S Corporations are a popular business entity – they allow for limitation of liability, may reduce self-employment taxes, and income is passed through to the owners, resulting in only one level of taxation, while providing a “corporate veil” for liability protection. There are a number of possible pitfalls for the unwary, particularly if the company operated as a C Corporation prior to electing S Corporation status. This series on S Corporation pitfalls will discuss some of the more common issues, and some of the more serious… pitfalls that can have costly results without proper planning…
First, as a rule of thumb, do not hold appreciable assets, such as real estate or passive investments in an S Corporation. Why not? You probably know that there is generally no resulting tax when cash is distributed from S Corporation earnings. What many people fail to realize is that the distribution of appreciated property will result in a taxable transaction. When property is distributed from any type of Corporation (S Corporation or C Corporation) the distribution is made at the property’s Fair Market Value. This means that there is a realized taxable gain on the difference between the Fair Market Value at the date of distribution and the tax basis. You will pay tax on the transaction, and your resulting tax basis in the asset after distribution will be its Fair Market Value at the date of distribution.
This problem is most commonly avoided by distributing cash from the S Corporation to the owners, who then use the funds to purchase real estate, or other passive investments. These assets are frequently purchased through a limited liability company (LLC) to preserve pass through treatment of the income. If the real property is used by the S Corporation in its business, the property is then rented back to the S Corporation. The difference is that distributions from LLC’s (and partnerships) are made at the asset’s tax basis, with no gain or loss recognized on the distribution (resulting in a deferral of tax until the property is actually disposed of). Your basis in the distributed asset will be the same as it was in the hands of the LLC.
Placing appreciable assets into LLC’s instead of S Corporations will provide greater flexibility for future tax planning, and possibly defer the payment of income tax.
For many companies the transition to IFRS will not result in a major change… the big exception is in the manufacturing and retail industries, as IFRS does not allow the use of LIFO (the Last In First Out method of accounting for inventory). Because LIFO treats the last item to be purchased as the first item to be sold, the use of LIFO generally increases the cost of goods sold during periods of inflation. This reduces a company’s assets and earnings, but can result in large tax savings. It is because of this dichotomy that the IRS requires businesses to use LIFO for their book accounting records and financial statements if they wish to use it for tax purposes. Additionally, use of LIFO is generally restricted to mid-to-large sized companies, as it requires additional administrative work to track multiple LIFO layers for each type of inventory, and to prepare tax Uniform Capitalization adjustments on each layer.
Enter IFRS (from 2014 to 2016 for publicly traded companies – transition dates for privately held businesses have not yet been announced). Exit LIFO. If companies can no longer use LIFO for book accounting purposes, they will not be able to use it for tax accounting. This will give rise to a flood of paperwork to the IRS, as each company requests permission to change accounting method (which must be formally requested, even though the change is required and unwanted). More importantly, it will result in a huge income tax liability for nearly all companies required to make the transition.
So far the IRS has not offered any hint of resolution on this matter… and it looks like our manufacturers and retailers may pay the price.
A number of countries don’t allow foreign people (including foreign business entities) to own land in certain areas. The most well known of these countries is Mexico, but I have recently come across a similar situation in Canada, and know of cases in Great Britain. As a work-around, the land is usually held in trust for the foreign owner. This may not seem as though it creates any tax issues, but it does. Unfortunately foreign trusts have at times been used to try to shelter income off-shore in foreign tax havens, so the IRS has strict reporting requirements for foreign trusts… and the penalties for not filing the related forms are huge! (In some cases 35% of the trust assets per year). Even if you don’t think of the trust as a “real trust” – the IRS probably will (they are commonly referred to as “Land Trusts” or “Mexican Land Trusts”). We recently enlisted the services of tax attorney, Jean Ryan at Sideman Bancroft, LLP, to analyze a Canadian land trust. Although the client “never thought of it as being a real trust,” her answer was that it the IRS may treat it as trust, because of the language in the document. So if you own beachfront property in Mexico – lucky you, but in all seriousness, talk to your tax advisor to make sure that you don’t lose it all in penalties.
Oversight of seemingly insignificant, immaterial assets such as bank balances could cost you big money in penalties.
The IRS has disclosure reporting requirements for ownership or control over foreign assets. The disclosures relate to control over a foreign business entity or trust, receipt of gifts or inheritances from foreign sources, and ownership in (or signing authority for) a foreign bank or investment account. The penalties for not filing the disclosure forms on time, or incomplete filings, include both civil and criminal penalties, with civil penalties starting start at a minimum of $10,000 per person, per year, per failure to file.
The IRS recently announced a reduction in the Foreign Bank Account Reporting (FBAR) penalties and disclosure penalties for those with an interest in foreign entities (foreign companies, foreign trusts, etc.) if they voluntarily disclose previously unreported information prior to September 23, 2009. This sounds great, but penalties are still being assessed at 20% of the maximum value in the bank account at any point during the last 6 years (or 20% of the maximum value of the assets held by a business), which may be substantial. In certain circumstances the penalty may be reduced to 5%, but these cases are very limited. Even worse, an IRS memorandum directs examiners that “no reasonable cause exception may apply” – so there is no getting out of these penalties because of an innocent mistake. This can be unfair, as many of those failing to file these forms don’t know that the requirement exists. The commissioner also threatened in a statement that “the situation will only become more dire” for those who do not self-correct, directing examiners to pursue both civil and criminal penalties that are available for non-compliance. The good news is that if you self-correct in time, a “get out of jail free card” is still available.