Question for tax pros about S-corps.

22 Replies

Sally and Johnny are both the sole owners and employees of a pair of unrelated S corps in the same city. They don't know each other, but Sally and Johnny make and sell widgets. They both also W2 themselves $50k/yr, which is what a typical widget maker/seller earns if they work for someone else. Both are identical in all ways except as specified below. Their personal and business checking and savings accounts all pay identical interest rates.

Come December, they both look at how much is in their business savings account. After W2ing themselves, they both have another $100k sitting there.

Sally gives herself a nice "shareholder distribution" (recall, she owns 100% of the shares) as a Christmas bonus to herself of $80k, leaving $20k in the business for operating expenses going into the new year on December 24th.

Johnny decides to leave the funds "in the business," for "future investments." None of those "future investments" are going to happen this year. 

Both have 100% access and control over the amount of money that they had their business pay themselves, and both both have 100% access to another $100k. 

Sally's "mortgage qualifying income" is obviously a METRIC BOAT LOAD higher than Johnny's, but what are the implications for their respective federal tax bills? Who can expect to pay more? 

Originally posted by @Michael Plaks :

@Chris Mason

Except for some extremely rare situations, they pay the same amount of taxes

 Agreed with Micheal. Distribution is not taxable. It’s a return of capital that was invested before or earned before. 

If you don’t capital invested or previously earned to have 80k in the business, there is nothing to distribute. So when you take out 80k as distribution, that amount was either you put in as captial contribution ( common stock or Apic for a S-Corp) or it was previously earned and retained in the Corp as retained earning.

You are just taking that out. 

Sometime it’s possible that your distribution is taxable is your basis in the Corp is less than 0. Its gets technical from here. 

@Chris Mason

"Sally's "mortgage qualifying income" is obviously a METRIC BOAT LOAD higher than Johnny's, but what are the implications for their respective federal tax bills?"

Their taxable income and tax returns will look the exact same based on everything you laid out.

Distribution in excess of basis may be a concern in Sally's situation, but if she's working with her tax pro year round (and not just in the spring), she'll be aware of this and they can work to mitigate or even eliminate it.  After the tax year closes everything is hindsight...

@Michael Plaks @Paul Allen @Ashish Acharya and @Eamonn McElroy ,

Thanks, that's along the lines of what my research indicated, but wanted to hear it from some knowledgeable tax pros such as yourselves. I encounter about as much Johnnys as I do Sallys (Sally can get a mortgage in an amount she wants, Johnny probably can't, and it appears that Johnny isn't even saving on the tax bill, so what's the point?), I'll be referring Johnny to this thread and telling him to consult with his tax professional (or one of you if Johnny doesn't have one; but was kind of secretly hoping for a California CPA to answer) with any additional questions. 

What are the things to look out for in terms of "distribution in excess of basis" if Sally is 100% owner and always has been? 

Another question, probably more lawyer territory: In addition to Johnny having a hard time getting a mortgage in an amount he wants, his business has way more liquid funds in it than Sally, who just has operating expenses. Totally lawyer territory here (feel free to chime in if that's you!), but wouldn't this seem to indicate that Johnny is slightly more at risk in the event of a law suit than Sally? Sally Widgets, Inc, has $20k in it, Johnny Widgets, Inc, has $100k in it.

Really a big part of what I'm getting at is "Hey, Johnny, distribute all that money to yourself in December, so you can get a mortgage. It's probably not going to cost you anything on your tax bill (consult with your tax professional to confirm), and as an added bonus you will be able to buy a house/rental next year, and on top of that you might be less exposed to law suits (consult with your lawyer to confirm)."

@Chris Mason

I'm failing to see how Johnny is in a better position for a mortgage...  The mortgage broker/banker should be counting both Johnny's W-2 income from the S Corp and his passthrough income from the S Corp.  Counting the distributions as income is doubling up on the passthrough income from the S Corp.  There shouldn't have to be cash flow manipulation with the S Corp distributions -- a seasoned mortgage broker/banker will see that both Johnny and Sally are equally qualified for a mortgage.

Basis in S Corp stock needs to be tracked to watch out for taxable distributions from the S Corp, among other things.  Most CPAs handle this for their S Corp clients.

Originally posted by @Eamonn McElroy :

@Chris Mason

I'm failing to see how Johnny is in a better position for a mortgage...  The mortgage broker/banker should be counting both Johnny's W-2 income from the S Corp and his passthrough income from the S Corp.  Counting the distributions as income is doubling up on the passthrough income from the S Corp.  There shouldn't have to be cash flow manipulation with the S Corp distributions -- a seasoned mortgage broker/banker will see that both Johnny and Sally are equally qualified for a mortgage.

Basis in S Corp stock needs to be tracked to watch out for taxable distributions from the S Corp, among other things.  Most CPAs handle this for their S Corp clients.



I am in agreement that there "shouldn't" need to be cashflow manipulation. What we as human persons "see" isn't really relevant; Fannie Mae and Freddie Mac need to "see" it. Pick a random S corp client of yours, be a robot, fill this out, you might be surprised:

https://new-content.mortgageinsurance.genworth.com/documents/calculators/Training%20Form%2091%20(2017-2018)_12413401.pdf

We see people show up in a corvette, business bank accounts show $50k/mo coming in with only $5k/mo going out in expenses, then you fill out the form based on tax returns, and Fannie/Freddie think the dude is broke as a joke. You think you must be missing something, send those tax forms to 4 different lenders and 4 different underwriters come back with the exact same Fannie/Freddie-defined number you came up with. Call the taxpayer/borrower up, and (specific to S corps) a very VERY common lamentation is "well I leave it all in my business, but it's still my money." Enter the "non-qm" and "alt doc" loans with their trash rates stage left....

Hopefully Fannie/Freddie coming out of federal conservatorship rationalizes things a bit.

It's not substantially different in your line of work. It doesn't really matter what you personally think the person's tax bill should be, it matters what the IRS code says it is, and sometimes the tax code is out of line with reality.

@Chris Mason

That pdf proves my point Chris...  No where in it are distributions taken into consideration, only taxable passthrough income.

Again, Johnny and Sally are equally qualified.  If a broker or banker says they're not it's time to find a new one.

Originally posted by @Chris Mason
I am in agreement that there "shouldn't" need to be cashflow manipulation. What we as human persons "see" isn't really relevant; Fannie Mae and Freddie Mac need to "see" it. Pick a random S corp client of yours, be a robot, fill this out, you might be surprised:
https://new-content.mortgageinsurance.genworth.com/documents/calculators/Training%20Form%2091%20(2017-2018)_12413401.pdf

We see people show up in a corvette, business bank accounts show $50k/mo coming in with only $5k/mo going out in expenses, then you fill out the form based on tax returns, and Fannie/Freddie think the dude is broke as a joke. You think you must be missing something, send those tax forms to 4 different lenders and 4 different underwriters come back with the exact same Fannie/Freddie-defined number you came up with. Call the taxpayer/borrower up, and (specific to S corps) a very VERY common lamentation is "well I leave it all in my business, but it's still my money." Enter the "non-qm" and "alt doc" loans with their trash rates stage left....

Hopefully Fannie/Freddie coming out of federal conservatorship rationalizes things a bit.

It's not substantially different in your line of work. It doesn't really matter what you personally think the person's tax bill should be, it matters what the IRS code says it is, and sometimes the tax code is out of line with reality.

Chris, I'm with @Eamonn McElroy here. Your worksheet should produce identical results for Sallie and Johnnie. Both of them will have, using your example above, ($50k - $5k) x 12 = $540k on Line 1 of their K-1s, regardless of their distributions. On your worksheet, this number goes on Page 3, Line 8, the first row. Same for both Sallie and Johnnie.

Is it possible that the problem was completing this worksheet incorrectly?

 

Originally posted by @Michael Plaks :
Originally posted by @Chris Mason
I am in agreement that there "shouldn't" need to be cashflow manipulation. What we as human persons "see" isn't really relevant; Fannie Mae and Freddie Mac need to "see" it. Pick a random S corp client of yours, be a robot, fill this out, you might be surprised:
https://new-content.mortgageinsurance.genworth.com/documents/calculators/Training%20Form%2091%20(2017-2018)_12413401.pdf

We see people show up in a corvette, business bank accounts show $50k/mo coming in with only $5k/mo going out in expenses, then you fill out the form based on tax returns, and Fannie/Freddie think the dude is broke as a joke. You think you must be missing something, send those tax forms to 4 different lenders and 4 different underwriters come back with the exact same Fannie/Freddie-defined number you came up with. Call the taxpayer/borrower up, and (specific to S corps) a very VERY common lamentation is "well I leave it all in my business, but it's still my money." Enter the "non-qm" and "alt doc" loans with their trash rates stage left....

Hopefully Fannie/Freddie coming out of federal conservatorship rationalizes things a bit.

It's not substantially different in your line of work. It doesn't really matter what you personally think the person's tax bill should be, it matters what the IRS code says it is, and sometimes the tax code is out of line with reality.

Chris, I'm with @Eamonn McElroy here. Your worksheet should produce identical results for Sallie and Johnnie. Both of them will have, using your example above, ($50k - $5k) x 12 = $540k on Line 1 of their K-1s, regardless of their distributions. On your worksheet, this number goes on Page 3, Line 8, the first row. Same for both Sallie and Johnnie.

Is it possible that the problem was completing this worksheet incorrectly?

 

I actually don't complete the worksheets when it's S corps (& that's a generic Freddie Mac worksheet, not mine), just send it off to underwriting for the authoritative answer in a day, sometimes a few different lenders' underwriters. It's their calculation that matters anyways, not mine. Sometimes you see variance between them, usually not. Most tax forms and business entities make intuitive sense, S Corps not so much. For things like LLCs and Schedule E, the tax form is just a P&L.

@Chris Mason Does it not matter how they started the year. Are we assuming equal account values? Sally is starting the next year with an extra 20k. Take distribution and place on tax free investment like ira change equation?

Scorp as we all know flows down to us personally so we are not DOUBLE taxed....not giving advice, that is what they tell me.

@Chris Mason

Probably not relevant to your question at hand, but California is unique in that S-corps pay a 1.5% tax (subject to minimum $800 tax too). Most, if not all, other states treat s-corps as totally passthrough at the state level. So I presume Johnny and sally could be in different situations if both aren’t in California.

*this post does not create an attorney client or cpa client relationship. The information contained on this post is not to be relied upon. Readers should seek professional advice.

@Chris Mason

I studied this worksheet, as did @Eamonn McElroy . We would have completed it exactly the same for both Sallie and Johnnie.

If the underwriters come up with different results for these two people - then either they do not understand the worksheet or they do not understand K1 form. Or both, since they are, well, under-writers and not over-writers. ;)

I think I've been asking the wrong question, or not asking clearly enough. Thanks for the answers, I've been looking at that, then at people's tax returns, then at underwriter-calculated incomes, then back to the answers in this thread, and thinking back at what people (who may be committing tax fraud for all I'm qualified to know) "tell" me about why their taxes are done this way or that.

When Sally kicks that $80k from her business to herself, what defines if it does - or does not - appear on K-1 line 1, "ordinary business income"? What would be Sally's (or her CPA's) motive to either have it appear there, or have it not appear there? Or, expressed another way, Sally shows $80k on K-1 line 1 "ordinary business income," but Johnny shows $0 (I was assuming, perhaps incorrectly, that Sally shows $80k b/c she paid herself $80k, and Johnny shoes $0 b/c he paid himself $0).

@Chris Mason

Distributions generally do not affect taxable income.

Based on your OP, Both Johnny and Sally's box 1 on their K-1s will be $100k (roughly that amount for simplicity  -- I won't drag in beginning of the year balances and book to tax adjustments).  Sally's box 16D will be $80k however and Johnny's box 16D will be blank.  Box 16D reflects "distributions".  This box affects basis but generally not taxable income (unless a "distribution in excess of basis" occurs).

You're treating distributions as a tax deduction for the S Corp and income on the personal return.  They are not and shouldn't be treated as such.  Both Johnny's and Sally's taxable income from the S Corp is as follows: $50k salary, and 100k passthrough taxable income.  Again, distributions do not affect taxable income.  Distributions are effectively just shifting money from one pocket to another for a SMLLC taxed as an S Corp.

An S Corp is a "passthrough entity".  This means contributions and distributions are generally non-taxable events.

"I was assuming, perhaps incorrectly, that Sally shows $80k b/c she paid herself $80k, and Johnny shoes $0 b/c he paid himself $0"

This is perhaps our disconnect...  The mechanics of an 1120S and Schedule K-1 from an 1120S don't work the way you laid out.

@Eamonn McElroy in reality Johnny shows $0 on that line. I get lots of those. That's why underwriters think he's broke. Based on your post, would you say that the possibilities are either a) he really is broke and his "I just dont pay myself" isn't accurate, or b) he's lying to the IRS?

Originally posted by @Chris Mason


@Eamonn McElroy in reality Johnny shows $0 on that line. I get lots of those. That's why underwriters think he's broke. Based on your post, would you say that the possibilities are either a) he really is broke and his "I just dont pay myself" isn't accurate, or b) he's lying to the IRS?

If Johnny is showing $0 on Line 1 of form K-1, then he is probably self-preparing his S-corp tax return without having a clue how to do that. Eamonn described in a lot of detail how the K-1 should look, and I have nothing to add. Tell your Johnny to stop pretending he is an accountant and hire a professional.

Originally posted by @Michael Plaks :
Originally posted by @Chris Mason


@Eamonn McElroy in reality Johnny shows $0 on that line. I get lots of those. That's why underwriters think he's broke. Based on your post, would you say that the possibilities are either a) he really is broke and his "I just dont pay myself" isn't accurate, or b) he's lying to the IRS?

If Johnny is showing $0 on Line 1 of form K-1, then he is probably self-preparing his S-corp tax return without having a clue how to do that. Eamonn described in a lot of detail how the K-1 should look, and I have nothing to add. Tell your Johnny to stop pretending he is an accountant and hire a professional.

 Johnny is representative of lots of people actually, but yeah I'll go back to my line about "if you want to borrow from Aunt Fannie Mae, you've got to get right first with Uncle Sam."

Originally posted by @Chris Mason
Originally posted by @Chris Mason

 Johnny is representative of lots of people actually, but yeah I'll go back to my line about "if you want to borrow from Aunt Fannie Mae, you've got to get right first with Uncle Sam."

Where we seem to have a disconnect is your assumption that Johnny is cheating the IRS. My assumption is that he is simply clueless in tax preparation and is too cheap to hire a pro.