TAX STRATEGIES FOR "S" CORPORATIONS AND THEIR OWNERS
Don't get set out to sea in a rubber raft by making a tax-mistake with your "S" corporation
You knew you needed to incorporate your business for the “liability protection” that corporation can afford to owners; and you knew you needed to be an “S” corporation because they didn’t pay any Federal (and only a small amount of state) tax. You signed the election papers when you incorporated and that is what you know about the “S” thing you elected. But I need to let you know that there may be some bad news comin-round the corner! The IRS has put an emphasis on examining “S” corporations that may be operating in a dangerous manner. Dangerous that is, in the tax sense. Here is why the government is looking closely at “S” corporations. In a January 2010 study by the Government Accountability Office, 68% of “S” corporation returns filed for tax years 2003 and 2004 misreported at least one item! So as far as audit bait goes, it looks to the IRS that auditing an “S” corporation is going to be a sure money-maker.
Is there anything you can do to limit your exposure to IRS audits on your “S” corporation? Fortunately the answer is yes. What follows are a couple of suggestions that will go a long way towards reducing your exposure to IRS audits and, as important, if you get audited, give you some protection against negative IRS assertions. A note before you begin: you need to do these things NOW not when you get a notice of an IRS audit...now!
1. Pay yourself a “reasonable” salary: The election that you signed to become an “S” corporation is one where the corporation effectively elects to be taxed as a partnership. In that tax scheme the owners (partners) are taxed on their proportionate share of the business income. The owners also receive their proportionate share of all the tax attributes that the business generates and reports them on their individual income tax return.
The “S” corporation can generally distribute the earnings of the business through to the shareholders in proportion to their ownership with no tax consequence. This is a wonderful tool and it is where a lot of “S” corporation owners get tripped up. You see as a corporation the shareholder who works in the business is expected to take a salary and report it as compensation; the corporation will report this compensation on a W-2 at the end of the calendar year along with reporting all of the other employees’ compensation. Of course the salary reported by the shareholder/employee is a business deduction which reduces the business net income which, in turn, reduces the amount of income passed through the “S” corporation to the shareholders. So the income reported by the shareholders is identical, one way or the other, with or without the W-2.
The big deal is, however, if the shareholder/employee does not receive a “reasonable” salary then there is no Social Security of Medicare paid into those programs and the government is losing revenue as a result. What the IRS audit will do if the shareholder/employee doesn’t take a “reasonable” salary is recommend that any distributions that are made be recharacterized as W-2 compensation and not a pass-through of income as the distribution would have been recorded originally.
Throughout this explanation you notice that the word reasonable is in quotes. The reason is because what a reasonable salary would be is somewhat subjective and if you look at the issue ahead of time you will be able to show the auditor that you have taken a salary as required and that the salary is reasonable. That could give the auditor no room to roam and that is good for your result.
2. Keep business and personal items separated: This is also an important aspect of an “S” corporation. If a reasonable person can look at the transactions you execute in the corporation and conclude that the corporation is nothing more than a sham, then you may have lost the liability protection you desired upon incorporation. Also, since we are thinking about IRS audits, if on audit the auditor finds personal items going through the books they will be reclassified as either distributions to you or as compensation. Neither reclassification will be good for you so it is best to keep your personal items personal and your business expenses business. Don’t co-mingle the two!
3. Document all shareholder loans: If a shareholder makes a loan to the “S” corporation the terms of the loan need to be documented. The terms include the amount of the loan, how long the loan will be open (or how long until the Corporation must repay the loan), the interest rate on the loan and the required payments. The interest rate should be at a minimum the Applicable Federal Rate for the date of the loan based on the term of the loan.
4. Keep Track of your own basis: Your basis in your “S” corporation stock determines the limit of corporation losses that you can deduct on your individual income tax return. Basis also determines the upper limit for the amount of tax-free distributions that you can receive from the “S” corporation. And, finally, when all is said and done and you sell your “S” corporation stock, your basis is what will be used to determine the amount of gain or loss you will report on your individual income tax return.
Do you have any questions about your "S" corporation? Contact us and so can discuss them. There is never any obligation or fee for the initial contact.