One of the fallouts from the Tax Cuts and Jobs Act (TCJA) is the increased scrutiny by the IRS of S corporations and their shareholders. They are especially interested in several tax liability issues regarding distributions, officer loan repayments, officer salaries, and the sale of assets acquired while a C corporation.
A shareholder of an S Corporation is required to take reasonable wages from their profitable business. By not doing so, they increase their chances of an audit and lose the full deduction of any shareholder health insurance premiums.
For the S Corporation to take the full deduction, the shareholder’s W2 must include these premiums. If not, they are reported on the shareholder’s personal tax return, but subject to limitations.
If audited, the IRS can conclude that an S corporation shareholder has attempted to evade payroll taxes by disguising employee salary as corporate distributions. They can recharacterize the distributions as salary and require payment of employment taxes and penalties, including payroll tax penalties of up to 100% plus negligence penalties.
Distributions from an S corporation are not considered income as long as the distribution does not exceed the shareholder’s stock basis. Excess distributions are taxed as capital gains on the shareholder’s personal tax return.
The stock basis is the measure of investment made by each shareholder. You begin calculating stock basis with the amount of money and property the person contributed to the business when the shareholder joined the S Corporation. Every year you increase the basis by the amount of the corporate income that you report on your taxes.
The increase includes ordinary income, tax-exempt income (which you still must account for), and excess depletion incurred on the business’s assets.
The shareholder’s basis in the company is decreased by the stockholder’s share of the business’s losses and the S corporation’s nondeductible expenses.
Any additional funds the stockholder transfers from the business will increase the stockholder’s basis; any distribution the stockholder receives from the S corporation will decrease his basis.
Loans made to shareholders can be a particularly problematic issue with the IRS.
If audited, unless the loan is documented, and has repayment with interest, the loan will be reclassified as a distribution. Without the stock basis mentioned above, there will be capital gains.
New Checkbox on Schedule E
S corporation shareholders should be aware of a new checkbox added to line 28 of the individual taxpayer return, Schedule E (Form 1040).
This box should be checked if the shareholder reports a loss, has received a distribution, has disposed of stock, or has received a loan repayment from an S corporation. The shareholder must attach documentation that details their S corporation ownership basis.
As the IRS is cracking down in these areas, it is imperative that S corporation shareholders stay on top of these issues.