Davis & Bellomo

Many corporations have chosen to be taxed as S corporations.  When an entity chooses to be taxed as an S corporation, there are certain tax considerations that need to be addressed.  The following is a brief discussion of a few select items to consider for S corporations before year-end:

Shareholder Compensation
It’s important that an S corporation pay reasonable compensation for services that shareholders provide to the corporation. It is not uncommon that S corporation shareholders pay themselves a small salary and take large distributions to avoid paying the employment taxes (FICA and Medicare) associated with paying themselves a reasonable salary.  This approach is risky because the Internal Revenue Service is aware of this avoidance and may upon exam determine that distributions are disguised salary and reclassify some or all of the distributions as salary and not only collect the payroll taxes, but any penalties and interest for failure to pay those taxes.  Before year-end S corporations that have paid little salary and large distributions, should consider whether these distributions should be reclassified as wages and pay the associated payroll taxes before year end.
2% or Greater Shareholders
Fringe benefits paid to shareholders who own more than 2% shareholders are not deductible by the S corporations. Instead, fringe benefits are added to the wages of the 2% or greater shareholders and are deductible as compensation. Common fringe benefits that need to be included in a greater than 2% shareholders wages are:
• Premiums paid by the corporation for a health plan or long-term health care
• HSA payments made by the 2% or greater shareholder and/or any contributions made by the corporation to the shareholder’s HSA account
• Premiums paid in excess of the first $50,000 of company paid term life insurance,
• Personal expenses paid with corporate funds, such as life insurance premiums where the corporation is not the beneficiary of the proceeds
These items need to be communicated to the S corporation’s payroll provider in order for them to be included in W-2 of the 2% or greater shareholders.  We recommend that the S corporation proactively contact their provider to ensure that the appropriate adjustments are made before year-end.

 

C Corporation Accumulated Earnings and Profits
For those S corporations which were previously taxed as C corporation, there may be accumulated earnings and profits (AE&P) from the years that the corporation was a C corporations. If the corporation has sufficient cash, there may be an opportunity to distribute the AE&P before year-end to take advantage of the preferential federal dividend rate of 15%. Generally, distributions from an S corporation are made from the accumulated adjustments account (AAA) which is primarily the accumulated earnings during the S corporation period.  However, for those S corporations that have AE&P, an election is available to treat the distributions as having been made from AE&P before AAA thus removing the possibly adverse tax consequences of distributing the dividends in future years when they would be subject the ordinary versus the preferential 15% available to the end of 2010.