Is Your S Corporation At Risk? Things Your Tax Preparer Might Not Be Telling You

Blue Heron CPAs often performs business consulting for those thinking about forming an S Corporation. There are many questions we ask that go far beyond the tax liability, like reasonable compensation. To ensure that an S Corporation is the right entity structure for our clients as it relates to taxes. Much of those questions relate to managing basis, paying yourself in an S Corporation, and the expected normal operations of the company. Understanding the consequences of making an S election is important.

This article identifies potential red flags that we commonly see in S Corporations. This article does not identify all errors or all issues we commonly see. This resource intends to help individuals educate themselves through proper communication with their tax preparers. Your tax preparer should be capable of having a conversation towards any of the below topics. This will help further qualify whether that preparer is the correct person for the service you are being provided.

S Corporations

Many small business owners form S Corporations to take advantage of significant tax benefits, especially those related to self-employment taxes. However, navigating the complexities of S Corporation operations can be challenging. Prior to electing an S Corporation, you should evaluate the complexities for whether you intend to comply with the law. In this blog article, we'll explore three common issue areas we see in S Corporations: reasonable compensation, managing your basis, and mileage for personal cars. Many tax preparers put the responsibility of compliance for these requirements on the taxpayer. Taxpayers are responsible for accurately and properly filing their tax returns and following the rules and regulations for their respective entities.

Reasonable Compensation: Paying Yourself In An S Corporation

One of the most critical issues for S Corporation owners is paying yourself in an S Corporation, also known as "reasonable compensation." The IRS closely scrutinizes the salary that owners pay themselves. This prevents individuals from reducing their tax liability by paying too little in wages and taking the rest as distributions. Here are some key points to consider when paying yourself in an S Corporation:

What is Reasonable Compensation?

Reasonable compensation is the salary an S Corporation owner or shareholder should pay themselves for their work within the business. There is no direct guidance on how to calculate reasonable compensation but the IRS guidance below discusses a potential calculation.

Documentation Matters

Proper documentation on how you came to your salary number is crucial. Maintain records of salary surveys, job descriptions, and any other information that supports the chosen salary level. This documentation is invaluable in case of an IRS audit.

Tax Implications

Reasonable compensation is subject to payroll taxes (Social Security and Medicare), while distributions are not. Paying too little in salary can lead to IRS penalties and additional tax liabilities including their ability to classify past distributions as wages.

Social Security in Retirement

There are consequences to underpaying self-employment tax. When calculating a Social Security benefit during retirement, reduced wages can heavily reduce the future benefit you receive.

IRS Guidance on S Corp Reasonable Compensation

How To Ask The Question To The Preparer:

“I was reading into S Corporation requirements, and it mentions reasonable compensation as a requirement to operate as an S Corporation. Should I be on the company’s payroll and am I taking the proper amount of salary?”

To ensure compliance, it's advisable to consult with a tax professional. A professional can help determine a reasonable compensation level that aligns with IRS guidelines and industry standards.

Managing Your Basis: The Foundation of Tax Planning

Basis in an S Corporation is the investment that the shareholders have in the company. Like understanding the cost of what you put into a house when you sell it or stocks as you sell them, you have a basis in your company. The IRS requires taxpayers to track their basis, a crucial calculation for tax purposes. Basis may not affect your income and the taxes you owe every year which is why it is a hidden dagger that has severe tax consequences in future years.

Increased Basis

Basis can increase through various means. I usually think of this as putting additional investment into the business.

• Additional capital contributions (cash or property).
• Allocated income (including taxable and tax-exempt income –
  issued through K-1).
• Taxable loans to the corporation (Research At-Risk Basis)
• Certain tax deductions and losses.

Decreased Basis

• Receive distributions (Money withdrawn outside of payroll).
• Allocate losses, deductions, and nondeductible expenses (Issued
  through K-1).
• Deduct certain losses that exceed your basis.

Managing Your Basis

Your company’s basis is recognized through Schedule M-2 which is located on Page 5 of the 1120-S. It is required for every S Corporation to track and report basis properly. On your individual return, a Form 7203 is likely filed to report the individuals basis within the S Corp.

Identifying Basis Mismanagement

Signs of basis mismanagement include the following common red flags. If you see any of the following, it is worth asking your accountant if your basis is accurately tracked and why it is reported this way. The below does not identify that a mistake has been made. It identifies that there is a high likelihood that you should talk to your accountant.

1. Negative Basis reported on M-2 line 8, Balance at the end of the year.
2. If you have withdrawn money outside of salary, Line 7 on the M-2 should have a value within it.
3. No basis reported on Line 1 of the Schedule M-2
4. Large numbers reported on Line 3 or Line 5 of the Schedule M-2 unless significant investment has been made by the shareholders.
5. If you have not taken out a loan, Line 8 of Schedule M-2 may be similar to the current value of cash, inventory, and equipment you have in the company. If there is a dramatic difference, it is worth asking your accountant why.
6. If Line 7 has a number of the Schedule M-2 but no Form 7203 exists on your individual tax return.

IRS Guidance on S Corp Basis Consideration

How To Ask The Question To The Preparer:

“I was reading into S Corporation requirements to manage your basis. I was hoping you might be able to explain the Schedule M-2 to me along with my Form 7203.”

To properly manage your basis, work closely with a tax professional who specializes in S Corporations. They can help you establish a basis tracking system, maintain accurate records, and ensure that you're compliant with IRS regulations.

Vehicle Expenses for S Corporation Owners

Have you ever been advised by TikTok or a friend to title a new vehicle under the business because it becomes a tax deduction? Your friend might be right, but they are likely not explaining the entire story for how you must treat that vehicle for the future. S Corporation owners often use personal vehicles for business purposes. S Corporation owners also may use business vehicles for personal use. Keep in mind that shareholders who are actively working within the S Corporation are considered employees of the S Corporation. Properly handling vehicle expenses is essential for tax efficiency but also a requirement to the IRS which reduces tax liabilities. Here are some key considerations:

Personally Owned Vehicle

1. Business Mileage Deductions: S Corporation owners may reimburse the mileage driven for business purposes as a mileage reimbursement. Keeping detailed records of business-related trips, including dates, destinations, and mileage is required. We recommend using a mileage app that automatically tracks your trips as a resource for creating a mileage log. The IRS provides a standard mileage rate that can be used for reimbursement.
2. Personal Use vs. Business Use: Clearly distinguish between personal, commute, and business use of your vehicle. Only the mileage driven for legitimate business purposes may be reimbursable.
3. Expense Reimbursement: If your S Corporation reimburses you for vehicle expenses, ensure that the reimbursement is properly documented and aligned with IRS regulations. Excess reimbursement may have tax consequences.
4. Accountable Plan: It is recommended for S Corporations to have an Accountable Plan to determine the reimbursements to employees along with other fringe benefits.

Business Owned Vehicle

1. Leasing the Vehicle: Personal use of a business vehicle is considered a fringe benefit which may be taxed as income to the employee. See Publication 15-B for further guidance.
2. W-2 Reporting: Your payroll provider should be made aware of the total income to be associated as wages to the employee with the proper codes identified on the W-2.
3. Mileage Tracking: The IRS still requires that mileage be tracked in the case that a business vehicle is personally utilized by an employee.
4. Majority Business Use: Deductions may be disallowed, and income may be assigned to the employee in the case that an employee is utilizing a business vehicle for majority personal purposes.

IRS Guidance on S Corp Employee Fringe Benefits:

• Publication 15-B
• Publication 463

There is not great guidance specifically towards the topic of vehicles held in S Corporations. There are common mistakes around vehicle deductions through business vehicles titled in the business’ name.

How To Ask The Question To The Preparer:

I have been researching how to get the maximum amount of deduction for my business vehicle and I came across an article describing the mileage reimbursement for personal vehicles. Are we currently performing a reimbursement and are we claiming a deduction?

I hope this article is helpful to those who have trouble approaching tough conversations about accounting and taxes. It is important to remember that the taxpayer, you, is ultimately responsible for your tax return and the numbers included on that return.

Conclusion

S Corporations offer numerous advantages, but they also come with complexities that require careful attention. Understanding reasonable compensation, basis, and mileage reimbursement rules is crucial for maintaining compliance with tax regulations and optimizing your tax strategy. Consulting with tax professionals, keeping accurate records, and managing basis effectively will help you navigate these challenges successfully and maximize the benefits of your S Corporation structure.