S corporations are pass through entities, but lack the flexibility of partnerships.  When more than 20% of the stock of an S corporation is sold, the issue arises as to how to account for income to the shareholders during the year.  The default rule is to wait until the the end of the year, determine income for the year and then allocate it on a per day basis.  For example, if shareholder A owns 50% of the S corporation and sells all of his stock on October 1 to shareholder B and the S corporation has $100 of income, shareholder A will be allocated $75 of income.   But what if all $100 of income is earned after October 1?  Poor shareholder A will be allocated $75 of income, but will have no right to receive any of it since he wasn’t a shareholder when it was earned.  This creates a phantom income problem for shareholder A.

What is the solution for shareholder A?  Well if all shareholders agree the S corporation can elect to use the cut off method.  The cut off method creates two separate tax years-one to the date of sale and one after.   The cut off method can be elected anytime before the tax return is filed. However, there will usually be a winner and a loser here.  In this case shareholder B would be disadvantaged to agree to the cut off method.  Therefore, it is recommended that shareholder A require the cut off method to mandated in the stock purchase agreement.

Many times we shy away from doing the hard things that we need to do to improve.  For example, in golf everyone is trying to get more distance.  Many try to get there by getting a super light driver or buy the latest get long quick training aid.   In reality, you get longer by training the golf muscles hitting golf balls.  One of the best drills for both distance and quality of the strike is one arm golf shots.  You simply can’t consistently make good contact if you don’t have your arm in sync with the torso.  If you can sync your torso and arm swing you will hit better shots.

On August 8, 2018 the Treasury issued proposed regulations under Code Section 199A, a provision that was part of the 2017 tax act that provides a 20% deduction on “qualified business income.”  Code Section 199A is a very complex provision, but every business owner needs to be advised as to whether it applies to the business owner and, if so, whether the business owner should structure his business to claim it or whether he or she should structure the business as a C corporation to take advantage of the lowered corporate tax rate of 21%.

Generally, for taxpayers with taxable income under the threshold amounts of $157,500 single and $315,000 married filing joint, organizing as a sole proprietor or pass-through entity will produce more tax savings than operating as a C corporation.  This is only a generality, however.  A taxpayer needs to sit down with a tax professional and do projections on business income and taxes as a C or as a sole proprietor or pass-through to determine the best course, and it should be noted that differences exist between types of pass-through entities and between pass-through entities and sole proprietors.

These proposed regulations are not law, but can be relied on by the taxpayer.  An analysis of the proposed regulations is well beyond the scope of this blog.  Some of the questions that arose under Code Section 199A have been addressed, however, such as (i) reclassifying employees as independent contractors so that their income is eligible for qualified business income treatment (doesn’t work), (ii) narrowly defining the catch-all for special services, trades or businesses where the reputation of the employees or owners is a “principal asset” to product endorsements, licensing revenue from use of individual’s image, likeness or trademark, and appearance fees and (iii) a business aggregation rule, allowing taxpayer’s to aggregate related businesses.

Code Section 199A has made choice of entity a complex decision.  Let me know if I can help you with that analysis.