Income or Not???

[Terry D EA]

Here is a scenario that I am currently dealing with. I will apologize for the lengthiness but to get a good response it is necessary. XYZ recycling company has been experiencing significant financial difficulty and has ceased operations. This is an S-Corp with a single shareholder who has a captial account in excess of 50k. Also, under the recommendation of a business counselor, single shareholder has stopped taking a salary and has filed for unemployment. Again, XYZ corp is no longer producing any products, all employess have been laid off and there is no revenue from normal business operations.

I have been preparing the tax returns for this company as well as tracking all depreciation and shareholder basis. With that said, I don't know why they waited so long to involve me but all of the company assets were held as a lien against a loan. I recommended the shareholder withdraw funds from a 401K account to pay off the debt to free up the assets. That has been done and the amount of the 401K withdrawl has been added to the capital account. Just a note, the sharehold is 60 years old and withdrawing funds from a 401K was not my first choice but was the only funds available to pay off the loan to free up the assets so they could be sold. Now the shareholder is involved in securing materials for production under the existing company name to sale to other recyclers for production at a fee (commission). The fees are small and I am not sure at this time what expenses there are against the fees.

1. I see no problem with XYC company buying and selling raw materials to another recycler for a fee.

2. The fact that XYZ company has to pay back debt and by using these funds to do so falls under the normal course of business and shouldn't throw up any flags??.

3. Any remaining amounts after expenses can be used to repay the shareholder as well as the shareholder can take a draw against capital.

Here are the main questions, under this scenario, should the shareholder continue receiving unemployment? Wondering if the NCESCU can say the shareholder is actively employed and make the shareholder return any funds received from unemployment? Personally I say no due to the fact the shareholder will only receive a return of capital or loan repayment. Under number (3), none of the funds the shareholder receives are taxable again because they are a return of capital and loan payback. Is my thinking correct on this?

A family memeber who is a (Newly licensed) CPA has made the statment that the IRS would want to know under this scenario who and where the income is coming from and who is producing it. That statment has confused me as I thought as I stated above it was pretty clear if I am correct. I don't think the IRS cares where and who is producing the income unless that income is taxable. Simply put, XYZ company is almost insolvent as the liabilities exceed the assets and yes these total liabilities include loans owed to the shareholder and I don't see anything wrong with what is happening here.

Each time I think about this, I can't wrap my head around the family member's statement. So, any opinions are appreciated.

[Lion EA]

Maybe he was asking if the S-corp is now generating income (and might or might not pay the shareholder/employee) or if the shareholder is working outside the S-corp as an independent contractor. That was not clear to me, and is my question.

I also was not clear on whether the shareholder cashed in a 401(k) that did not come from the S-corp to put the funds into the S-corp or if the S-corp closed out their own 401(k) to use for operating funds. I think you'll want a legal opinion on this issue.

I do not know how your state labor department views an S-corp shareholder/employee collecting unemployment when not receiving a salary while the S-corp does have assets and is starting to generate revenue again. (Or, the person is now working as an IC collecting commissions.) I know one question the CT DoL asks is do you have a business.

You have more than just tax issues here.

[JohnH]

A couple of quick thoughts.
You said the 401K withdrawal was added to capital, but then you mentioned loan repayments coming from the ongoing activities. Seems like the simplest way to handle this would have been to just classify the money as loans from the Shareholder to the corp, unless you're trying to increase basis in order to deduct losses on the personal return.

I think this is the point that the young CPA is making, and I believe I agree with him. Money being repaid to the shareholder isn't income to him, it's a loan repayment or return of capital, as the case may be. But the business activities which generated the money available to repay the shareholder must come from profits. (The cash for repayment has to come from somewhere - unless additinal money is borrowed from outside sources, it has to come from profits). Since it's an S-corp, the profits will show up on his personal return via the K-1. (If the amounts are very large, this alsointroduces a "no salary/low salary" red flag scenario in an S-corp)

On the other hand, if the business isn't generating profits, there will be no money available to repay the sharholder and this is all irrelevant. The only thing I can think of which might affect the net profit matter would be lingering depreciation on assets already paid for in a prior year. There might also be some unusual effects if the business reports on an accrual basis AND if there are huge differences year-over-year. But in many cases, once a business gets in trouble its actual bookkeeping results begin to more closely resemble a cash-basis taxpayer anyhow.

There's no definitive rule that I'm aware of with NCESC in this situation. But if they draw a bead on him, this could be problematic. They have quite a bit of clout and you don't have many ways to fight them if they decide against your client, unless he's ready to pay big bucks for representation. Keep in mind that NC is under a cloud right now with respect to excess unemployment borrowings. Who knows when they might decide a crackdown may help reduce the debt. I'd be very careful in giving him advice on this issue.

[Terry D EA]

John I agree with you totally and the 401K was a personal 401K that was used to pay off the S-Corp debt to free the assets. The profits should be very low if any at all which negates the S-Corp employee/non employee thing. I thought it easier too to just call it a repayment of a shareholder loan since their previous accountant had not properly tracked the shareholder basis. This company began in 1998 and I came on board in 2007 and the only thing I have done is classify everything the shareholder gives as a loan. I am not sure if the "young CPA" knows all of the circumstances and I do agree as well, if there is income where did it come from. and maybe I was thinking way past that. And like you, I am wary of the NCESCU as well. My best suggestion at this time is to evaluate what the bottom line may look like and make a decision from there. First instinct is to stop unemployment.

[imjulier]

Terry-

I know in Colorado that Scorp owners being able to claim unemployment at all is a loophole. Some of the s-corp owners I have work and pay themselves and then as soon as they don't have work, they don't pay themselves and collect unemployment....while the s-corp still has cash and they can take distributions. Even discussion with the unemployment office did not deter these s-corp owners from believing they were eligible and unemployment personnel had no idea and could not answer their questions. Rubs me the wrong way as the SH work for 6 months and pay themselves $100K and then collect unemplyoment while the company still exists and they look for their next contract. Probably not helpful but it sounds to me that there could still be income being generated by the S-corp owner.

Julie

[OldJack]

>>

3. Any remaining amounts after expenses can be used to repay the shareholder as well as the shareholder can take a draw against capital. number (3), none of the funds the shareholder receives are taxable again because they are a return of capital and loan payback. Is my thinking correct on this?<<

Draws/payments are first made out of the AAA account before a return of capital! Loans and capital payments come after salary payments. So IRS reclassifing your distributions would make the payments taxable.

>>A family member who is a (Newly licensed) CPA has made the statement that the IRS would want to know under this scenario who and where the income is coming from and who is producing it..<<

The CPA is correct in that S-corp Officer Salary must be paid if there is income/profit before any draw or payment to the officer shareholder. The IRS has authority to reclassify your capital distribution as officer salary in order to collect payroll taxes.

>>I don't think the IRS cares where and who is producing the income unless that income is taxable. Simply put, XYZ company is almost insolvent as the liabilities exceed the assets and yes these total liabilities include loans owed to the shareholder and I don't see anything wrong with what is happening here.<<

The IRS would certainly care in as much as the corp has cash to pay distributions, then they have cash to pay an officer salary with payroll taxes. The officer certainly produced the sales and should be paid. I think you are taking the wrong approach and frankly cashing the 401k was a pretty dumb decision when guarantee of loans would have been much better.

[Terry D EA]

Thanks Jack and I am going to do more research on reclassifying distributions to shareholders. The guarantee of loans I am not famaliar with but what I do know is there were no funds to guarantee anything and all of the assets were held as cololateral on a loan to a financial institution. I saw this as the only way to free the assets up to sell them off. When this was suggested there wasn't any talk of any way to produce any income and the S-Corp was looking toward total liquidation. I also suggested a bankruptcy lawyer as well and to the best of my knowledge the shareholder has not pursued that direction either. What are your recommendations?

[OldJack]

>>Again, XYZ corp is no longer producing any products, all employess have been laid off and there is no revenue from normal business operations.<<

The business probably should be in liquidation if it is not operating and has large debt. Unless the owner/shareholder has given personal guarantees on the S-corp debt, liquidating the corp would minimize his tax liability. Debt owed him in liquidation would likely be tax deductible as a capital loss. You have to determine facts for what tax and personal results would be to the shareholder.

Having the owner/shareholder pay personal income tax on his 401k just to invest into a closed business with debt is probably not going to save the business and the owner probably does not have money to pay the personal income tax on the 401k. Most, if not all, of the equipment has probably been fully depreciated and sale would result in the owner having taxable gain [1120S-k1] again with no money to pay the personal income tax. Unless the 401k money pays off the equipment the sale proceeds will go to the lender so again the owner has no money to pay income tax.

Maybe you should let the financial consultant take the blame for not saving the company. After all he is an expert that probably helped create this mess? LOL

[Terry D EA]

Thanks again Jack and I do value your opinion. The possibilities you have stated are true for the most part. A major part of the assets have been depreciated completely but there are a few with a fairly significant value that have not. I am meeting with the shareholder and their bookkeeper tomorrow and all of these issues will be discussed. As far as any remaining depreciation on the assets that is my responsibility as I have been tracking that and is easy to produce. You are right, it is a mess and one that I will bow out of if there are too many other's in the mix. As I have stated in the past with this person all it does is add confusion. Most of these opinions are not coming from someone who is experienced in S-Corp taxation including the young CPA.

[OldJack]

Good luck with it Terry. Best get paid up front or maybe drop out.