Say It Isn’t So! IRS Increasing Surveillance of S-Corp Dividend Distributions ??
Tax is not my bag. But did I see something recently to the effect that the IRS was ramping up to look very hard at distributions from S-corps. Have you seen anything about that?
The issue, of course, is owners taking distributions in lieu of, or to supplement, ordinary compensation.
I consult to very high growth-profile business starts, small and medium businesses. Essentially I become the “CFO” for firms that are just not quite ready to hire a full time CFO. We work *with* CPA’s, EA’s, and Counsel. We don’t do tax and very little financial accounting, but you can imagine that there is some tension between our firm and the CPA’s.
My problem is half of my client base take distributions for at least some of what a reasonable person would class as ordinary compensation. These are not warrants or convertibles, but flat out dividend distributions. Interestingly, all were set up by CPA’s.
What gives? How should I advise these folks? What is the risk to the corporation and to the shareholder-owners?
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That's an an interesting
That's an an interesting thing to share, I really wasn't familiar with these terms and many things are new for me as I am starting my own business soon as I get my small business loans approved.
Consequences of Dividends Reclassified as Salary
I found out some more information on the consequences of dividends being reclassified as salary. This also applies to an independent contractor being reclassified as an employee...
The company is responsible for all the employment taxes it would have paid on the amount reclassifed as salary. In addition, it is responsible for paying the employee's share of FICA and federal income tax withholding. The federal income tax amount can be avoided if the employee reported the income and paid the appropriate federal tax.
Penalties and interest may also apply.
The employee's share of the taxes can be abated or reduced in very specific circumstances. See IRS Publication 1976, Section 530 Employment Tax Relief Requirements. and Headliner 152, IRS Offers Tips on How to Correct Reporting of Missclassified Employees.
Also note that states have similar rules. For instance in California, the employer will be required to pay the state employer taxes (SUI & ETT) as well as the employee share of SDI and state taxes that should have been withheld. Like the federal tax, state income tax can be abated if the company can prove the employee reported the income and paid the appropriate tax.
Salary vs Dividends for S-Corporations
Yes, the IRS is definitely looking closely at dividend distribution to S-Corp shareholders.
In fact the acceptance letter sent to all new S-Corps specifically states that the IRS will re-characterize dividends paid to shareholders in lieu of salary for services rendered.
There is also a tax article on the IRS website going back to 2003, S Corporation Officers Performing Services Are Employees; Pay Is Wage reiterating your point. So this really isn't that new.
The risk to the corporation is the IRS will re-characterize dividends as salary and the corporation will be liable for back employment taxes, penalties and interest. Plus the IRS will let your state tax dept. know and you'll be dealing those employment taxes too. Very messy & potentially very expensive.
It doesn't surprise me that a CPA would set up this kind of arrangement. Many feel their job is to minimize their client's taxes and a few are very aggressive in reaching that goal... They usually get billable hours when the IRS comes calling down the line too.
The best bet is to make sure every shareholder who materially participates in the business takes a reasonable salary. Not exorbitant, not minimum wage, but reasonable. Which is, of course, a huge gray area. Some say distributions should never exceed salary. Some say the split should be 60/40 heavy on the salary. Some say as long as the salary is not zero you're OK. The problem is there is no black and white guidance from the IRS.
Perhaps sending the shareholders a copy of the IRS article above will help. And you might as well document that you have given them the information to CYA. In the end, you can only give information and then your clients have to decide what risks they are willing to take.
Good Luck!!
Well, if that is the case,
Well, if that is the case, can't the IRS claim that ANY dividends not taken as salary are taxable? So what's the point of dividends at all?
S-Corp Dividends
The reason why people pay dividends is to avoid social security & medicare taxes and also to pay the lower tax rate on dividends.
Generally dividends are a distribution of retained earnings that have accumulated over time. Dividends are a legitimate way to return income to "investors".
If I'm a shareholder not actively involved in the running of an S-Corp I have to pay taxes on my share of the money the S-Corp makes every year even if I don't receive any cash from the S-Corp. If I don't get a dividend (or return of capital) I have to dig into my own savings to pay the tax on the S-Corp's earnings.
This usually isn't the case for most small businesses I see. In most cases the shareholders are actively running the business and receive a salary for their efforts.
The problem is in S-Corps, investors & employees are the same people. And the IRS treats earned income (salaries) very differently from unearning income (interest, dividends & capital gains).
Some people are paying themselves dividends to avoid paying taxes on earned income. Because there are a few people that do, the rest of us are subject to more scrutiny by the IRS.
Distributions
I'm not sure I understand the difference. If I pay tax on the income of the scorp and then pay tax when I receive a distribution, isn't that the same as a corporation?
Doesn't the income become the retained earnings? Can you just have a distribution of cash against the Capital contribution(s) you made to start the business or during its life?
Thanks in advance for the insight.
Tax on S-Corp Distributions
Distributions to S-Corp shareholders are not taxed like dividends to C-Corp shareholders.
The S-Corp shareholder pays income tax in the year the profit is earned even if the profit is never distributed. The C-Corp shareholder only pays tax on the dividend when they receive the cash or other property from the corporation.
Yes, after the year closes, the income does go to retained earnings. And yes, you can have distributions of cash against capital contributions.
However, the materially participating shareholder of an S-Corp is a statutory employee of the S-Corp. And therefore must be paid a reasonable salary. The point of the post is to warn S-Corp shareholders that the IRS is stepping up enforcement of this requirement.
If you own an S-Corp and are only taking distributions and no salary, or an unreasonably low salary, the IRS can reclassify your distributions to salary and require the corporation to pay back taxes, interest and penalties on the misclassified payments.
I hope this answers your questions!
L:)
I understand the point of
I understand the point of the post, but again I ask the question about double taxation. If I pay tax on the income of the scorp which goes to retained earnings and then get a distribution from retained earnings in the form of a dividend, am I not being taxed twice? Worse yet, scorp dividends are taxed at my personal rate as apposed to the prefered rate of a ccorp at 15%.
Please help me with this delema.
S- Corp Distributions not taxed as Dividends
Hi,
You only pay tax on S-corp profits once, for the year its earned. When you take a distribution in later years you do not pay taxed on it again, rather it reduces your basis in the S-Corp.
Say in Year 1 my S-Corp has $1000 in taxable profit. I pay federal income tax of $100 on that. Later I take a distribution of $300. My basis in the company is now $700. I do not pay taxes on the $300. It is reported on my K-1 I receive from the S-Corp but it doesn't show up anywhere on my personal tax return. It isn't reported as dividends on 1099-DIV either.
Does this help??
L:)
Ok! So I reduce my basis,
Ok! So I reduce my basis, namely my capital account to zero, what then? I have then recovered all the money I put into the company and is it then taxed as regular income? Scorps div's are taxed as regular income, right?
I'm just trying to wrap my head around this whole deal. Are you saying that a distribution out of retained earnings just reduces retained earnings and the cash account and does not affect the income statement?
If you have no more basis,
If you have no more basis, then the distribution are taxed at (usually) long-term capital gains rates.
S-Corp profits are taxed as regular income. The only time the term "dividends" makes sense for an S-Corp is if has earning from years that it was a C-Corp.
Yes :)
L:)
That makes sense. Is it
That makes sense. Is it common though for small s-corps to undergo much scrutiny?
I'm a new s-corp and I pay myself a reasonable salary. I have a CPA who is very careful to be fair when figuring my taxes, and she doesn't "take chances" when filing for clients.
However, because of all the talk lately about s-corps I'm living in fear I'll have an audit. Though I'm up to date with everything, and have paid my fair share in taxes, the very idea of a labor-intensive audit gives me chills.
My s-corp only brings in less than $40,000 a year (before expenses/taxes). Is such a small amount usually targeted for an audit? I know anything's possible but I guess I'd just like to feel like I don't have to have such a fear of it.
S-Corp Dividends
In 2005, the IRS started a new study to assess how well S-Corps are abiding by the restrictions placed on S-Corps, see article. So yes, this is definitely something the IRS is looking very closely at.
Anyone can be audited, but by being conservative, you are greatly reducing your chances of an audit as no red flags get raised to catch the IRS's attention.
Sole-proprietors (Schedule C) returns are statistically more likely to be audited than an S-Corp.
Relax. Even if you get audited it should go very smoothly because you can produce the records to back up your income and expenses. It sounds like you have everything under control. :)
L:)
You've Got to Manage Risk Like You Manage Your Biz
I've done a fair bit of research since posting my first question that started this thread. The American entrepreneurial spirit seems to live on no matter what Congress throws at it.
Part of the reason for an S-Corp election is to allow small business owners some of the advantages of incorporation, understanding that most of the revenue generation of a small business is the direct result of the owner's efforts. Otherwise the owner(s) wishing to incorporate (C-Corp) would be taxed on corporate earnings, and so the idea goes, again on their personal earnings, so-called double taxation. I see a lot of advantages to the C-Corp at the outset, but it depends on your goals.
To me the S-corp form only makes sense if (1) you are not planning to grow at some number, say 160%(example-not calculated) beyond what you and your partners could earn as individuals; (2) you understand that the business advantages such as credit and equity funding are quite limited; and you are ok with far fewer legal advantages (e.g. protection of minority positions, simple transfer of equity, many forms of equity, etc.)
As for taking distributions from retained earnings along with salary, it looks like this is almost expected by the IRS and quite OK. As there is no guideline, it looks like just another risk you have to manage head-on. I think that the key is that the salary has to be reasonable in the overall context. Two owners of an S-Corp with an EBITDA of $40M each take a $20K salary and $400,000 in distributions, somebody is going to look at that real hard, especially the state.
When cashflow allows, you should pay yourself as salary about what a hired employee would be paid for the same work. That's what is done in the valuation of a close corp, so I would think it's going to pass any smell-test. The problem that comes to mind is that when you are first starting out, a 'reasonable' salary may not be possible, so you are going to take a much smaller salary and take distributions when you can. The accounting and tax question then is "What is the difference between an S-Corp 'dividend' and a sole prop's 'draw,' and does it really matter to the IRS in the short run?"
Those distributions are going to be taxed one way or another. One concern I'd have, especially early on in the lifecycle of the company, is that the dividends look great until finding out that on the personal side I'm stuck in AMT-hell with no escape. In the early stage that could not only hurt the taxpayer/owner, but seriously tie up his/her ability to keep the business going!
As a non-tax trained finance guy my advise is to be sure you have a realistic and reliable cash basis pro forma projection of your business - income statement AND balance sheet for just 2 or 3 years. Then have your tax pro model posssible tax returns for 2 years (2 years because of the way AMT works). This is often a neglected task except for high-income earners, but you need both because of the pass-thrus in S-Corps. Have the tax pro look over the biz model (my bias is that you should do the biz models yourself - there are lots of people who can get you started, but do the work on your own), and spend a little time with your banker, insurance person, and broker/money manager. (What, you don't have those kinds of people on your side? That's something you need to change, pronto.) This way you are doing the minimum to manage your future rather than the other way round!!
LINDA - By the way, I solved my problem as a Rent-A-CFO with the few S-corps I have with owner's taking large distributions by doing just what I advised above. I took a deep breath, did what I wanted to avoid, and quit treating S-Corps like the traditional entities I'm used to. By passing complex business pro formas over to the tax pro's and insisting on pre-season, written planning, the owner/shareholders are better served. The business strategy and finance planning product is far better because it's real in every way.
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A professional is someone who can do his best work when he doesn't feel like it.
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