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S Corporation Accounting Example

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Dear Tax Guide,

I recently became a shareholder of a 3 member professional association in Florida. We filed Form 2553 and elected to operate as a subchapter S corporation. It's a small business and income is based upon what each shareholder earns.

It seems that the company should file IRS Form 1120S and send K-1s to each shareholder. The shareholders would then use the K-1 to complete Schedule E and eventually their Form 1040.

If the three shareholders keep their revenue and expenses separate, where do they reconcile their accounts? Where do the individual shareholders detail their deductions? On the 1120S or their respective 1040?

For example: if Joe earned $10,000 and had $3,000 in deductions; Kevin earned $20,000 and had $10,000 in deductions; and Scott earned $1,000 and had $6,000 in deductions. Assume further that all shareholders pay themselves a salary as they earn the fees and there were no capital contributions. Would Joe receive a K-1 for $7,000? Would Kevin receive a K-1 for $10,000? What would Scott's obligation be? Could Scott utilize the loss by carrying it forward or offsetting W-2 income?

Thank you for your help.

Dear Reader,

Forming a Subchapter S-Corporation (definition, profile) and accounting for each partners' income and expenses is worth doing accurately. Let's take a step-by-step approach to your question, starting with the beginning.

Your corporation was incorporated in the State of Florida, and subsequently elected Subchapter S status using IRS Form 2553.

There are three shareholders in the corporation, and each contributed zero dollars as an initial investment in the company. (I will ignore the impossibility of the shareholders not contributing any money to the business.) For the purposes of this example, I shall assume that the three shareholders own an equal share of the company's equity, in other words, that each shareholder owns exactly 33.33% of the business.

Using proper S-corporation accounting methods, the income and expenses for the business are reported at the corporate level. Then, each shareholder's share of net profits is reported and taxed on each shareholder's personal Form 1040.

The accounting method you proposed, where each shareholder reports his income and expenses separately, is improper. You are attempting to treat each shareholder as if they are sole proprietors. Instead, all income and expenses are reported at the corporate level, and then allocated to shareholders based on their percentage of ownership.

Here's how a simplified income statement might look for your S corporation:

Gross Receipts
Joe's sales: 10,000
Kevin's sales: 20,000
Scott's sales: 1,000
Total Gross Receipts: 31,000
Other income (interest, etc.): 0
Total income: 31,000

Officer's compensation
Joe's compensation: 5,000
Kevin's compensation: 10,000
Scott's compensation: 500
Total officer's compensation: 15,500
Payroll taxes (7.65% of salary): 1,186
Other business expenses: 19,000
(Joe's, Kevin's and Scott's incurred expenses, added up)
Total Expenses: 35,686

NET INCOME (LOSS): (4,686)

Each shareholder therefore receives one-third, or $1,562, of the net loss on his K-1. Since each shareholder has invested exactly zero dollars in the corporation, the loss exceeds each shareholder's basis in the S-corporation's stock, and therefore the loss is disallowed on the shareholder's personal 1040 until the shareholder's basis in the stock is increased.

Yes, that's right, the loss will be disallowed. The loss does not disappear, instead the loss is carried forward to next year. If the shareholder has basis in the stock, then the loss may be claimed. I provide tips for dealing with so-called negative basis in S-Corp Loan Basis and Negative Basis. I also discuss how to keep track of shareholder's equity basis and capital accounts in Accounting for S Corp Capital.

Each shareholder's 1120S Schedule K-1 will report ordinary business income (or loss) of ($1,562). This loss, as mentioned, is a non-deductible loss. The loss carries forward year by year until the shareholder increases his basis in the stock above zero. If a shareholder's stock basis had been at least $1,562 (or greater), then the shareholder would have been able to deduct the loss in full in the current year.

Additionally, each shareholder will receive a Form W-2 reporting his wages, income tax withholding, Social Security and Medicare withholding.

Perhaps you can understand why I think that having zero capital contributions by the shareholders is a bad idea. The shareholders are taxed on their salary income and receive no benefit in the current year for their business loss. This is bad tax planning.

My recommendation: shareholders should contribute cash to the S-corporation as an equity investment. This investment needs to be made by the end of the year in order for the shareholder to claim a net business loss.

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