The story is real but there are no names because everyone deserves privacy. A client was looking for help because she disposed of a home and didn’t know how to deal with the tax issues. This was simple. The facts were there, and not much I could do about it except crunch the numbers, which turbo tax does a great job of. Why on earth would she need a CPA?
The Problems: It turns out she divorced her husband three years earlier and they split their million dollar plus home (& mortgage) in the divorce, but they were going to hold onto it until the market turned around. Well, in the current year they sold the home at about a $750K loss. He had always done their return on turbo tax. So while they were waiting for the market to turn around, ex hubby decided to rent her half so when he came into town to visit their kids they would have a nice familiar place to stay. He paid her fair market rent/month but they called it additional child support so she wouldn’t have to report it on her taxes. To make it even more ridiculous, she and husband 2 (another smart guy who uses turbo tax) have another big home are now deep in excess of the $1MM mortgage limitation for homes 1&2. All of those excess deductions should be lost forever, only they are begging the IRS for an audit by claiming a deduction for all of around $125K of mortgage interest .
The Solution: As it turned out, the IRS had accepted their invitation to audit and denied all of the mortgage interest. We correctly amended the three and two year earlier tax returns to re-categorize the property as a rental the rental. This moved the activity from personal to business and recognized a passive loss which was deferred until the year of disposition. All losses became active upon disposition, wiped out current year taxable income and came to a net operating loss for the year and carried back to wipe out unpaid tax debt for the previous two years. We also proved the correct mortgage interest deduction. Fortunately the audit gave me single point person to funnel the corrections through and all of the adjustments are already on record as having been audited.
The Unsolvable Problem: The client spoke with her ex-husband and let him know that I was able to get her losses deducted and he was looking for the same help. I explained that had been helping him with his taxes 3 years ago when housing prices had plummeted, conversion to rental would have been an obvious tactic to take but since he was renting the ex-wife’s half for personal use, calling his half rental property would not fly. In short because of different treatment of the exact same piece of properly, one ex-had a business deduction of close to $450K and one had a nondeductible personal loss of about the same.
It would have cost him around $350 per year to get his tax return done and the advice that goes along with it. Yea for turbo tax!
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.