CPE Link Archives

S Corporations are Entity of Choice; 68% of S Corps Misreport

A recent IRS study shows that S corporation return filings (Form 1120S) increased dramatically and continue to be the most prevalent type of corporation filing. For Tax Year 2006, almost 2/3rds of all corporations filed a Form 1120S. The total number of returns filed by S corporations for Tax Year 2006 increased to nearly 3.9 million, from nearly 3.2 million reported in Tax Year 2002 and 722,444 in 1985. In 2006, there were 6.7 million S corporation shareholders. S corporations became the most common corporate entity type in 1997.

According to IRS data, about 68% of S corporation returns filed for tax years 2003 and 2004 (the years data were available) misreported at least one item. About 80% of the time, misreporting provided a tax advantage to the corporation and/or shareholder. The most frequent errors involved deducting ineligible expenses. Even though a majority of S corporations used paid preparers, 71% of those that did were noncompliant.

Reasonable compensation still an issue for S corporations – The GAO report also focused attention on the loophole that allows shareholders to reduce payroll taxes by reducing wage compensation. The IRS admitted that their efforts to enforce the adequate compensation rules for S corporation shareholders have been limited. For fiscal years 2006 through 2008, the IRS examined less than half of one percent of S corporations who filed.

Misreporting of shareholder basis is also a common problem, permitting shareholders to claim excess losses averaging $21,600 per taxpayer based on IRS audits for the period 2006 to 2008.

(Note: The above information was excerpted from Vern Hoven’s manual used in CPE Link’s Federal Tax Update: Part 4 webcast.) Webcasts are scheduled November-January. In Part 4, you’ll get an update on all corporate changes, partnership changes, and IRS audit issues.

From Traditional IRA to Roth IRA: New Rollover Rules

For years prior to 2010, only taxpayers with modified AGI of $100,000 or less generally were permitted to convert a traditional IRA into a Roth IRA. For years beginning in 2010 and after, the AGI limitation has been eliminated. Thus, regardless of AGI, all otherwise eligible taxpayers will be allowed to convert an IRA to a Roth IRA. The amount converted is includible in income as if a withdrawal had been made, but no early withdrawal penalties are assessed.

Two-year income spread if conversion done in 2010 – For conversions occurring in 2010, unless a taxpayer elects otherwise, none of the amount is includible in gross income in 2010, with half of the income resulting from the conversion includible in gross income in 2011 and h, income inclusion is accelerated if converted amounts are distributed before 2012. In that case, the amount included in income in the year of the distribution is increased by the amount distributed, and the amount included in income in 2012 (or 2011 and 2012 in the case of a distribution in 2010) is the lesser of: (1) half of the amount includible in income as a result of the conversion; and (2) the remaining portion of such amount not already included in income. The following example illustrates the application of the accelerated inclusion rule.

Example – Betty has a traditional IRA with a value of $100,000 consisting of deductible contributions and earnings. Betty does not have a Roth IRA. She converts the traditional IRA to a Roth IRA in 2010, and as a result of the conversion, $100,000 is includible in gross income. Unless Betty elects otherwise, $50,000 of the income resulting from the conversion is included in income in 2011 and $50,000 in 2012.

Later in 2010, Betty takes a $20,000 distribution, which is not a qualified distribution and all of which, under the ordering rules, is attributable to amounts includible in gross income as a result of the conversion. Under the accelerated inclusion rule, $20,000 is included in income in 2010.

The amount included in income in 2011 is the lesser of (1) $50,000 (half of the income resulting from the conversion); or (2) $80,000 (the remaining income from the conversion). The amount included in income in 2012 is the lesser of (1) $50,000 (half of the income resulting from the conversion), or (2) $30,000 (the remaining income from the conversion, i.e., $100,000 – $70,000 ($20,000 included in income in 2010 and $50,000 included in income in 2011)).

Preparer note – While you cannot elect out of the two year spread on only a portion of the conversion income in 2010 (it’s an all or nothing election), husband and wife may each make separate elections for their individual IRA accounts. For example, a wife could elect to report her conversion income in 2010 and her husband could report his 2010 conversion income in 2011 and 2012. This may result a better spread of the income. The same taxpayer is allowed to make separate elections for separate IRA accounts.

If you need guidance on answering the question, “should my client convert to a Roth?” check out CPE Link’s Federal Tax Update: Part 2 webcast scheduled November-January.. You’ll get a myriad of planning ideas and even access to a simple, but sophisticated, calculator. (Note: The above information was excerpted from Vern Hoven’s manual used in the webcast.) In addition to coverage of the IRA & Individual Retirement area, you’ll get an update on Real Estate & Investment, and Estates, Trusts & Beneficiaries.