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Placing an S Corporation on the Cash
Basis for Certain Expenses Paid to Shareholders Editor: Editor’s
note: This case study has been adapted from PPCs Tax Planning
GuideS Corporations, 18th Edition, by Andrew R. Biebl, Gregory B.
McKeen, George M. Carefoot and James A. Keller, published by
Practitioners A special rule applies to expenses paid by an accrual-method S corporation to a cash-method shareholder, if paid after the end of the corporations tax year. According to Sec. 267(a)(2), the corporation cannot deduct such expenses until they are includible in the shareholders income; in other words, the corporation is placed on the cash basis for these expenses. (As illustrated in the final example, this rule does not cause a problem if the S corporation and shareholder use the same tax year.) Under Sec. 267(e)(1)(B)(ii), this rule applies to an expense paid to a person who owns (directly or indirectly) any of the S corporations stock.
Example Jancorp is an accrual-method S corporation with a September 30 year-end. On Sept. 30, 2005, it owes $1,500 in equipment rent to Janet, its sole shareholder, and pays her on Oct. 1, 2005. When does Jancorp take the deduction for the rent? When is the income taxable to Janet? Even though the rent is properly accruable on September 30, Jancorp cannot take the deduction until it pays it. Thus, the corporation shows the expense on its return for the year ended Sept. 30, 2006. Janet, however, must report the income on her 2005 return. To summarize, Jancorp takes the deduction when the expense is paid, instead of when accrued, and will show the expense on its return for the year ended Sept. 30, 2006. Janet must report the income in the year before the year in which Jancorp is allowed the deduction.
Strategy Planning is needed to ensure that the corporate deduction and the inclusion in shareholder income occur in the same tax year. To prevent mismatching, Jancorp could have paid the expense on Sept. 30, 2005. It would then show the deduction on its return for the year ended Sept. 30, 2005; Janet would show the income on her 2005 return. Alternatively, Jancorp could have waited until Jan. 1, 2006, to make the payment; in such case, both the corporations expense and Janets income would be reported in 2006. However, the tax adviser should be alert to circumstances when it would be favorable to have an item included in income, even though the S corporations expense is not deducted until the next tax year. Example: Janet has a net operating loss (NOL) carryforward she will apply against her 2005 income. In 2006, she will have a significant amount of taxable income. If Jancorp pays the rent on Oct. 1, 2005, Janet can use the NOL against her income (that includes the rental payment) in 2005. The corporation will deduct the expense in the year ended Sept. 30, 2006. The expense will reduce Jancorps passthrough income to Janet, and will effectively lower her 2006 taxable income.
Eliminating Mismatching The potential for mismatching shareholder income and corporate expense under this rule does not exist if the corporation and shareholder both use a calendar year. Example: Jancorp is on a calendar year, accrues the rent on Dec. 31, 2005 and pays it on Jan. 1, 2006. The corporation takes the deduction on its 2006 return; Janet reports the income in 2006. |
