We Are Your S-Corporation CPAs in New York
At MEDOWS CPA, PLLC we have a lot of clients who are S-Corporations. S-Corps have different federal and New York State tax treatments as compared to C-Corporations and unique requirements concerning compensation to officers and the treatment of debt between the corporation and shareholders. We hope this information is useful. As Certified Public Accountants in New York City we are also aware of the unique tax treatment of S-Corps at the state and local level and in particular the treatment by the City of New York. Below is a brief introduction, for further questions, please contact our S-corp CPAs in Manhattan.
S Corporations – Introduction
An S-corporation is a pass-through entity that is treated very much like a partnership for federal income tax purposes. As a result, all income is passed through to your shareholders and taxed at their individual tax rates. However, unlike a C-corporation, an S- corporation’s income is taxable to the shareholders when it is earned whether or not the corporation distributes the income. Because an S corporation has a unique tax structure that directly impacts shareholders, it is important for you to understand the S corporation distribution and loss limitations, as well as how and when items of income and expense are taxed, before developing your overall tax plan.
In addition, some S corporation income and expense items are subject to special rules and separate identification for tax purposes. Examples of separately stated items that could affect a shareholder’s tax liability include charitable contributions, capital gains, Sec. 179 expense deductions, foreign taxes, and net income or loss related to rental real estate activities.
These items, as well as income and losses, are passed through to the shareholder on a pro rata basis, which means that the amount passed through to each shareholder is dependent upon that shareholder’s stock ownership percentage. However, a shareholder’s portion of the losses and deductions may only be used to offset income from other sources to the extent that the total does not exceed the basis of the shareholder’s stock and the basis of any debt owed to the shareholder by the corporation. The S corporation losses and deductions are also subject to the passive-activity rules.
Other key points to consider when developing your comprehensive tax strategy include:
- the availability of the Code Sec. 179 deduction at the corporate and shareholder level;
- reporting requirements for the domestic production activities deduction;
- the tax treatment of fringe benefits;
- below-market loans between shareholders and S corporations; and
- IRS scrutiny of distributions to shareholders who have not received compensation.
S Corporations – Audit Triggers
S corporations remain “king of the entities” among those forms of doing business nationwide. Except for the unincorporated sole proprietorships, the S corporation is the most popular form of small business in the United States. In fact, over the past 15 years, the number of S corporations has quadrupled. That trend has not gone unnoticed by the IRS.
Combine the rising popularity of the S corporation with intense pressure put upon the IRS by Congressional leaders to close the “tax gap” (the difference between what is owed and what is collected) and the perfect storm for more IRS audits has developed. A recent report on the tax gap by the IRS, attributes a significant portion to 80 percent of it on small businesses. According to the IRS, some S corporations have “pushed the envelope” with aggressive tax strategies.
The IRS has reported that audits of S corporations have increased in recent years. The IRS has begun to place more emphasis on the growing area of flow-through entities, “a source of potential noncompliance.”
The IRS is also looking closely at S corporation compensation practices. In particular, auditors’ eyebrows are being raised if salaries paid by an S corporation to its principal owner or owners look suspiciously low. One scenario involves a technique in which the S owner/employee draws a low salary to avoid employment taxes that ordinarily would be due on additional wages but would escape tax if passed through as dividends. A review of W-2 income and total distributions received by the S corporation owner-employee during the year may be in order for many businesses.
Taking High Compensation Without Dividend Danger
As the owner of a closely held C corporation, you know that your company’s earnings are theoretically exposed to a double tax. Earnings are first taxed to the corporation and those that are distributed to you as dividends are taxed on your individual income tax return, without the company getting a deduction for the payments.
On the other hand, the company can deduct the salary it pays you. While you have to pay tax on the salary, unlike dividends, salary is taxed only once. And while dividend income is taxed as net capital gains rates (at a maximum 20 percent rate if all income exceeds a $457,600 threshold for joint filers, $406,750 for single individuals), that is an additional 15 or 20 percent that you may not otherwise have to pay with proper compensation planning. What’s more, dividend income is also subject to the 3.8 percent Net Investment Income (NII) surtax if an individual’s overall income exceeds a $200,000/$250,000 level.
Does this mean that the double tax can be avoided simply by increasing your salary rather than by paying dividends? No, there are two potential problems with that approach. First, the company can only deduct reasonable compensation. Second, if compensation is set at the high end of the scale and is later found to be unreasonable, the IRS can charge the owner with a constructive dividend on the unreasonable portion of the compensation.
What then can be done? Proper planning can maximize the amount of compensation the company can pay in a way that will increase its chances of being able to withstand an IRS challenge.
The basic test of reasonableness, as applied by the IRS and many courts, is whether the amount paid is analogous to that paid by employers in like businesses to equally qualified employees for similar services. In this respect, the total compensation package is examined including contributions to retirement plans and other employee benefits.
As a result, a showing of special skills may help to justify reasonableness. It also can be helpful if the individual performs different roles for the company (for example, chief executive officer and designer of a new product).
Another possible approach may be to set up a portion of an owner’s compensation to be paid as bonuses if profits meet certain levels. While the IRS has attacked such contingent compensation arrangements in family companies, some courts have upheld them where the agreement was set up when the business was started or when the amount of the future earnings was questionable, and the agreement was consistently followed during the ups and downs of the business.
Few businesses start out with the owners able or willing to pay themselves what they are really worth. Even after the business is successful, periods of economic slowdown, may force belt tightening. It is in these situations that an owner may have an opportunity to enter into a formal contract with the company calling for a share of the profits as added compensation when things improve.
If this is done it’s important to include in the corporate minutes the record showing that the owner was underpaid at the time the agreement was entered into. The minutes also should show that the contingent payment out of future profits is merely intended to provide an incentive for the owner to put forth his best efforts to build the business and to make up for the periods of underpayment.
Attention to such details when planning compensation arrangements should help the owner fend off or blunt future attacks on compensation when the business proves highly successful and substantial compensation is paid under the agreement. For more information, feel free to contact the NYC Certified Public Accountants at MEDOWS CPA, PLLC.
Pros and Cons of S-Corporations
There are several advantages and disadvantages of the S corporation form. Especially popular among small businesses, the number of S-corporations has quadrupled in the past 15 years and, hands down, is the most common form of doing business except for the unincorporated sole proprietorship. While its popularity indicates that consideration of operating your business as an S corporation is certainly wise, “going with the crowd” is not always the best choice. What is right for your business and your unique circumstances should control what action you take. For more information, feel free to contact the NYC S-Corp CPAs at MEDOWS CPA, PLLC.
Some of the advantages of operating a business as an S corporation are:
- Your personal assets will not be at risk because of the activities or liabilities of the S-corporation (unless, of course, you pledge assets or personally guarantee the corporation’s debt).
- Your S-corporation generally will not have to pay corporate level income tax. Instead, the corporation’s gains, losses, deductions, and credits are passed through to you and any other shareholders, and are claimed on your individual returns. The fact that losses can be claimed on the shareholders’ individual returns (subject to what are known as the passive loss limits — S-corps pay tax at the highest corporate rate on their excess passive income) can be a big advantage over regular corporations. Liquidating distributions generally also are subject to only one level.
- The S-corporation has no corporate alternative minimum tax (AMT) liability (however, corporate items passed through to you may affect your individual AMT liability).
- FICA tax is not owed on the regular business earnings of the corporation, only on salaries paid to employees. This is a potential advantage over sole proprietorships, partnerships, and limited liability companies.
- The S-corporation is not subject to the so-called accumulated earnings tax that applies to regular corporations that do not distribute their earnings and have no plan for their use by the corporation. Nor because of their pass-through nature do they risk being characterized as a personal holding company.
Some of the disadvantages are:
- S-corporations cannot have more than 100 shareholders (but with husband and wife being considered as only one shareholder). Further, no shareholder may be a nonresident alien.
- Corporations, nonresident aliens, and most estates and trusts cannot be S corporation shareholders. Electing small business trusts, however, can be shareholders, a distinct estate planning advantage.
- S-corporations may not own subsidiaries, which can make expansion difficult, unless the subsidiary is a Qualified Subchapter S Subsidiary (a 100% owned S corporation or QSub); and termination of the QSub’s status can be treated as a sale of assets.
- S-corporations can have only one class of stock (although differences in voting rights are permitted). This severely limits how income and losses of the corporation can be allocated among shareholders. It also can impair the corporation’s ability to raise capital. However, the Small Business and Work Opportunity Tax Act of 2007 eliminated the treatment of bank director stock as a second class of stock.
- A shareholder’s basis in the corporation does not include any of the corporation’s debt, even if the shareholder has personally guaranteed it. This has the effect of limiting the amount of losses that can be passed through. It is a disadvantage compared to partnerships and limited liability companies, and is one of the main reasons that those forms are usually used for real estate ventures and other highly-leveraged enterprises.
- S-corporation shareholder-employees with more than a 2-percent ownership interest are not entitled to most tax-favored fringe benefits that are available to employees or regular corporations.
- S corporations generally must operate on a calendar year.
- An S-corporation may be liable for a tax on its built-in gains, if, among other things, it was a C corporation prior to making its S corporation election. Under the American Recovery and Reinvestment Act of 2009, no tax will be imposed on an S corporation’s net recognized built-in gain if the seventh tax year in the 10-year recognition period preceded the tax year for a tax year in 2009 or 2010. Under the Small Business Jobs Act of 2010, Congress shortened the holding period even further, to five years, in the case of any tax year beginning in 2011, if the fifth year in the recognition period precedes the tax year beginning in 2011. The American Taxpayer Relief Act of 2012 extended the five-year holding period requirement through the end of 2013.
Fact Sheet on Wage Compensation for S-Corporation Officers
An S-corporation is a pass-through entity that is treated very much like a partnership for federal income tax purposes. As a result, all income is passed through to the shareholders and taxed at their individual tax rates.
However, the nature of the shareholders’ income is subject to IRS scrutiny, especially if they provide more than minor services to the corporation. Shareholders who receive or are entitled to receive payment are considered employees whose compensation is subject to federal employment taxes. This becomes problematic if shareholders have not received “reasonable compensation” for services rendered to the corporation, but have received significant corporate distributions of cash and property, or loans.
There are numerous factors that are considered when determining “reasonable compensation,” including time and effort devoted to the business, duties and responsibilities, training and experience, payments to non-shareholder employees, and what comparable businesses pay for similar services. For more info, contact a NYC CPA at MEDOWS CPA, PLLC today.
Open Account Debt between S Corporations and Their Shareholders
Final regulations have been released regarding the treatment of open account debt between S-corporations and their shareholders. The regulations provide rules regarding the definition of open account debt, and adjustments in basis of any indebtedness of an S corporation to a shareholder for shareholder advances and repayments of loans to the S-corporation. Since you have outstanding loans from your shareholders, you may be interested in the tax impact of these regulations.
In general, if a shareholder’s basis in a debt owed to him or her by an S corporation has been reduced by pass-through losses from the S-corporation, gain must be recognized by the shareholder if the corporation pays down the debt. The repayment of open account debt may result in ordinary income.
Regulations were originally proposed in response to a court ruling in which advances of open account debt by taxpayers to their closely held S-corporations provided the taxpayers with basis to offset repayments of open account debt made by the corporation prior to each advance. Because the multiple advances by the taxpayers and repayments by the S-corporations were treated as open account indebtedness, they were treated as a single indebtedness rather than separate indebtedness. The basis of the indebtedness was, therefore, computed by netting the advances and repayments at the close of the year. As a result, by restoring the basis in their debts, the advances that the taxpayers made to the S-corporations shielded them from the realization of gain on debt repayments.
Under final regulations, open account debt cannot exceed $25,000 per shareholder at the close of the year. For example, an S-corporation with ten shareholders could have up to $250,000 of open account debt as long as no single shareholder advances more than $25,000. If the balance of the indebtedness at the end of the year exceeds $25,000 for a shareholder, the entire amount is no longer considered open account debt and the shareholder may have to report income on repayments.
These regulations are important to your shareholders if their basis in their open account debt is reduced for prior pass-through losses.
Please feel free to contact the Manhattan S-corp CPAs at MEDOWS CPA, PLLC regarding the tax and accounting for your S-Corporation in New York.