S Corporation essentials for tax pros, part 2

In the last article, I covered some of the basic concepts of an S corporation and the benefits of being taxed as one. Here is more information you should be aware of in order to effectively serve your clients.

Compensation strategies

Shareholder-employees of S corporations typically use two methods for compensation:

1. An employee salary if they perform employee-type functions.
2. Shareholder distributions, which avoid having to withhold taxes and are not subject to self-employment tax.

It’s crucial to strategically structure these strategies to minimize the risk of an audit and optimize tax savings. Proper documentation and finding a balanced approach in determining these amounts are key.

Employee salary

Shareholders (owners) working in the S corporation are deemed employees. Consequently, they must be compensated with a regular salary, with taxes withheld before any distributions are made. The S corporation is obligated to offer fair compensation to its shareholder-employees for their services before allocating non-wage distributions.

According to Section 7436 of the Internal Revenue Code, the IRS can reclassify non-wage distributions (exempt from employment taxes) to wages (subject to employment taxes). This authority is backed by various legal precedents, allowing the IRS to reclassify different forms of payments to shareholder-employees as taxable wage expenses.

Therefore, a reasonable compensation amount must be established and documented. The basis for reasonable compensation is the value of services rendered, irrespective of the company’s profits or losses. For further insights, check out “Navigating reasonable comp for niche-based clients” and “Reasonable comp: Demoting a CEO makes sense.”

One highly recommended tax planning and software resource is RCReports, which helps determine and document reasonable compensation that meets IRS criteria and guidelines. Paul Hamann, author of the two articles above, is with RCReports. Book a 30-minute demo at https://go.rcreports.com/dkk-bookdemo, and if you use promo code DKK100, you will save $100 off a premium subscription.

Shareholder distributions

S corporations are permitted to distribute profits to shareholders tax-free, as long as these distributions do not exceed the shareholder’s investment in the stock (stock basis). Should distributions surpass this threshold, any excess is subject to be taxed as a long-term capital gain.

Important: S corporations still pay tax on the net income of the business; however, it is only subject to federal and state income taxes.

It’s essential to adhere to company bylaws when allocating profits. Distributions from income that have already been taxed are not taxable again, provided the stock basis is sufficient to cover these distributions. However, these distributions should only occur after a reasonable salary (subject to payroll taxes) for any services rendered to the corporation.

Distributions must be aligned with the ownership shares of the corporation. This means that if there are multiple shareholders, the distribution must be divided based on each one’s ownership percentage. Owners of S Corporations should be cautious about uneven distributions. According to IRS rules, distributions that do not reflect ownership proportions could imply the existence of a second class of stock, which is not permissible for S Corporations. Such a scenario could lead to the revocation of S Corporation status, resulting in the business being treated as a C Corporation and potentially taxed at higher corporate rates.

Shareholder loans

A shareholder loan is a debt-like form of financing provided to shareholders or from shareholders. There are two types of shareholder loans when you have an S corporation:

1. Loans to shareholders.
2. Loans from shareholders.

When an owner makes a loan to the business, it is considered a loan from shareholders. In this situation, the owner takes funds from a personal account and deposits them into the business account. Conversely, money that comes from the company to the owner creates an advance or loan that is booked as a loan to shareholders. These transactions could create problems with the IRS if not documented properly.

Debt must meet two requirements to qualify as debt basis:

1. Debt must run directly from the shareholder to the S corporation.
2. The debt must be bona fide.

Whether a debt is bona fide is a facts and circumstances determination, and the weight given to each factor varies depending on the facts of the case. Case law describes factors that include, but are not limited to, whether:

• There is a written instrument.
• There is a stated interest rate.
• There is a maturity date.
• The debt is enforceable under state law.
• Expectation of repayment is reasonable.
• The creditor has remedies upon default (security interest or the position of the lender with respect to other creditors).
• Repayments were made or the parties complied with the terms of the agreement.

Many court cases address what constitutes bona fide indebtedness, and most circuit courts of appeal list factors used in making this determination. In analyzing whether there is bona fide indebtedness, consider the factors used by the circuit court controlling the shareholder’s case.

Loans to shareholders

When a shareholder requires financial assistance and lacks alternative options, a loan from the corporation can be a viable solution. However, corporations frequently provide funds to their shareholders without considering the potential tax implications. Often, these transactions lack formal documentation, established interest rates, or defined repayment plans. This casual approach can result in unforeseen and expensive tax repercussions, especially if subjected to an IRS audit. If there is no formal agreement, then this is most likely a distribution.

Loans from shareholders

To be deemed lawful, loans made by shareholders to the corporation must adhere to all applicable rules and regulations. In the absence of a promissory note and a defined payment schedule, such loans are categorized as open account debts. Direct loans from shareholders to an S corporation play a significant role in tax planning. They offer a debt basis in situations where there is no stock basis, enabling the deduction of losses instead of suspending these losses until the basis is replenished.

Shareholder basis

Shareholders acquire basis through the original purchase of stock, additional equity contributions, and cumulative net income less distributions. In addition, any loans made to the S corporation by a shareholder increases debt basis. It is important to note that distributions reduce stock basis, but do not reduce debt basis. Basis is important because it is the first test to determine if a shareholder has a deductible loss from the company. The fact that a shareholder receives a K-1 reflecting a loss does not mean that the shareholder is automatically entitled to claim the loss.

Stock basis

It is important that a shareholder know their stock basis when:

• The S corporation allocates a loss and/or deduction item to the shareholder. In order for the shareholder to claim a loss, they need to demonstrate they have adequate stock and/or debt basis.
• The S corporation makes a non-dividend distribution to the shareholder. In order for the shareholder to determine whether the distribution is non-taxable, they need to demonstrate they have adequate stock basis.
• The shareholder disposes of their stock. As with any asset, including C corporation stock, when an asset is sold or disposed of, the basis needs to be established in order to reflect the proper gain or loss on the disposition.

Since shareholder stock basis in an S corporation changes every year, it must be computed every year.

Debt basis

Debt basis in an S corporation refers to a shareholder’s investment in the corporation through loans directly made to the company. This concept is crucial because it allows shareholders to claim deductions for their share of the corporation’s losses beyond their stock basis. Essentially, if a shareholder has exhausted their stock basis, the debt basis can provide an additional avenue for deducting losses. The debt basis is increased by direct loans to the corporation and decreased by repayments of those loans.

It’s important to note that only loans made directly from the shareholder to the corporation increase debt basis; loans from third parties, even if guaranteed by a shareholder, do not. Accurate tracking of debt basis is vital for tax purposes, because it impacts the shareholder’s ability to realize tax benefits from the corporation’s losses and dictates the tax treatment of loan repayments.

Basis issues

Although a comprehensive examination of stock and debt basis is not covered in this article, it is an important topic you should become familiar with—and learn to properly serve your clients. While there are several basis issues that could be addressed, here are a few items to be aware of:

• Keeping track of the basis is the shareholder’s responsibility. Nonetheless, as tax professionals, we are aware that clients may not fully grasp this concept. It should be part of our role to manage this on their behalf.
• Distributions and taxation: Distributions to shareholders can have tax implications. If distributions exceed the shareholder’s basis, the excess is taxed as a capital gain.
• Uneven distributions: If the IRS determines that uneven distributions created a second class of stock, the corporation could lose its S corporation status. This change would subject the corporation to the tax rules applicable to C corporations, which could result in higher taxes and double taxation of corporate income.

Understanding basis issues is essential for tax professionals to help S corporation shareholders navigate the tax implications of their investments and activities within the corporation.

Making the election

If you think your client can benefit from making an S corporation election you will need to file Form 2553, Election by a Small Business Corporation, and have it signed by all of the shareholders. This form gives the IRS information about the entity requesting and eligibility for electing this tax treatment. Once the information is complete, the form is mailed or faxed to the IRS; the address varies depending where the principal office of the business is located. Then the waiting begins. The response time is generally within 60 days from the time the IRS receives the application.

Filing form 2553

You will need the following information to help your client file Form 2553:

Part I

• The name and address of the corporation.
• The employer ID (EIN) of the corporation (or LLC).
• The date and state of incorporation.
• Whether the corporation has changed its name or address after applying for S corporation status.
• The tax year for which the election is to be effective. There are several options for selecting a tax year.
• If there are more than 100 shareholders, but your client is treating members of a family as one shareholder to keep the number under 100, there is a box to check.
• The name, address, and phone number of a corporate officer or legal representative who can be contacted for more information.
• If the business is filing the election late, they have the opportunity to claim that they had “reasonable cause” for filing late.
• The final section lists all the shareholders who must consent to the election, with the number or percent of shares owned, date acquired, and tax year of each shareholder. Each shareholder must also sign and date the form.

Part II includes questions about the corporation’s tax year.

Part III relates to Qualified S Trust Elections.

Part IV relates to Late Corporate Classification Election Representations.

Filing deadline

The IRS requires that the Subchapter S Election be filed:

• No more than two months and 15 days after the beginning of the tax year the election is to take effect, or
• At any time during more than two months and 15 days after the beginning of the tax year that the election is to take effect.

For example, if the business starts on Jan. 7, the business must file the election no later than March 15. Failing to file means the business—since it’s referring to the business—will not receive Subchapter S status for that tax year.

Late elections

What happens if your client misses the filing deadline? Revenue Procedure 2013-30 can be the solution to most late S elections and allows the election to be filed within three years and 75 days of the date entered on the Line E of Form 2553 (the original requested effective date).

Note: At the top of the late Form 2553 always write: “FILED PURSUANT TO REV. PROC. 2013-30” when filing a late election.

Resources

As tax professionals, it’s crucial to stay informed and compliant to help clients navigate the complexities of S Corporation taxation, management, and unnecessary tax burdens. I hope these articles serve as a solid foundation on your journey to support your clients. As you continue to dive deeper into the intricacies of S Corporations, remember that this learning path is a stepping stone to becoming a trusted expert who can effectively assist clients in maximizing their benefits while adhering to regulatory requirements.

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