In this video, I’m going to cover the 4 biggest mistakes you can make to generate S-Corp double taxation. And if you thought double taxation was reserved just for C-Corps, then you would be wrong. And if you formed or are thinking about forming an S-Corp because you assume it’s going to save you tax, then you’re going to want to make sure you avoid S-Corp double taxation, which is very easy to trigger. Because S-Corp double taxation is a timing difference, it is always a very bad tax result that is much much worse than C-Corp double taxation. S-Corp double taxation CAN be avoided by tax planning but very often isn’t because you as the business owner need to understand the basics, even if you have a great CPA. There are certain types of businesses that should almost never be S-Corps based on your business model, and even if it makes sense to be an S-Corp, you should be aware of what actions you might take as a business owner that will make it too late for your CPA to prevent double taxation on your return.
And if you’re thinking, well I’ve had an S-Corp for years and I’ve had no problems, you should know that the IRS only just started requiring a new Form to be submitted with your S-Corp return where you’re required to submit enough information for the IRS to know if you’re subject to double taxation. AND the worst part is that if you don’t fill out that form, then the default that gets submitted is THE most unfavorable tax position that the IRS can then use against you later in an audit to subject you to double taxation in that tax year and future tax years even when you shouldn’t have been.
This is one of the most important tax concepts to understand as an S-Corp business owner but it’s also complex. And It’s very rarely explained to clients because it’s based on a more technical tax concept that a lot of CPAs don’t even fully grasp. So let’s get into it.
So what is S-Corp Double Taxation? It’s completely unlike C-Corp double taxation, which consists of income tax and dividend tax. C-Corp double tax happens because your business is making money, either in the current year or cumulatively when looking at prior year profits, and then because you choose to take out the profits, you incur the second layer of tax.
For S-Corps, the first layer of tax for is still income tax, but the second layer is usually a result of taking out the money too early and has nothing to do with whether you are in a profit, in fact, you’re more likely to generate this second layer of S-Corp tax from being in a loss. It’s often the equivalent of getting taxed on loan money, which is supposed to be non-taxable, but TIMING changes your tax result. It is very often the difference between taking out cash from the S-Corp on Dec 31 instead of Jan 1. On Dec 31, withdrawing the money may mean you’re double taxed, but withdrawing on Jan first may mean you’re good to go.
The technical tax term for generating S-Corp double tax is called exceeding tax basis. You NEVER want to exceed tax basis, which is measured as of December 31 of each tax year.
So let’s look at the formula in its most basic form – it’s prior year ending tax basis + capital contributions plus income minus losses minus distributions. It’s a cumulative number, so it needs to be tracked continuously from year to year.
The Top 4 Reasons S-Corp Owners are Double-Taxed
The first and most common reason is that your business has third party debt. If you’re a debt heavy business, unless you’re loaning your own money, then you are going to have to constantly monitor your S-Corp basis. A general rule that will help is keeping enough cash in the bank to at least cover your third party debt. The reason this is a problem is because you’ll notice the formula I gave you earlier doesn’t give you tax basis for third party debt even if you personally guarantee the debt, which is unique to S-Corps. Third party debt gives you CASH that you can withdraw, but doesn’t increase your tax basis, so essentially if you take that cash out of the business, you just triggered the double tax. For example, if your business had 100k of taxable income, plus a 100k loan, then you will have 200k of cash in the bank. You can only withdraw 100k of the 200k in that tax year with only one layer of tax because only the taxable income increased your tax basis, not the debt. Third party debt is very common for businesses that buy business vehicles or other heavy equipment, or buy a piece of real estate for the business. If this is a function of the business you run, then you need to be keeping a healthy business bank account, particularly close to the end of your tax year.
The second reason you may get double taxed is because you’re taking depreciation, especially 100% bonus depreciation. So let’s look at an example. Your business is new and it made 100k of net income. Therefore, you have 100k in the bank as your only asset. In December, you take out a loan of 50k to buy a new business vehicle because you heard from a non-tax professional friend that putting a vehicle on your business is always a great move tax-wise. You then take 100% bonus depreciation on the vehicle because it’s over 6,000 pounds and it’s 100% business use. You now have 50k of taxable income, but still have 100k of cash in the bank since the 50k depreciation you took was not actually a cash outflow. See what just happened here – you increased your tax basis by 50k because it increases only for your taxable income, so if you take any amount out of your bank account over the 50k before December 31, you now exceed your tax basis and have double taxation. Had you waited until Jan 1, you could have made sure to have income the following year to cover the distribution, but you didn’t know and now it’s too late.
The third reason you may trigger S-Corp double taxation is that you have disorganized accounting or inconsistent tax return preparation. I see so many tax basis issues from people keeping bad records. Remember that S-Corp basis is cumulative so issues from your records in prior years impacts your current year basis. The most common issue I see is when people switch tax preparers or go between filing their own return to a preparer and back, they completely lose track of their basis. Then unless you pay your new preparer to recalculate your basis, your beginning basis is often wrong and can generate the double tax on your return.
The fourth reason S-Corp double tax is most often triggered is because of a prior year that was prepared incorrectly. So if you had a preparer who filed your return showing 100k of taxable income, when your taxable income was truly 150k, you only get basis for the actual amount reported. What’s interesting about this one is for other types of business tax returns, those types of mistakes usually leave open exposure just for that tax year, so if it was 8 years ago, then you can usually relax and know that it’s outside the statute of limitations for the IRS to audit you. However, for an S-Corp, that mistake can follow you and create exposure in future tax years since it also didn’t give you the tax basis you need to withdraw the cash from a future year tax free. So you’ll pay capital gains rates at the time of the withdrawal.
Now that you know the most common situations to look out for, let’s go over a couple creative ways the IRS can use this as a sword against you:
First, you can actually look at what the IRS successfully did with PPP funds to make them taxable. So when PPP was passed, Congress tried to make it non-taxable in the code. But the IRS just didn’t want to agree with the view that it was non-taxable. So they said ok sure it’s non-taxable, but then you can’t deduct the wages it covered, which is the same thing as making it taxable. Then when that was shot down by Congress, the IRS said OK fine, but you don’t get tax basis until the loan is forgiven, which means if you pull the funds out too early, then you get taxed on it. So if you got PPP in 2020, but it was forgiven in 2021, then taking too much money out of your S-Corp in 2020 would result in a layer of tax on loan money because of timing and poor tax planning.
Second, I have a whole separate video on this IRS sword called the duty of consistency and I’ve linked to it above. It’s when the IRS can use the fact that you didn’t track your own basis and reported the incorrect tax basis to them on one return, as a reason why you should keep that lower basis. They can say they relied on the information you provided and if it’s detrimental to the IRS for you to change what you reported, then you don’t get to change it even if doing so would make it correct.
And if you have questions about what I just shared in this video and would like to speak with me and my team, then click this link to book a call with us.