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S Corporation

Keep Your S Corporation Safe from the IRS

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Like many business owners, you may have structured your business as an S corporation because of the tax benefits it offers. An S corporation provides the same limited liability as a traditional C corporation, but it generally avoids the double taxation associated with a C corporation. You and the other shareholders (if any) pay income taxes on corporate income directly.

Once you have an S election in place, it’s important to make sure you avoid taking any action that would put the election in jeopardy. Your corporation’s failure to meet certain tax law requirements on an ongoing basis could result in the IRS’s termination of its S corporation status.

Ownership

An S corporation generally may not have a corporate shareholder. (Exception: An S corporation may be wholly owned by another S corporation.) All shareholders generally must be individuals, estates, certain trusts, or tax-exempt 501(c)(3) charitable organizations. However, a partnership may hold S corporation stock as a nominee for an eligible shareholder. Nonresident aliens may not be shareholders. A foreigner, non-citizen, resident alien may be an S shareholder, but you need to be careful because there are special qualification requirements, including  requirements regarding physical presence in the United States.

Number of Shareholders

An S corporation may not have more than 100 shareholders. For purposes of this limit, the IRS treats a husband and wife as one shareholder, as it treats certain other related individuals.

S Corporation Stock

An S corporation may have only one class of stock. Generally, a corporation has only one class of stock if all outstanding shares of the corporation’s stock confer identical rights to distribution and liquidation proceeds.

Many small business owners have troubles with this requirement, by not making distributions to owners according to the ownership percentages.

For more help with individual or business taxes, connect with us today. Our team can help you with all your tax issues, large and small.

A S Corporation Loss Equals a Personal Tax Deduction

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Business owners aren’t in business to lose money. So there’s not much to like about a nonprofitable year. For a shareholder in an S corporation, however, a down year can have an upside — the corporate loss may give rise to a personal tax deduction.

S Corporation Basis

Standing between an S shareholder and the loss deduction is a tricky tax computation known as “adjusted basis.” Under the tax law, you have to limit your loss deduction to your adjusted basis in your corporate stock and in any debt the company owes you.

Adjusted basis, essentially, it’s a figure that tracks the shareholder’s investment in the company for tax purposes. The basis number changes every year to account for any money flowing between the company and the shareholder — distributions, capital contributions, loans, and loan repayments — as well as for the shareholder’s allocated share of corporate income or loss. The order in which you increase or decrease the stock basis is very important. You can find out more information about how to calculate the S corporation basis on the IRS website.

S Corporation Loss

If you anticipate an S corporation loss for the year, as an S shareholder you should find out whether you will have enough basis to benefit from the projected loss deduction. If not, it may be possible to increase basis by making a contribution to capital or by loaning the company money before year-end. In the case you have loss and deduction items in excess of stock and/or debt basis you have to suspend them and carry them over to next year. You also need to be mindful that a distribution in excess of stock basis represents a capital gain. When you give us a call today, our tax professionals can offer guidance so that the transaction will pass IRS muster.

S Corporation and Reasonable Compensation

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If your company is organized as an S corporation, you may wonder whether it is better to take income from the company as salary or as cash distributions. Of the two options, distributions carry the least tax cost because they are not subject to employment taxes. But that doesn’t mean you shouldn’t take a paycheck from your firm. As a matter of fact, you must pay yourself a reasonable compensation.

IRS Warning about Reasonable Compensation

Over the years, the IRS has made a point of warning S corporations not to attempt to avoid federal employment taxes by having corporate officer/shareholders treat their compensation as cash distributions, payments of personal expenses, or loans instead of as wages. According to the IRS, distributions must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.

What Is a “Reasonable” Compensation?

Thus, in order to avoid problems with the IRS, you should be sure to take a reasonable amount of salary if you receive any direct or indirect payments from your company. However, the tax law has no hard-and-fast guidelines regarding what is considered “reasonable compensation.” When the issue has come up in court, the determination has been based on the facts and circumstances of the particular case. Therefore, various factors have come into play, including:

  • Duties and responsibilities
  • Time and effort devoted to the business
  • Training and experience
  • What comparable businesses pay for similar services
  • Timing and manner of paying bonuses to key people
  • Payments to employees who are not shareholders
  • The corporation’s dividend-paying history
  • Compensation agreements
  • The use of a formula to determine compensation

The IRS has a special page dedicated to S corporation compensation where you can find out more information.

An Exception

What about an S corporation officer who doesn’t perform any services for the corporation — or whose services are very minor? In this relatively unusual situation, assuming the officer receives no direct or indirect pay, he or she would not be considered an employee.

For more help with individual or business taxes, connect with us today.

Home Office and S Corporation Shareholder

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Can you still get a deduction for your home office if you are an S corporation shareholder? The answer is yes.

There are two options. Either you rent a portion of your home to the S corporation as office or storage space, or the S corporation reimburses you for the home office use under an accountable plan.

First option: renting a portion of your home office to the S corporation

If you rent a portion of your home to the S corporation, you must do it so at fair market value. Otherwise, the IRS may reclassify the excess rent over the fair market value as wage income, resulting in additional payroll taxes and penalties. Or, the IRS can argue that the rent is a disguised distribution.

The rental income must be reported on schedule E on your personal tax return. However, due to the fact that you lease your home space to your employer, there are limitations on the deductions you can take. You can only claim the deductions that would be deductible in the absence of any business use, generally mortgage interest and real estate taxes.

In addition, because you rent property to a business in which you materially participate, the “self-rental” rules apply, which re-characterise the rental income as active income, while the rental loss remains passive.

The advantage of renting your home office to the S corporation is that it reduces the net income of the S corporation, thus reducing the “reasonable salary” threshold, giving you some savings on the self-employment tax.

Second option: reimbursement under an accountable plan

The company must have an accountable plan in order to take advantage of this options.

Per the IRS, “to be an accountable plan, your employer’s reimbursement or allowance arrangement must include all of the following rules:

  1. Your expenses must have a business connection — that is, you must have paid or incurred deductible expenses while performing services as an employee of your employer.
  2. You must adequately account to your employer for these expenses within a reasonable period of time.
  3. You must return any excess reimbursement or allowance within a reasonable period of time.”

See IRS Publication 463 for more information.

You must use your home office exclusively and regularly for business.

You have to comply with all the requirements for the home office deduction, including the principal place of business test.

When you have multiple work locations, to determine whether or not your home office is your principal place of business, “you must consider:

  • The relative importance of the activities performed at each place where you conduct business, and
  • The amount of time spent at each place where you conduct business.

Your home office will qualify as your principal place of business if you meet the following requirements:

  • You use it exclusively and regularly for administrative or management activities of your trade or business.
  • You have no other fixed location where you conduct substantial administrative or management activities of your trade or business.”

See IRS Publication 587 for more details about the business use of your home.

With this option you save, not only on self-employment taxes, by reducing the “reasonable salary” threshold, you also save on income taxes, because you don’t have to pick any income on the personal return, as was the case with the rental scenario.

In addition, if you have a qualified home office and another work space, like a shop, the commuting miles between your home and your other work place are now becoming deductible. Actually you can deduct the cost of any trips you make from your qualified home office to another business location, like meeting clients, for example. Don’t forget that you also need to reimburse these miles under the Accountable Plan.

To learn more about tax rules and regulations, request a free consultation or call us at 832-919-8448.