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What’s the “Right Amount” of Compensation for an S Corporation Shareholder/Employee?

The S corporation has been used by small business owners to avoid payroll taxes, and the IRS knows it. In fact, there is a compliance initiative underway to find as many of those abusive situations as possible and assess appropriate payroll taxes. Here is a case that describes how a CPA got into trouble with his own S corporation, how he got out, and how you can avoid the mistakes he made.

An unpublished opinion of the U.S. Tax Court provides an important insight into the issue of “reasonable compensation” when considering a defensible minimum amount for an S corporation shareholder/employee. Many tax advisors agree that you can use this opinion as reliable guidance (even though it is not binding precedent) when planning such compensation. Here’s a brief summary of the relevant facts and the Court’s decision.

Wiley Barron, a CPA, formed an S corporation to practice public accounting in Arkansas. The S corporation made substantial distributions of profits to him, but treated only $2,000 — in one quarter during a three-year period — as compensation subject to employment taxes. The S corporation was examined for payroll tax compliance by an IRS “officer/examiner” specially trained to deal with worker classification and payroll tax issues. She assessed payroll tax deficiencies to account for reasonable compensation and Wiley appealed to the U.S. Tax Court, where he represented himself under the Court’s small case procedures.

In its opinion, the Tax Court said that Wiley “was the individual who was solely responsible for making management decisions and for controlling every facet of (his) business.” He was the only CPA employed by the corporation, he worked at it nearly full time, but he didn’t pay himself a salary. Since the general rule is that a corporate officer is an employee [See Internal Revenue Code Section 3121(d)], it’s fairly obvious that Mr. Barron was using his S corporation to avoid employment tax on his compensation: in this case, all or part of the S corporation’s earnings which were distributed to him.

Mr. Barron is certainly not the first small business owner to use an S corporation to avoid payroll taxes on his income, and the IRS has aggressively pursued many of them. Until now, the position of the IRS had been — and the Courts had generally agreed — that the entire amount of S corporation distributions should be reclassified as compensation.

But the outcome of this particular case is unique and offers guidance for establishing reasonable compensation at less than total distributions from the S corporation. The Tax Court agreed with the revenue officer/examiner’s proposed adjustments, which were based on information from Robert Half Associates regarding what “reasonable compensation” for a CPA of Mr. Barron’s training and experience would be in the area of Arkansas where he practiced. That “reasonable compensation” was in the range of $45,000 to $49,000 for the years in dispute. Even though the S corporation had distributed from $56,000 to $83,000 in those years, only the amount of “reasonable compensation” based on the reliable comparable data was recharacterized as compensation and subjected to Social Security and Medicare taxes.

You do not have to live with uncertainty on this issue. We can help you determine reasonable compensation levels for S corporation shareholder/employees. We have full access to reliable comparable data and a complete library of federal tax reference material. Please call us to schedule an appointment.

Choosing The Right Type of Business Entity

Choosing The Right Type of Business Entity is an Important Decision

If you are forming a small business, you face several choices: Sole Proprietorship, Partnership, C-corporation, S-corporation, Limited Liability Partnership and Limited Liability Company. Here are the basics.

When you start a business, you have many choices to make. One key decision is choosing the form of business entity in which you will operate. For starters, you can set up your business as a Sole Proprietorship, C-Corporation, S-Corporation, LLP (Limited Liability Partnership), or an LLC (Limited Liability Company).

How can you narrow that list down? Small businesses typically decide against a C-Corporation, because C-Corps generate two levels of federal income tax. The C-Corporation pays one level of tax when it files its federal corporate tax return, Form 1120. A second layer of tax is imposed when the C-Corporation’s profits are distributed to the shareholders as dividends. Those dividends are reported and taxed on the individual’s federal tax return, Form 1040. Together, these two levels of taxes are referred to as “double taxation.” State income taxes may also apply to both C-Corporation profits and distributed dividends. Overall, the tax picture for C-Corps is far from ideal for small businesses. Even the current 15% tax rate on dividends does not completely do away with the disadvantages of double taxation.

Doing business as a sole proprietor eliminates the double taxation curse. There are no corporate taxes to pay, and you only pay individual taxes on your net profits, typically reported on Form 1040, Schedule C. However, as a sole proprietor, you lack the legal protection that corporate status gives you. Owners of corporations enjoy limited liability, but sole proprietors do not. Simply stated, if you’re a sole-proprietor, your personal assets are at risk if the business is sued—very risky indeed!

That leaves LLCs, LLPs, and S-Corporations. LLPs and LLCs are similar in many ways. One key difference is that LLPs must be owned by more than one individual. Remember, the “P” in LLP stands for partnership, and so by definition a single individual can’t own a partnership. So if you had an LLP with two owners and one died, serious problems that might even cause the business to close could result.

The choice quickly narrows to an LLC or an S-Corporation. Which is more appropriate for your business?

Well, they are both “pass-through” entities that allow you to avoid double taxation, operating a business without paying corporate taxes. Net profits are reported by the owners in their individual tax returns, and both also offer protection from unlimited liability. Your liability will be limited to your investment in either entity.

When choosing between an S-Corporation and an LLC you need to consider many things. What may be appropriate under one set of circumstances may not be in another. Every business is different, and every owner has different needs and expectations. Let’s review the attributes of each type of entity to help you decide.

THE S CORPORATION

Created in 1958, the S Corporation was, for many years, the standard form of organization for conducting a small business. S Corporation status provides a way for you to avoid the double taxation imposed upon C Corporations and their shareholders. One advantage of the S Corporation is that income is taxed personally to the shareholders. However, your personal risk remains limited to your investment. In other words, double taxation is avoided and you get the protection of limited liability.

Your corporation chooses “S-Status” by filing a special election, Form 2553. Bear in mind that the “S” status of the Corporation only impacts taxes. Shareholders of S Corporations have all of the same legal protections as those in C Corporations. But as once said by a famous Tax Court judge, “A corporation is like a lobster pot. It’s easy to get into…difficult to get out of.” In other words, once you have established an S Corporation, it would first have to be liquidated if you wanted to change to an LLC, and liquidation of a corporation can result in taxable gains to the shareholders.

THE LIMITED LIABILITY COMPANY (LLC)

LLCs started in 1977 in Wyoming and have quickly become a popular form of business entity across the country. By default, LLCs with more than one owner (member) are taxed as partnerships, while single-member LLCs are taxed as sole proprietorships. As with S corporations, with an LLC you only pay taxes with your personal return. However, if you decide to do business as an LLC, you are not stuck with it. Simply by filing a Form 2553 at the appropriate time, an LLC can become an S Corporation without having to liquidate. There is little risk of triggering a tax by changing from this form of doing business.

SETTING UP SHOP

Establishing an S corporation is relatively simple and inexpensive. An attorney or even you yourself can form a corporation by completing a series of “boilerplate” documents. These forms require you to complete the following information: who will own the business, the business’s activity and address, and other miscellaneous details. Aside from being registered as an “Inc., Co. or Corp.”, a corporation can also be registered as P.C. (Professional Corporation). This designation is for professionals who choose to operate in corporate form and is popular with doctors, lawyers, and accountants.

An LLC requires a bit more work to get started. Articles of Organization to be filed with the state and an Operating Agreement (like a Partnership Agreement) should be drafted by a lawyer. In addition, business information about the LLC must be placed in a published ad to give notice to the public that the company is being started. An LLC can choose to be registered as a P.L.L.C. (Professional Limited Liability Company) when its owners are licensed by the state to engage in a professional practice — doctors, lawyers, accountants, etc.

DISTINGUISHING CHARACTERISTICS

An S Corporation might be more restrictive than an LLC. There can’t be more than 100 shareholders in an S Corporation. In addition, only individuals, estates, and qualifying trusts are permitted shareholders. An S Corporation may not have any non-resident alien shareholders. There can only be one class of stock ownership. Adding a second category or class of ownership terminates the “S” Election, which could lead to unintended and unexpected tax consequences. The income and expenses from an S Corporation are allocated on a per-share/per-day basis. Your business’s net income, after paying you a reasonable salary, would not be subject to self-employment taxes on your individual return.

The amount of your investment in the S Corporation — your cost basis — includes:

1) Your contributions of cash and property
2) Your share of S corporation profits not distributed to you
3) Loans made directly to the Corporation by you

This “basis” calculation is important because it is your tax cost. The more you have invested, the more “write-offs” you can claim when there are losses.

LLCs offer more flexibility than S Corporations. They can have an unlimited number of owners and any person, business, or trust can be a member or owner. With an LLC you can choose to allocate particular types of income and expenses among owners. Doing this can get pretty complicated, so be sure to speak with us about “special allocations.” On the negative side, the status of the business’s net income as subject to self-employment taxes is unclear. Current thinking is that reasonable compensation should be paid in the form of guaranteed payments, subject to SE tax, with the balance of income — attributable to capital or the work of employees — not subject to SE tax.

Your basis (tax cost) in an LLC includes:

1) Your contributions of cash and property
2) Your share of LLC profits not distributed to you
3) Your share of the LLCs debts to others. (In an LLC, loans to the company can increase your tax basis if you are personally liable for them. In an S corporation, only your direct loans to the company can increase your tax basis.)

LLCs provide more ways to increase your tax basis. This illustrates a significant advantage of LLCs over S Corporations. Because of the way these calculations are done, your cost basis may be higher for an investment in an LLC than if you set up shop as an S Corporation.

CONCLUSION

Many businesses should probably start as an LLC. Advantages include flexibility of ownership, ability to gain tax basis from liabilities, and pass-through of profits and losses. If a corporate entity is determined to be required later, the change from LLC to corporation is quick and generally tax-free.

Dangers in Shareholder Loans…

Dangers in Shareholder Loans Continue

Loans between shareholders and closely held corporations are subject to special tax scrutiny and if not properly documented, can produce adverse tax results.

Loans from corporations to shareholders are the subject of an IRS Audit Technique Guide that stresses the possibility of treating them as distributions and therefore taxable as dividends. The IRS also continues to vigorously litigate the status of losses from shareholder loans to closely held corporations that turn out to be uncollectible. Either way, loans from or loans to, these arrangements must meet certain minimum standards. Here’s a list of the most important ones.

– Loans must be evidenced by a written unconditional promise to pay.
– Loans must be due on demand or on a stated due date.
– A rate of interest must be stated or determinable by reference to a published rate.
– The borrower must be creditworthy.
– Payments of principal and interest must be commercially reasonable (payments,
not made for years, while interest accrues, do not meet the standard).
– A source of repayment other than future income should be clearly identified and a
collateral interest established.

Protecting the classification of a loan can mean the difference between ordinary loss and capital loss treatment when a shareholder loan to a corporation cannot be repaid. Going the other way, payments to a shareholder that are not well documented as loans can be reclassified by the IRS as distributions — taxable dividends or distributions in excess of basis taxable as capital gains. Either way, these are bad outcomes for the individual shareholder.

Now is the time to clean up loan documentation and start making regular payments of principal and interest. In some cases, it may be advisable to borrow from a bank and pay off shareholder loans for a period of two or three months. That would be good evidence that the amount was a bona fide loan and that the shareholder is creditworthy.

We can assist you with proper loan documentation and can help you protect your transactions from IRS attack. Call for an appointment to discuss the specifics of your shareholder loans.

of Business Entity is an Important Decision

The Home Office Deduction…

The Home Office Deduction: Know the Do’s and Don’ts

Tax rules regarding the home office deduction have changed a lot over the years.

The law allows consultants, salespeople, and other self-employed workers to deduct home office expenses. So — are you permitted to deduct home office expenses if you do your administrative or management work at home and have no other office, even though you provide services or see customers away from the home office? As usual the answer is: “It depends.”

The deduction is permitted if you:

1 – use a portion of your dwelling exclusively as your principal place of business on a regular basis;
2 – use a portion of your dwelling to perform important business functions for which no other space is available;
3 – use a portion of your dwelling exclusively as a place of business to meet with patients, clients, or customers;
4 – use a separate structure – not attached to the dwelling – exclusively in connection with your trade or business; or
5 – engage in the trade or business of selling products and regularly use a portion of your dwelling to store products or samples.

The deduction is claimed by including a Form 8829 in your Individual Income Tax Return. Whether you claim depreciation or not, you must still file the Form 8829 to claim any portion of residential taxes, utilities, insurance, etc., as trade or business expenses.

Internal Revenue Code Section 280A(e)(6) does not permit deductions related to rental of a portion of an employee’s residence to her or his employer. That limitation effectively blocks deductions (other than taxes and mortgage interest that are deductible anyway) for renting part of your home to your S corporation.

We can explain the details of these rules. We know what documentation you need and how to prepare the Form 8829 to claim this important tax benefit. Just give us a call.