Prepared by someone else (prior year)

[ILLMAS]

I seen a tax return prepared by another tax preparer and that has left me scratching the little hair I have left on my head.

Basic details

• 1120S  (LLC), one K-1
• Owner buys, rehabs property and sells right away
• Property are reported as inventory
• Profits are passed to shareholder as ordinary income

Here is my concern, since I have not dealt with a client in this situation before:

• If they are in the business of buying/fixing/selling homes, shouldn't the profits be subject to SE taxes?

I did not see it (SE tax) when I reviewed the shareholder personal tax return, again I have not had dealt with a client like this before and just want to make sure to say the return was prepared correctly or incorrectly and it should be amended.

Thanks

[JohnH]

Seems as though they are using the S-corp in an attempt to bypass socsec/med tax because the net income of the S-corp is not subject to SE taxes,  However, if the owner is not receiving a salary from the S-corp which would approximate reasonable compensation for someone of his/her level of expertise, then this is potentially a big problem.  You might want to have that conversation with the client and make sure they are committed to paying themselves reasonable compensation going forward.  If not, then it would be wise to pass on the relationship.  Whether they do anything about prior-years' returns is an open question, but you definitely should not get on board with continuing this practice (if my assumption is correct that this is what is happening).

[ILLMAS]

Thanks John,  in this case the individual has a very small salary from another business, they are just pocketing the profits or buying more inventory from what I can tell and they are not receiving a compensation at all.

[BHoffman]

Did the SCorp shareholder take any distributions?  A discussion during a CPE class seemed to imply that no distributions means there is nothing for IRS to reclassify as missed reasonable salary. 

[ILLMAS]

6 minutes ago, BHoffman said:

Did the SCorp shareholder take any distributions?  A discussion during a CPE class seemed to imply that no distributions means there is nothing for IRS to reclassify as missed reasonable salary. 

Yes, there was a partial distribution.

[Lee B]

28 minutes ago, BHoffman said:

Did the SCorp shareholder take any distributions?  A discussion during a CPE class seemed to imply that no distributions means there is nothing for IRS to reclassify as missed reasonable salary. 

That doesn't make sense to me since the the taxability of income from an S Corp is based on S Corp profits not on whether income is distributed.

You should take a good look at all the components of reasonable compensation for this client .

[jklcpa]

 

17 minutes ago, cbslee said:

That doesn't make sense to me since the the taxability of income from an S Corp is based on S Corp profits not on whether income is distributed.

True, he is taxed on profits whether distributed or not, but paying a distribution shows that the entity has the ability and willingness to pay the shareholder even though he may be rolling a substantial amount of resources/profits into new projects. 

[BHoffman]

19 minutes ago, cbslee said:

That doesn't make sense to me since the the taxability of income from an S Corp is based on S Corp profits not on whether income is distributed.

You should take a good look at all the components of reasonable compensation for this client .

https://www.forbes.com/sites/anthonynitti/2014/02/04/tax-geek-tuesday-reasonable-compensation-in-the-s-corporation-arena/6/#5cf75f1641a2. See the last paragraph of the article.  This is a contentious issue, but if the shareholder received no distributions then perhaps there is nothing to re characterize. 

[Lee B]

I took a look a the Forbes article and the paragraph that you quote has no substantial support.

It falls in the arena of educated speculation. Plus Illmas has already said that a distribution was made and that the owner takes a "very small salary from another business."

In my mind that creates a scenario for a very winnable audit for a competent revenue agent.

If it was my incoming client, I would explain everything to the client and strongly suggest that he needs to pay himself compensation from the 2nd business.

If not, I would turn down the work and clearly explain why!

 

 

[BHoffman]

Cbslee,  I wholeheartedly agree that the client should take adequate payroll.

Sorry to have veered off topic by bringing up the question of whether SCorp salary can be an issue if the shareholder takes no salary, and also takes no distributions.

[BHoffman]

Here is the IRS fact sheet FS 2008 25 cited in the article:  See "What's reasonable compensation?"   I am curious about this  

https://www.irs.gov/pub/irs-news/fs-08-25.pdf

[FDNY]

Just to add my 2 cents, I've insisted my single shareholder's S Corp wages be set at what other comparable businesses pay for similar services, as per the fact sheet.  The income of the S Corp fluctuates but recently has been about 1.2M.  I have suggested over the last few years (when income was much lower) to put wages at 260K (a fair amount for his experience and industry standards), and to maximize SEP contributions from the S Corp. 

So I'm wondering, are wages now too low, as income has increased substantially to 1.2M?   He takes much of it out as distributions as expenses are low.

[BHoffman]

Tax court cases involving reasonable salary for S Corp officers generally settle on the max Social Security wage cut off.  See the above Forbes article for the specific cases. 

[FDNY]

My client's S Corp's revenue will be increasing substantially over the next few years.  Here is my concern going forward, he says a fair rate for his type of work in his field would be  $150-200/hr.  He puts in 25 hrs/wk  (he has another job), so that's how we came up with a 260K salary, using $200/hr x 25hrs x 52 weeks.   But expenses are low and he takes out substantial distributions.  So my understanding is, the salary is reasonable, the rest is gravy.  The S Corp's revenue could go up to 2M next year, I am wondering if I should recommend he increase his salary, I know he'll object, (distributions would be about 1.7M)  or, is it not an issue since he maxs out SS and will only be paying more in Medicare tax (he hates that).   I'm just trying to make everyone happy.

[ILLMAS]

I believe someone here posted a case about a CPA or accountant that argued his client was a had a substantial increase in salary every year after his client was fined for not having a reasonable salary.  If I remember, the person was making 20K as supposed to $200K, so the accountant would significantly increase the salary by $5K a year, that is a huge increase for someone making $20k lol.

[BHoffman]

FDNY - If you and the client have already determined his reasonable salary at a hefty $260k per year, and his hours haven't changed, then why would he need to increase his salary just because his investment in his company is doing well?  Unless he is the only one providing goods/services for sale to his customers I'd say that no one is going question his salary.  He's already paid taxes on the cash used for his distributions. The whole premise of the S Corp is to pay FICA only on income that is earned, and avoid the double taxation on dividends.  

I think we get tangled up with the reasonable salary for S Corp shareholders because there is no set calculation. The tax court cases were all about heinously low salaries and huge distributions. The court recharacterized that portion of the distributions to closely meet the SS wage limit in every case.  I think it's a relatively safe bet that the SS wage limit would, in most cases, satisfy the reasonable salary requirement. 

[FDNY]

Thanks BHoffman and ILLMAS.  I did think the same as you B, but I was concerned because all his income is generated by his own efforts that IRS may want more in salary.  Thanks for your response, we'll  leave it as is...as it should be.  Thanks, Bill