Tag: S Corporation

Living Trusts and QSSTs

~ C.O.R.E. Beliefs ~ Leave a comment

One of the tax projects that we are working on involves a couple where the husband passed away in 2012 who owned a successful small business.  As we go through the process of trying to make sure all the appropriate steps were taken, my research leads me to potential issues related to S Corporations, Living Trusts and QSST elections.  This is a simple thought experiment but the overall issue is likely to be a potential problem as baby boomer’s age and we find their estates have ownership of S Corporation stock.

Husband (H) was the owner of all the shares and owned the shares prior to his marriage to wife (W).  The S Corporations shares were titled to the living trust of Husband.  The shares, per the will, specified that half of the shares were to go to a marital trust and the other half directly to W.  The marital trust stated that W could not sell the shares and they would all go directly to their 4 children at the time of her death.

Husband passed away in 2012.  The problem beings when the 2012 return reports the S Corporation shares on the joint return which reported H as deceased and W as surviving spouse.  The Company’s tax preparer changes the name and tax id number to W’s on the 1120-s K-1 in accordance to W’s statements and their understanding of the living trust document.  All shares are now in W’s name and reported on her 1040 return as the preparer knew about the living trust arrangement.

This creates lots of problems.  The will stated how the assets were to be divided and from the look of it, it wasn’t handled correctly.  Possibly, the shares transferred directly to W through the living trust would be valid, but what about the shares that were supposed to be transferred to the marital trust?  If the shares are owned by the marital trust, was a Qualified Subchapter S Trust (QSST) election filed with the IRS?  Can the marital trust even qualify as a QSST because of the successor beneficiaries listed in the will?

If the QSST is considered invalid or isn’t made, then the S election is terminated.  Without a valid S election, the income is no longer passed to the shareholders.  Income is first taxed at the corporate level and then the dividends – the S Corporation distributions – are taxed to the shareholder at time of receipt.

The tax consequences can be significant.  Let’s say that the Company made $1.0 Million in taxable income as an S Corporation.  It distributes all $1.0 Million to the shareholders.  The shareholders, W in this case, would pay about $390,000 in tax.  Without a valid S election, the Corporation ends up being taxed on that $1.0 Million, which costs about $350,000 and then W is taxed on the $1.0 Million in dividends, which costs her personally about $200,000.

$550,000 in taxes compared to $390,000.  And worse, the Company owed the tax but it may have distributed all its available cash, leaving W to wonder how she is going to pay the tax bill.  And if she used the remaining $610,000 to pay her living expenses, she can’t even loan the money back to the Company to pay its tax bill.

And remember, this is for the last 5 years, so almost $800,000 in additional taxes could be owed.

If you own S Corporation stock and have it titled to your living trust, you may want to talk with your estate planning attorney or CPA to make sure instructions are available to make sure something like this doesn’t happen.  Make sure your will aligns with your living trust and takes into consideration the fact that some assets have special rules about transfers to trusts.  And if you need the name of a practicing attorney or accountant who specializes in trusts and estates in Oregon or Washington, let me know and I will send you a few contacts you can discuss your concerns with.  Proper planning will make sure your wishes are carried out well and your beneficiaries receive what you planned for them.

Have a great weekend.

Taxes and Small Business

~ C.O.R.E. Beliefs ~ Leave a comment

In our research for the upcoming Lunch and Learn, we discovered something quite interesting. I thought I would work through it here and try to figure out how to help small businesses plan effectively.

As part of the potential for tax reduction is an attempt to deal with flow-through entities; that is sole proprietorships, S Corporations and LLC’s. Currently, with flow-through entities, the tax on profits is paid by the owners. The problem becomes defining profits. Let’s look at 3 companies A, B and C.

Profits and Compensation

All 3 companies make $100,000 before owner compensation. A decides to pay herself $50,000 of wages, B decides not to pay any and C pays almost all in the form of wages. The tax consequences are remarkably different.

A B C
Taxable Income Before Owner Compensation      100,000      100,000      100,000
Owner Compensation        50,000              –        92,500
Company Payroll Taxes 8.0%          4,000              –          7,400
Taxable Income Passed Through        46,000      100,000            100
Income Tax for Owner
Wages        50,000              –        92,500
Taxable Income Passed Through        46,000      100,000            100
Taxable Income for Owner        96,000      100,000        92,600
Tax Liabilities 25.0%        24,000        25,000        23,150
Total Taxes Paid
Company Payroll Taxes          4,000              –          7,400
Owner Payroll Taxes          4,000              –          7,400
Income Taxes        24,000        25,000        23,150
Total Taxes        32,000        25,000        37,950
Taxes as a Percent of Income Before Comp 32.0% 25.0% 38.0%

The difference between the results is the payroll taxes which every employee pays and which every employer matches.  The problem is that the only statutory requirement is that “Compensation must be Reasonable”.   And this has been an audit headache as the term “Reasonable Compensation” is based upon the facts and circumstances of the particular taxpayer and Company.

This difference in the tax law has been around for decades and has been left to auditors and taxpayers to argue about the term “Reasonable Compensation”.    In this case, we have argued on all sides – that A’s and C’s compensation is reasonable and so is B’s.   Most professionals would worry about losing in B’s position but clearly any compensation less than the amount of taxable income before owner compensation is a win for the taxpayer by reducing employment taxes.

Given that there is already this disparity and given that Congress knows about it and has elected not to touch it yet should give us all pause for concern as Congress looks at passing a substantial rewrite of the tax law to both reduce rates as well as treat Business earnings with a different tax rate.

Deemed Wages

To address this issue Congress will need to figure out a way to address owner compensation. So far, in all the proposals they use a phrase “Deemed Wages” to account for owner compensation. Randy and I have debated this and we are of the opinion that what is likely to happen is that the IRS will publish a table of expected compensation for various businesses and the owner’s compensation should be close to that in order to be considered reasonable. If an owner wants to pay differently, there should be some written justification for the position, such as minutes to the board of directors or a memo from a meeting between the owners and their representatives.

Keep in mind though, that this is one areas where is almost no guidance as it hasn’t been touched before.

This change to how small business reflects taxable income will be major.  By addressing the disparity shown above, Congress will potentially eliminate an audit headache and improve compliance.  It may mean that some pay more and some pay less, but it could also help give taxpayers peace of mind by addressing the unknown of “Reasonable Compensation” and reducing the risk of money spent on litigating this issue.