PowerPoint Presentation ACOPA...7/29/2016 4 S Corporation Loss - example •S corporation is...

7/29/2016

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Kevin J. Donovan, CPA, EA, MSPA, FCA

Managing Member

Pinnacle Plan Design, LLC

Taxation Issues for CPAs

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Types of Business Entities

• C Corporations

• S Corporations

• Sole Proprietorships

• Partnerships

• Limited Liability Companies (LLCs)

– Taxed as corp, partnership or sole prop

• Partnerships of P.C.s

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C Corporations

• Profit taxed at corporate level at graduated rates (15% - 35%)

• Exception for certain Personal Service Corporations (PSCs)- 35% from first dollar [IRC §§11(b)(2); 448(d)(2)]

• Dividends taxed at shareholder level

• Owned by shareholders

• Liability separate from owners

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C Corporation Deductions

• Deductions for contributions made on behalf of

all employees (including owners) taken at

corporate level

• Deductions may cause losses resulting in

carryback (2 years) or carryover (20 years)

– May elect to waive c/b and instead just c/o

– Fiscal year PSCs may c/o only

– IRC §§172(b)(1)(A) / 172(b)(3) / 280H(e)

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C Corporation Loss - example

• Corporation expects taxable income of $0 in 2016 and $375K in 2017 (before any pension)

• Cash from 2017 earnings will be available before 2016 tax return due

• Max DB deduction $225K for 2016; $150K for 2017– Latter presuming 2016 max and assets = $225K at val date

• Adopt DB plan in 2016 - fund $225K by due date

• Creates loss of $225K in 2016

• Fund plan for $150K for 2017 bringing 2016 taxable income to $225K ($375K – $150K) before NOL C/O– $225K NOL C/O from ‘16 will reduce ‘17 taxable inc to $0

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C Corporation Loss - example

• Accrual basis corporation has taxable income of $100,000 each in 2014 and 2015 but limited cashflow– Returns filed with taxable income and taxes paid

• 2016 break-even but $200,000 excess cash flow due to collection of receivables

• In 2016 adopt plan and create net operating loss of $200,000

• Loss carried back to 2014 and 2015 and taxes paid recovered

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S Corporations

• Profit “passed through” (taxed) to owners,

taxed at individual level

• Profits taxed proportionate to ownership

interest (whether or not distributed)

– Unlike in partnership distributions must be

proportionate to ownership

• ‘S’ status is a tax election effecting only how

corporation is taxed

– Liability still separate from shareholders

– Owners treated as employees for plan purposes

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S Corporation Deductions

• Deductions for contributions made on

behalf of all employees (including

owners) taken at corporate level

– IRS Form 1120S, line 17

• Deductions may cause losses – usage

depends on shareholder “basis”

– Contributions to capital, shareholder loans to

corporation, undistributed prior earnings

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S Corporation Loss - example

• S corporation is break-even but has significant

cash from undistributed prior earnings

• S shareholder is active in business; also has

significant income from other sources

• S corporation can adopt plan and create loss

which can be used to offset other income

– Must have “basis” which is likely due to

undistributed prior earnings - IRC §1366(d)

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S Corporation Compensation

• Compensation = payroll

• Shareholders have two forms of income:

– Payroll

– Pass-through (dividends)

• Pass-through income may not be recognized as

compensation for plan purposes (Durando v.

U.S., CA-9, 11/16/95)

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S Corporation

Compensation Example

• Medical practice has net income of $400K before salary to Doctor

• CPA tells Dr. to take only $50K in salary to avoid payroll taxes on balance of earnings

• Balance of earnings will pass through to personal tax return on Schedule K-1

• For plan purposes compensation is $50,000

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S Corporation Comp. -

Reasonableness• Revenue Rulings 73-361 and 74-44

• Spicer Accounting, Inc. 918 F 2d 90 (CA-9, 1990); Joseph Radtke, SC, 895 F 2d 1196 (CA-7, 1989); Watson v. U.S., 668 F.3d 1008 (2012); Glass Blocks Unlimited, TCM 2013-180

• Reclassification of dividends to compensation results in taxes, penalties and possible plan qualification issues– S election confirmation contains warning to this effect

• Contributions to qualified plans are considered compensation when determining reasonableness Reg. §1.404(a)-1(b)

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Reasonableness• In 2008 the IRS issued a Fact Sheet (FS-2008-25)

• “Corporate officers are specifically included within the definition of employee for FICA (Federal Insurance Contributions Act), FUTA (Federal Unemployment Tax Act) and federal income tax withholding under the Internal Revenue Code. When corporate officers perform services for the corporation, and receive or are entitled to receive payments, their compensation is generally considered wages. Subchapter S corporations should treat payments for services to officers as wages and not as distributions of cash and property or loans to shareholders. ”

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Reasonableness• “The Internal Revenue Code establishes that any

officer of a corporation, including S corporations, is an employee of the corporation for federal employment tax purposes. S corporations should not attempt to avoid paying employment taxes by having their officers treat their compensation as cash distributions, payments of personal expenses, and/or loans rather than as wages.”

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Reasonableness• “Generally, an officer of a corporation is an employee

of the corporation. The fact that an officer is also a shareholder does not change the requirement that payments to the corporate officer be treated as wages. Courts have consistently held that S corporation officer/shareholders who provide more than minor services to their corporation and receive or are entitled to receive payment are employees whose compensation is subject to federal employment taxes.”

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Reasonableness

• “Some factors considered by the courts in determining reasonable compensation:– Training and experience

– Duties and responsibilities

– Time and effort devoted to the business

– Dividend history

– Payments to non-shareholder employees

– Timing and manner of paying bonuses to key people

– What comparable businesses pay for similar services

– Compensation agreements

– The use of a formula to determine compensation”

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Reasonableness• Employer from previous example audited two years

later and IRS determines that $150K of dividend distributions are to be reclassified as compensation. Dr’s compensation therefore $200K instead of $50K

• What if employer sponsors safe harbor 401(k) plan? SH contributions were based on $50K instead of $200K. Twelve month period to deposit SH contributions passed. VCP?

– Also elective deferrals not withheld when dividend payments made so operational failure

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Reasonableness

• Or employer sponsors DB plan where contribution influenced by current compensation. Additional $150K of compensation increases benefits and therefore funding requirement, resulting in possible funding deficiency– 10% excise tax on failure to meet minimum funding

requirement

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Plan contributions and

reasonable comp• Treasury Regulation 1.404(a)-1(b)• “In order to be deductible under section 404(a),

contributions must be expenses which would be deductible under section 162 ... Contributions may therefore be deducted under section 404(a) only to the extent that they are ordinary and necessary expenses during the taxable year in carrying on the trade or business …. In no case is a deduction allowable under section 404(a) for the amount of any contribution for the benefit of an employee in excess of the amount which, together with other deductions allowed for compensation for such employee's services, constitutes a reasonable allowance for compensation for the services actually rendered”

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Plan contributions and

reasonable comp

• Consider …

• Sole prop with comp $100K per year for last 3-years – so avg comp = 100K

• Assume that at current age could adopt DB plan and get $100K deduction

• Since pension not deductible in determining SE tax there would be a sizeable SE tax (~$14K)

• Incorporate – avg counts as controlled group

• $100K pension leaves no taxable income

• Reasonable comp OK due to above reg

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DUE DATE OF DEPOSITS

Accountants think they have until due date of tax

return to make contributions. With partnerships this

now lines up with minimum funding date (assuming

plan year = tax year and extension filed) but sole props

can still have until 10/15 to file

Our letters always say contribution due earlier of due

date of tax return or 8 ½ months after end of PY

At least for minimum funding …

Deductibility of contributions post 9/15 but pre 10/15

2011 Greybook Q&A 7 to follow

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Year deductible

• Presume that:

– payment made within 8 ½ months after year-end

– treated as prior year deposit for §412

– not deducted on prior year tax return, and

– nothing in writing designates contribution is “onaccount of” prior tax year

• How about deposit made 10/15 (within 404(a)(6)period for Sole Prop) for calendar year plan?

• Can contribution be “on account of” one year forminimum funding purposes and another year fordeduction purposes?

Year deductible

• Yes? Maybe?

• Revenue Ruling 77-82

– Taxpayer allowed to take deduction in 1975 for

contribution made within §404(a)(6) period, but

count for §412 in 1976 (§412 did not apply until years

beginning after 1975)

– Service cited following language in Temp. Reg.

§11.412(c)-12(c)(2) (allowing 8½ month post year-

end period to satisfy minimum funding in case of

pension plans other than single employer DB plans)

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Year deductible

– “The rules of this section relating to the time a

contribution … is deemed made for purposes of …

section 412 are independent from the rules

contained in section 404(a)(6) relating to the time

a contribution … is deemed made for purposes of

claiming a deduction for such contribution under

section 404.” [Temp. Reg. §11.412(c)-12(c)(2)]

(emphasis added)

• Greybook Q&A 7 (following slide)

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Year deductible

• A company has a calendar taxable year and sponsors a pension plan with a calendar plan year. Which of the following combinations are acceptable for a contribution made during the 2010 §404 contribution grace period (January 1, 2011 to September 15, 2011)?– a) Deduct contribution in 2010, reflect on 2010 Schedule SB.

– b) Deduct contribution in 2010, reflect on 2011 Schedule SB.

– c) Deduct contribution in 2011, reflect on 2010 Schedule SB.

– d) Deduct contribution in 2011, reflect on 2011 Schedule SB.

• RESPONSE

• a), c), and d) are acceptable. IRC §404(a)(6) deems a contribution made after the last day of a taxable year to be made on the last day of a taxable year if the payment is made on account of such taxable year. A contribution is considered to be on account of the 2011 plan year when reported on the 2011 Schedule SB and thus cannot be deducted on the sponsor’s 2010 tax return

• PERSONALLY I’M NOT BUYING THIS!

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Due Date Issue

• Effect of Extension. If a company files its tax

return prior to the original due date, but after

obtaining an extension of time for filing, the due

date under §404(a)(6) is the extended due date.

Revenue Ruling 66-144, affirmed by Revenue

Ruling 84-18 (see also 2002 IRS/ASPA Q&A #47)

• Conversely, an extension is not valid where the

return is filed prior to the original due date and

prior to filing for the extension. PLR 8336006

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Due Date Issue

• Consider an employer that has a $50,000

overpayment on their taxes when considering

their pension contribution

– Refund needed for pension contribution

• Due date of tax return is 3/15

• On 3/10 extension filed until 9/15

• Return filed 3/15 claiming pension deduction

• Refund received on 4/30

– and used to fund pension

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Plan must be in existence

• Engineered Timber Sales, Inc. v. Comr.,

74 T.C. 808 (July 22, 1980)

– Tax court ruled plan must be in existence &

executed prior to end of employer’s tax

year in order for a deduction to be taken

– IRS reiterated this in Rev. Rul. 81-114

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• The Service also ruled in 81-114 that if, under local law, a valid trust has been created by the end of the taxable year except for the existence of corpus, the trust will be deemed to be in effect if the corpus is furnished no later than the due date (including extensions) of the employer's tax return.

• Accordingly, it is not necessary to open an account for the trust prior to the end of the tax year. It is simply necessary that the documents are properly executed.

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• So using fiscal year plan where plan year

begins in tax year, ends after tax year, and

executing plan before end of plan year but

after end of tax year does not result in

deduction in prior tax year

– Plan year 9/1/15-8/31/16

– Tax year 1/1/15-12/31/15

– Plan signed 8/31/16 cannot take deduction in 2015

irrespective of fact that it’s signed before end of

plan year that begins in tax year

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Partnerships

• Reg. §1.404(e)- 1A(f)(1)– “… in the case of a defined contribution

plan, a partner's … distributive share of deductions allowed the partnership under section 404 for contributions on behalf of a self-employed individual is that portion of the deduction which is attributable to contributions made on his behalf …”

• i.e., if DC plan, partner deducts on personal tax return amounts contributed on his/her behalf

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Partnerships

• Reg. §1.404(e)- 1A(f)(2)– “In the case of a defined benefit plan, a

partner's distributive share of contributions on behalf of self-employed individuals and his distributive share of deductions allowed the partnership under section 404 for such contributions is determined in the same manner as his distributive share of partnership taxable income. See section 704, relating to the determination of the distributive share and the regulations thereunder.” (emphasis added)

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Partnerships

• IRS/ASPA 2000 - 6– Q. Field Service Advice 1999-743 indicates that 1.404(e)-

1A(f)(2), which requires allocations of defined benefit plan deductions to be made in accordance with each partner's profits interest, is still valid. Is this true? Assume a partnership has three equal partners, two of whom are covered under the partnership’s DB plan at a cost of $75,000 each. There are no other employees. The 404 reg appears to say that each partner is responsible for funding (and deducting) $50,000.

– A. Absent a special allocation in the partnership agreement we agree with the above result. A special allocation in the partnership agreement could result in the deduction being allocated to the two covered employees.

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Partnerships

• Not being a lawyer, I’m hesitant to opine on what the partnership agreement, written or oral, would have to say.

– From IRS Publication 541

– “The partnership agreement includes the original agreement and any modifications. The modifications must be agreed to by all partners or adopted in any other manner provided by the partnership agreement. The agreement or modifications can be oral or written.”

• Of late IRS apparently has been challenging allocations on audit

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Partnerships

• Percentage of compensation deduction issues with partnerships

• Code and ERISA clear that for retirement plan purposes the partnership is the employer and the partners are each employees

• It follows from there that the deduction limits are determined at the partnership level

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Partnerships

• Consider …

• Two 50% partners each with $150K comp (after required adjustments)

• Total employee comp $200K

• So total comp $500K and DC deduction limit $125K

• $25K allocated to employees

• $50K to each partner

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Partnerships

• CPAs will often contact TPA and say their ‘software’ is limiting partner to $37,500 (i.e. 25% of their comp)

• They need to be told to override software – possibly by lying to system and telling it it’s a DB plan

• Software has no way of knowing there’s comp over and above the partners’ that is supporting deduction

Unrelated partnerships –

Recent question on ACOPA Board

• Two partners own 30% each of partnership (P1) that has a PBGC covered CB plan and a 401(k) plan

• New, UNLREATED partnership (P2 - in which they are both partners) wants CB + PSP

– No common law employees

• P1 SE $600k each; P2 $500k each

• Pension deductions taken on partner’s individual returns for all plans

– Obviously39

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• Question (1) – does P2 plan force 6% cap on the P1 PS deduction?

• Question (2) – same question but does it force a 6% cap on the partners return?

• Question(3) – since there’s only 1 (personal) return for each partner, but 2 K-1’s, can each partner have TWO $265,000 limits or is $265k limit imposed on an omnibus level resulting in one $265k limit?

– E.g. Section 179 limit applies both at entity and individual levels

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• Answer 1• As long as each plan is only sponsored by the

specific partnership and the two partnerships are not under common control per 414(c) or an affiliated service group under 414(m), then each partnership stands alone when applying benefit and deduction limits to its plans

• Be careful to line up contributions and deductions for each plan with the income derived from the partnership sponsoring that plan

– You can then have multiple plans from different partnerships with multiple benefits and contribution limits

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• Answer 2

• Agree (with Answer 1) on legal issue

• However, showing that on the individual return – especially showing a DC deduction of twice the DC 415 limit – could prompt an audit or be questioned on audit and you will have to explain the issue to them

• Possibly have CPA do an attachment explaining in advance

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Partners with W-2s

• Compensation for self-employed (SE)

persons at times results in circular

calculations.

• In general, compensation is

– net income from self employment, less

– deduction for ½ of self-employment tax, less

– deductions for employer contributions made to

qualified plans on behalf of the SE person

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Partners with W-2s

• Deduction on behalf of SE person limited to

earned income (before plan contributions)

from trade or business establishing plan

• Precludes deduction in case of minimum

funding required for DB plan to extent

minimum funding exceeds earned income

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Partners with W-2s

• SE persons must normally make quarterly

tax payments to cover income taxes as well

as self-employment taxes, latter being SE

person’s version of FICA and Medicare taxes

• Whereas employees have income and

payroll taxes withheld from their paychecks

• SE persons are responsible for 100% of FICA

and Medicare taxes whereas in the

employee-employer relationship the

employer picks up half of the cost

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Partners with W-2s

• Above issues make it tempting to simply treat

partners as employees

– life seems simpler giving such folks a paycheck and

withholding taxes from such paychecks and having the

employer pickup half of the FICA and Medicare cost

• Apparently some accountants think this is OK, and

many of us have been faced with situation where

we’ve been informed that a partner has SE income

as well as W-2 income

• Is this OK?

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Partners with W-2s

• IRS and the courts say no

• In a series of revenue rulings (69-184, 81-300, 81-301) the Service held that an individual cannot be both an employee and a partner for employment tax purposes

• The Service also held that to the extent a partner renders services “outside the scope of the partnership” such services are those of an independent contractor and not an employee – This Service’s response to Code Section 707(a)(1) which

provides “If a partner engages in a transaction with a partnership other than in his capacity as a member of such partnership, the transaction shall, except as otherwise provided in this section, be considered as occurring between the partnership and one who is not a partner.”

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Partners with W-2s

• What to do?

• Assume you receive a census for a partnership and

the two 50% partners have W-2 wages listed, let’s

say $150,000 each

• In addition, the K-1s shows SE income for the

partners of $100,000 each

• The partnership sponsors a cash balance plan that

provides that the partners each get a pay credit of

50% of compensation and the partnership’s

intention is to fund the pay credits

– What’s the pay credit?

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Partners with W-2s

• Recall partner’s compensation is reduced for plan

contributions made on the partner’s behalf

• If entire $250,000 was SE income (and assuming no

outside W-2 income)

– SE tax would be ($250,000 * .9235 * .029) + (118,500 *

.124) = $6,695 + $14,694 = 21,389 and deduction for ½ of

the SE tax would be $10,695

– Compensation before pension would be $239,305 and pay

credit would be $239,305 / 150% = 159,537 * .5 = $79,768

(i.e., Compensation would be $250,000 – 10,295 – 79,768 =

159,537 and the pay credit would be $159,537 * 50% =

79,768.)

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Partners with W-2s

• With mixed bag how to handle?

– First, it would seem to me, irrespective of how comp

reported, deduction still limited to SE income

• Pay credit would be $75K from W-2 income plus

some number from SE income, latter recognizing

the full amount of the pension deduction (which

again, we’ve deemed to be equal to pay credit)

• SE tax on the $100,000 of SE income would be

$100,000 * .9235 * .029 = $2,678 and the deduction

for ½ of the SE tax would therefore be $1,339

– What’s pay credit though?

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Partners with W-2s

• I would say compensation for the SE piece is

($100,000 – $75,000 – $1,339)/150% = $15,774

• The pay credit would then be $75,000 + 15,774/2 =

$82,887

– That is, compensation is $150,000 + 15,774 = $165,774,

and 50% of $165,774 is $82,887

• What if there isn’t enough SE income?

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Partners with W-2s

• For example, what if in the previous example the

W-2 was $150,000 but SE income was only $10,000

(and the deduction for ½ of SE tax was $134)?

• It would seem to me that the deduction would be

limited $9,866. But the pay credit would still be

$75,000. What to do in such a situation?

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Partners with W-2s

• Ask the accountant, as he/she is the one that

created the issue in the first place

• In the end there will be a minimum required

amount that likely will exceed the SE income

• In such a case funding certainly shouldn’t occur

until following year at which time accountant could

correct reporting going forward and hopefully have

ample SE income for deduction

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Partners with W-2s

• For what it’s worth, others have argued that

partner should be treated as two persons – a

regular employee to the extent of W-2 comp and a

self-employed person to the extent of SE income

• With such treatment the portion of the deduction

allocable to the employee portion would be

deducted on the partnership return creating a loss

that possibly could be used against other income

• Personally I see no support for this treatment

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Partnership of P.C.s

• Plans of affiliated service groups treated as “multiple employer” plans [Prop. Reg. §1.414(m)-3(c)]

• Multiple employer plans provide for separate deduction limit for each employer [IRC §413(c)(6)]– Special election for plans in effective

prior to 1989

• Somewhat common in professional settings where partners are individual PCs and LLC employs non-owners

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Partnership of P.C.s

• For non-PBGC plans this means one

person partner/corps with $265K of

owner only payroll can deduct either

– $15,900 DC plus max DB, or

– $82,150 between DC and DB

– CPA needs to make sure comp is taken!

– Deduction for employees at LLC level

usually not an issue

Excess contributions

• Recall combined plan limit 25% of comp– Ignoring first 6% to DC

• What if more than 6% contributed to DC, and DB will bring total over 31%

– If DC contributed after year-end deduct excess over 6% in year contributed (while considering as prior year for plan purposes)

– If DB contributed after year-end consider amount over 31% as year contributed for tax purposes

– Otherwise election to ignore DB for penalty• Zimmerman posting?

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• In soft guidance to IRS examiners posted on the IRS website on May 19, 2016, the IRS stated “Absent further guidance, if nondeductible contributions are found during an examination, the IRC Section 4972(c)(7) election should be deemed to have been made by the employer and the excise tax under IRC Section 4972(a) should not be asserted, unless (1) the sponsor is making contributions to a multiemployer plan that exceed the full-funding limitation or (2) the sponsor is also making contributions to a defined contribution plan in the same year that exceed the IRC Section 404(a)(7) limits.”

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• “If the sponsor is making nondeductible contributions to a non-PBGC covered defined benefit plan (such as a professional service employer plan that has never had more than 25 active participants) and is contributing to a defined contribution plan, contact TEGEDC Area Counsel”

• Why does it matter??

• (https://www.irs.gov/retirement-plans/nondeductible-contributions-to-defined-benefit-plans)

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Controlled Group Deductions

• Consider: Two corporations, both owned by the same individual. Corp A sponsors a 3% safe harbor 401k plan with 2% profit sharing (Plan A), Corp B sponsors a defined benefit plan (Plan B). Assume all combined testing passes, and Plan A contributions are necessary for testing to pass in Plan B.

• In the past, Corp A has taken the deduction for contributions made to Plan A and Corp B has taken the deduction for contributions made to Plan B.

• In 2016, Corp A has no income, but Corp B does.

• Can Corp B make the contributions and take the deduction for these made to Plan A?

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• First, keep in mind that since this is a controlled group, the deduction limits are determined on a combined basis. So §404(a)(7) will apply to the group. [IRC §414(b)]

• Next, what do the regulations say about allocation of this deduction limit to the members of the controlled group?

– What regs!?

• Finally, since §404 does not specify who can deduct contributions, we should look to §162.

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• Code §162:– This section determines if expenses are ordinarily

deductible by a trade or business.

– It limits deductions to expenses which are “ordinary and necessary”

• In the past, the IRS has ruled that it is not an ordinary and necessary business expense for one corporation to provide retirement benefits for the employees of another corporation.– Rev Rul 69-525, Rev Rul 70-316, Rev Rul 70-532, PLR

8032079

• But can it be argued that the contributions to Plan A by Corp B are necessary in order for Plan B to remain qualified?

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• In Rev Rul 70-532, the IRS stated that the only exception to having each corporation take the deduction for the contributions allocated to its own employees is for termination liability payments under IRC §404(g).

• §404(g) specifically grants a corporation authority to deduct contributions made for purposes of meeting their termination liability for a PBGC plan, even though the corporation did not employ the employees in the plan.

• This is the only known exception for deductions

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• But what if Corp A wants/needs to deduct the contributions

made to Plan B?

• IRC §412(b)(2) states that each member of a controlled

group shall be jointly and severally liable for payments of

contributions required under code §430.

• Is this sufficient to justify the “ordinary and necessary”

requirement under §162?

– Many think so, but there is nothing official.

• Until we get regulations under 404, we need to be careful.

• Safest course of action is for each corporation to deduct the

contributions based on compensation paid by that

corporation.

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Overlapping Plan/Tax Year - DC

• Effect of overlapping Plan/Tax Year– Recall 25% limit based on tax-year compensation

• Example– Calendar plan-year

– June 30 tax-year

– Participant comp. June 30, 2016 = $400,000

– Employer contribution for 2015 plan-year = $75,000

– If timely, $25,000 of contribution for 2016 plan year could be deducted in tax-year-ended June 30, 2016

– But not matching cont. on post 6/30/16 deferrals• Revenue Rulings 90-105; 2002-46

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Overlapping Plan/Tax Year - DB

• Plan Year ≠ Tax Year– Limit determined for plan year beginning within

tax year

– Limit determined for plan year ending within tax year

– Weighted average of above based on number of months of each plan year falling within taxable year

– Same alternative used for each taxable year unless consent to change accounting method obtained under IRC §446(e)

– Reg. §1.404(a)-14(c)

– Still valid?66

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