A very beneficial tax break is available to certain small businesses and tax-exempt organizations.  The health care reform act signed into law in 2010 contains a provision for a Small Business Health Care Tax Credit.  This credit gives small businesses and not-for profit organizations a credit for the costs of health care coverage paid by the employer.

Basically the credit can be as much as 35 percent for eligible small employers and 25 percent for eligible tax-exempt organizations.  Tax-exempt organizations may receive the credit as a cash payment or may be applied to payroll taxes.  For a qualified small business or tax-exempt organization, this is something that should be investigated, and applied for.

The full credit is available for employers with ten or fewer full time employees and average annual wages of under $25,000.   A partial credit is available if the organization has fewer than 25 full-time equivalent employees and an average wage of under $50,000.

Employees who perform services for the employer during the taxable year are generally taken into account.  However, relatives and seasonal workers (less than 120 days) are excluded.  In addition, if you are not an employee your wages, hours, and premiums do not count in the tally.

Hours of service during the year must be determined to get the full-time equivalent number.  This may be done though counting actual hours, day-worked equivalency, or weeks-worked equivalency.  2,080 hours of service equals one full-time worker.

Wages are the total social security wages reported for each employee.  For a church whose pastor has opted out of social security, this can help boost the credit significantly, as the minister’s SS wages would be zero and is included in the calculation of average wages.

The credit is for a percentage of the health insurance premiums paid by the employer, premiums paid by the employee do not count, nor do premiums paid under a wage-reduction plan count.

The credit is calculated on Form 8941.  A tax-exempt organization that does not normally file a 990 would file a 990-T along with the 8941.  The credit is available through 2013.  Beginning in 2014, the credit amounts increase to 50% and 35% for businesses and tax-exempts, respectively. Additionally, beginning in 2014 the credit is available only if the insurance is purchased through an exchange.

If you would like more details on the credit, or if I can help you file for the credit, please feel free to contact me at jstancil@johnstancilcpa.com

There have been two developments in the taxation of cell phones in recent months.  These are important issues that have the potential to affect millions of employees and employers.  The first of these addressed the taxability of employer –provided cell phones.  The second addresses the issue of how the IRS will treat iPads and similar tablet computers.

The tax ramifications for employees with employer-provided cell phones has been an issue of considerable debate over the past few years.  The problem arose from the fact that cell phones were considered by the IRS as “listed property” meaning that substantiation of business use of the cell phone required highly-detailed records similar to what is required for automobiles.  The main problem with this was that virtually no one kept such records.  The Small Business Jobs Act of 2010 removed cell phones from the listed property category.  However, the Act did not address the taxability of the value of personal use of a cell phone by an employee or reimbursement of cell phone costs by an employer.

In September, 2011 the IRS addresses this issue.  Under the new guidance the IRS will treat the value of an employer-provided cell phone as excludable from an employee’s income, assuming that it is provided to the employee for noncompensatory business reasons. This means that the cell phone is provided as an essential part of his or her employment – reaching clients when away from the office or work related emergencies during off hours, for example.  A similar approach is provided for reimbursement of work-related costs of a personally owned cell phone.   It should be noted that the reimbursement cannot be a substitute for a portion of the employee’s regular pay.

It is recommended that organizations document for each employee the noncompensatory reasons for providing cell phones or reimbursing their costs.  This would include obtaining copies of the cell phone invoices and employee verification that the reimbursement is reasonable and necessary for the employee’s business needs.  Although not a direct tax issue, employers should have a written cell phone policy that is adhered to, in order to minimize or avoid liability issues arising from the employees’ cell phone usage.

In a related issue, the IRS has informally indicated that iPads and other tablet computers will be treated like cell phones for tax purposes.  When cell phones were removed as listed property, the law kept computers in that category.  Tablet computers produced somewhat of a dilemma as they have characteristics of both computers and cell phones.  Apparently, the IRS considers them more like cell phones than computers.  Hopefully, this is a step to removing computers from the listed property category since it is difficult to value the amount of personal use of these devices.

As we approach the end of 2011, it would be appropriate to review your tax situation before year-end and make any necessary adjustments.  Although it is possible that Congress will enact some last-minute tax changes, you should plan as if there will be no further changes in the tax law before year-end. We will look at some personal tax issues, then discuss a few business strategies to help you save on taxes.

Individuals

The cornerstone of tax planning is to (legally) accelerate deductions and defer income.  If you have stocks that are in a loss position, you might consider selling them before year-end, especially if you already have capital gains in the current year.  If you have some stocks that are showing gains do not sell them before December 31, and postpone the tax until a future year.  However, do not sell the stocks just to get a tax deduction.  I often counsel clients who have an unrealized loss on a stock to evaluate the stock in terms of its current cost.  “You thought this stock was a good buy at $50 a share.  It is now selling for $30.  Is it a good buy at $30?  If so, don’t sell it now.”

One of the easiest things to control in this area is the acceleration of deductions.  As an individual, bunch your itemized deductions if you are close to the standard deduction amount each year. That way you can itemize deductions in one year, and take the standard deduction next year.  Pay any outstanding medical bills before the end of the year if you are above the 7.5% AGI floor for these deductions.  If you place the amount on a credit card, it is deductible in the year in which it is posted to your account.

Accelerate any charitable contributions.  If the check is dated and postmarked prior to December 31, it is deductible in 2011.  A very attractive deduction is the contribution of appreciated capital gain property to a charitable organization.  In these situations you get a charitable contribution deduction for the fair market value of the donation, but you do not pay tax on the gain over your cost basis.  For example, you own some stock that cost you $10 a share.  It is now selling for $25 a share.  If you donate the stock to a qualified charitable organization, you get a deduction for $25 a share and pay no tax on the gain over your $10 cost.

If you normally take the sales tax deduction rather than deducting state income tax, you should be aware that this provision is slated to expire at the end of 2011.  It might be a good tax strategy to purchase a vehicle prior to the end of the year to take advantage of this deduction while it is still available.  This is also available for boats, motor homes and other major purchases on which you pay sales tax.

Businesses

For small businesses, you there are a couple of depreciation provisions that change as of December 31.  First, the amount of expenditures that qualify for the Sec 179 deduction is dropping significantly as of the end of the year.  Sec 179 allows small businesses to take a current deduction for the purchase of certain depreciable tangible personal property.  The expense limit for this deduction in 2011 is $500,000, but it drops to $139,000 at the beginning of 2012.

Secondly, the current 100% bonus depreciation provision expires at the end of this year.  This provision allows you to take depreciation of up to 100% of the cost of depreciable personal property placed into service in 2011.  In making purchases of depreciable assets in 2011 rather than 2012, you can expense more assets under Sec 179 or the bonus depreciation allowance.

If you own an interest in a partnership or S corporation and anticipate a loss for 2011, you should examine your basis to see if it is sufficient for you to fully deduct the loss.  If it is insufficient, take steps to increase your basis.

Self-employed individuals should consider setting up a retirement plan in order to reduce taxes and to help insure that you have provided adequately for your retirement.

Businesses can stock up on supplies in order to get a deduction for 2011 and reduce the tax bite this year.  In addition, examine your inventory and see if any of it is damaged or obsolete.  If so, take a write off for its cost.

Make sure your accounting records are up to date so that you know what your tax situation is, going into the last days of 2011.  You can’t make the right decisions without correct and current information.

Finally

For businesses and individuals, perform an overall financial checkup.  Assess your financial condition and your plans for the coming year.  Think about cash flow, retirement, health care, investment and estate planning.  Review your wills, health care proxies, and powers of attorney for any changes that need to be made.  It is never too early or too late to plan for the future.

I have only been able to hit the highlights of the laws in this short article.  If you wish more detail about any of these issues, feel free to contact me.  Or if you wish to discuss your tax situation as the year is ending, I will be glad to help evaluate your situation.

The IRS has announced an opportunity for employers to reclassify employees that have been incorrectly reported to the IRS as independent contractors.  There is a 20-point test that the IRS uses to classify workers as employees or independent contractors.  These criteria can be viewed on IRS Form SS-8.  This form can be utilized as a guideline or can be completed and returned to the IRS for a determination.

Generally speaking the issue of employee or independent contractor hinges on the amount of control exercised by the employer over the worker.  If a worker is classified as an employee, the employer must withhold social security, Medicare, and income taxes from wages and also pay the 7.65% employer’s share of social security and Medicare.  By classifying workers as independent contractors the employer can save the 7.65% of social security and Medicare.  However, if the worker is misclassified and should be an employee, this is illegal and can subject the employer to payment of the tax plus penalty and interest on the unpaid amounts.

Under the IRS Voluntary Classification Settlement Program (VCSP), qualifying employers may report these misclassifications to the IRS and pay 10 percent of the employment tax liability that may have been due for the most recent tax year. For this purpose, IRC 3509(a) specifies a rate of 10.68% which includes a portion of the taxes that should have been withheld from the employee.  No penalties and interest will be assessed.  In addition, the IRS will not subject the employer to an employment tax audit with respect to the worker classification of workers for prior years.  In exchange, the employer agrees to extend the statute of limitations of the assessment of employment taxes from three to six years for the first three years after entering into the program.  This applies only to the three years after the workers are properly reclassified.  The employer must agree to reclassify workers as employees and should apply at least 60 days before they want to begin treating them as employees.

For an employer who has misclassified workers, this is a tremendous opportunity to get their employment tax issues straight with the IRS at a minimal cost and eliminate the risk of an audit with full taxes, interest, and penalties payable.

In order to qualify the employer must:

1.  Currently incorrectly treat some workers or class of workers as independent contractors.

2. Have consistently treated these workers as non-employees and must have properly filed Forms 1099 for the workers for the                  previous three years.

3. Not currently be under audit by the IRS, the Department of Labor, or a state government agency for worker classification issues.

In order to apply for relief under VCSP, the employer should complete Form 8952.  This is a new form that is now available at www.irs.gov.  The IRS will then take action on the application and reserves the right to reject or accept each application.

There is apparently one downside to entering this program, aside from the extended statute of limitations.  When a worker is misclassified as an independent contractor, the employer also avoids the state unemployment compensation tax.  Confessing to the IRS may attract the attention of the state agency handling unemployment compensation issues and result in a liability for unemployment compensation tax, interest, and penalties.  Hopefully, some states will be amenable to a negotiated settlement.

The IRS release does not specify a sunset provision on this program, so employers are encouraged to quickly.

There have been a couple of recent changes in the tax rules that will impact a large number of taxpayers.  The IRS announced increases in the mileage rates, effective July 1, 2011.  Interestingly, after indicating for much of 2011 that the rates were not going to change, they announced the changes as gas prices were declining.

For the first half of 2011, the rate for business mileage was 51 cents per mile.  Mileage incurred July 1 – December 31, 2011, will be subject to a rate of 55 cents per mile.  Moving and medical mileage likewise increased, from 19 cents to  23.5 cents per mile.

Mileage incurred for charitable organizations did not change remaining at 14 cents per mile.  This rate is designed to cover only the cost of gas and has no provision in the rate for depreciation, maintenance, or other ownership costs.  This rate is fixed by Congress and cannot be changed by the IRS.

It will be important to keep track of your business, moving, and medical mileage and separate those miles incurred January 1 – June 30 from those incurred after July 1, since a dual rate applies this year.

As always, a contemporaneous log of your mileage should be maintained in order to comply with IRS rules and regulations and to make sure that you capture all deductible mileage.

The second change announced by the IRS deals with the length of automatic extensions to file certain tax return.  Partnership, trust, and estate tax returns will now be subject to a five-month extension.  This change was enacted in order to force pass-through entities such as partnerships to file their returns and provide Form K-1 to the owners in time for the owners to file their 1040 by the extended date of October 15.

Corporations, including S-Corporations, retain the six-month extension.  However, this does not create a problem for stockholders, as corporations are due March 15 when operating on a calendar year.  The extended due date would then be September 15.

This change is a change for the good, as it eliminates an October 15 rush to complete partnership, trust, and estate returns in time to prepare the extended 1040’s for K-1 recipients.

The 2010 Tax Relief Act was signed by the President in December, 2010.  Although this bill is primarily known for extending many tax breaks for individuals, the law also contains about 50 provisions affecting business.  Some are rather obscure such as a tax break for producing TV shows, grants for putting up windmills, rum subsidies for Puerto Rico and the Virgin Islands, and a break for people who buy race horses.  Since most of us aren’t involved in any of those, I am going to forgo a discussion of these provisions and move to those that are more broadly relevant.

Many of these tax breaks are simply extensions of provisions that were slated to expire at the end of 2010, so you may not see any reduction in your taxes from enactment of these provisions, but hopefully they will keep your tax bill from increasing.

Among these provisions that have been extended is the 25% credit for an employer who provides child care facilities.  This has been extended through December 31, 2012.

Bonus depreciation is back and it is on steroids.  Qualified investments made between September 9, 2010 and December 31, 2011 are eligible for 100% bonus depreciation.  After that, the steroids wear off and the bonus depreciation drops back to 50% for calendar year 2012, then disappears in 2013.

In a related vein, Sec. 179 expensing is set for a $125,000 dollar limit and a $500,000 dollar limit for tax years beginning in 2012. This number is indexed for inflation.  For 2010 and 2011 the limits were previously set at $500,000 and $2,000,000 respectively and were not changed with this legislation.  After 2012, it reverts to the prior levels of $25,000 and $200,000.  I can’t imagine Congress not doing something about this low limit beginning in 2012.  Stay tuned.

Employer-provided transit benefits include tax-free payments to employees for transit or vanpool costs up to $230 per month.  These two were made equal in a 2009 tax act and is extended through 2011.  After that time vanpool benefits drop to $120.  These amounts adjust for inflation.

The Work Opportunity Tax Credit encourages employers to hire employees from certain targeted groups.  The credit is 40% of the first $6,000 of the employee’s qualified wages.  Scheduled to expire on August 31, 2011, it has now been extended through December 31 of this year, with some modifications.

A number of business tax breaks that expired at the end of 2009 were extended through the end of 2011.  Among these are a 15-year recovery period for qualified leasehold improvements, restaurant building and improvements, and retail improvements; a seven-year motor sports entertainment cost recovery period; and five-year depreciation for farm machinery and equipment.

So here we are in another tax season, with a host of changes in the tax code for businesses, individuals, estates and trusts, and even not-for-profits.  Stay tuned, who knows what will be coming out of Congress next.  I have only attempted to overview the highlights of these changes.  If any of these apply to you and you would like more detail, please contact me or leave a comment.

An S Corporation needs to carefully monitor distributions to shareholders to be certain that there are no disproportionate distributions.  Failure to make distributions in proportion to ownership interests can void the S Corp election.  

Distributions to shareholders must be made in proportion to the ownership interests of the shareholders or a disproportionate distribution has occurred.  For example, if an S Corp has three shareholders owning 50%, 35% and 15% of the corporate stock, all distributions to shareholders should be in this ratio.  These are distributions of profits, if the shareholders are also employees, amounts paid to them in salary are not distributions for this purpose.

 A disproportionate distribution can occur inadvertently.  A loan to a shareholder that is not properly documented as a loan can be a distribution.  The distribution of non-cash property can be a distribution.   A sale of corporate property at less than fair market value can be a distribution.

 Under IRS regulations, disproportionate distributions are viewed as evidence of a second class of stock.  Since one of the requirements of an S Corporation is that it only have one class of stock, a disproportionate distribution can invalidate the S Corporation election.

 If a disproportionate distribution has occurred, the corporation must take immediate action to correct the error by equalizing the distributions.  The first step in this regard is to determine the actual distribution per share to each shareholder.

 Secondly, identify the shareholder who received the highest distribution per share.  Then, determine the amount that each shareholder should have received at that per share level.  Next, subtract the amount each shareholder received to determine the amount of equalizing distributions that must be paid to each shareholder. This must be done separately for each distribution that the corporation makes – each distribution stands on its own.

 It should then be determined if the distributions to each shareholder can be paid tax-free out of profits and do not violate corporate distribution limitations.  If this requirement cannot be met, other actions must be taken.  This can get complicated and is beyond the scope of this article.  You should consult with your tax professional if you find yourself in this situation.  Assuming this hurdle is overcome, the Board of Directors should authorize the equalizing distributions.  The distributions should be paid promptly. 

 If the corporation lacks the cash to make the distributions, it may be necessary for the shareholder to make loans back to the corporation.  If this is the case, the loans should be properly documented promissory notes with appropriate interest rates included.

 Let’s run through a simple example of one disproportionate distribution.  Go back to our hypothetical corporation with three shareholders owning 50%, 35%, and 15%, representing 50, 35, and 15 shares.  The shareholders receive distributions of $5,000 each.  It does not matter if the distributions were paid in cash or other assets.  The important factor is the fair market value of assets received by the shareholder.

 A – $5,000/50 shares = $100 per share

B – $5,000/35 shares = $142.86 per share

C – $5,000/15 shares = $333.33 per share

C has received the greater amount per share.  A must be given $233.33 per share time 50 shares, or $11,667 in additional distributions.  B will receive an additional $190.47 per share, or $6,666 total.

In summary, this brings us to a point that must be emphasized regarding S Corporations.  The corporation is an entity separate from its owners.  It may not be treated as an extension of the owners and corporate transactions must be maintained separate from personal business.  When the corporation is closely held, especially by close family members, there is a tendency to overlook corporate formalities.  To do so, however, you run the risk of losing the advantages of the corporate form of organization, as the courts and the IRS may rightfully ignore the corporate form of organization in these cases.

Knowing one’s cost basis in an S corporation is a vital issue for most owners of S corporations.  However, to many such shareholders, basis is not understood and not known. Part of the confusion arises from the fact that S corporations, LLC’s, and partnerships are faced with two different basis numbers – inside basis and outside basis.  Both are important, but the outside basis is more likely to become an issue annually for the shareholder.  Shareholders may not deduct losses from the corporation in excess of their outside basis.

 Inside basis is basically the balance in the owner’s capital account.  It represents the ownership interest in the corporation, but not necessarily what that ownership interest cost.  Inside basis is maintained on the corporate books.  It represents:

 The original amount credited on the corporate books for stock purchases.  Frequently, this will equal the amount invested, but it can vary when the interest is purchased from another shareholder and not from the corporation.

• Increases in the investment in the corporation through an owner’s share of the profits.
• Decreases in the investment in the corporation through distributions to an owner.
• Additional stock purchases in the corporation’s stock by an owner.

 Outside basis is more complicated, as it takes in a number of additional factors and must be maintained by the shareholder.  The corporation does not normally track outside basis. Unfortunately, many S corporation shareholders do not keep a record of their outside basis.  Outside basis includes:

 The original purchase price.

• Basis in any property contributed to the business.  This is the lower of fair market value or cost of property contributed to the corporation.
• Taxable gains that are recognized on the contribution of property.
• Liabilities of the corporation assumed by the shareholder.
• Tax-exempt income of the business.

 Outside basis is decreased by:

 Liabilities that the business assumes.

• Business and capital losses.
• Non-deductible business expenses (that are not capital items).
• Section 179 deductions.
• The corporation’s basis in property received from the business.
• Cash withdrawals.

 A word of explanation about liabilities is in order.  If a shareholder agrees to be responsible for a debt of the corporation, outside basis is increased by that amount.  Conversely, if the corporation agrees to pay a debt of the shareholder, the liability is assumed by the corporation and decreases outside basis.  A loan guarantee does not affect basis, the debt must be transferred to change basis.

 Basis may not be reduced below zero.  Therefore, losses in excess of basis are not deductible. These may be suspended for use in future use when basis has been restored.  The losses maintain their character (i.e. an ordinary loss carries forward as an ordinary loss). 

 Failure to maintain a record of outside basis can result in the shareholder deducting losses on the 1040 that are not allowable.  If an IRS audit ensues, additional tax may be levied in addition to interest and penalties. This could create some undue hardships is if the shareholder cannot demonstrate the amount of basis simply because of poor record-keeping.  The result could be the IRS assigning a basis on what the shareholder can prove, which would likely be grossly understated.

 Corporations engage in numerous transactions over the course of a year, and the basis consequences may not always be readily apparent.  In order to avoid surprises when tax time comes, shareholders should meet with their tax preparer prior to the end of the year to discuss events that have occurred during the year.  In addition to covering any basis issues that have arisen, the discussion should also cover compensation, loans to and from the corporation, and Section 179 deductions.

 Another problem with basis can be encountered occurs when there is a stepped-up outside basis.  This frequently occurs when the shares in a corporation are inherited from a prior owner. 

 For example, assume that Joe Smith is the founder and sole shareholder of SmithTech, Inc.  He began the company with an investment of $10,000.  The company prospered and was very profitable.  Joe unexpectedly dies in 2009.  The stock in SmithTech, Inc. is valued at $1,000,000.  His heirs receive a stepped-up basis of $1,000,000 in the corporation’s stock.

 The heirs are approached by an outside investor who offers to purchase the assets of the corporation for $1,000,000.  Assuming they accept the offer, there are some significant tax consequences.  The corporation has sold the assets that have an inside basis of $10,000 for $1,000,000.  This results in a gain on the sale of assets of $990,000 – income taxable to the shareholders.  They stand to lose the benefit of the stepped-up basis in the stock, and will pay taxes on the $990,000 gain.  In order to benefit from the stepped up basis, they must liquidate the corporation in the same year as the sale of the assets.  They can recognize a loss on the liquidation that will offset the gain on the sale of the assets. 

 If they do not liquidate the corporation in the year of the asset sale, the loss on liquidation of the corporation is a capital loss, deductible at the rate of $3,000 per year.  One solution would be to sell the corporation, rather than the assets. 

 Other situations may arise when there is a significant difference in inside and outside basis.  In short, basis is a complex issue that needs professional guidance and constant attention.  Shareholders should keep track of their basis and consult with their tax professional in order to avoid undesirable consequences.

A major issue for most S corporations is the matter of shareholder compensation and  benefits.  One of the advantages of an S corporation is the ability to avoid self-employment taxes on the earnings of the corporation.  However, payroll taxes cannot be totally avoided as the IRS requires that an employee/shareholder be paid a “reasonable” salary.  A related issue is benefits made available to the shareholder/employee.  There are restrictions on benefits that they can receive.  These shareholders often do not realize (or choose to ignore) that the corporation cannot be treated like a gift bag in which you reach in and give themselves personal benefits.

A shareholder/employee is required by law to receive a “reasonable” salary from the corporation.  The IRS does not define reasonable but takes into consideration several factors.  The salary must be commensurate with salaries paid comparable executives in similar situations.  However, the earning history of the corporation and unusually low salaries received in the early years of the business may be taken into consideration.  If the IRS deems the salary too low, the IRS may treat distributions to the shareholder as salary.  This, of course, affects the tax liability of both the corporation and the shareholder.  Conversely, if the IRS deems the salary to   be excessive, it will be recast as a distribution which also affects the tax liabilities of both entities.

Whatever salary is paid to shareholders, it must be paid for services actually rendered – you don’t get a salary just because you are a shareholder.  This salary is subject to withholding and payroll reporting.  In this regard the shareholder is treated like any other employee.  The salary amount should be approved by the board of directors of the corporation.

Benefits paid to a shareholder/employee who owns more than 2% of the stock of the corporation generally will be taxable compensation.  In addition, the board of directors must approve any of these benefits given to the shareholder.  Normal taxable benefits are reported on box 14 of the W-2 and are not subject to employment taxes.

A benefit is any non-business related item given to an employee/shareholder.  This would include any personal obligations of the shareholder paid by the corporation.  Examples would include the corporation paying the monthly car payment for the shareholder’s vehicle, the shareholder using corporate property for his/her personal use, or any other use of corporate assets for the benefit of a shareholder.  It is extremely important that personal and business transactions be kept separate and never mingled.

Related to benefits paid to shareholder/employees is the issue of paying benefits to shareholders who are not employees.  For example, it is possible for the corporation to pay the health insurance costs for a shareholder.  However, this creates a number of problems as the cost of the insurance is considered a distribution to the shareholder.  Assuming that not all shareholders received the identical benefit, this is then classed as a disproportionate distribution and may create difficulties with the IRS.

Once again we return to the familiar refrain “Keep corporate and personal transactions separate.”  Keep a separate bank account for the business, pay only business obligations from the business checking account.  Document board authorization for compensation paid to a shareholder.  Keep good records, and you will have a better chance to demonstrate your compliance with these rules and regulations.

When a business operates as a sole proprietorship or as a partnership, there are few legal and tax regulations that must be followed.  However, if that business converts to a corporation, a number of things change and the owner(s) must adhere to these new expectations or run the risk of having the corporate form of organization legally disregarded.  When a corporation is legally disregarded, the law treats it as though it does not exist.  In a worst-case scenario, this means that the limited liability protection provided by a corporation is lost, and the owners can be held liable for the debts and acts of the corporation.

Keep in mind that a corporation, whether an S corporation or a C corporation, is a legal entity separate and distinct from its owners.  This is unlike the situation with a proprietorship or partnership, in which the business and its owners are not treated as separate entities but are one and the same.  Therefore, the owners of the corporation must take extreme care to keep personal transactions separate from business transactions and to follow legal procedures for the corporation.

This article will discuss four pitfalls that S corporation owners must avoid:

1. Failure to keep minutes.
2. Failure to separate personal assets.
3. Shareholder loans.
4. Lack of basis.

The corporation should have an annual meeting at a minimum, with appropriate minutes maintained, indicating actions by the shareholders.  In addition, the board of directors should have periodic meetings with a written record of these proceedings.

Certain actions are reserved for the shareholders.   These actions occur at a meeting of the shareholders – a shareholder has no authority outside an official meeting of the shareholders.  This should not be confused with the meetings of the board of directors.  The shareholders are charged with the responsibility to elect and remove directors, amend the articles of incorporation and bylaws, approve the sale of all or substantially all of the corporate assets, approve mergers and reorganizations, and dissolve the corporation.  These are often infrequent events so the amount of record-keeping should not be burdensome.

Another set of actions are reserved for the board of directors.  Typical actions of the board include:

1. Authorizing the issuance of stock.
2. Electing the corporate officers.
3. Setting officer and key employee salary amounts.
4. Deciding whether to mortgage, sell, or lease real estate.
5. Approving loans to or from the corporation.
6. Authorizing bank accounts.
7. Any material matter facing the corporation

Any of the above actions by the stockholders or the board require proper approval and should be reflected in the appropriate minutes.  This is true even if the stock is owned by one individual who is also an employee and board member.  The minutes do not need to be elaborate, but they do need to be in writing and reflect the actions of the stockholders or board.  State laws vary regarding how often meetings, must occur, how many directors a corporation must have, and the format of the meetings (in-person, telephone, meetings by consent, etc.).

A second issue is the failure to separate personal transactions from corporate transactions.  Intermingling the two is referred to a piercing the corporate veil.  Keep in mind that the corporation is not a personal checkbook and personal obligations must not be paid out of corporate funds.  Likewise, property should be owned by the corporation and any debt associated with that property should be corporate debt.  This may require a transfer of personal assets to the corporation upon its founding and should be reflected in the corporate minutes.

Failure to document shareholder loans to and from the corporation is another pitfall that many corporations encounter.  First, these loans require board approval.  Secondly, they should be separated into “Due to” and “Due from” shareholder accounts on the books.

Third, these loans must be documented by a promissory note.  This note should contain repayment terms.  Additionally, if the amount of loans exceeds $20,000 at any time during the year, the note must bear interest.  Failure to include a required interest component could result in imputed interest to the shareholder and a failure to report the interest income and expense on tax returns for the shareholder and the corporation.

A final pitfall to be considered is the issue of the stockholder’s basis in the corporation.  Basis is simply the owner’s investment in the corporation.  However, it can be much more complicated as inside and outside basis must be considered.  Frequently the two are the same.

While this is an oversimplification, outside basis is maintained by the taxpayer and represents the owners’ original investment plus profits minus loses and distributions..  Inside basis is maintained on the books of the entity.  Inside tax basis is the initial investment (cash or the value of other assets) plus profits minus loses and distributions.  Losses in excess of basis cannot be deducted on the individual tax return of the owners.  This matter will be dealt with in more detail in the future.

It is  a good policy to meet with your tax advisor before the end of the tax year to see if there are any issues for the corporation that require action prior to the end of the year.  This will help to avoid or minimize any unpleasant tax consequences.