While the S corporation remains the most popular type of entity for operating a promotional products business, in today’s troubled times many problems—lingering unnoticed for several years—have begun to surface. These problems often result in an unexpected, whopping bill for past taxes, penalties and fines.
What problems could an S corporation encounter in the current economy? Shareholders in troubled S corporations may, for instance, be denied deductions for the losses of the promotional products business, a key benefit for many S corporation shareholders. Similarly, S-corp shareholders may be forced to recognize—and pay tax on—so-called “built-in gains” sitting dormant since the S corporation was formed. In fact, these shareholders could, conceivably, find themselves facing a substantial increase in their personal tax bills or even the disqualification of the S corporation’s status for a simple thing such as cancellation or forgiveness of the business’s indebtedness.
The S corporation is a pass-through entity, passing all profits, losses, tax credits, etc., to the tax returns of its owner/shareholders. An incorporated supplier or distributor of promotional products must choose or “elect” to be treated as an S corporation. The business must also qualify since the tax rules limit both the number and type of shareholders that an S corporation can have.
Once qualified, the promotional products business operating as an S corporation must file a return but generally pays no tax, passing along the responsibility for those losses or income to its shareholders. Unfortunately, once qualified, an S corporation can easily lose the S-corp status because of any number of missteps, often unintentional. And even though a troubled S corporation may pass through losses, it does not mean that a shareholder can always claim them.
Although actions affecting the S corporation and its shareholders are often beyond control, an awareness of these potential pitfalls and a few simple strategies can substantially reduce the higher tax bills associated with these issues.
CAUTION: DEDUCTIONS AT RISK
The at-risk rules of our tax laws deny a deduction for losses that exceed the amounts that an investor has at risk. The rules, which apply to both individuals and many closely held corporations, are designed to prevent taxpayers from offsetting trade, business or professional income by losses from investments in activities that are largely financed by non-recourse loans for which they are not personally liable.
Under the at-risk rules, loss deductions are limited to the amount of the taxpayer’s cash contributions to the business and the value of other property contributed to the activity. Amounts borrowed for use in the activity are also considered at-risk if the taxpayer has personal liability for the borrowed amounts or has pledged assets not used in the activity as security for the borrowed amounts.
Personal liability of the shareholder for borrowed amounts generally hinges on whether he or she is the ultimate obligor of the liability with no recourse against any other party. The at-risk rules apply to every individual taxpayer, including S-corporation shareholders, and they apply to the shareholder rather than the business.
The at-risk amount is determined at the close of the S corporation’s tax year. Thus, an S corporation shareholder who realizes that his or her at-risk amount is low and wishes to deduct an anticipated S corporation net loss can make additional contributions to the business before the close of the tax year.
The easiest method of ensuring the full benefits of any S corporation’s pass-through losses is, obviously, to increase the shareholder’s basis in the promotional products business entity. How does a shareholder increase his or her basis?
As mentioned, the original basis of a shareholder’s stock is the purchase price for the stock (money or fair market value of any property given in exchange for the stock). If a shareholder’s basis is reduced to zero, the remaining net decrease from losses and deductions is applied to reduce any basis in debt owed to the shareholder by the incorporated business.
The basis of an S-corporation shareholder’s interest can be increased by the amount of his or her distributive share of the operation’s taxable income or by any tax-exempt income. Similarly, any increase in a shareholder’s share of the S corporation’s liabilities, including the shareholder’s assumption of the operation’s liabilities or receipt of the entity’s property subject to a liability (limited to the fair market value of the encumbered property), is treated as a contribution of money that increases a shareholder’s basis in his or her interest.
KILLING AN S CORPORATION
The promotional products business’s status as an S corporation is a fragile thing. All shareholders must agree to begin business as an S corporation. Not only must they agree, but those shareholders must be “qualified” shareholders. Later in the S corporation’s life, that status can be lost if the business takes in an unqualified shareholder.
Creditor foreclosures on shareholder stock or creditors receiving corporation stock in exchange for corporate debt can create additional problems. If foreclosure creates an impermissible shareholder and, thus, termination of the S-corp status, the timing of the foreclosure event becomes important from a tax planning perspective.
Even where a new shareholder is a permissible shareholder (one who remains agreeable to being an S-corporation shareholder), the timing of the event is critical for income allocation purposes. After all, the general rule is that income, or loss, is allocated on a pro-rata daily basis.
SUSPENDED LOSS QUESTIONS
The losses and deductions claimed by S-corp shareholders may not exceed their basis in the promotional products operation’s stock and/or the basis of the corporation’s debt to them. Furthermore, under the tax rules, those disallowed losses must be treated as incurred by the corporation in the next tax year.
Despite the requirement to treat the suspended loss as incurred by the promotional products business in a later tax year, the loss is not reported on the operation’s tax return. It is an item tracked and reported only by the shareholder entitled to claim such “suspended losses.”
Also as noted, the normal basis limits continue to apply. That is, the losses and deductions passed through to a shareholder may not exceed the adjusted basis in the S corporation’s stock. What’s more, that loss is personal to the shareholder to whom it is disallowed and suspended and cannot be transferred in any manner. In fact, if the shareholder transfers all of his or her stock in the S corporation, the disallowed loss or deduction is permanently lost.
Going even further, the suspended loss cannot be carried over in a bankruptcy. Suspended losses are not like Net Operating Losses (NOLs) or similar carryover items but, rather, are more like a suspended passive activity loss.
A FINANCIALLY TROUBLED SHAREHOLDER
If the promotional products business operating as an S corporation is financially distressed, chances are good that one or more of its shareholders is facing financial problems. Whether the shareholder acted as a guarantor of the operation’s debt or the shareholder is liable for amounts loaned to or invested in the business, the shareholder will often seek bankruptcy relief at the same time the business is seeking similar protection from creditors.
Filing bankruptcy does not, of course, create a new taxpayer; the S corporation continues its existence and S corporation status is not affected. However, when an S-corp shareholder seeks individual bankruptcy protection, the bankruptcy estate becomes a taxpayer separate from the individual shareholder. The individual shareholder has the option to terminate his or her tax year upon filing bankruptcy, thereby often raising problems for other shareholders.
CANCELLATION OF INDEBTEDNESS
Under our tax rules, income from the discharge of indebtedness must be included in gross income. Naturally, debt cancelled by bankruptcy or insolvency of the operation or shareholders, as well as the discharge of qualified real property business indebtedness, are notable exceptions to the general rule.
A promotional products business, other than one operating as a regular C corporation, can choose to exclude from its gross income amounts realized from the discharge of debt related to real property used in a trade or business and secured by that property. Of course, to be excluded, the debt must be to acquire, construct or substantially improve the real property.
Whether the business has been hard hit by competition, business conditions or the economy, the type of entity employed can often multiply those problems.
While S corporations remain the most popular entity for operating a small business, financial problems both multiply and sneak up on unwary S corporation businesses—and their owner/shareholders.
Fortunately, an awareness of potential pitfalls for the troubled promotional products business operating as an S corporation along with a few strategies can often minimize any unfavorable tax consequences. Those strategies may also save the S-corporation’s status, allowing it to continue to pass its tax benefits along to its shareholders, presumably the reason for choosing the S-corporation entity.
Mark E. Battersby is an Ardmore, Pennsylvania-based freelance journalist.