Those who set up S corporations usually do so as their accountant told them that it could save taxes. This is often true. The S corporation can result in tax savings.
This may include the standard reduction in self-employment/payroll taxes or, for more advanced tax planning, income taxes. The ability to freeze the value of assets transferred to the S corporation and the ability to time gains by making distributions make the S corporation an excellent vehicle for minimizing taxes in a number of different situations.
For the uninitiated, these same concepts also make it easy for the IRS to make adjustments on audit. The recent Starer v. Commissioner, T.C. Memo. 2022-124 case provides an example of this. One of the issues in the case is the distribution of the S corporation’s appreciated assets to the S corporation owner.
Facts & Procedural History
The taxpayers owned a business entity that elected to be taxed as an S corporation. The business operated a horse breeding business, their personal residence, and six unimproved lots.
The taxpayers transferred the six unimproved lots to third parties. They did not report income or gain from these transfers as they took the position that two of the transfers were gifts and apparently that the other transfers were transferred as security for loans.
On audit by the IRS, the IRS concluded that the two gift transfers were actually constructive distributions of appreciated property and the other transfers were sales.
Litigation ensued in the U.S. Tax Court.
About Subchapter S Corporations
The S corporation is an entity that makes an election to be treated as an S corporation.
Once elected, the entity does not pay income tax. Rather, the entity reports its items of income and expense, and those items are then reported on the owner’s personal income tax returns. The owners report these items of income and expense from the S corporation regardless of whether the S corporation distributes anything to the owners during the year.
If the S corporation happens to make distributions to the owners, the distributions are either compensation or a loan or a return of capital or a distribution of the earnings and profits of the entity. The return of capital is tracked by the taxpayer’s basis in the entity and the distribution of earnings is tracked by the accumulated adjustments account (“AAA”). Compensation and distributions in excess of basis that are out of the company’s earnings (in excess of the AAA balance) are generally taxable to the owner.
If the language above is confusing, don’t worry as we don’t have to get very far into these rules for this article. All we really need to know for this article is that S corporation owners pay tax currently regardless of whether distributions are made and actual distributions may or may not be taxable.
Compensation vs. Constructive Distribution
On audit, the IRS may assert that the use of property owned by the S corporation for the owner’s personal use is either compensation to the owner or a constructive distribution to the owner (. IRS agents typically just pick the option that produces the most tax.
With the first option, compensation, the amount is deductible by the S corporation in computing its flow through income, but taxable as wages for the ower–generally just resulting in additional payroll taxes.
With the second option, the amount is only taxable if in excess of the basis and the AAA balance–resulting in income tax on the distribution.
Tax on Distribution of Appreciated Property
Similar to the second option, the tax may also include income tax on the gain on property owned by the S corporation if the property is distributed to the owner.
This type of gain is triggered if the property has appreciated in value from the time it was acquired by or contributed to the entity and the time of the distribution (it can also be triggered if the property has been depreciated by the S corporation).
A simple example is where a taxpayer owns a share of a publicly traded stock. If the taxpayer purchased the stock for $10 and then immediately transferred it to the S corporation and, say, 5 years later, the stock is distributed back to the taxpayer when it was valued at $30, the taxpayer would recognize a $20 gain on the distribution.
Luckily, this type of gain can be avoided with even basic tax planning.
Distributions that Benefit the S Corporation vs. the Owners
This brings us back to this case. The taxpayers argued that they transferred two properties to third parties. One of the properties was transferred to an acquaintance that the taxpayers had interacted in various ways over time.
The taxpayers argued that the distribution of this property was a loan and the third party just happened to not repay the loan. This is one way that the distribution could have been tax neutral.
The court did not accept this argument given the evidence presented. Though not expressly stated in the court opinion, the court’s opinion seems to imply that this was an argument made for the first time in court and that the taxpayers did not document the transaction in this manner. The court concluded that the distribution was either compensation for other dealings with this party or a gift made based on the relationship with this other party. The court found that the transfer benefitted the business owners rather than the business and, therefore, the transfer was a constructive distribution to the owners (and then a gift transfer to the third party).
As a distribution, one has to compare this to the taxpayer’s basis in the entity and their AAA balance to see if there is any tax due. Presumably, it did trigger tax given that the IRS opted to pursue this option rather than taking the position that the distributions were actually compensation to the taxpayers.
This case provides an example of the tax adjustments the IRS can make in audits with S corporations. The IRS auditor went with the constructive distribution avenue rather than taxable compensation, as it resulted in the highest amount of tax due given the taxpayer’s tax basis and AAA account. As this case shows, S corporation owners have to be careful not to use company assets for their own use or to distribute assets without first understanding the tax consequences.
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