S corporations Alliot Group conference

S CorporationsUpdate & Issues

Tom Norton, CPAWilliams Overman Pierce LLPRaleigh, NC

S Corp changes

◦ Not many specific to S Corps◦ 2010 K-1 appears to be no changes form 2009

Common Issues & Problems with S Corps

Agenda

User fees for requesting a letter ruling to waive the effect of an invalid S election

User Fee If S Corp’s Gross Income is

$625 less than $250,000 $2,000 > $250,000 and < $1,000,000 $14,000 $1,000,000 or more

Rev. Proc. 2010-1

Section 1374(d)(7) – somewhat reduced stress and impact of Sec. 1374 for 2009 and 2010 and 2011

Built-in Gain Tax Holiday

Pre-SBJA holding period is reduced where the 7th taxable year in the holding period preceded the taxable year beginning in 2009 or 2010

SBJA temporarily shortens the holding period of assets subject to the built-in gains tax to 5 years if the 5th taxable year in the holding period precedes the taxable year beginning in 2011

S Corporation Built-in Gain Holding Period

The result is a 7-year holding period for 2009 and 2010

5-year holding period for 2011 – applies to any conversion made in 2006 or before

Tip to clients –Consider selling in 2011 any BIG asset if elected prior to 2007

Absent further law changes – will revert back to 10 year period in 2012.

S Corporation Built-in Gain Holding Period - Continued

Shareholder’s basis is reduced by the amount of contribution flowing through to the shareholder

Contributions made before Jan 1, 2010 – basis is reduced by the shareholder’s pro rata share of the adjusted basis of the contributed property

Contributions after Dec 31, 2009 – basis is reduced by the shareholder’s pro rata share of the fair market value of the contributed property

Basis Adjustment for Non-cash Charitable Contributions

Reg-153340-09

Eliminates rules for using paper-based federal tax deposit coupons

Tax payments include estimated taxes, income taxes, excise, payroll, and withholding taxes

Proposed regs do not change existing rules for monthly v. semiweekly depositors

Proposed Regulation for EFT

If S Corp uses payroll service – they may not be signed up for EFTPS

If know may be subject to BIG tax – may have to sign up for EFTPS prior to March 15 to avoid incorrect deposit penalty.

BIG Tax Use EFTPS?

$195 per month per shareholder ◦ Max of 12 months◦ 1 shareholder = 12 x 195 = $2,340

Can be abated for reasonable cause

Any luck on getting penalties waived other than reasonable cause?◦ Can we use Rev. Proc. 84-35? – used by small

partnerships (small partnership all partners file on time reporting income from partnership)

Failure to File Penalties

The AICPA has proposed to the IRS a procedure similar to Rev Proc 84-35

  The penalty imposed by section 6699 may be abated if

reasonable cause can be shown.   We are requesting that the Service consider allowing reasonable cause to be deemed automatic if certain requirements are met.   Those requirements include the following:

  ◦ The S corporation must be composed of ten or fewer shareholders; ◦ the S corporation must have no tax liability due at the entity level; and ◦ all shareholders must have included all items of income, deductions

and credits from the S corporation on their own timely-filed personal income tax returns

AICPA Proposed Revenue Procedure

Preliminary results of National Research Program on S Corps which audited 1,200 for tax year 2003 and 3,700 for 2004 showed:◦ 12% underreporting for 2003 and 16% for 2004◦ Small S Corps (< $200,000 in assets) had

higher percentages of underreporting than large S Corps

Has S- Corp Audit Activity Increased?

Audit Possibilities?

2,000 returns per year for 2010-2012 focusing on employment status◦ Employee v. independent contractor◦ Reasonable compensation◦ S Corp distributions v. salary◦ Matching taxpayer identification numbers

Of the 2,000 returns, 1,500 from Small Business/Self-Employed division

Audit Possibilities? Payroll

S Corporations must only have one class of stock

Distribution differences in timing and/or amount are to could be viewed as a second class of stock

Avoid making disproportionate large distributions to a shareholder on an ongoing basis

A systematic pattern of distributions should be avoided

Should be corrected as soon as possible (loans – “catch-up” distributions)

Disproportionate Distributions

IRS requires that compensation is “reasonable”

There is no rigid set of rules for measuring the reasonableness of compensation – no definition of “reasonable” is contained in the Code

No single factor controls, but rather a combination of factors must be considered

Reasonable Officer Compensation

1. the character and financial condition of the corporation;

2. the role the shareholder plays in the corporation, including the employee's position, hours worked, and duties performed;

3. the corporation's compensation policy for all employees and the shareholder's individual salary history including the corporation's internal consistency in establishing the shareholder's salary;

4. how the compensation compares with similarly situated employees of similar companies;

5. conflicts of interest in setting compensation levels; and

Reasonable Compensation Factors IRS Considers

6. whether a hypothetical independent investor would conclude that there is an adequate return on investment after considering the shareholder's compensation.

7. the employee's qualifications;

8. the size and complexity of the business;

9. a comparison of salaries paid to sales and net income;

10. general economic conditions;

11. comparison of salaries to shareholder distributions and retained earnings;

Reasonable Compensation Factors IRS Considers – Continued

12. compensation paid in prior years;

13. the corporation's dividend history;

14. whether the employee and employer dealt at arms' length;

15. corporate intent; and

16. whether the employee guaranteed the employer's debt.

Reasonable Compensation Factors IRS Considers – Continued

Formal employment contract specifying that no or low salary is to be paid (Joseph Radtke - Dunn and Clarke P.A.)

Payment for services called a distribution or a draw (Revenue Ruling 82-83).

Compensation disguised as loans to shareholders – (Must be a “bona fide loan”)

Reasonable Compensation – Factors That Don’t Guarantee Reasonableness

Distributions can be recharacterized even if wages are paid◦ In Watson,

S Corp’s sole shareholder, a CPA Annual salary of $24,000 and dividend distribution of

$320,000 over two years IRS sought to recharacterize $60,044 of the dividend

income as compensation District Court, citied Rev. Rul. 74-44 and Joseph

Radtke, and held the IRS has the power to convert dividends to salary

Distributions Recharacterized

Used to think any compensation greater than zero was OK.

IRS seems to be more willing to attack very low salaries

What do you do after year-end if no salaries paid?◦ Reclass some distributions to salary – pay late

fees re payroll deposits?

What are Clients Doing -Reasonable Comp?

2% shareholder can claim deduction if◦ S Corp pays the premiums for the accident and health insurance

policy covering 2% shareholder (and his/her spouse and dependents); OR

◦ The 2% shareholder pays the premiums and provides proof of payment to the S Corp, and then the S Corp reimburses the 2% shareholder for the premium payments in the current tax year

Health insurance premiums paid or reimbursed as wages must be reported on the 2% shareholder’s and family members Forms W-2

If caught, Can we just amend the W-2(s)

Health Insurance Premium Deduction

Partnership exchanges assets and liabilities for corporation stock

Partnership liquidates distributing S Corp stock to partners

With a timely election, Corporation becomes an S Corp without ever being a C Corp

Potential Problem – Liabilities exceed basis of assets – gain upon contribution to S Corp.

Issues Partnership to S Corp Conversion

Not required if File 2553

IRS often will incorrectly process the 2553 or incorrectly ask for 8832 for which you have to correspond to correct

LLC Converting to S CorpFile 8832?

In general, no carryovers except against built-in-gains (BIG) (Code Section 1371 (b))

◦ C Corporation Credits and NOLs generally carryover to the S corporation upon conversion – however can only be used to offset Built in Gain Tax

Carrying Over Losses and Credits from C Corp Tax Years

No carryover from “C” year

However, any open tax year, 2003-2011, can be amended to revoke previous section 179 expense

Carrying Over Section 179 from C Corp Tax Years

If S Corp doesn’t have AE&P, AAA is not used as a measure of nontaxable distributions

If no AE&P – Basis in S corporation Stock determines if distributions are taxable

Instructions to Form 1120S state that AAA should be calculated each year, even if there is no AE&P

AAA With No AE&P

Loans from bank to S Corp that were cosigned and guaranteed by the taxpayers

A loan from the taxpayers’ C Corp to the S Corp

Short-term notes that were actually notes between taxpayers’ partnership and the S Corp

AJES reclassifying loans 2 years after origination –not accepted

Failed Attempts to Deduct Shareholder Losses Against Debt Basis

Cash advances made directly to the S Corp Best to have funds transferred and loaned

directly from shareholder

Court case addressing all of the above◦Russell,Donald v Commissioner TC Memo

2008-246

Successful Attempt to Deduct Shareholder Losses Against Debt Basis

Basis is adjusted by pass-through items and distributions to shareholders

Basis is 1. Increased by stockholder’s share of income and gain items;

then2. Decreased by distributions that are a nontaxable return or

basis; and, finally,3. Decreased by the stockholder’s share of loss and deduction

items

What may be thought as a dist in excess of basis – capital gain – may be ordinary income due to ordering rules (see example)

S Corp Basis Ordering Rules

New Co with a beginning basis of $0 has the following activity in year one◦ Ordinary Income $20,000◦ Section 179 Expense (20,000)◦ Distributions to S/H 10,000

How should the activity be recorded on the K-1?

How much and what character of carry-forward loss?

S Corp Basis Ordering Rules - Example

Basis Order Cumulative Carryforward

Beginning Basis 0 0

Ordinary Income

20,000 20,000

Distribution 10,000 10,000

Section 179 10,000 0 10,000

Ordinary Income

20,000

Section 179 (10,000)

Cfwd Sec 179 Loss

10,000

S Corp Basis Ordering Rules – Example Answer

When an S Corp conducts more than one activity, a schedule should be attached to the tax return, Form 1120S and the Schedules K-1, so the shareholders can identify the income or loss of each separate activity

Separate reporting required or proper classification by shareholders re: type of activity and passive activity classification

Reporting Multiple Activities

IRS ruled that administrative dissolution of an S Corp under state law (because its registration to do business in the state had expired) did not terminate the S election.

This is the first ruling holding that the S election did not terminate even though the corporation was not retroactively reinstated under state law

Relief from Corporation Dissolution under State Law

An S Corp shareholder can rent a portion of the shareholder’s home to the S Corp

Rental income must be reported on the shareholder’s Form 1040

Only allowable rental deductions are deductions deductible in the absence of any business use, generally mortgage interest and real estate taxes

May want to rent if shareholder does not itemize deductions or over $ 1 million limit

Way to get $ out of corp if have basis limitations

Renting Home Office Space

AICPA is petitioning that the following changes be made to tax return due dates

Proposed Due Date Change

Form Orig Due Ext Due

1065 March 15 Sept 15

1120-S March 31 September 30

1041 April 15 September 30

C Corp April 15 October 15

1040 April 15 October 15