Distributions from Partnerships and S-Corps

On several occasions, the following scenario has played itself out in my office: client comes in very excited, exclaiming that they are "going out on their own".  We file all the necessary paperwork to get an employer identification number, articles of incorporation, and have a quick run-through of how to keep up with income and expenses.  Then, they are on their merry way.

About a month later, the client calls and asks "how do I pay myself?"  

This is a common issue for small business owners, especially when they are set up in partnerships or S-Corps.  To begin, partners in partnerships typically do not draw salaries, and S-Corp shareholders only draw "reasonable compensation" during the year.  The remainder is taken by the partner/shareholder as a distribution, loosely defined as taking cash out of the business.  

Here is an example.  Jim is the 100% shareholder of Jim's Tools Inc, an S-Corp.  For the year, Jim has taxable profit of $100,000.  Of that, he pays himself a salary of $30,000, leaving the company with a $70,000 profit.  Jim will pay taxes on both his $30,000 paycheck and the $70,000 profit of the business on his personal return.  Assuming he is in the 25% tax bracket, his tax burden will be $25,000 ($30,000 paycheck + $70,000 business profit x 25% tax rate).  Based on these facts, he is permitted to distribute up to $70,000 of cash from the business to himself.  At the end of the day, he is left with $75,000 in his personal bank account after paying taxes.  

Partnerships work in a similar way, minus the salary.  The big difference is that the income from a partnership is likely to be subject to self-employment tax, since there is no salary involved.  In an S-corp, the shareholder will pay self-employment tax (payroll taxes of FICA and Medicare) on their paycheck.  Since a partnership does not pay a salary to the partner, the partner is responsible for this on their personal return.  But, distributions work the same way: if a partner has net profit for the year of $100,000, they will pay ordinary and self-employment tax on that money, but will be permitted a distribution up to $100,000.  

The main thing to remember is that S-Corps must pay a reasonable salary during the year to its shareholders, which is the tradeoff for the net earnings from the S-Corp not being subject to self-employment tax.  Partnerships and S-Corps should also keep track of their distributions during the year for reporting on the tax return at the end of the year.  



2016 filing season in review

When tax season comes to an end, I always like to take a moment to look back and see what went right, what went wrong, and what were the big issues of the season.  The 2016 filing season brought several challenges - health insurance forms no one understood, more late 1099's from investment companies, late depreciation laws, and constricted tax brackets.  But there were also some positives with decreased identity theft returns and better e-filing.  Following are just a few thoughts on the last 109 days.

Everyone owed taxes

I'm just going to be honest, the withholding tables don't work.  If you make more than $40,000/yr and/or your spouse works, you cannot rely on the withholding tables.  The tax brackets were constricted in 2015, meaning that taxpayers creeping into higher brackets owed more tax than was withheld.  Furthermore, in Arkansas, the withholding tables were updated to reflect new tax rates, yet several employers were either unaware or neglected to update employee withholding.  For example, the Little Rock School District sent a letter to all of their employees in February 2016 saying they used incorrect withholding amounts for their employees for 2015 and as a result they might owe tax.  If you owed tax, it's time to re-evaluate your withholding and make sure your W-4 is filled out correctly.  

Health insurance forms

Did you have health insurance all year?  Did it meet the essential minimum coverage requirements? If you didn't have coverage, do you qualify for an exemption?  Did you obtain insurance from a subsidized exchange?  Do you owe some of your premium tax credit back?  These are all questions I got really tired of asking.  On top of that, taxpayers got 1095 forms, and then voided 1095 forms, and corrected 1095 forms, or they didn't get them at all.  And, if a return was filed before a corrected 1095 form was received, the taxpayer received a notice.  I'm all about having a fair system and giving everyone an equal shot at affordable healthcare, but when it spills over into the tax world, the reporting should be held to the same standard as everyone else.  

Late 1099's

i understand the wash sale rule probably more than most people.  I understand the value of waiting until the end of January before brokerages with transactions can start putting together their 1099's.  But logistically, you have to think by the end of January they will know dividends, interest, etc. and all they are waiting on is to see if there are any wash sales.  When taxpayers that used to file in late February are now filing in late March because they don't get their 1099 until early March, it puts a lot of pressure on the system.  Hopefully as the cost basis and wash sale reporting gets under control, investment companies will be able to issue their 1099's earlier.  

Identity theft returns

It would appear (knock on wood) that the IRS has somewhat combated the filing of false tax returns.  For example, our firm did not have nearly the number of rejected returns as a result of something already having been filed as in prior years.  It will be interesting to see what happens on extended returns over the next few months, if the hackers have figured out to file after the deadline instead of early in the season.  

In all, the filing season went okay.  Now it's time to sit back, take a deep breath and a nap, then get to work on the extensions.  

Arkansas Early Childhood Education Credit

NOTE: This article has been updated after discussions with the Arkansas DFA.

Think having kids wouldn't pay off?  Think again.  

A credit is available to Arkansas taxpayers for dependents enrolled in a certified Early Childhood Education (ECE) facility.  The credit is worth 20% of the taxpayer's Federal dependent care credit.  The credit is in conjunction with the normal dependent care credit allowed to Arkansas taxpayers.  in short, a taxpayer with a child enrolled in an ECE facility can get a total credit of 20% of their Federal credit, part of which is refundable.  

AR taxpayers are entitled to the normal 20% of their Federal dependent care credit, but if their child attended a certified facility, then their credit is refundable.  

In order to claim the credit, the taxpayer must obtain a Form AR1000EC from the certified facility.  This form will have the facility's certification number and date certified, which the taxpayer will need both of to complete their return.  

It is important to note that not all facilities are ECE certified.  Therefore it is important for the taxpayer to request the Form AR1000EC early on so they will know if they are eligible for the credit.  

Why Depreciation No Longer Exists for Small Businesses

With Congress' passage of the Protecting Americans From Tax Hikes Act of 2015 (PATH), Congress did more than just protect Americans from tax hikes...they eliminated depreciation altogether for most small businesses.  

In PATH, Congress extended Section 179 depreciation permanently, which means that from 2015 until infinity, a business can expense 100% of the cost of most new or used assets in the year of purchase, as long as the cost doesn't exceed $500,000 or the total assets purchased don't exceed $2 million.  

This new law achieves what small business owners have been vying after for some time - that cash spent is directly related to a tax deduction.  

Couple this new law with the repair regs, which allow a small business to elect all expenses $2,500 or less are repairs and maintenance, and Congress has effectively eliminated the need for depreciation to extend over a number of years.  

Think about it: if a small business buys a new computer for $1,000, they can expense it.  If they buy a new x-ray machine for $25,000, they can expense it.  The only time a small business will get into a situation of having to depreciate an asset is if it does not qualify for Section 179 or it costs more than $500,000.  

This is a dream come true for small business owners that live by cash flow and want all of their purchases to translate into tax deductions.