment.
To the extent of
basis in the S
corporation, the
NOL flows to the
individual and
offsets other
income. If there
is still an NOL
after the offsets,
carry back two
years and
forward 20 years.
Easiest
None
Flows to
individual and
offsets other
income. If there is
still an NOL after
the offsets, carry
back two years
and forward 20
years.
Easy like the
proprietorship,
except you need to
file an annual
disclosure with the
state and keep
separate books to
ensure liability
protection.
Excellent with
multimember
LLC
Flows to
individual and
offsets other
income. If there is
still an NOL after
the offsets, carry
back two years
and forward 20
years.
Cost of disability
insurance on
owner
No deduction; no
tax to owner on
receipt of benefits
No deduction; no
tax to owner on
receipt of benefits
Death
Assets marked up
to fair market
value for heirs
Assets marked up
to fair market
value for heirs
Copyright 2014 by Bradford and Company, Inc.
May be deducted.
If deducted, the
No deduction; no
benefits are
tax to owner on
taxable to the
receipt of benefits
owner.
Corporation
Corporation
continues, value of continues, value
shares marked up of shares marked
to fair market
up to fair market
value
value
17
Notes
Example Where the S Corporation Was the Wrong
Choice
Countless thousands of business owners form S corporations without
thinking of the bottom-line results. Here’s a sad and true story. We changed
the names to protect the guilty.
At a robust cocktail party, Henry Smith asked his accountant, Jane Ford, if
he should become an S corporation. She said yes, retired, and moved to
Florida. Meanwhile, Mr. Smith changed his letterhead, business name,
etc., and became Henry Smith, Inc. He selected S corporation status, hired
a new accountant to replace the retired Ms. Ford, and learned that his new
S corporation did not reduce his taxes as he expected. Instead, S
corporation status increased his taxes by over $10,000.
Mr. Smith was most unhappy.
Mr. Smith’s thousands of dollars in lost money to taxes was only part of
what he lost. He spent many hours getting his credentials, letterhead,
business ads, etc., converted to the corporate form, not to mention the
money and time he spent incorporating, changing his bank accounts, etc.
Don’t make the big mistake Henry Smith made. See a physical comparison
of your entity numbers before making a decision.
Run the Numbers
Here is what Mr. Smith might have discovered if he had run the numbers.
You have one way to know for sure that the business entity you selected is
the best. You need to see it in writing. You also need to review it
periodically, by seeing it again in writing.
The “seeing it” part means a pencil-to-paper comparison of business
entities. Let’s say you have operated as a proprietorship and now need to
compare the proprietorship to the S corporation. Your comparison might
look like this:
Step 1: Net cash from proprietorship
18
Proprietorship
Net income from proprietor’s tax return
Less federal income taxes paid
$150,000
- 33,000
Less Social Security and Medicare taxes paid
Net cash to spend with proprietorship
- 16,000
$101,000
Copyright 2014 by Bradford and Company, Inc.
Step 2: Net cash from S corporation
Start with net cash to spend with proprietorship and
make adjustments.
S corporation
$101,000
Cash saved with S corporation on Social Security and
Medicare taxes with a $75,000 salary and $75,000 in
distributions
6,000
Cash lost because the S corporation triggers payroll
taxes on the hiring of your two children
-6,000
Estimated present value of annual after-tax cash loss
on retirement benefits due to contribution at the S corporation level being limited to $75,000 salary income
(versus the $150,000 net income at the proprietorship
level)
-4,000
Cash cost (after taxes) for extra S corporation tax
returns, annual filings with the state, and lawyer’s fees
-1,000
After-tax cash lost with S corporation medical plan
versus the benefits of the Section 105 plan at the
proprietorship level
-3,000
Additional state taxes on S corporation entity (these
are in addition to the state taxes on your pass-through
income)
-2,250
Net cash to spend with S corporation
$90,750
Step 3: Cash advantage to proprietorship
$10,250
Notes
You may or may not be able to make the comparison yourself. If not,
spend money with your tax advisor to get this comparison in writing.
Take the example computation above. Say Mr. Smith was told that he
could save $6,000 on self-employment taxes by becoming an S
corporation. That statement is true. But when you consider all the tax
factors, the S corporation was the wrong entity for him. The existing
proprietorship gives the business owner a $10,250 advantage over the S
corporation.
The big mistake is not seeing a big-picture, pencil-to-paper comparison of
tax benefits.
What’s Next?
Now that you have an idea of the tax factors that determine which tax
Copyright 2014 by Bradford and Company, Inc.
19
Notes
entity is right for your business. With this knowledge, you are well on your
way to becoming a tax-efficient business and keeping your hard-earned
money where it belongs—in your pockets.
In the next two sections, we move on to the tax secrets involved in forming
and starting up your S corporation.
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Section 4
Notes
Avoid These Common Mistakes
When Converting to an S
Corporation
Learn the tax secrets to forming an S
corporation.
At first glance, the corporate tax rules for forming an S corporation appear
simple.
They are not.
As a business owner, you probably know that the tax code is full of hidden
rules.
The IRS knows these rules. You need to know them too.
In this section, we do two things: First, we help you avoid the potholes
that destroy your S corporation. Image what a shock that is—to find out
that what you thought was your S corporation is not an S corporation, but
rather a C corporation. Ouch!
Second, we identify some of those rules that work to your advantage when
you operate as an S corporation.
Basic Requirements
Here is what your business must look like when it operates as an S
corporation:1
1. The S corporation must be a domestic corporation.
2. The S corporation must have less than 100 shareholders.
3. The shareholders can only be people, estates, and certain types of
trusts.
4. All stockholders must be U.S. residents.
5. The S corporation can have only one class of stock.
Copyright 2014 by Bradford and Company, Inc.
21
Notes
Simple, right? What often appears simple on its surface is not so simple at
all.
Mistakes about the Requirements
Some rules are a little hidden. If you violate one of them, your S
corporation magically reverts into a C corporation and this result could be
horrible.
To add to the horror, image if the S corporation reverts to a C corporation
for three years.2
Don’t let that happen.
Here are the hidden rules that most likely to apply to you.
Don’t Forget Your Spouse
If you live in a community property state, your spouse by reason of
community property law may be an owner of your corporation. This can be
true whether or not your spouse has stock in his or her own name.3
If your spouse is an owner, your spouse has to meet all the same
qualification requirements you do. This can raise two issues:
1. If your spouse does not consent to the S corporation election on
Form 2553,4 your S corporation is not valid.5
2. If your spouse is a nonresident alien, then your S corporation is not
valid.6
An LLC Can Be an S Corporation
You can create an LLC and then, by following the two steps here, make
that LLC an S corporation.
If you want to convert your LLC to an S corporation for tax purposes, you
need to do what we call “Check and Elect.”7 It’s easy, just two steps. You
first “check the box” to make your LLC a C corporation and then you
“elect” for the IRS to tax your C corporation as an S corporation. Here’s
how you take the two steps:
1. File IRS Form 8832 to check the box that converts your LLC to a C
corporation.8
2. Then file Form 2553 to convert your C corporation into an S
corporation.9
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Loans That Exterminate S Corporation Status
Notes
Don’t make a bad loan to your S corporation. With the wrong type of
loan, you enable the IRS to treat that loan as a second class of stock that
disqualifies your S corporation.
Small loans are okay. If the loan is less than $10,000 and the corporation
has promised to repay you in a reasonable amount of time, you escape the
second class of stock trap.10
Larger loans are more closely scrutinized. If you have a larger loan, your
loan escapes the second class of stock trap if it meets the following
requirements:11
1.
2.
3.
4.
The loan is in writing.
There is a firm deadline for repayment of the loan.
You cannot convert the loan into stock.
The repayment instrument fixes the interest rate so that the rate is
outside your control.
You Can Have a Separate Class of Nonvoting
Stock
One of the biggest complaints about S corporations is the one class of stock
requirement.
The thing is, you can have separate classes of stock, as long as the only
difference between them is the voting rights of each class.12
For example, you can create both voting stock and nonvoting stock, as
long as all other aspects of the stock are the same.
If you want to give someone distributions but not let that person have any
control over business decisions, give him or her nonvoting stock.
Nonvoting stock can be very helpful if you want to give money to
someone in a lower tax bracket, such as your retired parents. We cover this
“income splitting” strategy in more detail in Section 7.
Time of Filing Can Make a Big Difference
In general, your business needs to meet the requirements for S corporation
status on the day it files the S corporation election.13
Example. Suppose you want your business to be an S corporation in the
Copyright 2014 by Bradford and Company, Inc.
23
Notes
next tax year (“Year 2”).14 If you file your election this year “Year 1”) and
elect January 1, Year 2, as your effective date for the election, the IRS will
look to see if you meet the requirements as of that Year 1 day that you file
the election.
What if you want to be an S corporation, but don’t file the form before the
end of the year? No problem. The tax code gives you the first two months
and 15 days of the next year to file the election and have it effective on the
first day of the year.
For a calendar-year business, this means file by March 15 to have the
election effective on January 1.
However, in order to file in this expanded period, you must meet the
requirements for S corporation status for the entire year, even the period
before you filed the election.15
You also must get the consent of everyone who held stock in your
corporation for that year.
Example 1. Suppose you want to convert your business to an S corporation
in Year 2. You can file your election as late as March 15, Year 2. However,
your business must meet all the S corporation requirements as of January 1,
Year 2.
Example 2. Continuing with the example above, suppose you are in a
community property state and you get divorced in February Year 2. You
need your ex-spouse’s consent to the S corporation election because he or
she was a shareholder in January (during the time of your marriage).
Beware of Extra Taxes for Some C Corporations
If you operated your business as a C corporation, you may face some
special issues when you convert to an S corporation.
These can be fairly complicated, more complicated than you want to read
about now. But we have flagged these issues so you can keep an eye out for
them.
Built-in gains tax. If your C corporation’s assets are worth more than their
basis, you could face some high taxes when you sell those assets.16 We
cover this in Section 5, coming up next.
Loss of tax attributes. If your C corporation had loss carryover or
minimum tax credits, the tax code generally does not allow them while
your business is an S corporation.17
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LIFO recapture. You may face recapture tax if your C corporation used
the LIFO (Last-In, First-Out) method of accounting for its inventories.18
Notes
Passive investment income. You may face a special higher tax if your
previous C corporation had accumulated earnings and profits, and then
more than 25 percent of your S corporation’s income comes from passive
investment income (generally income from royalties, rents, dividends,
interest, and annuities).19
Endnotes – Section 4
1
IRC Section 1361; for a thorough checklist of how to qualify, see the Instructions for
Form 2553 (Rev. December 2007).
2
In most cases, the statute of limitations will prevent assessments for periods more than
three years in the past. See Barnes Motor & Parts Co. v U.S., 309 F. Supp. 298 (EDNC 1970)
(When a corporation’s original S election was found to be invalid, the IRS assessed taxes
for all years not barred by the statute of limitations.).
3
Community property states are Arizona, California, Idaho, Louisiana, Nevada, New
Mexico, Texas, Washington, and Wisconsin. In addition, Alaska is an opt-in community
property state where both parties can agree to make property community property. Note
that even if you live in a different state, if you moved into or out of one those states, these
issues might still affect you.
4
IRS Form 2553, Election by a Small Business Corporation (Rev. December 2007).
5
Reg. Section 1.1362-6(b)(2)(i).
6
IRC Section 1361(b)(1)(C).
7
The choice to be a C corporation is called “checking the box.” The choice to be an S
corporation is an election.
8
See Rev. Rul. 2009-15 (conversion from partnership status to corporate status treated as
contribution by partnership of assets to new corporation in exchange for stock followed by
liquidation of partnership); IRS Form 8832, Entity Classification Election (Rev. January
2012).
9
IRS Form 2553, Election by a Small Business Corporation (Rev. December 2007).
10
Reg. Section 1.1361-1(l)(4)(ii)(B)(1).
11
IRC Section 1361(c)(5)(B).
12
IRC Section 1361(c)(4).
13
See Rev. Rul. 86-141. The form for the S corporation election is IRS Form 2553, Election
by a Small Business Corporation (Rev. December 2007).
14
This example assumes your taxable year is the calendar year.
15
IRC Section 1362(b).
16
IRC Section 1374.
17
IRC Section 1371(b).
18
IRC Section 1363(d).
19
IRC Section 1375; definition of “passive investment income” in IRC Section
1362(d)(3)(C).
Copyright 2014 by Bradford and Company, Inc.
25
Notes
Section 5
S Corporation Tax on Built-In
Gains Is Trouble
Extra tax woes when converting from a C
corporation
Do you currently operate your business as a C corporation?
Do you plan to convert that corporation to an S corporation?
If so, you need to consider the built-in gains tax. The built-in gains tax
scares away many C corporation owners who want to convert their
business to an S corporation.
Should the built-in gains tax scare you? Will it apply?
The answer depends on the book and fair market values of the assets in
your C corporation. For some businesses, the built-in gains tax will be a big
problem.
How the Built-In Gains Tax Operates
If not for the built-in gains tax, C corporation owners could avoid
corporate-level tax on the sale of assets by converting to an S corporation
just before making the sale.
Lawmakers responded to this strategy by enacting a punitive tax on S
corporations that sell assets they owned while in the C corporate form.
Here is an example of how it works.
Suppose that just before you convert to an S corporation, your C
corporation owns real estate with a basis of $400,000 and a fair market
value of $1,000,000.
This means that at the time of your conversion from the C corporation to
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the S corporation, you have “unrealized built-in gains” of $600,000 in your
real estate ($1,000,000 fair market value minus $400,000 basis).
Notes
If you sell the real estate six months after your S corporation conversion,
you will pay a corporate level tax of 35 percent on the gain.1
Does this replace your shareholder-level tax? No! You pay the built-in
gains tax in addition to the tax you pay as a shareholder at your usual
individual rates.2
Ouch! The ouch is for two reasons:
1. Your S corporation pays the built-in gains tax at the highest
corporate rate of 35 percent. (Tax 1.)
2. The 65 percent of the gain remaining after payment of the built-in
gains tax now comes to the shareholder via the S corporation,
where the shareholder pays taxes at his or her personal rate. (Tax
2—double taxation.)
When you look those two taxes in the eye, you can see why you need to
do some planning.
Why You Need an Appraisal
If you are going to convert your C corporation to an S corporation, you
first need an appraisal, because appreciation that takes place after the
conversion is not subject to the built-in gains tax.
As you would expect, the IRS puts the burden on you to prove the fair
market value at the time of your C corporation’s conversion to an S
corporation.3
Using the example above, suppose you sell your real estate for $5,000,000
instead of $1,000,000. The IRS might demand that you pay built-in gains
tax on all $4,600,000 of gain, by claiming that the fair market value at the
time you converted your C corporation to an S corporation was
$5,000,000 and not $1,000,000.
With a good appraisal, you can prove the fair market value at the time of
conversion was actually $1,000,000. That proof would save you from
paying the 35 percent built-in gains tax on $4,000,000.
If you don’t have an appraisal, you still have a chance to prove the fair
market value at the time of conversion, but after-the-fact proof is often
more difficult and problematic.
Copyright 2014 by Bradford and Company, Inc.
27
Notes
Built-In Losses Reduce the Potential Tax
The total amount of gain potentially subject to the built-in gains tax is the
net unrealized built-in gain on all your C corporation’s assets.4
Let’s use the facts from the first example above, in which the C corporation
had the real estate with a basis of $400,000 and that real estate was worth
$1,000,000 at the time of conversion. Now let’s add stock to the asset mix
with a built-in loss of $600,000.
Bingo! Your total net unrealized built-in gain equals $0. (The $600,000
built-in loss offsets the $600,000 built-in gain.) Because your net unrealized
gain is zero, you pay no built-in gains tax.
Planning
You also can plan to pay lower built-in gains tax in a given year. That’s
because before you calculate your built-in gains tax for the year, you net the
properties you sold that had built-in gains with those properties sold that
had built-in losses.5
The planning idea here is easy. To reduce your built-in gains taxes, sell
your built-in loss property to offset your built-in gain property. Make sure
you do this during the same taxable year.
Do This
To make the gain and loss strategies work for you, you need proof of value.
That means you need to get an appraisal.
Remember, the burden is on you to prove the value of your built-in loss
property at the time you converted your C corporation to an S corporation.
Built-In Gain Taxes Apply Only to S Corporations
That Were Once C Corporations
If you never operated your business as a C corporation, you don’t have to
worry about the built-in gains tax. It does not apply to your S corporation.
The built-in gains tax applies only to S corporations that previously were C
corporations.
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Free after 10 Years
Under current law, you face potential built-in gains taxes for 10 years after
the date you converted your C corporation to an S corporation.6
Notes
Strategy. Wait 11 years to sell the old C corporation assets to totally
escape the built-in gains tax.
Hope. Lawmakers reduced the 10-year period to five years a couple of
times recently, but just for one-year periods. Perhaps once you get into
your 10-year period, lawmakers will reduce the required time to make your
tax life easier. You can always hope.
Convert the S Corporation to a C Corporation
You face no built-in gains tax when you convert your S corporation to a C
corporation. The tax applies only if you convert from C to S.
Don’t Liquidate
Beware. The built-in gains tax applies if you liquidate your S corporation
before the 10-year period expires, since liquidation is treated as a deemed
sale of your assets.7 For more on liquidation, see Section 17.
Endnotes – Section 5
1
IRC Sections 1374(a) and (b); 11(b).
2
Your individual tax is reduced somewhat, since you treat the built-in gains tax as a loss
sustained by the corporation for that year; IRC Section 1366(f)(2).
3
See, e.g., The Ringgold Telephone Company, TC Memo 2010-103.
4
IRC Section 1374(d)(1).
5
IRC Sections 1374(a) and 1374(d)(2).
6
In recent years, Congress has reduced the recognition period for currently existing S
corporations, and one can hope that they will do so again in the future. However, for C
corporations presently planning an S election, the recognition period is still 10 years. IRC
Section 1374(d)(7).
7
See IRC Section 336(a); IRM 4.11.7.8(3).
Copyright 2014 by Bradford and Company, Inc.
29
Notes
Section 6
Audit-Proof Your Salary
Save on employment taxes when you set your
salary correctly.
Why would you pick the S corporation as a form of business entity?
Your likely answer: cut self-employment taxes.
How do you do that?
Pay a low salary and take the remaining profits as distributions that are not
subject to the self-employment tax.
Save Employment Taxes
If Bill Smith operates as a proprietorship, he pays self-employment taxes of
$14,130 on his $100,000 of income.1 If Mr. Smith operates this business as
an S corporation and pays himself a salary of $50,000 and takes $50,000 as
a distribution, he saves $7,065 in self-employment taxes.
Distributions do not trigger the self-employment tax. You can see that Mr.
Smith has a powerful motive to keep the salary low.
Risk factor. If Mr. Smith’s salary becomes too low, he faces payroll tax
penalties of up to 100 percent as well as negligence penalties.2
The IRS is Not the Only Danger
The IRS is not the only government agency that gets upset by zero salary.
The Social Security Administration also has an interest in this issue. In
Ludeking v Finch, the taxpayer incorporated his sole proprietorship as an S
corporation. He took zero salary but received corporate distributions. The
court ruled that the Social Security Administration had the authority to
change improper dividends to wages for services performed.3
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Find the Balance
Notes
If you set your salary too low, the Social Security Administration and IRS
will cause you difficulty, increased payroll taxes, and huge payroll tax
penalties.
If the salary is too high, you cheat yourself from saving money on your
self-employment taxes.
This section will help you establish a salary that’s not too low and not too
high. Thus, if your purpose for the S corporation is to save money on selfemployment taxes, this section is for you.
Zero Salary is Out
The one-owner personal service S corporation with no employees has no
chance of claiming:
•
•
a zero salary, and
all S corporation profits as corporate distributions.
Example. Joseph Radtke operated his law practice as an S corporation. In
its third year after incorporation, the IRS audited Mr. Radtke’s S
corporation and reclassified all the distributions as salary. Mr. Radtke
made various arguments to both the district and appeals courts but lost
both times and had to consider the distributions as salary subject to payroll
taxes.4
The IRS consistently wins court cases against S corporations that pay zero
salaries.5
The combination of zero salary and big profit distributions to the S
corporation owner/operator rendering personal services simply does not
work
Bottom line, you have to take a salary.
Find A Reasonable Salary
What’s a reasonable salary? The IRS can’t tell you, as there are no specific
guidelines for reasonable compensation in the tax code or the regulations.6
There are also very few court cases regarding the reasonableness of S
corporation owners who take a salary that is above zero.
Copyright 2014 by Bradford and Company, Inc.
31
Notes
Why are there so few cases? The IRS has plenty of low-hanging fruit in the
zero-salary group. If the IRS has to choose between pursuing a case on
reasonable salary versus a case on no salary, the IRS will likely pick the no
salary case.
The IRS has spent little time and had little success in attacking S
corporation owners who take salaries. Further, with one million one-owner
S corporations already identified as easy targets because of their no-salary
policies, why would the IRS bother with taxpayers who take salaries?7
Planning note. When looking at court cases, keep in mind that the IRS has
lots of potential court cases to consider. The IRS does not take cases to
court that it thinks it is going to lose.
The National Taxpayer Advocate noted that it is difficult and time
consuming for the IRS to establish a fair and reasonable salary.8 Imagine
how much more difficult that task is for the IRS if you have a basis for a
reasonable salary and the IRS wants to challenge it.
Aim Low
In general, you will find a wide range of salaries that you can prove
reasonable. If your strategy is to save employment taxes, you want a
reasonable salary in the low range.
Document Your Decision
When you create your salary, create documents to show why you chose the
number you did. Do this at the same time that you set your salary.
In court, the question of a reasonable salary is a question of fact. Thus, step
one in building proof of a reasonable salary is gathering facts that support
the salary taken. A key fact is the amount that the corporation would pay
to a third-party employee to do the job. You might find this number in a
trade survey, from headhunters, or from job ads.
In determining the proper salary, the IRS notes that the courts have
considered the following:9
•
•
•
•
•
•
32
Training and experience
Duties and responsibilities
Time and effort devoted to the business
Dividend history
Payments to non-shareholder employees
Timing and manner of paying bonuses to key people
Copyright 2014 by Bradford and Company, Inc.
•
•
•
Payment by comparable businesses for similar services
Compensation agreements
The use of a formula to determine compensation
Notes
Strengthen your proof. Make ink annotations and other notes on the
pages so a later look shows that this evidence has been in the file for a
while. Good proof shows that you had this evidence at the time you made
the salary decision.
Mr. Watson’s Expensive Lesson
With good proof, you are not only armed should you be attacked by the
IRS, but also you may well have bulletproof armor.
Not too long ago, David Watson chose a risky salary at a level of about 10
percent of his distributions ($24,000 versus $222,000).
The IRS challenged him in court and won.10
Fortunately for us (but not Mr. Watson), we can learn from Mr. Watson’s
expensive lesson by seeing what factors the court considered important in
determining the reasonableness of an S corporation salary.
By applying these factors, you can arm yourself against the IRS by using
their techniques to your advantage. When you know what the IRS is
looking for, you can protect yourself in advance.
Basic Facts
David Watson operated his CPA practice as an S corporation that owned
a 25 percent interest in the accounting firm of Larson, Watson, Bartling, &
Juffer, LLP (LWBJ).
In 2003, LWBJ had approximately 30 employees and gross billings of
$2,949,739. Of this amount, Mr. Watson billed $200,380.
During 2003, LWBJ distributed profits of $175,470 to Mr. Watson’s S
corporation. That year, Mr. Watson’s S corporation paid him a salary of
$24,000 and wrote checks for profit distributions of $222,000 that year.
The court agreed with the IRS engineer who testified that Mr. Watson’s
proper salary should be $91,000, rather than the $24,000 that Mr. Watson
set for himself. This determination decreased the amount of profit not
subject to employment tax from $222,000 to $155,000.
Copyright 2014 by Bradford and Company, Inc.
33
Notes
Comment. Say this happened today. With $91,000 in salary and $155,000
in distributions, the S corporation and its owner would save over $9,000 in
FICA and Medicare taxes compared to a sole proprietorship.
The IRS Expert
The court deemed Igor Ostrovsky, an IRS general engineer, competent to
render an expert opinion regarding the fair market value of Watson’s
accounting services.
According to Mr. Ostrovsky, a general engineer for the IRS serves as a
consultant on audits and assists revenue agents in the valuation of
businesses, depreciation, tangible and intangible assets, and reasonable
compensation. On this matter, Mr. Ostrovsky testified that he did not share
his report with anyone at the IRS (this case was tried by the Department of
Justice).
His credentials include expert witness testimony in more than 20 cases,
including three on unreasonable compensation.
Mr. Ostrovsky holds bachelor of science degrees in electrical engineering
and mathematics and a master of business administration with a
concentration in finance, all from the University of Minnesota. He is also a
member of the National Association of Certified Valuation Analysts.
To prove that your S corporation salary is reasonable compensation, you
need proof. Having proof developed by an expert is icing on the cake.
How the IRS Expert Identified $91,000 as Salary
Mr. Ostrovsky presented the court with facts from his studies of:
•
•
•
accounting salaries for accounting and finance professionals listed
in the Robert Half International salary guide,
the annual financial statement studies of medium and small
companies from the Risk Management Association, and
the Leo Troy Almanac of Business and Industrial Financial Ratios.
He used information from his studies of the above references to establish
that he did his homework, but he did not use this information in setting
$91,000 as the salary for Mr. Watson.
For the $91,000 salary, Mr. Ostrovsky used the Management of an
Accounting Practice (MAP) survey that is conducted by the American
Institute of Certified Public Accountants.
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The MAP survey showed that owner-employees in a firm the size of
LWBJ would receive approximately $176,000 annually in combined
compensation and return on investment.
Notes
To drill down to the salary only, Mr. Ostrovsky found that a director (an
employee with no ownership interest) would earn $70,000 a year. Owners
billed at rates 33 percent higher than directors, so Mr. Ostrovsky used the
33 percent and a few minor adjustments to arrive at his $91,000 fair salary.
The Proof
You want in your files something like what Mr. Ostrovsky developed,
before the IRS thinks about sending you an audit notice. You could make
this part of your annual stockholder’s meeting and fold it into the
corporate minutes. You don’t need a valuation expert to do this for you,
although that certainly would not hurt.
You simply need good evidence of why your salary (low as it might be) is
a reasonable salary. Look to your trade association for evidence. Also,
look at commercial services such as those examined by Mr. Ostrovsky.
Fight the IRS
When the IRS first challenged Mr. Watson, the IRS claimed that
reasonable salary should be $199,000, far above the $91,000 that the court
ultimately decided.
Mr. Watson took the IRS to court, asking for summary judgment.
During the court’s fact finding, the IRS’s expert witness, Igor Ostrovsky,
several times amended his opinion of reasonable salary. As the court
finalized its inquiries, the IRS’s reasonable salary demand dropped to
$91,000, leaving $155,000 as dividend distributions.11
Mr. Watson did not technically win his case in court, but he dramatically
reduced the taxes he had to pay.
We give kudos to Mr. Watson for getting that salary down from the
original IRS demand of $199,000 to $91,000. That $108,000 drop saved
Mr. Watson serious cash.
Copyright 2014 by Bradford and Company, Inc.
35
Notes
Endnotes – Section 6
1
Self-employment tax rate of 15.3 percent is applied to 92.35 percent of the $100,000 of
self-employment income, for a net self-employment tax of $14,130. See IRS Schedule SE
for the 92.35 percent.
2
IRC sections 6651; 6656; 6672.
3
Ludeking v Finch, 421 F.2d 699 (8th Circuit 1970).
4
Joseph Radtke, S.C. v U.S., 65 AFTR 2d 90-1155, 895 F2d 1196, 90-1 USTC 50,113 (CA7,
2/23/1990) aff’m Joseph Radtke, S.C. v U.S., 63 AFTR 2d 89-1469, 712 F Supp 143 (DC
WI, 4/11/1989).
5
See, e.g., Veterinary Surgical Consultants, P.C. v Commr., 117 TC 141; Mike J. Graham
Trucking, Inc. v Commr., TC Memo 2003-49; Nu-Look Design, Inc. v Commr., TC Memo 200352; and Water-Pure Systems, Inc. v Commr., TC Memo 2003-53.
6
Fact Sheet 2008-25.
7
Annual Report to Congress, Volume 1 (2007), National Taxpayer Advocate, p. 314.
8
Annual Report to Congress, Volume 1 (2007), National Taxpayer Advocate, p. 314.
9
Fact Sheet 2008-25. The factors above come from C corporation cases involving excess
salary.
36
10
David E. Watson v U.S., 107 AFTR 2d 2011-311 (DC IA, 12/23/2010).
11
Watson, P.C. v U.S., 105 AFTR 2 2010-2624 (5/27/2010).
Copyright 2014 by Bradford and Company, Inc.
Section 7
Notes
Obamacare Revives S
Corporation Income Shifting
Strategy
Save over $6,000 when you give S corporation
stock instead of cash.
Suppose you want to give your parents $20,000 over the course of the year.
You and your parents have two choices for the amount you will allow the
government to collect in taxes:
•
•
You can pay $9,851 in taxes.
Your parents can pay $3,530 in taxes.
Both are perfectly acceptable choices. What’s the difference? The first is
the tax you have to pay before you can make the cash gift to your parents.
The second is the tax your parents pay on the income you distribute to
them through your S corporation.
When you give your parents stock in your S corporation instead of cash,
you shift the income to their lower tax bracket. This means your parents
end up with the same amount of money, $20,000 in the example that
follows, but the government collects a lot less tax.
How You Save
Here are the details of how you can save over $6,000 in taxes when you
give money to your parents through your S corporation.
Assume the following facts:
•
•
•
You file jointly with your spouse, and that joint return puts you and
your spouse in the 33 percent tax bracket.1
Your parents are in the 15 percent tax bracket.2
Your S corporation has $100,000 in profits (in excess of your salary
and other expenses).
Copyright 2014 by Bradford and Company, Inc.
37
Notes
If you are the sole owner of your S corporation, you pay income tax on 100
percent of the profits of your S corporation.
Thus, in order to give $20,000 cash to your parents, you have to first earn
$29,851. Then Uncle Sam takes his $9,851 cut in taxes. After taxes, you
have $20,000 left to give to your parents.
Now, let’s see what happens when you give your parents stock in your S
corporation instead of cash.
If you give them 23.53 percent of the stock, your parents receive $23,530 of
the company’s profits (23.53 percent times $100,000). Using this method,
Uncle Sam’s cut falls to $3,530, leaving your parents with $20,000 free and
clear after taxes.
In addition, once your parents are shareholders, you get the benefit of this
tax strategy year after year.
Nonvoting stock. If you want to ensure that you maintain control of your
corporation, create a second class of stock without voting rights.
Nonvoting stock does not affect your S corporation status.3 Nonvoting
shareholders receive distributions, but they cannot make business decisions
for the company.
Obamacare Revives Strategy for Shifting Income
to Children
Until recently, there was not much of a reason to shift income to your
children under age 24. The “kiddie tax” destroyed most of the benefits.
The kiddie tax works by raising your children’s tax brackets to your tax
bracket on their unearned income (such as distributions from your S
corporation).
However, when lawmakers created the new 3.8 percent Obamacare tax on
unearned income, they did not tie it to the kiddie tax. Thus, if you have to
pay the Obamacare tax, you can avoid that tax and a little more by shifting
income to your children.
Example
Assume the same facts as in the example above:
• You are the sole shareholder of your S corporation.
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•
•
Your S corporation earns $100,000 of profits in excess of salary and
other expenses.
You are in the 33 percent tax bracket, and you have enough net
investment income so that you have to pay the 3.8 percent Obamacare
tax (NIIT).
Notes
Now to these facts, let’s add three children, say, ages 10, 11, and 12. If you
give each child a 10 percent share of nonvoting stock, you and your
children cut your overall taxes by $2,820.
Here are the details of how this works:
•
•
Because your income is $30,000 less, you reduce your combined
income tax and NIIT by $11,040 ($30,000 times 36.8 percent).
Because of the kiddie tax, your children pay income tax at a higher
rate, but they do not pay the NIIT. Each child pays a total of $2,740 in
tax. All together, your three kids pay $8,220.4
Your savings of $11,040 minus the children’s taxes of $8,220 give you
$2,820 in savings.
Give to a custodian. If you are worried about giving cash to your children
outright, you can create a custodial account or a trust so that your children
will not be able to access the money until they reach a certain age.
Meanwhile, you can use the custodial money to pay the children’s
expenses.5 (Most state laws require you to pay the children’s necessaries.)
Don’t elect the tax on your return. Here’s a trap to avoid. You have an
election to include your children’s tax on your personal tax return. Don’t
do this.
In this example, the tax on your return includes the Obamacare tax.
Adding the children’s kiddie-tax income increases your income subject to
the Obamacare tax, defeating the purpose of this income-shifting strategy.6
To win, file the children’s tax returns separately.
Whom the Kiddie Tax Hits
The kiddie tax hits children under a maximum age limit and over a
minimum income limit.
Your child has to pay the kiddie tax if he or she is under age 18 at the end
of the tax year and has sufficient unearned income.7
Some older children also have to pay the kiddie tax on their unearned
Copyright 2014 by Bradford and Company, Inc.
39
Notes
income if their earned income does not exceed half of the child’s support
for the year. This rule applies to8
•
•
children who are age 18 on December 31 (end of the tax year) and
children who are under age 24 on December 31 (end of the tax year)
and full-time students.
Married children. Married children who file joint returns do not pay the
kiddie tax. For example, the married 15-year-old with unearned income of
$50,000 pays zero under the kiddie tax. The regular tax applies, but not the
kiddie tax. Nevertheless, you probably find it a bad idea to rush off and
help your 15-year-old find a spouse so he or she and you can avoid the
kiddie tax.
S Corporation Distributions and the Obamacare
Tax
Because the Obamacare tax is new, you may not be sure how it applies to S
corporation distributions. Here are the basic rules.
As you are the owner of your S corporation, your distributions generally
are not subject to the NIIT.
There are two ways that your S corporation distributions become subject to
the tax:
1. You do not materially participate in the business of your S
corporation (i.e., you spend less than 500 hours per year working in
the business and don’t materially participate some other way).9
2. Your S corporation earns net investment income, such as through
interest, dividends, and other investments, and that passive income
passes through to you on your K-1.10
When you operate your business as an S corporation, you usually have net
investment income only to the extent your S corporation earns money from
passive investments.
Income shifting. When you shift income to others, the idea is to shift the
income to people in lower income brackets; thus, the Obamacare tax
generally is not a problem, because the tax applies only to people who earn
more than $200,000 ($250,000 for joint filers).
Nevertheless, the people who receive the distributions probably do not
materially participate in your business. This means their distributions are
net investment income and if they make more than the NIIT threshold,
they pay the NIIT.
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Copyright 2014 by Bradford and Company, Inc.
Kids Who Earn Money
Notes
You can also get money to your kids by making them earn it. When your
kids work for the corporation, their earned income is not subject to either
the kiddie tax or the Obamacare tax (NIIT).
With this strategy, your children get the full benefit of the standard
deduction (up to $6,200), and they can deduct even more of their money if
they contribute to an IRA.
Your corporation must pay payroll taxes on the child’s earnings, but your
family’s savings are still decent (your 33 percent versus 15.3 percent
combined employer and employee FICA and Medicare plus
unemployment tax and other fees).
Caution. If you hire your child, you need to be sure the salary you pay the
child is reasonable. Also, if you work in certain hazardous professions, you
should research the child labor laws that may apply to your work.
Justify Your Salary
If your S corporation salary is too low, the IRS can reduce distributions to
your family members and apply the extra income to your salary, creating
additional employment taxes plus potential penalties for you.
This issue arises if you take an excessively low salary in order to create
more profits to shift to your family shareholders.
You avoid the problem by properly justifying your salary. Compare your
salary to the amount you would have to pay someone else (other than a
shareholder or family member) to do the same work, given the same
hours, level of training required, and other factors unique to your work.11
Document this comparison as best you can and put this in your file in case
you ever need proof for the IRS.
If you can prove that your salary is at least as much as it would cost your S
corporation to pay an unrelated person to do the job, then you are safe
from an IRS reallocation of income.12
Copyright 2014 by Bradford and Company, Inc.
41
Notes
Endnotes – Section 7
1
For 2014, the 33 percent bracket covers income between $226,851 and $405,100.
2
For joint filers in 2014, the 15 percent bracket covers income between $18,151 and
$73,800.
3
IRC Section 1361(c)(4).
4
Your children pay kiddie tax only on unearned income in excess of $2,000. They pay their
individual rates (10 percent) on the $2,000 in excess of their standard deduction ($1,000);
thus, the total for each child is ($8,000 times 33 percent plus $1,000 times 10 percent). See
IRS Publication 501 “Exemptions, Standard Deduction, and Filing Information,”
(December 3, 2013), p. 24.
5
Work with your tax advisor to set up this arrangement. If you do not create this account
the right way, you could run into problems.
42
6
See IRS Questions and Answers on the Net Investment Income Tax, Question 12.
7
IRC Section 1(g)(2)(A)(i).
8
IRC Section 1(g)(2)(A)(ii).
9
IRC Section 1411(c)(2); Reg. Section 1.469-5T(a)(1).
10
Reg. Section 1.1411-4(b).
11
Reg. Section 1.1366-3(a);
12
See Rocco v Commr, 57 T.C. 826, 832-833 (1972), decided under a predecessor statute.
Copyright 2014 by Bradford and Company, Inc.
Section 8
Notes
Client Questions on Salary
Issues
If you have questions from previous sections,
look here first for answers.
If you have questions about S corporation salary and distribution issues,
you may not be alone. In this section, we have assembled several common
questions that we receive from clients.
Take a look at the three questions in this section. You may just find the
answer you are searching for.
Question 1. Do I Pay Tax on Distributions?
Here are questions that have been on my mind, especially now that I’ve
just given my tax preparer my S corporation’s QuickBooks file to
prepare this year’s tax return.
1. After I take a salary and have dividends, are these dividends
subject to federal taxes?
2. Can I just have my S corporation write me a check for those
dividends or do they remain in the corporation?
Answer
First, the word “dividends” is the wrong word. Since you have never
operated your S corporation as a C corporation, the S corporation will
never pay you dividends. The technical term for after-tax money you take
from the S corporation is “distribution.”
Here’s the way all of this works. You receive a K-1 from the S corporation
that shows the net income of the S corporation after your salary and other
expenses. You pay personal income taxes on that net S corporation
income.
At this moment, the S corporation has the cash it earned and on which
Copyright 2014 by Bradford and Company, Inc.
43
Notes
you are paying taxes. Once you pay the taxes, the S corporation can
distribute this money to you without further taxation.
Thus, you have a choice. Keep the money in the corporation, say for
operating purposes, or take the money for personal use. In all likelihood,
you will want to take some cash to pay at least part of the taxes.
When the corporation writes you a check for the previously taxed income,
it makes a “distribution.”
Question 2. If I Have a Bad Business Month, Can I
Take Zero Salary?
I operate my business as an S corporation with the primary purpose of
saving self-employment taxes. I am the sole owner and the sole
employee. I am having a rough year and my salary shows it; no salary
one month, salary the next. Is this a problem? (T.D., Jackson, MS)
Answer
The fluctuating salary is a problem because it makes you look less like a
corporation and more like an individual who is simply using the S
corporation as a shield against the self-employment tax.
In revenue ruling 74-44, the IRS concluded that the S corporation is paying
wages and not a dividend when the payment is reasonable compensation
for services performed. This is a dicey determination. You need to prove
that your salary is reasonable.
For example, let’s say that your S corporation earns $150,000 for the year
and that you receive $50,000 as compensation. Is the $50,000 reasonable
compensation to you? What proof do you have? Are others in your
industry paid this amount? If you have some proof of the $50,000, your
chances of sustaining the $50,000 as salary and the $100,000 as S
corporation income are decent (although not foolproof).
On August 5, 2005, the Treasury Inspector General for Tax Administration
presented a report to the Senate Finance Committee showing that S
corporations were cheating the government out of employment taxes on
$13.2 billion in profits. Not too long after that, the IRS received
authorization to hire 5,000 new S corporation auditors.
Make sure you take the following steps:
1. Take a salary from your S corporation.
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Copyright 2014 by Bradford and Company, Inc.
2. Have proof that your salary is reasonable compensation.
This is no easy task. That’s why experts call this the “practice of
accounting.”
Notes
Question 3: Exception for Start-Ups?
Will the IRS permit an S corporation to pay its owner-employee zero
salary during its start-up phase when it earns little or no income or
incurs a loss? (R.E.V., Waynesboro, Va.)
Answer
If you have a start-up S corporation that earns little or no income, you do
not have to take a salary, particularly if the S corporation does not make
distributions.
Contrary to what some believe, the IRS cannot require a business to pay its
employees a minimum salary. Indeed, in one case involving an S
corporation owner-employee, the IRS stipulated to the court that it did not
have the authority to require the corporation to pay the sole shareholderemployee any particular minimum employee salary before it could pay
him distributions.1
The IRS will not object if an S corporation makes no payments at all to its
owner-employee because its business is earning little or no income. But
when the S corporation starts making money, it must first pay its owneremployee reasonable compensation, and then, if there’s any money left
over, it can distribute that excess as distributions (payroll tax–free).
State Minimum Wage Law
You may already know this: Be aware of state law.
Having your S corporation pay you a zero salary could violate your state’s
minimum wage law. The rules vary by state so this problem, if any,
depends on where your S corporation is located.
There is a federal minimum wage law, and 45 states have their own
minimum wage laws. Under the federal and many state minimum wage
laws, 20 percent equity business owners who actively manage the business
are exempt from minimum wage rules.2
But it seems you always find some contrarians where there is no
minimum-wage exemption for equity owners—for example, in California.3
Copyright 2014 by Bradford and Company, Inc.
45
Thus, in states like California, S corporations should pay their owneremployee at least the minimum wage.
Notes
Endnotes – Section 8
46
1
Watson v U.S. 757 F.Supp.2d 877 (S.D. IA 2010).
2
29 CFR 541.101.
3
See https://www.dir.ca.gov/dlse/FAQ_MinimumWage.htm.
Copyright 2014 by Bradford and Company, Inc.
Section 9
Notes
Tax Tips for the S Corporation’s
Fringe Benefit Realization
Tax law mistreats the S corporation owner with
regard to fringe benefits.
Your S corporation may not give you the tax-free fringe benefits you
desire.
In the good old days, the S corporation avoided double taxation, reduced
self-employment taxes, and also gave you all the fringe benefits.
The good old days are long gone (since 1982).1
Nowadays, when the S corporation is your business entity of choice, you
give up certain fringe benefits.
Two Questions to Ask
What is the best way for you and the S corporation to deal with this loss of
fringe benefits? That depends. You can choose from three methods, and
we’ll tell you which fringe benefits work best with each method.
The 2 Percent Shareholder Problem
For fringe benefit purposes, S corporations have two types of employees:
1. Owners: Employees who own more than 2 percent of the S
corporation’s stock
2. Non-owners: Employees who own 2 percent or less of the stock
If you are an owner-employee (i.e., you own more than 2 percent of the
stock), then you lose some of your fringe benefits.
Technically, the law treats owner-employees as if they were partners in a
partnership, and the law limits the fringe benefits that are available to
partners.
Copyright 2014 by Bradford and Company, Inc.
47
Notes
Family too. For purposes of fringe benefits, the IRS treats your family as
owning the same amount of stock that you do.2 So if you employ your
mother, for example, she is an owner in the eyes of the IRS even if she does
not own any stock in the corporation.
“Family” here includes your spouse, children, grandchildren and parents.3
Fringe Benefits Lost
The S corporation may not provide the more than 2 percent owneremployee with the following tax-free fringe benefits:4
•
•
•
•
Amounts paid to an accident or health plan
Group term life insurance coverage (which is excludable on a
regular employee up to the first $50,000 of coverage)
Meals or lodging furnished for the employer’s convenience
Tax-free benefits provided under a cafeteria plan
No-Problem Fringe Benefits
The following fringe benefits are available to a partner in a partnership and,
therefore, available to the more than 2 percent owner employee:5
•
•
•
•
•
•
•
•
•
•
Employee achievement awards6
Qualified group legal services plans7
Educational assistance programs8
Dependent care assistance programs9
No-additional-cost services10
Qualified employee discounts11
Working condition fringe benefits12
De minimis fringe benefits13
On-premises athletic facilities14
Medical savings accounts15
Three Strategies for the Owner’s Disallowed
Fringe Benefits
You and your S corporation have three tax choices for how to treat the
disallowed fringe benefits:
1.
2.
3.
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W-2 compensation to the owner-employee
Distribution to the owner-employee
Reimbursement by the owner-employee to the S corporation
Copyright 2014 by Bradford and Company, Inc.
Choice 1: W-2 Compensation
Notes
The S corporation may treat the disallowed fringe benefit as W-2
compensation to the owner-employee. In this case,
•
•
the corporation deducts the fringe benefit as compensation to the
owner-employee, and
the owner-employee receives the fringe benefit as taxable
compensation.
For sure, this is what you want to do with health insurance. In the next
section, we’ll discuss your health insurance options for your S corporation
and tell you about the special rules that make W-2 recognition critical for S
corporation owner-employees.
W-2 is the only way for health insurance. As we will explain in more
detail in the next section, the S corporation owner-employee needs the W2 recognition of the corporate-paid health insurance to realize a deduction
on his or her personal tax return. In effect, no W-2, no Form 1040 page 1
deduction for health insurance.
The good news is that the W-2 recognition of the S corporation’s payment
of the owner-employee’s health insurance is not subject to FICA or
Medicare.
When to avoid the W-2. W-2 recognition of the disallowed fringe benefits
other than medical is subject to FICA and Medicare taxes.16 Accordingly,
do not use W-2 recognition on other than medical, so that you save FICA
and Medicare taxes. Instead of the W-2, use choice 2 or 3 below to avoid
payroll taxes, including FICA and Medicare taxes.
Choice 2: Distribution
In this choice, the S corporation makes disallowed fringe benefits a
distribution by the corporation to the S corporation owner-employee.
The word “distribution” in this context is pretty much the same as
dividend in the C corporation context in that the distribution is coming
from income on which the S corporation owner has already paid the taxes.
With this approach,
•
•
the S corporation has no tax deduction, and
the owner-employee has no taxable income.
Copyright 2014 by Bradford and Company, Inc.
49
Notes
Thus, the disallowance of the fringe benefit does not trigger any additional
loss because of payroll taxes.
Remember, you do not want to use this approach with the health insurance
fringe benefit.17 Without the W-2 for medical, the owner of the S
corporation loses the Form 1040 page 1 medical deduction on his or her
personal tax return.
With the one-owner S corporation, there are no complications in using the
distribution strategy for disallowed fringe benefits other than medical.
However, should the S corporation have multiple owners, the S
corporation distributions need to avoid preferential dividend treatment that
could create a second class of stock and terminate the S corporation’s
election.
Choice 3: Reimburse the S Corporation
In choice 3, the owner-employee reimburses the corporation for the cost of
the fringe benefit. With the reimbursement, the owner-employee pays for
the fringe benefit personally.
Like the distribution method, the reimbursement method avoids FICA and
Medicare taxes and works perfectly for disallowed fringe benefits other
than medical.
Further, the S corporation owner who does not have previously taxed
earnings in the S corporation adequate for a distribution should consider
this method.
If you are using the reimbursement method, you need to ensure settlement
by December 31 or record the outstanding amount as a loan receivable by
the corporation from the owner-employee.
The one-owner S corporation often plays with fire with its owner-employee
advance accounts and loan amounts. Thus, you should strongly consider
making the reimbursement in a timely manner before the corporation
closes its year. In other words, avoid advances and loans.
Net Cash Cost of Fringe Benefit Loss
Since you lose some of your fringe benefits with the S corporation, is the S
corporation the entity that gives you the best after-tax cash return?
You may have to revisit the big picture in section 3. Consider how the loss
of certain fringe benefits plays into the rest of your overall tax picture.
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Copyright 2014 by Bradford and Company, Inc.
Final Thoughts
Notes
Once you decide that the S corporation is the best choice for you, then
consider how to treat the disallowed fringe benefits. Keep these points in
mind:
1.
2.
3.
4.
You absolutely, positively want to have the S corporation report
the heath insurance on a W-2 to the owner employee.
The health insurance on the W-2 is exempt from FICA and
Medicare.
Group life, meals and lodging, and cafeteria plan benefits
reported on the W-2 are not exempt from FICA and Medicare.
You can save FICA, Medicare, and other payroll taxes on the
disallowed group life, meals and lodging, and cafeteria plan
disallowed benefits by using either the distribution or the
reimbursement method.
Endnotes – Section 9
1
P.L. 97-354, Sec. 2, added IRC Section 1372.
2
IRC Section 1372(b).
3
IRC Section 318(a)(1).
4
S. Rep. No. 97-40, p. 22.
5
Starr and Sobol, 731-2nd T.M., S Corporations: Operations.
6
IRC Section 74(c).
7
IRC Section 120.
8
IRC Section 127.
9
IRC Section 129.
10
IRC Section 132(b).
11
IRC Section 132(c).
12
IRC Section 132(d).
13
IRC Section 132(e).
14
IRC Section 132(j)(4).
15
IRC Section 220(b)(4)(B).
16
Rev. Rul. 91-26; see also the IRS MSSP Training Guide, Car Wash Industry, Chapter 5,
Case Studies, Health Benefits Paid by S Corporation.
17
Notice 2008-1.
Copyright 2014 by Bradford and Company, Inc.
51
Notes
Section 10
The S Corporation Path to Health
Insurance Deductions
Learn the right way to deduct your health
insurance premiums.
Tax law forces the more than 2 percent shareholder of an S corporation to
take a roundabout path to get his or her health insurance deduction.
The tax rules are not what you would call logical, but if you follow the
steps in this section, you will not have a problem.
What Works?
Step 1. Have the S corporation pay the insurance company directly for the
cost of the health insurance.
Step 2. Have the S corporation include the cost of the health insurance as
additional compensation to the shareholder-employee on the employee’s
W-2 in box 1, subject to income tax withholding but exempt from Social
Security, Medicare, and unemployment taxes in boxes 3 and 5 of the W-2,
as appropriate.1
Step 3. Treat the W-2-reported health insurance as a cost of self-employed
health insurance.2 Enter this amount on page 1 of Form 1040, subject to the
rules for deducting this insurance (e.g., no deduction is permitted if your
spouse gets her insurance from an employer plan).
Be Thorough. Make sure your S corporation reimburses you for all
medical insurance that you pay for yourself and your family, including
Medicare and accident and health premiums paid to schools and athletic
programs to cover your children.
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Insurance Paid Personally
Notes
The S corporation owner-employee can pay the health insurance cost
personally, but if this happens, the owner-employee must have the S
corporation reimburse the cost of the insurance to the owner-employer for
the owner-employee to qualify for the health insurance tax deduction.3
Let’s examine how this works to create the deduction:
1. The S corporation owner-employee buys family health insurance in his
own name and pays a premium of $9,000 for the year.
2. The owner-employee files an expense report with his S corporation
asking for reimbursement of the $9,000.
3. The S corporation writes the owner-employee a check for $9,000.
4. At the end of the year, the S corporation puts the $9,000 on the owneremployee’s W-2 as either subject to or exempt from FICA and
Medicare.4
5. Because the health insurance is on the W-2, the owner-employee
claims the self-employed health insurance deduction on page 1of his
IRS Form 1040 (an above-the-line deduction).5
Insurance Paid by S Corporation
If the S corporation pays the policy premium directly to the insurance
company, steps 4 and 5 above occur. This is true whether the policy is in
the owner-employee’s personal name or in the name of the S corporation.
Payroll Taxes
You may have to pay payroll taxes on the amount you include in wages
for your insurance premiums. Here is how you find out whether the
payroll taxes apply to you:6
•
•
•
If the corporation does not provide health insurance to your nonowner employees, then you pay the payroll taxes.
If the corporation does provide health insurance to your nonowner employees, then you do not pay the payroll taxes.
If the corporation has no other employees, then you do not pay
the payroll taxes.
Flow Chart
The flow chart on the next page shows you how all of these steps work
together.
Copyright 2014 by Bradford and Company, Inc.
53
Notes
This flow chart explains how S corporation owners deduct their health
insurance premiums:
Beware of Your Spouse’s Employer
Were you eligible to participate in an employer-subsidized health plan
maintained by either you or your spouse’s employer? (Ignore your S
corporation when answering this question.) If so, you may not claim the
self-employed health insurance deductions for those months when you
were eligible to participate in an employer plan.7 (Note that the key phrase
is “eligible to participate,” not “actually participating.”)
The Cost of a Mistake
If you pay for the health insurance yourself and don’t submit it to your
corporation, the W-2 does not happen, and your cost of health insurance
becomes an itemized deduction, where it suffers from both
•
•
the 10 percent of adjusted gross income floor and
the phaseout of itemized deductions, possibly leaving you with no
deduction at all.
Solution. Make sure the W-2 happens.
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Amended Returns
Notes
Notice 2008-1 states that taxpayers who failed to claim deductions for selfemployed health insurance as discussed above may file amended tax
returns to claim the deductions. When such an amended return is filed, it
should include this statement: “Filed Pursuant to Notice 2008-1.” The
statement should appear at the top of the amended return.
Debits and Credits
In your S corporation’s books of account, you
1. debit health insurance and credit cash for the payment of health
insurance and
2. debit wages and credit health insurance for the owner-employee cost of
health insurance.
When the debits and credits are over, the cost of health insurance reduces
the checking account balance and becomes a wage to the S corporation
owner-employee.
S Corporation Disability Payments
A disability insurance policy provides income replacement for those
unable to work.
Although the disability replacement income policy is not a health and
accident policy, the IRS applies health and accident policy treatment to
these policies.8
Accordingly, the S corporation treats the premiums paid for an income
replacement disability policy on a “more than 2 percent” shareholderemployee as9
•
•
wages for withholding tax purposes that are
exempt from FICA and unemployment taxes.
The W-2 thus shows the additional wages in Box 1 (Wages), but not in
Box 3 or 5.
Should such “more than 2 percent” shareholder-employees become
disabled, they collect their disability income tax-free because they paid the
premiums personally via the payroll inclusion above.
The S corporation can exclude the W-2 income from FICA and
Copyright 2014 by Bradford and Company, Inc.
55
unemployment taxes when the plan of corporate disability payments
benefits employees generally or is for a particular class of employees, such
as key employees.10
Notes
Endnotes – Section 10
1
Notice 2008-1.
2
1040 Instructions (2012), posted Jan. 18, 2013, ps. 31, 32.
3
Notice 2008-1.
4
2012 General Instructions for Forms W-2 and W-3,
Posted Aug. 21, 2012, ps. 13, 14.
5
1040 Instructions (2012), posted Jan. 18, 2013, ps. 31, 32.
6
IRC Section 3121(a)(2); AKnn. 92-16.
7
Ibid., p. 30.
8
Rev. Rul. 58-90 states that disability income replacement
payments constitute amounts received through accident or
health insurance within the meaning of IRC Sections
104(a)(3) and 105(a).
9
Ibid; Rev. Rul. 91-26; Announcement 92-16, Fact Sheet
2008-25.
10
56
IRC Sections 3121(a)(2); 3306(b)(2).
Copyright 2014 by Bradford and Company, Inc.
Section 11
Notes
Health Insurance for Your Family
Know the rules on health coverage for your
parents, spouse, and children.
Your self-employed health insurance deduction includes for the cost of
health insurance for yourself, your spouse, and your dependents.1
Thus, you want to have the S corporation either pay the premiums for
both you and your spouse directly to the insurance company or reimburse
you for the costs paid by both you and your spouse for health insurance.
Parents Who Work for the Corporation
If your parents work for the corporation, you have to include the cost of
their health insurance in their wages.
This is because of the related-party stock attribution rules that apply to S
corporations. Under these rules, the IRS treats a person as owning the
same amount of stock that his or her parents, children and grandchildren
own.2
So if you are a more than 2 percent owner of the S corporation, so are your
parents, even if they don’t actually own any stock. The IRS attributes your
shares to your parents.
Example. Mrs. Hurst works for the S corporation, and she owns zero S
corporation stock. Her son owns 51 percent. By attribution, Mrs. Hurst
also owns 51 percent of the S corporation.3
Now, Mrs. Hurst owns more than 2 percent by attribution and is not
eligible for the tax-free health insurance benefit provided by the S
corporation to its employees.
The S corporation must include the cost of health insurance on Mrs.
Hurst’s W-2 as wages subject to withholding but not subject to Social
Security, Medicare, or federal unemployment.
If Mrs. Hurst wants a deduction for the health insurance on page 1 of her
Copyright 2014 by Bradford and Company, Inc.
57
Notes
Form 1040, she must report the proper amount of wages. Again, this is not
difficult, as it’s the amount in box 1 of her W-2 (wages and other
remuneration).
Next, she has to know enough to claim the self-employed health insurance
deduction on page 1 of her Form 1040.
How many S corporations and how many moms would get all these steps
right? You have to think that many miss this.
We suppose you were wondering about Mrs. Hurst. You will be happy to
know that she got this right, albeit she had to do it in court, almost as an
afterthought (perhaps it was).4
Children Up to Age 27
If you have children under the age of 27 for whom you pay their insurance
and for which you receive no tax deduction, you are now going to reap
some tax cash, thanks to recent changes in health care law.
The law extends the employer’s tax deduction for employer-provided
accident or health plan coverage to any employee’s child who has not
attained age 27 as of the end of the taxable year.5
This enables you, the business owner, to obtain a tax deduction where
none was available before. If you were paying your college student’s
insurance before and it did not qualify for deduction, this age 27 rule is a
windfall.
Before this law, you could deduct as a business expense the health care cost
of covering your employees and their spouses and dependents. However,
the old law and many insurance policies pretty much excluded your 22-,
23-, 24-, 25-, and 26-year-old children from employer coverage as
dependents.
Have the Corporation Reimburse You for Your
Children’s Insurance Costs
If you, the S corporation owner, claim your medical insurance deductions
as self-employed on page 1 of your Form 1040, you reimburse the cost of
your children’s insurance just as you do with your own insurance.
Example. Greg Smith operates his business as an S corporation that cannot
provide him with the medical fringe benefit. He has the corporation
reimburse him for his personal insurance costs and the monies he spends
58
Copyright 2014 by Bradford and Company, Inc.
for health insurance coverage of his 22- and 23-year-old children.
At the end of the year, the corporation issues a W-2 to Mr. Smith that
contains the insurance reimbursements as taxable income. Now, because
Mr. Smith has this set up correctly, he deducts the insurance cost for
himself and his two under-age-27 children on page 1 of Form 1040.
Notes
Who Are Your Children?
For purposes of the under-age-27 provision, “child” means an individual
who is a son, daughter, stepson, stepdaughter, or eligible foster child of the
taxpayer.6
An eligible foster child means an individual who is placed with the
taxpayer by an authorized placement agency or by judgment, decree, or
other order of any court of competent jurisdiction.7
You treat a legally adopted individual as your child by blood. The blood
rule also applies when an individual is lawfully placed with you for legal
adoption.8
Nine Important Facts
Here are nine facts to keep in mind about the under-age-27 child:9
1.
2.
3.
4.
5.
6.
7.
8.
9.
Child must be parent’s biological, adopted, foster or step child.
Child need not live at home.
Child need not be parent’s dependent.
Child can be single or married.
Employers may rely on employee-parent’s claim of child’s date of
birth.
Employer payment of child health insurance is not taxable to the
employee-parent.
Child must not attain age 27 during the tax year (i.e., for a
calendar-year taxpayer, the child must be under age 27 on
December 31).
Employers may assume that employees are calendar-year taxpayers
and may use the not-yet-age-27 on December 31 criteria.
Health insurance companies must allow dependent coverage until
age 26; thus, if the child turns 26 on July 20, he is under age 27 on
December 31.
To Consider
The addition of children under the age of 27 to the health plan creates
some tax planning considerations for you as the owner of a business. First,
Copyright 2014 by Bradford and Company, Inc.
59
if you have such a child, you obviously want to ensure tax deductions for
his or her cost of health insurance.
Notes
On the other hand, if you have a host of employees, you need to consider
the cost of covering the employees, the employees’ spouses, and also the
employees’ dependents.
Endnotes – Section 11
60
1
1040 Instructions (2008) for Line 29 on p. 29.
2
IRC Section 318(a)(1).
3
Richard E. Hurst v. Commr., 124 T.C. No. 2.
4
Ibid.
5
IRC Section 105(b).
6
IRC Section 152(f)(1)(A).
7
IRC Section 152(f)(1)(C).
8
IRC Section 152(f)(1)(B).
9
Ibid.
Copyright 2014 by Bradford and Company, Inc.
Section 12
Notes
How You Can Discriminate with
the Health Savings Account
The HSA provides you a tax-advantaged way to
pay for medical expenses.
As a business owner, one downside of most tax-advantaged health plans is
that you have to pay for employees if you want the health care for yourself.
Often, that’s too expensive to warrant the benefit.
If this describes you, you will be interested to know you can establish a
health savings account (HSA) for yourself without having to contribute on
behalf of your employees.1
Employees Too
Your employees can contribute to their own individual high-deductible
health plans and HSAs and then deduct the contributions on their
personal tax returns.
Want to Contribute for Employees?
If you wish, you can make contributions to your employees’ HSAs. You
deduct your contributions, and your employees receive the benefit of
your contributions tax-free, since the corporation’s HSA contribution is a
tax-free fringe benefit to the employee.2
The S corporation must report the contributions it made to the
employee’s HSA on Form W-2 in box 12, using the code “W.” This is
for informational purposes only.
as
tes, such
a
t
s
e
m
o
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, tax the
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HSA
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io
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a
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m
e
e
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o
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tes, the
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increases
n
io
t
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wages
the W-2
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to the st
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t
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o
p
re
Your S corporation deducts the contributions to the HSA as employee
benefit program expenses.3
Triggers Nondiscrimination Rules
If you contribute on behalf of employees, you must follow
Copyright 2014 by Bradford and Company, Inc.
61
Notes
nondiscrimination guidelines called HSA comparability rules. These
complex rules are designed to prevent you from giving larger HSA
contributions to highly compensated employees. But you may give larger
contributions to lower-paid employees.
If the employees contribute on their own behalf and you do not make
contributions on their behalf, you do not trigger the comparability rules
because you, the employer, are not making employer contributions.
How It Works for You, the Owner
The S corporation can make the HSA contribution to the owner without
having to make contributions on behalf of the employees.4
Because you are a more than 2 percent shareholder, contributions by your
S corporation to your HSA for services rendered are treated as guaranteed
payments that your S corporation deducts as compensation to you.5
For employment tax purposes, the S corporation treats the HSA
contributions as wages subject to income tax withholding but exempt from
FICA and Medicare taxes.6 Thus, both you and your S corporation benefit
on the FICA and Medicare by having the HSA paid by the S corporation.
You, the shareholder-employee, deduct on your individual IRS Form 1040
the HSA payments that your S corporation added to your W-2 income.
You complete your Form 1040 just as if you had made the payments
personally.7 After all, that’s what really happened when the S corporation
included the HSA payments on your W-2.
In summary, have the S corporation pay your HSA so that you save payroll
taxes. Then, claim the deduction on your Form 1040 by completing IRS
Form 8889, which transfers the proper amounts to Form 1040.
The S corporation may not make a pretax contribution to a more than 2
percent shareholder’s HSA.8 Contributions by an S corporation to a 2
percent shareholder-employee’s HSA for services rendered are treated as
guaranteed payments and are deductible by the S corporation and
includable in the shareholder-employee’s gross income.9
The shareholder-employee then deducts the amounts included in his or her
W-2 as if he or she had made the payments to the HSA individually.
Comparability Rules
Under the comparability rules, if you make contributions to one
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Copyright 2014 by Bradford and Company, Inc.
employee’s HSA, you must make comparable contributions to the HSAs
of all participating comparable employees. Contributions are considered
comparable if they are either the same amount or the same percentage of
the deductible under the high-deductible health plan.10
Notes
You can treat noncomparable groups of employees differently when you
make contributions to their HSAs. For example, full-time and part-time
employees may be treated differently, as can those with family versus
individual coverage. However, you cannot treat employees differently
based on their age, or by whether they are management or
nonmanagement employees.
Stiff Penalties
If you fail to follow the nondiscrimination rules, you face a stiff 35 percent
penalty on your total HSA contributions.11
HSA Big Picture
The idea behind the HSA is simple: instead of purchasing traditional
comprehensive health insurance, you obtain a high-deductible health plan
and then pair it with a tax-favored IRA-like HSA into which you make
contributions and then dip into to pay uninsured health expenses.
In addition to the ability to contribute or not on behalf of your employees,
the HSA offers the following six benefits:
Benefit 1: It’s Easy to Qualify
Qualifying for an HSA is easy. You just have to:
•
•
•
not be covered under another health plan,
not be a dependent on another’s tax return, and
be under age 65 (or not covered by Medicare).12
Benefit 2: Lower Health Insurance Premiums
The deductible for your high-deductible health plan must range from
$1,250–$6,350 for individual plans and from $2,500–$12,700 for family
plans.13 Health plans with such high deductibles cost less than plans with
low deductibles or no deductibles. Just how much you can save depends
on many factors, including the insurer involved, your deductible amount,
and your health history, age, and where you live.
Copyright 2014 by Bradford and Company, Inc.
63
Notes
Benefit 3: Tax Deduction for HSA Deposits and
the High-Deductible Health Plan
You can establish your HSA deposit account with any bank, insurance
company, mutual fund or other financial institution offering HSA products.
There are hundreds of options.
The amounts you deposit into your HSA are tax deductible, up to the
annual limit. For 2014, the limits are $3,300 for individuals and $6,550 for
families.14 This is deduction number one.
If you operate your business as a sole proprietor, S corporation, or singlemember LLC, you can also deduct the premiums for your high-deductible
plan.15 This is deduction number 2.
Deduction number 3 comes into play when you make HSA payments or
insurance payments as a fringe benefit for your employees.
The three deductions are “above the line” deductions that you can take
whether or not you itemize.16
The combination of lower health insurance premiums and tax deductions
for your HSA contributions can save you substantial money each year.
Benefit 4: HSA Funds Grow Tax-Free
Like an IRA, the money in your HSA grows tax free. Moreover, you can
invest the money in your HSA in almost anything: money market
accounts, bank certificates of deposit, stocks, bonds, mutual funds,
Treasury bills, and notes. You can obtain a self-directed HSA that gives
you complete control over how your money is invested.
Benefit 5: Tax-Free Withdrawals for Qualified
Health Expenses
If you or a family member needs health care, you can withdraw money
from your HSA to pay your deductible or any other medical expenses.
You pay no federal tax on HSA withdrawals used to pay qualified medical
expenses. However, if you use HSA funds to pay for nonmedical expenses,
you pay a penalty of 20 percent plus regular taxes on the improper
withdrawal.17
Qualified medical expenses are broadly defined to include any expenses
that would qualify for the medical and dental expenses itemized
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Copyright 2014 by Bradford and Company, Inc.
deduction.18 These include many expenses ordinarily not covered by health
insurance—for example, dental care, optometric care, acupuncture,
fertility treatment, and laser eye surgery.19 Thus, for example, you can
withdraw money from your HSA tax free to pay for eyeglasses.
Notes
Benefit 6: Penalty-Free Withdrawals at Age 65
Once you reach age 65 or become disabled, you can withdraw your HSA
funds for any reason without penalty. If you use the money for qualified
medical expenses, the withdrawals are completely tax free. But if you use
the money for nonmedical expenses, you pay regular income taxes on the
withdrawals.20
This means that, unlike all other existing tax-advantaged savings or
retirement accounts, HSAs can provide a tax break when funds are
deposited and when they are withdrawn. No other account provides both a
“front end” and a “back end” tax break. With IRAs, for example, you
must pay taxes either when you make the deposit or when you withdraw
your money.
The front- and back-end benefit feature can make your HSA an extremely
lucrative tax shelter—a kind of super IRA when you use the back end for
medical expenses.
Worth Considering
You have a number of reasons to consider the HSA. Perhaps most
important, the HSA likely makes it possible for you to obtain a taxadvantaged health plan without having to cover your employees to get it.
If you want to cover your employees, the HSA rules make it easy. Further,
you can contribute one amount on behalf of employees and a larger (or
lesser) amount to your HSA without worrying about the discrimination
rules.
And, of course, you have to smile when you consider the HSA part of the
plan that gives you the
•
•
•
front-end tax deduction,
tax-deferred growth, and
no tax on withdrawal if you use the funds for medical expenses.
Copyright 2014 by Bradford and Company, Inc.
65
Notes
Endnotes – Section 12
1
Sole proprietors, partners, and LLC members are not considered employees for HSA
purposes. IRS Pub. 969, Health Savings Accounts and Other Tax-Favored Health Plans (2012),
updated January 30, 2013, p. 7.
2
Notice 2004-2.
3
Instructions for Form 1120S (2012), p. 17.
4
Notice 2005-8.
5
IRS Pub. 969, Health Savings Accounts and Other Tax-Favored Health Plans (2012), p. 7.
6
Notice 2005-8.
7
IRC Section 223; Instructions for Form 8889, Health Savings Accounts (HSAs) (2012); Form
8889, Health Savings Accounts (HSAs) (2012); Form 1040, U.S. Individual Income Tax
Return (2012), line 25.
8
IRS Pub. 15-B, Employer’s Tax Guide to Fringe Benefits (2012), updated December 7, 2011, p.
16.
9
IRS Pub. 969, Health Savings Accounts and Other Tax-Favored Health Plans (2011), updated
January 11, 2012, p. 7.
10
Notice 2004-2.
11
Ibid.
12
IRS Pub. 969, Health Savings Accounts and Other Tax-Favored Health Plans (2011), updated
January 11, 2012, p. 3.
13
Rev. Proc. 2013-25.
14
Ibid.
15
See IRS Pub. 535, Business Expenses (2011), updated March 13, 2012, p. 18.
16
IRC 62(a)(19).
17
IRS Pub. 969, Health Savings Accounts and Other Tax-Favored Health Plans (2012), updated
January 30, 2013, p. 9.
18
Ibid., p. 8.
19
IRS Pub. 502, Medical and Dental Expenses (2013), updated December 17, 2013.
20
IRS Pub. 969, Health Savings Accounts and Other Tax-Favored Health Plans (2012), updated
January 30, 2013, p. 9.
66
Copyright 2014 by Bradford and Company, Inc.
Section 13
Notes
How to Deduct Car Expenses
When Incorporated
Separate your personal use from your business
use.
Question
I operate my business as a corporation. Should I own the business car
personally, or should the corporation own the business car?
Answer
You simplify record keeping if you have the corporation own the business
car.
If you own the car personally and you want a corporate deduction, you
have to consider how the corporation is going to reimburse you for
business vehicle use.
One absolute. You do not want to deduct the car individually as an
unreimbursed employee business expense. We explain why below. But
first, let’s look at a few tax rules.
If Financed
If the car is financed and you deduct your car individually as an
unreimbursed employee business expense, you may not deduct any
interest you pay on the car loan.1
However, if you use one of the two methods we explain below, the
corporation deducts interest as a corporate expense. Both methods work
equally well for deducting the business percentage of your interest
payments.
Copyright 2014 by Bradford and Company, Inc.
67
Notes
Cost of Insurance
Another factor to consider is the cost of insurance and how you use the car.
We’ve heard it both ways: cheaper insurance at the personal level and
cheaper insurance at the corporate level. Obviously, your insurance cost is
something to consider (make sure you have adequate coverage).
Worst Possible Deduction
This message is worth repeating—you absolutely do not want to deduct the
car as an “unreimbursed employee business expense” using IRS Form
2106. With this form, your car expenses become miscellaneous itemized
deductions that face two obstacles:
1. The deduction falls into the miscellaneous itemized deductions
category, where lawmakers reduce your deduction by 2 percent of
adjusted gross income. The 2 percent by itself is not a killer. That
comes next.
2. If you are subject to the alternative minimum tax (AMT), the AMT
destroys every penny of your individually deducted car expenses.
That’s as bad as it can get.
Solution 1—Corporate Ownership
Your first solution is to have the corporation own the car.
Corporate ownership triggers neither the 2 percent problem nor the AMT.
Solution 2—Corporate Reimbursement
Your second solution is to own the car personally and have the corporation
reimburse you for your expenses. We explain this method in more detail in
the following section.
Note that when the corporation reimburses you for your business vehicle
expenses, the expenses become corporate expenses. This makes the interest on
the vehicle loan a business expense to the extent of business use. (We
explain “business use” and “personal use” below.)
Corporate Deductions for Business Expenses
Suppose you follow solution 1, and your corporation owns the car. This
makes business expenses easy to deal with. Have the corporation pay
directly for the business expenses and then deduct them to the extent of
your business use.
68
Copyright 2014 by Bradford and Company, Inc.
Corporations may use the IRS standard mileage rate to reimburse
employees for corporate business use of their personal vehicles, but a
corporation may not use the IRS mileage method to deduct its corporateowned vehicles.2
Notes
Thus, for your corporate-owned vehicle, you will deduct expenses using
the actual expense method, which includes expenses for depreciation,
interest, Section 179 expensing, gas, oil, etc.
Personal Use of the Corporate Car
The big issue for corporate ownership is personal use. When you use the
car for personal reasons, you have to account for all non-business use.
You determine business and personal use by keeping a mileage log. The
percentage of miles you travel for business reasons is your percentage of
business use.
Because of your personal use of the corporate car, you need answers to the
following three questions:
1. Does the value of your personal use become taxable income to you?
2. How does your corporation compute the corporate deduction for
the vehicle?
3. How does your corporation compute the value of the income to
you?
Taxable Income for Personal Use
Does the value of your personal use become taxable income to you?
Maybe. Maybe not.
Taxable. If your S corporation treats the value of your personal use as W-2
compensation to you, then the value of your personal use is taxable
income to you.
Not taxable. If you reimburse the corporation for the value of your
personal use, you have no taxable income.
As you can see, the law does not give you (the owner of the corporation) a
free personal-use ride in the corporate-owned car.
•
•
You either pay for the ride with the reimbursement; or
you pay cash to the corporation for the ride, as we explain further
below.
Copyright 2014 by Bradford and Company, Inc.
69
Notes
Corporate Deduction
If your corporation treats the value of your personal use as W-2
compensation, then the corporation has a 100 percent business use vehicle
to deduct.
More Than 50 Percent
Because you are a more than 5 percent owner of the corporation, your
personal use of the corporate car is not a qualified business use for the
corporation.3
This “nonqualified use” has no effect on the W-2 or the amount you would
reimburse to the corporation for your personal use, but for the corporation
it can trigger the Section 280F straight-line depreciation rule and eliminate
the corporation’s Section 179 expense deduction for the vehicle.4
Example. Sam Allen owns 100 percent of his corporation, works as an
employee in the corporation, and drives a corporate-owned $50,000 pickup
truck with a 6,750-pound gross vehicle weight rating (GVWR). He uses the
pickup 43 percent for business purposes and 57 percent for personal
purposes. Because the pickup truck fails the more than 50 percent test, the
corporation may not
•
•
•
elect any Section 179 deduction on the pickup;
elect 50 percent bonus depreciation on the pickup; and
use MACRS to depreciate the pickup.
Because the vehicle fails the more than 50 percent business use test, the
Sam Allen corporation must use the straight-line method to depreciate the
pickup.5
You do not want this to happen to you. Keep your business use above 50
percent so that your corporation may elect Section 179 and/or bonus
depreciation.
Computing the Value to You
Your corporation does not calculate the value of your personal use based
on the cost to the corporation.
Because you both own and work in the corporation, tax law gives your
corporation only two methods for valuing your personal use of the
corporate-owned vehicle:
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Copyright 2014 by Bradford and Company, Inc.
1. The general valuation rule. A value equal to the amount you would
have to pay in an arm’s-length transaction to lease the same or
comparable vehicle on the same or comparable conditions (e.g., two
years) in the geographic area in which the vehicle is available for use.6
2. The lease valuation rule. An IRS created safe-harbor lease value
using the IRS lease value table calculations.7
Notes
Example. You drive the $50,000 corporate vehicle 20,000 miles, of which
20 percent, or 4,000, are personal miles. Using the IRS lease valuation
tables, the value of your personal use is $2,870, computed as follows:
•
•
$2,650 for the value of the vehicle ($13,250 from the IRS lease table8
times 20 percent), plus
$220 for gas (4,000 miles times 5.5 cents9)
The lease valuation tables include the value of insurance and maintenance
in the table but require an addition of 5.5 cents for fuel.10
W-2 or Not
Should your corporation put the value of your vehicle personal use on
your W-2? Or should you reimburse your corporation for your personal
use?
You likely save taxes when you reimburse the corporation for your
personal use. The reimbursement avoids payroll taxes, and the money you
use for that reimbursement may come from funds that were taxed at lower
rates or not taxed at all.
The corporation deducts 100 percent of the vehicle regardless of its putting
the value on your W-2 or accepting a check from you that reimburses the
corporation for your personal use.11
Loan or Distribution
Often the value of your personal use is not known until after the end of the
year. What do you do then?
One treatment is to have the corporation set up a loan at year-end for the
amount of your reimbursement. To ensure that this works, you need to
make sure that the loan is documented and repaid.12
With an S corporation, the S corporation could treat the required
reimbursement amount as a distribution of previously taxed profits.13
Copyright 2014 by Bradford and Company, Inc.
71
Good News
Notes
The rules make it easy to value and deal with personal use of the corporateowned vehicle.
The only complication is at the corporate level when your personal use is
50 percent or less. And that complication is simply using the straight-line
method for deducting the vehicle.
Don’t Forget the Most Important Part
Regardless of where you claim the car deductions, you need a mileage log.
If the corporation reimburses you, then you turn in the mileage log to the
corporation as proof of your business percentage use.
Here’s one rule to keep in mind: no mileage log, no deductions.
Endnotes – Section 13
1
IRC Section 163(h)(2)(A).
2
Rev. Proc. 2010-51 excludes corporations by not naming them. It specifically includes
self-employed individuals by naming them in Section 7.08 and employees by naming them
in Section 7.07.
3
IRC Section 280F(d)(6).
4
IRC Sections 280F(b)(1); 280F(d)(1); 179(d)(10).
5
IRC Section 280F(b)(1);168(g)(2).
6
Reg. Section 1.61-21(b)(4)(i).
7
Reg. Section 1.61-21(d). See also Reg. Section 1.61-21(c)(3)(ii)(C). The special
valuation rules are not available if the car is used by a control employee, thus the
vehicle cents-per-mile valuation rule and the commuting valuation rule cannot be used.
A control employee includes anyone who holds greater than 1 percent equity. Reg.
Section 1.61-21(f)(5)(iv). Additionally the cents-per-mile rule is excluded for vehicles
exceeding the luxury vehicle limits of Section 280F. Reg. Section 1.61-21(e)(1)(iii)(A).
8
Reg. Section 1.61-21(d)(2)(iii).
9
Reg. Section 1.61-21(d)(3)(ii)(B).
10
Reg. Section 1.61-21(d)(3)(i).
11
Instructions for Form 4562 (2012), Posted Jan. 16, 2013, p. 15.
12
Whether a shareholder’s withdrawals from a corporation are loans or dividend
distributions depends on shareholder intent to repay the corporation and whether the
corporation intends to be repaid. Miele, 56 TC 556 (1971). For S corporations, see Carl
E. Jones v Commr., TC Memo 1997-400. A reclassified loan to an S corporation
shareholder is treated as a distribution that, if greater than his basis in the corporation,
is taxed at capital gain rates.
13
72
IRC Section 1368.
Copyright 2014 by Bradford and Company, Inc.
Section 14
Notes
Tax Deductions for Personal Car
Used for S Corporation Business
How to get corporate deductions for the car you
own personally.
Is the vehicle you use for your S corporation business titled in your
personal name?
How about your spouse’s vehicle? In whose name is it titled, and do you
or your spouse use that personal vehicle for S corporation business?
Let’s say you have vehicles titled personally but used for S corporation
business. Does the S corporation pay some or all of the vehicle expenses?
Should it?
If this is your situation, you are traveling in the murky and mucky waters
of a tax law swamp. Why? That S corporation is a legal entity separate
from you and your spouse.
Start with This
You want your S corporation to have a nice clean set of books. The less
dirt you have on the S corporation’s books, the better. Corporate payments
of personal expenses either equal dirt or create a strong impression of dirt.
The IRS is attracted to dirt. Keep that in mind as a very good reason for
you to make sure your S corporation has a clean set of books.
Keep Personal Personal
If you drive a personal car for corporate business, it’s best to pay all the car
expenses personally and then have the corporation reimburse you using
either the IRS method or the actual expense method.
Alternatively, you could have the corporation pay some or all of your
Copyright 2014 by Bradford and Company, Inc.
73
Notes
personal vehicle expenses and classify those payments on the corporation’s
books as loans or advances to you. That’s not the best method, although
you can make it work.
Regardless of method, you need a clear record of the money spent if you
are going to properly seek corporate reimbursement under the actual
expense method.
Mileage Log
Regardless of who has title or how you operate your business—S
corporation, C corporation, single-member LLC, or proprietorship—you
absolutely need a mileage log to make your vehicle’s tax deductions stand
up to an IRS audit and/or (if you have to go this far) the court’s keen eye.
We have boiled down hundreds of court cases, and our summary
knowledge of those cases simply says no mileage log, no vehicle
deductions. It’s that clear.
Once you have the mileage log that shows the miles and percentage of use
of your personal car for S corporation business, you are ready to seek
reimbursement, using whichever of the following methods gives you the
best result:
•
•
Mileage at the IRS 2014 standard mileage rate of 56 cents a mile1
Actual expenses (including depreciation, interest, Section 179
expensing, gas, oil, etc.)2
The Mileage Method
To seek reimbursement under the mileage rate, you need proof of miles
driven for business. The IRS releases the mileage rate every year. For 2014
it’s 56 cents a mile, and for 2013 it was 56.5 cents a mile.3
If you drove 9,000 miles for S corporation business last year, your
reimbursement would be 9,000 miles at 56 cents a mile, for a total of
$5,040. For reimbursement, the S corporation writes you a check and
deducts this amount. You, the employee, receive the $5,040 tax-free as a
reimbursed employee business expense.
Important Part of the Mileage Method
Inside the 56-cent mileage reimbursement, you have 23 cents of
depreciation.4 With 9,000 business miles, you depreciated the business part
of the car by $2,070 for the year (9,000 times 23 cents). Let’s say that based
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on your business-use percentage, your original business basis in the car is
$16,000. After the depreciation deduction, your adjusted basis is now
$13,930 ($16,000 minus $2,070).
Notes
This adjusted basis is important. Why? Remember, this is a personal car
for which the corporation reimburses you when you use it for corporate
business. Here’s what many don’t know or forget and what you will now
know and use to your benefit:
1. The business basis is $13,930.
2. It’s on your personal books (if any such books exist, and if not, it’s
now locked in by your good memory).
3. When you sell this car, you will have a taxable gain or a deductible
loss on the business part.
Actual Expenses Method
Even if you own the car personally, your S corporation can reimburse you
for actual expenses of the car, including the Section 179 deduction and
depreciation.
In the actual expense reimbursement, the S corporation reimburses you for
the business percentage of your total vehicle expenses. Your mileage log
gives you the business percentage of use. And then your tax records (or the
corporation’s records) give you the total expenses.
The reimbursement includes depreciation5 for the year, as limited by the
passenger vehicle luxury limits. As you had with the mileage rate, you
have a business basis in this personally titled vehicle, and that business
basis determines your gain or loss on the sale.
How to Ask for Reimbursements
In technical terms, your corporation reimburses you under the
accountable-plan rules.6 Under these rules, you, the owner-employee, must
•
•
incur these expenses in the performance of your duties for the
corporation,7 and
substantiate the expenses to the corporation in accordance with any
specific conditions imposed by the Internal Revenue Code.8
For example, if your corporation reimburses travel, entertainment,
automobile, computer, or airplane expenses, then you (the employee) must
submit the documents that support these deductions in accordance with
the rules for the deductions.
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75
Notes
Travel. For travel, you must submit to the corporation receipts for
expenses of $75 or more, and you must justify the business reason for the
trips, etc.
Vehicle. For an automobile, the employee must prove the business use of
the vehicle, like keeping a three-month log of use, and have receipts for
expenses of $75 or more.
Home office. If you are reimbursed for the home-office deduction, your
corporation must demand proof that substantiates administrative use,
regular use, and exclusive use.
In other words, the corporation acts like an auditor for the IRS, making
sure that the expenses meet the requirements of the law.
Failure Is Not an Option
If you, the owner-employee, fail to submit adequate proof, your
corporation must include the expense reimbursements in your W2.9 Incorrect treatment causes payroll tax penalties, such as the 100 percent
trust fund penalty.10
With proper proof, your corporation gets the tax deduction for what it
reimburses you. You, the owner-employer who receives the
reimbursement, have no taxable income.11
The reason you have no taxable income is that the reimbursement is from
an accountable plan; therefore, the reimbursement is12
•
•
•
excluded from your gross income,
not reported as wages on your Form W-2, and
exempt from withholding and payment of employment taxes such
as FICA and FUTA (federal unemployment).
Result You Want
You do not want to claim the expenses personally as employee business
expenses on your IRS Form 1040. If you do claim employee business
expenses, two bad things can attack your deductions:
•
•
76
The 2 percent of adjusted gross income floor, which can reduce
your deductions
The alternative minimum tax (AMT), which totally disallows your
employee business expense deductions
Copyright 2014 by Bradford and Company, Inc.
Takeaways
Notes
When you own the car in your personal name, you don’t want the
corporation to directly pay for car expenses. Pay personally and then ask for
reimbursement.
The corporation can reimburse you for your business use under either the
actual expense method or the IRS mileage rate. The corporation deducts
the employee business expense reimbursement, and you are not taxed on
that reimbursement.
Remember that these deductions reduce the business basis in your car, so
you need to take this into account when you later sell or dispose of the car.
Endnotes – Section 14
1
Rev. Proc. 2010-51, updated by Notice 2013-80.
2
Reg. Section 1.62-2(d)(1).
3
Notice 2012-72 for 2013 and Notice 2013-80 for 2014.
4
Notice 2013-80.
5
Reg. Section 1.62-2(d)(1) allows reimbursements that include depreciation and Section
179 expensing.
6
Reg. Section 1.62-2(c)(2).
7
Reg. Section 1.62-2(d)(1).
8
Reg. Section 1.62-2(e).
9
Reg. Section 1.62-2(c)(5).
10
IRC Section 6672.
11
Reg. Section 1.62-2(c)(4).
12
Ibid.
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Notes
Section 15
The Best Way to Claim a Home
Office Tax Deduction for the
Owner of a Corporation
Why your corporation should reimburse you for
the expense.
When you operate your business as a corporation, knowledge is critical to
claiming the best tax deduction for an office in the home.
Technically, the owner of a corporation can claim tax deductions for a
home office in one of three ways, two of which are pitiful and need
rejection.
Reject 1. Rent Office to the Corporation
Whether you operate as an S corporation or a C corporation, you get
minor, zero, or negative benefit when you rent an office in the home to
your corporation.
IRC Section 280A(c)(6) disallows tax deductions for the home office on
rentals by employees to their employers.1 Thus, owner-employees do not
achieve home-office deductions on the rental of an office in the home to
their corporations.
S Corporation Example
Henry Jackson rents his home office to his S corporation for $9,600 a year.
The results are:2
1. $9,600 tax deduction for the S corporation
2. $9,600 in taxable income to Mr. Jackson reported on Schedule E of
his Form 1040
3. No deductions for the home, except otherwise already deductible
mortgage interest, property taxes, and personal casualty losses
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Thus, the S corporation deducts the rent, reducing the income reported on
the K-1 to the owner-employee; and then the owner-employee reports the
rent as income, producing a wash of the rent and income on Schedule E of
the tax return.
Notes
If you itemize deductions, you already benefit by your deductions for
mortgage interest, property taxes, and personal casualty losses.
Allocating the business part of mortgage interest and property taxes to
Schedule E does not increase your deductions, but the placement on
Schedule E moves the deductions above the line and that reduces adjusted
gross income, which can produce some minor benefit.
Reject 2. Claim the Home Office as an Employee
Business Expense
You face two unfair rules when, because you are an employee of your
corporation, you claim the office-in-the-home deduction as an employee
business expense:
1. You deduct your employee business expenses as miscellaneous
itemized deductions where tax law reduces your miscellaneous
deductions by 2 percent of adjusted gross income.3
2. Miscellaneous deductions subject to the 2 percent floor are not
deductible for that unbelievably nasty and downright unfair
alternative minimum tax (AMT).4
The 2 Percent Unfairness
We will explain this through an example. Say you and your spouse claim
$10,000 in employee business expenses and report $150,000 in adjusted
gross income.
First, to get any benefit, you must itemize deductions. Once you itemize,
you then reduce your miscellaneous itemized deductions by $3,000
($150,000 times 2 percent). Thus, your net deduction for employee
business expenses is $7,000 ($10,000 minus $3,000), assuming employee
expenses are your only miscellaneous deductions subject to the 2 percent
adjustment.
Here’s the unfair part. Your real deduction is $10,000. The self-employed
taxpayer deducts $10,000. But you, an employee of your corporation,
deduct only $7,000. That’s bad, but the AMT can make this much worse.
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79
Notes
AMT Unfairness
The AMT allows a zero deduction for miscellaneous itemized deductions
subject to the 2 percent adjusted gross income floor, like those employee
business expenses.
Holy Mackerel! The law allows the employee a home-office deduction for
regular taxes and then eliminates that regular-tax deduction for purposes of
the AMT. Yes, that’s how it works. Sad, but true!
Example. Using the same faces as above, you claim a $10,000 employee
business expense deduction for your home office. Under the regular tax,
the law gives you $7,000. However for the AMT, you lose that $7,000
deduction and get a zero deduction for your home office. That’s most
unfair and bad news!
Okay, enough for unfairness and the bad news: here’s good news.
Best Home-Office Deduction Method
As you have seen, neither the rental nor the employee business expense
proves satisfactory.
The answer is for corporations to reimburse employee-owners for home
office expenses. The concept is easy. The employee-owner submits an
expense report that contains the home office, and the corporation
reimburses that employee business expense.
The authorization to reimburse the employee is found in IRS Regulation
Section 1.62-2(d)(1), which allows as reimbursements the expenses in part
VI, subchapter B, chapter 1 of the Internal Revenue Code.5 Expenses
allowed in this section of the Code include, among others, business
expenses, depreciation, interest, and taxes.6
Example. You operate your business as a corporation, incur $10,000 of
office-in-the-home expenses, and submit an expense report to your
corporation for $10,000 in home-office expenses. The corporation deducts
the $10,000 as an office space expense. You, the employee-owner, have no
taxable income for your employee expense reimbursement. (Presto: Full
home-office deduction achieved.)
Accountable Plan
For this to work, you need to use an accountable plan.7 The accountable
plan requires that you, the owner-employee, must
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•
•
incur the expenses in the performance of your duties for the
corporation8 and
substantiate the expenses to the corporation in accordance with the
requirements imposed by the tax law.9
Notes
To meet this requirement, your substantiation must show:
1. exclusive and regular use of the office in your home;
2. use of the office for the convenience of your employer;
3. use of the office as a principal place of business or other qualified
use under the regulations; and
4. expenses to be reimbursed, including depreciation.
Your proof of regular use and administrative use requires some type of
entry in your diary book or appointment calendar. Keep the “timely entry”
requirement in mind when making these entries. In the record-keeping
chapter of IRS publication 463, the IRS says, “If you maintain a log on a
weekly basis that accounts for use during the week, the log is considered a
timely-kept record.”10
In addition, you need to gather the expenses for reimbursement. The
simple way to do this is to complete IRS Form 8829 as if you were going
to claim the home office personally. This form and its instructions contain
the rules and help you make the proper allocations.
Now that you have completed the form, submit it to the corporation for
reimbursement. The corporation writes the check to you for the amount on
your Form 8829 and keeps the form as part of the proof of the deductions.
You receive the check as a reimbursement of employee expenses—which
is not taxable to the employee.
With this reimbursement, your S corporation gets the deduction and you
have no taxable income.
A Most Satisfactory Solution
You have to admit that the office-in-the-home expense reimbursement
method has it all over the rental of the office to the corporation.
You also have to admit that the office-in-the-home expense reimbursement
is far better than the employee business expense deduction that falls into
the miscellaneous itemized deduction category where those deductions
suffer either:
•
•
reduction by 2 percent of adjusted gross income, or
disappearance in the AMT calculation.
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81
The reimburse-the-corporate-owner-employee achieves the full home-office
deduction for the owner of his or her corporation.
Notes
Endnotes – Section 15
1
IRC Section 280A(c)(6).
2
Chief Counsel Advice 200121070; also see PLR 8819009.
3
IRC Sections 67(a); 67(b).
4
IRC Sections 56(b)(1)(A); 67(b).
5
Reg. Section 1.62-2(d)(1).
6
Ibid.
7
Reg. Section 1.62-2(c)(2).
8
Reg. Section 1.62-2(d)(1).
9
Reg. Section 1.62-2(e).
10
82
Ibid, p. 26.
Copyright 2014 by Bradford and Company, Inc.
Section 16
Notes
Good-bye, S Corporation; Hello,
C Corporation.
Terminating Your S election.
What’s true one day in tax may not be true the next.
Tax rules and rates can change quickly, depending on how the winds of
Congress blow.
Thus, good tax planning requires reevaluation from time to time so that
you can maximize your business’s cash benefits according to the most
recent tax rates and breaks.
Every now and then you should go back to Section 3 and run a side-byside comparison of the different business entities to determine which
provides you the best overall benefit.
In this section, we explain what you need to do to convert your S
corporation into a C corporation.
How to Change from an S Corporation
The following describes how you can change your S corporation to the
entity of your choice.
You have two main choices for a new business form. You can do one of
two things:
1. Convert to a sole proprietorship or partnership (“liquidate”).
2. Convert to a C corporation (“terminate” the S election).
1. Liquidation
You can liquidate an S corporation just as you can any corporation. The
rules and considerations for this are generally the same as for C
corporations.1 We go into this in more depth in the next section, so if that
is your plan, go ahead and skip to Section 17.
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Notes
2. Termination of the S Election
You can convert your S corporation into a C corporation by terminating
the S election.
You can terminate the S corporation by either
•
•
sending the IRS a statement of “revocation,” or
altering your business so that it no longer qualifies as an S
corporation.
If you go the termination route, plan for the long term. Once you
terminate, you cannot reelect S status for five years (unless you get the
consent of the IRS).2
Revocation
The procedure for revocation involves two steps:3
1. Send the IRS a statement revoking your S corporation election. The
IRS does not provide an official form for revocation, but to make
your tax life easier, we prepared a sample form that you can use.4
2. Get written consent from more than half your shareholders
(explained below).5 Here, again, the IRS gives you the rules for
consent, but does not give you a consent form.6 No problem; we
made a consent form that you can use.
You can find both sample forms at the end of this section.
Consent Nitty-Gritties
There are some important points to keep in mind with regard to consents:
•
•
•
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If you live in a community property state, community law makes
your spouse a shareholder of your corporation in the absence of
specific steps to avoid that. Therefore, it’s most likely that your
community property spouse must give consent to the revocation.7
If you own the stock as a tenant in common, a joint tenant, or a
tenant by the entirety, you need the consent of the other tenant.8
Voting stock and nonvoting stock count equally for the purpose of
determining a majority of shareholders’ consent.9
Copyright 2014 by Bradford and Company, Inc.
Violate the Rules—the Alternate Termination
Choice 1 for terminating your S corporation election is revocation. Why?
You can easily do what’s needed for revocation. It’s crystal clear that
you’ve revoked your election. And you can specify the date your S
corporation election terminates.
Notes
In some rare cases, though, you may not be able to meet the requirements
of revocation. For example, you may not be able to get the written consent
of all the necessary shareholders by the time you want to terminate the
election.
If this happens, intentionally violate one of the requirements for S
corporation status.10 With the violation, you instantly say good-bye to your
S corporation. What happens is this: on the date of the disqualifying event,
the law terminates your S corporation election and your corporation
becomes a C corporation.11
For a list of violations that can work for you, see the basic requirements in
Section 4. Two easy violations are (1) creating a second class of stock and
(2) transferring stock to an ineligible shareholder.
Effective Date
If you revoke your S election in the first two and half months of your tax
year, the IRS considers your business a C corporation for the entire year.
The deadline for this is the 15th day of the third month.12 For a calendaryear taxpayer, this means March 15.
When the termination is outside the two-and-a-half-month window, you
divide the tax year into two periods: an S short year and a C short year.
You pay taxes as an S corporation for the first period and as a C
corporation for the second.
Example. Suppose you are on the calendar year and terminate your S
election on April 1. You pay taxes as you normally would for an S
corporation from January 1 to March 31, the day before the effective date
of termination. From April 1 to December 31, you pay taxes as a C
corporation.13
How to Split Income between the Short Years
If you have both an S and a C period, you have to divide the tax year’s
income, deductions, credits, and losses between the two. (We’ll refer to
income, deductions, credits, and losses below as a group and call them
“income” for short.)
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85
Notes
Here, again, you have a choice. You can choose from two options:
1. Divide your income evenly over the year, so you have an equal
amount for each day of the year.14
2. “Close the books” and treat the periods as entirely separate,
individual tax years.15
Default rule. Unless you elect otherwise, you must divide the income
evenly throughout the year.
Example. If you revoke your S corporation on April 1, you will have an S
corporation for 90 days of the year (31 plus 28 plus 31 equals 90). Thus,
you multiply your income for the entire year by 90/365 to determine the
income for the S portion.16 Likewise, you multiply the amounts by 275/365
to determine the income for the C portion.17
Close the Books. Alternatively, you could close the books and treat each
period independently. On the income and expenses you have in the S part
of the year, you pay taxes using the S corporation rules. For income in the
C period, you pay taxes using the C corporation rules.
Closing the books may give you tax planning opportunities. For example,
you may want to incur your expenses during the S corporation period, so
that you can pass them through to your individual return.18
In order to elect the close-the-books method, you must get the consent of
all the shareholders.19
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Endnotes – Section 16
1
See IRC Section 1371(a).
2
IRC Section 1362(g).
3
IRC Section 1362(d)(1).
4
The requirements for a statement of revocation are listed in Reg. Section 1.1362-6(a)(3)(i).
5
IRC Section 1362(d)(1)(B).
6
The requirements for consents are listed in Reg. Section 1.1362-6(b)(1).
7
Reg. Section 1.1362-6(b)(2)(i).
8
Ibid.
9
Reg. Section 1.1362-6(a)(3)(i).
Notes
10
See, e.g., T.J. Henry Assocs., Inc., 80 TC 886 (1983) (acq.) (to end S status, father
transferred one share to himself as custodian for his children).
11
IRC Section 1362(d)(2)(B); Reg. Section 1.1362-2(b)(2).
12
IRC Section 1362(d)(1)(C)(i); Reg. Section 1.1362-2(a)(2).
13
IRC Section 1362(e)(1)(A); Reg. Section 1.1362-3(a).
14
IRC Section 1362(e)(2).
15
IRC Section 1362(e)(3).
16
Taking into account both separately and nonseparately stated items; IRC Section
1362(e)(2)(A).
17
The tax for the C period must be annualized; IRC Section 1362(e)(5).
18
IRC Section 1366(a).
19
Reg. Section 1.1362-6(a)(5). The close-the-books method is required if you a) sell or
exchange 50 percent or more of the stock during the S termination year, or b) have a
Section 338 election.
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87
Sample Statement of Revocation of S Election under IRC Section
1362(a)
Internal Revenue Service Center
[Address of center where the S election was properly filed]
Statement of Revocation of S Election under IRC Section 1362(a)
[Name of corporation, address, and employer identification number]
[Name of corporation] hereby revokes its election under IRC Section 1362(a).
[Name of corporation] has ___________ total shares of stock (including nonvoting stock) issued and
outstanding at the time of this revocation. Enclosed with this Statement are the written consents of a
majority of shareholders.
The effective date of this revocation is ______________.
Please acknowledge receipt of this letter by stamping and returning the enclosed copy of this letter.
[Name of corporation]
By ____________________
[Title and name of officer who is authorized to sign the corporation’s income tax return]
Enclosures:
Copy of letter
Shareholder consents
(As an S Corporation Tax Secrets webinar participant, you have our permission to copy this statement and use
it as a guide for the statement that you submit. You should consider asking your tax advisor’s or lawyer’s assistance
in drafting your statement.)
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Sample Consent to Revocation of S Election under IRC Section
1362(a)
Name of Shareholder: _____________________
Address: ____________________________________________
Social Security Number (or other applicable taxpayer identification number): _________________
Number of Shares Owned by Shareholder: _______________
Date (or Dates) on Which Shares Were Acquired: _____________
Last Day of Shareholder’s Taxable Year: _________________
By signing below, 1) I declare under penalties of perjury that the foregoing statements are true to my
knowledge and belief, and 2) I hereby consent to the revocation of the S election under IRC Section
1362(a) for the following corporation:
[name, address, and taxpayer identification number of corporation]
____________________
[Signature]
____________________
[Date]
(As an S Corporation Tax Secrets webinar participant, you have our permission to copy this consent form and
use it as a guide for the consent forms you submit. You should consider asking your tax advisor’s or lawyer’s
assistance in drafting the consent form.)
Copyright 2014 by Bradford and Company, Inc.
89
Notes
Section 17
Don’t Let Losses Disappear
When You Liquidate Your S
Corporation
What to expect when you liquidate your
corporation.
Let’s say that the building and some other assets that your S corporation
owns have dropped in value.
Let’s say further that you want to
•
•
•
get rid of the S corporation (liquidate it),
keep the building and those other assets personally (you don’t want
to sell them), and
claim tax-deductible losses on any drop in value of the building or
other S corporation assets.
Is there a way you can do all this? There might be.
You could liquidate your S corporation. Liquidation is a deemed sale of
assets at fair market value. If everything works in the liquidation, you get to
•
•
use the losses as tax deductions on your personal tax return, and
keep the assets personally.
Tricky Road
You face a tricky road when navigating liquidation to keep the assets
personally and also realize and recognize tax-deductible losses. We will
help you with that in this section, so stay alert as we show you how to
navigate some large bumps in your path.
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Liability Protection
Notes
Since you had the assets in an S corporation, your planning likely included
liability protection. As you now liquidate and move the assets outside the
S corporation, do you still want liability protection?
If so, consider obtaining liability insurance and/or, after liquidation,
contributing the assets you now own personally to a new liabilityprotecting entity, such as a limited liability company (LLC).
Forget a New Corporation
Tax law prohibits the “liquidation reincorporation” technique.1 Should
you make this mistake, the IRS treats your new corporation as a
continuation of the old one, and you can simply say good-bye to your
liquidation and those tax deductions you were hoping to get.
You might ask: how about waiting awhile and then transferring the assets
to a new corporation? The problem here is that the rules are not clear on
how long you have to wait before you can reincorporate without the IRS
destroying your liquidation. In general, the longer you wait and the less
the new corporation resembles the old one, the safer you are.
Beauty: S Corporation Losses
S corporation liquidations follow the same rules as C corporation
liquidations.2 But the S corporation liquidation travels a different path.
When you liquidate your S corporation and you receive the assets, it’s like
the S corporation sold all its corporate assets at fair market value.3 The
corporation realizes gain or loss on the deemed sale, and this gain or loss
passes through to you, the shareholder.
It works like this. Say your corporation owns a tract of land with a basis of
$1 million but a lowly fair market value of only $600,000. On liquidation
you receive the land in exchange for your stock, and the S corporation
realizes a loss of $400,000 ($1 million basis minus $600,000).
The $400,000 loss passes through to you if—and that’s a big “if”—you
overcome the loss barriers we describe later in this section.
Consequences to You, the Shareholder
Every day, your S corporation incurs gains or losses. It passes them on to
you, and your stock basis changes—up for gains and down for losses.4
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91
Notes
(Although this happens daily, you likely make the adjustments only once a
year, at tax time.)
Now, let’s return to the liquidation example from above. The corporation
had a $400,000 loss when it liquidated the land and transferred it to you.
That loss passed to you. Your first step in this liquidation process is to
adjust the basis of your stock for that $400,000 loss.
In your second step, you recognize the exchange of your S corporation
stock for land and other assets of the S corporation. The law treats this
trade of your stock for the assets of the corporation as a taxable transaction
that results in capital gain or loss.5
Example. Say that at the time of liquidation you have a $700,000 basis in
your S corporation stock. After pass-through of the $400,000 land
liquidation loss from the corporation, your basis drops to $300,000.
Now you recognize receipt of the land (with a fair market value of
$600,000) in exchange for your S corporation stock (now with a basis of
$300,000). You have $300,000 of gain on the deemed sale of your stock to
the corporation for the $600,000 worth of land.
Let’s say that the S corporation held the land as inventory in its real estate
sales business. Because the land is held as inventory, the S corporation’s
$400,000 liquidation loss is an ordinary loss that passes through to you.
Your $300,000 gain on the trade of your stock to the corporation is a
capital gain from the sale of your stock. Thus, in this liquidation example,
you have a $300,000 capital gain and a $400,000 ordinary loss.6
That’s a good result. The question is, will you survive the pass-through loss
barriers?
Barriers to Pass-Through Losses
As the majority stockholder of your S corporation, you face three potential
barriers to your losses:
1. Disproportionate transfers
2. Recent tax-free contributions of property
3. Insufficient basis in your S corporation stock
1. Disproportionate Transfers
Most of this section is written for the sole owner of an S corporation. But as
you know, we have written about splitting income using S corporation
stock. If you used stock in the S corporation to split income, you no longer
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own 100 percent of the stock.
If your corporation has multiple shareholders in a liquidation, it should
transfer each asset proportionately to each shareholder.
Notes
In other words, if you own 99 percent of the company and your cousin
owns 1 percent, the corporation should give you a 99 percent interest in
the land and give your cousin a 1 percent interest. The same rule applies to
every asset the corporation owns. You get a 99 percent interest in each
asset, and your cousin gets the remaining 1 percent interest.
If your corporation does not distribute the assets proportionally, then the
corporation will not get to recognize any loss on property that it distributes
to a majority shareholder (someone who owns more than 50 percent of the
corporation’s stock).7
Example. Suppose the corporation gives you 100 percent of the land,
disregarding the minor ownership of your cousin. Since the transfer is not
proportionate, the corporation cannot recognize any of the $400,000 loss
on the land. Zero loss passes through to either shareholder.
2. Recently Contributed Property
If you owned the land personally and then gave the land to the corporation
in a tax-free contribution within the last five years, the corporation may
not recognize a loss on the land in liquidation.8
But if the corporation bought the land in its own name in an arm’s-length
transaction (including if it bought the land from you, the seller), then you
are safe.9
The recent contribution rule prohibits the corporation from recognizing a
liquidation loss on the land only if it distributes the land to a majority
shareholder.10 As the sole owner of the S corporation, you obviously fit in
the majority category.
Example. You contributed the land to the corporation in a tax-free
transaction four years ago when the land was worth $1.35 million. (The S
corporation’s basis is the same as your personal basis in this tax-free
contribution of property.11) Because you and the corporation violate the
five-year recent contribution rule, any loss on the land at liquidation does
not pass through to you.
3. Insufficient Basis
Beware: you are not permitted to reduce your S corporation stock basis
Copyright 2014 by Bradford and Company, Inc.
93
Notes
below zero.12 Thus, if you don’t have enough basis in your stock, you may
not use all the S corporation losses that pass through to you on
liquidation.13
Example. Let’s say your S corporation stock basis is $150,000 at the time
of the liquidation. When your S corporation liquidates and passes through
that $400,000 of loss from the land, your basis limits your recognition of
loss to only $150,000 because that reduces your stock basis to $0.
And that $300,000 capital gain on the stock (as described in the original
example) does not rescue the remaining $250,000 liquidation loss
($400,000 minus $150,000), because the liquidation loss is “inside the
corporation” whereas the stock transaction is “outside the corporation.”
Well, that’s bad news. But it gets worse. Guess what happens to the
remaining $250,000 of unused liquidation loss?
Here’s the answer (you are not going to like it): you lose the remaining
$250,000 loss—forever.14 Yikes.
So what does this mean? Run the numbers before you take action. If your S
corporation liquidation would create a $250,000 loss deduction that would
get lost, you likely don’t want to go the liquidation route.
Special Break for Stock Loss
If you have a loss on the exchange of your stock for the assets of your S
corporation, you can qualify for a special stock loss tax break.15 (Note: This
tax break applies to the stock transaction. It does not apply to pass-through
losses.)
The stock loss tax benefit lets you treat some of your capital loss as taxfavored ordinary loss, as follows:16
•
•
Up to $50,000 of the loss if you file as an individual
Up to $100,000 of the loss if you file a joint return
To qualify for this tax break, you had to invest less than $1 million in your
original capital contribution to your S corporation.
Example. Suppose your basis in your S corporation was $800,000 after
accounting for pass-through income and loss. When you receive the land
worth $600,000, you have a $200,000 capital loss on the stock.
If you file a joint return and qualify for this tax break, you can treat up to
$100,000 of your $200,000 capital loss as a tax-favored ordinary loss.
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Know This Ugly Part
Notes
This can kill the liquidation deal!
If your S corporation recognizes gain on “depreciable” property that it
distributes to you, the owner, then the corporation must treat any capital
gain as ordinary gain.17
Example. Suppose your S corporation owned a building in addition to the
land. If, in the liquidation, the capital gain attributable to the building is
$325,000, your corporation has to treat that $325,000 capital gain as
ordinary income.
The rationale behind this rule is that when you receive this building in
liquidation, you are going to depreciate the building and obtain ordinary
deductions, so you should not get a windfall with long-term capital gain
treatment. Although ugly and disappointing, it’s a fair rule.
Be Alert to the S Corporation Surprise
If you operated your corporation as a C corporation before converting to
an S corporation, you may have to pay built-in gains tax when you
liquidate.
Take a look at Section 5, S Corporation Tax on Built-In Gains Is Trouble,
for more on how the built-in gains tax works.
One Final Thought
Make sure you know what’s going to happen in your S corporation
liquidation before you liquidate.
Copyright 2014 by Bradford and Company, Inc.
95
Notes
Endnotes – Section 17
1
Reg. Section 1.331-1(c).
2
See IRC Section 1371(a).
3
IRC Section 336(a).
4
IRC Section 1367.
5
IRC Section 331(a).
6
The IRC Section 267 loss disallowance rule does not apply in the case of a complete
liquidation.
7
IRC Section 336(d)(1)(A)(i).
8
IRC Section 336(d)(1).
9
See Genl. Expl. of Tax Reform Act of ’86 (PL 99-514), ps. 341-344.
10
IRC Section 336(d)(1)(A).
11
IRC Section 362(a).
12
IRC Section 1367(a)(2).
13
Your basis in the S corporation includes your debt basis, so in making your decision
whether to liquidate, you need to consider both.
14
CCA 201237017, p. 4.
15
Majority shareholders recognize loss on the exchange of stock in liquidation. IRC Section
267(a)(1), second sentence.
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16
IRC Section 1244.
17
IRC Section 1239.
Copyright 2014 by Bradford and Company, Inc.
Section 18
Notes
Good Records are the Key to
Your Deductions
Pay attention to paperwork.
If you’re not good at paperwork, the corporate form of business is probably
not for you.
In this section, we show you two examples of how bad record-keeping
destroys S corporation deductions, and then we give you advice on how to
keep your records if you own multiple businesses.
Example 1—Improper Advances
William H. Bruecher III learned his lesson on record-keeping by paying
more than $27,000 in taxes on monies his corporation supposedly loaned
to him.
Mr. Bruecher’s corporation did not pay him a salary; rather, the
corporation paid his personal expenses, classifying the payments as
advances.
Advance Account on Corporate Books
Advances handled properly do not create a tax problem.
The IRS in an audit or the court in a decision first looks to see if the
advances are loans or dividends. If repayment by the owner and collection
by the corporation seem assured, or actually take place in a later year, the
advance is a loan.
Intent to Repay
To decide whether there is intent to repay, the court looks at factors such
as the following:
•
Promissory notes or other written promises to repay the advance
Copyright 2014 by Bradford and Company, Inc.
97
Notes
•
•
•
Interest charges on the advance
Collateral to ensure repayment
Past history of repayment
Neither Mr. Bruecher nor his corporation could produce any of these.
Further, the very personal nature of some of the advances (such as divorce
settlement payments, child support payments, and payments to the grocery
store) got the court’s attention.
In court, Mr. Bruecher delivered his self-serving testimony and presented as
evidence the corporate tax return, on which the advances were classified as
loans.
Not good enough, ruled the court, as it made the advances taxable
dividends to Mr. Bruecher.1
Strategy for Advance Accounts
When you operate as a corporation, the corporation is a separate legal
entity, and you should have a corporate paper trail that clearly reflects
intent and action.
With an S corporation, you should either offset the advances with the
distribution account or evidence the advances as interest-bearing loans.
Example 2—Using the Wrong Form
Ronnie Craft owned 50 percent of an S corporation. Both he and the other
owner took salaries of $50,000 a year from the S corporation.
The corporation adopted a resolution requiring Mr. Craft to pay for and
supply his own office space and vehicles for use on behalf of the S
corporation’s business. In other words, the corporation wanted Mr. Craft to
incur employee business expenses while promoting and taking care of the
corporation’s business, but the corporation was not going to reimburse Mr.
Craft for those expenses.
Mr. Craft incurred $17,604 of employee business expenses, but instead of
claiming them as miscellaneous itemized deductions, he put them on
Schedule C of his Form 1040.
Please Audit Me
This was a mistake. By reporting them improperly, he brought himself to
the attention of the IRS.
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Imagine how Mr. Craft’s tax return looks:
•
•
•
Notes
S corporation income from the K-1 on Schedule E
W-2 income from the S corporation on the first page of Form 1040
Schedule C income of zero, but expenses of $17,604
The naked expenses (no income) would stand out by themselves, but when
Mr. Craft added the S corporation name as the Schedule C business name,
he definitely brought himself to the IRS’s attention.
Why?
You might ask, “Why didn’t Mr. Craft just put the expenses on his tax
return as employee business expenses, where they belonged?”
We don’t know, but we would guess that he did that once and did not like
the result.
If you claim employee businesses expenses as miscellaneous itemized
deductions on Schedule A of your Form 1040, you can suffer in two ways:
1. Lose 2 percent. Tax law takes 2 percent of your adjusted gross income
and subtracts that from your miscellaneous itemized deductions.
2. Lose the entire deduction. The alternative minimum tax (AMT) does
not allow any miscellaneous itemized deductions for purposes of the
AMT. These deductions, which are allowed for the regular tax, are
disallowed for the AMT.
Bad Strategy
Mr. Craft and his fellow 50 percent shareholder put together the S
corporation no-reimbursement policy using a totally wrong strategy—a
strategy that put legitimate business expenses at risk, because now business
expenses become employee expenses, subject to the double threat
described above.
That is exactly what the court ruled. Mr. Craft had to treat the expenses as
employee business expenses, subject to all the dreaded rules that apply to
such expenses.2
What to Do
Make your corporation reimburse you for employee business expenses.
This is the key to maximum benefits. With the expenses on the corporate
return, the corporation gets the full deductions and you escape
Copyright 2014 by Bradford and Company, Inc.
99
Notes
•
•
the 2 percent pain, and
the AMT slaughter.
In your tax planning, avoid pain and slaughter whenever possible.
Other Points
Here are some other points to keep in mind:
•
•
•
For tax purposes, a corporation is a totally separate entity from its
shareholders.
The voluntary payment of corporate expenses by the shareholders
or employees may not be deducted by those shareholders or
employees on their individual tax returns. (To deduct these
personally, you need the corporation to make them your expenses
by resolution or policy.)
A corporate resolution or policy that requires a corporate officer to
assume certain expenses shows that those expenses are the
individual’s expenses incurred on behalf of the corporation to
further the corporation’s business.
Tips for Multiple Businesses
Suppose you own more than one business and you run each as its own
separate business entity (whether an LLC, an S corporation, or a C
corporation). How should you keep your records?
Each of the three businesses is a separate taxable activity. Each separate
legal entity should record its separate income and its separate expenses. No
commingling.
You should keep a tax diary to track business and personal mileage, travel,
entertainment, and time spent. One diary for all your activity is easiest.
With multiple businesses, it is cleanest to pay all diary expenses from
personal credit cards, personal checking, and personal cash.
Your next step is to submit a weekly expense report to each of the entities
for that entity’s share of expenses.
Instead of paying from a personal account, you could pay from one of the
business accounts and then submit the expense reports to the other
businesses. For tax purposes, this is not as clean as using personal
accounts, and it often trips up taxpayers. That’s why we prefer payments
from the personal account and then expense reporting to each of the
businesses.
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When you have options on which entity should bear the expense, you get
your best tax benefits from your operating entities. Passive entities such as
those holding rental properties may or may not produce deductions
because of the passive-loss rules.
Notes
Example. You might make rental property stops on the way to and from
your S corporation stops, giving you only S corporation mileage for such
trips.
Owning multiple entities poses a record-keeping burden. It’s not huge if
you stay on top of it, and this probably means doing so on a daily basis (or
certainly not less often than on a weekly basis). You will have to make
notations next to your business activities as to which entity gets the
expense. When you summarize your diary for the month, you might think
of using the low-end version of Quicken or some similar program that
makes it easy to distribute expenses.
Endnotes – Section 18
1
William H. Bruecher III v. Commr., TC Summary Opinion 2005-52.
2
Ronnie O. Craft v Commr., TC Memo 2005-197.
Copyright 2014 by Bradford and Company, Inc.
101
Guidebook Authors
W. Murray Bradford, CPA, has more than 30 years of experience
helping tax advisors, one-owner, and husband-and-wife-owned
businesses reduce their income taxes.
Mr. Bradford’s CPA experience is anchored by eight years with the
international accounting firm Price Waterhouse, where he enjoyed
the elite distinction of being selected for two tours of duty in the
firm’s Washington, D.C. national office. Among his impressive
achievements, Mr. Bradford maintained a Top Instructor rating at
the Becker CPA Review Course for 15 years.
Mr. Bradford is the publisher of Tax Reduction Letter, a monthly
tax-smart publication for the self-employed, and author of
numerous books and courses, including his most current title,
“Business Tax Deductions” (2014), a comprehensive on-the-go tax
course published by Bradford and Company, Inc.
Mr. Bradford holds active CPA licenses in Washington, D.C.,
Minnesota, and California. He is a member of the American
Institute of Certified Public Accountants, the California Society of
CPAs, the Minnesota Society of CPAs, and the Greater
Washington, D.C. Society of CPAs.
John Myrick, JD, LLM, is a tax attorney who specializes in the
taxation of family-owned and single-owner businesses. Mr. Myrick
has advised thousands of business owners and tax advisors with
regard to corporate taxation, retirement and estate planning, and
health and welfare programs for business owners and employees.
Mr. Myrick is a member of the Bradford Tax Institute and an
editor of the Tax Reduction Letter, a monthly publication for tax
professionals and the self-employed. He is also the co-author of an
upcoming tax course that covers tax-saving strategies for S
corporation owners.
Mr. Myrick is an active member of the bar in Texas, New York,
and California. He is a member of the Orange County Bar
Association, Tax Law Section, the Texas State Bar Tax Section,
the Los Angeles County Bar Association, and the American Bar
Association, Section of Taxation.
Copyright 2014 by Bradford and Company, Inc.