S-corp

[ILLMAS]

What is the proper way of taking a distribution from a S-corp with no payroll? The S-corp had two shareholder at one point, one sold his interest to the other, back in 2003, there after, the only shareholder left gets a k-1 and he pays the tax on his personal return. Payroll stopped when he bought out the other shareholder, he is getting paid from another business he owns, Let's say company A (1120) is a auto repair shop and his company B (1120S) owns the building and rents to company A. Company A pays rent to company B, company B pays the mortgage, insurance, r/e taxes and any major improvement, company A pays the payroll. So far company A has only paid about 4 months of rent for 2009, company B has had enough in its account to cover expenses, as of the end of October 2009, company has a profit (approx. 100K) which is the rent not paid to company B. If company A pays another 4 months of rent (approx. 40K) and the owner gives himself a bonus of about 20K, this will reduce his profit to about 40K, which is an average for this particular company. Here is my delimena, if he pays the rent to company B, there will be enough money for him to take a distribution, there is about 80K in retained earnings, so if he takes about 40K as a distribution/dividends then he will pay 15% of tax and not pay the 25 or 28% rate. Would taking a reasonable amount fly, company A pays him a salary of about 73K, so taking about 40K from company B as a distribution sound reasonable? Any help will be greatly appreciated.

[michaelmars]

problem 1]owning real estate in an s corp sucks

problem 2] each company stands on its own so you can't say one comapny pays wages so the other doesn't have to.

problem 3] s corp should pay wages but now you have real estate income which is not subject to se tax becoming subject!

if the lease was a triple net lease with the tenant paying all expenses you might have an arguement that the re income is totally passive and should not be considered earned income but the irs likes earned income subject to fica.

problem 4] he is self dealing-[renting to a related party] fair market rent needs to be established and will be considered active so other passive losses will not offset the income

[OldJack]

problem 1]owning real estate in an s corp sucks

Sucks only if you later want to take the property out to the shareholders. If the property is to be used or sold by the S-corp it has little difference.

problem 2] each company stands on its own so you can't say one company pays wages so the other doesn't have to.

This example may not have each company standing on its own due to what is called the "step transaction doctrine". Which basically say if the steps are in substance integrated the steps in between can be ignored. As long as Fair-Market-Value rent is paid there should be no problem with this arrangement.

problem 3] s corp should pay wages but now you have real estate income which is not subject to se tax becoming subject!

Rental real estate activity is reported on form 8825 attached to the S-corp tax return with the net income from the same shown on page 3 and the 1120S-k1 line 2. This is passive rental income that is passed to the shareholder to report on 1040 Sch-E. Therefore, it does not change the taxable income from 1120S, page 1 that might be subject to self-employment tax. Rental real estate net income is never subject to SE-Tax.

[OldJack]

Here is my delimena, if he pays the rent to company B, there will be enough money for him to take a distribution, there is about 80K in retained earnings, so if he takes about 40K as a distribution/dividends then he will pay 15% of tax and not pay the 25 or 28% rate. Would taking a reasonable amount fly, company A pays him a salary of about 73K, so taking about 40K from company B as a distribution sound reasonable? Any help will be greatly appreciated.

It is not clear but I assume your "delimena" has to do with income in the S-corp, Company B. An S-corp cannot pay a "dividend" (unless from prior taxable C-corp earnings) that would qualify for the 15% capital gains tax rate as it can only pay a "distribution of profits". Distribution of profits are not taxable since the entire yearly profits are always taxable to the shareholders as ordinary income regardless if there are any distributions. The S-corp MUST take a reasonable salary if there are profits from which to take the salary. Since Company B is a real estate activity it would be reasonable to calculate the salary based upon time and effort which would usually be low number of hours.

[kcjenkins]

Sucks only if you later want to take the property out to the shareholders. If the property is to be used or sold by the S-corp it has little difference.

I have to disagree with that one, Jack. If the S corp sells the property, it becomes ordinary income of the S corp, which means ordinary income to the shareholders, not cap gain income. That may be a significant difference, especially if held a long time, then sold at a large gain. There are no capital gains for S corps.

[kcjenkins]

Also, while the rental income is not subject to SE tax, when an S corp has income, the IRS takes the position that at least some payroll is required to whoever runs it. So that much income WAS converted from rental income to income subject to payroll taxes. Not all of it, sure. But some of it, or you invited an audit, for sure, these days.

[OldJack]

I have to disagree with that one, Jack. If the S corp sells the property, it becomes ordinary income of the S corp, which means ordinary income to the shareholders, not cap gain income. That may be a significant difference, especially if held a long time, then sold at a large gain. There are no capital gains for S corps.

KC, I believe you are thinking of the C-corp. Look at the 1120S-K1 boxes 7 thru 9 where the gain is reported for the shareholder to report on his 1040. Of course if the asset with gain is code sec. 1231 there will be an ordinary income factor but that would be true in any entity.

[OldJack]

So that much income WAS converted from rental income to income subject to payroll taxes.

I agree, but as I said in my post for this type rental property that would be a very low hourly rate amount. How much time would this client have spent with the rental business? Probably only a few hours a year with paying a few bills and the tax return!!

And you have to admit an S-corp liability protection has been better tested in courts than an LLC. I would guess this S-corp was established before the LLC became law in this state.

[michaelmars]

my comment of changing the classifcation of income was because the poster asked about taking the inocme out as wages-that would make the income suject to payroll taxes, work comp, dbl, etc.

Old Jacks comment about holding RE in an S corp is leaving out the main reason not to-refinancing down the road. if you refi in a partnership you put the money in your pocket, if you refi in an S corp you have to leave it in the corp or pay tax on the distribution as a dividend, and that usually uses up your basis for loses. the debt in a partnership gives you additonal basis

[OldJack]

Old Jacks comment about holding RE in an S corp is leaving out the main reason not to-refinancing down the road. if you refi in a partnership you put the money in your pocket, if you refi in an S corp you have to leave it in the corp or pay tax on the distribution as a dividend, and that usually uses up your basis for loses. the debt in a partnership gives you additonal basis

If you refi in a partnership and put the money in your pocket you lose the ability to deduct your loan interest as business or mortgage interest expense. The interest (or a part thereof) would be personal non-deductible interest, this is a result of what is referred to as the loan proceeds tracing rules. Putting refi money in your pocket is a dumb idea that clients are always trying to get away with and for tax purposes it doesn't work in any type entity. Also, if you take refi money out of a partnership it reduces your partnership basis offsetting the increase in refi debt basis so that does not work either.

If you refi in a S-corp with money staying in the S-corp you have S-corp deductible interest expense on the loan. If you take the refi money out of the S-corp you have either a NON-TAXABLE DISTRIBUTION up to accumulated profits in the AAA account (retained earnings) and capital gains for amounts in excess of the AAA account. You NEVER have taxable DIVIDENDS from an S-corp unless it was previously a C-corp paying out C-corp earnings that have not been paid before.

In the case of real estate there is virtually no difference in the "tax results" of a Partnership and S-corp ownership except the partnership can distribute the real estate property back to the individual without it being a taxable event.