by R. Dean Piccirillo, CFP®, CRPS®, AIFA®
Principal/Senior Financial Advisor
HBK Sorce Financial LLC

Currently, for Americans living on $45,000 or more per year during retirement, 18% of that income is generated from personal savings and investments. For millions of Americans, the personal savings and investments component of our income consists largely of Individual Retirement Accounts (IRA). IRAs are tax deferred personal retirement funds that allow you to save up to $5,000 per year ($6,000 if you’re age 50 or older). Tax deferral means you’re not currently paying income taxes on dollars earned inside of these investment vehicles; instead, the tax is deferred until you withdraw your money. Consequently, your money is working harder for you during the accumulation phase.
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The amount of loss permitted to be deducted by an S corporation shareholder is generally limited to the shareholder’s basis in corporate stock and/or debt.  Losses in excess of a shareholder’s basis in stock and/or debt is suspended and carried forward indefinitely to be used at such time as additional basis is created.  Thus, if a shareholder expects a loss for the current year, but anticipates not having sufficient basis to deduct the loss, one or more of the following techniques may be utilized to increase basis before year-end.

I.  Techniques for Creating Additional Basis:

• Cash Contribution: A shareholder may increase stock basis by contributing additional capital to the corporation before the last day of the corporation’s taxable year. This technique is generally used, however, only if all shareholders plan to contribute cash on a pro-rata basis.
• Stock Purchase: Stock basis is also increased by purchasing additional corporate stock prior to year-end, either from other shareholders or directly from the corporation.
• Cash Loan: A shareholder may increase basis by lending money directly to the S corporation. The loan will be respected so long as the shareholder is placed in the economic position of being a creditor.
• Back-to-Back Loan: A shareholder may personally borrow money and lend the proceeds directly to the S corporation. This back-to-back loan will generally result in a basis increase for the shareholder.
• Property Contribution: A contribution of property by a shareholder to an S corporation will create additional stock basis equal the basis of the property in the shareholder’s hands. A contribution of appreciated property will generally be tax-free to the shareholder so long as all shareholders contributing on that day own at least 80% of the corporate stock immediately after the contribution.
• Purchase of Stock or Debt for Shareholder’s Note: A shareholder should receive cost basis for S corporation stock or debt obligations purchased from a third party for the shareholder’s note.
• Payment of Corporate Debt: The payment of corporate debt guaranteed by the shareholder will increase the shareholder’s basis. Through subrogation, the corporation becomes indebted to the shareholder, and the result is the same as if the shareholder had loaned cash to the corporation, which in turn paid its own debt.
• Shareholder Loan Substitution: A shareholder’s basis is increased by the substitution of a shareholder’s own note for a corporate obligation for which the shareholder is a guarantor, so long as the corporation is released from the obligation and the creditor looks solely to the shareholder for satisfaction of the debt.
• Shareholder Assumption of Corporate Debt: Basis may be increased when a shareholder assumes a corporate debt and the corporation is released by the creditor.

II. Techniques Not Resulting in Additional Basis:

• Guarantee of Corporate Debt: It is important to note that the S corporation rules differ significantly from their partnership counterpart in that corporate debts to third parties do not increase a shareholder’s stock basis.  Thus, if a shareholder guarantees a corporate debt, the shareholder’s stock basis will not presently increase as a result the mere guarantee.
• Related-Party Loan: Loans to an S corporation from individuals or entities related to the shareholder generally do not result in a shareholder basis increase.

Mark R. Giallonardo, JD, LLM is a Principal in HbK’s Tax Department and currently supports HbK’s Florida offices. Mark has been developing tax planning strategies for owner-operated companies for more than 20 years and may be reached at (239) 263-2111 or mgiallonardo@hbkcpa.com.

Distributions from your S Corporation are generally tax free to the extent that you have basis in your stock.  However, when your C Corporation elected S status, all of its accumulated earnings and profits (E&P) were frozen.  Any distributions you take from E&P accrued when your business was a C Corporation are taxed as a dividend.

Under current tax law, qualified dividends are taxed at a maximum rate of 15%.  Starting in 2011, dividends will be taxed at the same rate as ordinary income.  The top marginal rate on ordinary income for 2011 will be 39.6% (unless new legislation is passed extending the current lower rate).  Given the expected increase to the tax rate on dividends, the cost of distributing your E&P may substantially increase.

Distributions are typically deemed to be made from accumulated E&P when they exceed the corporation’s accumulated adjustments account (AAA).  A corporation’s AAA generally consists of its net income or loss for all S Corporation years less any distributions that were sourced from AAA.  However, an S Corporation can elect, with the consent of all its shareholders, to distribute its earnings and profits before AAA.

If the corporation does not have sufficient cash on hand to distribute all of its E&P, it can eliminate E&P by distributing its own corporate notes, or by making a deemed dividend election.  A deemed dividend is a hypothetical distribution of E&P to all shareholders that is treated as being immediately contributed back to the corporation.  As a result, the stockholder pays tax on the deemed distribution and receives basis for the contribution.  The additional created basis can be used by the taxpayer to take losses otherwise suspended by basis limitations, or offset gain on the ultimate sale of the S Corporation Stock.

With the expected increase in tax on dividends, we suggest that you consider distributing your E&P in 2010.   There are many relevant considerations when deciding to distribute E&P.  Please contact us to discuss if it will be advantageous for you to distribute your E&P in 2010.

Tax Department – Hill, Barth & King For more information about how these changes relate to your unique circumstances, please call our Fort Myers office at 239-482-5522.