The owner of an engineering firm who was cheated by his two partners still had to pay tax on the $1 million stolen by his partners. Let’s see what happened and why if you have an S corporation it’s important to pay attention to how you take money out from your business.

S Corporation Distributions

Now let’s do a quick tax law lesson and talk about the intricacies of the S corporation distributions. This is helpful information to know as a business owner, even if you have a CPA or another tax professional doing your taxes at the end of the year. That is because, in order to save on tax money or even to avoid some unexpected tax traps, you, with the help of your CPA should monitor your S corporation distributions throughout the year, not only at tax time. This ensure you catch any problems with the distributions on time and you can correct them before year-end. You should also monitor your distributions in connection to a concept called shareholder basis, to ensure your distributions remain non-taxable.

Ways To Take Money Out From An S Corporation

When you take money out from an S corporation as a business owner, you can do so in three ways:

• You have to take a reasonable salary for the work you do for your business; which is subject to income tax and payroll tax,
• You can take out distributions of the remaining profits; generally are not subject to income tax or payroll tax, unless you have distributions over basis and this is a discussion for another blog,
• The business can loan you money;

If not done properly, both the distributions and the loans you take out from the business can create a second class of stock for your business.

Why Having A Second Class Of Stock Is A Bad Thing For An S Corporation?

Well, because an S corporation can have only one class of stock. Once you create another class of stock, your S corporation status is invalidated, changing your business’ tax classification to another tax status with unintended tax consequences for you and your business.

Let’s see how distributions could create a second class of stock when the business has more than one owner. The regulations state that a corporation has only one class of stock so long as all the shares confer equal rights to dividends and liquidation proceeds. The regulations also state that identical rights distributions and liquidation proceeds are determined based on the corporations governing provisions. Such as a corporate charter, articles of incorporation, bylaws, or an LLC’s operating agreement. And yes, an LLC can be treated as an S corporation for tax purposes. This means that the S corporation governing provisions should require distributions to owners according to their ownership percentages.

But what happens when even though the business documents require proportional distributions, the partners pay themselves disproportionate distributions? Will your business lose its S corporation status? This is the answer that this new tax court ruling provides. So, let’s see what went on.

Court Case

The business owner in this case opened an engineering firm with a friend who was an investor and they organized their company as an S corporation. In July 2003 the investor friend sold his business interest to our business owner and left the company. Then our business owner sold a 60% interest to two of his friends. One who bought 40% and one who bought 20%. By 2005 our business owner was left with 40%. This meant that each of these three people had to pay tax on their own share of the business profits. Because this is how an S corporation works.

An S corporation is a flow through entity. This means that the business does not pay tax on the profits. Instead, the owners report their share of the profits on their personal tax returns and pay the tax at the individual level. The partners have to pay tax on the profits regardless if they receive the profits or not. Thus, with an S corporation it is important that the business distributes the profits to its owners. Otherwise the owners pay tax on money that they did not receive.

What Happened?

Let’s see what happened in our story. These two new partners joined the board of directors and took on executive roles while our business owner remained the company’s lead engineer. The new co-owner friends almost immediately began to loot the business, or as one says in tax speak, made unauthorized distributions to themselves in excess of their proportionate ownership share. After quite a number of years, by 2012 our business owner had caught on to his new co-owner friends. He hired a CPA to reconcile the corporations accounts. They discovered that his friends embezzled more than 1 million from the company. Or at least this is what our business owner accused his friends of doing.

Eventually they did reach a state court settlement. But our business owner still had the problem of paying taxes on money that he did not receive. In order to avoid having to pay these taxes, he tried to argue that the S corporation status was involuntarily revoked by the unauthorized and grossly unequal distributions that the friends made to themselves. So, in his case, having an S corporation was not advantageous anymore. By looking to have the S corporation status revoked, he was hoping to cause the business to be taxed as a C corporation. In which case the owners have to pay tax only on the money received. But the IRS did not agree and said that doesn’t matter. Because the regulation tells the IRS to focus on shareholder rights under a corporation’s governing documents, not what shareholders actually do.

Court’s Opinion

The court sided with the IRS saying that ” The regulation plainly states that uneven distributions don’t mean that the corporation has more than one class of stock. Treas. Reg. §1.1361-1. A corporation is not treated as having more than one class of stock so long as the governing provisions provide for identical distribution and liquidation rights.”

Conclusion

In the end our business owner had to pay taxes on money he did not receive. Unfortunately for him, he did not employ a CPA from the beginning. A CPA who could have brought to his attention the discrepancies. And only when after years and years, when he started to suspect there is something wrong, he decided to turn to a tax professional. His case is riddled with a lot more issues that could have been avoided with the help of a tax professional.

You can check our YouTube channel for more subjects that you might find useful. If you are in need of a good CPA firm contact us!

Please note that this blog post is for informational purposes only and does not constitute tax, legal or accounting advice.

There is a new tax court case that shows the importance of retaining records for closed tax years. Even if the statute of limitations had expired for those years, the records are important.

Why Is It Important To Keep Records For Closed Tax Years?

Let’s see why. There is a new tax court ruling, TC Memo 2024-86. According to this, a tax return itself does not establish the basis of items that are carried forward. Instead, you have to have the actual past records to substantiate carry forward items to future tax years. As an example:

• depreciation,
• capital loss carry forwards,
• business credit carry forwards,
• the nondeductible basis in an IRA, or
• NOL carryforward deductions.

For example, you buy this year a piece of equipment for your business costing $5,000. You will need to keep the payment receipt and any other documentation for this piece of equipment for at least 9 years, if you depreciate this equipment using a 5-year asset life.
Why? Well, because the depreciation expense generated by this 5-year life equipment can span over six years of tax returns. This depends on the depreciation method you are using. Plus, three years statute of limitations for year 6 tax return. We get to approximately 9 years that the records must be kept. Of course, there can be situations that extend the statute of limitations beyond the three years and records must be kept even longer.

Court Case

In this new court case, the taxpayer owned a high-end Japanese steakhouse and claimed in 2008 depreciation on significant expenses for build-out improvements and equipment. However, he lacked records, like receipts or invoices to substantiate these capitalized expenses. The IRS accepted the business owner’s 2008 return as filed and it did not audit this return.

However, later returns were inconsistent having no depreciation claimed or very little depreciation for these 2008 capitalized expenses. And some returns were not filed at all for which the IRS prepared substitute returns in which it did not claim any depreciation. The IRS issued a Notice of Deficiency for several years. The business owner hired a CPA to prepare and submit amended returns. The CPA claimed additional depreciation deductions calculated using the basis for the capitalized expenses shown on the 2008 return. The IRS did not accept these amended returns.

What Happened In Court?

In court, the business owner argued that the IRS accepted his 2008 return, which should allow for depreciation deductions in later years under the Cohan rule. That’s because under the Cohan rule, if a taxpayer can show that they incurred a business expense, but cannot substantiate the exact amount, the court can estimate the amount and allow a deduction. The court must have a reasonable basis for the estimate and should approximate as closely as possible, bearing heavily on the taxpayer whose lack of records caused the inexactitude.
The court agreed that our business owner incurred expenses in 2008. But, noted that the figures on the 2008 return were unsubstantiated estimates. In addition, the court ruled that the taxpayer was entitled to depreciation deductions for the years at issue based on only one-half and not on 100% of the basis amounts reported on the 2008 return. If he had the receipts and the documentation for the 2008 restaurant build out improvements and equipment, he would have been allowed the entire amount of depreciation. The amount would have been claimed on the amended returns filed by his CPA for tax years between 2010 and 2012 and 2014 and 2016. Thus, our business owner lost hundreds of thousands of dollars in deductions.

You can check our YouTube channel for more subjects that you might find useful. If you are in need of a good CPA firm contact us!

Please note that this blog post is for informational purposes only and does not constitute tax, legal or accounting advice.

If you are an influencer on YouTube, TikTok and other social media platforms this article is for you. You need to understand how your income you earn as an influencer is taxed. The problem is, that although the influencer market is big and continues to grow exponentially, the IRS has not yet issued substantial guidance when it comes to the unique tax issues the influencers face.

Activities Generating Income

Let’s analyze some of the activities generating your income. Products you receive to promote, even if unsolicited, might be considered income or not.
If you promote these products, the fair market value of these products would be considered taxable income under the barter transaction rules. Although there is no IRS specific guidance in this area, these promoted products are similar to the high value gift bags and goody bags that celebrities appearing to an awards show might receive to create brand awareness and promote products. The IRS’ position on celebrity gift bags is that these represent taxable income. You can see the IRS’ frequently asked questions about this subject on this link.
If you receive these unsolicited products and you do not promote them, they could be considered a gift that can be excluded from income. The condition for a contribution to be considered a gift that is excluded from gross income is that:

• it has to be a result of the contributor’s detached; and
• disinterested generosity; and
• without the contributor receiving or expecting to receive anything in return.

Otherwise, the item may result in income equal to the fair market value of the item. Because it is hard to determine the intent of the contributor when it comes to influencers and because the tax treatment of unsolicited products that are not promoted is an ambiguous area, it would be best to return unsolicited items that you receive and you do not promote.

To make things easier:

• you can indicate on your social media platform that you do not accept unsolicited gifts for promotion; and
• for the items that you do promote, it is best to have a contract in place regarding your promoting services.

Exclusion Rule

There is an exclusion rule when it comes to low-cost products or services that lets you exclude them from income under the de minimis fringe benefit income exclusion. These are items for which the accounting would be impractical or unreasonable. But keep in mind that the frequency with which you receive these low-cost products matters. If you receive de minimis value items frequently from the same business then you would need to recognize income for these items. Check out the link in the description from our YouTube video for more info on fringe benefits rules.

Other Activities

Other activities you do as an influencer generate taxable income as well, such as:

• if you have sponsored videos,
• sponsorship by a brand for a podcast or
• income you receive related to ads on your videos.

You can check our YouTube channel for more subjects that you might find useful. If you are in need of a good CPA firm contact us!

Please note that this blog post is for informational purposes only and does not constitute tax, legal or accounting advice.

Explore this blog post for detailed information on the new postponed deadline, estimated tax payments, Special IRA and 401K distributions, and other valuable tax insights.

Deadline Postponed

Hurricane Beryl has caused significant damage in 67 Texas counties. The list includes Harris County and Montgomery County (for more counties click here).

In response, the IRS has announced it will postpone various tax filing and payment deadlines that occurred from July 5, 2024, through February 3, 2025.

This means that if you filed an extension for your 2023 individual or business tax return, now you have until February 3^rd 2025 instead of September 16^th or October 15^th, 2024 to file your 2023 return.

Estimated Tax Payments

Keep in mind that payments on these returns are not eligible for the extra time because they were due last spring before the hurricane occurred. But the quarterly estimated income tax payments due on Sept. 16, 2024, and Jan. 15, 2025 do qualify for the February 3^rd 2025 deadline.

There is nothing you need to do to get this hurricane relief if your IRS address of record is located in the disaster area.

Claiming The Losses

And if you suffered uninsured or unreimbursed hurricane losses, you can choose to claim them on either the 2024 return or on the 2023 return. You have until Oct. 15, 2025 to make the election. If you have already filed your 2023 tax return, you can file a 2023 amendment to claim the hurricane Beryl losses.

No 10% Penalty for Special IRA and 401K Distributions

In addition, you can take money out from your IRA or 401K without incurring the 10% early penalty withdrawal if you are younger than 59 ½. And you can spread the income over three years, instead of reporting the entire distribution on your 2024 tax return.

Maximum Distribution Limit

1.  Qualified disaster recovery distributions are limited to $22,000 per disaster for any qualified individual (across all plans and IRAs).
2. Timing of distributions: The window to take a disaster recovery distribution opens on the first day of the incident period for that qualified disaster (July 5th) and closes 180 days after the latest of (1) the first day of the incident period (July 5th) or (2) the date of the disaster declaration (Jul 9, 2024) (https://www.fema.gov/disaster/4798);
3. Tax treatment: Qualified disaster recovery distributions will not be subject to the 10% penalty tax on early distributions. For individuals, federal income taxes will be assessed over a three-year period starting in the year the qualified individual receives the distribution, unless the qualified individual elects to be taxed in full in the year of receipt.
4. What does it mean for an individual to sustain an economic loss by reason of a qualified disaster (Beryl)?
   Examples of an economic loss include, but are not limited to:
   Loss, damage to, or destruction of real or personal property from fire, flooding, looting, vandalism, theft, wind, or other cause,
   Loss related to displacement from the individual’s home, or
   Loss of livelihood due to temporary or permanent layoffs.

For more information about this tax relief you can click here.

Also, you can check our YouTube channel for more subjects that you might find useful. If you are in need of a good CPA firm contact us!

This material is for informational purposes only. It does not constitute tax, legal or accounting advice.

The Shoebox Method Does Not Substantiate a Deduction

When it comes to substantiating business expense deductions, meticulous record-keeping is essential. You should not rely on what the Tax Court has aptly dubbed the “shoebox method.” Let’s explore what this method entails and why it falls short in the eyes of the court.

What Is the Shoebox Method?

The shoebox method involves collecting receipts, invoices, and other financial documents related to business expenses. Rather than organizing and categorizing these records, people simply toss them into a shoebox or similar container. When tax time arrives, they present this collection as evidence to support their deductions.

The Tax Court’s View

In a recent case, Carol A. Wright and others v. Commissioner, the Tax Court rejected the shoebox method. The court emphasized that taxpayers must substantiate deductions by keeping clear and organized records. The shoebox approach, with its jumbled mess of receipts, fails to meet this requirement.

The Balancing Act: Clear Evidence

To substantiate deductions successfully, you need more than a shoebox full of receipts. Instead, they must provide clear and organized evidence that directly ties each expense to their business activities. In the Wright case, the court found that thousands of individual receipts, without proper organization, were insufficient to prove the amounts claimed.

Takeaway

As taxpayers, we should heed the lesson from the Wright case. Proper record-keeping is not just a formality; it’s a critical part of supporting our deductions. Whether you’re a business owner, freelancer, or investor, invest the time to organize your financial records. Avoid the shoebox method, and instead, create a system that allows you to correlate receipts with specific expenses. Your tax position will be stronger, and you’ll avoid unnecessary disputes with the IRS.

Remember, the shoebox may be handy for storing old sneakers, but it won’t help you win a tax deduction battle!

You can check our YouTube channel for more subjects that you might find useful. If you are in need of a good CPA firm contact us!

Please note that this blog post is for informational purposes only and does not constitute tax, legal or accounting advice.

The Internal Revenue Service (IRS) recently issued Notice 2024-55, providing guidance on new exceptions to the 10% additional tax on early distributions from retirement plans. This notice is part of the SECURE 2.0 Act of 2022, which aims to make retirement savings more accessible and flexible for you if you are facing unforeseen financial challenges.

What is the 10% Penalty?

Typically, early distributions from retirement plans, such as 401(k)s and IRAs, are subject to a 10% additional tax if taken before the age of 59½. This penalty is intended to discourage you from using your retirement savings prematurely.

New Exception to 10% Penalty for Emergency Personal Expenses

Under Notice 2024-55, the IRS has introduced an exception to this penalty for distributions taken to cover emergency personal expenses. This exception to 10% penalty allows you to access your retirement funds without incurring the 10% penalty, if you met certain conditions.

Key Points of the Exception

1. Definition of Emergency Personal Expenses: The notice describe emergency personal expenses as unforeseeable or immediate financial needs relating to necessary personal or family emergency expenses. An emergency personal expense distribution is includible in gross income, but it is not subject to the 10 percent additional tax under IRC section 72(t)(1).
2. Unforeseeable financial expenses: Are those expenses that are related, but not limited to medical care, accident or loss of property due to casualty, imminent foreclosure or eviction from a primary residence, the need to pay for burial or funeral expenses, auto repairs, or any other necessary emergency personal expenses.
3. Eligible Plans Examples: 401(k) plans, 403(a) annuity plans, 403(b) plans, governmental 457(b) plans, IRAs are eligible to permit these distributions.
4. Limitations: There are limitations on the dollar amount and frequency of these distributions. For instance, you can only treat a distribution as an emergency personal expense once every three calendar years unless you fully repay the previous distribution or your contributions to the plan equal the amount of the previous distribution.
5. Repayment Option: If you take emergency personal expense distributions, you are permitted to repay these amounts to certain plans, allowing you to restore your retirement savings.

Impact of the New Exception

In summary, this new exception provides a safety net for you if you are facing unexpected financial hardships, allowing you to access your retirement savings without the added burden of a penalty. Also, it reflects a more flexible approach to retirement savings, acknowledging that emergencies can arise and providing a means to address them without putting at risk your long-term financial security.

Additionally, for more detailed information, you can refer to the full text of Notice 2024-55 on the IRS website.

You can also check our YouTube channel for more subjects that you might find useful. If you are in need of a good CPA firm contact us!

This material is for informational purposes only. It does not constitute tax, legal or accounting advice.