Tax Planning Tips for S Corporations

Terumi Echols for Brilliant Solutions Group writes: S corporations provide some of the most powerful tax savings benefits for both investors and small business owners. According to the statistics by the IRS, S corporations represent the most popular type of a small business corporation. However, in making this election, some extra accounting complexity is introduced that prevents business owners from getting all of their legally entitled savings.

In order to be able to take advantage of all of these tax savings, you should focus on the following tips so that you do not miss out on anything.

1. Salaries Should Be Low, Yet Reasonable
S corporation profits are paid to business owners in two forms: salary or profit. Simply put, an S corp owner would generally receive two different types of checks from the business. One would be the payroll checks that will represent the wages of the employees, and the other would be a portion of the business’s profits.
The most important thing a business owner can do to maximize the profit and minimize the tax burden is to pay the shareholder-employees a low salary. However, it should be reasonable. The reason behind this is that when profit is paid out as wages, it is subjected to Social Security and Medicare taxes. This provides shareholder-employees with social security benefits upon retirement. On the other hand, when the profits are paid out as dividends, they are not subject to Social Security or Medicare taxes.

2. Minimize Distributions
Whenever a small business opts to have a corporation or a limited liability company (LLC) treated as an S corporation, the IRS sends out a warning instructing that the shareholder-employee wages should not be set too low. If the IRS finds the salary to be set too low, it can re-categorize the distributions (referred to as dividends) as wages. If you recall, wages are subject to Social Security and Medicare taxes; whereas, dividends are not. Because the IRS can re-categorize distributions as wages, it is better that you minimize the distributions in the first place. For instance, if the shareholders can save money with one method versus the other, it should be done so within the S corporation, rather than outside of it.

3. Shift Deductions to S Corporation Tax Return
You should also consider moving tax deductions from shareholder 1040 tax returns to the corporation’s 1120S corporation tax return where legally possible. This shift in deductions may not save the owner income taxes, but it will benefit by reducing the number of distributions made to the share holders. For example, let us suppose that an S Corporation made a profit of $150,000 before it paid the shareholder-employee wages. Meanwhile, an individual shareholder purchased health insurance at a cost of $10,000, saved $5,000 annually for retirement and made annual charitable contributions of $5,000. If these were paid by the corporation rather than the individual, then the shareholder would find himself or herself in the same position economically. However, the S corporation would be paying $130,000 as wages and distributions rather than the original figure of $150,000.

Conclusion
The above three tax planning tips can go a long way in helping out S corporations to reduce the taxes they have to pay. The secret to financial success lies in proper planning, and all businesses have to ensure that they plan well in advance to avoid any unpleasant surprises later on.

Brilliant Solutions Group is a team of Advanced Certified QuickBooks ProAdvisors.

Retroactive Tax Planning Re: U.S. Shareholders of Foreign Corporations

Jeffrey L. Rubinger, Nadia E. Kruler, Joshua Kaplan for Bilzin Sumberg Baena Price & Axelrod LLP write: U.S. shareholders of foreign corporations are generally not subject to tax on the earnings of such corporations until the earnings are repatriated to the shareholders in the form of a dividend.  Moreover, when a foreign corporation is resident in a jurisdiction with which the United States has a comprehensive income tax treaty, the dividends distributed to its individual U.S. shareholders are eligible for reduced qualified dividend tax rates (currently taxed at a maximum federal income tax rate of 20 percent).

Where a foreign corporation is classified as a “controlled foreign corporation” (“CFC”) for an uninterrupted period of 30 days or more during any taxable year, however, its U.S. shareholders must include in income their pro rata share of the Subpart F income of the CFC for that taxable year, whether or not such earnings are distributed.  A CFC is a foreign corporation, more than 50 percent of which is owned (by vote or value), directly or indirectly, by “U.S. shareholders.”  A U.S. shareholder, for the purpose of the CFC rules, is a U.S. person who owns, directly, indirectly or constructively, at least ten percent of the combined voting power with respect to the foreign corporation.

In addition to the inability to defer taxation on its share of a CFC’s subpart F income, one of the pitfalls of a U.S. shareholder owning stock in a CFC is that subpart F income is treated as ordinary income to the U.S. shareholder (currently taxed at a maximum federal income tax rate of 39.6 percent), regardless of whether the CFC is resident in a jurisdiction that has an income tax treaty with the United States.  Therefore, the U.S. shareholder would not be able to repatriate its profits at qualified dividend rates.

Among other things, subpart F income generally includes passive investment income (e.g., interest, dividends, rents and royalties) and net gain from the sale of property that gives rise to passive investment income.  Gain on the sale of stock in a foreign corporation, for example, falls within this category.  Consequently, when a CFC sells stock of a lower-tier corporation, the U.S. shareholders of the CFC will have to include their share of the gain from the sale as subpart F income, which will be taxed immediately at ordinary income rates.

Check-the-Box Elections

Pursuant to the “check-the-box” entity classification rules, a business entity that is not treated as a per se corporation is an “eligible entity” that may elect its classification for federal income tax purposes.  An eligible entity with two or more members may elect to be classified as either a corporation or a partnership. An eligible entity with only one member may elect to be classified as either a corporation or a disregarded entity.

Generally, the effective date of a check-the-box election cannot be more than 75 days prior to the date on which the election is filed.  However, Rev. Proc. 2009-41 provides that if certain requirements are met, an eligible entity may file a late classification election within 3 years and 75 days of the requested effective date of the election.  These requirements may be met if:

1. The entity failed to obtain its requested classification solely because the election was not timely filed
2. The entity has not yet filed a tax return for the first year in which the election was intended
3. The entity has reasonable cause for failure to make a timely election

The conversion from a corporation into a partnership or disregarded entity pursuant to a check-the-box election results in a deemed liquidation of the corporation on the day immediately preceding the effective date of the election.  Distributions of property in liquidation of the corporation generally are treated as taxable events, as if the shareholders sold their stock back to the corporation in exchange for the corporation’s assets.  As a result, the corporation shareholders would recognize gain on the liquidating distributions to the extent the fair market value of the corporation’s assets exceeds the basis of the shareholders’ shares.  In addition, subject to limited exceptions, the corporation generally would recognize gain on the liquidating distribution of any appreciated property.

Converting Subpart F Income into Qualified Dividends

A CFC that elects to convert from a corporation into a partnership or disregarded entity generally would recognize Subpart F income on the deemed liquidation, to the extent it holds property that gives rise to passive investment income (such as stock in subsidiary corporations).  The subpart F income inclusion rules only apply, however, when the foreign corporation has been a CFC for a period of 30 uninterrupted days in the given taxable year.  Where the election is made effective as of January 2, the liquidation of the foreign corporation would be deemed to occur on January 1 of that year.  Because the foreign corporation would be deemed to have been liquidated on January 1, it would not have been a CFC for 30 days during the year of liquidation.  As a result, subpart F income would not be triggered on the deemed liquidation of the foreign corporation.

In addition, as a result of the check-the-box election, a U.S. shareholder of the foreign corporation would recognize gain on the deemed liquidation as if the shareholder sold its stock back to the corporation in exchange for the corporation’s assets.  Section 1248(a) provides, however, that when a U.S. person sells or exchanges its shares in a foreign corporation that was a CFC during the 5-year period prior to disposition, the gain from the sale is recharacterized as a dividend to the extent of the allocable share of the earnings and profits of the foreign corporation.  To the extent the foreign corporation is resident in a country with which the U.S. has an income tax treaty, its individual U.S. shareholders would be eligible for the reduced qualified dividend income tax rate on such dividend.

This may be illustrated by the following example:

A, a U.S. individual, is the sole shareholder of X, a foreign corporation resident in a country with which the United States has a comprehensive income tax treaty.  X owns 40 percent of the shares of Y, another foreign corporation.  In October 2013, X sells all of its shares of Y.  X is a CFC and the net gain from the sale of the Y shares constitutes subpart F income.  As a result, the gain would have to be included in A’s gross income as ordinary income.  Instead, X files a retroactive check-the-box election pursuant to Rev. Proc. 2009-41 to be treated as a disregarded entity as of January 2, 2013.  The election results in a deemed liquidation of X on January 1, 2013.  Because X has not been a CFC for a period of 30 uninterrupted days in 2013, however, subpart F income is not triggered on the deemed liquidation of X.  In addition, the gain recognized by A on the deemed liquidation of X is recharacterized as a dividend and subject to tax at the reduced rates applicable to qualified dividend income.

As a result, the combination of Section 1248(a) and the retroactive check-the-box rules allows individual U.S. shareholders of a CFC to convert gain that would be realized upon the sale of the CFC’s assets from subpart F income (taxed as ordinary income at rates up to 39.6 percent) to qualified dividend income (currently taxed at 20 percent).  Following the deemed liquidation of the foreign corporation, because all of the assets would be deemed to have been distributed to the shareholders in complete liquidation of the corporation, and the shareholders would recognize gain on the receipt of the assets, the basis of the assets would be stepped up to fair market value, reducing or eliminating gain recognized upon the subsequent sale of the assets of the former CFC.

Lessons from Obama's tax return : Tax Efficiency

Ken Weingarten, AdviceIQ for USA Today writes: Recently the White House released President Obama's 2013 tax return. What financial planning lessons can we all learn from the return of the most powerful couple on the planet?

First, the president received a large tax refund this year. The Obamas' overall tax liability last year was slightly more than $98,000. In addition to just over $100,000 withheld from his regular salary of $400,000, the president paid estimated taxes of nearly $17,000.

He got back those estimated taxes and then some. I think the estimated tax payments were protective payments to ensure that his income as an author created no tax penalty. With a bit more planning during the year, though, the president might see that he clearly overpaid his taxes and so provided the U.S. government with an interest-free loan.

Second, the president's salary is apparently based on reported wages of $394,796. The difference in salary and reported wages may be a health insurance deduction; I need to see his W-2 wage and tax statement. He did not contribute to a voluntary retirement plan.

All federal employees qualify for the Thrift Savings Plan, a 401(k)-type of retirement account for them. The president had a chance to defer $23,000 last year (the plan's $17,500 regular deferral plus his $5,500 catch-up for those 50 and older.) This constituted a great tax deduction for the Obamas; I am unaware of any reason barring the president from contributing.

Third, Obama realized more than $100,000 of self-employed income from royalties off his books. For this income, he did contribute to a simplified employee pension plan (SEP).

Did he consider a Solo 401(k) to shelter even more of this income and get a larger tax deduction? He can shelter an additional $23,000 of self-employed income if he uses a Solo 401(k) instead of a SEP.

The president also saw $3 of dividend income. Basically, he owns no equities in his non-retirement investment portfolio but only, from what I gather, U.S. Treasury obligations taxable at ordinary income tax rates.

One recommendation: The president can use tax-free municipal bonds in the non-retirement portion of his portfolio instead of U.S. Treasury bonds. This reduces his taxable interest from the Treasuries' obligations.

(Again, do certain limitations restrict him from owning municipals? Or does he recall that his own program pushes for a 28% exemption cap on munis for the wealthiest investors?)

Obama does appear to own equities through a Vanguard 500 Index fund (VFINX) in a retirement account from previous employment. From an asset location standpoint, it's better that he owns tax-efficient equity funds, such as an index fund in a non-retirement account, and uses the retirement account for assets that are less tax-efficient (the taxable bonds he owns in his non-retirement account work).

The president does not seem diversified in his asset allocation. Owning just the Standard & Poor's 500 and a few U.S. Treasury obligations leaves out quite a bit. What about small-capitalization stocks, international equities or real estate investment trusts?

Next, Obama reported home mortgage interest of more than $42,000 for 2013. His 2012 financial disclosure statement indicates that his mortgage is between $500,000 and $1 million and his interest rate at that time 5.625%.

My first thought: Why doesn't he refinance this mortgage? Last year, 30-year mortgage rates were below 4%. Even with a jumbo loan, he can beat 5.625%. Also, with Treasury rates below 3% for 10-year bonds, can he simply cash in some bonds and pay off the mortgage?

Yes, he gets a nice deduction for paying that interest; he also pays tax on his bonds' interest. Assuming the mortgage is at least $750,000, a 3% pick-up (the difference between interest paid on a mortgage and interest earned on Treasuries) is $22,500 a year. Maybe no big deal to a statesman who stands to earn millions giving speeches the rest of his life but still money the Obamas can contribute to many charities important to them.

Finally, we see that, yes, the president paid Obamacare taxes. His return doesn't note if he complained about it.

Did he consider a Solo 401(k) to shelter even more of this income and get a larger tax deduction? He can shelter an additional $23,000 of self-employed income if he uses a Solo 401(k) instead of a SEP.

The president also saw $3 of dividend income. Basically, he owns no equities in his non-retirement investment portfolio but only, from what I gather, U.S. Treasury obligations taxable at ordinary income tax rates.

One recommendation: The president can use tax-free municipal bonds in the non-retirement portion of his portfolio instead of U.S. Treasury bonds. This reduces his taxable interest from the Treasuries' obligations.

(Again, do certain limitations restrict him from owning municipals? Or does he recall that his own program pushes for a 28% exemption cap on munis for the wealthiest investors?)

Obama does appear to own equities through a Vanguard 500 Index fund (VFINX) in a retirement account from previous employment. From an asset location standpoint, it's better that he owns tax-efficient equity funds, such as an index fund in a non-retirement account, and uses the retirement account for assets that are less tax-efficient (the taxable bonds he owns in his non-retirement account work).

The president does not seem diversified in his asset allocation. Owning just the Standard & Poor's 500 and a few U.S. Treasury obligations leaves out quite a bit. What about small-capitalization stocks, international equities or real estate investment trusts?

Next, Obama reported home mortgage interest of more than $42,000 for 2013. His 2012 financial disclosure statement indicates that his mortgage is between $500,000 and $1 million and his interest rate at that time 5.625%.

My first thought: Why doesn't he refinance this mortgage? Last year, 30-year mortgage rates were below 4%. Even with a jumbo loan, he can beat 5.625%. Also, with Treasury rates below 3% for 10-year bonds, can he simply cash in some bonds and pay off the mortgage?

Yes, he gets a nice deduction for paying that interest; he also pays tax on his bonds' interest. Assuming the mortgage is at least $750,000, a 3% pick-up (the difference between interest paid on a mortgage and interest earned on Treasuries) is $22,500 a year. Maybe no big deal to a statesman who stands to earn millions giving speeches the rest of his life but still money the Obamas can contribute to many charities important to them.

Finally, we see that, yes, the president paid Obamacare taxes. His return doesn't note if he complained about it.