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March 2010
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Finance and Taxes: Multiple troubles for troubled S corporations
While the S corporation remains the most popular type of entity for operating a chiropractic practice or business, in today’s troubled times many problems have begun to surface.
These S corporation problems, problems that may have been unnoticed for several years, often result in an unexpected, bill for past taxes, penalties, and fines.
Shareholders in troubled S corporations may, for instance, be denied a deduction for the losses of the chiropractic practice, or be forced to recognize — and pay tax on — so-called “built-in gains” that have been dormant since the S corporation was formed.
S corporation shareholders could face a substantial increase in their personal tax bill or even the disqualification of the S corporation’s status for such things as cancellation or forgiveness of the practice’s indebtedness.
Although actions affecting the S corporation and its shareholders are often outside their control, awareness of these potential pitfalls along with a few, simple strategies can substantially reduce the higher tax bills associated with many S corporation troubles.
S corporations
The S corporation is a pass-through entity — passing all profits, losses, and tax credits to the tax returns of its principal/shareholders. An incorporated chiropractic practice must choose or “elect” to be treated as an S corporation. The business must also “qualify” since tax rules limit the number and type of shareholders an S corporation can have.
Once qualified, the chiropractic practice 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 shareholder(s). Unfortunately, once qualified, an S corporation can easily loose its status because of any number of missteps and often without even being aware of it. Also remember that even though a troubled S corporation may pass through losses, it does not mean a shareholder can always claim them.
Caution: Deductions at risk
The at-risk rules of our tax laws deny a deduction for losses that exceed the amounts an investor has at risk. The rules, which apply to individuals and many closely-held corporations, are designed to prevent taxpayers from offsetting trade, business, or professional income by losses from investments in activities largely financed by nonrecourse loans for which they are not personally liable.
Under at-risk rules, loss deductions are limited to the amount of the taxpayer’s cash contributions to the practice or 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. At-risk rules apply to every individual taxpayer, including S corporation shareholders, and apply to the shareholder, rather than the practice.
The at-risk amount is determined at the close of the S corporation’s tax year. Thus, an S corporation shareholder who realizes his or her at-risk amount is low and wishes to deduct an anticipated S corporation net loss can make additional contributions to the chiropractic practice.
Building basis
One method of ensuring the full benefits of any S corporation’s pass-through losses is to increase the shareholder’s basis in the chiropractic practice entity.
The original basis of a shareholder’s stock is the purchase price for the stock (money or fair market value [FMV] of any property given in exchange for the stock). If a shareholder’s basis is reduced
The basis of a interest can be increased by the amount of his or her distributive share of the practice’s taxable income or by any tax-exempt income.
Similarly, any increase in a shareholder’s share of the 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 FMV 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 status as an S corporation is a fragile thing. To begin business as an S corporation, all shareholders must agree and be “qualified” shareholders. Later in the S corporation’s life, that status can be lost if a shareholder rebels or the practice, knowingly or unknowingly, 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 corporation status, the timing of the foreclosure event becomes important from a tax-planning perspective.
Even where a new shareholder is a permissible shareholder, the timing of the event is critical from income allocation purposes.
Suspended loss questions
The losses and deductions claimed by shareholders may not exceed their basis in the practice’s stock and/or debt to them. Furthermore, those disallowed losses must be treated as incurred by the corporation in the succeeding tax year. However, 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.”
The normal basis limits continue to apply. The losses and deductions passed through to a shareholder may not exceed his or her adjusted basis in the S corporation’s stock.
A financially troubled shareholder
If the chiropractic practice operating as an S corporation is financially distressed, one or more of its shareholders may also be facing personal financial problems.
Whether because the shareholder acted as a guarantor of the practice’s debt or is liable for amounts loaned to or invested in the practice, the shareholder will often seek bankruptcy relief at the same time the practice is.
The filing of bankruptcy by an S corporation does not create a new taxpayer; the S corporation continues its existence and its status is not affected. However, when an S corporation shareholder individually seeks 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 bankruptcy filing, 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. Debt cancelled by bankruptcy or when the practice or the shareholders are insolvent, as well as the discharge of qualified real property business indebtedness, are notable exceptions to the general rule.
A chiropractic practice, unless operating as a regular ‘C’ corporation, can choose to exclude amounts realized from the discharge of debt related to real property used in a trade or business and secured by that property. To be excluded, the debt must be to acquire, construct, or substantially improve the real property.
Whether the practice 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, these strategies may help save your S corporation’s status, allowing it to continue to pass its tax benefits along to its shareholders.
Mark E. Battersby is a tax and financial advisor, freelance writer, lecturer, and author with offices in suburban Philadelphia. He can be reached at 610-789-2480.
DISCLAIMER: The author is not engaged in rendering tax, legal, or accounting advice. Please consult your professional advisor about issues related to your practice.
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