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How to Asses S-Corporation Tax Exposure to Built-In Gains

Built-In gain taxes apply to S Corporations that were once C-Corporations. If you never operated your business as a C corporation, your corporation will not be exposed to built-in gains tax.  Additionally, you face no built-in gains tax when you convert your S corporation to a C corporation since this tax applies only if you convert from C to S

The built-in gains concern many C-corporation owners who want to convert their business to an S-corporation. Built-in gains tax exposure depends on the book and fair market values of the assets in your C corporation. For some businesses, the built-in gains tax will be a big problem, for others it can pose virtually none at all.

If your corporation is exposed to built-in gains tax, your S corporation pays the built-in gains tax at the highest corporate rate. The percent of the gain remaining after payment of the built-in gains tax now comes to the shareholder via the S corporation, where the shareholder pays taxes at his or her personal rate.

The built-in gains tax is designed to prevent C corporation owners from avoiding corporate-level tax on the sale of assets by converting to an S corporation before making the sale.   Lawmakers responded to this strategy by enacting a punitive tax on S corporations that sell assets they owned while they were under C-corporation structure.

If you are going to convert your C corporation to an S corporation, you first need an appraisal, because appreciation that takes place after the conversion is not subject to the built-in gains tax. The burden of proof is on the taxpayer to prove the fair market value at the time of conversion.

The total amount of gain potentially subject to the built-in gains tax is the net unrealized built-in gain on all your C corporation’s assets. To reduce built-in gains taxes, taxpayers often sell built-in loss properties to offset built-in gain properties during the same taxable year.

Taxpayers face potential built-in gains taxes for ten years after the date of conversion from a C-Corporation to an S-Corporation. Another common tax planning strategy is to  wait eleven years to sell the old C-corporation assets to totally escape the built-in gains tax.

Be aware that the built-in gains tax applies if you liquidate your S corporation before the 10-year period expires, since liquidation is treated as a deemed sale of your assets.

Camuso CPA PLLC’s focus and specialization delivers a unique perspective on best industry practices to provide the most value to clients.

Contact us today for financial and tax planning and get your finances in orderhttps://www.camusocpa.com/contact/#/

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Avoid Common Mistakes When Converting to an S Corporation

Your business must meet specific requirements when it operates as an S corporation. If you violate any of them, your S-corporation reverts into a C corporation for three years which will result in double taxation and potentially be a costly error:

  • The S corporation must be a domestic corporation.
  • The S corporation must have less than 100 shareholders
  • The shareholders can only be people, estates, and certain types of trusts
  • All stockholders must be U.S. residents
  • The S corporation can have only one class of stock

If you live in a community property state, your spouse may be an owner of the corporation whether the stock is in only one person’s name because of community property law. If your spouse is an owner, your spouse must meet the all the S-Corporation qualification requirements. Your spouse must consent to the S corporation election on Form 2553 and your spouse must be a US resident.

You can create an LLC and then convert that LLC into an S corporation by following “Check and Elect” procedures:

  • File IRS Form 8832 to check the box that converts your LLC to a C corporation
  • Then file Form 2553 to convert your C corporation into an S corporation

Taxpayers can make these elections within the first two months and fifteens days of the next year to have it effective on the first day of the year. In general, your business needs to meet the requirements for S-corporation status on the day it files the S corporation election. For a calendar-year business, this means it must file by March 15 to have the election effective on January 1. The business would be required to meet the requirements for S corporation status for the entire year, even the period before you filed the election. Business owners must also obtain the consent of everyone who held stock in your corporation for that year to complete the election.

Specific types of loans can have negative implications to S-Corporations status with the IRS. If business owners make the wrong type of loan to their S-corporation, the IRS will treat that loan as a second class of stock and disqualify the S corporation. If the loan is less than $10,000 and the corporation has a written promised to repay you in a reasonable amount of time the loan will not be treated as a second class of stock and the S-Corporation will maintain its status.

If you have a larger loan, your loan is not considered a second class of S if it meets the following requirements

  • The loan is in writing.
  • There is a firm deadline for repayment of the loan
  • You cannot convert the loan into stock
  • The repayment instrument fixes the interest rate so that the rate is outside your control

 

S-Corporations can have separate classes of stock, as long as the only difference between them is the voting rights of each class For example, you can create both voting stock and nonvoting stock, as long as all other aspects of the stock are the same.  This is useful if you want to give someone distributions but not let that person have any control over business decisions.  Nonvoting stock can be very useful tax planning tool if you want to give money to someone in a lower tax bracket, such as your retired parents. We cover this strategy in more detail in later articles.

If you previously operated your business as a C corporation, you face special issues when you convert to an S corporation. These can be complicated, and will be covered in later articles.

Below are some issues to keep in mind:

  • Built-in gains tax
  • Loss of tax attributes.
  • LIFO recapture.
  • Passive investment income

 

Camuso CPA PLLC’s focus and specialization delivers a unique perspective on best industry practices to provide the most value to clients.

Contact us today for financial and tax planning and get your finances in orderhttps://www.camusocpa.com/contact/#/

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Streamline Your Accounting System – A CPA’s Perspective

Maintaining records allows you to gain perspective on your company and provides a basis for business decision making. The level of documentation and systems that you invest time and money into utilizing will depend on your level of business development and financial sophistication.

Business owners and investors in earlier stages of business often do not keep records or have very poor recordkeeping systems which exposes their business to an unnecessary level of risk. The business owner or investor does not know how their business or investments are performing throughout the year and they cannot properly substantiate deductions.

The first step to implementing a proper system is to develop a better system for documenting all income and expenses and maintaining them properly.  Business owners and investors can do this by first establishing a separate business bank account and following best practices detailed in an earlier article regarding commingling funds: https://www.camusocpa.com/finance/commingling-funds-a-cpas-perspective/#/

All payments that are made to vendors or creditors should be paid by cash or credit to maintain a document trail to track payments. All receipts and miles driven for businesses should be tracked and recorded in apps that allow ease of use and accessibility.

Additionally, before allowing any contractor to perform work for your business, they should be required to complete a W-9. All work and payments that you make should be codified in a signed agreement.

All records should be maintained on a business computer, with two backup versions maintained on the cloud and a thumb drive with a folder hierarchy that allows you to easily find and sort data.

Following the above guidelines is the first step to developing a system that will allow you to gain value from utilizing comprehensive software as your business advances.

After business owners or investors have established and integrated a documentation system they can utilize technology to help organize and file applicable documents. This will allow greater freedom to generate financial information so that you can measure business or investment performance.

At this level of financial sophistication and business activity taxpayers do not need comprehensive automated accounting systems but do need timely and accurate financial information for personal and bank purposes. This can be accomplished through a combination of the use of spreadsheets and banking tools.

Business owners and investors should create separate checking accounts for each business, rental property, or investment that they own.

This streamlines the process of tracking expenses and developing financial statements. Each quarter take the time to analyze and log your income and expenses into an excel spreadsheet, reconcile your bank accounts, and review your financial position with your CPA. https://www.camusocpa.com/contact/#/

In the next article on upgrading your accounting system, we will discuss accounting automation and outsourcing your accounting function: http://bit.ly/CamusoAcctII

All investors, agents and business owners should implement best practices regarding business account segregation and general accounting practices.  Maintaining separate personal and business accounts is the first step to establishing foundational accounting practices for your finances.

 

Camuso CPA PLLC  offers a series of services to develop and tailor a first-rate accounting system for your business needs.  Reach out to our team regarding any questions about commingling funds or establishing a first-rate accounting system.

Contact Us Today: https://www.camusocpa.com/contact/#/

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