Cincinnati, OH · Member since 2013 · 292 posts · 81 votes
After meeting with my CPA today, and going through a number of back posts from the BP forums, I'm interested in hearing more about how the IRS oversees the balance between S-Corporation compensation versus flow-through shareholder income.
Perusing the IRS information, they state:
It seems to me that if you use a S-corp, pay yourself only a small salary, and are very actively involved in your flips, the IRS can step in and reclassify most of your pass-through as wages. My CPA didn't seem to think this was much of a problem, and stated that it was very seldom that he'd seen this occur. I'd much rather be conservative and avoid potential (and costly) pitfalls down the road.
While the rule seems to be plain, I'd like to know how it's actually implemented in real life. Has anyone had this happen to them?
My CPA is pretty middle-of-the-road when it comes to these things (not to conservative and not too aggressive). For the past 5 years, he's told me (and I've listened) to pay myself about 40% of my income as salary and take the rest as distributions. He believed that 40% (given the 6-figure income) was considered "reasonable salary."
This year, he's telling me to up that salary percentage to 60% of income. He says that the IRS is getting tougher in their rulings, and that 60% is probably better to avoid audit and negative audit determinations.
So, I'm now paying myself 60% of my income as salary and 40% as distribution.
Please don't construe this as advice on what you should do...I'm just relaying what my CPA is telling me and what I'm doing...
My CPA is pretty middle-of-the-road when it comes to these things (not to conservative and not too aggressive). For the past 5 years, he's told me (and I've listened) to pay myself about 40% of my income as salary and take the rest as distributions. He believed that 40% (given the 6-figure income) was considered "reasonable salary."
This year, he's telling me to up that salary percentage to 60% of income. He says that the IRS is getting tougher in their rulings, and that 60% is probably better to avoid audit and negative audit determinations.
So, I'm now paying myself 60% of my income as salary and 40% as distribution.
Please don't construe this as advice on what you should do...I'm just relaying what my CPA is telling me and what I'm doing...
Pat L. It'd most likely be a sole-employee S-Corp. However, depending on the outcomes, I may modify it.
J Scott I think that's sound non-advice. :) I suspect that the percentage in my case may need to be higher, as I'll (initially, hopefully) be having fewer "non-shareholder employees".
My CPA also insinuated that the current IRS troubles make it less likely of an audit occurring; this seems like wishful thinking, and not a risk I'm interested in taking.
The IRS is definitely pushing hard for SE taxes etc ....even though we took low to reasonable W2 wages & declared 'full time involvement'.
Just be careful of dealer status with your flipping scenario.
Apart from other issues the IRS auditor didn't like another LLC being paid management fees but it passed after scrutiny (including the operating agreement etc) along with the rental by the S-Corp of LLC owned office space, tools, mileage allowances etc.
Another thing we did when the the S-corp was flush with cash was hold financing for several of our Commercial property LLC's thus creating a passive income stream.
The S-Corp has also purchased two (>6000lb) work trucks as a 100% deduction. Other years we had other nice 179 deductions that reduced profits to zero.
As a sole employee S-corp I take advantage of a solo SD401(k) which allows much larger contributions which in turn we use to hold notes on arms length properties sep from the S-Corp holdings.
On review since 2004 I have only taken a salary of 25%-30% of gross plus the 401(k) contribution. This S-Corp's net (since 2008) has always been close to zero. BUT the majority of our properties are buy & hold with others sold contract for deed etc. (not much cap apprec here).
The S-corp audit was for the 2007-2008 returns but then the LLC got nailed for 2009 & 2010. However, as reported in other posts that was eventually a wash.
its the proverbial 'cat & mouse' but the cat has traps (that keep moving) :)
J Scott My CPA touched on the dealer status issue as well, describing how to set up multiple entities in order to treat flips as capital gains, rather than ordinary income.
He stated that it's not a clear dividing line, and that the IRS uses both the number of properties flipped and the time that they're held. Evidently he has arranged for people to structure a number of partnerships, with each one responsible for one or two properties, so that when the income is reported it isn't all coming from one entity. Supposedly, because the number of properties are spread out between different entities, it's less likely to trigger IRS interest. I didn't really feel this was ethical, nor something that fits in with my strategy, but there are people pursuing this setup. YMMV.
More here: http://www.nuwireinvestor.com/articles/real-estate-dealer-or-investor-51401.aspx
Ideally, you are living a corporate lifestyle, where your company covers the expenses of many things for you like cell phones, gasoline, gym membership, car insurance, business trips & training, office supplies/furniture/equipment, etc.. other business expenses.
It's best to have a written employment agreement which spells out what the company will pay for.
This should eat up a good portion of your "profits" then you would pay your self a small ( very small) salary, with the rest being paid as distribution payments.
Keep your cash flow properties in one entity and do all quick flip deals in a different entity. don't mix them.
You can use a 3rd entity for management. It has no real estate assets. It only does management.
I wasn't sure of Ben Skove's potential volume & if all properties were to be 'flipped' or some held.
I flipped a few but (so far) escaped dealer status in both the S-corp & LLC's.
Pat L. My buy and holds are in a LLC - I was looking into a S-corp for several potential upcoming flips. I want to keep it reasonably simple, particularly at this point, so that all the profits don't flow to my CPA and lawyer....
J Scott My CPA touched on the dealer status issue as well, describing how to set up multiple entities in order to treat flips as capital gains, rather than ordinary income.
First, I'm not a tax professional, but I've spoken with lots of them, and this is my take...
If you're treating flips as capital gains, you're illegally evading taxes. No ifs, ands or buts. Contrary to popular belief, being labeled a "dealer" doesn't mean that all your properties are subject to ordinary income; likewise, not being labeled a dealer doesn't mean that all of your properties are subject to capital gains.
Each property will need to stand on its own merits, and the determination of whether a particular property should be taxed as ordinary income or capital gains will be made based on the intent of the transaction, not a "dealer" label applied to a business or individual.
That said, if you are labeled a "dealer," you may find that you have a higher bar set for declaring one of your properties to be an investment as opposed to inventory. That's why a lot of tax professionals will suggest flipping in one entity and investing in another. That way, you can demonstrate a pattern to the IRS that will likely make proving intent a bit easier.
Supposedly, because the number of properties are spread out between different entities, it's less likely to trigger IRS interest.
Not breaking the rules is much different than trying to avoid getting caught breaking the rules. Your CPA is trying to avoid getting caught.
That seems to be the case, which is why I felt it to be unethical. It seemed to be a case of shell partnerships set up in an attempt to circumvent detection. Needless to say, I'd rather pay my fair share and abide by the rules.
That seems to be the case, which is why I felt it to be unethical. It seemed to be a case of shell partnerships set up in an attempt to circumvent detection. Needless to say, I'd rather pay my fair share and abide by the rules.
Just a word of advice
don't use the words 'patriot' or 'tea party' in the name of your S-Corp :) :)
That seems to be the case, which is why I felt it to be unethical. It seemed to be a case of shell partnerships set up in an attempt to circumvent detection. Needless to say, I'd rather pay my fair share and abide by the rules.
Just a word of advice
don't use the words 'patriot' or 'tea party' in the name of your S-Corp :) :)
Better yet, register as a democrat and send a copy of the registration form with your yearly return, your "fair share" may actually be less. At a minimum you would get express service.
Please forgive me in advance, I’m just a newbie trying to learn a thing or two and I am not even sure if what I’m asking is feasible and/or legal.
Originally posted by J Scott:
That's why a lot of tax professionals will suggest flipping in one entity and investing in another. That way, you can demonstrate a pattern to the IRS that will likely make proving intent a bit easier.
Could you please explain on this a little more? I am currently struggling with trying to determine what an ideal structure of a flipping company is. Does this idea suggest to have a flip company that pays out its profits as wages and also have a separate entity that acts almost as an investment firm that finances the flipping company and is paid back with interest to take advantage of capital gains?
Does this idea suggest to have a flip company that pays out its profits as wages and also have a separate entity that acts almost as an investment firm that finances the flipping company and is paid back with interest to take advantage of capital gains?
Nope, nothing that complicated...
I was merely suggesting that you aggregate like-type investments (from a tax standpoint) under the same entity. For example, all flips will pay ordinary income taxes, so do all flips under one entity (or one set of entities). All rentals will pay capital gains, so do all rentals under a separate entity (or set of entities).
I hate to ask another elementary question but I want to make sure I have the correct understanding. When you say rental properties are taxed at capital gains, do you mean the actual sale of the property and not the cash flow from rent?
The reason I ask is that I read (without verifying) that a rental company's income is considered passive and therefore not eligible/ideal to be an S Corp. Instead it would be a LLC and the cash flow would be added onto yearly income. However, in a rental company the house is a depreciable asset and it would make sense that any amount over book value received from a sale should be taxed at the capital gains rate.
I hate to ask another elementary question but I want to make sure I have the correct understanding. When you say rental properties are taxed at capital gains, do you mean the actual sale of the property and not the cash flow from rent?
I'm not a landlord, not a tax professional, but my understanding is that:
- If you're a professional landlord, income is considered earned income;
- If you're not a professional landlord (you're renting out a room or the other side of your duplex), income is unearned income;
- If you're selling a rental property, the income is considered capital gain.
Audits on this topic are coming up more and more often.
Much of this depends upon the type of work being done and what you are doing. Also who is doing the work? Are there employees? A manager?
With an S-corp holding company isn't really an issue. This is a problem with a C-corp.
In regards to "Dealer Status" IT IS PER TRANSACTION. Not all of your transactions will be treated as such. Therefore, I'm very curious as to what plan he came up with in regards to capital gains as using the S-corp essentially negates that unless you're holding long term and for other reasons.
They can look at your other activities and other corporations in an audit, so don't think you're too lucky.
J Scott basically repeated everything I've stated in other threads. Group like activities together. btw, for not being your expertise, you definitely have a lot of it down.
In regards to rental situations. The sales are capital gains or not; however, the rental income itself is "ordinary rental income/loss".
Steven Hamilton II I didn't give him the opportunity to go into detail how he would structure matters - it didn't seem to jibe with what little I knew about capital gains vs ordinary income, and felt unethical - so I can't answer as to exactly how he was doing it. The little I was able to gather initially was setting up a series of partnerships with various family members (your kids, etc) so as to spread the flipped properties between entities. I appreciate your advice and that of J Scott in regards to it not passing the smell test.
As far as compensation vs. pass-through, I'm choosing to be very conservative at this stage, given the amount and type of work that I'll be doing. I have to admit I was surprised that I was the one advocating for higher compensation, not him.
Ben
The idea of getting the kids involved is a great suggestion.
We started with legit documentation of gifting each year etc from birth.
Then as a high income producing property became avail, & they were 18, we would let the kids assume ownership & take the income. We also have loaned the kids money & held the fully documented mtg(s) on said properties if they didn't have enough to capitalize the purchase.
Always Beholding to the Fed Approved interest rates & this has definitely passed scrutiny.
We then evolved into trusts to hold the same as its easier to manage the holdings & (hopefully) eliminates future spousal/probate, privacy issues etc. The distinct ancillary advantage is the fact the kids are becoming very aware (@ a young age) of RE investment potential & the convoluted financial implications.
Good luck
Dealer Status can be determined by the number of transactions in a year. Some states also have laws defining dealer status. This also affects state income tax laws for your consideration.
At last check, the Federal government considers 25 or more transactions in a single year classifieds you as a dealer.
At this point, both the state and federal government may require you to register as a dealer. There are penalties if you do not. Some tax advisors are unaware or fail to consider this when giving advice. I always considered a tax attorney much more quailifed than a CPA. At least you have his tail on the line with you.
They also know many attempt to get around this by having multiple companies. Be careful if you have multiple entities owned or controlled by a single entity. You may be raising red flags without your knowledge.
There are some very legitimate strategies that can be implemented utilizing Family Limited Partnerships(FLiP). I am a big fan of those when used properly.
The key is a reasonable compensation amount that way you can take advantage of certain benefits.
Tom Goans,
There is no number of transactions that classifies you as a dealer. It is based upon the characteristics of the transaction. Most Tax Attorney's only know the legal matters. Many do not know the tax law itself. I've worked with enough of them to know how little they do know.
Forget how the IRS treats it! You should know how an underwriter treats it, which is very different than the IRS!!!!
Full Disclosure: I'm a commercial underwriter.
If you are trying to get a loan, you must take a distribution (on your K-1) from the company. If you don't YOU WILL NOT GET CREDIT for that company's profitability!!!!