S-Corporation Officer Reasonable Salary

IRS launches in February 2010 random employment tax audits. The goal of this Employment Tax National Research Project, the first in 25 years, is to figure out where the IRS can get the most money through audits. One key issue is S-Corporation owner / officer / shareholder reasonable compensation / salary / wages. The IRS loses huge amounts of money when S-Corporation owners take unreasonably low salaries, mainly due to loss of the 6.2% Social Security portion of the FICA tax. Social Security tax applies to the first $106,800 of salary but does not apply to S-corporation distributions / dividends.

S-Corporation Tax Court Case on Basis and Losses

In the tax court case Rodney Jordan v. Commissioner, shareholder loans were bona fide, as reported on the S-corporation tax return, but some repayments were taxable income because S-corporation tax losses had reduced the shareholder’s cost basis in the debt. It was also determined that the debt was open-account debt and that some S-corporation tax losses were disallowed for lack of basis.

Small Business Tax Net Operating Loss Election Clarified

The IRS has issued clarification on the election to carry back a small business tax net operating (NOL) loss 3, 4, or 5 years. In this case the IRS has taken the pro-taxpayer interpretation regarding which years’ revenues are used to determine whether the loss is a qualifying small business tax NOL. The election may be made by filing the applicable refund claim forms, by attaching a statement to the tax return for the year in which the small business tax NOL arose.

S-Corporation Built-In Gains Period Now 7 Years

The new stimulus law, the American Recovery and Reinvestment Act of 2009, signed into law by President Obama on Feb. 17, temporarily reduced the S-Corporation built-in gains period from 10 to 7 years. For tax years 2009 and 2010, S-corporations can avoid C-corporation maximum-rate income tax on built-in gains. Built-in gains are generally gains that were unrealized at time of conversion from C-corporation to S-corporation. Generally these gains are subject to the maximum C-corporation tax rate if realized (the property is sold) by the S-corporation within 10 years of S-election.

Employee-Shareholder Reasonable Compensation

In addressing the issue of employee-shareholder reasonable compensation in the Menard Inc. tax court case, the Court of Appeals for the Seventh Circuit rejected the Tax Court's multi-factor approach in favor a single “independent investor” test. Under the independent investor test, if a hypothetical independent investor would consider the rate of return on his investment to be far higher than he had any reason to expect, the compensation paid is presumptively reasonable [regarding whether the compensation is unreasonably high, in the case of a C-corporation]. However, the presumption may be rebutted by evidence that the company's success was the result of extraneous factors, such as an unexpected discovery of oil under the company's land, or that the company intended to pay the owner/employee a disguised dividend rather than salary. Menard Inc. v Commissioner (CA 7 3/10/2009).

Bonus Depreciation Under the New Tax Act

Businesses can deduct 50% of the cost of most types of new property other than buildings. Used property does not qualify. Ordinary depreciation is deducted on the remainder of the cost basis, so total first year depreciation deduction is more than 50%. Alternatively, the Section 179 expense election can be used to deduct the entire cost of the property in the first year, if the taxpayer qualifies.

S-Corporation Shareholder-Guaranteed Debt = No Basis to Deduct Losses

Tax court case Russell, TC Memo. 2008-246, reaffirms AGAIN that shareholder cannot deduct losses financed with debt in the name of the corporation. The S-corporation borrowed money from a bank and the shareholder guaranteed the debt. When the S-corporation incurred losses, the shareholder was not allowed to use the debt guarantee as basis to deduct the losses, which were suspended.

Tax News Roundup 22 Dec 2008

Rental real estate: Where taxpayers showed good faith, IRS granted extension to treat all their interests in rental real estate as single rental real estate activity (PLR 200851001). This is good news for taxpayers, but an expensive and risky way to go about it. Better to just make the election on the tax return.

S-Corporation: IRS allowed continued treatment as an S-corporation even though stock was issued to stock to LLC/ineligible shareholder, ruling that the action was inadvertent (PLR 200851008).

S-Corporation: IRS did not allow a corporation to re-elect S-corporation status before the 5-year post-termination period was up (PLR 200851003).

S-Corporation: IRS continuing to allow late S-corporation elections where reasonable cause can be shown (PLR 200851015; PLR 200851022).

Trust: Trust disregarded and self-employment tax imposed on distributions where trusts lacked economic substance (Alfred J. Olsen, et ux. v. Commissioner, TC Memo 2008-275).

Estate: Estate allowed to deduct attorney's fees for estate administration, although attorney's papers were sloppy and record was otherwise “thin” (Estate of Thelma G. Hurford v. Commissioner, TC Memo 2008-278.