Archive for Sub-chapter S
If you are a shareholder of an S corporation you are responsible for keeping track of your own basis (investment value) in the S corporation of which you own shares. Tracking shareholder basis is usually not the S corporation’s responsibility.
You can have stock basis and loan basis, which are usually adjusted each year based on the S corporation’s operations.
It is important to annually calculate your shareholders basis in the S corporation stock you own for the following reasons:
• You can claim losses and deductions passed through on Schedule K-1 to the extent of their stock and loan basis [§1366(d)(1)].
• If you receive a non-dividend distribution from the S corporation, it’s nontaxable to the extent of you stock basis [§1368(b)(1)].
• When you disposes of the S corporation stock, gain or loss on the disposition is calculated using you stock basis.
Stock basis starts with your initial contribution of capital to the S corporation’s capital account or the price paid for the stock. This amount is adjusted annually, as of the last day of the S corporation year, in the following order [Reg. §1.1367-1(f)]:
(1) Increased by all income including tax-exempt income reported on Schedule K-1 and excess depletion.
(2) Decreased by property distributions including cash made by the S corporation that are reported on Schedule K-1 in Box 16 with code D.
(3) Decreased by nondeductible non capital expenses, such as illegal bribes, kickbacks, fines and penalties, expenses and interest related to tax-exempt income, and the nondeductible portion of meals and entertainment.
(4) Decreased by deductible losses and deductions reported on Schedule K-1.
Stock basis can never go below zero.
If non dividend distributions exceed stock basis, the excess is taxed as capital gain on your personal return [§1368(b)(2)].
If deductible losses and deductions exceed stock basis, they can be deducted to the extent you have loan basis and any amount in excess of loan basis is suspended and carried over to the succeeding tax year.
You can elect to reduce your stock basis by deductible losses and deductions before decreasing their basis by non deductible expenses [Reg. §1.1367-1(g)]. If this election is made and nondeductible expenses exceed your stock and loan basis, the excess retains its character and is carried over to the succeeding tax year. If the election is not made, any excess nondeductible expenses are lost, not suspended and not carried over.
Loan basis starts with a loan substantiated with loan documentation from you the shareholder of the S corporation to the S corporation. In other words, it includes a traditional, written note with a reasonable stated rate of interest. It does not include third party loans to the S corporation that you guarantee or co-signs.
Loan basis is adjusted as follows:
• Losses and deductions (deductible and nondeductible) passed through on Schedule K-1 reduce stock basis before they reduce loan basis.
• Loan basis can never go below zero. If deductible losses and deductions exceed your stock and loan basis, the excess is suspended and carried over.
• If there are different types of losses and deductions, the allowable loss and deduction items must be prorated.
• If loan basis has been reduced by pass-through losses and deductions, any net increase in a subsequent year restores the reduced loan basis before it increases your stock basis [Reg. §1.1367-2(c)].
A net increase is the amount by which the increases to stock basis exceed the decreases to stock basis including non dividend distributions.
• Non dividend distributions are not taxable if there is a “net increase” for the year, even if you have no stock basis.
• Reduced loan basis is restored by any “net increase” for the year before any loan repayments during the year are taken into account [Reg. §1.1367-2(d)(1)].
These loan repayments must be allocated in part to a return of your basis and in part to the receipt of income. If the loan is a written note, the note is a capital asset and the income will be capital gain.
As an S corporation shareholder you must establish that you have enough basis in the S corporation before you can claim any pass-through losses or deductions. Basically S corporation shareholders usually tend to get into trouble when they assume that non dividend distributions from an S corporation are entirely nontaxable. Be sure to verify that the distribution does not exceed your stock basis. Also be sure to be aware of the various ordering rules for adjusting stock and loan basis in an S corporation.
Considering the scope of the reasonable cause language to the Code Sec. 6699 penalty for late filing of an S corporation return, the Tax Court determined that the failure to timely file a 2008 2008 1120-S tax return was due to reasonable cause not subject to penalty in Ensyc Technologies v. Comm’r, T.C. Summary 2012-55 (6/14/12). The following are the facts as I understand:
1. Ensyc Technologies, an S corporation operated entirely by its president who works from his home in Idaho with the assistance of subcontractors, had its tax returns prepared by an accountant in Nevada.
2. Ensyc’s annual tax return for 2008 was due March 16, 2009.
3. On March 10, 2009, Ensyc’s accountant sent Ensyc IRS Form 1120S, U.S. Income Tax Return for an S Corporation, to file with the IRS. The accountant also sent copies of Schedules K-1, Shareholder’s Share of Income, Deductions, Credits.
4. Ensyc’s files contained a copy of a Form 1120S bearing the President’s signature dated March 16, 2009.
5. The IRS has record receiving a Form 1120S from Ensyc on September 11, 2009 postmarked September 8, 2009.
6. The 1120-S form itself was dated February 24, 2009.
7. Code Sec. 6699 basically states that an S corporation not timely filing its annual tax return is liable for a per-shareholder penalty for every month the tax return is late up to 12 months. However the penalty is not imposed if the failure to timely file the return is due to reasonable cause.
8. On the theory that the Form 1120S it received on September 11, 2009, was the only Form 1120S Ensyc had filed for tax year 2008, the IRS assessed a $6,408 late-filing penalty.
9. On February 1, 2010, Ensyc requested a collection-review hearing with the Office of Appeals regarding levy action.
10. The IRS Office of Appeals determined that Ensyc did not timely file a Form 1120S nor did it have reasonable cause for failing to timely file the form and sustained the levy.
11. Ensyc took the case to the Tax Court, arguing that it was not liable for the late-filing penalty because it mailed a Form 1120S on March 16, 2009.
12. The Tax Court examined the possible explanations for why the IRS had no record of receiving the Form 1120S and essentially determined that the tax return was not timely mailed.
13. The Tax Court then considered whether there was reasonable cause for not filing the form on time noting that no judicial opinion had yet considered the scope of the reasonable cause exception to the Code Sec. 6699 penalty.
14. The court applied the ordinary-business-care-and-prudence test from IRC 6651 concluding that Ensyc exercised ordinary business care and prudence in its efforts to timely file its Form 1120S for 2008.
15. The Tax Court specifically noted that the President routinely mailed Ensyc’s tax returns on time. Further he mailed the Schedules K-1 to Ensyc’s shareholders and that an Ensyc shareholder filed an annual individual income-tax return on April 15, 2009 reflecting the shareholder’s pass through loss.
16. The court believed the President’s testimony that he thought he had mailed the 2008 Form 1120S on March 16, 2009. As a result, the court found that Ensyc’s failure to timely file a Form 1120S for the 2008 tax year was due to reasonable cause and, thus, Ensyc was not liable for the Code Sec. 6699 penalty.
17. It was also noted that pursuant to INTERNAL REVENUE CODE SECTION 7463(b), this opinion may not be treated as precedent for any other case.
I think the lesson learned here is to file on time and avoid the penalty.
If you qualify to take the deduction, use the Self-Employed Health Insurance Deduction Worksheet to figure the amount you can deduct. However use IRS Publication 535 instead if any of the following applies.
According to IRS INSTRUCTIONS you may be able to deduct the amount you paid for health insurance for yourself, your spouse, and your dependents. The insurance can also cover your child who was under age 27 at the end of 2011, even if the child was not your dependent. A child includes your son, daughter, stepchild, adopted child, or foster child.
Enter the total amount paid in 2011 for health insurance coverage established under your business
(or the S corporation in which you were a more-than-2% shareholder) for 2011 for you, your spouse, and your dependents. Your insurance can also cover your child who was under age 27 at the end of 2011, even if the child was not your dependent. But do not include amounts for any month you were eligible to participate in an employer-sponsored health plan or amounts paid from retirement plan distributions that were nontaxable because you are a retired public safety officer
Enter your net profit* and any other earned income** from the business under which the insurance plan is established, minus any deductions on Form 1040, lines 27 and 28. Do not include Conservation Reserve Program payments exempt from self-employment tax
Self-employed health insurance deduction. Enter the smaller of line 1 or line 2 here and on
Form 1040, line 29. Do not include this amount in figuring any medical expense deduction on Schedule A
*If you used either optional method to figure your net earnings from self-employment, do not enter your net profit. Instead, enter the amount from Schedule SE, Section B, line 4b.
**Earned income includes net earnings and gains from the sale, transfer, or licensing of property you created. However, it does not include capital gain income. If you were a more-than-2% shareholder in the S corporation under which the insurance plan is established, earned income is your Medicare wages (box 5 of Form W-2) from that corporation.
One of the following statements must be true.
You were self-employed and had a net profit for the year.
You were a partner with net earnings from self-employment.
You used one of the optional methods to figure your net earnings from self-employment on Schedule SE.
You received wages in 2011 from an S corporation in which you were a more-than-2% shareholder. Health insurance premiums paid or reimbursed by the S corporation are shown as wages on Form W-2.
The insurance plan must be established under your business. Your personal services must have been a material income-producing factor in the business. If you are filing Schedule C, C-EZ, or F, the policy can be either in your name or in the name of the business.
If you are a partner, the policy can be either in your name or in the name of the partnership. You can either pay the premiums yourself or your partnership can pay them and report them as guaranteed payments. If the policy is in your name and you pay the premiums yourself, the partnership must reimburse you and report the premiums as guaranteed payments.
If you are a more-than-2% shareholder in an S corporation, the policy can be either in your name or in the name of the S corporation. You can either pay the premiums yourself or the S corporation can pay them and report them as wages. If the policy is in your name and you pay the premiums yourself, the S corporation must reimburse you. You can deduct the premiums only if the S corporation reports the premiums paid or reimbursed as wages in box 1 of your Form W-2 in 2011 and you also report the premium payments or reimbursements as wages on Form 1040, line 7.
But if you were also eligible to participate in any subsidized health plan maintained by your or your spouse’s employer for any month or part of a month in 2011, amounts paid for health insurance coverage for that month cannot be used to figure the deduction. Also, if you were eligible for any month or part of a month to participate in any subsidized health plan maintained by the employer of either your dependent or your child who was under age 27 at the end of 2011, do not use amounts paid for coverage for that month to figure the deduction.
If you were eligible to participate in a subsidized health plan maintained by your spouse’s employer from September 30 through December 31, you cannot use amounts paid for health insurance coverage for September through December to figure your deduction.
Medicare premiums you voluntarily pay to obtain insurance that is similar to qualifying private health insurance can be used to figure the deduction. Amounts paid for health insurance coverage from retirement plan distributions that were nontaxable because you are a retired public safety officer cannot be used to figure the deduction.
If you qualify to take the deduction, use the Self-Employed Health Insurance Deduction Worksheet to figure the amount you can deduct. However use IRS Publication 535 instead of the Self-Employed Health Insurance Deduction Worksheet in these instructions to figure your deduction if any of the following applies.
You had more than one source of income subject to self-employment tax.
You file Form 2555 or 2555-EZ.
You are using amounts paid for qualified long-term care insurance to figure the deduction.
In my dealings with the US Treasury Department regarding worker classification disputes I have learned that although in reality there may be shades of gray distinguishing between what constitutes an employee and what constitutes an independent contractor the US Treasury has some very specific positions. Here are four that will hopefully help you make the correct determination and avoid future problems:
1. A relationship between an employer and an employee exists when the person for whom the services are performed has the right to control and direct the individual who performs the services, not only as to what is to be done, but also how it is to be done. It is not necessary that the employer actually direct or control the individual, it is sufficient that the employer merely has the right to do so. The designation of a worker as an agent, sub-contractor or independent contractor is irrelevant if the relationship of employer and employee exists. The degree of importance of each factor varies depending on the occupation and the factual context in which the services are performed.
2. A worker who is required to comply with another person’s instructions about when, where and how he or she is to work is ordinarily an employee. This control factor is present if the person or persons for whom the services are performed have the right to require compliance with instructions. Some employees may work without receiving instructions because they are highly proficient and conscientious workers or because the duties are so simple or familiar to them. Furthermore, instructions, that show how to reach the desired results, may have been oral and given only once at the beginning of the relationship.
3. Lack of significant investment by a person in facilities or equipment used in performing services for another indicates dependence on the employer and, accordingly, the existence of an employer-employee relationship. The term “significant investment” does not include tools, instruments, and clothing commonly provided by employees in their trade; nor does it include education, experience or training.
4. A person who can realize a profit or suffer a loss as a result of his or her services is generally an independent contractor, while the person who cannot is an employee. “Profit or loss” implies the use of capital by a person in an independent business of his or her own. The risk that a worker will not receive payment for his or her services, however, is common to both independent contractors and employees and, thus, does not constitute a sufficient economic risk to support treatment as an independent contractor. If a worker loses payment from the firm’s customer for poor work, the firm shares the risk of such loss. Control of the firm over the worker would be necessary in order to reduce the risk of financial loss to the firm. The opportunity for higher earnings or of gain or loss from a commission arrangement is not considered profit or loss.
It seems to me that a relatively significant problem for most Sub chapter S Corporations is accounting for the capital accounts of each and every single shareholder. The company must maintain reasonably detailed records of each shareholder’s equity investments of cash and property, loans that each shareholder advances to the company as well as distributions made to shareholders to arrive at shareholder’s equity.
Shareholder’s Equity is reflected in the shareholder’s capital account. This account should show the dollar amount of cash investments, and value of property donated to the company. A shareholder who contributed cash of $100,000, a computer worth $20,000, and software worth $4,000 would have a capital account showing a total investment of $124,000. The capital account is adjusted from time to time to reflect additional equity investments. Additionally, the capital account is adjusted at the end of the year to reflect each shareholder’s pro-rata share of income and expenses.
Unlike limited partnerships and limited liability companies, shareholders of S-corporations must divide the corporation’s net income in strict proportion to their share of ownership. If a shareholder has contributed exactly one-third of the company’s capital, then exactly one-third of the company’s net profit or loss must be allocated to that shareholder. A shareholder’s capital account needs to reflect the shareholder’s investments and current basis in the S-Corporation’s equity or liabilities. A shareholder is invested in the S-Corporation to the extent that a shareholder has made an equity investment or advanced a loan to the company.
The capital accounts come into play in two crucial parts of an S-Corporation’s financial and tax reporting. First, the capital accounts are reported on the company’s balance sheets as shareholder equity and loans from shareholders. Second, each shareholder’s capital account can be summarized on Form 1120S Schedule K-1. Insufficient capital investments can cause shareholders to fail to meet the At-Risk rules for losses and can cause business losses to be suspended or even become non-deductible. Generally speaking the adjusted basis of a shareholder’s stock is calculated as follows:
Adjusted basis at the beginning of the year
+ Share of all income items that are separately stated, including tax-exempt income
+ Share of all non-separately stated income items
+ Share of deduction for excess depletion of oil & gas properties
- Distribution of cash or property to the shareholder that was not included in the shareholder’s wages
- Share of all loss and deduction items that are separately stated, including Section 179 deductions and capital losses
- Share of all non-separately stated losses
- Share of non-deductible expenses, such as the non-deductible portion of meals & entertainment expense or non-deductible fines and penalties
- Share of depletion for oil & gas properties not in excess of the property’s basis.
= Adjusted basis in S-Corporation stock at the end of the year
Overall, the S-Corporation reports total income and expenses at the company level, and passes-through a share of net profit or loss to individual shareholders. The S-Corporation needs to maintain excellent records regarding each shareholder’s investment of cash or property. These records are crucial for establishing each shareholder’s percentage of ownership in the company.
Generally, S-Corporation accounting is the same as C-Corporation accounting. Income and expenses are reported at the corporate level, and the nature of various types of income and expense are identified at the corporate level as well. S-Corporations can choose an accounting method best suited to report the income and expenses of the company. S-Corporations are not required to use the accrual method of accounting; they may choose the cash method or a hybrid method of accounting if those methods of accounting.
Income and expense items retain their character when they are passed-through to S-corporation shareholders. Long-term capital gains, for example, earned by the S-corporation are passed through as long-term capital gains to shareholders. S-Corporations therefore need to identify types of income and types of expenses for the benefit of their shareholders.
Donating Property to an S-Corporation. Shareholders can invest cash or property to an S-Corporation. A shareholder might contribute a computer, desk, reference books, and software programs to her newly formed S-Corporation in addition to her cash investment. The value of the shareholder’s property is the lower of (a) the fair market value of the property, or (b) the shareholder’s adjusted basis in the property.
Certain entities, such as partnerships, are required annually to file K-1s with the IRS and provide a copy to their partners. The IRS estimates that partnerships filed almost 26 million K-1s during 2011. Revenue Procedure 2012-17 provides new rules describing when partnerships may provide K-1s electronically to partners.
These new rules make it easier for partnerships to provide this necessary information to their partners, and will reduce the expense associated with printing and mailing K-1s to partners who elect to receive them electronically. The partnership must receive the partner’s consent before providing K-1s electronically, instead of on paper similar to the new rules governing the electronic furnishing of the 1099 and W-2s.
The revenue procedure also addresses how the consent can be provided electronically — including secure e-mail and through the partnership’s internet page. The revenue procedure defines how the partnership is to provide instructions about accessing and printing electronic statements and the partnership’s responsibility if the K-1 is electronically not deliverable.
Having spent way too much time dissecting a balance sheet today I thought it might be a good idea to put out a cash basis balance sheet basic overview post.
A balance sheet is a snap shot at a specific point in time – usually the end of a quarter or fiscal year – that depicts the value of an entity’s assets as they relate to its liabilities and equity. The basic formula or equation that needs to balance is …
ASSETS = LIABILITIES + OWNER’S EQUITY
I learned how to run a trial balance on a chart of accounts back in the 80′s at Marquette University and find myself to this day going back to the basic precept of ‘T’ accounts to untangle the most complicated balance sheets. Leave it to the Jesuits to know their accounting.
In the ‘T’ accounts most primitive form, whenever a transaction is recorded 2 entries are made, one on the left side of the ‘T’ account and the other on the right side of a corresponding ‘T’ account. This will be broken down further below but generally speaking when it comes to cash basis balance sheets if a chart of accounts is set up with the general idea of ‘T’ accounts in mind then running a trial balance at the end of a period should be a breeze.
In my opinion the basic rules of thumb for building or reconstructing a balance sheet are as follows:
1. Analyze the financial event or transaction.
2. Identify the accounts affected.
3. Classify the accounts affected.
4. Determine the amount of increase or decrease for each account.
5. Apply the left-right rules for each account affected. Make the entry in T-account form.
6. ‘T’ account names should ideally correspond to the line items listed on the balance sheet such as Cash, Prepaid Rent, Supplies, Account Payable and Equity,.
Again for a balance sheet to ‘balance’ as it were the value of the entity’s assets must equal the sum of its liabilities plus its owner’s equity.
Asset accounts show items of value owned by a business. For example say you invested $100,000 in a corporation. That cash infusion is now an asset of the corporation. Cash increases appear on the left side of the Cash ‘T’ account, an asset account. Decreases are shown on the right side. The cash investment of $100,000 (a) is recorded on the left side of the Cash account.
When you invested $100,000 in this corporation you become an owner or of the corporation. Owner’s equity appears on the right side of the accounting equation (Assets = Liabilities + Owner’s Equity). Increases in owner’s equity appear on the right side of the T account. Decreases in owner’s equity appear on the left side. In this case an investment of $100,000 (a) increases your capital account by $100,000 and is entered on the right side of the Capital account.
Shareholder ‘X’, Capital
In this case you invested $100,000 from your personal savings into the business checking account creating the following entries:
a. The asset account, Cash, is increased by $100,000.
a. The owner’s equity account is increased by $100,000.
Left-Right Rules for ‘T’ accounts
Again keeping in mind that the equation is basically
Asset ‘T’ Accounts = Liability ‘T’ Accounts + Owner’s Equity ‘T’ Accounts
Left – Increases to asset accounts are recorded on the left side of the T account, decreases on the right.
Right – Increases to owner’s equity and liability accounts are recorded on the right side of the T account, decreases on the left.
Recording an Asset Acquisition
The business issued a $5,000 check to purchase a computer and other equipment.
b. The asset account, Equipment, is increased by $5,000.
b. The asset account, Cash, is decreased by $5,000.
Recording a asset purchase using credit
Liabilities are amounts a business owes its creditors. Liabilities appear on the right side of the accounting equation (Assets = Liabilities + Owner’s Equity). Increases in liabilities are on the right side of liability T accounts. Decreases in liabilities are on the left side of liability T accounts. For this example let’s say the business bought office equipment for $6,000 on account from Office Plus.
c. The asset account, Equipment, is increased by $6,000.
c. The liability account, Accounts Payable, is increased by $6,000.
Purchasing Supplies with Cash
The business issued a check for $1,500 to North Shore Office Supply, Inc to purchase office supplies.
a. The asset account, Supplies, is increased by $1,500.
b. The asset account, Cash, is decreased by $1,500.
Notice that the Cash account now shows three transactions: the initial investment by the owner (a), the cash purchase of equipment (b), and the cash purchase of supplies (d).
RECORDING PAYMENT TO A CREDITOR
The business paid $2,500 to North Shore Office Supply to apply against the debt of $6,000 shown in Accounts Payable.
a. The asset account, Cash, is decreased by $2,500.
b. The liability account, Accounts Payable, is decreased by $2,500.
Recording Pre-Paid Rent
The business was required to pay rent in advance. You set up an asset account called Prepaid Rent.
a. The asset account, Prepaid Rent, is increased by $8,000.
b. The asset account, Cash, is decreased by $8,000.
An account balance is the difference between the amounts on the two sides of the ‘T’ account. First add the figures on each side of the ‘T’ account. Then subtract the smaller total from the larger total with the result being the account balance. If the total on the right side is larger than the total on the left then the balance is recorded on the right side. If the total on the left side is larger, the balance is recorded on the left side. This is true even if there is only one entry.