Actually, a Recession is a Great Time to Launch That New Startup

/in /by

It’s safe to say that there are a lot of people worried about an impending global recession thanks to the economic slowdown that the ongoing COVID-19 pandemic has brought with it – and your average entrepreneur and startup founder is chief among them. Obviously, it makes sense to assume that with so many people watching what they spend and with so much uncertainty in the air, it’s too risky to launch that business of your dreams anytime in the near future.

But at the same time, that idea and reality may not line up quite as nicely as you’d think. In fact, some argue that entrepreneurs actually should not worry about a potential recession for the simple reason that the state of the global economy doesn’t directly impact startups on a large scale.

There are definitely factors that will determine whether or not a startup will succeed, but they have less to do with the coronavirus, with an impending global recession, or with any other large-scale matters than you might think.

The Positives of Founding a Startup in a Recession: What You Need to Know

One of the major reasons why founding a startup in a recession isn’t necessarily the major issue you thought it was going to be has to do with the fact that products and services are generally cheaper during these periods of economic downturn. Smart entrepreneurs aren’t scared by this – they’re ready and waiting to take advantage of it.

While larger companies are looking for any opportunity to retract and shed costs, those struggling businesses will likely sell off a lot of their assets at bargain basement rates. Retailers and other organizations will usually drop their prices in an effort to move as much inventory as possible before it’s too late. Interest rates fall to their absolute lowest, meaning that opening new lines of credit (or borrowing money in general) has never been easier.

Sure, none of this is exactly positive for those larger organizations – but it’s good news for your new startup that couldn’t have come along at a better time. Provided that you already have a plan in place, you can save on costs and still bring your vision of the perfect company into reality at the exact same time.

Top Talent Will Always Be Looking for Opportunities

Along the same lines, your startup will obviously need high quality employees to work for, though depending on the financial side of your business, getting to that point may often feel easier said than done.

But in the event that a global recession does occur, this is another one of the major reasons why this could actually be good news for your efforts. As soon as a global recession sets in, those larger companies are going to begin shedding workers – and fast. As unemployment rates rise across the country, it means that there will be a far larger number of qualified, passionate, and talented people available to fill whatever positions you have available.

By putting in the effort today to put a strong hiring plan in place, you’ll know exactly what type of candidates to go after as soon as they become available. Not only that, but you’ll likely be able to secure these people at lower rates than you would have had the job market been stronger in your industry.

In fact, a lot of people agree that this is actually a great opportunity to bring in a co-founder to compliment your skill set. Never forget that a big part of your success will ultimately be determined less by what you do and more by who you’re able to surround yourself with. If you’re able to attract qualified individuals who A) believe in what you’re trying to accomplish, and who B) fill in a lot of the skills gaps that you yourself possess, you’ll be in a far better position than you otherwise would have been – and earlier on in your company’s lifecycle as well.

Entrepreneurs Solve Problems. That Will Always Be True (and Necessary)

In the end, the same factors that will impact whether a startup can succeed are as true today as they were before any of us had ever heard about the coronavirus. They are and will always involve your founding team and their ability to solve a problem for a paying customer. Starting your business with a qualified, well-balanced, and experienced team is something you simply cannot overstate the importance of.

People will always have problems and they will always look to new and innovative companies to help solve them. Yes, the problems may change given what is going on in the world – but the fact that people are looking for real, effective solutions will not.

In other words, it’s still all about the product-market fit, the same as any other time. If your startup was founded on a genuinely innovative idea that spoke directly to the heart of a universal problem that a lot of people are experiencing, it will find its success. It may take a bit longer in a global recession, sure – but the odds are very much in your favor.

Oftentimes, achieving this product-market fit has little to do with wider macroeconomic trends, which is exactly why a recession is probably a far better time to launch your startup than you thought it was going to be. Once you also remember the simple fact that all recessions eventually come to an end – and that those startups that were founded on a stable foundation are in the best position to rebound at that time – you’re looking at a very exciting position for any entrepreneur to be in.

Still Waiting for the IRS to Cash Your Check?

/in /by

During the COVID-19 pandemic, the IRS has furloughed many of its employees or had them work from home to mitigate the spread of the virus. Many IRS offices remained shuttered for months, and a backlog of millions of pieces of unopened mail accumulated in trailers set up outside IRS facilities.

This includes unopened mail with payment checks, which creates a problem for many e-filed returns with tax due because the IRS computer shows a tax return filed but no payment made. Because the IRS utilizes a significant amount of automation, its computers began automatically spitting out tax-due notices, including to those who had mailed in payments. While most IRS facilities have reopened and IRS employees have returned to work, it will take them weeks, if not months, to get all of the backlogged mail opened and processed.

After receiving complaints from taxpayers and members of Congress, the IRS put information on its website about these outstanding payments: the payments will be posted as of the date when they were received by the IRS, not the date when the Service processes them. In most cases, this will eliminate or minimize penalties and interest for late payments. So, if you mailed a check to the IRS that has yet to clear your bank, with or without a return, the IRS says that you should not cancel or put a stop-payment on the check. However, you should be sure that you have adequate funds in the account from which the check was written, so that the check will clear when the IRS does process it.

Normally, the penalty for a dishonored payment (a bounced check) of over $1,250 is 2% of the amount of the check, money order, or electronic payment. If the amount is $1,250 or less, the penalty is the amount of the check, money order, or electronic payment, or $25, whichever is lower.

To provide fair and equitable treatment during the COVID-19 emergency, the IRS is providing relief from bad-check penalties. The dishonored payment penalty will be waived for dishonored checks that the Service received between March 1 and July 15 due to delays in IRS processing. However, interest and other penalties may still apply.

The IRS has also decided to suspend mailing certain tax-due notices to taxpayers temporarily until the unopened mail backlog is cleared up. If you have received a tax-due notice but know that you already paid the tax, the IRS asks that you wait to contact it about any unprocessed paper payments that are still pending.

So, for now, taxpayers who have uncashed payments need to be patient. There’s no reason to send additional correspondence to the IRS that would just be added to the mountains of unopened mail, and due to high call volumes, phoning the IRS will be of little use at this time.

If you have any further questions, please give our office a call.

Do You Know Unemployment Benefits Are Taxable?

/in /by

With the passage of the CARES Act stimulus package earlier this year, the federal government added $600 to the normal state weekly unemployment benefits and increased the number of benefit weeks to a total of 39.

In many cases, workers are receiving unemployment benefits for the first time in their lives, and they may not be aware that the benefits are fully taxable for federal purposes. Potentially making matters worse is that most states also tax unemployment benefits. This may come as a surprise with a potentially unpleasant outcome for many when it comes time to file their 2020 tax return next year.

Those who received unemployment benefits will be sent a Form 1099-G (Certain Government Payments) from the state that paid the benefits. This tax form shows the amount of unemployment benefits received and the amount of tax withheld, if any.

There are several states where unemployment benefits are not taxable. Seven states do not have a state income tax, so obviously, unemployment benefits are not taxable in those states, which are:

  • Alaska
  • Florida
  • Nevada
  • South Dakota
  • Texas
  • Washington
  • Wyoming

Seven states have state income tax, but do not tax employment benefits. They include:

  • California
  • Montana
  • New Hampshire
  • New Jersey
  • Oregon
  • Pennsylvania
  • Tennessee
  • Virginia

Two states exempt 50% of amounts above $12,000 (single taxpayer) or $18,000 (married taxpayers). They are:

  • Indiana
  • Wisconsin

If you’ve collected unemployment compensation this year, your benefits’ impact on your tax bill will depend on a number of factors, including the amount of unemployment received, what other income you have, whether you are single or married (and, if married, whether you and your spouse are both receiving unemployment benefits), and whether you had or are having income tax withheld from benefit payments.

If you have questions about the taxation of unemployment compensation, please give our office a call.

Ready for the 1099-NEC?

/in /by

The Internal Revenue Service has resurrected a form that has not been used since the early 1980s, Form 1099-NEC (the NEC stands for non-employee compensation). This form will be used to report non-employee compensation in place of the 1099-MISC, which has been used since 1983 to report payments to contract workers and freelancers. Form 1099-MISC has also been used to report rents, royalties, crop insurance proceeds and several other types of income unrelated to independent contractors.

The revival of the 1099-NEC was mandated by Congress with the passage of the PATH Act back in 2015. However, there have been some complications with implementing the form, so its use has been delayed. It will now make its return debut in 2021 for payments made in 2020.

The reason for the change is to control fraudulent credit claims—primarily for the earned income tax credit (EITC), which is based on earned income from working. Scammers were filing tax returns before the normal February 28 due date for 1099-MISC, which does not give the IRS the time to cross-check the earned income claimed in the returns. As a stopgap measure, 1099-MISC filings that included non-employee compensation were required to be filed by January 31, the same due date as W-2s, another source of earned income. By using the 1099-NEC for non-employee compensation, the IRS will be able to eliminate the problems created by having two filing dates for the 1099-MISC.

As a result, the 1099-MISC has also been revised, and Box 7—where non-employee compensation used to be entered—is now a checkbox for “Payer made direct sales of $5,000 or more of consumer products to a buyer (recipient) for resale.” Other boxes after Box 7 have also been reorganized.

The 1099-NEC is quite simple to use since it only deals with non-employee compensation, which is entered in Box 1, and there are entries for federal and state income tax withholding.

1099-NEC

If you operate a business and engage the services of an individual (independent contractor) other than one who meets the definition of an employee, and you pay him or her $600 or more for the calendar year, you are required to issue the individual a Form 1099-NEC soon after the end of the year to avoid penalties and the prospect of losing the deduction for his or her labor and expenses in an audit.

The due date for filing a 1099-NEC with the IRS and mailing the recipient a copy of the 1099-NEC that reports 2020 payments is February 1, 2021. (Normally the due date is January 31, but because that date falls on a weekend next year, the due date becomes the next business day, February 1, 2021.)

It is not uncommon to have a repairman out early in the year, pay him less than $600, then use his services again later in the year and have the total for the year exceed the $599 limit. As a result, you may have overlooked getting the information from the individual needed to file a 1099 for the year. Therefore, it is good practice to always have individuals who are not incorporated complete and sign an IRS Form W-9 the first time you engage them and before you pay them. Having a properly completed and signed Form W-9 for all independent contractors and service providers eliminates any oversights and protects you against IRS penalties and conflicts. If you have been negligent in the past about having W-9s completed, it would be a good idea to establish a procedure for getting each non-corporate independent contractor and service provider to fill out a W-9 and return it to you going forward.

IRS Form W-9, Request for Taxpayer Identification Number and Certification, is provided by the government as a means for you to obtain the vendors’ data you’ll need to accurately file the 1099s. It also provides you with verification that you complied with the law in case a vendor gave you incorrect information. We highly recommend that you have potential vendors complete a Form W-9 prior to engaging in business with them. The W-9 is for your use only and is not submitted to the IRS.

The penalties for failure to file the required informational returns are $280 per informational return. The penalty is reduced to $50 if a correct but late information return is filed no later than 30 days after the required filing date or it is reduced to $110 for returns filed after the 30th day but no later than August 1, 2021. If you are required to file 250 or more information returns, you must file them electronically.

In order to avoid a penalty, copies of the 1099-NECs you’ve issued for 2020 need to be sent to the IRS by February 1, 2021. They must be submitted on magnetic media or on optically scannable forms (OCR forms).

This firm prepares 1099s for submission to the IRS. We provide recipient copies and file copies for your records. Use the 1099 worksheet to provide this office with the information needed to prepare your 1099s.

Fighting Financial Fraud

/in /by

This article discusses how the coronavirus pandemic, and in particular, telecommuting, has raised a new set of problems for managers in terms of company fraud. Working from home has its benefits, but as a company owner or manager, it also has a lot of risks. Tools to fight fraud have been increasing through the years, but now more than ever, your company can benefit from understanding these tools and utilizing them in your business. Check out this article for more details.

To view this article, click HERE to access the original content.

Is a Roth IRA conversion right for you this year?

/in /by

The COVID-19 pandemic has been causing havoc in the global markets and the U.S. economy. In these uncertain times, it’s important to stay on top of your financial status, including taking measures to protect your retirement nest egg over the long term. One idea to consider is converting a traditional IRA to a Roth IRA.

Traditional vs. Roth

First, let’s review the key differences between traditional and Roth IRAs:

Traditional IRAs. Contributions to a traditional IRA may be wholly or partially tax-deductible. But deductions are phased out if these two conditions are met:

  1. Your modified adjusted gross income (MAGI) exceeds a specified level, and
  2. You (or your spouse if you’re married) are an active participant in an employer-sponsored retirement plan.

Therefore, depending on your situation, some or all of your traditional IRA may not reflect deductible contributions.

Traditional IRA distributions that are attributable to deductible contributions or growth in the account are taxable at ordinary income rates.

Roth IRAs. Contributions to a Roth are never tax-deductible, regardless of your MAGI (though your ability to contribute in a given year may be phased out if your MAGI exceeds certain limits).

Qualified distributions from a Roth IRA that’s been in existence for at least five years are 100% tax-free. For this purpose, qualified distributions include withdrawals:

  • Made after age 59½,
  • Made on account of death or disability, or
  • Used to pay qualified first-time homebuyer expenses (up to a lifetime limit of $10,000).

Nonqualified Roth IRA distributions are taxed at ordinary income rates under special “ordering rules.” When you take a distribution, contributions are treated as coming out first, so this part is exempt from tax because the contributions weren’t deductible. This treatment is followed by conversion and rollover amounts and, finally, earnings. These ordering rules reduce any potential tax liability during the first five years of the account’s existence.

In other words, when you convert assets in a traditional IRA to a Roth, you’re usually doing it for the lure of tax-free payouts in the future. But a conversion isn’t a slam-dunk by any means.

Factors to consider

Under prior law, you had until October 15 of the same year to reverse (or “recharacterize”) an ill-fated conversion. For example, a reversal might have been advised if you converted the account and then asset values subsequently declined. However, under the Tax Cuts and Jobs Act, for 2018 and beyond, you can no longer recharacterize a Roth IRA back into a traditional IRA.

So, it’s important to think through the details before you convert to a Roth IRA. Some of the questions to ask when deciding whether (and when) to make a conversion include:

How much tax will you owe? When you convert to a Roth IRA, you must pay tax on the funds transferred, just like a traditional IRA distribution. You might not want to convert if your account balance is high and you expect asset values to drop. Conversely, a declining value might encourage a conversion.

Do you have money to pay the conversion tax bill? If you don’t have enough cash on hand to cover the taxes owed on the conversion, you may have to dip into your retirement funds. For example, you might arrange to pay the tax out of the funds being converted. This will erode your nest egg, however. The more money you convert and the higher your tax bracket, the bigger the tax hit.

What’s your retirement horizon? Your stage of life can affect your decision. Typically, you wouldn’t convert a traditional IRA to a Roth IRA if you expect to soon retire and start drawing down on the account right away. Usually, the goal is to allow the funds to grow and compound over time without any tax erosion.

How do you expect your tax rate to change in retirement? If you anticipate being in a lower tax bracket when you retire than you’re in now, you may not want to convert — it might be easier to absorb tax on future distributions than it is to pay a conversion tax this year. On the other hand, if you expect to be in a higher tax bracket in retirement than you’re in now, a conversion now often makes sense, absent any other extenuating circumstances. To complicate matters, Congress could change tax rates in the future.

Will you have other sources of retirement income, besides your IRAs? If most of your retirement funds are invested in assets that would trigger taxes on distribution — such as growth stocks or a 401(k) plan — a Roth conversion may provide some flexibility later in life. It can help meet your lifestyle or estate planning objectives without triggering tax on every withdrawal. Because you can’t predict how the tax laws will change over time, it’s a good idea to build some tax diversification into your accounts.

Another important factor to consider is required minimum distributions (RMDs). While RMDs have been waived for 2020 due to the COVID-19 pandemic, normally with a traditional IRA, you must begin taking RMDs by April 1 of the year after the year you turn age 72. (This age was raised from age 70½ by the SECURE Act, effective for taxpayers who didn’t turn age 70½ before January 1, 2020 – that is, who were born after June 30, 1949.) For each subsequent tax year, an RMD must be made by December 31 of that year.

However, there are no mandatory lifetime distributions with a Roth IRA. This can help preserve wealth for your heirs.

A common misconception

Converting a traditional IRA to a Roth IRA isn’t an all-or-nothing deal. You can convert as much or as little of the money from your traditional IRA account as you like. So, you might decide to gradually convert your account to spread out the tax hit over several years.

A gradual conversion strategy can allow you to pay the conversion tax from money currently at your disposal instead of tapping into your retirement funds. As a result, your nest egg won’t be diluted by the amount you have to subtract to pay the tax.

Furthermore, if you convert a traditional IRA in stages, you may pay less tax overall because more of the transferred amount will be taxed at lower rates under the federal graduated income tax rate system.

What’s right for you?

Always contact your tax advisor before converting a traditional IRA to a Roth IRA. He or she can discuss the pros and cons, along with providing other retirement planning recommendations.

© 2020

Rolling over capital gains into a qualified opportunity fund

/in /by

If you’re selling a business interest, real estate or other highly appreciated property, you could get hit with a substantial capital gains tax bill. One way to soften the blow — if you’re willing to tie up the funds long term — is to “roll over” the gain into a qualified opportunity fund (QOF).

What is a QOF?

A QOF is an investment fund, organized as a corporation or partnership, designed to invest in one or more Qualified Opportunity Zones (QOZs). A QOZ is a distressed area that meets certain low-income criteria, as designated by the U.S. Treasury Department.

Currently, there are more than 9,000 QOZs in the United States and its territories. QOFs can be structured as multi-investor funds or as single-investor funds established by an individual or business. To qualify for tax benefits, at least 90% of a QOF’s funds must be QOZ property, which includes:

QOZ business property. This is tangible property that’s used by a trade or business within a QOZ and that meets certain other requirements.

QOZ stock or partnership interests. These are equity interests in corporations or partnerships, with substantially all their assets in QOZ property.

Final regulations define “substantially all” to mean at least 70%.

What are the benefits?

If you recognize capital gain by selling or exchanging property, and you reinvest an amount up to the amount of gain in a QOF within 180 days, you’ll enjoy several tax benefits:

  • Taxes will be deferred on the reinvested gain until the earlier of December 31, 2026, or the date you dispose of your QOF investment.
  • There will be a permanent reduction of the taxability of your gain by 10% if you hold the QOF investment for at least five years — and an additional 5% if you hold it for at least seven years.
  • If you hold the QOF investment for at least 10 years, you’ll incur tax-free capital gains attributable to appreciation of the QOF investment itself.

The only way to obtain these benefits is to first sell or exchange a capital asset in a transaction that results in gain recognition. You then would reinvest some or all of the gain in a QOF. You can’t simply invest cash.

You or your heirs will eventually be liable for taxes on some or all of the original gain. Consider ways to avoid those taxes, such as holding the original property for life or doing a tax-free exchange.

How do you report QOF gains?

In February 2020, the IRS issued guidance on reporting gains from QOFs. It gives instructions on how to report the deferral of eligible gains and how to include those gains when the QOF investment is sold or exchanged.

Taxpayers who defer eligible gains from such property (including gains from installment sales and like-kind exchanges) by investing in a QOF must report the deferral election on Form 8949, “Sales and Other Dispositions of Capital Assets,” in the deferral tax year. And taxpayers selling or exchanging a QOF investment must report the inclusion of the eligible gain on the form.

Who can help?

The rules surrounding these QOFs are complex. We can help you further explore the idea.

© 2020

5 tips for safe intrafamily loans

/in /by

If a relative needs financial help, offering an intrafamily loan might seem like a good idea. But if not properly executed, such loans can carry negative tax consequences — such as unexpected taxable income, gift tax or both. Here are five tips to help avoid any unwelcome tax surprises:

  1. Create a paper trail. In general, to avoid undesirable tax consequences, you need to be able to show that the loan was bona fide. To do so, document evidence of:
  • The amount and terms of the debt,
  • Interest charged,
  • Fixed repayment schedules,
  • Collateral,
  • Demands for repayment, and
  • The borrower’s solvency at the time of the loan.

Be sure to make your intentions clear — and help avoid loan-related misunderstandings — by also documenting the loan payments received.

  1. Demonstrate an intention to collect. Even if you think you may eventually forgive the loan, ensure the borrower makes at least a few payments. By having some repayment history, you’ll make it harder for the IRS to argue that the loan was really an outright gift. And if a would-be borrower has no realistic chance of repaying a loan, don’t make it. If you’re audited, the IRS is sure to treat such a loan as a gift.
  2. Charge interest if the loan exceeds $10,000. If you lend more than $10,000 to a relative, charge at least the applicable federal interest rate (AFR). Be aware that interest on the loan will be taxable income to you. If no or below-AFR interest is charged, taxable interest is calculated under the complicated below-market-rate loan rules. In addition, all of the forgone interest over the term of the loan may have to be treated as a gift in the year the loan is made. This will increase your chances of having to use some of your lifetime exemption.
  3. Use the annual gift tax exclusion. If you want to, say, help your daughter buy a house but don’t want to use up any of your lifetime gift and estate tax exemption, you can make the loan and charge interest and then forgive the interest, the principal payments or both each year under the annual gift tax exclusion. For 2020, you can forgive up to $15,000 per borrower ($30,000 if your spouse joins in the gift) without paying gift taxes or using any of your lifetime exemption. But you will still have interest income in the year of forgiveness.
  4. Forgive or file suit. If an intrafamily loan that you intended to collect is in default, don’t let it sit too long. To prove this was a legitimate loan that soured, you’ll need to take appropriate legal steps toward collection. If you know you’ll never collect and don’t want to file suit, begin forgiving the loan using the annual gift tax exclusion, if possible.

© 2020

“Small” is bigger than ever

/in /by

Is your business eligible for expanded tax benefits?

Small businesses enjoy several tax advantages that may allow them to reduce their tax bills, defer taxes and simplify the reporting process. Until recently, federal tax rules generally defined “small business” as one with average annual gross receipts of $5 million or less ($1 million or $10 million in some cases) for the three preceding tax years. But the Tax Cuts and Jobs Act (TCJA) increased the threshold to $25 million for tax years beginning after 2017.

The new threshold expands eligibility for small business tax benefits to a greater number of companies. It also simplifies tax compliance by establishing a uniform definition of “small business.” Previously, different thresholds applied depending on the tax accounting rules involved, as well as a company’s industry and whether it carried inventories.

Small business benefits

Potential benefits of small business status include:

Cash accounting. Businesses that pass the gross receipts test are eligible to use the cash method of accounting for tax purposes. Typically, but not always, the cash method allows a business to defer more taxable income than the accrual method.

Note that, as before, companies that are structured as S corporations, limited liability companies (LLCs) or partnerships without a C corporation partner — and that don’t carry inventories — may use the cash method regardless of their level of gross receipts.

Avoidance of inventory accounting requirements. Small businesses need not account for inventories, which can be complex, time-consuming and expensive.

Relief from uniform capitalization rules. Small businesses are exempt from these rules, which require companies to capitalize, rather than expense, certain overhead costs, adding complexity to the tax reporting process and potentially increasing their tax liability.

Eligibility for completed-contract method. Small businesses are permitted to use the completed-contract method, rather than the percentage-of-completion method, to account for long-term contracts expected to be completed within two years, allowing them to defer tax until a contract is substantially complete.

Full deductibility of business interest. The TCJA generally capped deductions for net business interest expense at 30% of adjusted taxable income. Small businesses are exempt from this limit.

Be aware that, for businesses that normally would be subject to the limit, the Coronavirus Aid, Relief and Economic Security Act (CARES Act) generally increases the limit to 50% for 2019 and 2020. (Special partnership rules apply for 2019.)

Related entities’ receipts included

When determining your company’s gross receipts, you must include not only your own receipts, but also those earned by certain related entities, such as other members of a parent-subsidiary group, a brother-sister group or combined group under common control. A parent-subsidiary group exists when one company owns more than 50% of one or more other companies. For example, if your company owns 51% of another company — or another company owns 51% of yours — you must combine that company’s gross receipts with your own when determining whether your gross receipts are below the $25 million threshold.

Your company is part of a brother-sister group if the same five or fewer persons collectively own at least 80% of each company and certain other requirements are met. For example, if the same three partners each own 30% interests in partnerships A and B, the two entities’ gross receipts must be combined in evaluating their small business status. A combined group exists when a parent is part of a parent-subsidiary group and a brother-sister group. In that case, both groups’ gross receipts are combined.

Be aware that, when calculating a person’s ownership percentage, you must include interests owned by certain family members.

Tax shelters need not apply

There’s an important exception to the general definition of small business: If your company is deemed a “tax shelter,” it won’t qualify for small business benefits, even if its gross receipts are below the $25 million threshold. Usually thought of as tax-advantaged investment vehicles, tax shelters may also include companies structured as partnerships, S corporations or LLCs that allocate more than 35% of their losses to limited partners or other “limited entrepreneurs.”

See the small picture

If your company’s average gross receipts are $25 million or less, consult your tax advisor to find out whether it’s eligible for small business tax benefits. If it is, determine whether a change in accounting methods may be worthwhile to take advantage of these benefits. If it’s not currently eligible, there may be planning opportunities to qualify for these benefits in the future.

© 2020

The proper care and feeding of your S corporation

/in /by

Diligence required to avoid inadvertent termination and loss of tax benefits

The S corporation continues to be a popular entity choice, combining the liability protection of a corporation with many of the tax benefits of a partnership. But these benefits come at a price: S corporations must comply with strict requirements that limit the number and type of shareholders, prohibit complex capital structures, and impose other restrictions.

Advantages of S corporation status

Like a traditional corporation, an S corporation shields its shareholders from personal liability for the corporation’s debts. At the same time, it provides many (though not all) of the tax benefits associated with partnerships.

The most important tax benefit is that an S corporation, like a partnership, is a “pass-through” entity, which means that all of its profits and losses are passed through to the owners, who report their allocable shares on their personal income tax returns. This allows S corporations to avoid the double taxation that plagues traditional C corporations, whose income is taxed at the corporate level and again when distributed to shareholders.

S corporations, unlike partnerships, lack the flexibility to allocate profits and losses among their shareholders without regard to their relative capital contributions. But S corporations have one important advantage over partnerships: Shareholders need not pay self-employment taxes on their shares of the profits, provided they receive “reasonable” compensation.

S corporation requirements

To qualify as an S corporation, Form 2553 — Election by a Small Business Corporation — must be filed with the IRS. In addition, the corporation must:

  • Be a domestic (U.S.) corporation,
  • Have no more than 100 shareholders (certain family members are treated as a single shareholder for these purposes),
  • Have only “allowable” shareholders (see below),
  • Have only one class of stock (generally, that means that all stock confers identical rights to distributions and liquidation proceeds; differences in voting rights are permissible), and
  • Not be an “ineligible” corporation, such as an insurance company, a domestic international sales corporation or a certain type of financial institution.

Allowable shareholders include individuals, estates and certain trusts. Partnerships, corporations and nonresident aliens are ineligible. A trust is an allowable shareholder if it’s domestic and qualifies as one of the following:

  • A grantor trust, provided it has only one “deemed owner” who’s a U.S. citizen or resident and meets certain other requirements,
  • A testamentary trust established by a shareholder’s estate plan,
  • A voting trust,
  • A qualified subchapter S trust (QSST) — that is, one 1) that distributes all current income to a single beneficiary who’s a U.S. citizen or resident, and 2) for which the beneficiary files an election with the IRS, or
  • An electing small business trust (ESBT) — to qualify, 1) all of the trust’s potential current beneficiaries (PCBs) must be eligible S corporation shareholders or nonresident aliens (NRAs), 2) no beneficiaries may purchase their interests, and 3) the trustee must file a timely election with the IRS. Generally, PCBs are persons who are entitled to distributions or may receive discretionary distributions.

Be aware that grantor and testamentary trusts are eligible shareholders for only two years after the grantor dies or the trust receives the stock.

Avoiding termination

Preserving S corporation status requires due diligence. Among other things, you should:

  • Continually monitor the number and type of shareholders, scrutinize the terms of any trusts that hold shares, and ensure that QSSTs or ESBTs have filed timely elections,
  • Include provisions in buy-sell agreements that prevent transfers to ineligible shareholders,
  • If shares are transferred to an ESBT, make sure all PCBs are eligible shareholders or NRAs, and
  • If shares are held by grantor or testamentary trusts, track the two-year eligibility period and make sure trusts convert into QSSTs or ESBTs or transfer their shares to an eligible shareholder before the period expires.

Also, avoid actions that may be deemed to create a second class of stock, such as making disproportionate distributions.

Don’t take your eye off the ball

If your business is organized as an S corporation, it’s critical to monitor your shareholders and activities continually to avoid inadvertent termination of your company’s S corporation status. At worst, termination means the loss of substantial tax benefits. At best, it means going through an expensive, time-consuming process to seek relief from the IRS and, if successful, have your S status restored retroactively. Contact your tax advisor with any business entity questions.

© 2020