Individuals who start new corporations often claim to their accountants that they have S corporations. However, study for CPA preparation reveals the particular steps required for establishing these entities. Status under S corporation rules necessitates making a specific election. Moreover, continued qualification for an S election depends upon following established IRS rules.
Among the criteria for S corporations described in CPA exam material are restrictions about the number of shareholders, the type of stock the corporation may issue, and the type of income it’s allowed to generate. If an S corporation takes any disallowed action, the election is terminated and the company reverts to a regular C corporation.
By acting to maintain S status, a corporation is a pass-through entity for its shareholders. The income is similarly taxed as described for partnerships in CPA review courses. However, unlike partners, S corp shareholders do not owe self-employment tax on company profits. Securing this benefit triggers a limitation in how shareholders are compensated. Those who are active in the business must receive a reasonable amount of wages as employees. As a result, they are entitled to distributions of profit as shareholders that escape payroll taxes.
Advice about wage compensation and distributions is just one of the areas where accountants counsel S corporation owners. An even more significant matter for S corporations taught in courses for CPA licensing concerns shareholder basis. The ability of S corporation shareholders to deduct pass-through loses is limited to their stock and debt basis.
Adjustments to basis are a hot topic at the IRS. In addition, a number of court case rulings were recently decided against taxpayers who tried to use S corporations for shifting income or evading taxes.
The case against a taxpayer named Broz involved his ownership of several S corporations. He attempted to establish basis by having the profitable companies qualify for borrowing, which they then loaned to the unprofitable businesses. His failure to properly set up the back-to-back loan strategy failed to satisfy the court. He lacked sufficient basis in the unprofitable corporations to offset taxable profit of the other corporations.
In the Barnes case, the owner of S corp stock lacked sufficient basis to deduct a loss, which he properly carried forward to the subsequent year. He did not use the suspended loss in the first year for which he had enough basis. The court ruled that he is not permitted to utilize the carry forward loss because he failed to use it in the initial allowable year.
These are just a few examples of the traps that await unwary S corporation shareholders. In these and other instances, accountants who fully comprehend S corp issues from CPA study materials are highly valuable advisers. Plenty of pitfalls exist for maintaining the S election and assuring capture of all tax benefits.
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.