Posts Tagged ‘S corporation’

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How much K-1 loss can I deduct? Start with your basis.

Wednesday, April 10th, 2013 by Joe Kristan

20130410-1If search statistics for the Tax Update are any indication, one of the most pressing issues for people who end up here is “why can’t I deduct my K-1 loss?”

There are three main reasons why your S corporation or partnership loss might be non-deductible:

1. You can’t deduct losses in excess of your basis.
2. Even if you have basis to deduct losses, the basis has to be “at-risk,” and
3. Even if the basis is “at-risk,” losses that are “passive” might be limited.

So how do you know your basis?

 

COMPONENTS OF BASIS

- Your basis starts with your initial investment in your ownership interest.

-It is increased by taxable income and deductible expenses, as reported in lines 1-12 of the 1120-S K-1, or lines 1-13 of the 1065 K-1.

-It is increased by tax-exempt income (like municipal bond income) and reduced by permanently non-deductible expenses (like the 50% non-deductible portion of meals and entertainment expenses); these are reported on line 16 of the 1120S K-1 and line 18 of the 1065 K-1.  If you have a business that generates depletion deductions, your “excess depletion” from 1120S K-1 line 15c, or line 20 of your partnership K-1, also reduces your basis.

- It is increased by capital contributions, which appear nowhere on the 1120S K-1 and on Part I, line L of the 1065 K-1.

- It is reduced by distributions, which are on line 16 of the 1120-S K-1 and Line 19 of the 1065 K-1.

If your losses exceed your basis, your losses are limited to your basis.   If you have multiple deduction items, you have to prorate them to fit your basis.

Example

Lets say you have an S corporation interest that starts 2010 with $3,000 in basis.  You have a K-1 line 1 loss of 9,000, line 4 interest income of $2,000, and a charitable contribution passing through on line 12 (code A) of $1,000.

You have $5,000 in basis to deduct your $10,000 in in expenses – the opening $3,000 in basis plus the positive $2,000 interest income.  You pro-rate the $10,000 expenses — you can (potentially) deduct $4,500 of line 1 loss and $500 of charitable contributions.  The remaining deductions carry forward until you increase your basis via contributions, loans, or future income.

Even if you have basis, that just gets you past one hurdle.  Your basis still has to be “at-risk,” and you can’t deduct a loss that’s “passive.”  More on that later this week.

This is, of course, a simple example.  It gets more complicated if there are distributions during the year (they count first), and if there are non-deductible expenses, like meals and entertainment.   Shareholders can count direct loans they make to an S corporation in basis — but not borrowings by the S corporation from anybody else, and not guarantees of S corporation debt.  You can learn more about S corporation basis at the IRS web site.

Come back for more 2013 filing season tips through April 15!

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Bad records help stick struggling S corporation owner with extra salary

Thursday, December 27th, 2012 by Joe Kristan

S corporation K-1 income isn’t subject to self-employment or payroll taxes.  This tempts S corporation owners to take minimal salary and take earnings out as S corporation distributions instead.   Former vice-presidential nominee and model husband John Edwards famously used an S corporation to minimize his payroll taxes.

20121227-1The IRS has had success in imposing additional payroll taxes when owners of profitable S corporations take little or no salary.  Yesterday the Tax Court also imposed payroll taxes on the owner of a struggling S corporation.

The owner of a small Twin Cities courier business reported wages of $24,452 to $28,452 in 2004-2006.  He took only $2,400 in salary in 2007.  The IRS found that $55,000 was transferred from the S corporation to the owner’s bank accounts in 2007 and imposed payroll taxes on that amount of salary.

How do we know the business struggled?  The Tax Court explains:

During petitioners’ operation of H&H up to some point in 2009, H&H either lost money every year or earned little income. In 2009 petitioners finally closed the business down, after losing their home on  account of losses incurred in the business and their inability to make payments on a home equity loan obtained in 2004 to finance their purchase of the business.

This wasn’t like the CPA who earned around $200,000 from his busienss and reported salary of only $24,000.  Yet the IRS didn’t let the taxpayer’s financial ruin stand in the way of an assessment of additonal payroll taxes.  The Tax Court upheld part of the assesment:

     We believe and accept petitioner’s testimony that he in fact paid significant H&H expenses with cash using funds received from H&H. For example, petitioner credibly testified that after finishing deliveries, truck drivers often would assist with repairs on the trucks and that he would pay the drivers cash for their assistance. No evidence indicates any unusual personal use by petitioners of the funds in question received from H&H.

     In spite of the limited evidence before us, we believe it improper and excessive to charge petitioner with receipt from H&H in 2007 of $52,600 in additional wages. However, we also believe petitioner’s reported H&H wages of $2,400 are unreasonably low.

Unfortunately, as you might have guessed from this, the taxpayer’s records were a mess.  The Tax Court used a very rough estimate:

To estimate what portion of the funds petitioner received from H&H in 2007 is to be treated as wages, we believe it appropriate to average petitioner’s wages for 2002 through 2006 and to use the average wage amount as the total for petitioner’s 2007 H&H wages subject to employment taxes — namely, $30,445.

I think the result would have been better if the taxpayer had kept better records.  If the taxpayer had kept personal and company spending separate and could account for all expenses, the Tax Court might have left him alone.

Still, I think the IRS and the Tax Court did the taxpayer a disservice.  Lee Iacocca famously took a $1 salary when he was in charge of struggling Chrysler.  If Warren Buffett can hold his salary to $100,000 in a fabulously profitable company, it’s plain mean to stick a struggling owner with additional salary just to collect more payroll taxes.

Fortunately this is a “summary opinion,” which isn’t supposed to serve as precedent.  A better-represented and better-organized taxpayer might well do better.

Cite:  Herbert, T.C. Summary Opinion 2012-124

 

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Tax Roundup, 9/21/2012: Area S corp owner knocks on Supreme Court door. And breaking! Businesses aggressively cut costs!

Friday, September 21st, 2012 by Joe Kristan

West Des Moines CPA asks Supreme Court to overturn employment tax assessment on S corporation income.  The taxpayer has filed a petition asking the U.S. Supreme Court to overturn the Eighth Circuit decision imposing employment tax on his share of S corporation income.  The taxpayer had around @200,000 of income from his accounting S corporation but only called $24,000 of it compensation, treating the remainder as K-1 income not subject to FICA and Medicare tax.  The courts raised his “salary” to about $90,000.

The petition says that the Eighth Circuit decision (Watson, 668 F.3d 1008 (8th Cir. 2012)) conflicts with a Seventh Circuit decision treating a C-Corporation CPA firm as paying disguised dividends through management companies.  While I know and admire the attorneys on the Watson petition, the Seventh Circuit case (Mulcahy, Puritsch, Salvador & Co) doesn’t really cover the same ground as Watson.

The Supreme Court only hears a small fraction of cases it is asked to hear, so the chances for a Supreme Court decision on this issue are poor.

Related: Eighth Circuit upholds ‘Watson’ decision requiring increased comp for CPA S corporation shareholder; When professional C corporations go bad

Link: Tax Analysts subscriber link to Watson petition.

 

Janet Novack, Senate Report Details HP & Microsoft Offshore Tax Ploys:

A new report from the Senate Permanent Subcommittee On Investigations asserts Microsoft  Corp. and Hewlett-Packard have used “aggressive” offshore ploys to save or defer billions in U.S. corporate tax.

For any expense other than tax, nobody would question the wisdom, let alone the patriotism, of “aggressive” cost-cutting.  Related: Transfer Pricing and Common Sense, Martin Sullivan, Tax.com.

 

West Des Moines Patch, Metro Developer Walters Pleads Guilty to One Count of Bank Fraud:

Metro area developer Randal L. Walters pleaded guilty Thursday to one count of bank fraud in connection with a loan to develop a Des Moines area condominium project, announced federal court officials in a news release.

During the plea proceeding in federal court, Walters, 55, of Polk County, admitted to diverting money borrowed from First Bank of West Des Moines for a Des Moines area condominium project know as the Meadow Cove project, the release said.

The story said prosecutors are recommending against prison time.

 

Jim Maule, Subsidies and Tax Breaks:

When a special interest or specific industry gets a tax break, it causes one or the other, or a combination, of two things to happen. First, if nothing else is adjusted, the reduction in tax revenues causes an increase in the federal deficit, which in turn adversely affects everyone. Second, if revenue is maintained, it means other taxpayers must pay more in taxes to make up for the reduction in taxes for the special interest or specific industry, and that clearly affects everyone.

It’s just as true on the state level.

 

Jaywalker hunting on the moors: US tax net closes on Americans living in Britain. (Financial Times via Tax Break)

Richard Morrison,Context and Background on the Nonpayers Debate (Tax Policy Blog)

TaxProf, Fleischer: Are Whistleblowers the New IRS Business Model?  Paul Caron links to a New York Times piece by Victor Fleisher on the role of snitches in tax administration.

Anthony Nitti, Is Now a Good Time to Convert Your S Corporation to An LLC?

Jason Dinesen, “Consumer Reports” Highlights Identity Theft

TaxGrrrl, Millions More Taxpayers Subject to Health Care Penalty Tax

Kay Bell, 6 million Americans expected to face Obamacare’s uninsured penalty, er, tax

Jack Townsend, Sentencing Enhancement for Defendant Perjury at Trial

Trish McIntire, e-Services and TIGTA

Robert D. Flach interviews TAX BLOGOSPHERE BUDDY – JAMAAL SOLOMON, EA

 

Have a great weekend!

 

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IRS: you aren’t allowed to escape our trap!

Tuesday, June 19th, 2012 by Joe Kristan

Flickr image courtesy Woodswalker under Creative Commons license

A bunch of McDonalds franchisees in Utah were run in a multy-entity structure: the restaurants were operated in one corporation, while a management company provided payroll, training and benefits services to the restaurants to the operating company.  In 2002 they began working with a consultant who advised them to make an S election for the management company and start an ESOP in it.  The management company also began a non-qualified deferred comp plan for the highly-compensated employees of the managmeent company.

The ink had barely dried on the new structure when the IRS issued new regulations that pretty much wrecked it all.  New rules on S corporation ESOPs, combined with the deferred comp plan, changed everything, as the Tax Court explains (my emphasis):

 On July 21, 2003, the Commissioner issued temporary regulations under which, for the first time, the definition of synthetic equity under section 409(p)(6)(C) included employee balances under nonqualified deferred compensation plans such as the NQDCP which petitioners had established within the management company…

Where the deemed-stock ownership tests of section 409(p) are violated, there are significant consequences to the disqualified persons, to the S corporation, and to the ESOP. Prohibited allocations in favor of disqualified persons are treated as currently taxable to the disqualified persons, sec. 409(p)(2)(A), and excise taxes equal to 50% of the total prohibited allocations are imposed on the S corporation, sec. 4979A. Further, the ESOP will not satisfy the requirements of section 4975(e)(7) and will cease to qualify as an ESOP.

But other than immediate tax, a 50% penalty tax, and ESOP termination, the structure would work just fine.  So the franchisees went back to the drawing board.  They bought the management company stock back from the ESOP. paid out the deferred comp balances of about $3 million, and terminated the ESOP under their own terms.  The taxpayers pretty much undid their plan and went back to their old setup.  But the IRS had another surprise:

On audit respondent determined that petitioners’ July 12, 2004, purchase and acquisition from the ESOP of the stock in the management company occurred for the principal purpose of avoiding or evading taxes by obtaining a loss deduction to which petitioners would not otherwise have been entitled, and respondent disallowed under section 269 the approximate loss deduction of $2,969,000 petitioners claimed.

They weren’t even joking.  Now Sec. 269 is a very obscure and rarely used tool in the IRS terror kit.  In the rare cases when it is used, it usually involves C corporations trying to buy net operating losses or tax credits.  I have never heard of it used on an S corporation, and the Tax Court seemed surprised too:

Respondent acknowledges that because S corporations are passthrough entities for Federal income tax purposes and do not keep their own deductions and losses (i.e., S corporation deductions and losses automatically pass through to the shareholders), it is extremely rare that the Commissioner would seek to make a section 269 adjustment in the context of a taxpayer’s acquisition of an S corporation.

The Tax Court sensibly saw things the taxpayers way.  The judge pointed out that the taxpayers would have been stuck with a bad tax structure caused by IRS rules adopted after they had already set it up (citations omitted):

The above transactions and steps clearly were related and planned as part of an effort to avoid problems created for petitioners by the Commissioner’s temporary regulations, to restructure the management company, and to terminate the ESOP; but they represent valid and real transactions with economic effect that require our recognition as legitimate business transactions.

It’s disturbing to see the IRS try to use Sec. 269 here.  Every ownership structure is tax-motivated in one way or another.  To challenge  a taxpayer’s entity structure is an improperly tax-motivated transaction, absent some weird result like a windfall tax loss or credit, is grossly improper.  This kind of position would result in penalties if taken by a taxpayer.  Taxpayers should be able to collect a similar penalty from the IRS when the agency litigates abusively like this.

Cite: Love, T.C. Memo 2012-166

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Tax Court: you can use distributions from one S corporation to restore basis in another.

Thursday, June 7th, 2012 by Joe Kristan

An important Tax Court decision issued yesterday validates a traditional S corporation planning tactic from an overreaching attack by the IRS.  Incidentally, it validates some old Tax Update advice.

S corporations, as longtime readers know, don’t generally pay their own tax.  Instead corporation income and loss passes through to the shareholders’ 1040s.  The ability to deduct corporation losses is a popular feature of S corporations, but it is limited.  Shareholders can only deduct S corporation losses to the extent they have basis in either their stock of the S corporation or loans they have made directly to the corporation.

S corporation basis starts with your investment in the company.  Income passed through to shareholders increases their basis, as do capital contributions.  Basis is reduced by losses and distributions.  Distributions of funds earned as an S corporation are generally a tax-free recovery of basis.

Taxpayers with more than one S corporation often find their basis is in the wrong place.  They may have plenty of basis in a profitable corporation, but they need more basis in a sister corporation that is losing money to deduct the losses.  The logical answer is distribute funds from the profitable business and contribute it to the loser.  That was the strategy used by a Kentucky auto dealer S corporation, Auto Acceptance, and a sister finance company, CNAC.  The Tax Court explains how the business worked:

Auto Acceptance is a car dealership, and CNAC is a finance company that deals exclusively with Auto Acceptance’s customers. Auto Acceptance is primarily engaged in the purchase of used vehicles at auction and the resale of those vehicles. CNAC purchases retail installment notes related to the vehicles that Auto Acceptance sells.

From 2004 through 2006 Auto Acceptance was losing money, while CNAC was making money.  Their accounting firm advised the common owners of the companies to make distributions from profitable CNAC and contribute them to money-losing Auto Acceptance so they could deduct the Auto Acceptance losses.  Unfortunately, CNAC’s cash was tied up in receivables, so instead CNAC distributed the receivables to shareholders, who then contributed them to the capital of Auto Acceptance. 

Along comes the IRS, saying that the distributions and contributions never took place.  The taxpayers had paperwork that convinced the court that IRS was wrong.  The IRS raised an uglier argument: that there was no substance to the transaction.

Respondent also argues that no economic outlay was made, because the resolutions and adjusting journal entries made to the books of the related companies were devoid of any economic reality and did not alter the economic positions of the parties.

This argument is similar to that made regarding “circular loans” among S corporations.  The IRS has successfully disallowed basis increases when one S corporation “loans” money to shareholders, who then “loan” the money to another S corporation, which then loans the money back to the corporation where it started.  The Tax Court said this case is different (my emphasis, footnotes omitted):

Respondent also argues that no economic outlay was made, because the resolutions and adjusting journal entries made to the books of the related companies were devoid of any economic reality and did not alter the economic positions of the parties. We find that the distributions and contributions did have real consequences that altered the positions of petitioners individually and those of their businesses. As petitioners point out, the distributions and contributions created actual economic consequences for the parties, because the accounts receivable had real value in that they were legitimate debts that Auto Acceptance owed to CNAC and thus were legitimate assets of CNAC. Petitioners’ contribution of the accounts receivable resulted in their being poorer in a material sense in that the accounts receivable were no longer collectible by them individually.

When petitioners received the accounts receivable from CNAC, as they had every right to do, and contributed them to Auto Acceptance, that transaction reduced the liabilities of Auto Acceptance; made Auto Acceptance solvent in terms of its assets exceeding its liabilities; and increased the net worth of Auto Acceptance, exposing a greater amount of its assets to its general creditors. At the same time, petitioners’ bases in CNAC were reduced by the amounts of the accounts receivable that CNAC had distributed to them, thereby reducing their ability to receive future tax-free distributions from CNAC. See sec. 1368.

The fact that the CNAC accounts receivable were distributed to petitioners and then contributed to a related entity does not require a finding that there was no economic outlay.

This supports thoughts I posted in 2004 regarding the owner of the Dart Trucking business, a Mr. Oren, who lost his deductions when the IRS disallowed basis increases from circular loans:

If Dart had instead made a cash S corporation distribution to Mr. Oren, and if Mr. Oren had then contributed the cash to the loss corporations, Mr. Oren would probably have gotten his losses. If the loss corporations then had loaned the contributed funds right back to Dart, the transaction might have still failed, but the IRS would have had a tougher argument. If the funds were left in the loss corporations, it’s hard to see where the IRS would have been able to challenge the losses.

The Moral?  The tax law allows S corporation holding companies now.  If you have commonly-owned S corporations, you can combine their basis by contributing them to an S corporation holding company and making “Q-Sub” elections.  That way you don’t have to worry about shifting basis before year-end.  If for some reason you can’t form an S corporation holding company, or really don’t want to, you should use distributions from the profitable corporation — not loans — to restore basis in the loss corporation.  You shouldn’t then stash the cash back in the starting corporation. 

Also, in this case the shareholders carefully documented their transactions; the paperwork was critical to winning the case.  So remember, paperwork really matters.

Anthony Nitti has more.

Cite: Maguire, T.C. Memo. 2012-160

 

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Tax pro’s airplane deduction misses the runway.

Tuesday, May 29th, 2012 by Joe Kristan

A man who operated tax prep businesses in California and Nevada probably felt that he knew how to arrange things to stay out of tax trouble.  The Tax Court decided otherwise last week in the case of Joseph Anthony D’Errico v. Commissioner. 

TPM was a C corporation set up by the taxpayer to provide management services to S corporations that he owned in the tax prep business.  It’s possible that he used the C corporation for the “bracket racket,” diverting enough income from the S corporations to fully use the 15% corporate bracket, but the case doesn’t say so.  The taxpayer sold his S corporation businesses in 2005, which would leave the taxpayer with a management C corporation with nothing to manage. A few weeks before the January 1, 2005 sale of his businesses, the corporation got another asset:

 In December 2004 TPM purchased a Cessna airplane (airplane) for $137,500. Mr. D’Errico  had a pilot’s license and several years of flight training at the time TPM purchased the airplane. Mr. D’Errico testified that TPM purchased the airplane in order for him to travel quickly between TPM’s purported office at the Barton Drive home in Stateline, Nevada, and his two active tax preparation corporations

So what does a mangement company with nothing to manage do with its airplane?

On December 29, 2004, TPM entered into an “Aircraft Leaseback Agreement” (leaseback agreement) which allowed the flight training company Flying Start Aero to make the airplane “available to the public for rental” for no more than 75 hours per month. The leaseback agreement stated that TPM was entering into the agreement “with the intention of generating some revenue for the purpose of offsetting a portion of the aircraft operating costs”. Even though the airplane was leased to Flying Start Aero, TPM was still responsible for airplane expenses such as insurance and maintenance. The lease was canceled by Flying Start Aero in early 2006 upon TPM’s failure to pay such expenses.

The airplane was not used in TPM’s tax management related business during 2005 or 2006. Petitioner claimed in his testimony that he used the airplane on business related trips in both January and April 2007. However, Mr. D’Errico did not introduce a log of his airplane use during 2007 into evidence. The only 2007 airplane records summarized expenses one Matthew Laughlin incurred in a trip to Los Angeles. Mr. Laughlin had been Mr. D’Errico’s certified flight instructor since Mr. D’Errico began to fly in 2001. Mr. D’Errico testified that Mr. Laughlin “came out from Denver to talk to me about multiple uses for the airplane. He thought it would be a good idea for us to start our own flight school, in which he would have a flight school and I would rent the airplane to his flight school.”

Perhaps it was an excellent idea, though nothing apparently came out of it.  Deducting the airplane expenses in the corporation also seemed like a good idea:

On its TYE April 30, 2006, tax return TPM reported income from the airplane rental of $21,869, airplane expenses of $17,042, and airplane depreciation of $11,408. On its TYE April 30, 2007, tax return TPM reported no airplane rental income,7 airplane expenses of $19,351, and total depreciation of $7,324.

The corporation also deducted expenses for a Chevy Tahoe that the taxpayer testified was “exclusively for business use,” according to the opinion.  The corporation also deducted phone expenses, “supplies,” and meals.  The corporation paid “rent” to the taxpayer for an office in his home.  Also:

TPM deducted utility expenses for the Barton Drive home of $2,695 and $2,491 for its TYE April 30, 2006 and 2007, respectively. These expenses included cable television, Internet, gas, electric, and certain repairs.

Well, the corporation didn’t have a business to manage.  Maybe having cable and Internet gave it something to do. 

The Tax Court didn’t like the deductions.  It had this to say about the airplane:

TPM argues that the airplane was necessary for its tax management business because Mr. D’Errico had to travel between Nevada and southern California to fulfill TPM’s business obligations to [his tax preparation S corporations sold in 2005]. However, at the time TPM purchased the airplane, Mr. D’Errico knew that he was going to be selling… TPM has produced no evidence that the airplane was used in TPM’s tax management business after 2004.

The Tax Court didn’t just disallow the deductions (my emphasis):

As discussed above, TPM failed to establish that it conducted business-related activities at the Barton Drive home, with the result that the rent payments made to Anthony D’Errico are not deductible by TPM. Further, Mr. D’Errico failed to introduce evidence to support his claim that he used only a portion of the Barton Drive home as his personal living area. Neither the lease between TPM and Anthony D’Errico nor the sublease between Mr. D’Errico and TPM identifies certain areas of the Barton Drive home reserved for TPM’s business use. We find that Mr. D’Errico derived a personal benefit from his use of the entire Barton Drive home and received constructive dividend income as a result of the rent payments made by TPM.

Petitioners have also failed to prove TPM’s entitlement to deductions for the airplane expenses. Further, petitioners have failed to introduce evidence to show that Mr. D’Errico did not benefit from TPM’s purchase of the airplane or TPM’s paying for rental of another airplane for Mr. D’Errico to fly. Mr. D’Errico admitted that he “enjoy[ed] flying and everything” and that he used the rented airplane to continue his flight training. Mr. D’Errico also discussed using TPM’s airplane to start a flight training school with his certified flight instructor, Mr. Laughlin. Finally, petitioners failed to substantiate any amount of business travel or lack of Mr. D’Errico’s personal use of the airplane during the years at issue. We find that Mr. D’Errico derived a personal benefit from the airplane expenses paid by TPM and received constructive dividend income as a result.

When an expense of a C corporation is changed to a “constructive dividend” in an audit, the taxpayer loses twice: the corporation loses a deduction, but the taxpayer gets extra dividend income. 

The Moral? Sometimes when taxpayers sell their business, they think it might be a good idea to keep the business around “in case they need it.”  That’s fine, if pointless, but when you don’t have a business any more, you no longer have a reason to claim business expense deductions.  If the corporation pays arguably personal expenses, you run the risk of losing the corporation deduction while boosting your personal tax bill.   That’s true no matter how much you know about taxes.

Cite: D’Errico, T.C. Memo 2012-149.

 

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So is Newt really vindicated?

Thursday, March 1st, 2012 by Joe Kristan

While his presidential campaign seems to be fading, Peter Reilly at Forbes says that at least Newt’s tax return filings are looking better after last week’s decision on S corporation compensation by the Eighth Circuit in the Watson case:

I think Newt is being more than generous to Medicare compared to what the IRS has let Mr. Watson get away with. Of course, the other side of the argument is that the IRS made Mr. Watson pay payroll tax on almost half his total compensation while Newt is at less than 10%. So it depends on whether you want to focus on the percentage or the absolute number.

I don’t think you can focus on either exclusively. You have to look at comparable employees in the business, if any, and what they are paid, as well as the role of capital in the business.
Prior coverage: Eighth Circuit upholds ‘Watson’ decision requiring increased comp for CPA S corporation shareholder

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So what is the right S corporation salary?

Wednesday, February 22nd, 2012 by Joe Kristan

By affirming yesterday that a West Des Moines CPA had to pay FICA taxes on about $91,000 of his earnings from his professional S corporation — instead of the $24,000 he put on his W-2 — the Eighth Circuit helped make the first marks in the big unmapped area of how much compensation S corporations must pay their employee owners.
Income reported on an S corporation K-1 isn’t subject to FICA and Medicare taxes. This tempts S corporation owner-employees to skip the W-2 and take out all of their earnings as S corporation distributions. The IRS naturally doesn’t like that, and they have been successful for some time in attacking S corporations paying zero salary.
The case decided yesterday made a bold challenge to the IRS position. Rather than taking a zero salary, the S corporation shareholder took a $24,000 salary, with the rest of his $200,000 or so earnings from his practice coming out as S corporation distributions. This avoided the 12.4% combined FICA tax and the 2.9% Medicare tax on the difference. The taxpayer argued the $24,000 was all the salary he intended to pay, and that the IRS had no authority in the tax law to upset this intent.
The appeals court declined to accept the taxpayer’s stated intent as decisive:

However, even if intent does control, after evaluating all the evidence, the district court specifically found “Watson’s assertion that DEWPC ‘intended’ to pay Watson a mere $24,000 in compensation for the tax years 2002 and 2003 to be less than credible.” We will not disturb this finding on appeal.

So $24,000 compensation for a CPA whose practice earns $200,000 isn’t “reasonable,” but, at least in this case, $91,000 is. What does that tell an S corporation owner trying to set his compensation?
Colorado CPA Anthony Nitti draws this conclusion:

The IRS is taking a formal, quantitative approach towards determining reasonable compensation, so to adequately advise our clients, we must be prepared to do the same thing.

Roger McEowen adds:

The bottom line is that S corporation salaries must not be set too low in an attempt to avoid payroll taxes. The good news, however, is that

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Year-end tax planning: the closing Built-in Gain Tax window

Wednesday, December 14th, 2011 by Joe Kristan

If you a taxable corporation, the tax law is designed to tax you twice: first when the income is earned, and again when the income is distributed. Taxable “C corporations” used to be able to liquidate to avoide the second test, but the 1986 tax reforms ended that.
S corporations don’t have the double tax problem. Their earnings are taxed directly on their owner returns. Once reportable on the owner 1040 returns, they can be distributed without a second tax. If taxable income is left in the S corporation, it increases the owner basis in the S corporation stock, reducing the gain on sale or liquidation.
So why don’t corporations just make an S corporation election on Form 2553 and liquidate? Wouldn’t the liquidation gain increase your stock basis, allowing an offsetting stock loss?
The “Built-in Gain Tax” is why not. The 1986 reforms enacted a rule saying that when a C coproration becomes an S corporation, any “built-in gains” at the time the election takes effect are subject to a special 35% corporation tax if they are recognized in a taxable transaction — such as a sale or liquidation — in the ten year “recognition period” starting with the first S corporation tax year. The after-tax amount is then taxed on the owner 1040s. The result is similar to a taxable sale by a C corporation followed by a taxable distribution of the after-tax proceeds. Iowa has a similar Built-in Gain Tax.
For 2011 sales only, Congress has reduced the built-in gain “recognition period” to five years. That means an S corporation with an election over five years old can sell built-in gain assets this year without paying the 35% built-in gain tax. But the 10-year period resumes next year.

Example: Abel Farmer made an S election effective January 1, 2005 for AF Farms, Inc. The sole asset of AF Farms, Inc. is 200 acres of farmland with a basis of $40,000 and a value at the date of the S corporation election of $440,000. The land is worth $1,640,000 today. If the land is sold this year, there is no Built-in Gain Tax, because the 5-year recognition period ended December 31, 2009.

If the land is sold next year, a ten-year recognition period applies. The built-in gain is the $400,000 difference between value of the land on the date of the S election and its basis, producing $140,000 in Built-in Gain Tax.
That means there might be a real incentive for closing a built-in gain sale this year. Otherwise the S corporation might have to hold on to the built-in gain property for a few more years to outlast the ten-year recognition period.
We’ll keep running these 2011 year-end tax tips through December 31!

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For want of a QSUB, the shelter was lost

Tuesday, October 11th, 2011 by Joe Kristan

Presidio Advisors, LLC, a boutique firm at the center of the tax shelter industry of the late 1990s, got another spot on its record last week in the Court of Federal Claims. This time, the losers weren’t outside tax shelter investors, but Presidio’s founders.
Presidio put together a basis-shifting shelter that involved transferring assets to “qualified subchapter S subsidiary,” or QSUB. If an S corporation owns 100% of the stock of another corporation, the subsidiary’s activities are included on the S corporation return if the subsidiary makes a “QSUB” election.
Presidio set up a shelter deal where it set up a corporation, PCC, to buy equiment from a foreign corporation for consideration for $11.7 million, including an obligation to close a $12 million short sale on treasury securities. The equipment had a built-in loss of around $11.4 million, based on this value. The organizers contributed the PCC stock to an S corporation called Prevad, owned largely by lead figures in Presidio. PCC was intended to be a QSUB of Prevad.
PCC then contributed the property to Presido Advisors, LLC, which then sold the property for a big loss, which passed through the LLC K-1 to the QSUB and thence to the Prevad S corporation return.
Except for one little problem. The court explains:

In this case, petitioners contend that PCC was a QSub of Prevad, entitling Prevad to treat PCC’s assets as its own, as of the effective date of the election. They further assert that Prevad assumed PCC’s $11,881,813 basis in the latter’s equipment before that equipment was contributed to Presidio on November 8, 1998. The latter must be true if Presidio has any hope to deduct the $10,644,471 loss it claims on Presidio’s subsequent sale of the equipment. In its motion for partial summary judgment, however, respondent argues that Prevad’s election to treat PCC as a QSub was not effective as of November 8, 1998, such that PCC’s allegedly stepped-up basis in its equipment did not carry over to Presidio. It would appear that respondent is right.

Did somebody fail to file a QSUB election? No; it looks more like the shelter organizers were careless in throwing their entities around:

Rather, petitioners admit that Prevad did not become the sole shareholder of PCC until November 6, 1998. Petitioners, moreover, further admit that Prevad did not retain its ownership of PCC, but rather, on the same day, transferred its shares in PCC to Presidio. Accordingly, PCC was not held by a Subchapter S corporation for the entire retroactive period in question and thus failed to qualify as a QSub.

It’s not clear the shelter would have worked if the equipment had been a QSUB on November 8, but it clearly fails once the court decides that it wasn’t. Without an effective QSUB election, the loss is locked in a C corporation with no income of its own.
The Moral? Paperwork matters. If you are basing a big transaction on effective dates of incorporations and tax elections, and you are cutting it close, make very sure that your paperwork has all of the right dates.
Cite: Presidio Advisors LLC, Ct of Federal Claims No. 05-411.

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Tax Court: pledge of stock of one S corporation doesn’t create “at-risk” basis for related S corporation

Wednesday, September 7th, 2011 by Joe Kristan

If you want to deduct losses from your S corporation, you need to clear three hurdles:
- You have to have basis in your S corporation stock or debt from a personal loan to the S corporation;
- The basis has to be “at-risk”; and
- You have to not run afoul of the “passive loss” rules.
A Michigan couple tripped over the first two tests in Tax Court last week, leaving them with a $16 million deficiency. We talked about the basis problems yesterday, so let’s hit the “at-risk” problem.
The taxpayers borrowed money to fund “Alpine,” a money-losing S corporation. They pledged the stock of another S corporation, “RFB,” as security on the loan.
Congress enacted the “at-risk” rules in the Ford administration to shut down that era’s tax shelters. Taxpayers would enter equipment leasing partnerships financed with debt secured by the equipment. If the loan went unpaid, the lender could repossess the equipment, but the partners weren’t personally on the hook. The at-risk rules fought this by saying a pledge of other property “used in the business” does not by itself create at-risk basis. A pledge of personal property not used in the business, in contrast, does make you “at-risk.” While Congress wasn’t willing to let equipment lessors cross-collateralize their lease property to get at-risk basis, it was willing to let taxpayers deduct losses if they put their personal assets on the line.
The Tax Court held that in this case the RFB stock was “property used in the business” because it had business ties to Alpine (citations omitted):

Pledged property must be “unrelated to the business” if it is to be included in the taxpayer’s at-risk amount. The Alpine entities were formed by petitioner to expand RFB’s existing cellular networks. RFB also used some of Alpine’s digital licenses to provide digital service to RFB’s analog network areas. RFB then allocated income from the licenses back to Alpine. The RFB stock is related to the Alpine entities.

The Tax Court held that even if the RFB stock were unrelated, the taxpayers were not really on the hook for the loans in any case.
The at-risk rules are obscure and often overlooked. That can be dangerous. You don’t have to have a business set up as a tax shelter to run into these rules. Any time you have financing where you are not personally on the hook for a loan, except in third-party real estate financing, these rules can bite. Even if you personally liable for a loan, the at-risk rules can still apply if the loan is from a related party, especially a party connected with the business.
Cite: Broz, 137 T.C. No. 5
Related:
Brother-sister S corporations can be bad basis news
S CORPORATION SHAREHOLDER LOSES BASIS APPEAL

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If you no longer own your S corporation shares, you no longer have their basis

Thursday, August 11th, 2011 by Joe Kristan

The key advantage of owning S corporation shares is that you are only taxed once on the business income. If you withdraw your taxable income as a distribution, it is a tax-free return of your basis. If you leave your taxable income in the S corporation, it increases your basis in your shares, reducing your gain or increasing your loss on any eventual sale.
C corporations, in contrast, are taxed twice. The corporation pays tax on the earnings; the shareholder pays tax when the after-tax earnings are distributed or when they are recovered by selling the shares.
There’s one catch: once you no longer own the shares, you no longer have basis. A California shareholder learned this the hard way in Tax Court this week.
The shareholder had 100,000 shares of S corporation stock with a basis of $866,795 — all but $200,000 of which was retained S corporation earnings. In 2002 the shareholder gifted 95,000 of the shares to his son. Under the tax law, a gift recipient steps into the donor’s basis. That left the donor-father with basis of $42,340.
Even so, the S corporation distributed over $600,000 to the taxpayer in 2003, when his remaining 5% stake generated $19,123 taxable income. The math didn’t work.
While the taxpayer didn’t report any income from the $600,000 distribution, the IRS saw it differently. When a distribution exceeds a taxpayers basis, capital gain results. The IRS assessed tax on a $548,664 capital gain.
The Moral? If you give shares away, you can’t act like you still own them. While the tax law has some flexibility to allow “ex-dividend” distributions based on prior share ownership, that’s limited. If your son owns the shares, he gets the basis.
Russ Fox has more.
Cite: Miller, T.C. Memo. 2011-189.

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So I have a K-1 loss. What do I do with it?

Tuesday, April 12th, 2011 by Joe Kristan

Yesterday we discussed how K-1 items carry to different spots on your 1040. If the K-1 has lots of losses, though, you may not be able to use them. There are three restrictions on K-1 losses for most of us:
1. You can’t deduct losses in excess of your basis.
2. Even if you have basis to deduct losses, the basis has to be “at-risk,” and
3. Even if the basis is “at-risk,” losses that are “passive” might be limited.
So how do you know your basis? The K-1 might not be much help — if it’s an S corporation K-1, it’s no help at all. It’s best to track your own basis.

(more…)

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S corporation law firm has to pay FICA taxes on owner, associates

Thursday, March 3rd, 2011 by Joe Kristan

20110303-1.jpgA little Louisiana Hot Sauce can make your scrambled eggs great, but the whole bottle probably ruins them. Using S corporations to reduce employment taxes works something like Louisiana sauce — you can overdo it.
That’s the lesson we learn from a Louisiana law firm’s Tax Court case this week. The Donald G Cave law firm was an S corporation. It filed returns on the basis of having full-time attorney employees, as Tax Court Judge Marvel explains:

Donald Cave considered petitioner an “attorney incubator” because he generally hired recent law school graduates with little prior professional experience.
…
Donald Cave believed it was appropriate for petitioner to treat the associate attorneys and Mr. Matthews as independent contractors because he did not have sufficient control over their work. The record does not disclose, however, the basis on which Donald Cave determined it was appropriate for petitioner to treat the associate attorneys, Mr. Matthews, and himself as independent contractors.

The Tax Court opinion goes through each person that the IRS wanted to treat as an employee, starting with Mr. Cave, the owner:

An officer of a corporation who performs substantial services for the corporation and receives remuneration for such services is an employee for employment tax purposes…
In 2003 and 2004 Donald Cave was petitioner’s president, made virtually all corporate decisions with respect to petitioner, received a percentage of the legal fees recovered in cases he handled, and received draws from petitioner of $48,000 and $360,000 in 2003 and 2004, respectively. These facts tend to establish that Donald Cave was petitioner’s employee within the meaning of section 3121(d)(1).

The case doesn’t indicate whether any earnings passed through on Mr. Cave’s K-1; to the extend they did, he was able to avoid Medicare taxes on that amount.
The judge also decided the associate attorneys were under sufficient control by Mr. Cave that they should be treated as employees.
The Moral? S corporations can reduce professional employment taxes under current law, but don’t overdo it. If you pay yourself no salary, or a token one, you are looking for trouble with the IRS.
Cite: Donald G. Cave a Professional Law Corp, T.C. Memo 2011-48
Related: Court sets ‘reasonable’ comp for Iowa CPA S corporation shareholder
Flickr image courtesy Trucknroll under Creative Commons license

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More on the ‘John Edwards Shelter’

Wednesday, January 26th, 2011 by Joe Kristan

The Smartmoney tax blog has a bit of history on the use of S corporations to reduce employment taxes — the issue in a recent case involving a Des Moines-area CPA.

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Wall Street Journal spotlights area CPA S corporation court loss

Saturday, January 22nd, 2011 by Joe Kristan

Today’s Weekend Wall Street Journal picks up on the case of the local CPA who only paid himself a $24,000 salary on around $200,000 in income from his S corporation. He took the rest through his K-1, avoiding FICA tax on the K-1 amount. The U.S. District Court in Des Moines last month ruled that the CPA had to pay employment taxes on an additional $67,000 for two tax years.
The article says the CPA plans to appeal the decision. It quotes him as saying “The IRS can disallow a tax deduction for unreasonably high compensation, but the law doesn’t give it the authority to raise pay in order to collect extra payroll taxes.” The article adds:

Independent tax expert Robert Willens in New York says this will be a hard argument to win.

The article then goes on to discuss the problems of determining S corporation owner compensation:

What is a fair ratio of profits to pay? There isn’t one answer, experts say. A company with substantial capital or assets, such as a manufacturer, often is able to justify lower pay than one selling personal services like a law or accounting firm. Says Mr. Willens: “I would tell a client that for personal services, 70% would be the absolute floor and might not get the job done,” he says.

I don’t think percentage estimates are that useful. There are many factors that come into play. The argument for paying high compensation would normally be stronger in a professional firm than in a manufacturing or distributive business, because more of the profit would be due to the owners’ work. I don’t think the IRS can force a struggling business to give its owner a raise to make the salary “reasonable.” If you have an absentee owner, or minor children owning interests in a family business, zero can be a reasonable number.
In a professional practice, the place to start is probably the compensation of non-owner professionals. A full-time attorney or CPA owner who gets paid less than the hired help is asking for trouble.
UPDATE, 1/24: The TaxProf has more. The Iowa LLC blog also weighs in.

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Court sets ‘reasonable’ comp for Iowa CPA S corporation shareholder

Thursday, December 30th, 2010 by Joe Kristan

The IRS last week won a battle in the war against S corporation owners who pay less salary — and less FICA and Medicare tax — than the government would wish. A U.S. District Court in Des Moines ruled against a Des Moines-area CPA who took only $24,000 annual salary of his approximately $200,000 in earnings for 2002 and 2003 from his CPA business. The court reclassed $67,044 of his S corporation distributions as salary for each year, giving him FICA/Medicare wages of $91,044.
The IRS hates the use of S corporations to minimize FICA taxes — the so-called “John Edwards Shelter.” S corporations are not taxed on their own income; instead the income is taxed directly on the tax returns of their owners via a K-1 information return. Unlike partnership income, S corporation K-1 earnings are not subject to the 12.4% combined employer-employee FICA tax and the 2.9% Medicare tax, S corporation shareholders try to get away with as low a salary as possible. That’s why every IRS letter accepting an S election includes a stern warning to take an appropriate salary.
This case involved a CPA firm that was apparently set up as a partnership of S corporations, with a separate S corporation for each partner. Each S corporation would pay salary to its shareholder. The judge decided that $24,000 just wasn’t enough (emphasis added):

A reasonable person in [the Taxpayer

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Kansas City attorney gets unwanted review of his tax work

Wednesday, August 11th, 2010 by Joe Kristan

A former Grant Thornton attorney who got his start with Coopers and Lybrand in St. Louis will have to tread carefully in providing tax services. A ruling handed down yesterday forbids A. Blair Stover from organizing three specific tax planning schemes. It also tries to keep him from getting too creative with other plans:

Defendant is enjoined from organizing, establishing, promoting, selling, offering for sale or assisting in any financial or tax related arrangement without submitting, in writing to an IRS designee, a detailed plan explaining the financial or tax arrangement and all steps necessary for the arrangement to be legal under the tax code. No such plan shall be implemented by Defendant or with his assistance unless IRS approval is granted or thirty (30) days have passed since Defendant sought approval.

On the positive side, at least any plans he does offer will be government approved, sort of.
The court shut down three structures based on funneling income through “management fees” to controlled corporations defer or eliminate taxes on the income. The plans, according to the Justice Department, cost the Treasury $100 million. Regarding one such plan, using S corporations with Roth IRAs, the court says:

Defendant’s reasoning is so specious that he should have known it was wrong. An S corporation is a corporation: it is formed just like any other corporation and must satisfy the requirements of other corporations. The only thing that distinguishes an S corporation from any other corporation is that it has taken the election under subchapter S of the Internal Revenue Code.
…
Defendant knew or should have known the Roth/S structure was not viable. Many of the reasons have been stated. The initial flaw was in determining that Roth IRAs could own shares in a subchapter S corporation. Corporations may elect to be treated like a partnership for tax purposes, but the underlying premise is that their income will be taxed. Any structure that allowed income to not be taxed was of dubious validity. Defendant decided not to heed Revenue Ruling 92-73 simply because it was a Revenue Ruling he believed was unworthy of acceptance.

While the court is hard on Mr. Stover, it doesn’t put him out of the tax business. Sometimes state professional regulators step in after judicial findings; it will be interesting to see whether Missouri regulators take any action.
UPDATE: District Court: First Amendment Prohibits Complete Ban on Lawyer-’Huckster’s’ Rendering of Tax Advice (TaxProf Blog)
Cite: U.S. v Stover, USDC-WD-Mo, Case No. 08-6018-CV-SJ-ODS
Justice Department press release.

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You pay the taxes, I’ll keep the income

Friday, July 2nd, 2010 by Joe Kristan

The Iowa Court of Appeals this week said a majority S corporation shareholder had to pay an estate for taxes it paid on corporate income during a buy-sell agreement dispute. I explain in my new post at Iowabiz.com, Shareholders held hostage.

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Will the S corporation tax increase stay dead?

Friday, June 25th, 2010 by Joe Kristan

The “extenders” bill, with its tax increases on small S corporations and private equity, fell three votes short of the 60 needed to move it through the Senate yesterday. The Senate leadership is giving up for now and moving on to other things.
It seems that the S corporation tax increase might have been the deal breaker for Olympia Snowe, the Maine Republican whose opposition sealed the fate of the bill. Tax Analysts reports ($link):

“It certainly could have been different,” Snowe said. Snowe claimed that Democratic leaders had broken a promise to abandon a provision that would impose self-employment payroll taxes on many S corporation shareholders.
…
Snowe has said that she would like to refine the definition of reasonable compensation for shareholders. But she said that the S corporation provision as written was a “broadside attack” on small businesses.

That makes me think that the S corporation tax increase won’t be back this year. Congratulations and thanks are due to all of you who contacted your congresscritters to fight the S corporation tax.
The outlook for private equity is less clear. The increased tax on “carried interests” might have passed if the S corporation provision hadn’t stopped the bill. One private equity manager who I’ve been updating on the bill said this morning that it’s just a matter of time:
Thanks Joe. We have decided to proceed with the sale of _______ for a number of reasons, including the threat of this legislation. I am just going to continue to assume it passes eventually since I believe that the only greater villain in this country than someone who receives income from a carried interest is a Goldman employee who also gets carried interest income.

The rest of the bill might well resurface later this year. There remains plenty of money and influence wanting to push through the 70-odd “temporary” tax breaks in HR 4213, including money for research credits, biodiesel, Nascar and Hollywood. But it clearly is no slam-dunk. For at least a brief golden moment it appears possible that “temporary” tax subsidies will finally become so.
Kay Bell has more. Update: More from the TaxGrrrl.
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