S-Corp questions

[cientax]

Have a client that was told by a friend that if they elect S-Corp status, that the profits can be kept in the corporation and not pay tax on the profits until they are used in future years.

Can anyone explain to me how this is done when the K-1 shows the profits as ordinary income to each shareholder?

Thay insist that they don't have to show it as income as pass thru to personal return because they didn't distribute the profits and kept in the corps account.

I did explain to the about the retained earnings, but they still don;'t understand and don't want to pay tax on the profits. What to do?

Thanx.

[Guest Taxed]

Is this a C corp thinking about changing to S corp?

Are you talking about the AAA account of S corp that takes into account the retained earnings of the C corp?

[cientax]

I believe they ARE C-Corp (not sure at this time they didn't say and I didn't think of asking since one of them is a regular client, the other is new) and want to elect S-Corp status then they say they will desolve at year end. The election is late but extension has been filed. They feel they have reasonable cause for the late election.

[Guest Taxed]

If they go from C-corp to S-corp and have the AAA absorb the retained earnings from the C-corp then they dissolve the S-corp, the retained earnings will be distributed as dividends and become taxable. So all they accomplished is a year's deferral? Is that their motive?

[cientax]

Now that I recall, they did mention to me that it is a C-Corp but that they never operated until mid year 2012 and never filed 1120's for the corp. I'm really not sure what their motive is at this time other than they just don't want to be taxed on the profits of the S-Corp. I haven't talked to either of them since April. I just checked the sos web sit and it shows they are active and incorporated in Oct 2009.

[Guest Taxed]

If the C - corp was incorporated in 2009 and did not have any activity till mid year 2012 where did all this retained earnings come from? What kind of business are they in? They should have been filing 1120 all the way back? Have you seen their P/L and balance sheet.

If I was you I would proceed with caution! There may be more to this matter and I hope you have the resources to back you up if you take this engagement.

[cientax]

I have seen the P & L but no balance sheet. They did not provide the balance sheet and I don't know if they have one. One of the shareholders wife is keeping the books for the company I believe. They are in the roofing business and P & L shows a small profit of about 20K but they just don't want to pay tax on any profits. I'm really not understanding what their motive is completely since they plan to desolve at end of year. I actually doubt that they will qualify for the S-Corp status under reasonablve cause and will eventually have to file the 1120 and pay the tax there. They did not pay wages. I tried to talk them into making the S-Corp election for this year instead of filing for a late election under reasonable cause but they refused and wanted to defer the income then desolve.

Any ideas? Thanks

[JohnH]

I have an idea. Give their stuff back to them and let the hairstylist they are presently getting their advice from continue to handle this high-level tax planning. If you take this project on, you'll wish you had never seen them when the IRS correspondence begins. And anything that doesn't meet their wierd expectations will be your fault.

[Guest Taxed]

Now that you mention the shareholders did not pay themselves any wages, the IRS will be looking for SE taxes if 100% of that is distributed as dividends. I can tell you that IRS was looking at that aspect.

Two years back i was referred to a client that was not paying any SE taxes and his prior accountant was of the opinion that as long as it was all dividends no SE taxes were applicable. So when I asked well why have you come to me, they showed me the IRS notice.

Better break them the bad news now and make sure your fees cover all the work that will be required. I would recommend a retainer and hourly billable because you don't know where this is going to go.

Oh. I always get very nervous when a new client tells me that a wife or GF is doing the books of the company and she is not a trained bookeeper. God only know what you will find after you review their books.

There is an excellent article on this issue by Donald Cunningham, PhD and Paul Erickson, JD, CPA.

[OldJack]

When a client tells you how they want their taxes done its time to tell them to find another tax preparer!

[Jack from Ohio]

"RUN Forrest RUN!! This guy will get you nothing but in deep trouble. So many things wrong with the information posted.

Give his information back and save yourself grief.

"You have asked me to prepare your returns in a manner that does not comply with the ethical standards I must abide by in Circular 230."

[rfassett]

It might be time for educating the client. I would tell him that you need to see prior year corp returns before you can advise whether to make the S election. But the direct answer to the question on the table is that S-Corp net income, with permitted adjustments, is taxed ratably on the shareholders individual tax return in the year in which the S-Corp year ends (usually Dec unless granted permission for other by the IRS). The amount of cash (profits) left in the business or taken out of the business has nothing to do with the amount of income subject to tax.

[Guest Taxed]

I have a feeling this client is not of the type that can be 'educated' to do the right thing. Hope cientax has a bullet proof engagement letter if he takes this project. I also have a feeling, once he starts looking at the books there will be some surprises!

[cientax]

Thanks for all the input and I will take the advice given and run for the hills, which aren't too far away.

[JohnH]

Not that you need to explain your decisions to a prospective client, but if you felt the need to do so, you could always print out this thread and show it to them.

[Guest Taxed]

I am not so sure showing a client a printout of our blog is a good idea! It has our back and forth and the colorful language!

Perhaps you can take the points we discussed and put it in a business letter as to reasons why you are making a certain recommendation.

Just my opinion!

[jainen]

>>if they elect S-Corp status, that the profits can be kept in the corporation and not pay tax<<

That is absolutely true. If the corporation elects S-status, it will pay no tax on its profits. No distribution is required, so the profits can compound tax-free until needed. It is a common business strategy to take advantage of C-status in early years when there is little or no income, and switch to S-status when it starts making money.

Apparently, however, your clients do not understand the implications for individual shareholders which will vary according to unrelated factors. As this is a complex issue, I would not advise them on it one way or another without a planning engagement billed separately.

[Guest Taxed]

But once they dissolve the Sub S will the distrubution of profits be taxable to the shareholders? I would think so?

[JohnH]

Nope, the profits are not taxed upon distribution.

The profits are taxed to the shareholders as they are earned, regardless of when distributed.

[Terry D EA]

You probably don't need my two cents worth by now. But, John and Jainen have given the best advice here.

[jainen]

>>John and Jainen have given the best advice<<

Thank you. John had several good suggestions, so take your pick. I only had one, but I prefer it. Especially the penultimate word, which doesn't get enough use in this good-hearted forum.