The IRS is monitoring S Corps for one big thing. If your S Corporation has a loss, you will need to pay attention this IRS audit red flag.
S Corporations are considered pass-through entities. That means that income or loss is reported on a Schedule K-1 for each shareholder. The shareholder then reports the income or loss on his or her individual tax return.
If there is a loss, you, as shareholder, can only use the loss on your personal return if you have sufficient basis in the S Corp. Basis is calculated one of two ways. There is equity basis and debt basis.
Equity basis begins with the initial capital contribution that you make to the S Corporation. It is increased by the income you received and any additional stock you purchase or additional paid in capital you make to the company.
It is decreased by your share of company loss and distributions you receive. The basis cannot go below zero. If it does get below zero, this becomes a taxable event to the shareholder.
There is also a loan basis. Direct loans you make to the S corporation from your own resources increase your loan basis. Loans others make to the S Corp that you merely guarantee don’t count unless you pay the loan.
You increase your loan basis by:
Making additional loans to the corporation
Deferred (unpaid) interest added to the loan
You decrease your loan basis by:
Repayments of principal
Debt forgiven by you
Principal amount of a loan converted to stock
Your share of net loss in excess of the adjusted basis in your stock
You use either the stock basis or equity basis in determining the amount of basis for purposes of using a loss from the company against your other income.
In other words, if your loss is bigger than either of the bases, then it’s not going to be fully usable.
That’s the part that the IRS is zeroing in on. If there is a loss in the S Corp, is there sufficient basis?
Your tax return doesn’t necessarily have enough information for them to find that out, so they could audit you to find out.
They pulled a few tax returns for the audit and found they had low hanging fruit. A lot of people didn’t have sufficient basis for the write-off. They took it anyway, which meant they paid less tax. And that’s pretty easy to spot, once you ask for the records.
The disadvantage to them (and advantage to you) is that it’s a fairly complicated part of tax law. They will need to use more experienced IRA auditors and if they’re tied up in S Corp audits, they won’t have time to look for other things.
Good news for you unless you happen to have an S Corp with a loss. Make sure you and your CPA have a firm grasp on the rules for calculating basis.
Equity basis is mainly a case of good accounting and historical records. Loan basis, though, has another wrinkle.
In a recent Tax Court case (Messina, 9th Circuit), the taxpayers had two S Corps. One had income and one had a loss. The one with the income loaned money to the one with the loss.
The problem is that while that is a legitimate transaction, it doesn’t increase the shareholder’s loan basis. The shareholder argued that he could simply have taken a distribution or loan from the first corporation and then loaned it to the second one. He was the sole owner of both.
The Tax Court didn’t disagree.
Sure, he could have done that.
But, he didn’t.
And that meant he didn’t increase his basis and that meant the loss was disallowed.
All it would take would be some easy paperwork trails and the properly filed tax return to fix this. BUT it has to be done ahead of time.
If you’ve got a question about this, there are a couple of ways I can help.
You can get a personal, customized consultation with me. We’ll talk about more than just this, obviously, because I want to make sure you walk away with a clear and concise step-by-step list of action items for you and your advisors to get you set up for success with more asset value, higher cash flow and less tax.
To be clear, we ONLY talk about legal tax strategies. There is nothing fishy or sneaky here.
That’s because you don’t have to cheat to win at the tax game. The tax strategies are written to be used, but you have to follow the rules.
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