Small Business Taxes & ManagementTM--Copyright 2009-2016, A/N Group, Inc.
For the first part of this article go to S Corporations, Partnerships, and LLCs--Basics, Misconceptions and Traps--Part I.
S Corporation Rules and Requirements
S corporations are just corporations that have elected to be taxed under special rules where the income and losses are passed through to the shareholders. Most, but not all, states recognize S corporations the same way the IRS does. There are a number of rules associated with S corporations. Violating them could result in a loss of S status. Should that occur, losses will be disallowed to the shareholders and profits will be taxed at the corporate level.
Making the S election is usually pretty straightforward. All the shareholders must agree to make the election and sign the form (IRS Form 2553). In many states no separate election is necessary, filing the federal form automatically qualifies the corporation for S status in the state; in others you must file a separate state form.
Generally, the form must be filed within 2-1/2 months the corporation first has shareholders. Existing corporations can elect S status for a year by filing Form 2553 by March 15 of that year (calendar-year corporations). There are exceptions to the rules, but this is not the place to make a mistake. You don't want to find out some years down the road that you've been denied S status. While the election form is relatively simple, even professionals have been known to make errors.
There are several requirements associated with the shares of an S corporation:
The first requirement is unlikely to cause a problem for most corporations. All members of a family and their spouses are considered as a single shareholder for determining the 100-shareholder limit.
The second and third requirements can present pitfalls. Partnerships, corporations, and nonresidents cannot be shareholders. If an existing shareholder sells his or her shares to one of these persons, the S election will be terminated. An IRA cannot be a shareholder. (An inadvertent termination can often be remedied, but not without effort.)
The last requirement sounds innocent, but can often be a problem. While you're unlikely to inadvertently issue preferred shares, the IRS has held that unequal distributions to shareholders can result in a second class of stock. For example, Fred Flood and Sue Sharp each own 50% of Madison Inc. Fred takes a $50,000 salary; Sue takes only $10,000 annually. Neither takes any cash distributions. But Madison pays all the expenses of a car for Sue which Sue uses only 10 percent for business. The 90 percent of personal use is a distribution to Sue. Since Sue has gotten a preferential distribution, Madison may now have two classes of stock. Debt other than straight debt can be considered a second class of stock (e.g., convertible debt). Differences in voting rights generally won't constitute a second class. Health or accident insurance premiums paid on behalf of a 2-percent plus shareholder aren't considered distributions for the second class of stock requirement.
As always, the rules are far more complicated than discussed above. There are other requirements as well as exceptions.
This is one of the drawbacks of partnerships and S corporations. Certain fringe benefits paid to any partners or more than 2-percent shareholders of an S corporation are not deductible. The fringe benefits generally include:
Health insurance premiums are deductible, but only if included on the employee/shareholder's W-2. The employee can then deduct the amount toward his or her adjusted gross income on their personal tax return. Meals and lodging furnished for the convenience of the employer include meals provided on company premises when employees can't leave because of work requirements.
Most other fringe benefits, such as employee discounts, working condition fringes, no-additional cost services, and de minimis fringes should be deductible by the partnership or S corporation.
This is a technical area that's beyond the scope of this article. However, you should be aware that stock ownership or an interest in a partnership can be attributable to a related party. For example, you own 50 percent of the stock of Madison Inc. You pay the health insurance for your son who is an employee of Madison. Your son is deemed to be a more than 2-percent shareholder. In order for his health insurance to be deductible, you would have to include his health insurance premiums on his W-2.
Excessive salary issues have generally involved C corporations. Because dividends from a C corporation are not deductible by the corporation but income to the shareholder, the best tax way to take money out of a C corporation is generally by salary. But excessive salaries can be challenged by the IRS and deemed to be, in part, dividends.
With an S corporation, partnership, or similar entity, the IRS may take issue with excessive salaries paid to relatives, claiming you're trying to shift income to a lower bracket taxpayer. For example, you're the sole shareholder of Madison Inc. a highly profitable medical electronics manufacturer. You're in the top tax bracket. Your son works for the business on a part-time basis. He has a college degree but no special skills, but you pay him $275,000 per year. The IRS may decide he's only worth $35,000 and disallow a deduction for the remainder.
If there is any question as to the salary paid to a relative, you should document hours worked and be able to show the salary is not excessive.
Most states tax S corporations the same as the Federal government does. (There are certain exceptions.) Of more concern are S corporations, partnerships and LLCs doing business in more than one state or where you have a nonresident shareholder. The partnership, S corporation, etc. must file in each state in which it does business. (Check with your tax advisor on the definition of doing business.) The shareholders or partners must file a personal tax return in those states or file a composite return. A couple of examples may clarify.
Example 1--Madison Inc. is a Massachusetts corporation owned by two Massachusetts residents, Mark and Kristen. Madison is also doing business in New York. Madison has to file a New York state S corporation return. Both Mark and Kristen have to file New York nonresident individual income tax returns reporting Madison's share of New York income on their nonresident returns.That's the general approach. Some states allow the use of a composite return. If that's the case the corporation can file a return for the nonresidents and pay the tax directly. While the approach is simpler, the total tax should be about the same. Some states require composite returns; in some it is optional (if available). Many states now require making installment payments for nonresident shareholders.
Example 2--Madison Inc. is a Massachusetts corporation owned by Mark and Kristen. Madison does business only in Massachusetts. Mark is a Massachusetts resident; Kristen is a New York resident. Kristen has to file a Massachusetts nonresident return reporting her share of Madison's income.
Converted C Corporations
Converting from a C (regular) corporation to an S corporation is generally easy and you can usually avoid any current tax consequences. But there are traps to watch out for.
The first is the built-in gains tax. It involves appreciated assets held by the corporation while it was a C corporation and sold by the S corporation. Because the sale of appreciated assets would be taxed twice to a C corporation, but not to an S corporation, were it not for the built-in gains tax, converting to an S corporation would provide a loophole.
Example--In 1996 Madison Inc., then a C corporation, purchased 100 acres of land for $100,000. In 2015 when the land is worth $400,000, Madison converts to S corporation status. Madison sells the land in 2017 for $650,000. Any appreciation in the land after Madison converted to S corporation isn't subject to the built-in gains tax. But the $300,000 gain ($400,000 value at time of conversion less $100,000 purchase price) is subject to the special tax.
The tax rate is the highest tax rate applied to corporations. The tax does not apply to assets held by the S corporation longer than 5 years at the time of sale. Thus, in the example above, if Madison had converted to S corporation status in 2010, the tax would not have applied. If you have assets that could generate gain (such as buildings, land, etc.) talk to your tax adviser. He may suggest an appraisal when a C corporation converts.
As always, the rules are more complex and you may be able to avoid the tax by careful planning.
The second danger associated with a converted C corporation involves excess net passive investment income. The S corporation must first have accumulated earnings and profits as a C corporation (while the rules aren't exactly the same, accumulated earnings and profits are similar to retained earnings). Then it must have more than 25 percent of its gross receipts from royalties, rents, dividends, interest, and annuities. An S corporation that meets these tests is subject to a separate tax at the highest corporate tax rate on the excess net passive income.
While the tax is unlikely to affect most operating corporations (an S corporation in the business of renting property enjoys a special exception to the rent rule), there is a real danger for corporations where operations have been terminated. For example, Madison Inc. has been in business for many years about half of them as a C corporation. It sells most of its operations for cash. Rather than distributing the cash, the corporation invests it and collects dividends and interest.
The third trap uses the same tests as in the second (excess net passive income and accumulated earnings and profits) but adds a third test--three years of excess passive income. Here the penalty is termination of S corporation status. Clearly something you want to avoid.
The fourth trap involves distributions. Generally, distributions of income from S corporations are nontaxable. The shareholders pay tax on all the income when earned, so they avoid a second tax on distributions. For converted C corporations with accumulated earnings and profits distributions out of the earnings while the entity was an S corporation are nontaxable. But once those earnings have been distributed, additional earnings will be from accumulated earnings and profits of the former C corporation and are taxed just like ordinary dividends.
There are several options to avoiding these problems, but they may depend on your specific situation. Talk to your tax advisor.
We've discussed basis in other places, but a review is worthwhile. Generally, your basis in an S corporation, partnership or LLC is equal to:
Your original and any subsequent capital contributions, + your share of the income of the entity, + your share of the separately stated income (e.g., dividends, interest, etc.), - your share of the losses, - your share of the separately stated deductions (e.g., Sec. 179 expense option), - your share of the distributions.
There are a number of items that can enter into the calculation (such as when property rather than cash is contributed to the entity), but the basic approach remains the same. In addition to your basis in equity capital, S corporation shareholders and partners have a basis in any money loaned to the entity. Partners can increase their basis in the partnership by partnership debts for which they are liable. Once your equity basis has been exhausted by losses, additional losses will reduce your loan basis.
Your basis is important for determining your amount at-risk, the amount up to which you're allowed to deduct the losses of the entity. It also determines your gain or loss on the sale of the business.
Just because you can't take the losses doesn't mean they don't reduce your basis. The Sec. 179 expense option can create a particular trap. Because of a limitation, you may not be able to use the deduction elected by the S corporation or partnership, but your share of the amount elected will reduce your basis.
Another trap arises from nondeductible expenses. Even though they don't decrease your profit or increase your loss, they do reduce your basis. The most commonly encountered one is the 50 percent of meal and entertainment expenses that aren't deductible.
We've said that income and losses of S corporations, partnerships, LLCs, etc. are passed through to the partners, shareholders, etc. That's generally true, but in order to take the losses you have to pass some tests. The first we discussed in Part I, material participation. (Actually the material participation test is applied first.) But you also have to have sufficient amount at-risk. That is, your economic investment in the entity must be at least as much as the losses.
What's your amount at-risk in the entity? A complete discussion would be involved, but most taxpayers won't get into the nuances. In most cases, your amount at-risk is very similar to your basis. And, in many cases, a shareholder or partner needs to go no further. But there can be substantial differences, particularly in the case of partnerships. Here are some points:
Two examples based on simple situations should help clarify.
Example 1--Mark invests $5,000 in Madison Inc. to start the business (he's the only shareholder). During year 1 Madison has income of $30,000 and Mark takes a distribution of $9,000. Mark's basis in Madison at the end of year 1 is $26,000 ($5,000 + $30,000 - $9,000). In year 2 Madison has a loss of $15,000 and Mark takes a distribution of $2,000. Mark's basis at the end of the year is $9,000. In year 3 Madison has a loss of $16,000; Mark takes no distribution. Mark can only deduct $9,000 of the $16,000 loss. The remaining $7,000 loss can be carried forward and used in a year when he has sufficient basis.Here comes a trap. Assume Madison ceases operations (just to simplify the example) when Madison starts repaying the loan to Mark, a portion of each principal payment will be income because Mark's basis in the loan is only $3,000.
Example 2--The facts are the same as in example 1, but in year 3 Mark loans Madison $10,000. The loan increases his total basis in Madison to $19,000 (the $9,000 equity basis at the end of year 2 plus the $10,000 loan basis). Mark can take the full $16,000 loss, leaving him with no equity basis (you use equity first) and only $3,000 in loan basis ($10,000 original loan basis less $7,000 loss applied to loan basis).
A second trap involves loans from a party who has an interest in the entity other than as a creditor. For example, Mark and Kristen are 40-60 shareholders in Madison. Mark wants to increase his interest to 50 percent and borrows $30,000 from Kristen to make an equity investment. Mark is not at risk for the $30,000 additional investment.
It sounds like we spent a considerable amount of time explaining what may sound like a fine point. However, many small businesses are financed with only a minimal amount of equity and a large amount of debt.
Partnerships, LLCs and sole proprietorships can get more complicated. The basic rules are the same. But your amount at-risk in a partnership or sole proprietorship is increased by any loans for which you are personally liable and decreased by the relief of any debt for which you are liable. For example, Mark and Martha are 50-percent partners in Madison Co., a general partnership. Each contributed $5,000 to start the business. Madison borrows $20,000 from Chatham Bank to purchase inventory. Mark and Martha are considered to have increased their amount at risk by their share of the loan, $10,000 each.
But that increase is elusive. Assume Madison has losses of $30,000 ($15,000 for each) in the first year. Mark and Martha can deduct all the losses because their amount at risk is $15,000 each. That decreases the at risk amount to zero. Assume in year two Madison has cash flow but no profit for the partners. Madison uses $10,000 of the cash generated to pay off the bank loan. Mark and Martha will have $5,000 of taxable gain because of the reduction in the bank loan. A similar situation could occur if the partner is no longer at-risk with respect to the loan or investment.
Sale of Interest
Selling your interest in an S corporation can be as simple as signing over the shares of stock. More than likely you'll draft a purchase and sale agreement providing for a noncompete clause, payment terms, etc. Some of the proceeds will be outside the gain or loss on the business. For example, the noncompete agreement is usually between the owner of the business and the buyer. The corporation isn't involved. It's more complicated in the case of a partnership, since there are a number of special issues to be dealt with and that's beyond the scope of this article. However, the starting point for computing gain or loss is similar.
Whether you have a gain or loss on the sale of an asset is determined by your selling price and the basis. That can be good news or bad news, depending on your basis. Keep in mind that your basis in an S corporation or partnership depends on your equity investment plus any income less losses and distributions. For example, Mark started Madison Inc. with $5,000. Over the years Madison has had income of $85,000; Mark takes no distributions. He sells his stock for $160,000; he has a $70,000 gain (selling price of $160,000 less $90,000 basis). Martha started Chatham Inc. with a $100,000 investment. Chatham has losses of $90,000; her basis is $10,000 ($100,000 investment less $90,000 in losses). Martha sells her stock for $160,000. She has a gain of $150,000 ($160,000 selling price less $10,000 basis).
As always, things can be more complicated. The point to remember here is that your gain or loss is based on more than just your original investment.
In our Part I of this article we said it really doesn't matter if you take a distribution or not, the income from an S corporation, partnership, etc. is taxable to you. But what about the distribution? Is that taxable? This is another time when the answer depends on your basis.
Generally, distributions up to your basis are nontaxable. Distributions in excess of your basis are taxed as a capital gain.
Example--Mark invested $5,000 to start Madison Inc. Madison has had earnings of $23,000. Mark takes a distribution from the company of $35,000. At the time of the distribution, Mark's basis in Madison was $28,000. Of the $35,000 distribution, $28,000 is nontaxable, the remaining $7,000 is treated as a capital gain and, assuming the required holding period is met, taxed at long-term capital gain rates.The rules for partnerships are similar. How can you distribute more money than you put in? Simple. If you financed the business with debt or even have accounts payable, you could have cash available for distribution.
In the discussion above we've assumed that only cash is distributed. Distributing property (e.g., a truck used in the business given to your son) will complicate the issue. A distribution of appreciated property by an S corporation could result in a taxable gain. And the amount of the distribution will be the fair market value of the property. A distribution of property by a partnership won't result in gain until it's sold by the partner. But a distribution of property encumbered by a liability (a truck with a loan outstanding on it) can trigger an overall decrease in partnership liabilities. The reduction in the partners' liability will result in a deemed distribution to the partners.
While we've listed a number of traps for partnerships, LLCs, and S corporations, the good news is that most are not encountered during normal operations. Most business owners run their business for years and never come close to getting caught. The traps are usually encountered when there's an unusual transaction, for example a distribution of property, large losses, etc. Here are some red flags:
Chances are your tax preparer computes your basis when he does your tax return (most tax preparation software does it automatically if you've entered the proper original data). Ask him or her about your basis. If you're unsure of your status, take to your preparer or tax adviser before taking a distribution or engaging in any transactions with the entity.
Copyright 2009-2016 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 12/26/16