The following list contains procedures and reminders for treatment of specific items for S Corporations and S Corporation owners.
Unreasonable Compensation - S Corporations must determine if shareholders are paid reasonable compensation for their services. Wages to shareholders are subject to payroll taxes and distributions are not. To prevent the avoidance of payroll taxes, the IRS has ruled that distributions made in lieu of reasonable compensation may be recharacterized and treated as compensation. The S Corporation could then potentially be liable for unpaid payroll taxes and applicable penalties.
Retirement Plan - Consider retirement plan contributions made through salary deferrals and optimizing compensation levels to maximize additional contributions.
Personal Use of Auto - When an auto is owned or leased by an S Corporation and driven by an employee and/or shareholder for personal use, an amount is added to that employee's compensation (or W-2). The calculation is based on the fair market value of the auto and the percentage of miles driven personally versus miles driven for business purposes. The amount to be added to compensation is taxable for all tax types: federal, state, local, FICA, and unemployment. In certain cases, an election can be made to forgo federal and state income tax withholding on the additional income included in the W-2 for the personal use of autos.
Insurance Premiums Paid - If the S Corporation pays health and accident, long term care, or disability insurance premiums for more than 2% shareholders, the amount deducted by the corporation is added to that shareholder's compensation. Shareholders will then generally be eligible to take the deduction for self employed health insurance from their AGI on page one of Form 1040. Refer to the RubinBrown 2009 Employer's Guide to Payroll & Fringe Benefits for further guidance.
Preparing 1099s for Vendors - 1099s should be prepared for any non-employee and business that is not incorporated that is paid $600 or more for services, awards, commissions, or fees. All payments to attorneys, regardless of incorporation should receive a 1099. Review all vendors and payments to determine who should receive a 1099. Review all non-employee activity to make certain they should not be paid as employees for payroll tax purposes. A list is available at IRS.gov to help determine if an individual should be an employee or an independent contractor.
Cafeteria Plans - More than 2% shareholders are unable to participate in cafeteria or Section 125 plans.
Retirement Plan Loans - Shareholders, unlike non-shareholder employees, are not able to borrow money against their retirement plan accounts (a qualified plan) unless the plan contains specific rules that will allow the shareholders to obtain a loan. These rules include if the loan:
- is available to all plan participants on a reasonably equivalent basis,
- is not made available to highly compensated employees in an amount greater than the amount available to other employees,
- is made in accordance with specific loan provisions set forth in the plan,
- bears a reasonable rate of interest and is adequately secured.
Accrued Bonus - Accrual basis S Corporations are not able to deduct bonuses or any other form of compensation for shareholders (or anyone related to the shareholder) until the compensation is included in that shareholder's income.
Many S Corporations either loan their shareholders money or have borrowed from shareholders. When either of these occurs it is important to consider whether a below-market loan exists. If the interest rate is less than the applicable federal rate (AFR), then a below-market loan exists and further calculations must be made. All shareholder loans should be documented with signed promissory notes.
Closing Books at Year End
When preparing to close the books of an S Corporation the following accounts should be reviewed for accuracy:
- Meals and entertainment - confirm you have substantiation for all expenses in this account. Meals ordered in for meetings or for the benefit of the employer can be fully deducted. Holiday parties are also fully deductible. Travel is fully deductible and should be reported in a separate account.
- Maintenance and repairs - be sure account does not contain assets that should be capitalized.
- Review all related party transactions - no accruals may be deducted to cash basis related parties (i.e. rent or interest) and therefore should be paid by year end.
- Consider, if eligible, electing Section 179 to expense allowed amount of capitalized assets placed in service in current year. Keep in mind that all limits apply not just to the S Corporation but also to the individual shareholders. For example, if Shareholder A owns 50% of S Corp1 and 75% of S Corp2 the pass through amount of Section 179 expense to Shareholder A for 2009 cannot exceed the $250,000 limit.
Distributions from Accumulated Adjustments Account (AAA) vs. Taxable Dividend from Accumulated Earnings and Profits
If the S Corporation was previously a C Corporation and has undistributed Accumulated Earnings & Profits (AE&P), you may want to consider the following tax planning opportunities. The following is not an all inclusive discussion of the tax ramifications on this topic.
Consideration should be given to electing to pay a taxable dividend from the S Corporation before, or in lieu of, taking a tax free distribution from AAA. If the election is made, all distributions are treated first as made from AE&P until AE&P is fully depleted, and then as made from the AAA account.
This could be advantageous if the S Corporation is, or may become, subject to entity level corporate tax on excess net passive income (interest, dividends, rents, royalties, annuities, etc.). The entity level tax rate imposed on excess net passive income is 35%.
If the dividends paid meet the requirements to be classified as “qualified dividends”, they will be subject to a maximum income tax rate of 15% in 2010. Historically this is a low maximum tax rate for dividends. An overall evaluation of payments from the S Corporation should be made taking the above mentioned comments into consideration. This could reduce the chances of having an unwanted negative tax result in the future.
Shareholder Distributions and Basis
All shareholder distributions must be made according to ownership percentages. Shareholders must have sufficient basis in their stock in order to take tax-free distributions. In addition, shareholders are only able to deduct S Corporation losses up to the amount of their stock and qualified debt basis.
Only the following are eligible S Corporation shareholders:
- Grantor trusts can continue as an eligible shareholder for two years beginning on the grantor's date of death.
- Testamentary trusts receiving stock from a will is an eligible shareholder for two years after the stock is transferred to it.
- Trusts created to exercise voting power of stock transferred to them.
- Qualified Subchapter S trusts that only have one income beneficiary and must distribute, or be required to distribute all accounting income each year.
- Electing small business trusts that meet the following:
- Trust may not have a beneficiary other than an individual or an estate that would themselves be eligible to be an S Corp shareholder.
- Interest in the trust cannot be purchased; it must be acquired through gift or inheritance.
- The trust must elect to an ESBT.
- Certain single-member LLCs
- Certain charities
Under U.S. Treasury Department guidelines, we hereby inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used by you for the purpose of avoiding penalties that may be imposed on you by the Internal Revenue Service, or for the purpose of promoting, marketing or recommending to another party any transaction or matter addressed within this tax advice. Further, RubinBrown LLP imposes no limitation on any recipient of this tax advice on the disclosure of the tax treatment or tax strategies or tax structuring described herein.
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