Update on S-Corporation Failure to File Penalty

I had previously discussed this issue in my 1/22/09 post entitled “S-Corporation Failure to File Penalty”, but there have been so many comments and updates since January that I felt I should post a formal update.  It is an important issue now that the the first few rounds of IRS abatement request responses have been sent out and the fact that we still do not have a Rev Proc similar to 84-35 (automatic abatement for partnerships) issued to address this penalty.

Just to quickly review the basics from the previous post, this penalty is charged to S-Corporations that failed to file their 1120S return timely, which means you either failed to extend your return and filed after the March 15th deadline, or you extended but did not file by the September 15th extended deadline.  Other details of note on the penalty:

  • Begins for returns filed after 12/20/07
  • $85 per shareholder per month late ($89 for returns due after 12/31/08)
  • Applies to any entities taxed as an S-Corporation

I recently sent an abatement letter for a client that used some of the language from Rev Proc 84-35, and even though the IRS abated the penalty, they made a point about the fact that they did not base the decision on any reasoning from 84-35.  In the response letter, the IRS stated that the abatement was ”based solely on the fact that you have a good history of timely filing and timely paying”. They also stated the removal was a “one-time consideration” and that future penalties would only be abated if the information met the “reasonable cause criteria”.

The thrill of getting the penalty abated quickly faded as I realized that this is not good news for S-Corporations if a Rev Proc similar to 84-35 is not forthcoming.  Based on recent reports of plummeting Federal tax revenues, I doubt we will see a Rev Proc anytime soon that would provide automatic abatement for small S-Corporations like we have for partnerships, so I would definitely suggest a few things with regard to requesting abatement of this penalty:

  • If you request abatement of penalties, do not use any language from Rev Proc 84-35 – you are just inviting a short lecture from the IRS.
  • If you have a history of timely filing and paying, state this in the letter as the reasoning for your abatement request along with an apology or two.
  • If you do not have a good history – hopefully you have a sad story of unusual circumstances that will work as reasonable cause.  In my experience, the IRS rarely abates penalties for reasonable cause.

Lastly – in the future, FILE TIMELY!  March 15th is the deadline and if you are not going to be able to file by that date, make sure you call your CPA or accountant to make sure an extension is filed.

If you received a penalty notice and would like assistance in dealing with the IRS, feel free to contact us to find out more about our services.

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To 179 or Not to 179

International CXT

For most business owners faced with questions on how to depreciate their fixed assets, usually the most common response is to expense as much as possible using Section 179 and then depreciate the remaining portion using MACRS.  This makes sense and usually saves considerable tax in the current year; however, you might want to put some more thought into that question the next time your CPA calls when working on your tax return as there are some additional considerations that you should be aware of:

1) Recapture

Like a ghost, recapture can come back and haunt you and the great deduction you took a few years may end up costing in the end with a higher tax rate on the gain from sale of the asset.  Capital gains rates are great right now (although that may be changing after the elections), but if you sell personal property that you took 179 depreciation on, you will end up with ordinary income rather than the capital gain you were hoping for.  The formulas are complex and it is something you would have to sit down with a CPA or accountant to discuss fully and apply it to your specific circumstances, but the bottom line is that you need to consider how long you will be holding a fixed asset when you are deciding on depreciation.  If you are planning on selling the asset after a few years, MACRS depreciation could be a better route to go in the long run.

2) The “Next Year”

Life is great in a tax year when you have a big 179 depreciation deduction, but what about the “next year”?  Lets say you had a good year and made a healthy net income, so in December you bought a ton of new equipment, or maybe a new commercial van that still qualifies for Sec 179 (maybe the above pictured truck over 14,000 GVW).  April comes and you get a big refund and your safe harbor estimated tax payments are nice and low – life is good.

You have another good year and get to December, but the problem is that you do not need much new equipment because of all you purchased last December and trading for a new vehicle using a 1031 exchange will have minimal impact.  Luckily, you realized the problem from reading my blog and called your CPA before year-end to get your 4th quarter estimated tax payments adjusted; however, this is not often the case.  For most, the “next year” can be painful – especially for those who file closer to October 15th.  Estimated tax payments are always based on 100% of the prior year tax liability less withholdings (110% if AGI is over $150k), and so if Sec 179 depreciation lowers you taxable income by $50k, you will be paying estimates based on that reduced amount.  Then the next year if business net income was the same but you only have $10k in Sec 179 deductions, your taxable income is going to be $40k higher – which can result in large amounts due with the return since your estimates were based on the reduced income from the prior year.   The next thing you know you are learning about installment agreements.  😦

3) Shareholder Basis Issues

If you are an S-Corp and you max out your 179 depreciation deduction ($125k for 2007, $250k for 2008 due to the Economic Stimulus Act), you could end up with a large loan to shareholder balance on your tax return.  This results mainly because most smaller S-Corporation owners take distributions based on cash flows and book net income; however, deductions like Sec 179 cause a distortion of net income on the tax return and a timing difference (as an asset that would have been depreciated over 5 years is now expensed completed in the current year).  If taxable net income is much lower than the book income that the distributions were based on, then you can end up with distributions in excess of your debt basis to the point where you have reduced retained earnings to zero and the excess distributions become a loan to shareholder account that technically you should be charging regular interest on (unless you want to take the excess distributions as capital gain).  The banker will then look at your return and see that you owe the company a large sum, and even though they understand Sec 179 and timing differences, they still do not like seeing this account when renewing a loan.  It is definitely something to consider if you have similar circumstances and you have to face renewal every year.

Bottom line – think before you 179 and always look to the “next year” and beyond.

Incorporation Breakeven Point?

1120S

In talking with non-incorporated small business owners that are not clients of our firm, I often ask why they have not formed an S-Corporation for their business.  A common response I have been hearing is that their accountant or CPA told them that they had not reached the “breakeven point” for incorporating.  Some have even told me that their accountant or CPA actually quantified the “breakeven point” at a specific sales dollar amount.

Now, while I agree that some smaller businesses are better off as sole proprietorships, I disagree with this type of broad recommendation and concentrating too much on income as your deciding factor on whether to incorporate or not.  There are many other factors and benefits to consider…

1) Reduction of Audit Risk

Many often overlook this benefit of incorporation because they think it will never happen to them or they just don’t like thinking about it; however, it is definitely a benefit of forming a corporation and it is especially beneficial for industries with high audit risk like construction and restaurants.

Last year the IRS hired a large number of auditors in Portland and cities around the country and really ramped up compliance audits.  Having been through several audits of sole proprietorships reported on a Schedule C in the last few years, I have witnessed first hand the the inconvenience and cost related with going through an audit.  It is very “taxing” mentally, emotionally, and physically even when you have a CPA or lawyer to represent you, so I would definitely consider these costs when considering incorporation if you are in a high risk industry.

I am not suggesting that S-Corporations are free from audit risk; in fact, they have their own audit issues like reasonable compensation and excess distributions.  Rather, in general the audit risk is simply lower than with a businesses reported on Schedule C.  Also, corporations require much more detailed records and reporting, so usually the chances of errors are much lower.  I have seen some accountants make some fairly material errors simply because it was a Schedule C and a balance sheet was not required.

2) Limitation of Liability

Many business owners overlook this benefit as they believe they are protected by their insurance, or they simply think it will never happen to them.  However, in today’s litigious society with lawsuits abounding, you need to protect your personal assets and a corporation clearly separates corporate and personal assets and limits your liability in most cases to the assets of the corporation.  You should always seek the counsel of a lawyer regarding the specifics of your circumstances; however, if a business owner is in a field that has high risk of lawsuits, then an S-Corporation could really minimize that risk as opposed to staying a sole proprietor and running the risk of facing a lawsuit that can reach your personal assets.

3) Better Financial Documentation

The fact that you have to report more financial data to the IRS and keep more accurate records is often looked on as a downside to S-Corporations; however, I have seen an upside with this in the S-Corporation clients I have worked with over the years – the S-Corporation pushes you in the direction of better bookkeeping.

Sole proprietorships tend to have very poor books and records primarily because they do have to report a balance sheet.  Often, sole proprietors submit a list of expenses, a box of receipts, or even worse – an inter-mingled mess of business and personal expenses that you are magically suppose to be able to separate.  This lack of internal organization and separation of the business entity leads to poor decision making as there is nothing close to a financial statement that the business owner could review and base decisions on.  As a CPA, I see this all the time and you have to wonder how people stay in business like this.

It may take a few years after incorporation, but most small S-Corporation owners have to start keeping better records.  Loans have to be tracked and reconciled, shareholder activity has to be documented and recorded accurately, payroll has to be processed, and reimbursements have to be made for expenses paid personally.  Over time, and with the help of software, this becomes easier for the business owner and eventually they are using the internal financial statements and reports in business decisions and planning.  Yes, it is much more costly and time-consuming, but I see the S-Corporation as the much needed motivation to force us into effective business operation as financial reporting is vital to a successful business.

4) Wage & Payroll Tax Considerations

Another factor you have to look at is the industry the business owner operates in and the level of wages that would be considered “reasonable” for work that the business owner performs.  In some industries and in some positions, an average, reasonable wage that you would find in a salary guide is going to be much lower than others – which means greater tax savings with an S-Corporation since you only pay the equivalent of self-employment tax on the wages paid to the shareholder.  A dentist or doctor is going to have to have a much higher wage than a contractor or a consultant, so again – you cannot look purely at a sales volume breakeven point.

You also have to look at the number of employees that the business will have and the turnover.  With the Oregon Employment Department, if you only have minimal number of employees and low turnover, then after two years you could qualify for the lowest state unemployment rate – which is now at 0.7%.  Savings from incorporating will be much greater than a business owner with high turnover .

The Bottom Line

I admit, I am quite partial to the S-Corporation; however, it is not right for every business and situation.  However, the most important thing to remember with incorporation or any tax decision is to consider more than just the tax dollar savings.  There are always many other factors to consider and I strongly recommend talking with your accountant or CPA and have them walk through all the costs and benefits with you.  If you are looking for a CPA in the Portland area, we would be love to talk to you.  www.PandGCPA.com