With the farming season here in Idaho winding down, we are meeting a lot of clients to bring books up to date and do tax projections. Like much of America, many of our clients have structured their operations to take advantage of corporate elections under subchapter S of the tax code. Originally written into the co de to give small operations a simplified version of the traditional corporation, now much of the popularity is driven by potential tax savings.
The S corporation election has a lot going for it, but to protect the election and reap the most benefit from the S election, we can’t treat it like an open range and wander all over the landscape. Some mistakes simply cost more in taxes; others can invalidate the whole election. Here are some items on our checklist to review each year to minimize problems.
(Fair warning, there is not a lot of detail on these items here. It would fill this whole issue if we tried, so I’m just trying to bring these to your attention.)
The first item to check is the officer payroll. We’ve got to receive a reasonable salary for shareholders working in the corporation. While “reasonable” is in the eye of the beholder, some things will likely cause you a problem. If half of your employees make more than you, that seems odd. Maybe you take 10 times your salary as distributions for personal expenses – that seems out of balance. There is really no bright line to know what is right in every situation, but let’s be realistic and take a look each year.
I like to remember that in an S corporation officer payroll is another tool to save taxes. For example, the officer's salary is the only pathway to deduct our health insurance. The officer salary is also the base for retirement contribution limits and, combined with a simple retirement plan, is a powerful tax break. We can also protect the business use of autos by using the lease-inclusion rules for personal use through the paycheck.
The second checkup item is our basis (or net investment). An S corporation shareholder must track this if there are distributions or an operating loss that pretty much covers everyone. Basis is a running record of the money you’ve invested, adding in the profits and subtracting the distributions with the balance carried from year to year. If a shareholder takes more money out than basis, there can be phantom taxable income. If the S corporation has an operating loss but you got no basis, that loss can’t be used until you get some basis.
The good news is that prudent management and leaving operating capital in the business probably means your basis is OK. But this is such a big issue for the IRS, they’ve added another form for this last year – a basis problem can sneak up on you. This makes it a good item to check on to avoid a surprise.
The third item to check is that our distributions are in proportion to stock ownership. The most common threat to the S election is unequal distributions; we’ve got to make sure every stockholder gets the same distribution amount relative to their shares. Let’s say the parents give each of the kids, including the off-farm kids, some shares. However, the kid working the farm gets twice the distribution amount per share. Unequal distributions can also happen if we have a habit of paying a shareholder’s personal bills or credit cards out of the corporation. Those payments get treated as distributions and can quickly get out of balance between shareholders.
A best practice to avoid unequal distribution problems is to be a bit more formal and disciplined. Set an amount per share, pay on a schedule and pay personal bills on personal accounts.
These first three ought to be operational checks we should do every year for as long as our business operates to get the tax results we expect.
The fourth item is an issue that has shown up with the popularity of businesses originally organized as a limited liability company (LLC) and then later making an S election. Many boilerplate operating agreements for LLCs contain some provisions about maintaining capital accounts related to partnerships. Unless that is immediately fixed, the S election is invalid and you revert to a regular corporation. Because that can result in the dreaded double tax at corporate and individual levels, you should carefully review those agreements to avoid a really nasty surprise.
The fifth and final checkup item is to build or update a file with the organizing documents and annual records. Check that the secretary of state registration is current. Document the officer's salary and why it was set to that amount. If loaning money to the corporation, have a note in place and follow it. If you’re renting personal land to the farm, have a lease. Getting items down on paper can protect your deductions and make sure you get the expected result.
In short, build a document file. It doesn’t have to be complicated or have a lot of legalese – just get it down on paper. Besides protecting the business, it is a great way for all parties to be literally on the same page.
There is way more detail to these issues than I can boil down in an article like this, but please take this away: S elections are fragile, so to protect your benefits, do the checkup with your tax professional..jpg?t=1687979285&width=640){kind=logo}
