Incorporated small businesses with one shareholder operating the enterprise frequently create headaches for Enrolled Agent tax work. These entities require separate tax returns and specific accounting procedures. Owners of S corporations are permitted to withdraw distributions from their businesses without any tax consequence, but they must follow precise guidelines.
Excessive transfers of funds from an S corporation to its shareholder are usually recorded as loans, which trigger special rules from Enrolled Agent education. Similar factors affect money loaned by shareholders to their corporations. Whenever an entrepreneur places personal funds in a corporation – or vice versa – certain formalities are required. The borrowing must bear interest. When no document specifies a stated amount of interest, tax law requires computation of imputed interest.
Calculations of imputed interest are a crucial area of Enrolled Agent courses. The IRS publishes applicable federal rates of interest each month. Normally, interest on loans from entrepreneurs to their S corporations has no net tax impact. A shareholder’s imputed interest income is offset by the reduced S corporation profit from deducting the interest expense. However, any amount loaned by an S corporation to its shareholder does cause an increase in the tax determination. The S corporation has higher income in the amount of imputed interest, which is passed through to the shareholder. But, the interest assessed on the shareholder is nondeductible.
Starting in 2013, a different tax result arises for high-income individuals making loans to their S corporations. This is a consequence of the new 3.8 percent Medicare tax illuminated in upcoming EA CE courses. That assessment is imposed on net investment income for individuals with gross income above the $200,000 threshold – or $250,000 when married filing jointly. Imputed interest encompasses new meaning by its inclusion in the category of investment income.
The new Medicare tax is computed on either net investment income or adjusted gross income over the threshold, whichever is lower. Imputed interest earned by an S corporation shareholder will not increase AGI because the corporate profit is reduced by an equal amount. However, when AGI already exceeds the threshold level so that the Medicare tax is calculated on investment income, adding imputed interest to the equation increases the tax assessment.
Enrolled Agents should discover how to recognize situations where the new tax on net investment income is applicable for S corporation shareholders. No tax effect is caused in instances of AGI lower than the $200,000 limit – or $250,000 for joint filers. When the amount of AGI over the limit is less than imputed interest, only that excess AGI is subjected to the tax. If imputed interest is less than the amount by which AGI exceeds the threshold, all of the interest incurs the new tax. This adds a new area of complexity to EA training and enhances the importance of comprehending applicable federal rates and imputed interest.
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.