Posted by Courtney Kopec, CPA
Utilizing the tax advantages of the S Corp for closely-held businesses run by self-employed shareholder-owners requires attention to some basic rules, planning, and documentation so that the transfer of money between the shareholder and corporation is reported correctly. The potential alternative is a costly lesson when the IRS sends a notice to reclass shareholder transactions as wages subject to income and payroll (Social Security and Medicare) tax. Past GAO and IRS studies found $91 billion of misreported income per year by pass-through entities. Unsurprisingly, the majority of errors were beneficial to the shareholders due to their basis of reporting. The IRS is now stepping up its audit efforts of pass-through entities, particularly S corps. Knowing your shareholder basis and having a discussion with your accountant will enable you to make better financial decisions and benefit from tax savings.
C corp earnings are taxed twice, when earned and then when distributed to the shareholder, but S corp earnings only once. The S corp shareholder is required to adjust and keep track of basis in the S Corp to preserve the single level of taxation benefit. What can happen? When a shareholder takes a distribution, but has no basis, it is treated as a gain. Passive losses and payment of personal expenses may decrease shareholder basis in their S corp stock and loans to zero and cause subsequent “loan repayment” to be taxable as ordinary income. (See TC Memo 2016-161.)
When businesses need cash to operate and owners put money into the business, the decision of classification as a shareholder loan or capital contribution has future tax implications. If a shareholder intends a loan classification, the cash infusion should be acknowledged with a written document describing a schedule of principal and interest payments.
Corporations pay employees for the performance of its services. The payment of reasonable compensation that is subject to income and payroll taxes is evidence that the shareholder-employee relationship is at arm’s length and avoids self-dealing. There are no payroll taxes on the pass-through income that flows from the Form K-1 and so in the absence of a reasonable wage to shareholders in an IRS examination, the auditor is analyzing the treatment of shareholder distributions seeking to reclassify them as wages. By taking salary, a shareholder employee can limit tax exposure by contributing to a pension, a benefit not otherwise available.
When a corporation pays for employee personal expenses, the expenses are generally considered fringe benefits or wage subject to income and payroll tax. Payments of a shareholder’s personal expenses are often netted against a shareholder loan to the corporation. However, if the loan is not formalized, it may be considered an open account that an IRS audit can reclassify as compensation and subject to income and payroll taxes. Personal expense distributions among shareholders of an S corp must be proportional to the ownership percentages or the distributions violate the S corp rules that mandate one class of stock. Get caught, and S corp status could be revoked and result in a most onerous IRS reclassification.
Careless regard for the basics can prove costly when the taxman cometh. Ask your accountant to calculate your S corp stock and loan basis so you can confidently understand and manage the IRS classification of your distributions. Financial projections show how to best classify and contemporaneously document the transfer of money to shareholders to substantiate the tax positions reported on the tax return. Reach out to your trusted advisor so you will know your basis – not just think you know.
Courtney Kopec, CPA is a tax senior in REM's New York City office.