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Lane
Lane, JD, CFP, MBA, CRPS
Category: Tax
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Experience:  Juris Doctorate, CFP and MBA, Providing Financial & Tax advice since 1986
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Question for NPVAdvisor . They say An S Corporation can have

Customer Question

Question for NPVAdvisor . They say An S Corporation can have only one class of stock, all outstanding shares of the corporation's stock confer identical rights to distribution and liquidation proceeds. Can you clarify this? Does that mean the share percentage should be equal, for example, two shareholders must have 50/50 %, or it can be 60/40 %? Or they are just talking about the type of stock? Also, what are the options to offer stock as an incentive to employees?


And how would that be treated on an S Corp side and on an employee side? Would an employee of an S Corp who gets stock for example at 2% share be issued a K1 with pass through 2% share of net income/loss from an S Corp?


 

Submitted: 1 year ago.
Category: Tax
Expert:  Lane replied 1 year ago.

NPVAdvisor :

You have it right, the are just talking about the TYPE of stock ... in other words, you can't have preferred shares, for example, where those preferred shareholders would get preference upon liquidation of the failing of the business

NPVAdvisor :

The percentage of ownership can be whatever you want ti to be ... and siply issuing the number of share to the founders that coincides with the % of ownership (and capital contributed) is a clean and simple way to do it

NPVAdvisor :

If you did offer shares to employees, that's fine.

NPVAdvisor :

THey will just need to report that as income based on the fair market value of the stock at the time it is provided

NPVAdvisor :

DO remember, however, that one that person becomes an s_corp shareholder ... because the S-Corp is a pass-through, they will be taxed on their proportionate share of profits every year

Customer:

So they will get a K1 with pass through share that will be taxed?

NPVAdvisor :

S-corps, like unlike C-Corps are passthroughs (just as are sole proprietorships, partnerships and LLCs by default)

NPVAdvisor :

ONly C-Corps and trusts pay their own taxes... the rest pay taxes on the profits as they happen, whether those dividends are distributed or not

Customer:

Yes I know that, just trying to understand how it would affect an employee if the stock is issued?

NPVAdvisor :

Onle last piece as a heads-up... you CAN have voting and non-voting shares, this doesn't break the one-class rule

Customer:

Also, can you give me some information about stock employee incentive options for an S Corp that is not publically traded?

NPVAdvisor :

Sure hang on a sec, I just saw an excellent piece on this ....

Customer:

I am confused how does that work. For example, two people open an S Corp with 50/50. How do they issue stock to employees? Do they have to sell their own shares?

NPVAdvisor :

What the S-corp s first approved... there are a number of share approved (by the board of directors) and a number issued

NPVAdvisor :

The issued shares are usually what's apportioned to te founders

NPVAdvisor :

Then you can issue more stock to the others asyou see fit

NPVAdvisor :

THis does, of cour dilute the percentage of ownership that the founders own

NPVAdvisor :

you CAN also simply sell your shares

Customer:

Ok so for example, they can establish an S Corp 50/40 % and have 10 % as outstanding to give to employees?

NPVAdvisor :

Actually, in that scenario, you would authorize, say, 100 shares, then issue 40 to one owner and 40 to the other (it's only issued shared that have any value)

NPVAdvisor :

then later go ahead and issue the additional share either as compensation or you could sell them to raise additional cpital

NPVAdvisor :

either way, your original 50/50 ownership would be diluted ... in that example it you issued the ramianin 10 all at one time, you'd have a 40% a 40a5 some other owners that own 10% together

NPVAdvisor :

sorry for the typos ... 1 40% owner ... another 40% owner and then (again, if you issued to remaining 10 shares to say 10 people) you have those 10 people owning the remaining 10% of the company

NPVAdvisor :

You'd really need to retain an attorney to draw up contracts for this, but you could also do stock options:

NPVAdvisor :

Nonqualified Stock Options. Instruments granted by the corporation to the
employee, giving the employee the right to purchase corporate stock at a designated price through
some future date. Under IRC §83(e)(3), options are not taxed at the date of grant unless they have a
readily ascertainable fair market value. Must be careful that options do not create a second class of
stock and violate S corporation status.

Customer:

So when you originally establish an S Corp, you have to do fully 100% and then later you can give shares to employees? I am totally confused about percentage and stock how it plays together?

NPVAdvisor :

That wuld be what's called non-qualified stock options

NPVAdvisor :

You could also do Inventive stock options:

NPVAdvisor :

Incentive Stock Options. An option to purchase stock in the corporation at
some future date. However, incentive stock options allow the holder to receive special tax treatment
upon their exercise that is not available to the holder of a nonqualified stock option, provided the
incentive stock option meets rigid statutory qualifications. See IRC §422. If these requirements are
met, the holder may generally exercise the options free of tax, and postpone the taxable event until
such time as the stock received is sold (after a two-year holding period of the option and a one-year
holding period of the stock) for capital gains treatment.

NPVAdvisor :

Think of it this way. If there are 100 shares out there (actually issued) then the number of shares owned represents the percntage

NPVAdvisor :

issue 100 shares? each owner will (if you want 50% ownership) own 50 shared

NPVAdvisor :

shares

Customer:

Ok, got it. So it doesn't seem like a good idea to do as employees will have to pay taxes on the share of % net income that will pass through from an S Corp, correct?

NPVAdvisor :

Yes, thats the biggest problem S-Corp owners face who do that.... the additional shareholders get a K-1 and have to pay tax on the profit

NPVAdvisor :

(in terms of issuing additional stock)

Customer:

Are there any tax benefits to do it for the company at all?

NPVAdvisor :

It DOES pass some of the tax burden to those shareholders ... and it offsets the need to pay out cash flow as compensation

NPVAdvisor :

but remember the S-corp doesn't really have tax issues, it's a 100% pass through ... the shareholders have tax issues

Customer:

Right, but with issuing stock I am assuming they will want some distribution from the net income of an S Corp

NPVAdvisor :

Well, thats right (I would!) BUT you don't have to. The board of directors makes that decision

NPVAdvisor :

Thatrs exectly where the rub comes so many ntimes

NPVAdvisor :

THe board/officers decide to keep the money in the business checking but those "distributive shares of profits" they're called, come out on a K-1 to all the shareholders in proportion to the amount of the company they own

NPVAdvisor :

and those K-1s flow to the shareholder's 1040 n line 12 (business income or loss)

Customer:

Right. Another quick questions if you are familiar with that... Charitable contributions don't get recorded as a business expense on an S Corp but it pass through to the shareholders and they deduct it on their personal schedule A , correct?

NPVAdvisor :

that's exactly right ... the S-corp is not a taxable entity

NPVAdvisor :

it can deduct operating expenses from it's profit, but it can't contribute capital... as the capital is really in the hands of the shareholders

NPVAdvisor :

also one more thing to kep in mind.... shareholders that didn't contribute anything to the company do not get to take even the operating losses

Customer:

I guess my question is then if an S Corp gives charity to church for example, then how it gets recorded on books? Does it go under equity and then included on everyone's K1s?

NPVAdvisor :

that's why the books have to account for capital accounts... when someone buys share from an original owner, then they've contributed capital and can deduct ther proportionate losses UP TO that amount contributed

NPVAdvisor :

There's no reason that I can think of for the S-corp to contribute... just have the taxable entities do it directly

Customer:

Losses can be deducted up to your basis, to my understanding

NPVAdvisor :

That's right

NPVAdvisor :

that's another reason that compensation as shares ends up upsetting some ... they have no basis, so cannot use the losses in a loss year

NPVAdvisor :

on the charitable deduction... it's ging to end up on the indivuals schedule A , so why run it through the S-Corp

Customer:

Well, sometimes businesses give charity from their business account so trying to figure how to account for that and how to record it....

NPVAdvisor :

Sure, you can do it.... maybe to build goodwill in the comunity... advertising in effect

NPVAdvisor :

But it's just another item of expenses and ends up lowering the owner's profit

Customer:

yes but what if its not to build good will, just plain charity giving from an S Corp or even sole proprietor business

NPVAdvisor :

again, seems to me it's just extra record-keeping

NPVAdvisor :

S-corp gives it, becomes and expense on the 1120 and that lowers the profit (income) to the owner

NPVAdvisor :

... owner gives it directly (also lowers income of the owner) by the ame amount an limited in the same ways

NPVAdvisor :

running it through the S-corp is just extra entried for the same net effect

NPVAdvisor :

(sorry again0 "extra entries"

NPVAdvisor :

that's the whole point

NPVAdvisor :

S-corps. sole proprietors, Partnerships, LLs not elecing to be taxed as C-corps are not taxable entities

NPVAdvisor :

they are pass throughs

NPVAdvisor :

alter-egos, if you will

Customer:

Yea but not in the same way , as the net income will get reduced instead of a shareholder itemizing the deduction on a schedule A

NPVAdvisor :

but its the same

NPVAdvisor :

lowers income b the same amount

NPVAdvisor :

shcedule a reduces taxable income dollar for dollar

NPVAdvisor :

a business espenses lowers profits (taxable income) dollar for dollar

Customer:

OK. Seems like issuing stock is a bad way to motivate employees, could end up quite the opposite due to all complications

NPVAdvisor :

for S-Corps yes, there are definitely some snags

NPVAdvisor :

Here's an excellent article on some of these issues:

Customer:

only corporations can issue stock, correct? Not the LLC or any other entities?

NPVAdvisor :

that's right

NPVAdvisor :

LLCs have members

NPVAdvisor :

partnerships have partners

NPVAdvisor :

sole proprietorships have proprietors :)

NPVAdvisor :

One of the reasons to go S-corp rather than LLC IS the ability to raise capital later through the issuing of additional stock

NPVAdvisor :

while retaining control (by not distributing VOTING shares)

Customer:

I am thinking the best way to go is an LLC but being taxed as an S Corp

NPVAdvisor :

Byt LLCs provide ALL of the best parts of the corporation (separation of business assets from personal assets, for liability, creditor, lawsuits, etc)

NPVAdvisor :

withough all of the formatlities of the corporation

NPVAdvisor :

AND you CAN elect S-corp treatment later on

Customer:

Right, that's probably the best

Customer:

ok, thank you

NPVAdvisor :

You're very welcome

NPVAdvisor :

If this HAS helped, I would appreciate a feedback rating of 3 (OK) or better … That's the only way they will pay us here.


HOWEVER, if you need more on this, PLEASE COME BACK here, so you won't be charged for another question.

Lane, JD, CFP, MBA, CRPS
Category: Tax
Satisfied Customers: 4379
Experience: Juris Doctorate, CFP and MBA, Providing Financial & Tax advice since 1986
Lane and other Tax Specialists are ready to help you
Expert:  Lane replied 1 year ago.

Thank you Marina!

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If you'd like to work with ME again just say "For Lane only," at the beginning of your next question.


OR for NPVAdvisor ... both seem to work.

Thanks again!

Lane

Customer: replied 1 year ago.

Hi, I have an issue with doing JE for payroll taxes that were paid this year but there were for wages December last year and since the company had no books last year and wants to start books this year, how to record it correctly without having to reconcile and book 2012 December records?? If you think you can help I will post a questions but I need specific JEs to record it correclty if there is a way..

Expert:  Lane replied 1 year ago.

Marina,

My strengths are in corporation & business entity law, taxation and personal & corporate finance, but this is a question better suited to an accounting person. This is a classic CPA question.

I would post a question that starts with the wording, "I need CPA help on journal entries ... "

Thanks for thinking of me

Lane


Customer: replied 1 year ago.

Ok, thank you! Another question, a person is a Sole propr but on payroll and I know everything about it being wrong, etc. but its too late now so trying to figure how it would affect the 2013 tax returns since he gets a w2,the wages get deducted on a Shedule C so its a wash but still trying to figure if that would affect the botXXXXX XXXXXne on the tax return or not

Customer: replied 1 year ago.


Another thing is when we talked about the ISO stocks, the information I got wasn't quite correct as ISO stock get treated differently than any other stock options. Still need full information on that subject.

Expert:  Lane replied 1 year ago.
The difference will come in the area of self-employment tax (this is why I recommend that as you get to 50,000 or so of profit, an s-corp ALL OTHER THINGS BEING EQUAL may make some sense).



Let's say we have two businesses making the same net profits of $60,000 last year ($5,000/month). The only difference is that X is a Sole Proprietor and Y is the sole shareholder/owner in an S-Corporation.

In the sole proprietorship, there is no difference between X and the business. X has to pay self-employment taxes (Social Security + Medicare) of 15.3% on the entire $60,000 annual net profit, or about $9,200. He also must pay federal and local income taxes on that income.

Y however, wears two hats: she is the sole shareholder of that corporation, and also the sole employee. As the corporation shareholder, she owns a business with $5,000 of overall profits each month, but also pays out $4,000 for that one extremely loyal employee. That means $1,000 per month is not paid out as salary, and will be distributed to the shareholders (her) as dividends, or unearned income.

At tax time, Y gets $48,000 a year in earned income as an employee, and $12,000 in S-Corp distributions as a shareholder. You only pay self-employment taxes on earned income. $48,000 x 15.3% = $7,400. She also must pay federal and local income taxes, the same amount as X.

So as an S-Corporation, Y paid $1,800 a year less than X in taxes.

But for a sole proprietor, it is, as you said a wash here. It's all EARNED, self employment income, whether you "call" it a salary or not.



Customer: replied 1 year ago.


Thank you for your information. It makes sense however what I am trying to figure out is how would it affect the botXXXXX XXXXXne on the tax return if a Sole Proprietor gets a W2 and those wages are deducted on a Schedule C plus the employer tax portion gets deducted so the net income of a Sole propr is reduced by the amount of his w2 wages. Does that make sense? The point is we don't want to get into troubles with the IRS since a Sole prop can't be on payroll to begin with but if it would not change the botXXXXX XXXXXne either way, I don't think we would get into troubles.

Expert:  Lane replied 1 year ago.


If the quarterly payroll taxes were paid and both the employer and employee portions have already been sent in (as if this were an S-Corp and there was nothing but salary - no dividend) ...

... then when you do the schedule C and calculate the self employment taxes appropriately, ... the owner will have paid the self employment tax twice (once as 1/2 employee and 1/2 employer ... and then again as a self employment tax)

Make sense?

Customer: replied 1 year ago.


Right. So you think it would be a wash? His net income gets reduced by his wages and by employer portion tax so he pays SE tax only on that reduced net income .On W2 wages he already paid SE through the payroll. For example, the gross is 20K, his wages 10k so net 10K subject to SE tax instead of 20K if he did not take wages.... The only thing I think would cause a difference would be FUTA and SUTA taxes as that get's paid to and gets deducted as employer tax. What do you think?

 

We just dont want to get in trouble with the IRS and get hit with the penalrties and additional taxes if they recalculate everything as it should be meaning no W2 for the owner, etc... But I can't really figure out if it would change the boXXXXX XXXXXne at all..

Expert:  Lane replied 1 year ago.


That's right, you'll just need to explain in the taxes that the self employment tax was "pre-paid."

Customer: replied 1 year ago.


So I guess the only think the owner is loosing on FUTA and SUTA taxes as the company pays that as well for him but he as an owner does not need to pay unemployment taxes and he can't even get unemployment. Right? But those unemployment taxes get deducted as a business expense together with the employer portion taxes.. I think, thats where the problem can arise

Expert:  Lane replied 1 year ago.

Yes,

In most cases, self employed workers and/or freelance workers who lose their income are not eligible for unemployment benefits.

That's because employers typically contribute to a fund for unemployment benefits for EMPLOYEES and if you are operating as self employed, you would not normally have paid into the unemployment fund.

You may want to call the unemployment office and see if he can get a refund.

http://www.edd.ca.gov/Unemployment/

http://workforcesecurity.doleta.gov/unemploy/
Customer: replied 1 year ago.


I think, for us to get a refund we would have amend all payroll quarterly tax reports and revoke his W2 and correct it to 0...

Customer: replied 1 year ago.


Do you know if unemployment fed and state taxes paid for himself as a sole prop are deductible?

Expert:  Lane replied 1 year ago.

I would say no, as they are not actual tax liabilities.

They were paid by mistake.

I would just ask for a refund.
Customer: replied 1 year ago.


Amazing as so many sole proprietors do that and think it is OK and a right way to pay taxes by putting themselves on payroll.

Expert:  Lane replied 1 year ago.


I have not really seen a lot of that myself, but I'm sure it does happen.

Most, don't want all that extra paperwork.

HOWEVER, I must say that nothing surprises me anymore.

What I think I probably see the most is sole proprietors that don't realize until the start doing their taxes that they even need to do the Schedule C & SE and pay those self employment taxes.

But it really IS all over the board.

Customer: replied 1 year ago.

Right. I have dealt with two sole proprietors so far that pay themselves with W2s....I think, it gets too complicated on many levels, and I heard during the audit the IRS agent won't let it go as there are different rules when it comes to SEP IRA if you use a schedule C or W2...So for me you are just giving a reason for an audit

Expert:  Lane replied 1 year ago.

I completely agree.

This is certainly good experience though.

Once you see these things happen, it's easy to remember to advise clients to think it through ahead of time.

Customer: replied 1 year ago.


Ok, thank you for your help. I still need help with creating the trial balance and ISO stock options. Too bad you aren't familiar with that.

Expert:  Lane replied 1 year ago.


Journal entries not my forte.

ISO's ? ... would be glad to work with you on that one, if you'd be willing to handle it as a different question.

And, positive feedback would be appreciated on this series (gotta pay the bills)

Let me know...

Lane

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Lane
Lane
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Juris Doctorate, CFP and MBA, Providing Financial & Tax advice since 1986