Most accountants get their first exposure to all the intricacies about various types of business entities during CPA exam review. Much of the information from distinctive study sections overlaps. For instance, the legal differences among entity classifications impact their tax consequences and preparation of financial records.
Ask any CPA engaged in public accounting the most crucial element to derive about a client and you will hear that identification of entity type is the keystone. That is the starting point for deploying any other accounting matters described in CPA study material.
Entity classification affects the advice an accountant renders to the principal parties in the business. This is especially crucial when dealing with owners of S corporations. These entities are popular vehicles for businesses. But, they entail multiple considerations that are commonly misunderstood. Public accountants are well advised to capture an especially thorough understanding about the nuances of S corporations that extends the description in courses for CPA licensing.
Many S corporation shareholders mistake the tax simplification of their entities as permitting the same actions as partnerships. Unfortunately, some procedures have the adverse result of terminating the S election and the commensurate tax advantages.
One dangerous step that often arises in S corporations with multiple shareholders is making distributions in improper proportions. Theoretically, an S corp may distribute amounts that are not proportional to shareholder ownership. This does not automatically terminate the S election. That is a commonly misunderstood element of CPA study. Proportional distribution merely seems logical because S corporations are only permitted to have one class of stock
The expectation is that each S corp share should entitle the owner to the same distribution as all other shares. The existence of a single class of stock implies that every share has equal rights to distributions. But, rights are different than actual distribution amounts.
As long as disproportionate distributions are not indicative of multiple classes of stock, accountants should allow their S corp clients to make them. The key to retaining the S election is simply assuring that the rights to proportional distributions remain intact. This demands reference to distribution rights in a corporate charter, articles of incorporation, bylaws, and other agreements between shareholders.
These facts provide some clarity as to why CPA review material includes information about business law and company documents. Accountants might have to inspect the papers of a business before delivering accurate advice. Although most situations call for helping S corporations make corrective distributions that result in proportionality to ownership, accountants need to know that some disproportionate circumstances – such as timing differences in distribution payments – are permissible to disregard.
IRS Circular 230 Disclosure
Pursuant to the requirements of the Internal Revenue Service Circular 230, we inform you that, to the extent any advice relating to a Federal tax issue is contained in this communication, including in any attachments, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.
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