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Archive for Corporations

Subdividing Your Land? Consider an S Corporation for Lower Taxes

By Kim M. Larsen EA CTFS
Saturday, February 28th, 2015

Did you know that Section 1237 allows individuals selling lots on subdivided land to get out of ordinary income taxes and pay at the lower capital gains rate? Well, if you’re classified as a real estate dealer (as are many who sell real estate on a regular basis), you can forget about it. You have $1 million in appreciation on your land? Yup, you’re paying taxes of up to 35 percent.

Capital gains rates, on the other hand, are capped at 15 percent. We’re talking possible tax savings of hundreds of thousands of dollars. Wouldn’t it be nice if you too could benefit from those reduced tax rates? With the right strategy, you can!

The Developer Entity

All you have to do is set up a developer entity to sell your land to. That entity then develops the land. And, how does this change your tax status? Well, it divides your income into two categories: 1) profits on subdividing, developing, and advertising the lots are ordinary income, and 2) the land sale is a capital gain.

Again assuming that the total appreciation for your land is $1 million, let’s say developing it makes you $500,000 in profit. With a separate developer entity, you pay $325,000 in taxes (15 percent times $1 million plus 35 percent times $500,000). But, if you did not set up the separate developer entity to purchase your land, you pay $525,000 in taxes (35 percent on the entire $1.5 million).

Tip: You only get the long-term capital gains tax rates if you were holding the land as an investment and owned it for more than a year.

Here’s what to do:

  1. Create an S Corporation—This is the developer. If you own the land, you can simply set up a single-owner S corporation. In the case of a partnership (including some LLCs), you and your partners will also create an S corporation, but you’ll divide the stock according to your ownership interests.
  2. Sell the Land to Your S Corporation—You’ll make this sale at fair market value. Use the installment payment method in order to pay the capital gains rate on your profits and the ordinary income rate on the interest paid to you by the S corporation. How you set up the loan terms is up to you. You may or may not want a down payment, or the interest may only apply to a certain period of the loan, for instance. Of course, you will be required to charge some interest.
  3. Develop the Property and Sell—Finally, your developer entity will prepare the lots for sale. All of the money it makes for subdividing, developing, and advertising is corporate income that passes to you and any other shareholders. Although you still have to pay your ordinary income tax rate on this money, you saved with the capital gains rates on the sale to your S corporation. Basically, the profits have been divided between you and your corporation. Notice the advantage here: you end up paying at the lower tax rate for your biggest profit and at the higher tax rate only for your smaller profit.

Why an S Corporation?

Technically, you could set up either an S or a C corporation as the developer entity for these purposes. However, you’re likely to face double taxation as a C corporation, and you won’t get the lower capital gains tax rates. So, usually that option doesn’t make a whole lot of sense.

What you definitely do not want to do is set up a controlled partnership (including controlled LLCs) as your developer entity. Per tax law, a partnership must treat the gains as ordinary income if the property it purchases will not be used as a capital asset.[1] For your purposes (selling the lots at a profit), the property is certainly not a capital asset for the developer entity. With a corporation, on the other hand, you avoid such rules because you are not selling the property for stock.[2]

How Does This Method Stand Up against Audits?

Whenever your business dealings involve transactions between two entities you have an interest in, the IRS will be watching you closely. If you do not take care of all the details, the IRS could ignore your little corporate developer entity structure and just go ahead and tax everything at your ordinary income rates.

What do you need to document?

  • The sale of your land to the S corporation
  • When using the installment method (promissory notes), evidence that the corporation pays on the principal and interest when its due and follows all loan terms[3]
  • That the formation of the corporation was separate from its purchase of the appreciated land (otherwise, the IRS could argue that the land was capital used in exchange for stocks—see Section 351[4])
  • A professional appraisal of the land and evidence that this is the price you charged the S corporation

In a nutshell, keep your business and personal finances separate—always. Do not confuse your S corporation with yourself as an individual. It is a separate entity, and as long as you treat it as such, you and the IRS will get along just fine.

  1. IRC Section 707(b)(2) ↑
  2. IRC 351(b) ↑
  3. See Jolana S. Bradshaw v. U.S., 50 AFTR 2d 82-5238, 82-2 USTC ↑
  4. IRC Section 351 ↑
Categories : Corporations, Land, Tax Planning

Rent Your Home to Your S Corporation and Get Double the Tax Benefits

By Kim M. Larsen EA CTFS
Saturday, February 28th, 2015

S corporations are one of those funny structures that make you wonder if you’re living in another dimension. The corporation is a separate entity from you, but tax benefits pass through the corporation to your advantage. For a sole owner of an S corporation, the lines between individual and company can sometimes become blurred, even in terms of tax law.

Generally, the IRS is very strict about your making sure you keep your personal finances separate from those of your S corporation. That’s why it seems unbelievable that you could rent your home to your own S corporation and receive a tax advantage from this situation. Doesn’t that cross the lines of personal and business interests? Unbelievable or not, if you play your hand right, you may very well be able to pull off this rental deduction situation.

14-Day Rule for Free-Rent

According to the free-rent rule, you cannot take personal residence deductions against rental income when you rent your home for less than 15 days, and the income for that 14-day or less period is not taxable.[1] Furthermore, in Roy, the court ruled that for tax-free rental cases using the 14-day rule, it is not necessary for the rent to be at fair market value (although you probably should document that it is anyway for your S corporation).[2] The free-rent rule is in IRC Section 280A(g), and it provides you with two distinct tax advantages:

  1. On the personal side, you don’t have to report the rent as taxable income, and
  2. On the corporate side, your company gets to deduct the amount it spent on rent.

According to Section 280A, the tax-free residence-rental rule takes precedence over the other provisions in Section 280A. That means this particular tax code is the key to defending the rental of your personal home tax strategy. However, you are going to come up on several obstacles to getting these benefits. Let’s see what they are and how you can get around them.

You can’t get a deduction for renting to your employer.[3] Section 280A(c)(6) states that an employee cannot take a deduction when renting to the employer. For your S corporation, you are the employee; you are the employer. Therefore, you cannot rent to yourself without breaking this rule, right?

Not so fast. When using the 14-day rule, you as an employee are not entitled to any deductions anyway. So, this problem isn’t really a problem at all! Whether you can get personal deductions or not, you still get rental income tax-free. Additionally, as stated above, the 14-day tax-free rent rule overrides this because it is also a provision in Section 280A.

You can’t take deductions for entertainment facilities.[4] All this really means is you need to be careful about how you have your S corporation rent your home. What will it be using the space for? If your company will be entertaining prospects or customers (including patients), then this puts the brakes on your plan. Although there are exceptions, you’re better off just not renting your home to your business for purposes of entertaining. If you absolutely must use your home for entertainment, limit to those situations that are exempt from the entertainment facility rules.[5][6]

You can’t deduct rental to a related-party.[7][8] It turns out this is another one that’s actually not an issue at all. It seems like renting from yourself would count, but that’s not exactly what’s happening here. Your corporation is renting from you, and as a separate entity, your corporation is not you, and it is not related to you (as in the way your family is related to you).[9] Additionally, the related-party rule prohibits deductions when the recipient does not have to include income “by reason of the method of accounting.”[10] But, that’s not the case here. The reason you don’t have to include the income is because tax law says you don’t have to.

You can’t deduct personal, family, or living expenses.[11] Every business owner should be aware that you cannot deduct these kinds of expenses. However, renting out your home to a third-party is not a personal or family use. Tax law already recognizes that some uses of the home, such as a home office, are not included in these categories.[12]

You have to prove an ordinary and necessary business expense.[13] Renting space for business meetings and/or the annual holiday party is unarguably an ordinary and necessary business expense. Every year, businesses deduct these expenses with no problems. On your corporation’s side, the business purpose of this rental expense is clear. Tip: Document your business use of the space, perhaps even taking photos of the activities.

The IRS could consider this a bogus rental with the substance-over-form doctrine.[14] If you follow the advice of avoiding entertainment facility rules, charging fair market value rent, ensuring that business activities actually take place, and documenting all of this, there’s really no reason for suspicion of fraud. After all, tax law itself allows you to take the rent tax-free, and it’s not an issue of substance-over-form for your corporation to deduct rent for business meetings or a space for holiday parties.

There you have it—all of the information you need to justify your personal tax-free rent income and a business expense deduction for your S corporation. As long as you know the rules and document properly, you can come out ahead with your taxes. Remember, paying taxes is about paying what you owe—no more and no less. So, if tax law allows you to avoid taxes or take deductions, it’s your right to do so.

  1. IRC Section 280A(g) ↑
  2. Leslie A. Roy v Commr., TC Memo 1998-125 ↑
  3. IRC Section 280A(c)(6) ↑
  4. IRC Section 274(a)(1)(B) ↑
  5. IRC Section 274(e)(4) ↑
  6. IRC Section 274(n)(2)(A) ↑
  7. IRC Section 280A(d)(2) ↑
  8. IRC Section 267(a)(2) ↑
  9. IRC Section 280A(d)(2)(A) ↑
  10. IRC Section 267(a)(2)(A) ↑
  11. IRC Section 262 ↑
  12. IRC Section 280A; Rev. Rul. 76-287 ↑
  13. IRC Section 162 ↑
  14. Gregory v Helvering, 293 U.S. 465, 14 AFTR 1191 (1935); Frank Lyon Co. v United States, 435 U.S. 561, 573, 41 AFTR 2d 78-1142 (1978) ↑
Categories : Corporations, Home, Real Estate, Rental Properties, Tax Planning

How to Know if the S Corporation is Your Best Choice in Entity Structure

By Kim M. Larsen EA CTFS
Friday, February 27th, 2015

You have a lot of details to consider when it comes to choosing the entity structure for your business. You can run it as a sole proprietorship, a single-member LLC, an S corporation, or a C corporation. How do you know which is the best choice? One of the biggest considerations is how your choice in entity structure affects your tax bill, and that’s exactly what this article looks at—specifically focusing on the pros and cons of the S corporation.

What an S Corporation Is

An S corporation is basically a federal tax election status. Your company can be formed as either an LLC or a corporation and still make the S corporation election.[1] That means your business name could end with (and legally be) “LLC”, but for tax purposes, you file as an S corporation. This tax status allows your company’s tax credits, deductions, and income to pass through to you as shareholder. For the right kind of business, this could grant liability protection with the benefits of personal taxation.

Knowing the Rules

In order to qualify for S corporation status, you only need to meet a few rules that are fairly easy for singly-owned businesses (or even husband-wife ownership teams):[2]

  • You must be a domestic corporation (LLC’s are included in this designation).
  • You must have no more than 100 shareholders.
  • Each individual shareholder must be either a US citizen, resident alien, or estate. Certain types of trusts and tax-exempt entities may also be shareholders.
  • Your business must carry one class of stock only.

So, the real question is: does an S corporation election make sense for your business?

Pros and Cons

No matter which entity structure you choose, you’ll come across both advantages and disadvantages. There is no one choice that works for every business and consistently generates the most tax advantages. You will need to do your research and make the best determination for you and your company. That being said, weighing the tax savings is an important part of the decision-making process.

Here are the positive tax implications for electing S corporation status:

  • You Pay Less in Payroll Taxes—Operating as an S corporation makes the owner both a shareholder and an employee. This means you 1) receive distributions for your investment in the business, and 2) receive a salary for the work you do. The salary is paid to you by your corporation (because it acts as a separate entity from you as an individual), and thus is subject to payroll taxes. However, because you also receive income as an investor, you have the opportunity to pay yourself a lower wage (reducing your payroll taxes) and still make good money on the dividends. Of course, you should research what a reasonable wage would be—the IRS can ding you for paying yourself too little in salary.
  • You Can Split Taxable Income—This can be a tax advantage if you want to provide money to someone, such as a parent. You basically have two options. You can give the money directly to your mom or dad as a gift, but this comes out of your after-tax dollars because you’ve already earned the money and must pay income tax on it. Alternately, you can give the parent a share in your company’s stock, so that the gift money comes in the form of dividends. The second option is probably the better one if your parent is in a lower tax bracket than you are because you’ll be able to provide the same amount of cash with less going to taxes.

For example, your parent is in the 10 percent tax bracket and you’re taxed at 35 percent. You have to make $15,385 at your tax rate in order to give an after-tax gift of $10,000. But, if you give stock that earns $11,111, your parent still gets $10,000 after their 10 percent taxes. Of course, the second method also means your parent is now part owner in the company, so you’ll have to weigh the consequences. Note that this strategy is not a good choice for splitting income with your children because they will be subject to the kiddie tax for investment income over $1,900 if they are younger than 19 or in college and younger than 24.[3]

  • You Avoid Double Taxation—In general C corporation dividends are taxed at 15 percent. In addition, a C corporation is in the 15 percent income tax bracket for the first $50,000 it earns; however, the income tax percentage jumps up to 35 percent if your business is a personal service corporation, and you still have to pay taxes on dividends on top of that. If your corporation’s income exceeds $50,000, it has moved into the 25 percent income tax bracket. You can see that the numbers keep creeping up, since the amount you’ll earn (and pay taxes on) in dividends depends upon what’s left after income taxes. With an S corporation, you are likely to avoid this frustrating situation.

With these advantages, you may already be considering taking the S corporation election, but remember that no entity is a perfect choice all around.

Here are some reasons you may decide not to go with an S corporation for tax purposes:

  • You’ll Have Corporate Paperwork (and Extra Fees)—If your business currently operates as a sole proprietorship, you’re in the easy situation of paying your taxes on Schedule C of Form 1040. However, if you switch to an S corporation, you will take on all the corporate tax paperwork that comes along with it. Remember, your corporation will be a separate entity from you as an individual, so you will have paperwork for each. Pretty much any time money goes anywhere between you and your corporation, you’ll have more required paperwork to fill out. Because you probably have neither the time nor the expertise to handle all of these tax, accounting, and legal documents, you’ll likely need to pay for a tax preparer (and/or accountant) and lawyer. When you operate as a sole proprietor or single-member LLC, in contrast, you and your business share assets, and money can flow more easily between the business and yourself (but you should still keep the finances separate!).
  • Your Assets are Not Yours—As mentioned above, a sole proprietorship or single-member LLC has one set of assets, and they belong to the business owner. But, when you create an S corporation and designate business assets, you no longer own those items—the corporation does. This means you’ll be watched much more closely regarding how assets are used, and taking company assets for personal use can trigger a taxable event. Of course, even sole proprietors must watch out for Section 179 recapture rules.
  • You May Have to Pay Extra State Taxes—Some states require S corporations to pay state income taxes or franchise taxes. And, here’s the bigger kick in the teeth, it’s not offset by any additional personal tax deductions for you.
  • Your Heirs May Have Higher Taxes—Upon your death, a sole proprietorship or single-member LLC’s assets are valued individually at fair market value, which usually means lower taxes for your heirs.[4] For a corporation, on the other hand, the company’s stock is marked up to fair market value, and this could be much different from the value of the individual assets.
  • You Get No Break on Medical Costs—If you’re a more than 2 percent owner in your corporation, you won’t be getting much in tax benefits for your health insurance, and neither will your spouse. You see, attribution rules dictate that your spouse has the same ownership interest as you. So, if you’re a 100 percent owner, your spouse also has 100 percent interest in the company. This also means you cannot provide your employee-spouse with a Section 105 medical reimbursement plan, unlike the owner of a sole proprietorship or LLC. The Section 105 benefits are not counted as W-2 income.
  • You Have to Pay Payroll Taxes for Your Employed Children—A proprietorship and single-member LLC both get the benefit of no payroll taxes for wages earned by their own underage children. They also don’t pay Medicare, FICA, or employment taxes for the owner’s kids. Unfortunately for S corporation owners, both the corporation and the child will be subject to payroll taxes.
  • You May Lose Out on 401(k) Contributions—Because your S corporation income is divided between salary and distributions, you’ll have less money available to contribute to your retirement plan. Contributions are based on your salary, and you’ll probably have kept this amount low in order to save on self-employment taxes.

If none of these disadvantages deters you, then an S corporation may be a good fit for your company. The main reason to opt for an entity structure other than sole proprietorship is to attain liability protection. So, ask yourself how much liability protection you need for the type of business you’re in, and then hire a tax professional to help you figure out which entity structure generates the biggest tax savings for you. You’ll more than make back the money spent on professional advice in the years of tax-savings from choosing the appropriate entity structure.

  1. IRC Section 1361(a)(1) ↑
  2. IRC Section 1361(b); Reg. Section 301.7701-3(c)(1)(v)(C) ↑
  3. IRC Section 1(g)(2); Rev. Proc. 2011-52 ↑
  4. IRC Section 1014(a) ↑
Categories : Corporations, Section 105 Medical Plan, Self-employment Tax, Tax Planning

How to Shift Corporate Ownership and Save on Taxes

By Kim M. Larsen EA CTFS
Friday, February 27th, 2015

It pays to plan ahead in almost any situation in life, and the future of your corporation is no different. You have multiple options for what to do with your business when you’re ready to step aside, but we’re going to focus on one in particular that provides you with a nice tax-saving strategy. In a private letter ruling, one man who owned 100 percent of his company’s stock was able to gift some of his stock to his children and then sold the rest to his corporation.[1] The great news is you can use the strategy with anyone—not just your kids.

Here’s how it worked for him:

  • He had a third-party appraiser determine the per-share value of the corporation.
  • His two children wanted to own and run the company, so he gifted shares to each of them.
  • Right after that, the corporation redeemed the remaining stock, providing the man with cash and a promissory note. This last move is important because it means that the children then owned 100 percent of the corporation and the father had the promise of future payments, as well as immediate cash.

What It Means in Terms of Taxes

In a situation like the one above, the recipients are not subject to any taxes for the gifts. The previous owner may be subject to taxes, depending upon how much each of the shares was worth. You pay no gift taxes for amounts less than $14,000 in 2014.[2] Anything over that amount dips into your estate tax and lifetime gift tax exemptions.[3]

Now, another thing to consider is how you will be taxed. You want to be taxed at the tax-favored capital gains rate for selling the stock to your corporation. In order to make this happen, you’ll need to file the right IRS-required elections for complete termination, as well as those that will allow you to avoid stock attribution rules on the shares given to the gift recipient(s).[4]

Without the termination election, you will be subject to taxes at the dividend rate, and you would receive no offset for your basis. Capital gains, on the other hand, are offset by your basis so that you are only taxed on the net gain. In addition, the cash plus promissory note combination is an installment sale, meaning the taxes will be paid on the cash only in the first year, and then tax payments will be made each year after that on the gains and interest received. As for the corporation itself, it will be able to deduct the interest it pays on the promissory note.

Of course, you should check the applicable mid-term minimum federal interest rates for such situations.[5] These rates can be used for your calculations when planning your retirement strategy. Also, you’ll want to use appropriate rates when you establish the promissory note.

In summary, by using this particular strategy for shifting corporate ownership, you’ll get up-front cash, interest on the promissory note, and tax-favored capital gains treatment on taxes. The recipient or recipients of your business have no tax burden on the transaction, and the corporation gets to deduct the interest payments made to you on the promissory note. This strategy works well if, like the man in the private letter ruling, you plan to transfer your corporation to your children. But, it works just as well for transferring the company to an employee, colleague, or current shareholder. Exiting your business should be planned just as carefully as every other decision you have made along the way.

  1. Private Letter Ruling 201228012 ↑
  2. IRC Section 2503(b); Tax Foundation ↑
  3. IRC Section 2010(c)(3); Tax Foundation ↑
  4. IRC Section 302(c)(2)(A)(iii) as specified by Reg. Section 1.302-4(a) ↑
  5. http://apps.irs.gov/app/picklist/list/federalRates.html ↑
Categories : Capital Gains, Corporations, Retirement, Tax Planning

Have you out grown your S Corporation?

By Kim M. Larsen EA CTFS
Sunday, February 22nd, 2015

Here’s a cold hard fact for you business owners: the US has the highest statutory corporate tax rate in the world.[1] Of course, this is a thorn in the side of many business owners, considering the competitive disadvantage it gives in the global economy. As you’re no doubt aware, however, tax laws can change quickly. Given the current climate, it’s possible that S corporation owners may soon be considering the switch to either a C corporation or sole proprietorship.

It turns out that even the president has called for a change in the tax laws governing corporations. He has suggested that the maximum federal tax rate be 28 percent, and even lower than that for manufacturers.[2] The current federal rate is maximum 35 percent, so this would be a significant change. However, at the same time that the reduction of corporate rates is being discussed, individual tax rates are rising. In fact, the highest individual tax rate (39.6 percent) is now higher than the maximum corporate tax rate![3]

But, what does all this mean for business owners? It means that if you currently own an S corporation, you may be better off converting your business to a C corporation if individual taxes continue to rise and corporate taxes fall. So, you’ll want to keep a close eye on the changes in tax law in the coming years. Please note: Every business is different, and this advice may not be applicable to you, depending upon the industry you’re in. Always run the numbers before making a change in entity structure.

If the time comes when you are, indeed, ready to change your entity structure to something other than an S corporation, here’s what you need to know.

Moving Away from the S Corporation

Regardless of the reason you are converting your S corporation to another entity structure, the ways to do so remain the same. You have two options:

  1. Liquidate your business and convert to a sole proprietorship or partnership. Liquidating an S corporation is fairly similar to liquidating a C corporation.[4] You’ll basically need to sell your assets and convert them to personal assets. Using this option allows you the flexibility to reincorporate your business in the future if you choose to do so.
  2. Terminate the S election on your tax documents and convert to a C corporation. You have two options for doing this. You can send the IRS a revocation of your S election with two simple steps: 1) prepare a form stating your revocation, and 2) acquire the written consent of more than half your shareholders.[5] Note that the IRS does not provide these forms. Alternately, you can change certain aspects of your business so that it no longer qualifies for S corporation status. If you choose either one of these termination methods rather than liquidating, you will not be able to elect S corporation status again for your business for five years (unless you request special consent from the IRS).[6]

When you decide to convert to a C corporation using the revocation method, you’ll want to make sure you follow all the correct procedures regarding the consents:

  • Community Property States—If you live in one of these states, your spouse is automatically a shareholder in your corporation unless you took specific steps to prevent this. That means your spouse will also have to provide consent if you are the sole shareholder.[7]
  • Nonvoting Stock—When determining whether you have majority shareholder consent, know that nonvoting stock counts equal to voting stock.[8]
  • Tenant Rules—You must have the other tenant’s consent for stock you own as a joint tenant, tenant by the entirety, or tenant in common.

We’ve laid out the details for two separate ways to convert your S corporation to a C corporation, but if at all possible, you should use the revocation method. Why? Because it gives you clear documentation showing that you have ceased your S corporation. Trying to disqualify your business for S corporation election does not provide you with a specific date that your business ceased to be an S corporation.

However, if it’s not possible to meet the revocation requirements on time, all you have to do is violate one of the requirements for S corporation status intentionally.[9] The date of the violation is the date your S corporation ceases to exist and becomes a C corporation.[10] A couple of easy ways to invoke a disqualifying event is to create a second class of stock or give stock to a shareholder who is ineligible for S corporation stock.

Timing It Right

If a change in tax law does make it advantageous for you to ditch the S-corporation entity structure, then you’ll want to make sure you complete the change on time in order to get the full benefits. Completing the revocation in the first two and a half months of the tax year means the IRS considers your business a C corporation for the whole year.[11]

If you miss this deadline, you can still get some of the benefits intended from the change. You’ll simply have an S short year and a C short year, dividing your tax year into two periods. Whatever day you finalize the termination of your S corporation is the date your C corporation tax period begins.[12]

Having a split tax year means you have to divide all your income, credits, losses, and deductions between the two periods. You have two options for doing this: 1) you can divide the amounts evenly over the course of the year, or 2) you can treat the two as entirely separate tax years, that is, you close the books.[13] The first option is the default method, so you’ll have to specifically elect the second option if you so choose.

To figure the amounts by dividing them evenly throughout the year, you simply determine how many days your company was an S and how many it was a C. For example, if you close the S corporation on April 1, your business spent 90 days as an S (January 1-March 31). The entire year’s income, credits, losses, and deductions would be multiplied by 90/365 to get the S year portion.

Alternately, if you close the books and treat the periods as two separate tax years, you may be able to plan your expenses in order to maximize the deductions under a specific entity structure. You could, for instance, incur larger expense under the S corporation and pass them through to your individual return.[14] In order close the books, you’ll need consent from all shareholders.[15]

The choice of entity structure for your business is an important one. However, it doesn’t have to be permanent. Occasionally, it is to your advantage to keep an eye on changes in tax laws that affect the entity structure of your company. As always, check your strategies with your tax advisor to make sure you follow all procedures and obtain the proper documentation.

  1. See this Tax Foundation article. ↑
  2. See the Washington Post article on this. ↑
  3. 2014 tax brackets ↑
  4. See IRC Section 1371(a) ↑
  5. IRC Section 1362(d)(1)(B). ↑
  6. IRC Section 1362(g). ↑
  7. Reg. Section 1.1362-6(b)(2)(i). ↑
  8. Reg. Section 1.1362-6(a)(3)(i). ↑
  9. T.J. Henry Assocs., Inc., 80 TC 886 (1983) ↑
  10. IRC Section 1362(d)(2)(B); Reg. Section 1.1362-2(b)(2). ↑
  11. IRC Section 1362(d)(1)(C)(i); Reg. Section 1.1362-2(a)(2). ↑
  12. IRC Section 1362(e)(1)(A); Reg. Section 1.1362-3(a). ↑
  13. IRC Section 1362(e)(3). ↑
  14. IRC Section 1366(a). ↑
  15. Reg. Section 1.1362-6(a)(5). ↑
Categories : Corporations, Tax Planning

How You Can Deduct Your S Corporation Board Meeting with Your Spouse

By Kim M. Larsen EA CTFS
Wednesday, February 18th, 2015

When it comes time to deduct business expenses on a tax return, most corporation include expenses for board meetings. After all, that’s undeniably a business expense, right? Well, sometimes it’s not so clear, like when the only two board members are a wife and husband. If you and your spouse jointly hold stock in your S corporation, how do you prove your right to a deduction? Can you go to a restaurant or take a business trip and still deduct the meeting?

Proving Your Business Purpose

When your board meeting consists of just your spouse and yourself, you have to be careful that the IRS has sufficient evidence documenting the business activities of the meeting. How do they know the event was a board meeting, and not just a pleasant lunch date? Husbands and wives have been conducting business together since before the birth of US tax law. You can study precedent cases to find out how the IRS is likely to view your situation.

Unfortunately, not many cases exist regarding this particular scenario, so you have to look at similar situations regarding deductible business expenses. In the case of Ben Heineman, the IRS questioned him for building an office at his vacation property, costing $1.4 million in today’s dollars (the office was built in 1969). Heineman stated that he could perform certain work (such as making business plans) better with his family and away from the distractions of the Chicago offices. Not exactly the same situation as a board meeting, but the same requirements for determining whether an expense is business or personal.

Heineman was the president and CEO of Northwest Industries, Inc., which had its principal offices in Chicago, IL. Not wanting to spend his summers in Chicago, he built the office at his vacation home in a resort area, Sister Bay, Wisconsin. During the period of the year when Mr. Heineman used this office (from about August until Labor Day), he worked at least 5 hours per day, six to seven days per week. He used this time to perform duties essential to the Chicago offices, including long-term business planning.

In the end, the courts ruled in favor of Mr. Heineman, stating it didn’t matter if it would have been less expensive for him to get a second office in Chicago. He had a necessary and ordinary business reason for the trip—he could concentrate better on his work at that location. Therefore, he was entitled to his deduction.

What the Heineman Case Means for You

Why is this case important for your board meeting scenario? The only deductions that Mr. Heineman claimed were depreciation on his office building and maintenance expenses for it. He did not claim traveling expenses for the trip between Chicago and Wisconsin. However, he did travel—to his vacation property. According to tax law travel regulations, you are able to deduct business expenses incurred on a trip that is otherwise personal, and that is why Mr. Heineman was able to deduct his second office expenses.

The same travel regulations would apply to you if you take your spouses-only board meeting to an out-of-town location. So, what you need to show the IRS (with accepted documentation) is:

  1. Business was the primary purpose of the trip, and
  2. Business actually took place during the trip.

All you have to do to establish business as the trip’s primary purpose is to ensure that you conduct business on more days than you partake in personal activities. Fulfilling the requirement that the trip was necessary for business is tougher. How do you show that it was necessary to go out of town? Again, look at Heineman. You could have some very good reasons for going out of town to conduct business: get away from ringing phones, find peace and quiet to concentrate, or not to be distracted by email or employees.

As for proving that you conducted business, you simply keep records of evidence that you did work. These could include:

  • Documents generated on this trip (such as a business plan)
  • A recording of business conversations that took place
  • Evidence that you were in a business setting
  • A print log showing you physically printed business documents to be discussed and reviewed

The out-of-town board meeting can be a bit of hassle to document, so if you’re banking on the deductions making the cost of the trip worthwhile, you’d better make sure you plan efficiently and can back up your claim to the business purpose of the trip. The funny thing, however, is that an in-town board of directors meeting for a wife and husband is even more difficult to prove.

You see, tax law specifies that you cannot deduct personal, family, or living expenses. That means deducting a meal at a restaurant as a business expense is going to be awfully difficult to justify to the IRS, particularly when no one else is participating other than you and your spouse. You’ll see why with an example of a couple who was not allowed to deduct their board meeting expenses.

Mr. and Mrs. Duquette were the sole board members of Norman E. Duquette, Inc. and attempted to deduct expensive meals at two separate restaurants on January 1 and February 1. At the meals, they discussed items such as approval of payment for trips and determining whether to move the business to Naples, Florida. Unfortunately for the Duquettes, the court decided that the couple had no evidence that the issues required significant discussion.

The Duquettes had no employees, and the couple both lived and worked together. The court found no proof that could justify a husband and wife having an expensive dinner in this situation, when they could have just as easily had the discussions elsewhere without the expense. Here is the IRS’s standard stance on the matter (from the Internal Revenue Manual): “Board meetings between husband and wife are not ordinary and necessary business expenses, but personal entertainment expenses, and are therefore not deductible” (Treas. Reg. Section 1.162).[1]

The takeaway from this is that fine dining expenses are not deductible as a wife-and-husband board meeting under official IRS policy. That does not necessarily mean you cannot deduct such expenses, but you’d better be prepared to have a rock-solid justification for it (i.e. a well-documented business reason). Unlike the Heineman case, the Duquette case does not set a precedent (and neither does the IRS audit manual).

Applying the Cases to Your Situation

If your spouse-only board meeting needs to be away from home, either in-town or out, you need to be able to answer the question “Why?” Heineman had something concrete to show the IRS and the court—a business plan that he developed because he was able to concentrate and focus better at the second office. The Duquettes, in contrast, failed to produce any evidence of work effort during the meetings.

To take advantage of deductions for a spouses-only board meeting for your S corporation, you should be confident that you have at least a 50-50 shot at your reasons being accepted, and whoever prepares your taxes has to back up that assertion. Your tax preparer is at risk of severe penalties for filing a return that doesn’t have a justifiable 50-50 chance. When using this strategy, show the Heineman case to whoever prepares your taxes. But, remember that you are highly unlikely to be able to deduct the in-town, husband-and-wife meeting at a restaurant.

Still want to conduct a meeting during a meal? If it’s an issue that requires a third party, such as your attorney, then go ahead! It’s only when spouses dine together exclusively that the deduction becomes difficult. But, when the two of you are meeting to discuss business matters with someone else who is necessary to the discussion, it makes sense that you must find a location to meet (just be sure to document the business purpose!).

  1. Internal Revenue Manual 4.10.10, Paragraph 9707. ↑
Categories : Business Expenses, Corporations, Entertainment, Tax Planning, Travel

Want to Convert to an S Corporation? Watch Out for These Common Mistakes

By Kim M. Larsen EA CTFS
Tuesday, February 17th, 2015

At some point, many proprietors weigh the benefits of switching to an S corporation. In truth, an S corporation entity structure does offer a variety of tax advantages. The basic process of converting to an S corporation is fairly simple.[1] However, tax law always has its hidden caveats.

When dealing with the IRS, they always know their rules. Unfortunately, taxpayers are not always so fortunate. That’s why you need to make sure you understand the tax ramifications before you start paperwork and other steps to switch your company over to an S corporation. For one thing, you want to make sure that the IRS views your S corporation as exactly that, and not a C corporation, which works completely differently when it comes to taxes. Also, you’ll want to understand all those tax advantages available to you. If you’re not aware of them, you can’t use them.

Functioning as an S Corporation

So, just because you have an S corporation on paper doesn’t necessarily mean that’s what you’re operating as. In order to be work under this entity structure, you have to meet these basic requirements:[2]

  • The company must be a domestic corporation;
  • It must have fewer than 100 shareholders;
  • Only people, estates, and certain kinds of trusts can be shareholders;
  • Only US residents can be shareholders; and
  • The corporation can have stock only in one class.

These rules should be fairly easy for the typical business owner to meet. However, the rules have a few hidden elements, and if you miss one of them, the S corporation will revert to a C corporation, possibly with disastrous results to your business. In fact, the IRS can revert your entity to a C corporation for up to three years back.[3]

Tricky Rules

Here’s one of the implied rules that don’t get listed about S corporation—community property laws. If you live in a state with community property laws, your spouse may be an owner in your corporation, even if he or she doesn’t actually have in stock by name.[4] This means your spouse also has to meet all of the requirements. In community property situations:

  • Your S corporation is invalid if your spouse is a nonresident alien.[5]
  • Your S corporation is invalid if your spouse fails to consent to the S corporation election on IRS Form 2553.[6][7]

In fact, entity structures are a lot more fluid than you may think. LLCs can easily become an S corporation for tax purposes by taking only two steps. It’s called “Check and Elect”[8].

  1. File Form 8832 and check the box to convert your LLC to a C corporation.[9]
  2. Then, file Form 2553, which allows the IRS to tax your C corporation as an S corporation.[10]

Here’s another tip about implied rules that sneak into those requirements. Certain types of loans paid by you to your company can be treated by the IRS as a second class of stock for your corporation. Look at the rules above—more than one class of stock and your company is disqualified from filing taxes as an S corporation.

Usually, loans under $10,000 are okay, as long as your corporation has a plan in place to pay back the loan relatively quickly.[11] Larger loans, however, are a bit of a stickier situation. You can still avoid them being classified as a second class of stock if:

  1. You have the loan in writing;
  2. Your corporation has a firm deadline for repaying the loan;
  3. The loan cannot be converted into stock; and
  4. The instrument for repayment uses a fixed interest rate, keeping the rate out of your control.[12]

So, loans may be viewed as stock and cancel out your S corporation benefits. But, it turns out you actually can safely have two different classes of stock, as long as the two kinds of stock have no differences except voting rights (a hidden benefit!).[13] This means you could create a class of voting stock and a class of nonvoting stock. You just have to keep all other aspects of the stock the same. Nonvoting stock can be a big advantage when you want to allow certain people to have distributions but no ability to make business decisions.

What Else You Need to Know

As with any tax requirement, filing to create an S corporation must be completed at the right time. Your business typically has to meet all S corporation requirements on the day you file the election.[14] Here’s an example of how the deadlines work. If you file in 2014 to be an S corporation with an effective date of January 1, 2015, then you must meet the requirements on the day you filed—in 2014.[15]

What this means is you should not file unless and until your business meets the requirements. Luckily, if you forget to file before the end of the previous year, you’re able to file up to two months and 15 days after the first of the year (March 15 for a business that uses the calendar year as the taxable year), and your S corporation will still be effective as of the first of the year. Keep in mind, however, that this only works if your business met all the S corporation requirements from the beginning of the year and you had the consent of all shareholders for that year.[16]

Remember the community property state laws? They could come into play here. If you live in a community property state and get divorced on in February, you would need your ex-spouse’s consent for the S corporation election because they were a shareholder during January, while you were still married.

Additionally, C corporations wanting to convert to an S corporation may face their own unique challenges. Here’s a quick overview of concerns that may cost you extra in taxes:

  • Built-in Gains Tax—To convert, you’ll sell your C corporations assets upon conversion. This means you could be subject to the built-in gains tax if the assets are now worth more than their basis.[17]
  • Passive Investment Income—Higher taxes are an issue when more than 25 percent of your S corporation’s income is passive investment income, such as rents, interest, dividends, royalties, or annuities, and the previous C corporation had accumulated profits and earnings.[18]
  • LIFO Recapture—This is a recapture tax that you may owe if the LIFO (Last-In First-Out) accounting method was used for your C corporation’s inventories.[19]
  • Loss of Tax Attributes—Generally you lose out on the ability to claim C corporation losses or take minimum tax credits when you switch over to an S corporation.[20]

As you can see, it’s easy to think you followed all the rules and still get caught in a tax trap. Fortunately, now that you’re aware of the additional hidden rules, you’ll see them coming and be able to plan ahead so that you don’t find yourself in a tax disaster. S corporations can generate significant tax benefits, but make sure the change is worth it and you follow the rules.

  1. The “S” in S corporation refers to its location in the tax code: Subchapter S of Chapter 1. ↑
  2. IRC Section 1361; you can find a thorough checklist of how to qualify in the Instructions for Form 2553. ↑
  3. The statute of limitations typically prevents assessments for periods more than three years in the past. See Barnes Motor & Parts Co. v U.S., 309 F. Supp. 298 (EDNC 1970) ↑
  4. Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin are community property states. Also, Alaska allows married couples to opt-in to community property. ↑
  5. IRC Section 1361(b)(1)(C). ↑
  6. IRS Form 2553, Election by a Small Business Corporation ↑
  7. Reg. Section 1.1362-6(b)(2)(i). ↑
  8. The choice to be a C corporation is called “checking the box.” The choice to be an S corporation is called an election. ↑
  9. See Rev. Rul. 2009-15 and IRS Form 8832, Entity Classification Election (Rev. January 2012). ↑
  10. IRS Form 2553, Election by a Small Business Corporation ↑
  11. Reg. Section 1.1361-1(l)(4)(ii)(B)(1). ↑
  12. IRC Section 1361(c)(5)(B). ↑
  13. IRC Section 1361(c)(4). ↑
  14. See Rev. Rul. 86-141 and IRS Form 2553, Election by a Small Business Corporation. ↑
  15. Assuming your taxable year matches up with the calendar year. ↑
  16. IRC Section 1362(b). ↑
  17. IRC Section 1374. ↑
  18. IRC Section 1375; see definition of “passive investment income” in IRC Section 1362(d)(3)(C). ↑
  19. IRC Section 1363(d). ↑
  20. IRC Section 1371(b). ↑
Categories : Corporations, Tax Planning

The Relationship between Your Salary and Your Taxes

By Kim M. Larsen EA CTFS
Tuesday, February 3rd, 2015

It’s no secret that the more money you earn from your S corporation, the higher your tax bracket. But, have you actually run the numbers to see what damage—if any—your current salary is actually doing? If not, it’s time you did. As a business owner, you can’t leave financial matters to chance.

A big, fat salary may look nice, but it could actually be losing you money. By capping your own income at the proper amount, you can save yourself thousands of dollars in taxes. The old adage, “A penny saved, a penny earned” certainly applies when it comes to dealing with tax brackets.

Calculating the Right Number

Some may think the solution is to dramatically reduce your salary, but watch out for that tactic! If you set your salary too low, this can also arouse the suspicion of the IRS and elicit an audit. Did you know that if you set your salary unusually low, you could end up paying not only back taxes, but also penalties and interest? Luckily, this article is your guide to getting the amount right—for the most advantage and least audit risk.

The IRS actually has guidelines to setting reasonable salaries for S corporation owners. Keep in mind these are just guidelines created by the IRS—not tax law—but playing by IRS rules goes a long way towards reducing your chances of audit. The good news for you is that a few recent court cases help taxpayers like you to understand how these guidelines are held up (and how you can justify your salary).

Salary Case Examples

First, let’s look at how reducing your salary lowers your payroll taxes. For a sole proprietor earning $100,000 in business income for the year, $14,130 will be paid in self-employment taxes.[1] However, if you form an S corporation and give yourself a salary of $50,000, you pay only $7,650 of payroll taxes between yourself and your corporation combined.[2] That’s nearly $6,500 in tax savings! The remaining $50,000 can be considered a distribution, and those are not subject to payroll taxes.[3]

To see how all this is viewed by the IRS, let’s examine the results of precedent cases:

  • The S Corporation Accountant—David Watson operated his accounting business as an S corporation.[4] His corporation also happened to be a 25 percent partner in an accounting firm. For several years, the firm paid Watson’s corporation more than $200,000. Watson’s self-appointed salary, however, was only $24,000. As you can guess, this is far below the average salary for an accountant.

In fact, the IRS determined that for the area of the country where Watson did business, a reasonable salary was more like $91,044. They came to this conclusion using the Management of Accounting Practice survey conducted by the American Institute of Certified Public Accountants, which listed compensation. For an accountant with no investment interest, average salary was $70,000.

However, Watson did have investment interest. Considering that owners billed at rates 33% higher than directors, the IRS’s valuation expert then increased the reasonable amount by 33% and decreased that amount to reflect fringe benefits that were not taxed—coming up with the $91,044.

In the end, the court sided with the IRS expert and Watson’s salary was adjusted to the more reasonable number. He still took the majority of his income payroll tax-free as distributions (giving him bigger savings than he would have as a sole proprietor), but he got hit with $23,431.23 in payroll taxes owed, penalties, and interest.

  • The Real Estate Professional—Sean McAlary entered the real estate business before the housing crash.[5] His success allowed him $240,000 in distributions from his S corporation in 2006. The mistake he made was taking absolutely no salary—$0—despite being entitled to $24,000, according to corporate minutes.

Using methods similar to those above, the IRS valuation expert determined a reasonable salary of $100,755. Using the California Occupational Employment Statistics Survey, the expert found real estate brokers’ median wage to be $48.44 per hour. That wage was then multiplied by a 40-hour work week and again by 52 weeks. This was despite evidence that McAlary actually worked longer hours and rarely took days off. The court adjusted this finding slightly, and McAlary’s salary for tax purposes was considered to be $83,200, still making distributions a majority of his income.

  • The Glass Blocks Manufacturer—Frederick Blodgett produced glass blocks to be used in homes and other real estate. Unfortunately, the construction industry in his area had a bad year in 2006, and his company felt the fall.[6] So, in the following two years, he ended up loaning his S corporation $55,000. The corporation’s net income for each of the two years was $877 and $8,950.

For 2007 and 2008, Blodgett drew no salary from his corporation. Instead, he took what he described as a mix of distributions and loan repayment, in a total of $30,000 per year. His plan was not viewed his way by the court. The “loans” were deemed capital contributions, making 100 percent of his corporation’s payments to him distributions.

It was decided by the IRS, and held up by the court, that the $30,000 per year distributions would be assigned as Blodgett’s salary. Rather than doing calculations like those in the above cases, the IRS simply stated that someone in Blodgett’s field would make at least that much. The decision gave Blodgett’s business a net loss for the year.

Applying the Lessons

You can see a few tips from these examples. First of all, when setting your salary, consider what other professionals in your field make in your area. Being self-employed, you may not always be able to match yourself to a single profession with compensation statistics. In that case, choose a best match that you can reasonably back up.

Of course, you are also a business owner, so after comparing wages, you’ll need to adjust for several factors. Decrease your wage to account for:

  • Your business’s profit relative to similar businesses in your area (if your profits are smaller);
  • The number of hours you work (if you work less than full-time); and
  • Factors that contribute to your corporation’s success outside of your own personal efforts (for instance, unusually good market conditions for a particular year).

If you’re able to reduce your salary by a reasonable amount because of one of these circumstances, be sure to document your reasoning in the corporate minutes. The lower salary will give you big savings on payroll taxes, as long as it remains reasonable.

As a final note, you do not have to take a salary if your S corporation is not making a profit.[7] Just be prepared by understanding that taking distributions in a year you don’t take a salary is a major red flag to the IRS. If you don’t take a salary in a particular year, try to eliminate or at least minimize the distributions you take.

Reducing your salary is a legal tax strategy for S corporation owners. As long as you don’t take it to the extreme, the technique is an easy way to keep more of your cash. So, research comparable salaries in your area, adjust it downward if you can do so justifiably, and always document your strategy.

  1. Assuming a 15.3 percent self-employment tax rate is applied to 92.35 percent of the income. See Schedule SE for rate details. ↑
  2. $50,000 x 15.3 percent. ↑
  3. Rev. Rul. 59-221. ↑
  4. Watson v US, 668 F.3d 1008 (8th Cir.). ↑
  5. Sean McAlary Ltd, Inc., TC Summary Opinion 2013-62. ↑
  6. Glass Blocks Unlimited, TC Memo 2013-180. ↑
  7. See Davis, d/b/a Mile High Calcium, Inc. v US, 74 AFTR 2d 94-5618. ↑
Categories : Audits, Corporations, Payroll, Tax Planning

Are You Liquidating Your S Corporation? Keep Track of Your Losses

By Kim M. Larsen EA CTFS
Tuesday, February 3rd, 2015

Change is a constant part of life, and perhaps you’re at the point where you’re moving on from your S corporation. It’s a big change, but just because you’re ending your ties with that particular business doesn’t mean it has disappeared entirely from your finances yet. You want to make sure that you get the most from your tax deductions when you disband your corporation.

Liquidation

That’s where liquidation can come into play. If the building and some of the assets owned by your corporation have decreased in value, liquidation (selling the assets at fair market value) allows you to:

  • Keep the building and some of the assets personally, and
  • Use losses from the drop in value on those assets to claim tax deductions on your personal tax return.

Of course, turning a business loss into a personal benefit is like a soufflé; if you don’t follow the instructions exactly, it could fall flat. So, here’s a little guidance:

  • Protect Your Assets—When your assets belonged to the corporation, you probably planned ahead and included some kind of liability protection for them. Well, they don’t stop being worth protecting after liquidation, so you can choose from a couple of options to keep them safe. Once choice is purchasing liability insurance. Another option is to transfer the personal assets to a limited liability company (LLC) or other limited-liability entity structure.
  • No New Corporations—Don’t create a new corporation, at least not as far as your now-personal assets are concerned. Tax law disallows the reincorporation of liquidations.[1] In some cases, if you wait long enough, you may be able to re-use the assets for another corporation you create. However, tax law doesn’t specify a specific amount of time that makes this action allowable. The longer you wait, the safer your liquidation will be. You also decrease the chance of the IRS denying your liquidation if your new business is distinct from the previous one.

Considering Losses

Although the particulars are different, S corporation liquidation is subject to the same rules as C corporation liquidation.[2] Since you are the shareholder of your S corporation, any gains or losses realized through the sale of assets pass through you. You see, when you receive the assets from your corporation, it’s as if they were sold at fair market value.[3]

Example: Your S corporation owns a piece of land. The basis is $1 million, but the fair market value is only $600,000. At the time of liquidation, you get the land in trade for your stock. The corporation then has a loss of $400,000 ($1 million minus $600,000). Now, if you can overcome the IRS loss barriers, then that loss passes to you for tax-deduction purposes.

Here are the loss barriers that may prevent you from realizing a deduction:

  • Inadequate Basis in Stock for Your S Corporation—This one is simple to calculate. Basically, you cannot reduce your stock basis lower than zero.[4] If you’re stock basis at time of liquidation is $150,000 and your losses are $400,000, you can only realize $150,000 of losses because any more would take your basis below $0. So, if you don’t have enough basis in stock, you could lose a whopping $250,000 in deductions.[5]
  • Tax-Free Property Contributions Made Recently—Was your corporation’s land previously your personal land? If so, and you gave it to the corporation within the most recent five years as a tax-free contribution, then the corporation cannot claim a loss on the land during liquidation[6] because the land was distributed to a majority shareholder (you, as the sole owner of an S corporation).[7] Put simply, you don’t get to deduct any losses. This does not apply, however, if the corporation bought the land, even from you.[8]
  • Disproportionate Asset Transfers—The majority of this information applies to sole owners of an S corporation, but as you may know, you can split income with S corporation stock. When you do that, you no longer own 100 percent of the company. In that case, the assets from liquidation must be transferred proportionately among all shareholders. Using the land scenario above, let’s say you own 99 percent of the stock, and your friend owns 1 percent. For the land, you should get a 99 percent interest from the corporation, with the other 1 percent going to your friend. Such would be the distribution for each asset. However, if you do not follow this rule, and you distribute assets disproportionately, the corporation cannot recognize loss on any property allocated to a majority shareholder (one who owns more than 50 percent of the stock).[9] As an example, if your corporation ignores the minor ownership of your friend and gives you all the land, no one will get to deduct the $400,000 loss. You do not want that to happen.

If these barriers create a problem for your ability to realize full loss deductions, liquidation may not be your best option.

What about Stock Losses?

Up until now we’ve talked about pass-through losses (the losses that passed from the corporation to you in liquidation). But, you’ll be happy to know that you also get a special tax break on stock losses.[10] This benefit allows you to consider some of your capital loss to be ordinary, tax-favored loss in amounts up to $50,000 if you file an individual return or $100,000 if you file a joint return.[11]

Of course, there is a stipulation. To qualify for this tax break, you must not have invested $1 million or more into the original capital contribution to your S corporation. Here’s a practical application using the land example above, and considering you meet the contribution qualification. After calculating your pass-through income and loss from the liquidation, you have an $800,000 basis. You then receive the land, valued at $600,000. You have a $200,000 capital loss on the stock ($800,000 minus $600,000. If you’re married and filing jointly, you can consider up to half of that $200,000 an ordinary loss (tax-favored).

The Deal Breaker

In the event that property passed from your S corporation to you is depreciable property (such as a building), any gain recognized on that property must be treated as ordinary income, not capital gain. This pretty much destroys your tax benefits from liquidation.[12] Why is the IRS oh-so-cruel? Actually, their reasoning makes sense. Upon receiving the building in liquidation, you will get ordinary deductions by depreciating the asset yourself. Getting the additional long-term capital gain benefits would be like double-dipping.

An additional warning: For those who operated a company as a C corporation, and then converted to an S corporation, you may be subject to the built-in gains tax when you liquidate.

It may seem like a lot to think about, but be sure to go over these guidelines when you’re ready to liquidate your S corporation. You could be looking at big money in liquidation assets. So, make sure you get the deductions you’re entitled to.

  1. Reg. Section 1.331-1(c). ↑
  2. See IRC Section 1371(a). ↑
  3. IRC Section 336(a). ↑
  4. IRC Section 1367(a)(2). ↑
  5. CCA 201237017, p. 4. ↑
  6. IRC Section 336(d)(1). ↑
  7. IRC Section 336(d)(1)(A). ↑
  8. See Genl. Expl. of Tax Reform Act of ’86 (PL 99-514), p. 341-344. ↑
  9. IRC Section 336(d)(1)(A)(i). ↑
  10. IRC Section 267(a)(1), second sentence. ↑
  11. IRC Section 1244. ↑
  12. IRC Section 1239. ↑
Categories : Corporations, Tax Planning

How to Make Your Proprietorship a Corporation

By Kim M. Larsen EA CTFS
Monday, January 26th, 2015

As a business owner, converting your sole proprietorship to a corporation can have tax advantages. When you’re ready to incorporate your business, the first thing you’ll need to do is prepare and file your corporate documents[1]. You probably already guessed that paperwork needed to be filed, but hold on there—your business is not a corporation yet. Filing the required documents is not the only step in the process.

Transferring Assets

Filing incorporation documents creates an empty corporation. Your business, however, continues operating as it always has, as a sole proprietorship. For your business to fill that empty corporate shell, you have to move your assets over to the corporation in exchange for stock. Basically, when you are incorporating your business, it becomes its own entity rather than an extension of you. Here’s a tip: You don’t have to transfer all of the assets to the corporation. You can keep some under your name. In fact, it would be wise to consult your tax adviser about which assets are better kept in your name.

In the case that you maintain control of your corporation, the exchange of assets for stock is tax-free[2]. How do you know if you control your corporation? For tax law purposes, “control” means that directly following the exchange, you own at least 80 percent of the combined voting power over all the stock and you own at least 80 percent of each of the stock classes without voting rights[3]. This rule of the tax-free exchange always applies, regardless of when you form the corporation.

Be aware: Your family’s stock (including that of your spouse) does not count toward your 80 percent ownership. If, for example, after the exchange you own 70 percent and your spouse owns 30 percent, you do not meet the control criteria. That means you lose the tax-free exchange. Luckily, there are ways around this problem. Your spouse can join you on the transfer, such that both of you are contributing property for the stock. By making the exchange together, you qualify for tax-free status as a group[4].

Considerations When Doing Business with Your Corporation

Since your corporation is a separate entity from you, you have effectively created a new person for tax purposes. This means that you and the corporation do not share assets, and you cannot use each other’s assets without certain consequences. After all, you can’t just use your neighbor’s assets without compensating the person, right?

Here are some scenarios you’ll want to consider:

  • Using Corporate Assets—What if you would like to use your corporation’s assets? You simply have to arrange the use like you would with any other unrelated business acquaintance. You can treat your borrowing of corporate assets like any of the following situations:
  • Compensation,
  • A fringe benefit,
  • A purchase,
  • A lease,
  • A dividend, or
  • Any other economic arrangement business people might enter into.

You should be aware that because you control these arrangements between you and the corporation, the IRS will keep a close eye on the terms you arrange. If the IRS thinks you are mishandling such an arrangement or interchanging your assets with the corporation’s assets, it has the authority to reallocate your deductions, income, and assets in the manner it approves[5].

Usually, these reallocations will not be to your benefit. So, you need to protect yourself when dealing with your new corporation. That means documenting all your transactions and using fair market value terms to the best of your ability.

  • Contributing Debt—When you incorporate your company, it’s not only assets that you can transfer to the corporation. You can also transfer your business debt, such as mortgages and outstanding loans[6]. For tax purposes, this poses no problem; however, your creditors may have a different opinion.

For an asset tied to debt, such as an office building, you will probably need approval from the creditor before transferring the asset to your corporation. It’s not a big deal if you don’t get approval, though. You can always make arrangement with your corporation to compensate you for the use of assets still in your name (e.g., by paying rent to you).

  • Dual-Purpose Assets—Even after careful doling out of assets, you will probably still have some items that you use for both business and personal uses. Your car is an example of these. In such cases, you will have to make your own reasonable decisions based on how the assets are used. The best strategy is to talk to your tax adviser about your options for dual-purpose assets.

When determining how to classify these dual-purpose assets, you may want to consider liability. Incorporating your business does a wonderful job of protecting your personal assets. This is because business creditors are then limited to dealing with the corporation’s assets.

  • Handling Third Parties—When you transfer assets, some of those may have third parties involved. Any permits, licenses, or bank accounts, for instance, will need to be changed and put into the name of the corporation. They cannot remain under your name. It may cost money to make these changes, but by doing so, you avoid the cost of contract penalties and additional taxes. These costs are just part of changing your business over to a corporation.

This article gives you a good overview of how to handle incorporating your sole proprietorship. Now you know what to be thinking about (and documenting!) when it’s time to make the change. Good luck in your endeavors, and be sure to check with your accountant when it comes down to the nitty-gritty!

  1. The necessary documents and process for filing vary between states. ↑
  2. IRC Sections 351(a); 361(a). ↑
  3. IRC Section 368(c). ↑
  4. See Burr Oaks Corp., 43 TC 635, 651 (1965), aff’d, 365 F2d 24 (7th Cir. 1966), cert. denied, 385 US 1007 (1967). ↑
  5. IRC Sections 482; 7701(o). ↑
  6. IRC Section 357(a), (c). However, in some instances, you may recognize gain. ↑
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