S Corp LLC Form 1120S Business Tax Prep
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S Corp LLC Form 1120S Business Tax Prep
An S-Corp is not a taxable entity. An LLC S-Corp is a Form 1120S reporting entity that elects to pass through income, losses, deductions, and credits to shareholders. S-Corp Shareholders "report" their share of income or loss on their personal tax returns, utilizing Form 1120S Schedule K-1 produced by the S-Corp tax return. Here's an overview of Form 1120S for S Corps.
Shareholders are assessed tax on their LLC business tax income at their individual income tax rates. S Corp shareholders do not pay self-employment/payroll taxes on their share of profits on their personal return. What is an S Corp?
The website LLC University has an excellent explanation and answers to just about any questions you may have about LLC S Corps.
Form 1120S LLC Tax Prep
S Corp shareholders pay income tax on their personal returns. Unlike LLC partners, S Corp shareholders do not pay self-employment/payroll tax on their share of the S Corp business tax net profit on their personal returns.
What is self-employment (SE) tax?
SE tax is both the employer and employee side of Social Security and Medicare. Social Security is currently 6.2% for both employee and employer so the Social Security total is 12.4%. Medicare is 1.45% for both employee and employer so the Medicare total is 2.9%. The combined total is 15.3%.
If you are an LLC S-Corp shareholder and pay yourself on a W-2 basis, you pay the 15.3% on your W-2 Box 1 Gross Taxable Wages since you are the LLC S-Corp and, therefore, you are both employer and employee.
Since LLC S-Corp shareholders do not pay self-employment tax on their share of LLC S-Corp profits, it's not hard to figure out the game that has been played by LLC S-Corp shareholders throughout the history of LLC S-Corps.
The name of the game for LLC S-Corps is avoidance of paying self-employment/payroll taxes by taking either small or no W-2 income and large non-taxable distributions or draws. This lack of required payment of self-employment tax has resulted in two long existing problems with preparation of LLC S-Corp tax returns.
The first problem with LLC S-Corp tax return preparation is owners/shareholders who take more in distributions than they take in W-2 payroll.
Distributions VS W-2 Wages
A distribution, also known as a draw, is simply a return of equity or the amount the shareholder has invested in the business.
A distribution/draw is normally not taxable income to the shareholder nor is it a deduction for the LLC S-Corp.
The following is from the IRS web site:
Corporate officers are specifically included within the definition of an employee for FICA (Federal Insurance Contributions Act, i.e., Social Security and Medicare), FUTA (Federal Unemployment Tax Act) and federal income tax withholding under the Internal Revenue Code.
When corporate officers perform services for the corporation, and receive or are entitled to receive payments, their compensation is generally considered wages.
Subchapter S-corporations should treat payments for services to officers as wages and not as distributions of cash and property or loans to shareholders.
The Internal Revenue Code establishes that any officer of a corporation, including S-corporations, is an employee of the corporation for federal employment tax purposes.
S-corporations should not attempt to avoid paying employment taxes by having their officers treat their compensation as cash distributions, payments of personal expenses, and/or loans rather than as wages.
One S-Corp case with this problem is owned by politician Newt Gingrich that at least 3 tax attorneys say is a red flag for an IRS audit because of the amount of distributions versus the amount of W-2 wages.
LLC S Corp Distributions Exceeding W-2 Wages
We are not trying to pick on Newt, but at first glance, this case seems to be classic S-Corp avoidance of paying employment tax.
Gingrich’s tax return shows his S Corporation, Gingrich Holdings, accounted for the bulk of his $3,142,066 adjusted gross income in 2010.
The corporation paid him nearly $2.5 million in distributions beyond his salary and wages total of $252,500, his tax return and 2011 federal financial disclosure filing show.
If the IRS determines that tax avoidance was the purpose of the amount of distributions versus the W-2 wages, then Gingrich's S-Corp will be assessed penalties that are 100% of the underpaid tax, plus interest.
If you are an LLC S-Corp owner, this is not a road you will want to go down.
While Gingrich's chances of being audited are high, he is not necessarily going to get slammed by the IRS.
Here are some key factors that will determine whether tax avoidance was the purpose of the $2.5 million in distributions:
What Is Reasonable Compensation For An S-Corp?
Exactly how much is a "reasonable salary" for an S-Corp of this type?
Here's where the argument can possibly swing in the taxpayer's favor....if the CPA or tax preparer did their homework.
The instructions to the Form 1120S, U.S. Income Tax Return for an S Corporation, state:
Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.
The amount of the compensation will never exceed the amount received by the shareholder either directly or indirectly.
However, if cash or property or the right to receive cash and property did go to the shareholder, a salary amount must be determined and the level of salary must be reasonable and appropriate.
There are no specific guidelines for reasonable compensation in the Code or the Regulations.
The various courts that have ruled on this issue have based their determinations on the facts and circumstances of each case.
Some factors considered by the courts in determining reasonable compensation:
Training and experience
Duties and responsibilities
Time and effort devoted to the business
Payments to non-shareholder employees
Timing and manner of paying bonuses to key people
What comparable businesses pay for similar services
The use of a formula to determine compensation
As you can see, the case against Gingrich is not necessarily a slam-dunk for the IRS.
We know nothing of the details of this case, but would not be shocked if Gingrich's CPA firm was 100% prepared for an IRS audit.....even before the end of the tax year in question.
Indeed,Mr. Gingrich saved about $69K in Medicare taxes with this strategy. Stay tuned for the final disposition of this case.
It is interesting to note that there has NEVER been a case where the courts have reclassified distributions to salary in excess of the Social Security wage base.
This approach makes sense. Why?
Because once compensation equals the Social Security wage base, the payroll tax savings on the shareholder-employee’s remaining distributions amount only to the 2.9% Medicare tax.
The preparation of S Corporation tax returns (Form 1120S) has, for many years, been an area of income tax preparation that the majority of income tax preparers are, quite frankly, either incompetent, not aware of the regulations, or are knowingly taking advantage of the lack of historical compliance enforcement by the IRS.
We know that is a bold statement.
Finally, someone agrees with us...no less than the GAO!
The Government Accountability Office (01/19/2010) released Tax Gap: Actions Needed to Address Noncompliance with S Corporation Tax Rules (GAO-10-195):
About 80% of the time, misreporting provided a tax advantage to the corporation and/or shareholder.
The most frequent errors involved deducting ineligible expenses, which could decrease S-corporation shareholder tax liabilities.
Even though a majority of S-corporations used paid preparers, 71% of those that did were noncompliant.
Stakeholder representatives said that preparer mistakes may be due to the lack of preparer standards as well as their misunderstanding of the tax rules.
Shareholders of S-corporations also made mistakes in calculating basis – their ownership share of the corporation – when taking losses passed to them from the corporation, potentially decreasing their total taxes.
IRS officials as well as stakeholder representatives said that calculating and tracking basis was one of the biggest challenges for shareholders, and that S-corporations themselves were in a better position in most cases to calculate basis for their shareholders.
The second major problem with LLC S-Corp tax prep is the calculation of shareholder basis, or Capital Account.
What Is Shareholder Basis?
The simplest explanation is that shareholder basis is your equity in the business. In other words, how much do you have invested?
Think about it.
It's just simple logic that you cannot take a loss on something that you have no investment in.
Yet, it is mind boggling the number of personal tax returns that we see with LLC S-Corp K-1s, that have zero or negative shareholder basis....but still take their share of the LLC S-Corp loss on their personal tax return.
Simply put, this means the taxpayer took a loss on an asset for which they did not invest one dollar.
How can you take a loss on an asset that you paid nothing to acquire?
The simple answer is....you can't.
For many years, the IRS did not have the capability of detecting these errors.
However, with improved computerized matching capabilities the IRS is slowly catching up with erroneous personal tax returns that contain S Corp basis errors.
Each of these two major LLC S-Corp preparation problems (the discrepancy between W-2 salary and distributions/draws and capital account/equity versus loss deductions) are now major audit issues for the IRS.
Why do we point to the lack of competency and compliance in the preparation of LLC S-Corp returns?
Simply because for many years we have lost a number of potential S-Corp clients when we pointed out the errors on their prior year personal and LLC S-Corp tax returns and the tax cost to them of correcting the errors.
It did not take long for them to find the door....in fact, they couldn't find it fast enough!
Of course they returned to their original preparer who incorrectly prepared their S Corp tax return....but saved them tax dollars...erroneously.
That is just human nature at work.
The sad truth is that most of them were probably never caught by the IRS.
However, thanks to computers....the IRS capability of detecting S-Corp errors on personal tax returns should dramatically improve in the coming years.
Multistate Tax Considerations
Many S-corps do business in multiple states and must file income or other tax returns in them.
Many states have been more aggressive in going after out-of-state companies doing business in their states.
Many of these businesses do not realize they have an exposure to a state’s taxes until they receive a nexus questionnaire from that state.
For more information regarding multistate tax for LLC S-Corps, read this AICPA Journal of Accountancy article.
Our Promise To S-Corp Shareholders
If you are the owner/shareholder of an S-Corp, here's our promise to you.
We do not promise to save you more tax dollars than any other tax preparer.
We do promise that the taxable income on your Form 1120S Schedule K-1 that flows through to your personal tax return will be the lowest legally possible.
We also explain in detail the LLC S-Corp rules and how they interact with your personal tax return...and how to make those rules work in your favor....legally.
If you want an expert to prepare your LLC S-Corp business tax return correctly and keep you in compliance with IRS regulations....Contact CPAs James Howe or Renee Kolodziej for the correct preparation of your S-Corp business tax and personal tax return.
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