An S-Corp. election can significantly reduce taxes for small business owners and be part of a good tax plan but it is not for every situation. Here is why.
Let’s say an s-corp., after paying the owner reasonable compensation of $50k, earns a profit of $63K. Remember distributions of profits irrelevant. (For 2013 social security is capped at $13700). The owner would save $9639 in Social Security and Medicare. Great! When things go reasonably well the S-corp can be a beautiful tax saving vehicle.
Now for the other side. Let’s say the owner experience a couple of bad years and actually showed a loss. Assume also that the business earlier borrowed money to fund capital expansion, keep up with growth and was still paying off the debt, and the owner cosigned on the note. The business losses pass through to the owners, (just like income) and the owners get a nice deduction on their income, but only to the extent of their basis. Unfortunately loans to the company, even when guaranteed by and owner, (unlike partnerships or disregarded entities) do not count toward basis. In short if basis is $0 then deductions are $0. What’s even worse is any distributions in excess of basis are taxable as Capital Gains. This means you can have a loss on the business, not take the deduction and still have capital gains.
Let’s take this a step further. Lastly assume after a couple of bad years the business is turning around and the business makes 100K. However, equity & basis are still negative at end of year but the owner pulls out $75K to live on. In this situation there is pass-through income of $100K to be taxed AND capital gains of $75K. Not so much feeling the love now.
The above is a worst case illustration (at least we hope it is), and there are positions that could be taken lessen the impact. Officer loans could be established or even dissolution and reform as a different entity. For simplification, I have not addressed the differences between Retained Earnings, Accumulated Adjustments Account and Basis. Of Course, specific situations vary and you should consult your CPA when you are expecting these difficulties.
Tax entity selection can have some unforeseen consequences as individual situations evolve. You and your CPA should have frank discussions about what is happening with our business, outside the height of tax season.
Congratulations, you took advantage of the first time home buyer credit in 2008, 2009 or 2010 but now you have to move. Well it turns out there is a catch to the credit, (this is aside from the big question of whether or not tax dollars should be used to subsidize the construction industry under the guise of helping people buy homes). Generally, if you quit using that home as your main home within 36 months of purchase you are required to pay back the credit in full that year. (Home buyer credit) Interestingly enough, if you died you are deemed to having quit using that home as your primary residence and may have to repay the credit.
As they say, the devil is in the details, but in this case it could be salvation. There are some important broad exceptions to this. The most far reaching is if you sold your home to an unrelated party your repayment of the credit is limited to the gain on the sale of your home. This repayment limitation applies to all 3 years of the credit including 2008.
If you are unfortunate enough to lose money on the deal then you do not have to repay the credit beyond any amount already repaid. In most cases form 5405 needs to be filed recognizing the disposition with your tax return. If you look at the form sections IV & V will get a clear picture of how this works.
Like I said, the devil is in the details and specifics count in taxation. Form 5405 and the instructions are relatively concise and easy to understand on this issue. As always, consulting a CPA is a good ideal as well.