Many mom-and-pop business owners, and their tax preparers, fail to understand two important tax issues involving “S” corporations, a very common form of organization for small companies. Those potential trouble spots are the reasonable compensation that needs to be paid to active owners, and the stock and debt basis needed to properly deduct losses.
To define our terms: simply put, an “S” corporation allows its owners to report the business’s profits or losses on their personal tax returns.
If an owner is actively involved in a trade or business that operates as an “S” corporation, and if that owner pulls any money from the corporation, then that owner must pay himself a “reasonable compensation.” By compensation, I mean amounts to be reported on a W-2, subject to Social Security and Medicare taxes, and subject to income-tax withholding.
Obviously, the owner’s desire is to pull money out as distributions that aren’t subject to payroll taxes. Some taxpayers tell their preparers to just report on a W-2 “whatever the standard amount is.” But there is no so-called standard and there is no rule of thumb for this. The IRS determines what is “reasonable compensation” on a case-by-case basis. The amount taken should be supported by independent data. That would include studies of compensation in a comparable industry, and should be properly documented. To just show all the money taken out of an “S” corporation as distributions, and nothing on a W-2, invites unwelcome attention to that return.
The other downside to keeping the wages unreasonably low is that it will reduce the owner’s Social Security benefits. Less paid in during the working years means less taken out in retirement. Low-balling the owner’s salary may also reduce the amount the owner can put into a private retirement plan, such as an IRA.
If you anticipate that your “S” corporation will have a loss this year, you need to make sure you have a “basis” to be able to deduct that loss on your personal tax return. Basis is affected by the amount of money you have either contributed or loaned to your corporation, adjusted for the net pass-through of income, losses and distributions.
If you don’t have enough basis to deduct the losses – meaning you haven’t put in enough money – then you may want to consider lending some money to the corporation. But that means using your own money. You cannot create basis by guaranteeing a loan that a third party makes directly to the corporation. In court case after court case, shareholders keep trying this approach and keep losing. This approach most likely will always fail.
Because this can be complex and tricky, you should be sure to consult with your tax adviser before trying to restructure your corporation’s debt.
One other caution: If your corporation owes you money, repayment of that loan may not always be tax free. If the loan had previously been used as basis to deduct losses, then the repayment of that loan may create a taxable gain.
Again, this can be a complicated area. I strongly urge anyone who owns an “S” corporation to contact your tax adviser. I also strongly urge you to request that your tax adviser maintain records supporting the calculation of basis.
There was talk at one time about the IRS requiring taxpayers to provide a copy of the calculations used to determine basis. If that should come to pass, having good records of all the money you have put into and taken out of your business will certainly make your life much easier.
Randy McIntyre is a Certified Public Accountant and a partner in McIntyre, Paradis, Wood & Company, CPAs. He has worked in public accounting since 1977, in Wilmington since 1992. His firm is built on a history of service, technical expertise, and innovative to provide the expertise of larger firms with a personal, one-on-one approach. To learn more about McIntyre, Paradis, Wood & Company, see www.mpwcpas.com. He can be reached at [email protected] or 910-793-1181.
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