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The Pass-through Deduction: Things every business owner needs to know

Sep 21, 2018 12:16 PM

By Dan Packard, CPA, CFE, CVA

Tim Anderson, CPA

Scott Nielson, CPA

 

Recent tax changes have dramatically impacted the opportunities available to small business owners.  One of the largest opportunities now available is the pass-through deduction (Section 199A deduction), by which a taxpayer can deduct up to 20 percent of income from partnerships, s corporations, or sole proprietorships.  The availability of the deduction is influenced by your industry, the nature of your income, the structure under which you operate your business, and whether you’ve adequately prepared before year end.  Simply put, the deduction isn’t simple.  However, your ability to understand the deduction and properly plan can result in substantial tax savings.

The Basics

Effective for tax years beginning after December 31, 2017 and before January 1, 2026, a taxpayer is entitled to a deduction equal to 20% of the taxpayer’s “qualified business income” earned in a “qualified trade or business.” The deduction is limited, however, to the greater of:

  • 50% of the W-2 wages with respect to the qualified trade or business, or
  • The sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property.

The resulting deduction is then subject to a second limitation equal to 20% of the excess of:

  • The taxable income for the year, over
  • The sum of net capital gains

The purpose of this overall limitation is to ensure that the 20% deduction is not taken against income that is taxed at preferential rates.

“Qualified Business Income” is the net amount of qualified items of income, gain, deduction, and loss with respect to a qualified trade or business that are effectively connected with the conduct of a business in the United States. However, some types of income, including certain investment-related income, reasonable compensation paid to the taxpayer for services to the trade or business, and guaranteed payments, are excluded from qualified business income.

“Qualified trades and businesses” include all trades and businesses EXCEPT the trade or business of performing services as an employee and "specified service" trades or businesses: those involving the performance of services in law, accounting, financial services, and several other enumerated fields, or where the business's principal asset is the reputation or skill of one or more owners or employees.

The W-2 wage limitation does not apply to taxpayers with taxable income of less than $157,500 for the year ($315,000 for married filing jointly) and is phased in for taxpayers with taxable income above those thresholds. Income from specified service businesses is not excluded from qualified business income for taxpayers with taxable income under the same threshold amounts.  Consequently, taxpayers, regardless of the industry wherein they operate, can achieve the pass-through deduction if taxable income is $315,000 or less.

 2018 Passthrough Deduction Flow Chart

 

Maximizing the Pass-through Deduction

Given that the pass-through deduction is primarily designed to benefit qualified trades or businesses and those with taxable income less than $315,000 (MFJ), taxpayers should engage early in tax planning to ensure they maximize the benefit.  Below are several ideas you should consider and discuss with your CPA during tax planning:  

  • Retirement Plan Contributions: Increasing retirement plan contributions, especially for the business owner, is a great idea irrespective of the pass-through deduction.  Safe harbor 401(k) profit-sharing plans can provide significant benefits to a business owner and their spouses, and also allow staff to contribute to the 401(k) plan at a relatively low cost to the business.  Furthermore, the business owner can adopt a defined benefit or cash balance plan that can provide for extreme contributions for the owner, subject to some limitations.  Implementation of a pre-tax retirement plan will reduce your taxable income and help you achieve the income thresholds that yield the largest pass-through deduction. 
  • Employment of Your Children in your Business: Paying your children the highest reasonable amount for the services they render will further reduce taxable income.  Thanks to the increased standard deduction, each child can now earn up to $12,000 annually that is free of federal income tax. 
  • Be Cautious with Capital Gains and Investment Income: Interest, dividends, and capital gains all serve to increase taxable income.  Consequently, it is wise to review investment portfolios to ensure capital gains are not needlessly being recognized as assets are moved.  Furthermore, when selling real property, 1031 exchanges should be considered whenever possible to defer gains and reduce taxable income.  As a reminder, Section 1031 allows a taxpayer who owns real property held for investment or used in a business to exchange property and defer paying taxes if the taxpayer acquires a like-kind replacement property to be held for investment or used in a business.  This allows taxpayers to potentially use all of the proceeds from the sale of the relinquished property to leverage into more valuable property, increase cash flow, diversify into other properties, expand business operations, reduce management or consolidate into one larger replacement property.  When considering replacement properties, be sure to consider Opportunities Zones and the tax benefits associated with investment in these types of properties. 
  • Charitable Contributions: Charitable contributions present a highly effective way to reduce taxable income.  Charitable contributions can take many different forms: cash contributions to qualified 501(c)3 organizations, non-cash contributions of household items, and contribution of highly appreciated property, such as stock, art, or real property.  Taxpayers can specifically take a charitable deduction for qualified conservation contributions, which are contributions of a qualified real property interest to a qualified organization exclusively for conservation purposes. A qualified real property interest for this purpose can be the taxpayer’s entire interest in the property, a remainder interest or an easement that restricts the use of the property in perpetuity. Conservation purposes include (1) preserving land for outdoor recreational use by, or education of, the general public; (2) protecting relatively natural habitats of fish, wildlife or plants; (3) preserving open space (including farmland or forest space) for scenic enjoyment of the general public or under a governmental conservation policy yielding significant public benefit; and (4) preserving a historically important land area or a certified historic structure.  This type of donation can be facilitated in many different ways. 
  • A Dilemma: Real Estate and Business Management Entities: Administrative and management companies provide billing, collection, human resource, and other ancillary services.  Intrinsically, administrative and management companies are qualified trades or businesses.  Business owners that do not generate qualified business income have been incentivized to establish these types of entities to create intercompany service agreements and generate qualified business income.  These separate management companies are commonly owned by the business order, the business owner’s spouse, or the business owner’s children.  If your business is utilizing an administrative or management company, the services provided should equate to the fees that are paid.  Minutes should be prepared annually to document the services that were performed.  Before adding an administrative or management company to your business structure, be aware of the published guidance from the Treasury Department.  The Treasury regulations include an anti-abuse rule designed to prevent taxpayers from separating out parts of what otherwise would be integrated with the non-qualified trade or business, such as administrative functions, in an attempt to qualify those separated parts for the pass-through deduction. 

If a business owner owns business real estate in a separate entity, he or she may be inclined to increase the rent paid from a non-qualifying business activity to the rental entity to create qualified business income.  Unfortunately, if the real estate entity leases only one property (the business real estate), there is authority that the real estate entity isn’t a qualified trade or business.  Additionally, paying too high a rent risks having it recharacterized if rent exceeds the fair market value of facilities in the geographic area.  In an effort to combat this, the real estate entity may consider hiring maintenance and janitorial staff and require the operating entity to reimburse for those costs.  

The new tax bill has created many questions that have yet to be answered.  Consequently, it is difficult to know which strategies will provide the most meaningful benefit moving forward.  Strategizing with CPAs at Cooper Norman can help you find the best route forward.  We encourage you to start tax planning as soon as possible. 

 

Tax
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Tax Reform Summary

Dec 7, 2017 02:14 PM

If you are feeling confused by the recent tax reform proposals, you are not alone. With the Senate narrowly passing their version of tax reform early Saturday morning, both the House of Representatives and the Senate have now each passed their own versions of a tax legislation bill, but the two versions include many technical differences.

We have been closely monitoring the progress of these bills. Although the final details of the bill are yet to be determined, it is clear that it will have a dramatic impact on your 2018 tax return (filed in 2019).

House and Senate Republicans are set to reconcile differences between the two tax bills.  Here are a few highlights of things that may affect you.

 Individual tax rates

  • The House bill collapses the current seven brackets into four and keeps the top tax rate of 39.6%, although it raises the income level at which that applies. The changes would take effect in 2018.
  • The Senate bill has seven brackets, but reduces the top rate to 38.5% (currently 39.6%) for income over $500,000 for single filers and $1 million for couples filing jointly. The Senate bill also reduces income levels on other brackets compared with the current levels.

 Obamacare individual mandate

  • While the House bill makes no changes to the Affordable Care Act, the Senate bill would repeal the individual mandate that requires Americans to purchase health insurance or face a tax penalty.

 Mortgage interest deduction

  • The House bill would reduce the mortgage interest deduction for future home purchases.  Homeowners would be limited to deducting interest on up to $500,000 in mortgage debt. Deductions for second homes would no longer be allowed. Existing mortgages would not be affected.
  • The Senate bill does not change any of those provisions.

 Estate tax

  • The House and Senate bills would double the exemption next year for assets subject to the estate tax, a levy of as much as 40% that hits heirs of large estates.
  • The current exemption levels are $5.49 million for an individual and about $11 million for a couple.

 Alternative minimum tax

  • The House bill eliminates the alternative minimum taxes for individuals and corporations.
  • The Senate bill also repeals the tax, but AMT would return in 2026 as part of the expiration of the changes to that part of the tax code.

 Corporate rate reduction

  • The House and Senate bills permanently cut the corporate tax rate to 20% from 35%. The House cut would take effect next year, but the Senate bill delays it until 2019.

 Tax rate on pass-through businesses

  • The House and Senate bills also reduce taxes on pass-through businesses — sole proprietorships, partnerships, limited liability companies, and S corporations.
  • The changes are complicated and the bills take different approaches to those taxes.
  • The House bill would cap the top tax rate for pass-throughs at 25%, down from 39.6% individual rate.
  • The Senate plan would continue taxing pass-through businesses at the individual rate that would apply to the owner, with a top proposed rate of 38.5%. But the Senate bill would allow most pass-throughs to deduct about 23% of their business income from their taxes. 
  • This would likely exclude many service-based companies.

 State income tax

  • If you itemize your deductions, you can deduct state and local income taxes or sales taxes. Both proposals would eliminate the state and local income tax or sales tax deduction for individual taxpayers.
 
 
Dan Packard, CPA, Cooper Norman
You can read more about the author Dan Packard, MAcc, CPA, CFE, CVA here. 
 
Tax
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2015 BYU Idaho Tax Competition Winners

Jun 16, 2015 10:21 AM
The winners of the 2015 BYU Idaho Tax Competition are:
 
First Place 
• Derek Ward
• Amanda Gardner
• Jordan Ward
• David Jacobs
 1st Place winners of the BYU Idaho tax competition
 
 
Second Place 
• Richard Butler
• Brandon Caywood
• Preston Davison
• Shane Riley
 2nd Place winners of the BYU Idaho Tax Competition
 
 
Third Place 
• Bryce Olson
• Brantley Brooks
• Jonathan Price
• Brandon Pelfrey
 3rd Place Winners of the BYU Idaho Tax Competition
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CN Mobile App

Dec 13, 2013 06:10 PM
Cooper Norman is proud to announce the release of CN Mobile, an Apple-based app to help you with your everyday business needs.  Cooper Norman recognizes that mobile applications have become a fundamental expectation of the modern taxpayer. Our team is focused on resolving your ongoing needs and is dedicated to keeping you connected and informed.

 CN Mobile is designed to help individuals and business owners manage their day-to-day operations quickly and efficiently. CN Mobile is perfect for when you're on the go, need to make a quick reference, or need to calculate the implications of a business decision. CN Mobile connects you to today’s financial news or market trends. CN Mobile also keeps you involved in tax law changes and offers planning ideas.

 

CN Mobile features the following:

 

  • Blog Feed to Cooper Norman’s most recent news and events.
  • Web resources to help you quickly navigate to frequently referenced sites.
  • Current and pertinent tax facts, including our annual tax fact brochure.
  • Business and financial calculators, INCLUDING:
    • Basic Calculator - The basic calculator is designed to perform basic addition, subtraction, multiplication, and division functions. Great for quick use and reference.
    • Breakeven Analysis - The breakeven analysis calculator is designed to demonstrate how many units of your product must be sold to make a profit.
    • Cost of Missing a Discount Calculator - Cost of missing a discount is the equivalent annual interest rate of a discount on early payment to a supplier. Calculate the annual cost of missing a discount.
    • Economic Order Quantity Calculator - Economic order quantity is used to determine the most efficient order size for a company. EOQ applies only when demand for a product is constant and each new order is delivered in full when inventory reaches zero.
    • (iPad Only) Financial Ratio Analysis - The financial ratio analysis offers insight into the profitability, performance, and solvency of any given company's operations.
    • Idaho Investment Tax Credit Calculator - Determine the amount of Idaho income tax credit you qualify for based on capital expenditures made in Idaho during the current year.
    • Like Kind Exchange - If you exchange either business or investment property that is of the same nature or character, gain can be deferred. This calculator is designed to calculate recognized loss, gains and the basis for your newly received property.
    • Loan Calculator - Enter the total loan amount, the annual interest rate, and the number of years the loan will be in existence to determine your monthly payment and total interest.
    • (iPad Only) Net Present Value/Capital Budgeting Calculator - Annual cash flows are used to analyze potential investments by companies, known as capital budgeting. Projected cash flows are generated, and analyzed to determine whether a project meets required criteria for approval.
    • Pay or Play Optimization Calculator - Determine whether it is more advantageous to provide your employees qualified health coverage or subject yourself to the penalties imposed by healthcare reform.
    • (iPad Only) Regular Income Tax Calculator - Use this calculator to get a general idea of what your eventual tax liability may be. Begin by selecting your filing status.
    • Retirement Plan Contribution Calculator - Use this calculator to determine your maximum contribution amount for the different types of small business retirement plans, such as Individual 401(k), SIMPLE IRA, or SEP IRA.
    • (iPad Only) Self Employment Income Tax Calculator - Normally, these taxes are withheld by your employer. However, if you are self-employed, operate a farm, or are a church employee, you may owe self-employment taxes.
  • Portal Access to your personal tax and financial information.
  • Links to Cooper Norman’s social media, as well as comprehensive information about Cooper Norman and the services offered.
  • For iPhone users, quick phone links to each office.

 CN Mobile App, Cooper Norman, CPAs and Business Advisors, Twin Falls, Idaho Falls, Pocatello, Idaho, Accountant, Calculators

Download the app today!  In celebration of our  60th anniversary, Cooper Norman is making the mobile app free to download during the month of January, 2014.
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Safeguarding Your Operations Fraud Prevention and Internal Controls

Sep 4, 2013 04:40 PM

Are you vulnerable to fraud? Do you have adequate controls in place to prevent it?

Occupational fraud continues to be threat to small business.  As regional producers, we often forego critical safeguards necessary in preventing fraud due to perceived costs and unnecessary redundancies. This deficiency results in an increased vulnerability to fraud, and accounts for larger median losses than larger operating counterparts. Recent surveys estimate that the typical organization loses 5% of its revenues to fraud each year. Applied to the estimated 2011 Gross World Product, this figure translates to a potential projected global fraud loss of more than $3.5 trillion.  These surveys estimate the median loss caused by the occupational fraud to be $140,000.  More than one-fifth cases caused losses of at least $1 million.

My experience as a fraud examiner has afforded me many unique insights.  I have met several business owners, observed many business structures, and evaluated just about every method of embezzlement and theft.  One commonality among all these examinations is the reason it happened – failure to implement adequate internal controls.   Many business owners feel they’ve safeguarded their business by surrounding themselves with people they know and trust.  Unfortunately, these relationships of familiarity and trust often create an ideal environment for fraud to occur.  It sedates the business owner, making him or her numb to the warning signs of fraud.  No amount of familiarity can completely acquaint us with the reasons a person commits fraud.  The fraud triangle is a model for explaining the factors that cause someone to commit occupational fraud. It consists of three components which, together, lead to fraudulent behavior:

  • Perceived unshareable financial need
  • Perceived opportunity
  • Rationalization

The financial needs and rationalization an employee may have to commit fraud cannot be adequately diagnosed in a conventional business environment.  However, the opportunity he or she may have to commit fraud is within the control of the business owner.  It is the responsibility of the business owner to put roadblocks in place.  According to recent surveys, the presence of anti-fraud controls is notably correlated with significant decreases in the cost and duration of occupational fraud schemes. Victim organizations that had implemented any of the common anti-fraud controls experienced considerably lower losses and time-to-detection than organizations lacking these controls.  Many of these controls do not have substantial costs associated with them and can be easily implemented in any business structure.

The following are useful controls that should be considered in your organization:

Separation of Duties

Separation of duty, as a security principle, has as its primary objective in the prevention of fraud and errors. This objective is achieved by disseminating the tasks and associated privileges for a specific business process among multiple users. This principle is demonstrated in the traditional example of requiring two signatures on a check.  An organization should maintain appropriate separation of duties between accounting functions and provide necessary review and oversight to these functions.

When separation of duties is performed appropriately, the following functions will occur separately:

  • Authorization function (e.g. sign checks).
  • Recording function and preparing source documents (e.g. printing checks).
  • Custody of asset whether directly or indirectly (e.g. receiving payments in the mail, or mailing payments to vendors).
  • Reconciliation or audit (e.g. monthly bank reconciliations).

Bank Reconciliations and Control of Bank Statements

Monthly bank reconciliations should be performed on all cash accounts by someone who does not make bank deposits or initiate cash disbursements. This reconciliation should be performed before the end of the month in which the bank statement is received.  All bank reconciliation should also be reviewed by a member of management to ensure that correct balances were used and that there are no unusual reconciling items.  A member of management should also open the monthly bank statement and review it for any unusual items (e.g. checks with one signature) prior to giving the statement to the individual performing the reconciliation.

Petty Cash Reconciliation

Your organization should keep all petty cash in a secure lock box.  A simple log should be maintained with a record of when petty cash is disbursed, who petty cash was distributed to, and what the petty cash was used for.  The log should also show when petty cash is added to the lock box.  Reconciliation should be performed between checks on the bank statement made out to petty cash and deposits recorded on the petty cash log.

Physical Controls

Measures to control physical access include the obvious practice of locking doors, desks, and file cabinets so that unauthorized personnel cannot gain access. Other measures are becoming increasing important (and affordable).  These measures include employee IDs and passwords, computerized security systems, and electronic surveillance systems.  Measures like electronic surveillance systems also lend to an operation’s productivity.

Physical controls will help to reduce the risk of fraud in the following ways:

  • Many frauds require that the perpetrator come into physical contact with either the asset being misappropriated, or the related asset records, in order to conceal the fraud. Reducing physical access reduces opportunity.
  • Physical access controls are often the most visible to potential perpetrators. Strong controls in this area send a powerful deterrent message. Conversely, loose physical controls invite challenge.
  • Access controls that do not prevent fraud often assist in the fraud investigation process (for example, determining what actually happened and narrowing down suspects).

Administrative Rights, Passwords, and Closing Dates in Accounting Software

Management’s login should be the only login in your accounting system that has been given all administrative rights.  Usernames and passwords should not be shared. Closing dates should also be used to ensure that data from prior periods cannot be modified once it has been finalized.  All members of management should have equal rights and authority in the accounting software.

Be Sensitive to “Red-Flag” Behavior

Fraudulent behavior often manifests itself through an employee’s behavior.  The following have been identified as potential signs of fraudulent behavior:

  • Does the employee never call in sick regardless of how physically ill they appear, or has the employee stopped taking full weeks of vacation in which someone else performs their duties?  A reluctance to take regular holidays may be due to the need to conceal an on-going fraud.  Fraud can often come to light during a sudden and unexpected absence of the person perpetrating it.  Some organizations have a rule that staff must take several consecutive days’ of vacation each year – both for the physical well-being of the employee and to reduce the opportunity for long-term fraud to go undetected.  During the employee’s absence, another employee should be asked to perform the job functions of the vacationing employee.
  • Is the employee working odd hours when no one else is there?  Regular late working by individual employees should always be investigated, as it may result from a need to cover up fraudulent activities in absence of other members or staff.  A trusted employee can be in a powerful position, especially if management has become relaxed about monitoring their activities.
  • Has an employee’s lifestyle suddenly greatly improved with no explanation?  An apparent discrepancy between an employee’s earnings and their lifestyle is a common indicator of fraud.

A Fraud Response Plan

A fraud response plan should include the general company policy on fraud and should also set out the action to be taken when fraud is suspected.  Having a detailed fraud response plan in place helps ensure that everyone is clear about the action that needs to be taken if and when fraud is identified or suspected.  Thinking about the issues in advance helps management ensure all the relevant aspects are covered.  It is difficult to react promptly without a plan to follow.  A detailed document setting out the policies and procedures to be followed in the case of fraud has the following benefits:

  • It demonstrates that management is in control of the situation
  • It can help to minimize the risk of further loss once fraud is detected
  • It should improve the chance of recovering the loss already incurred, or maximize the amount recoverable
  • It provides a clear statement to employees that management will not condone fraud and will take appropriate action against anyone found to be involved in fraudulent activity

The Control Environment

A functional control environment is best maintained by management.  Management can encourage an anti-fraud culture emphasizing corporate responsibility.  Management should define fraud; so that employees are aware of what actions constitute fraud and/or misconduct and what consequences exist for engaging in fraudulent behavior.  They should also ensure that all employees know the procedures in the event of a fraud being discovered or suspected, including how to report fraud.

Occupational fraud is more likely to be detected by a tip than by any other method. The majority of tips reporting fraud come from employees of the victim organization. Identifying the most common sources of tips is essential to crafting a system that encourages individuals to step forward with information. While just over half of all tips originated from employees, research reveals that several other parties (customers, vendors, etc.) tip off organizations to a substantial number of frauds.  Creating an environment where the reporting of fraudulent behavior is encouraged will be of great benefit to your organization.

Implement Sporadic Fraud Prevention Check-Ups

It is always cheaper to prevent fraud than to detect it. Since fraud can be a catastrophic risk, implementing sporadic fraud prevention check-ups can save your company from disaster. Research suggests that the strongest deterrent to fraud is perceived invigilation.  If your employees think someone is looking, they will likely not risk being discovered.  The Fraud Prevention Check-Up can pinpoint weaknesses in your organization and help you mitigate the risk.  A certified fraud examiner will be a necessary element of this prevention measure.

Fraud is an expensive drain on a company’s financial resources. In today’s globally competitive environment, no one can afford to throw away the five percent of revenues that represents the largely hidden cost of fraud. If your organization is not identifying and tackling its fraud costs, it is vulnerable to competitors who lower their costs by doing so. Strong fraud prevention processes help increase the confidence investors, regulators, audit committee members and the general public have in the integrity of your company’s financial reports.

 

This article appears in the September 2013 edition of Potato Grower Magazine.

Sources:

www.acfe.com

www.aicpa.org

Dan Packard, MAcc, CPA, CFE, Certified Fraud Examiner, Idaho Falls, Idaho

Author:

Daniel Packard, MAcc, CPA, CFE

Certified Fraud Examiner

Cooper Norman

1000 Riverwalk Drive, Suite 100

Idaho Falls, ID  83402

(208) 523-0862 Work

(208) 523-5656 Home

(208) 201-6205 Cell

dpackard@coopernorman.com

www.coopernorman.com

 

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S Corporation Basis

Jun 18, 2013 12:00 AM

S Corporation Basis

An S corporation shareholder reports corporate income or loss on the personal income tax return for the year in which the corporate year ends (Sec. 1366(a)). Losses or deductions passed through to the shareholder first reduce stock basis. After stock basis has been reduced to zero, remaining loss amounts are applied against debt basis (Sec. 1367(b)(2)(A)). Debt basis is not reduced by passthrough losses or deductions if the debt has been satisfied, disposed of, or forgiven during the corporation’s tax year (Regs. Sec. 1.1367-2(b)). A “net increase” first restores debt basis to the extent debt basis has been reduced by losses or deductions in tax years beginning after 1982 (Sec. 1367(b)(2)(B); Regs. Sec. 1.1367-2(c)(1)). A “net increase” is, generally, the amount by which the sum of passthrough income and gains exceeds the sum of passthrough loss, deductions, and distributions.

Example 1: B Inc., a calendar-year corporation, was formed on Jan. 1, 2010. At formation, P contributed $50,000 in exchange for 100% of B’s stock and loaned $45,000 to the corporation. The corporation’s nonseparately stated (taxable) income or loss for each year is as follows: 

image 1

The corporation had no other income or expense items. No loan payments were made to P, and P did not contribute additional capital to the corporation. B distributed $100,000 to P in 2012. Is P’s basis adequate to permit full deduction of corporate losses?

image 2

P has stock basis of $48,000 (after taking into account distributions to P of $100,000 during the year) and debt basis of $45,000 at the end of 2012. Each loss was fully deductible in the year it occurred because P had sufficient basis in stock and debt to cover the loss.

Planning to Obtain Additional Basis

In a year losses decrease stock and debt basis to zero, the losses can be deducted in that year only if the shareholder increases basis. (Basis must be increased before the end of the corporation’s tax year.)

Increase stock basis by:

  • Contributing cash to the corporation. If necessary, a shareholder could personally borrow the money from an unrelated lender and contribute the proceeds to the corporation. The shareholder, rather than the corporation, should make the loan payments.
  • Contributing property to the corporation in exchange for stock. The shareholder’s stock basis is increased by his adjusted basis in the property. If the shareholder recognizes gain on the transaction, the gain also increases stock basis.
  • Purchasing additional shares. The shareholder could purchase the shares from the corporation or, if there were other shareholders, from one or more of the other shareholders.

Increase debt basis by:

  • Lending money to the corporation. If necessary, the shareholder could personally borrow the money from an unrelated lender and use the proceeds to make the payments. The shareholder, rather than the corporation, should make the loan payments to the lender.
  • Paying all or part of corporate debt that the taxpayer has guaranteed. Banks and other lenders may require that the shareholders guarantee loans that are made to the corporation. If the shareholder makes payments on such guaranteed loans, those payments increase his debt basis. If necessary, the shareholder could personally borrow the money from an unrelated lender and use the proceeds to make the payments. Note that merely guaranteeing a loan does not give the shareholder debt basis.
  • Having the lender substitute a shareholder’s note for a note from the corporation to a third-party lender. If the lender substitutes shareholder’s note for that of the corporation and releases the corporation from liability to repay the debt, the shareholder obtains debt basis because the corporation then becomes indebted to the shareholder under the doctrine of subrogation.
  • Advancing the corporation funds as open account debt. Open account debt owed to the shareholder provides debt basis. Within limits, open account advances and repayments can be netted and treated as one indebtedness. However, under the regulations, open account debt is treated as if it were evidenced by a written note when the balance of open account debt equals or exceeds $25,000 at the end of the corporation’s tax year.

Planning tip: Shareholders who increase basis by making contributions to capital should, if possible, purchase stock from the S corporation. If the transaction is structured to fit the requirements of Sec. 1244, and the stock later becomes worthless, the resulting loss will be treated as an ordinary loss. If the shareholder makes contributions to capital and does not acquire Sec. 1244 stock, any resulting loss will be short-term or long-term capital loss, depending on when the contribution was made.

Claiming Business or Nonbusiness Bad Debt Loss at Shareholder Level

Shareholders who increase basis by making loans to the S corporation can take a bad debt loss if the loan becomes uncollectible. Shareholders can deduct two types of bad debt losses: business and nonbusiness (Sec. 166). Business bad debts result in ordinary losses; nonbusiness bad debts result in short-term capital losses. The shareholder can claim a business bad debt loss when the loss from a worthless debt is incurred in the shareholder’s trade or business (Sec. 166(d)(2); Regs. Sec. 1.166-5(b)). A shareholder may establish that a loan to another business (such as the shareholder’s S corporation) is a business loan if it was made to protect the taxpayer’s status as an employee, source of income, business relationship, or business reputation.

In Litwin, 983 F.2d 997 (10th Cir. 1993), the Tenth Circuit allowed a shareholder/employee’s business bad debt deduction for amounts loaned to the corporation. The deduction was allowed because the taxpayer’s predominant motives for making the loans were that he (1) wanted to remain employed, earn a salary, and remain useful to society; (2) spent a large portion of his time working for the corporation; (3) intended to draw a salary in the future; and (4) took a sizable risk when he guaranteed loans in excess of his investment (indicating a motive besides investment). Although the taxpayer’s loans were much larger than the salary anticipated in the near future, the court ruled his business motives outweighed his investment motives.

In contrast, the Seventh Circuit ruled that a taxpayer’s advances to a controlled corporation did not result in business bad debts (Hough, 882 F.2d 1271 (7th Cir. 1989)). The taxpayer received no compensation from the corporation and was not considered to be in the business of loaning money, nor was he in the business of selling corporations he owned. Thus, when a taxpayer’s predominant motivation for making loans is to protect his investment as a shareholder, nonbusiness bad debt status generally applies.

The Ninth Circuit held that a shareholder/employee’s business bad debt deduction for loans he made to his corporation was a miscellaneous itemized deduction subject to the 2% floor and not an adjustment to gross income as the employee had contended (Graves, 220 Fed. Appx. 601 (9th Cir. 2007), aff’g T.C. Memo. 2004-140). The court relied on Sec. 62(a)(1), which provides that trade or business expenses do not include those connected with services as an employee. The performance of personal services as an employee does not constitute carrying on a trade or business (Temp. Regs. Sec. 1.62-1T(d)).

Tax
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Qualified Small Business Stock

Jun 12, 2013 04:38 PM

Qualified Small Business Stock

For taxpayers other than corporations, Sec. 1202 excludes from gross income at least 50% of the gain recognized on the sale or exchange of qualified small business stock (QSBS) that is held more than five years. As described more fully below, for qualifying stock acquired after Feb. 17, 2009, and on or before Sept. 27, 2010, the exclusion percentage is 75%, and for qualifying stock acquired after Sept. 27, 2010, and before Jan. 1, 2014, the exclusion percentage is 100%. The amount of the exclusion is 60% in the case of the sale or exchange of certain empowerment zone stock that is acquired after Dec. 21, 2000, and sold before 2015.

The gain eligible to be taken into account for purposes of this exclusion is limited to the greater of $10 million or 10 times the taxpayer’s basis in the stock (Sec. 1202(b)(1)). The limitation is computed on a per-issuer basis, with lower limits applying to married individuals filing separately. In the case of married individuals filing joint returns, gain excluded under this provision is allocated equally between the spouses in applying the exclusion in later years. Gain excluded under this provision is not used in computing the taxpayer’s long-term capital gain or loss, and it is not investment income for purposes of the investment interest limitation. For purposes of the modifications to income for computing a noncorporate taxpayer’s net operating loss deduction, the partial exclusion is not allowed (Sec. 172(d)(2)(B)).

Qualifying Small Businesses

The issuing corporation must be a qualified small business as of the date of issuance and during substantially all of the period that the taxpayer holds the stock. A qualified small business is a subchapter C corporation other than a domestic international sales corporation (DISC) or former DISC; a corporation with respect to which an election under Sec. 936 is in effect or that has a direct or indirect subsidiary with respect to which such an election is in effect; a regulated investment company; a real estate investment trust; a real estate mortgage investment conduit; or a cooperative. The corporation also generally cannot own (1) real property that is not used in the active conduct of a qualified trade or business with a value exceeding 10% of its total assets; or (2) portfolio stock or securities with a value exceeding 10% of its total assets in excess of liabilities.

To qualify as QSBS, the stock must be:

  • Issued by a domestic C corporation with no more than $50 million of gross assets at the time of issuance;
  • Issued by a corporation that uses at least 80% of its assets (by value) in an active trade or business, other than in certain personal services and types of businesses described in more detail below;
  • Issued after Aug. 10, 1993;
  • Held by a noncorporate taxpayer (meaning any taxpayer other than a corporation);
  • Acquired by the taxpayer on original issuance (there are exceptions to this rule); and
  • Held for more than six months to be eligible for a tax-free rollover under Sec. 1045 and more than five years to qualify for gain exclusion.

The $50 million standard is fixed and is determined by reference to the amount of cash and the aggregate adjusted bases of other property held by the corporation. For a corporation’s stock to be QSBS, the following must apply:

  • At all times after Aug. 10, 1993, and before it issues the stock, the corporation must have aggregate gross assets that do not exceed $50 million (Sec. 1202(d)(1)(A)).
  • Immediately after it issues the stock, the corporation must have aggregate gross assets that do not exceed $50 million. For this purpose, amounts received in the stock issuance are taken into account (Sec. 1202(d)(1)(B)).

A company may pass into and out of those standards, but there are consequences. If a corporation satisfies the gross asset limitation on the date the stock was issued but later exceeds the $50 million asset threshold, stock that otherwise qualifies as QSBS does not lose that character solely because of the later event. However, once a corporation (or a predecessor corporation) exceeds the $50 million asset threshold, it can never again issue QSBS.

At least 80% (by value) of the corporation’s assets (including intangible assets) must be used by the corporation in the active conduct of a qualified trade or business (Sec. 1202(e)(1)). If in connection with any future trade or business, a corporation uses assets in certain startup activities, research and experimental activities, or in-house research activities, the corporation is treated as using such assets in the active conduct of a qualified trade or business. Assets that are held to meet reasonable working capital needs of the corporation, or are held for investment and are reasonably expected to be used within two years to finance future research and experimentation, are treated as used in the active conduct of a trade or business. If a corporation has been in existence for at least two years, only 50% of these working capital assets will qualify as used in the active conduct of a qualified trade or business. In addition, certain rights to computer software are treated as assets used in the active conduct of a trade or business.

A qualified trade or business is any trade or business other than those involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any other trade or business where the principal asset of the trade or business is the reputation or skill of one or more of its employees. The term also excludes any banking, insurance, leasing, financing, investing, or similar business; any farming business (including the business of raising or harvesting trees); any business involving the production or extraction of products of a character for which percentage depletion is allowable; or any business of operating a hotel, motel, restaurant, or similar business.

Qualifying Entities

A taxpayer does not have to own stock directly to benefit from the QSBS rules. Nonrecognition of gain is possible through a partnership, S corporation, regulated investment company, or common trust fund if the following apply:

  • All eligibility requirements with respect to QSBS are met;
  • The entity held the qualifying stock for more than five years; and
  • A taxpayer sharing in the gain held the interest in the passthrough entity at the time the taxpayer acquired the qualifying stock and at all times thereafter.

In addition, a partner, shareholder, or participant cannot exclude gain received from an entity to the extent that the partner’s, shareholder’s, or participant’s share in the entity’s gain exceeded the partner’s, shareholder’s, or participant’s interest in the entity at the time the entity acquired the stock. To be eligible, the stock must be acquired by the taxpayer after Dec. 31, 1992, at the original issuance (directly or through an underwriter) in exchange for money, other property (not including stock), or as compensation for services provided to the corporation (other than services performed as an underwriter of the stock).

The American Recovery and Reinvestment Act of 2009, P.L. 111-5, provided an extra incentive for investment in small businesses. The Sec. 1202 exclusion was increased from 50% to 75% (a 60% exclusion remained the same for the sale or exchange of certain empowerment zone stock) for any gain from the sale or exchange of QSBS acquired after Feb. 17, 2009, and before Jan. 1, 2011, and held for more than five years (Sec. 1202(a)(3)).

Temporary 100% Exclusion

The Small Business Jobs Act of 2010, P.L. 111-240, made additional changes to the exclusion rules related to certain small business stock. For QSBS acquired after Sept. 27, 2010, and before Jan. 1, 2011, the exclusion percentage increased to 100%.  The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312, extended by one year the application of the 100% exclusion for QSBS, so that it applied to otherwise qualifying stock acquired before Jan. 1, 2012. The American Taxpayer Relief Act of 2012 (ATRA), P.L. 112-240, retroactively extended for two more years the 100% exclusion of the gain from the sale of QSBS, so that it applies to otherwise qualifying stock acquired before Jan. 1, 2014. The other requirements, including the five-year holding period requirement, were not changed.

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IRS Proposes Employer Play-or-Pay Regulations Under Health Care Reform

Jun 12, 2013 04:26 PM

Employee Benefits and Pensions

Near the end of 2012, the IRS issued proposed regulations (REG-138006-12) on the employer shared-responsibility provisions under Sec. 4980H, enacted by the Patient Protection and Affordable Care Act, P.L. 111-148 (PPACA), and sometimes referred to as the “play-or-pay” rule. The proposed regulations address many questions that prior IRS guidance had not completely answered and provide important transitional relief.

Key to the implementation of the PPACA are the employer shared-responsibility provisions of Sec. 4980H. Effective in 2014, these provisions require “applicable large employers” to offer their full-time employees (and their dependents) the opportunity to enroll in an employer-sponsored health insurance plan that provides employees with “minimum essential coverage” with “minimum value” at an affordable cost. Employers that fail to provide the required coverage face the prospect of having to make potentially significant payments—called “assessable payments” in the Code, although they function like a penalty.

The PPACA required the IRS, along with the U.S. Department of Labor and the U.S. Department of Health and Human Services, to provide substantial guidance on many of its provisions, including how to determine (1) what are applicable large employers; (2) who is a full-time employee; (3) what “minimum essential coverage” means; (4) how to value the coverage; and (5) when coverage is affordable. In response, the IRS issued a series of notices, including:

  • Notice 2011-36, defining employers and employees;
  • Notice 2011-73, defining affordability;
  • Notice 2012-17, providing guidance on how an employer may classify new employees as either full time or part time, focusing particularly on employees whose status is initially uncertain;
  • Notice 2012-58, further refining earlier guidance and assuring employers that the guidance can be relied on through at least the end of 2014; and
  • Notice 2012-59, regarding the maximum 90-day waiting period for plan entry.

The proposed regulations incorporate and consolidate the guidance in the notices, as well as provide guidance in areas the notices had not addressed. One of the new areas addressed is how an applicable large employer calculates the assessable payment for not offering minimum essential coverage or the assessable payment for offering insurance deemed to be unaffordable, or for not providing minimum value.

The proposed regulations define generally applicable terms at Prop. Regs. Sec. 54.4980H-1; define an applicable large employer at Prop. Regs. Sec. 54.4980H-2; provide a methodology for determining full-time employees at Prop. Regs. Sec. 54.4980H-3; and set forth the assessable payment calculations at Prop. Regs. Secs. 54.4980H-4 and 54.4980H-5. The proposed regulations are effective for periods beginning after Dec. 31, 2013, and, as noted in the preamble, can be relied upon by taxpayers pending the issuance of final regulations or other guidance.

As a compilation of prior guidance, the proposed regulations do not provide any particular surprises. However, the preamble indicates the IRS is well aware of many of the schemes some employers have apparently considered as a way around the rules. In this respect, the proposed regulations provide an anti-abuse rule at Prop. Regs. Sec. 54.4980H-3(e)(5) to address practices that have the effect of circumventing or manipulating the application of the employee rehire rules. In addition, the IRS said in the preamble it plans to address in final regulations a shared-employee arrangement whereby an employer co-employs an employee along with a temporary staffing agency, with each purported employer employing the individual for 20 hours a week. The IRS believes the staffing agency would rarely, if ever, be the true employer and that the primary purpose of using such an arrangement would be to avoid the application of Sec. 4980H.

Employers and Employees

The assessable payments under Sec. 4980H apply to “applicable large employers,” employers that in the prior calendar year employed on average at least 50 full-time employees and/or their equivalent in part-time, temporary, seasonal, or other non-full-time employees. For each month in the prior calendar year, the employer adds the number of full-time employees (employed an average of at least 30 hours per week or 130 hours per month) plus full-time equivalent employees (FTEs).

To obtain the number of FTEs, the employer determines the aggregate number of hours of service performed in each calendar month by all non-full-time employees (up to 120 hours for any employee) and divides that number by 120 (retaining any fraction for the month but, after adding to full-time employees for each month and averaging the monthly totals for the year, rounding down to a whole number). Although this determination is made on an annual lookback basis, under the proposed regulations’ transitional rule for 2014, employers may use a period of at least six consecutive months in calendar 2013. An employer is not an applicable large employer if its full-time employees and FTEs exceeded 50 for no more than 120 days during the calendar year and the employees in excess of 50 who were employed during that period were seasonal workers.

Sec. 4980H applies to all common law employers, including government entities, tax-exempt organizations, and churches. All employees of a controlled group under Sec. 414(b) or (c), or an affiliated service group under Sec. 414(m), are taken into account in determining whether the members of the controlled group or affiliated service group together constitute an applicable large employer. Interestingly, however, pending further guidance, government entities, churches, and conventions or associations of churches may rely on a reasonable, good-faith interpretation of Secs. 414(b), (c), (m), and (o) in determining whether a person or group of persons is an applicable large employer.

The statute does not define “employee.” The proposed regulations define an employee under the common law standard described at Regs. Sec. 31.3401(c)-1(b) and an employer under the common law standard described at Regs. Sec. 31.3121(d)-1(c). Applying this standard consistently, the proposed regulations provide that a sole proprietor, a partner in a partnership, and a 2% S corporation shareholder are not employees.

Most employee-benefit-related items in the Code include leased employees, as defined in Sec. 414(n), within the definition of employee. However, Sec. 4980H does not cross-reference Sec. 414(n), nor vice versa. Accordingly, leased employees who are not common law employees of the recipient employer are not employees for the purposes of defining an applicable large employer or determining the number of employees when computing a recipient employer’s assessable payment. Of course, if these individuals are not employees of the recipient employer, that means the leased employees will be the employees of the employee leasing company.

The proposed regulations provide guidance on how the applicable large employer standards apply to foreign employers with a U.S. presence and foreign employees of U.S. entities. In this regard, hours of service generally do not include those worked outside the United States. This rule applies irrespective of the residency or citizenship status of the individual. Therefore, foreign-based employees will not have hours of service and, thus, will not qualify as FTEs. However, all hours of service for which an individual receives U.S.-source income are counted for these rules.

Determining Full-Time Employee Status

Normally, the question of who is and who is not a full-time employee is straightforward. However, the proposed regulations provide guidance on how to treat employees with variable work hours, rehired employees, seasonal employees, and employees who have a change in employment status, as well as for how an employer may classify newly hired employees. Complex in many respects, this guidance involves lookback periods, stability periods, and administrative periods.

In the simplest terms, an employer may adopt a measurement period of no less than three and no more than 12 months to determine whether a variable-hour employee is a full-time employee. Issues related to the definition of seasonal employees are reserved for the final regulations or future guidance. In the meantime, employers may apply reasonable, good-faith interpretations of the definition of seasonal workers under Sec. 4980H(c)(2)(B)(ii) and Department of Labor regulations to which it refers.

Dependents

With respect to assessable payments, Sec. 4980H does not define “dependents.” The proposed regulations define an employee’s dependent as the employee’s child (as defined in Sec. 152(f)(1)) who is under 26 years old. Thus, the term “dependent” does not include an employee’s spouse or any other person who may be the employee’s dependent for other purposes of the Code. See also the discussion of transition relief for dependent coverage, below.

Assessable Payment Rules

An applicable large employer that fails to offer minimum essential coverage or offers coverage that is unaffordable or does not provide minimum value may be liable for an assessable payment under Sec. 4980H(a) or (b) only if one or more full-time employees are certified to the employer by a health benefit exchange as having received an applicable premium tax credit or cost-sharing reduction. In such instances, an employer will have an opportunity to respond to the exchange’s certification before the IRS takes action to collect the payment.

The assessable payment amount for failing to offer minimum essential coverage (Sec. 4980H(a)) is 1/12 of $2,000, or $166.70, per month per full-time employees over the number 30. The assessable payment amount for offering coverage that is not affordable or does not provide minimum value (Sec. 4980H(b)) is the number of full-time employees certified as enrolled in an exchange plan, multiplied by 1/12 of $3,000 ($250) per month. (The dollar amounts are adjusted for inflation after 2014.) The latter payment amount is subject to an overall limitation of what the payment amount for failing to provide minimum essential coverage would have been.

An employer will be deemed to have made an offer of coverage if, considering all facts and circumstances, the employee has an effective opportunity to elect to enroll (or decline to enroll) in the coverage at least once during the plan year.

Interestingly, even though Sec. 4980H(a) does not give a basis for this, the proposed regulations provide that if an employer offers coverage to all but 5% of its full-time employees in a calendar month or, if greater, five full-time employees (and their dependents), the employer is considered to have offered coverage to substantially all full-time employees and is not subject to the Sec. 4980H(a) assessable payment for failing to provide coverage. However, if one of the employees who is not offered coverage does obtain subsidized coverage through a health benefit exchange, the employer will be subject to the $250 per month penalty under Sec. 4980H(b).

As used in the proposed regulations, the terms “minimum essential coverage” and “minimum value” have the same meaning as provided, respectively, in Secs. 5000A(f) and 36B(c)(2)(C)(ii), as well as in any related regulations or other administrative guidance. Minimum essential coverage is a plan or coverage offered in the small or large group market within a state (including grandfathered plans) or a governmental plan. Coverage provides minimum value if the plan’s share of the cost of allowed benefits is at least 60%.

Affordability

An employee who is offered coverage by an applicable large employer may be eligible for a premium tax credit or cost reduction if that offer of coverage is not affordable within the meaning of Sec. 36B(c)(2)(C)(i). Coverage is affordable if the employee’s required contribution for self-only coverage does not exceed 9.5% of the employee’s household income for the tax year. Recognizing the difficulty of determining household income, the IRS has established three affordability safe harbors for the purpose of the assessable payment rule. These safe harbors apply even if a health benefit exchange grants the employee a premium tax credit or cost-sharing reduction.

An employer may use one or more of the affordability safe harbors only if the employer offers its full-time employees and their dependents the opportunity to enroll in a plan that provides minimum essential coverage and that provides minimum value with respect to the self-only coverage offered to the employees. Use of any of these safe harbors is optional, and the employer may choose to apply the safe harbors for any reasonable category of employees, provided it does this on a uniform and consistent basis for all employees in a category.

Form W-2 safe harbor: An employer will not be subject to an assessable payment with respect to a full-time employee if that employee’s required contribution for the calendar year for the employer’s lowest-cost, self-only coverage that provides minimum value does not exceed 9.5% of that employee’s wages as reported in Box 1 of Form W-2, Wage and Tax Statement, wages. The applicability of this safe harbor is determined after the close of the calendar year. To qualify for this safe harbor, the cost of coverage must remain at a consistent amount or percentage of W-2 wages during the calendar year. The rules provide adjustments for employees not offered coverage for the entire calendar year and for plans that operate on a fiscal-year basis. One issue with respect to the Box 1, W-2 wages approach is that Box 1 wages are reduced by employee pretax contributions to plans established under Secs. 125, 401(k), 403(b), and 457(b). Accordingly, employee decisions with respect to how much to contribute to these plans will cause variations in the net wages of individual employees who have substantially the same gross wages.

Rate-of-pay safe harbor: An employer can use the rate-of-pay safe harbor with respect to an employee for a calendar month if the employee’s required contribution for the month for the lowest-cost, self-only coverage that provides minimum value does not exceed 9.5% of an amount equal to 130 hours multiplied by the employee’s hourly rate of pay as of the first day of the coverage period (generally the first day of the plan year). For salaried employees, monthly salaries are used, and the employer may use any reasonable method for converting other payroll periods to monthly salaries.

Importantly, an employer may use this safe harbor only to the extent it does not reduce the hourly wage of hourly employees or the monthly wages of salaried employees during the calendar year (including through the transfer of employment to another member of the employer’s controlled group).

Federal poverty-line safe harbor: An employer will satisfy the poverty-line safe harbor if the employee’s required contribution for the calendar month for the lowest-cost, self-only coverage that provides minimum value does not exceed 9.5% of the annual amount established as the federal poverty line (for the state in which the employee is employed) for a single individual for the applicable calendar year, divided by 12. While clearly the most expensive in that it provides the greatest employer subsidy, this federal poverty-line approach also is the simplest to administer (particularly for a calendar-year plan).

Provided that it does so on a reasonable and consistent basis, an employer may use different safe harbors for different groups or categories of employees.

Controlled-Group Issues

Even though the regulations aggregate all employers in a controlled group to determine applicable large employer status, the determination of whether an employer is subject to an assessable payment and the amount of any such payment is made on a member-by-member basis. Therefore, the liability for, and the amount of, any assessable payment under Sec. 4980H is computed and assessed separately for each applicable large employer member, taking into account that member’s offer of coverage (or lack thereof) and number of full-time employees.

However, this separate determination of liability does not permit each member of the controlled group to use the 30-employee offset of Sec. 4980H(c)(2)(D). The 30-employee offset permits an applicable large employer to reduce its number of full-time employees by 30 solely for purposes of calculating either the assessable payment for not offering minimum essential coverage under Sec. 4980H(a) or the overall limitation under Sec. 4980H(b)(2) where the employer does not offer affordable or minimum-value coverage.

For example, an employer with 75 employees that does not offer minimum essential coverage for any month in a year would calculate its assessable payment as $90,000 ((75 − 30) × $2,000)). The Code and the proposed regulations require the applicable large employer members to allocate the 30-employee offset ratably among all members, based on the number of full-time employees employed by each applicable large employer member during the calendar year. Under the proposed regulations, fractional numbers are rounded up to one, even if the rounding rule results in an aggregate reduction for the entire group that exceeds 30.

Transition Rules for Fiscal-Year Plans and Dependent Coverage

By statute, the assessable payment rules apply on a calendar-year basis. However, many employers operate their plans on a fiscal-year basis. The proposed regulations provide some transitional relief in this area. If an applicable large employer member maintains a fiscal-year plan as of Dec. 27, 2012, the relief applies with respect to employees of the applicable large employer member (whenever hired) who would be eligible for coverage, as of the first day of the first fiscal year of that plan that begins in 2014 (the 2014 plan year) under the eligibility terms of the plan as in effect on Dec. 27, 2012. If these employees are offered affordable, minimum-value coverage no later than the first day of the 2014 plan year, no Sec. 4980H assessable payment will be due with respect to that employee for the period prior to the first day of the 2014 plan year.

The IRS recognized that not all employers’ plans cover dependents. Accordingly, the proposed regulations provide that any employer that takes steps during its 2014 plan year toward satisfying the provisions relating to offering coverage to the dependents of its full-time employees will not be liable for any assessable payment solely on account of a failure to offer coverage to the dependents for the 2014 plan year.

The proposed regulations provide employers with the necessary guideposts and some valuable transition rules needed to begin planning for the 2014 effective date of the play-or-pay rules. However, considering the imminence of that date, the proposed regulations leave many smaller employers with little time to structure their workforce to avoid being deemed applicable large employers subject to the shared-responsibility payment.

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Reasonable S-Corporation Wage

Feb 1, 2012 10:04 AM

Tax File Memo

Reasonable S-Corporation Wage

Facts

The taxpayer is a medical professional engaging independently in profit-generating activities within his S-corporation.  The S-corporation does not employ any other individuals, and all cash inflows are related to his activities.

Issues

What constitutes a reasonable wage?

Conclusion

The taxpayer will report all cash distributions to himself as wages for services performed.

Analysis

According to IRS FS-2008-25, corporate officers are specifically included within the definition of employee for FICA (Federal Insurance Contributions Act), FUTA (Federal Unemployment Tax Act) and federal income tax withholding under the Internal Revenue Code. When corporate officers perform services for the corporation, and receive or are entitled to receive payments, their compensation is generally considered wages.  Subchapter S corporations should treat payments for services to officers as wages and not as distributions of cash and property or loans to shareholders.

The Internal Revenue Code establishes that any officer of a corporation, including S corporations, is an employee of the corporation for federal employment tax purposes.  S corporations should not attempt to avoid paying employment taxes by having their officers treat their compensation as cash distributions, payments of personal expenses, and/or loans rather than as wages.

The instructions to the Form 1120S, U.S. Income Tax Return for an S Corporation, state "Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation."

The amount of the compensation will never exceed the amount received by the shareholder either directly or indirectly.  However, if cash or property or the right to receive cash and property did go the shareholder, a salary amount must be determined and the level of salary must be reasonable and appropriate.

There are no specific guidelines for reasonable compensation in the Code or the Regulations. The various courts that have ruled on this issue have based their determinations on the facts and circumstances of each case.

  • Training and experience
  • Duties and responsibilities
  • Time and effort devoted to the business
  • Dividend history
  • Payments to non-shareholder employees
  • Timing and manner of paying bonuses to key people
  • What comparable businesses pay for similar services
  • Compensation agreements
  • The use of a formula to determine compensation

In Veterinary Surgical Consultants, P.C. v. Commissioner, 117 T.C. No. 14 (2001) aff'd without published opinion, No. 02-1214 (3rd Cir. Dec. 18, 2002), the S corporation's sole shareholder and officer provided all services on behalf of the S corporation and generated all of the S corporation's income through services that he provided. The corporation did not pay the shareholder a salary; rather, the corporation distributed its net income to the shareholder, who then reported the payments (as indicated on the Schedules K-1) as nonpassive income from the S corporation. Consequently, the S corporation did not pay any FICA (social security and Medicare) or FUTA (unemployment) taxes under §§ 3111 and 3301 of the Internal Revenue Code. The court stated that §§ 3121(a) and 3306(b) generally define "wages," for federal employment tax purposes, as all remuneration for employment. Pursuant to §§ 31.3121(a)-1(b) and 31.3306(b)-1(b) of the Employment Tax Regulations, the form of the payment is immaterial. Under § 3121(d), the term "employee" includes an officer of a corporation. Section 31.3121(d)-(1)(b) provides an exception for officers who do not provide any services (or provide only minor services) and who neither receive nor are entitled to receive remuneration. The court therefore held that "an officer who performs substantial services for a corporation and who receives remuneration in any form for those services is considered an employee, whose wages are subject to Federal employment taxes." Id. at 7. The court also stated that "an employer cannot avoid Federal employment taxes by characterizing compensation paid to its sole director and shareholder as distributions of the corporation's net income, rather than wages." Id. at 8. Accordingly, the S corporation's payments to the shareholder were recharacterized as wages. See also, Spicer Accounting, Inc. v. United States, 918 F.2d 90 (9th Cir. 1990).

IRS INFO 2003-0026 states that if a shareholder of an S corporation performs services for the corporation, any distribution to the shareholder, even if legally declared under state law by the S corporation as a dividend, will be characterized as "wages" subject to employment taxes where in reality the payments are for services. An S corporation cannot avoid employment taxes merely by paying the corporate shareholder "dividends" in lieu of reasonable compensation for services performed.

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Expense Deferral with Related Parties

Feb 1, 2012 10:01 AM

Expense Deferral with Related Parties

Facts

Taxpayer is a 10% owner of an accrual basis S-corporation.  The Taxpayer sold inventory to the S-corporation, but plans to defer receipt of income until after year end.  The S-corporation accrued an expense for the receipt of inventory.

Issue

Can the Taxpayer defer the receipt of income while the S-corporation accrues an expense for the receipt of inventory?

Conclusion

If the taxpayer does not meet the definition of a related party, then (s)he may defer income to the subsequent year.

Analysis

A corporation that uses the accrual method of accounting must observe a special rule when dealing with cash basis related parties.  If the corporation has an accrual outstanding at the end of any taxable year with respect to such a related party, it cannot claim a deduction until the recipient reports the amount as income (IRC §267(a)(2)).  This rule is most often encountered when a corporation deals with an individual who owns more than 50 percent of the corporation’s stock.

IRC §267 further clarifies that attribution rules apply in determining who qualifies as a related party.  IRC §267(b) defines related parties as:

  • Members of a family
  • An individual and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for such individual
  • Two corporations which are members of the same controlled group
  • A grantor and a fiduciary of any trust
  • A fiduciary of a trust and a fiduciary of another trust, if the same person is a grantor of both trusts
  • A fiduciary of a trust and a beneficiary of such trust
  • A fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts
  • A fiduciary of a trust and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor of the trust
  • A person and an organization to which section 501 (relating to certain educational and charitable organizations which are exempt from tax) applies and which is controlled directly or indirectly by such person or (if such person is an individual) by members of the family of such individual
  • A corporation and a partnership if the same persons own--
    • more than 50 percent in value of the outstanding stock of the corporation, and
    • more than 50 percent of the capital interest, or the profits interest, in the partnership
    • An S corporation and another S corporation if the same persons own more than 50 percent in value of the outstanding stock of each corporation
    • An S corporation and a C corporation, if the same persons own more than 50 percent in value of the outstanding stock of each corporation
    • Except in the case of a sale or exchange in satisfaction of a pecuniary bequest, an executor of an estate and a beneficiary of such estate

IRC §267(c) outlines constructive ownership of stock as follows:

  • Stock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust shall be considered as being owned proportionately by or for its shareholders, partners, or beneficiaries
  • An individual shall be considered as owning the stock owned, directly or indirectly, by or for his family
  • An individual owning any stock in a corporation shall be considered as owning the stock owned, directly or indirectly, by or for his partner
  • The family of an individual shall include only his brothers and sisters (whether by the whole or half blood), spouse, ancestors, and lineal descendants
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