Let's talk
about S corporations.
There are
two types of corporations: C corporations and S corporations. Think Amazon or
Apple and we are talking about "C" corporations: they file their own
returns and pay their own taxes. Think of family-owned Schmidt Studebaker
Carriage & Livery and we are talking about "S" corporations: only
so many shareholders, do not normally pay tax, the numbers flow-through to the
owners who pay the tax on their personal returns.
S
corporations are almost the default tax structure for entrepreneurial and
family-owned businesses, although in recent years LLCs have been giving them a
run for their money. They are popular because the owner pays tax only once
(normally), as contrasted to a C corporation with its two levels of tax.
But there
are rules to observe.
For example,
you have to keep track of your basis in your stock - that is, the amount of
after-tax money you have invested in the stock. Your basis goes up as you put
the business income on your personal return, but it also goes down as you take
distributions (the S equivalent of dividends) from the company. You are allowed
to take distributions tax-free as long as your basis does not go negative. Why?
Because you paid tax on the business income, meaning you can take it out
without a second tax.
Accountants
keep permanent schedules to track this stuff. Or rather, they should. I have been involved
in more than one reconstruction project over the years. You have to present these
schedules upon IRS audit.
I did not previously
have a worse-case story to tell. Now I do. The best part is that the story
takes place in Cincinnati.
Gregory
Power is a commercial real estate broker with offices first on Montgomery Road
and then on Hosbrook Road. He started his company (Power Realty Advisors, Inc.)
in 1993. Somewhen in there he used Quicken for his accounting, and he would
forward selected reports to his accountant for preparation of the returns.
COMMENT: Quicken is basically a check-register program. It tracks deposits and withdrawals, but it is not a general ledger - that is, the norm for a set of business books. It will not track your inventory or depreciable assets or uncollected invoices, for example.
There was
chop in the preparation. For example, the numbers were separated between those Mr.
Power reported as a proprietor (Schedule C) and those reported on the S return.
Why? Who knows, but it created an accounting problem that would come back to
haunt.
He lost
money over several years, including the following selected years:
1995 (191,044)
1996 ( 70,325)
2002 ( 99,813)
Nice thing
about the S corporation as that he got to put these losses on his personal
return. To the extent his return went negative, he had a net operating loss
(NOL) which he could carry-over to another year. Mind you, he got to put those
losses on his personal return to the extent he did not run out of basis - yet
another reason to maintain permanent schedules.
He took
distributions. In fact, he took distributions rather than taking a salary,
which is a tax no-no. The IRS did not come after him on this issue because it
had another angle of attack.
He had the
corporation pay some of his personal and living expenses, which is another
no-no. Accountants will reclassify these to distributions and tell you to stop.
Some of his S corporation returns did not show distributions. This is not
possible, of course, as he was taking distributions rather than salary. That
tells me that the accountant did not have numbers. It also tells me the
accountant could not maintain the schedules - at least not accurately - that we
talked about.
Sure enough,
his big payday years came. There was tax to pay ... except for those NOLs that
he was carrying-forward from his bad years. He told the IRS that he had over
$500,000 of NOLs, which he could now put to good use.
Problem: He
did not have those schedules.
Solution: He
or his accountant went back and reconstructed those schedules.
Problem: The
IRS said they were bogus.
Solution:
You go to Tax Court.
COMMENT: It would have been cheaper to keep schedules all along.
Mr. Power
ran into a very severe issue with the Court: it does not have to accept your
tax returns as proof of the numbers. The
Court can request the underlying books and records: the journals, ledger and
what-not that constitutes the accounting for a business.
The Court did
so request.
He trotted out
those Quicken reports and handwritten summaries.
The Court
noted that Mr. Power was somehow splitting numbers between his proprietorship
and the corporation, although it did not understand how he was doing so. This
made it difficult for the Court to review a carryforward schedule when the Court
could not first figure-out where the numbers for a given year were coming from.
Strike one.
The Court
wanted to know what to do with those tax returns that did not show
distributions, which it knew was wrong as he was taking distributions rather
than a salary.
Strike two.
And there
was the matter of personal expenses being paid through the company. It appears
that in some years the corporation deducted these expenses, and in other years
it did not. The Court wasn't even sure what the amounts were. It did not help
when Mr. Power commingled business and personal funds when buying his house in
Indian Hill.
Strike
three.
His business
accounting was so bad that the Court bounced the NOL carryforward. The whole
thing.
He owed tax.
He owed penalties.
And no one
knows if he really had an NOL that he could use to sop-up his profitable years
because he had neglected his accounting to an extreme degree. He could not
prove his own numbers.
But Mr.
Power has attained tax fame.
