S Corporations Issues: 1) Stock & Debt Basis 2) Reasonable Compensation 3) Fringe Benefits Richard Furlong, Jr. Senior Stakeholder Liaison December 14, 2016 CPA Continuing Education Society of PA S Corp Taxation An S corp is generally not taxed on its income since it is a pass-through entity. The shareholders report the pass-through items and pay the tax. Items of income, loss, deduction or credit are grouped into two categories: 1. Separately stated items 2. Non-separately stated items Exceptions Include: Built-in Gains Tax, Excess
Net Passive Investment Income Tax and LIFO Recapture Tax. 2 Shareholder Loss Limitations Before losses can be claimed by an S corp shareholder they need satisfy the following three loss limitations: 1. Stock & debt basis limitations - IRC 1366(d) 2. At-risk limitation - IRC 465 3. Passive activity loss limitation - IRC 469 Must Overcome Each Hurdle! 3 Shareholder Loss Limitations Loss Limitation Flow Chart
Does the Shareholder have Adequate Stock and Debt BASIS? YES Is the Shareholder At Risk in Stock and Debt? NO Loss not allowed on 1040. If partial basis, follow YES arrows for that amount. NO Loss not allowed on 1040. If partial at risk, follow YES
arrows for that amount. YES Is the Activity Passive for the Shareholder? NO YES Loss Allowed on Shareholders Return Loss is limited to passive income or not allowed on 1040.P 4 Shareholder Loss Limitations
There are three shareholder loss limitations: 1.Stock & debt basis Losses should not reflected on Form 1040 2.At-risk limitation Losses should be reflected on Form 6198 3.Passive activity limitation Losses should be reflected on Form 8582 5 Stock & Debt Basis Importance Basis is important since the shareholder needs to know the amount of his/her stock and debt basis when the:
S corp allocates a loss/deduction item to the shareholder, S corp makes a non-dividend distribution to the shareholder, or Shareholder disposes of their stock. 6 Each Year the Shareholder Needs to Know The amount of Stock basis Debt basis
Suspended losses due to stock & debt basis Suspended losses due to at-risk Suspended losses due to passive activity limitations 7 Stock & Debt Basis Shareholders Schedule K-1 Each shareholder will receive Form Sch. K-1 from the S corp, the K-1 does not state The amount of the loss which can be claimed, or
It is not the corps responsibility to track shareholders stock and debt basis. Although some corps will maintain this information for its shareholders; tracking stock basis is the shareholders responsibility. The amount of the non-dividend distribution which is taxable. 8 Stock & Debt Basis Schedule K-1 9
Stock & Debt Basis Distributions from an S Corp Non-dividend distributions (Sch. K-1, 16d) Reduce stock (not debt) basis, but not below zero Distributions in excess of basis are taxed as capital gains (generally long-term) Dividend distributions (Form 1099) Do not affect basis Occur if corp has C corp earnings and profits
10 Stock Basis Generally a shareholders stock basis starts with cost, just like any other asset. The Adjusted basis of S corp stock is UNIQUE in that it goes up and down each year based upon the corps pass-through items. Stock basis is determined at the end of the corporate year; there are special rules when a shareholder sells or disposes of their stock. 11 Stock Basis: Stock Basis Ordering Rule, IRC 1367-1(f) Stock Basis will be adjusted in the following order: 1. Increased for income items and excess
depletion, 2. Decreased for non-dividend distributions, 3. Decreased for nondeductible expenses, and then 4. Decreased for items of loss and deductions. 12 Increases to Stock Basis Item Sch. K-1 1. Ordinary Income Box 1
2. Separately Stated Income Items Boxes 2-10 Boxes 16a&b 3. Tax-Exempt Income 4. Excess Depletion over Property Basis Box 15c 13 Decreases to Stock Basis 1. 2.
3. 4. 5. Item Ordinary Loss Separately Stated Loss and Deductions Nondeductible Expenses Non-Dividend Distributions Depletion for Oil and Gas Sch. K-1 Box 1 Boxes 2-12d and 14l, 14m Box 16c Box 16d
Box 17r 14 Stock Basis Example 1 - Facts Dave the sole shareholder of an S corp, has $15,000 of stock basis and no debt basis as of 1-1-2015. Dave received a K-1 for 2015 reflecting the following: Box 1 (20,000) Box 9 4,000
Box 12A 5,000 Box 16C 1,000 Box 16D 12,000 Ordinary business (loss) Net section 1231 gain Charitable contributions (50%) Nondeductible expenses Distributions 15 Stock Basis Example 1 - Basis Computation 1-1-15 Stock basis 15,000 Plus: Net section 1231 gain 4,000 Stock Basis before distributions 19,000
Less: Non-dividend distributions (12,000) Stock basis before nondeductible 7,000 Less: Nondeductible expense (1,000) Stock basis before loss & deductions 6,000 16 Stock Basis Example 1 - Basis Computation (continued) 2 Stock basis before loss & deductions Less: Ordinary business loss (20,000/25,000 x 6,000)
Less: Charitable contributions (50%) (5,000/25,000 x 6,000) 12-31-2015 Stock basis 6,000 (4,800) (1,200) 0 17 Stock Basis Example 1 - Suspended Loss Computation (continued) 2015 Ordinary business loss Allowable business loss (20,000) (4,800)
Suspended ordinary business loss (15,200) 2015 Charitable contributions Allowable charitable contributions 5,000 (1,200) Suspended charitable contributions 3,800 18 Stock Basis: Issues on the Computation of Stock Basis Issues:
Failing to compute stock basis Not following the ordering rules Establishing initial stock basis Failing to do the above may result in: Distributions in excess of stock basis not properly included in income
Losses claimed in excess of basis Improperly computing gain / loss on disposition of stock 19 Stock Basis: Gain Does Not Increase Basis Gain on taxable distributions do not increase a shareholders basis. Only income and gain items reported to the shareholder on their K-1 increase their basis.
Basis will never be increased for a gain resulting from the shareholder receiving something. 20 Shareholder Debt Basis IRC 1366(d)(1)(B) states that losses are allowed up to the amount of the shareholder's adjusted basis of any indebtedness of the S corp to the shareholder.
S corp shareholder does not get basis in the third party debts of the entity. The question to be answered is What qualifies as indebtedness of the S corp to the shareholder? 21 What Qualifies as Indebtedness of the S Corp to the Shareholder? Treas. Reg. 1.1366-2(a)(2)(i) Provides that shareholders obtain basis in indebtedness if the S corp owes a bona fide debt directly to the shareholder. Finalized and effective on July 23, 2014.
22 Bona Fide Debt Case Law Factors 1. a written instrument 2. a stated interest rate 3. a maturity date 4. an enforceable debt under state law 5. a reasonable expectation of repayment 6. creditor remedies upon default; and 7. repayment or other conduct that indicates the parties upheld the terms of the debt. For additional factors see Notice 94-47. 23 Entity Level Debt
The shareholder does not get basis in third party entity-level debt. There is no bona fide debt between the shareholder and the corp. 24 Loan Guarantees Guaranteeing a loan or acting as a surety, accommodation party, or in any similar capacity does not give rise to basis in indebtedness.
Treas. Reg. 1.1366-2(a)(2)(ii) 25 Payment on Loan Guarantee When a shareholder makes a payment on bona fide indebtedness of the S corp for which the shareholder has acted as guarantor or in a similar capacity, then the shareholder may increase the shareholder's basis of indebtedness to the extent of that payment. Treas. Reg. 1.1366-2(a)(2)(ii)
26 Judgment on Default Loan Guarantee In Montgomery v. Commr, T.C. Memo 2013151: Judgment was imposed on the shareholder as a result of his loan guarantee. Shareholder did not make any payments. Shareholder did not become the primary obligor. Ruled Judgment on default does not create debt between the shareholder and the corp so no debt basis is allowed. 27 Co-Maker or Co-Borrower
Both the shareholder and corporation borrow from the bank. Shareholder owes the bank. Corporation owes the bank; corporation does not owe the shareholder. No bona fide debt between the shareholder and the corporation so no debt basis allowed. Salem v. Commr, TC Memo 1998-63 aff'd, 196 F.3d 1260 (11th Cir. 1999) 28 Back to Back Loans
A back-to-back loan is when a person borrows money from one party and lends that money to another. In the case of an S corp, the shareholder usually borrows money and then lends it to his S 29 Bank Loan to Shareholder followed by Loan to S Corp
The shareholder is personally liable for the debt and there is bona fide indebtedness from the S corp to the shareholder so debt basis is allowed. Gilday v. Commr, T.C. Memo 1982-242 30 Related Entity Loans Money to S Corporation A shareholders Profitable Corp loans money to the shareholders Loss S Corp. Loss S Corp does not owe the
shareholder anything (there is no bona fide debt between S Corp and shareholder) so debt basis is not allowed. Rev. Rul. 69-125. 31 Loan from Related Party to Shareholder then Loaned to S Corp Based on the facts and circumstances, one must determine if there is bona fide debt from S Corp owed to the shareholder. If there is bona fide debt, debt basis is allowed.
Treas. Reg. 1.1366-2(a)(2)(iii), Example 2. 32 Restructure of Related Party Loans A shareholders Profitable Corp loans money to the shareholders Loss S Corp. Profitable distributes note to shareholder and the note is now between shareholder and Loss S Corp. If there is bona fide debt, debt basis is allowed.
Treas. Reg. 1.1366-2(a)(2)(iii), Example 3. 33 Distribution from Related Party to Shareholder then Loan to S Corp Distribution made from Related Entity to shareholder followed by a contribution from the shareholder to S Corp. If a distribution occurred, the shareholders basis in the related entity has decreased and his basis in S Corp has increased. Maguire v. Commr, T.C. Memo. 2012-160
34 Circular Flow of Funds Generally funds start with one entity, are lent or distributed to other persons and/or entities, and end up with the original entity. May provide the shareholder with debt basis. When the transaction lacks substance or the shareholder is merely a conduit, the shareholder is not allowed debt basis. 35
Examples Circular Flow of Funds Lack Substance Oren v. Commr, 357 F.3d 854 (8th Cir. 2004) Restructured investments where Profitable loaned money to Shareholder who loaned money to Loss within a few days Loss transferred money to Profitable. Kaplan v Commr, T.C. Memo 2005-218 Bank loaned money to shareholder. Shareholder loaned money to Loss, loss sent money to Shell Corp, Shell Corp sent money to shareholder who repaid the bank within a few days.
36 Debt Basis Debt Basis - IRC 1367(b)(2)(A) The code provides that once a shareholder's stock basis has been reduced to zero, any excess losses are applied to the shareholder's outstanding basis in loans to the corp. Losses and deductions which exceed a shareholders stock basis are allowable to the extent of the shareholders basis in loans. Debt basis is computed similarly to stock basis
but there are some differences (distributions only 37 look to stock basis). Debt Basis Debt Basis - IRC 1367(b)(2)(A) (continued) Losses and deductions claimed against a shareholders debt basis reduce the shareholders basis in the debt. If an S corp repays reduced basis debt to the shareholder, part or all of the repayment is taxable to the shareholder.
38 Debt Basis Example 2 Gain on Loan Repayment Facts: The shareholder loans his corp $10,000 The shareholder claimed losses in excess of stock basis of $6,000 This results in the shareholder having a basis in his or her note of $4,000. What is the gain on loan repayment if the S corp repays $1,000 of the note?
39 Debt Basis Example 2 Answer Facts: The shareholder loans his corp $10,000 The shareholder claimed losses in excess of stock basis of $6,000 This results in the shareholder having a basis in his or her note of $4,000. What is the gain on loan repayment if the S corp repays $1,000 of the note? 60%[a] X $1,000 = $600 Gain
[a] = ($10,000 - $4,000) / $10,000 40 Reasonable Compensation A corp elects S corp status to obtain special tax treatment for federal tax purposes. However, minimizing employment taxes is not one of the intended benefits. S corps must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corp before non-wage distributions may be made to the shareholder-employee. 41 Reasonable Compensation Table C Corporation
S Corporation (1) Employee Employee (2) Salary Salary (3) W-2 W-2 (4) Employment Tax on 1120
(5) Dividend Employment Tax on 1120S Non-Taxable Distribution (with exceptions) Partnership Self Employed, not Employee Distributive Share/ Guaranteed Payment Self-Employment Income SE Tax at 1040 Non-Taxable Distribution
(with exceptions) 42 Reasonable Compensation Determination The key to determining reasonable compensation is determining what the shareholder-employee did for the S corp. Generally, you would look to the source of the S corps gross receipts. The three major sources are: 1. Services provided by the shareholder- employees 2. Services of non-shareholder employees 3. Capital and assets of the corp 43 1120 S Officer Compensation
Applicable Law Officers are Employees for FICA (IRC3121(d)(1); FITW (IRC 3401(c)) and FUTA (IRC33-6(i)) Rev. Rul. 73-361 Rev. Rul. 74-44 44 Reasonable Compensation Factors Some factors in determining reasonable compensation include: training and experience,
duties and responsibilities, time and effort devoted to the business, dividend history, payments to non-shareholder employees, timing and manner of paying bonuses to key people, what comparable businesses pay for similar services, compensation agreements, and the use of a formula to determine compensation. 45 Remuneration in Lieu of Wages
Officer must receive some sort of remuneration, characterized as: Distributions Loans to Shareholders Payment of Personal Expenses Independent Contractor Payments to Related Companies 46 Officer Compensation in Examinations
Reasonable salary Comparable to a fair wage paid to unrelated party Corporate Officers are, by statute, employees 47 Officer Compensation Court Cases
Veterinary Surgical Consultants, P.C., T.C. Memo 2003-48 Mike J. Graham Trucking, Inc., T.C. Memo 2003-49 Superior Proside, Inc. v. Comm., T.C. Memo 2003-50 Nu-Look Design, Inc. v. Comm., T.C. Memo 2003-52 Water-Pure Systems, Inc. v. Comm., T.C. Memo 2003-53 48 Reasonable Compensation Authority Several court cases support the authority of the IRS to reclassify other forms of payments to a shareholder-employee as a wage expense which
are subject to employment taxes. Veterinary Surgical Consultants, P.C. Reinforced vs. Commr, 117 T.C. 141 (2001) Employment Status of Joseph M. Grey Public Accountant, P.C. Shareholders vs. Commr, 119 T.C. 121 (2002) Reasonable Reimbursement for Services Performed David E. Watson, PC vs. U.S., 668 F.3d 1008 (8th Cir. 2012) 49 S Corp Fringe Benefits
Fringe benefits paid to or on behalf of an employee/shareholder must be included in the employees gross income unless they are statutorily excluded from income. Excluded fringe benefit is deductible by the corp and not includible in income of the employee. IRC 1372 states that, for employee fringe benefits, an S corp shall be treated as a partnership and a 2% shareholder shall be treated as a partner of such partnership.
50 Fringe Benefits >2% Shareholder (Taxable) The benefits affected by IRC 1372 are referred to as Listed Benefits. Examples include: Group-term life insurance coverage up to $50,000, IRC 79; Medical reimbursement plans and disability plans, IRC 105; Payments to accident and health plans, IRC 106; Meals and lodging furnished for the convenience of
the employer, IRC 119; Benefits provided pursuant to a cafeteria plan, IRC 125. 51 Fringe Benefits Reporting Medical Insurance Premiums Health and accident insurance premiums are deductible by the S corp and reportable as wages, subject to income tax withholding. These additional wages are not be subject to Social Security, or FICA, or FUTA taxes.
The 2-percent shareholder-employee may be eligible for an above-the-line deduction in arriving at AGI if the medical care coverage was established by the S corp and the shareholder met the other selfemployed medical insurance deduction requirements. For more information, see S Corporation Compensation and Medical Insurance Issues page on the www.irs.gov website. 52 S Corp Tips
When electing S corp status, timely file Form 2553. Timely file the S corp income tax returns, the corporate filing requirement for calendar year taxpayer is March 15th. Remember a shareholder should maintain his or her basis computation and confirm whether there are any distributions in excess of the shareholders basis or if loss and deduction items should be limited. 53 S Corp Tips (continued) To claim loss and deduction items the shareholder must overcome the stock and or debt
basis, at risk and passive activity limitations. Pay all shareholder-employees a reasonable wage before making distributions or loans to shareholders. Report fringe benefits through payroll. Be aware that if a shareholders spouse is eligible for subsidized health insurance coverage through another employer the shareholder is not entitled to the self-employed health insurance deduction. 54 Additional Information
www.irs.gov Key word: S Corporation Schedule K-1 (Form 1120S), Shareholders Share of Income, Deductions, Credits, etc. and Instructions to Schedule K-1 (1120S). Form 1120S, U.S Income Tax Return for an S Corporation 55 QUESTIONS Richard Furlong, Jr. Senior Stakeholder Liaison
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