S-corp and audit

[AuditorTurnedGood]

OK actually you make a point that is on the minds of lawmakers, but "personal service" corporation is not a designation for an S-Corp. Do you not agree that the rules at this time do not put on these requirements?

Well, a PSC isn't exactly what we're discussing, with it's disgusting 35% tax bracket on the corp level (shiver), because as you point out, an S-corp is de facto not a PSC. If the S-Corp owner/officer does't have a significant capital investment in the business, the business doesn't have significant assets, and there is no "human capital" in the business, I think it stands to reason that the efforts of the S-Corp officer are what create the profits, mostly because there are no assets to leverage to create profit, and that compensation for services provided is the definition of salary.

As a service based business, with most of my s-corp clients in the same boat, am I forcing through 100% of profit as salary? No. In my case, could the IRS easily reclass my distributions to salary and make the above argument? I have no employees, very little invested, and virtually no assets, so I think if they wanted to swat at flys with Scudd missles, they could make a pretty good argument for it. And I'd appeal.

[JG EA]

Well, a PSC isn't exactly what we're discussing, with it's disgusting 35% tax bracket on the corp level (shiver), because as you point out, an S-corp is de facto not a PSC. If the S-Corp owner/officer does't have a significant capital investment in the business, the business doesn't have significant assets, and there is no "human capital" in the business, I think it stands to reason that the efforts of the S-Corp officer are what create the profits, mostly because there are no assets to leverage to create profit, and that compensation for services provided is the definition of salary.

As a service based business, with most of my s-corp clients in the same boat, am I forcing through 100% of profit as salary? No. In my case, could the IRS easily reclass my distributions to salary and make the above argument? I have no employees, very little invested, and virtually no assets, so I think if they wanted to swat at flys with Scudd missles, they could make a pretty good argument for it. And I'd appeal.

I shouldn't have confused my point and brought up PSC.

My point was just that personal service isn't a factor for S-Corps in the rules right now as far as anything I've read. (Unless they don't take reasonable compensation.)

I do yell at my clients at any given point in the year when they don't have enough money at that time to give themselves a payroll check but have the money to take a distribution. I think in that case the IRS could justify changing it into payroll. They then have to make up later so that at the end of the year (ideally each quarter) they have enough in payroll. I had a client give himself a bonus in a prior quarter that didn't come through as payroll and I made him redo everything (I did the work) and change it into payroll. They way I looked at it - he called it a bonus - plenty of profit - so that seemed best to me.

[AuditorTurnedGood]

[QUOTE=JG EA;88341]I do yell at my clients at any given point in the year when they don't have enough money at that time to give themselves a payroll check but have the money to take a distribution.QUOTE]

Good to know I'm not the only one who yells.

ATG

[BHoffman]

This begs another question:

What if the shareholder takes monthly distributions through the year, but has no idea whether he will have profit by the end of the year?

If profit exists at year end, is it acceptable to recharacterize the distributions as salary by treating them like "employee advances" against one year-end "bonus" paycheck?

For example: (for simplicity sake, let's just assume FICA only)

Total distributions taken through the year - $10,000

One paycheck issued at 12/31 for gross wages of $10,765.

FICA withheld - (765)

Net check - $10,000.

The net check amount would be credited against the prior distributions taken during the year instead of Cash.

Would the IRS look at monthly distributions and want to recharacterize them as salary and impose late filing and late payment penalties? Or, would they accept the year end bonus as satisifying the officer salary requirement as long as the payroll taxes were remitted for the year?

On the other hand:

What if the shareholder ends the year with a loss, but has still taken distributions? As far as I know, if there is a loss then no salary is required as the cash would come from "borrowed" funds, like a business loan or accounts payable, or previously taxed income, like contributed capital.

[BHoffman]

Also, since PSCs are permitted to make an S election I'm grateful that JG EA brought it up. It's those PCs and PSCs taxed as SCorps that bring up a lot of these types of questions.

[AuditorTurnedGood]

Great point, Bhoffman

I run into this almost constantly, and have wondered the same thing. Many of my clients end up with 0 claimed Q1-3 on the 941, and then all of the salary paid out in the last 3 months of the year. We end up doing a reclass from distributions to officer's comp and pay in the taxes by december 31. Not that this is right, but so far, so good. I'd be interested in what the "right" answer is.

ATG

[Gretel]

I am afraid the right answer depends on the auditor. After all, we can only do the best with what we have. What is a client supposed to do if he honestly doesn't know his bottom line until the end of the year. In this economy it's rather more of an issue than in other times I think.

Of course the money hungry IRS can penalize for payroll reports not done and paid throughout the year but maybe a court what have more common sense and decide in favor of the client. But then again, who wants to go to court?

[BHoffman]

With the greater scrutiny of SCorp officer salaries, it's likely that some cases will land in court and I hope those here who follow the tax court cases will share info.

BTW: The IRS is given the dirty work of enforcement and collection by the money-hungry Congress. The Congress is elected by entitlement-hungry voters.

[Gretel]

BTW: The IRS is given the dirty work of enforcement and collection by the money-hungry Congress. The Congress is elected by entitlement-hungry voters.

Yes, in general this is true. It still depends on power-hungry or not so power-hungry auditors and/or on insecure newcomer-auditors or seasoned and more-secure auditors if you have hell or just a reasonable audit.

[BHoffman]

Well, I suppose the audit supervisor is there for salvation from hell

[ChEAr$]

This begs another question:

What if the shareholder takes monthly distributions through the year, but has no idea whether he will have profit by the end of the year?

(snipped for brevity....)

In this case, shareholder should NOT take "distributions", but rather characterize such
as a loan, to be settled up at year's end, depending on profit or lack of it.

[BHoffman]

Thanks Harlan - do we then get into the interest rules about loans to shareholders over $10k? What if the distributions that could be recharacterized are closer to $40k? And, if the amount will be recharacterized at year end anyway, would that matter?

I suppose the credit could be made to contributed capital - as though the shareholder cashed his paycheck and put the money back into his company - rather than against distributions - would that make a difference? I report contributed capital separately on the tax return but it does sort of "net" with the distributions as it affects basis.

For a few reasons, I don't like shareholder loans to and from SCorps. They rarely get "paid back" and seem to just sit there on the balance sheet making trouble. I'm especially averse to using a "Loan to Shareholder" to avoid recognizing gain from distributions in excess of basis.

Thanks to everyone for your comments. This is an interesting topic for me and I'm grateful for your thoughts.

[Davc]

Note that if a Corp uses a loan to fund distributions then the interest is not deductible but aloan to fund payroll generates a deductible expense.

[ChEAr$]

Ouch

Thanks Harlan - do we then get into the interest rules about loans to shareholders over $10k? What if the distributions that could be recharacterized are closer to $40k? And, if the amount will be recharacterized at year end anyway, would that matter?

I suppose the credit could be made to contributed capital - as though the shareholder cashed his paycheck and put the money back into his company - rather than against distributions - would that make a difference? I report contributed capital separately on the tax return but it does sort of "net" with the distributions as it affects basis.

For a few reasons, I don't like shareholder loans to and from SCorps. They rarely get "paid back" and seem to just sit there on the balance sheet making trouble. I'm especially averse to using a "Loan to Shareholder" to avoid recognizing gain from distributions in excess of basis.

Thanks to everyone for your comments. This is an interesting topic for me and I'm grateful for your thoughts.

Contributed capital? Never would I recharacterize anything into that. Look at
accounting 202 textbooks (maybe) on formation of corporations.

But you were first talking about dollars taken out of the corporation by the shareholder,
hence at end of month I would credit bank and debit shareholder loan; or, if there is
a shareholder TO the corporation,simply reduce the amount corporation owes him.

So, end of year, shareholder has "drawn" 24,000 and the "loan to shareholder" account,
a current assets has that debit balance. Determine profit (according to GAAP) first to
find out how much you must work with, and then determine his annual salary.

Nothing wrong with an annual salary. In the last century, uh.. make that next to last
century, British army officers were always paid that way.

And I use the same annual salary approach with one of my clients, whose S corporation
business is a sideline apart form his day job. Depending on preliminary profit with everything recorded on the books except his salary, he (with my "suggestions" of course) will then determine his annual salary.

On the other hand, I've another S corporation client owned by father and son equally
who draw equal bi weekly salaries. This year, for the first time, there will be a coporate
loss after these regular salaries. Granted that the loss will be split 50/50 and flow
through to their personal 1040's, but even though I've recommended they reduce their
salary in view of these current events, and thereby save some FICA tax, they decided
not to. Go figure! (grin

[Jiggers]

Gross would be $10,828.37

[QUOTE=BHoffman;88363]This begs another question:

For example: (for simplicity sake, let's just assume FICA only)

Total distributions taken through the year - $10,000

One paycheck issued at 12/31 for gross wages of $10,765.

FICA withheld - (765)

Net check - $10,000.

QUOTE]

I think the gross would be $10,828.37, with $828.37 being the SS/MED withheld.

You take the net and divide by .9235. I use that formula for some farmers who just issue "net" checks. They don't have a calculator with them in the middle of a pasture or field when the checks are written while sitting in the front seat of their pickup.