Accounting Question.

[Perchoutofwater]

My accountant is out of town until next week, and I had this idea I wanted to run by him, but thought I'd ask some of y'all as well.

 

My company is a S-Corp. This year we are going to lose a substantial amount of money, and in order to keep the bonding capacity where we want it to be we are going to have to reinvest in the company. The way it is set up currently is I own 1/3, my brother owns a 1/3 and my father owns a 1/3. More than likely we will each have to put $XXX,XXX back into the company sometime in December. My father no longer works or draws a salary. My brother work and I both draw salaries.

 

My brother and I both have trusts (to keep the wives at arms length from company) that will pay our portions. Basically all the company stock and all money that has been distributed from the company in past years is in the trusts, and the wives signed prenumps that makes anything left in the trust off limits in the event of a divorce, but anything we take out of the trusts is community property.

 

I've got two questions.

1) Rather than taking our normal salaries can we forgo taking salaries, and take what we would normally take in salary out of the trusts? Thinking behind this is if we did it right we could take the money out of the trust in a manner that we would be paying long term capital gains on it. By not taking a salary we wouldn't have to pay payroll taxes on ourselves or income taxes on that income. So basically we would be paying capital gains on the same amount of money we would otherwise be paying both payroll and income taxes on, which would save us quite a bit of money I would think. I believe it would also make it where we wouldn't have to pay SS on that money as well. Am I correct in this? In most years the trust gets a distribution from the company so this is just a one time type thing, that we couldn't keep doing. Am on the right track here?

 

2) If because my brother and I are not taking salaries it reduces the losses of the company, can we then pay the $XXX,XXX less what we took out of the trusts to make up for the salaries while my father still pays the $XXX,XXX he would have to pay anyway with out it affecting the proportion of ownership, and causing problems with the IRS?

 

ETA: I ran this by my CPA's assistant and she said she didn't see anything wrong with it, but would have to ask the CPA when he gets back.

Edited January 5, 2011 by Perchoutofwater

[yo mama]

Issue 1: maybe. You obviously can't take distributions from the trust unless the distributions are authorized by the terms of the trust and the trustee. While you haven't provided enough information to say exactly what the tax consequences would be in connection with the trust distributions, I can't think of any reason why you'd have to pay payroll taxes, SS, etc. on such trust distributions.

 

Issue 2: if you try to reduce yours and your brother's contributions by the amount of the salary you didn't take - but your dad still kicks in the full $500,000 - I could easily see the IRS taking the position that: (1) the S-corp constructively paid your salary; and (2) that you then made a capital contribution of that cash back to the S-corp. If that were to happen, not only would you have income tax issues on the salary, but the S-corp would have payroll, SS, and other related responsibilities. But that's the IRS. I think the pivotal issue is how your capital accounts are maintained. If you give up the salary, contributed just $200,000 to the S-Corp, and you capital account only goes up by $200,000 then you might be cool from an income tax perspective (but consult with your CPA/attorney on that). Your dad's capital account would go up by the $500,000 he contributed, so you guys would have dissimilar capital accounts. That's not necessarily a bad thing, but yours and the company's CPA would have to get that right.

 

Another issue here is the S-corp's shareholder agreement. If it requires that all capital contributions/cash calls be pro rata then you may be violating the terms of that agreement. That would not be advisable.

[Perchoutofwater]

The trust is not an issue. It is only set up to separate it from community property. I don't have any problem pulling openly traded stock out of it. The only thing I can't pull out is stock in the company. If the company doesn't pay a distribution into the trust this year (which it won't) the only income in the trust will be dividends on openly traded stock and capital gains from the sell of openly traded stocks.

 

With regard to question #2 I'm just wanting to make sure if we do this, one the IRS can't come back on us, and that when it is all said and done that we all still have the same proportion of ownership as we currently have. Obviously Dad wouldn't have a problem with it as if it works the way I think it would, the loss would be less thus due to not having to pay payroll tax and SS on it, thus making the amount needed to maintain our bonding capacity less and reducing how much new money we have to invest in the company. I guess I'll have to dig up the company charter.

[yo mama]

The trust is not an issue. It is only set up to separate it from community property. I don't have any problem pulling openly traded stock out of it. The only thing I can't pull out is stock in the company. If the company doesn't pay a distribution into the trust this year (which it won't) the only income in the trust will be dividends on openly traded stock and capital gains from the sell of openly traded stocks.

 

With regard to question #2 I'm just wanting to make sure if we do this, one the IRS can't come back on us, and that when it is all said and done that we all still have the same proportion of ownership as we currently have. Obviously Dad wouldn't have a problem with it as if it works the way I think it would, the loss would be less thus due to not having to pay payroll tax and SS on it, thus making the amount needed to maintain our bonding capacity less and reducing how much new money we have to invest in the company. I guess I'll have to dig up the company charter.

I've seen the IRS make some pretty crazy arguments, and they love to recharacterize transactions in the manner that generates the most tax. So there is *always* risk that the IRS will try and give you trouble. As to ownership remaining 1/3 each, the easiest way to avoid a potential headache is to have all capital contributions be 1/3rd each.