Q 1:

Subject: S corporation Shareholders

Kerry,  My question regards whether a S Corporation can have Inactive (authorized but not issued) shares.  A S corporation had 3 originals Shareholders but 2 of the Shareholders were bought out by the Corporation thereby leaving the remaining Shareholder with 100% Ownership and Control.  However, that shareholder has taken the Position that she is only a 45% owner (her original share percentage) and the remaining 55% are owned by the “Corporation”.  I believe this position is in conflict with IRS rules regarding individuals reporting all income/losses thru their Personal Tax Returns.  Can you recommend any references that might clear this up.  I live in Louisiana but do not believe the Community Property Laws impact the question.  Any help will be GREATLY appreciated. 

A 1:

It is quite natural to have more authorized shares than are actually issued to owners.  In fact, I have long recommended that, when setting up a corporation, a much larger number of shares be requested so that there will always be some in reserve without the need to file additional papers with the Secretary of State’s office.

For S corp purposes, only the outstanding shares count.  The unissued and treasury (bought-back) shares are completely irrelevant.  Thus, you are correct that the remaining shareholder now has a 100% share.  It is impossible for an S corporation to be its own shareholder.  In fact, corporations of any kind are legally barred from being owners of an S corp, or else the S corp election is automatically terminated.

This is such a basic matter that it points out the true underlying malady here – trying to run a business without the assistance of a professional tax advisor.  Your friend needs to hire the services of a competent tax advisor ASAP before she puts herself in serious tax and legal jeopardy.

Kerry Kerstetter

Q 2:

Thanks Kerry , Do you know of any Court Cases that deal with this issue?

A 2:

I don’t know of any such cases.  In fact, I doubt if any exist because your friend’s interpretation of ownership allocation is so wacky that I seriously doubt if anyone would take it all the way to court. 

The concept of basing S corp allocations on shares issued and outstanding is so cut and dried that no tax professional would be crazy enough to pursue your friend’s theory and be laughed out of the court. 

The purpose of S corps is to pass through 100% of their net income or loss to the shareholders.  It makes no sense by any stretch of logic to think that 55% of the corp’s income would stay with the corp itself and not be passed through just because that stock has been retired or repurchased by the corp.  The remaining shareholder now has an effective ownership of 100% of the corp and is required to report 100% of the corp’s income on her 1040.  If the ownership change took place mid-year, there are a variety of methods by which to allocate the corp’s net income between the old shareholders and the remaining one.

As I said earlier, this is why matters of tax law are not suitable for amateurs.

Kerry Kerstetter

 

Q:

I was viewing your website and got your email address.  You seem to know what your talking about, so I have a question for you that I have not been able to get a clear answer on.  My husband and I sold our first home, which we used as a rental for a while, in September of 2003.  We did not pay any gains because we had lived in it two of the previous five years.  Well, we are now planning on moving.  We have lived in our current house for over five years, but, if we sell before September of 2005 will we have to pay a gain because the sale of our rental was less than two years ago?  Does it make a difference if we are rolling any income from the sale into the new home we are having built?  Please let me know if you know anything about this sort of thing.

A:

As I’ve explained on my website, buying or building a new home has been entirely irrelevant to the calculation of taxable gain since May of 1997. 

You failed to mention why you are going to be moving before September 2005.  If it’s just your own choice, a sale before the two year anniversary of your previous home’s sale will be fully taxable.

However, if the sale is happening so soon due to health, employment or other unforeseen circumstances, you would be able to get around the once in two year limit.

You should discuss your circumstances with a professional tax advisor who has experience applying this rule.

Good luck.

Kerry Kerstetter

 

Q:

Subject: s vs c corps

 

hi kerry, thanks for publishing this info. i just read your page on s vs c corps and have a couple of questions. if the company does not have any initial shareholders how is the taxation of income to the principal officers of the company? what if the company never has any shareholders? what kind of entity would you recommend for a real

estate broker in the state of CA?

thanks,

A:

It is not possible to have a corporation with no shareholders.  A corporation is legally required to have at least one share of stock issued out of the total that were authorized when it was chartered.

There are far too many variables involved for me to be able to advise the best entity and jurisdiction to use for your particular situation via this medium.

To work out the best solution for your particular circumstances, you really need to work with a tax pro who can help you set up a strategy that will work for you.

Good luck.

Kerry Kerstetter

 

Q:

Subject: Please help with some tax questions…

Hi Kerry,
I just read your articles on tax exemption for the sales of a primary residence.  I purchased my current home (only property that I own or have owned) about a year ago in California.  I’m looking to move shortly since I’m getting married and will have a 3-year old living with me (actually they both currently live with me).   Our current neighborhood, though sufficient for my own purposes, is not exactly what I’d call child friendly.  We do not feel safe, as a family should.  We also work excessively far from our home, over 50 miles each way.

I would like to move from this location approximately 20 miles westward (towards the coast).  Is there a way that I can get an exception on the gain from the sale of this house?  I expect to see a gain of approximately $70,000-$100,000 (did quite a few upgrades in the past year).  Reading through your summarized pages, I don’t seem to qualify for any of the posted exclusions.  As it is, I can’t afford to move without extracting maximum gain from my current house and with trends in the market, I will be shut out from any possibility by next summer.

If you find some free time, I would truly appreciate any and all advice that you can give.  My realtor knows little (very sweet woman, but not the sharpest tool in the shed), and even those at H&R Block seem to be caught in a time warp.  Some professional information would be greatly appreciated.

Thanks in advance,

A:

I don’t see a problem here.  Either getting married or having a child move in are the kind of life changing unforeseen circumstances that would make you eligible to use the prorated exclusion of gain.  After being there a year, this means that you could exclude at least $125,000 or profit; more than enough to cover your situation.

Good luck.

Kerry Kerstetter

Follow-Up:

Hi Kerry,

This is great news.  How do I petition or write a letter to in order to get my exemption?  Obviously, in California, I will have to petition both the IRC and the California Franchise tax board, but I don’t want to start sending out blanket letters to either of those two agencies.  The progress and resolution of the exemption will take years.  Do you happen to have an address and contact department who I should send my information and claim to?

Thanks in advance.  Your site as well as your personal assistance has been a HUGE relief.  Being in a state that promotes family values and wellness, you would think they would make it easy to better your situation, but that is not the case.  Real estate agents are virtually worthless and getting help directly from the IRS is nothing more than a game of cat and mouse.

Thanks again.  I’ll send you pictures of my new house once this is all said and done.

Regards,

A:

That is not how this works.  You don’t need to get anyone’s permission ahead of time when claiming the tax free exclusion for residence sales.

If you feel that you qualify for an exclusion, you just report the sale and the amount of gain excluded under Section 121 on Schedule D with your 1040.  If you are claiming the pro-rated exclusion for special circumstances, it is a wise move to attach an explanation of what those circumstances were. 

As with anything on your 1040, IRS will have three years to decide if they will accept your exclusion or ask you for more details.  My philosophy has always been to attach more than enough documentation of your case so IRS will have no need to request anything more from you.  This has never failed to head off IRS challenges of the several tax returns I have prepared with similar circumstances.  It is also one of the main reasons I advise against using IRS’s electronic filing system because that does not allow any additional explanations of unusual items.

This is a very basic part of the tax law, which makes me nervous for your ability to do things properly.  You should work with a tax pro or you are very likely to screw things up.  Obtaining tax advice from IRS or Realtors is absolutely nuts.  Stick with CPAs and Enrolled Agents who believe in the philosophy of helping their clients save money as I discuss on my website.

Good luck.

Kerry Kerstetter

 

Q:

Subject: Basics of Corporations

Hello Kerry,

 

First of all, thanks so much for taking the time to put together and to post the Corporations Internet page. Your explanations are excellent, and so helpful!

 

I have a question, and I can only hope that you have a minute. Am I to understand that an LLC can protect personal assets much like a corporation can? My brother and I are starting a landscaping business (in NC), and of course it will be quite small (for starters)—just us two.

 

From what I’m reading, a simple LLC is the way to go, until we get a little bigger, and then we may want to consider an S-Corp. Will we still be protected as an LLC (assuming we have basic liability insurance for our business)? Just in general, for a small startup, would you advise an LLC?

 

Thanks so much for taking the time to read my questions. I hope you have a moment to respond. But in any case, thanks again for the great information you’ve posted!

 

Best Regards,

A:

As I always say, there is no such thing as a one size fits all for businesses.  Neither is it wise to base important decisions such as this on anything other than a direct consultation with a tax pro who understands how to set things up in the best way for your and your brother’s unique circumstances.

That said, there are a few issues that need consideration in your email.  

First, it this true that the LLC entity, if used properly, can shield its members from personal liability in the same way as a corporation.

However, if you already see a need for an actual corporation down the road, I don’t see the benefit of starting off with an LLC as a “bunny slope” towards your ultimate goal.  LLCs can’t be converted into corporations.  They are technically different kinds of legal entities.  You would need to file brand new paperwork, and pay new fees, to charter your corporation.  I am not familiar with North Carolina’s LLC and corp paperwork; but in many states, the LLC paperwork is actually more complicated and the fees are more expensive than they are for corporations.  It is also occasionally the case that the taxes on LLCs are higher than they are for corporations. That is definitely the case in California, which assesses a tax on LLCs based on their gross receipts in additional to the $800 per year minimum tax it hits corporations and LLCs with.  This may not be the case yet for NC; but states that are desperate for revenue do look to the PRC for ideas.

If you do choose to just skip the middle step and set up a corporation, be darn sure you have studied the issues I have raised regarding the pros and cons of C versus S corps.   If your business is going to show profits, S corps can end up costing you a lot more in taxes than will a C.  Your only mentioning LLCs and S corps leads me to believe that you haven’t adequately analyzed this matter.

I have found that LLCs are very useful entities for joint ventures between people.  However, they make most sense as something that will last out the life of the project, and not as a stepping stone to a corporation.  Take a look at the credits of movies.  They are almost always set up as LLCs that are there to account for the expenses and income of that one project, which is a joint venture between various companies and individuals.  When the film and its revenues run out, the LLC is dissolved.  It is not converted into a new corporation.

That is just my opinion.  I’m sure there are some folks, especially professionals who earn fees by setting up LLCs and  corporations, who would love for you to try the LLC and then a corporation.  You’ll be paying them to set up the LLC, to properly terminate the LLC, set up the corp, and possibly terminate the corp.  However, corporations do have potentially eternal life; and can last forever, unlike LLCs and partnerships, which are tied to the life span of their owners.

Those are just some issues to consider when you discuss this with a tax pro.

Good luck.

Kerry Kerstetter

Follow-Up:

Wow Kerry!

 

Thanks so much for the detailed response. It’s so nice of you to take the time to do that, especially since I’m a stranger.

 

After I sent my e-mail to you, I re-read the pages on your site, and I did see how you had pointed out that the C-corp may be a better choice than the S in many cases, and I think that will be the way to go. Also, your response to me highlighted the fact that moving from an LLC to a Corporation is not a simple, or even natural, transition. You’re pointing this out will save us a lot of headache. Thanks!

 

I will definitely take your advice, and talk to a tax pro in NC before making any moves. Thanks again for your kind responsiveness!

 

Best Wishes to you, and know that you’re doing good work!

 

Thanks!

 

 

Taxes for our rulers are like crack to a drug addict. Once they get hooked, they will only want more.