Here are today’s four hottest tax issues for closely held businesses, together with ways to take advantage of new opportunities, protect yourself from becoming an audit target, and avoid unfavorable tax treatment…

HEALTH COVERAGE DEDUCTION

More-than-2% S corporation shareholders cannot deduct their health insurance premiums as a business deduction. The premiums are fully deductible, if otherwise qualified, as an adjustment to gross income (on page one of Form 1040). In the past, the IRS has made it clear that for a sole proprietor, the premiums are deductible whether the policy is purchased in the name of the business or in the proprietor’s name.

The problem for S corporation shareholders: The IRS had said in 2006 that only coverage for a company plan qualified for this deduction. Premiums paid on a health plan in the individual’s name would be deductible only as an itemized medical expense to the extent that medical costs exceed 7.5% of adjusted gross income (AGI).

New opportunity: Now, the IRS has changed its view. An above-the-line deduction is allowed for premiums on health insurance policies held in the owner’s (rather than the corporation’s) name if the corporation…

  • Pays the premiums or reimburses the owner for them.
  • Includes the payments as wages on the owner’s W-2 form. Note: Even though the payments are wages, they are usually not subject to Social Security and Medicare (FICA) taxes.
  • Refund potential: S corporation shareholders who failed to claim an above-the-line deduction on their 2006 returns, but qualify under the new tests, should consider filing an amended return. Write “Filed Pursuant to Notice 2008-1” across the top of Form 1040X.

    SHAREHOLDER COMPENSATION

    The National Taxpayer Advocate, an IRS employee whose job it is to protect the rights of taxpayers, criticized the IRS for not paying enough audit attention to S corporations that have been avoiding employment taxes by underpaying compensation to owners. This underpayment resulted in an estimated $5.7 billion of the tax year 2000 tax gap (the spread between what the government collects and what it should collect).

    Why the S corp gap? A shareholder pays income tax on his/her share of the corporation’s net earnings as well as on any salary paid to him — but only the salary portion is subject to FICA taxes. Effectively, the shareholder’s income taxes are the same regardless of how money is characterized, but both the shareholder and corporation save employment taxes if there’s little or nothing counted as “salary.”

    The courts have consistently supported the IRS’s assertion that an owner who performs services for the corporation must be paid “reasonable compensation” — paying out no compensation is clearly unreasonable. The issue: What’s reasonable?

    The IRS has created an “inadequate compensation” project to address the issue. Factors likely to come into play…

  • The owner’s role in the company — hours worked, duties performed.
  • Comparison with other companies — comparable pay for comparable work.
  • Condition of the company — the more profitable, the better able to pay higher compensation.
  • Hypothetical investment test — what would a hypothetical investor in the company think is reasonable compensation?
  • Pitfall: In view of this new IRS project, expect to see increased scrutiny of compensation paid to S corporation owner-employees. Affected corporations should pay appropriate compensation to thwart possible challenges.

    RECLASSIFICATION OF WORKERS

    There has been an ongoing battle between the IRS and businesses over the classification of workers as employees or independent contractors. The IRS prefers the “employee” designation because this means that companies are responsible for employment taxes. (They have to withhold income tax and the employees’ share of FICA as well as pay the employer share of FICA and unemployment taxes.)

    Companies usually prefer “independent contractor designation,” since this means that workers are responsible for their own taxes — companies need only report payments of $600 or more annually to workers on Form 1099-MISC.

    The IRS has become even more aggressive in pursuing this issue. Recent steps…

  • There is a new form — Form 8919, Uncollected Social Security and Medicare Tax on Wages — that workers are encouraged to file if they perform services for a firm that did not withhold FICA from pay and the worker believes he is an employee. (There are seven reasons listed that could be foundations for this belief, such as the fact that coworkers performing the same jobs are treated as employees.) The form alerts the IRS to review the worker’s status at the employer level.
  • A new audit program is in the works. The IRS has informally let it be known that it will be using a new electronic matching program to find companies that pay at least five workers $25,000 or more whom they classify as independent contractors where such workers do not perform services for any other businesses. In the IRS’s view, these workers are effectively employees and should be treated as such.
  • Bottom line: Review your worker classification to be sure that you’re treating workers properly. For more information, listen to the IRS Tax Talk Today podcast recorded on November 6, 2007, entitled “What’s Hot in Employment Taxes: Independent Contractor or Employee?” at www.taxtalktoday.tv.

    DEDUCTION OF A BUSINESS’S EXPENSES

    In small businesses, owners often take a casual approach to paying bills — they view their pocketbook and the company’s as one and the same. Tax-wise, this can be risky, as demonstrated by some recent cases. Tax impact of an owner paying the business-related bills…

  • Corporations. A shareholder who is required to pay business-related expenses without reimbursement from the corporation can deduct these costs only as a miscellaneous itemized deduction. This means that an amount equal to the first 2% of AGI becomes nondeductible. And, if the shareholder is subject to the alternative minimum tax, he loses any tax benefit from the write-off.
  • Trap: A corporate resolution requiring a shareholder to pay certain expenses of or for the benefit of the corporation clearly establishes that they are the shareholder’s obligation. (That is, the expenses are deductible only on the shareholder’s personal tax return as a miscellaneous itemized deduction.) The shareholder cannot circumvent this rule by claiming a deduction on Schedule C of Form 1040. As the Tax Court has now reinforced, the shareholder is not a sole proprietor, but rather a shareholder-employee whose unreimbursed employee business expenses can only be claimed on Schedule A of Form 1040.

    If there is no corporate resolution requiring the shareholder to cover these expenses, then the shareholder’s voluntary payment is treated either as a contribution to the capital of the corporation (which increases the shareholder’s basis in his stock) or as a loan to the corporation. For an S corporation shareholder, loans to the corporation increase basis in debt — the measurement for deducting losses that pass through from the corporation to the shareholder. Only the corporation can claim a deduction for these expenses.

    Best way: The corporation should create an accountable plan to reimburse shareholders for their payment of corporate expenses. In this way, the shareholders have no income from the reimbursements (they are simply made whole) — the corporation deducts the expenses that the shareholders have paid on its behalf.

  • Partnerships. In contrast to corporations, when a partner is required — as written into the partnership agreement or by another written agreement between the partners — to pay partnership expenses, the partner can deduct the amounts he paid. The deduction is claimed on Schedule E of Form 1040, so the partners get the full benefit of the write-off.
  • Note: The same treatment would apply to limited liability companies that are taxed as partnerships.