Distributions from Partnerships and S-Corps

On several occasions, the following scenario has played itself out in my office: client comes in very excited, exclaiming that they are "going out on their own".  We file all the necessary paperwork to get an employer identification number, articles of incorporation, and have a quick run-through of how to keep up with income and expenses.  Then, they are on their merry way.

About a month later, the client calls and asks "how do I pay myself?"  

This is a common issue for small business owners, especially when they are set up in partnerships or S-Corps.  To begin, partners in partnerships typically do not draw salaries, and S-Corp shareholders only draw "reasonable compensation" during the year.  The remainder is taken by the partner/shareholder as a distribution, loosely defined as taking cash out of the business.  

Here is an example.  Jim is the 100% shareholder of Jim's Tools Inc, an S-Corp.  For the year, Jim has taxable profit of $100,000.  Of that, he pays himself a salary of $30,000, leaving the company with a $70,000 profit.  Jim will pay taxes on both his $30,000 paycheck and the $70,000 profit of the business on his personal return.  Assuming he is in the 25% tax bracket, his tax burden will be $25,000 ($30,000 paycheck + $70,000 business profit x 25% tax rate).  Based on these facts, he is permitted to distribute up to $70,000 of cash from the business to himself.  At the end of the day, he is left with $75,000 in his personal bank account after paying taxes.  

Partnerships work in a similar way, minus the salary.  The big difference is that the income from a partnership is likely to be subject to self-employment tax, since there is no salary involved.  In an S-corp, the shareholder will pay self-employment tax (payroll taxes of FICA and Medicare) on their paycheck.  Since a partnership does not pay a salary to the partner, the partner is responsible for this on their personal return.  But, distributions work the same way: if a partner has net profit for the year of $100,000, they will pay ordinary and self-employment tax on that money, but will be permitted a distribution up to $100,000.  

The main thing to remember is that S-Corps must pay a reasonable salary during the year to its shareholders, which is the tradeoff for the net earnings from the S-Corp not being subject to self-employment tax.  Partnerships and S-Corps should also keep track of their distributions during the year for reporting on the tax return at the end of the year.  

Why Depreciation No Longer Exists for Small Businesses

With Congress' passage of the Protecting Americans From Tax Hikes Act of 2015 (PATH), Congress did more than just protect Americans from tax hikes...they eliminated depreciation altogether for most small businesses.  

In PATH, Congress extended Section 179 depreciation permanently, which means that from 2015 until infinity, a business can expense 100% of the cost of most new or used assets in the year of purchase, as long as the cost doesn't exceed $500,000 or the total assets purchased don't exceed $2 million.  

This new law achieves what small business owners have been vying after for some time - that cash spent is directly related to a tax deduction.  

Couple this new law with the repair regs, which allow a small business to elect all expenses $2,500 or less are repairs and maintenance, and Congress has effectively eliminated the need for depreciation to extend over a number of years.  

Think about it: if a small business buys a new computer for $1,000, they can expense it.  If they buy a new x-ray machine for $25,000, they can expense it.  The only time a small business will get into a situation of having to depreciate an asset is if it does not qualify for Section 179 or it costs more than $500,000.  

This is a dream come true for small business owners that live by cash flow and want all of their purchases to translate into tax deductions.  

Why mileage?

When it comes to cars, self employed individuals and small business owners usually have the same two questions: how much of the initial purchase can I write off, and should I keep up with mileage or actual expenses?  I will address the first question in a later article once Congress retroactively increases the depreciation limits for 2015.  The second question is a little more straightforward but with a few special circumstances to consider.  

Taxpayers that use a vehicle for business purposes and are not eligible to be reimbursed for their expenses can deduct either mileage or actual expenses on their tax return.  This is especially handy for self employed individuals that spend quite a bit of time in the car, such as real estate agents or commercial salespeople.  Often, taxpayers assume actual expenses will generate a higher deduction, but that is not always the case.  

Consider this: taxpayer drives a Toyota Camry that has a 17 gallon gas tank and gets 25 miles per gallon on average.  Assuming gas is $2/gallon, that means the taxpayer could drive 425 miles for $34.  The mileage rate for 2015 is 57.5 cents per mile, which means that same 425 miles would generate a $245 deduction using the standard mileage rate.  In this case, mileage is a much better method to use than actual expenses, and that will almost always be the case when the taxpayer has a fuel efficient vehicle in an environment of low gas prices.  

There are a few precautions to take when deciding whether to use actual expenses or mileage on a vehicle.  One is once the decision is made, it usually cannot be changed in the future i.e. a taxpayer cannot take actual expenses one year and mileage the next.  Another is the historical trend that the IRS is usually 1-2 years behind in aligning the mileage rate with expected actual expenses.  The mileage rate is designed to be one number that covers gas, maintenance, and depreciation on a per-mile basis.  From 2014 to 2015 the standard mileage rate increased 1.5 cents, while average gas prices decreased.  It can be expected then that the 2016 rate most likely will be less than 57.5 cents per mile due to the decrease in gas prices, but that will not necessarily be consistent with gas prices in 2016 (which could go up).

Mileage rates for 2016 are expected to be released close to the end of the year (December 2015).  My guess is 55 cents per mile.   

Why a "flat tax" won't work

As we near the 2016 election season, you will undoubtedly hear some candidates tout their desire for a "flat tax" or a "fair tax".  Being in the tax profession, I could not agree more that our current tax system is cumbersome and complicated.  But, getting rid of the IRS and taking the country to a flat/fair tax is not as easy as it sounds.  Following are a few reasons why.  

Income

In most of the examples of the flat tax I have seen, a flat 15% is deducted from someone's paycheck, instead of Federal withholding, FICA, Medicare, etc.  This sounds great, but what about people that don't get a real paycheck?  What if all my income is derived from investments or partnerships / S-corps?  Are interest and dividends considered earned income for the flat tax?  Is the gross income from my partnership subject to the flat tax, even though I might have distributed more or less of that to myself during the year?  In the end, someone will have to determine what "income" is subject to the flat tax, which will ultimately lead to the same loopholes and treatments that we have in place today.  

Incentives

Our current tax code offers several incentives to businesses for purchasing capital assets and maintaining employees.  For example, Section 179 and bonus depreciation allow a taxpayer to expense 50% or 100% of a qualified asset in the year it is purchased.  This gives the business an immediate tax benefit for purchasing new equipment.  If that goes away, businesses are likely to ride out their equipment longer, putting a strain on parts of the economy where the equipment is manufactured.  If new equipment is not purchased, the manufacturing companies won't need to keep as many plants open, meaning people will ultimately lose their jobs.  

Pressure

Another reason why we won't be able to easily walk away from our current tax structure is pressure - pressure to fund Social Security, Medicare, and the Affordable Care Act.  If all contributions to Social Security that come from your paycheck and self-employment taxes ceased today, then Social Security benefits would probably run out next week.  If revenue is not received from your paycheck and the net investment income tax to fund Medicare, then millions of people would go without health coverage ... next week.  And, a function of the Affordable Care Act is for people that receive subsidies to pay them back if their income exceeds what they estimated when they applied for coverage.  If those don't get paid back, then the whole Affordable Care Act will fail ... next week.  I'm not saying I agree with all of these policies, but I am saying that the pressure to keep them going is stronger than the pressure to move away from our current tax system.  

In closing, a flat tax sounds great on the surface.  But, it can't apply universally to every situation, and it might end up doing more harm than good.  Remember, we already have a flat tax built into our current tax system - it's called the Alternative Minimum Tax, which requires people in a certain income level to pay at least 26% income tax.  

New tax due dates

At the end of July, Congress passed the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015.  This bill includes several provisions related to the Highway Trust Fund, road improvements, and health care for veterans.  But, it also included changes to tax return due dates which will take effect for tax years beginning after December 31, 2015.  

Background

Prior to the passage of this law, tax return due dates followed a schedule we have all been familiar with for many years.  For calendar year taxpayers, the due dates were March 15 for corporations (C and S) and April 15 for partnerships, individuals, and trusts.  Corporations, partnerships and trusts got an extension to September 15, and individuals to October 15.  Also, calendar year benefit plans (Form 5500) were due July 31 with an extension to October 15, and annual reports of foreign bank accounts (Form 114) were due June 30 with no extension.

For years, the AICPA and other tax advocacy groups pushed to change the deadlines of corporations and partnerships.  Corporations claimed March 15 was too soon to complete their return, especially large corporations that filed in several states.  Individuals would also find themselves in a bind if they received a K-1 from a partnership at 5pm on April 15th, not giving them enough time to complete their 1040.  The new dates are designed to alleviate some of these time constraints.  

New due dates

For tax years beginning after December 31, 2015 (2016 tax year, filed in 2017), the new due dates are as follows: S-corporations and partnerships are due March 15, and C-corporations, individuals, and trusts are due April 15.  Partnerships and S-corps, will get an extension to September 15, while C-corps and individuals get until October 15 on extension.  Trusts on extension will get until September 30.  Form 5500 will still be due July 31, but will get an extension until November 15.  Finally, Form 114 will now be due on April 15 with an available 6 month extension to October 15.  

Practical application

There are a few benefits to the new deadline structure.  For large partnerships with several unrelated partners, potentially having a K-1 in March as opposed to April will allow individual taxpayers to file on time when they might not have been able to before.  And, for large C-corporations, the added month to close out the year and finalize the tax return will reduce some of the pressure to complete the return, especially if there are many states involved.  The true burden will be placed on the tax preparer, who will have to juggle the new deadlines for partnership and C-corporations.  

Keep in mind there is nothing stopping partnerships and S-corps from requesting an automatic extension on March 15 and completing the returns under the same timeframe as in the past.  By doing this, the time burden will ultimately stay with the individual to complete their return by the due date once their K-1 is received.  The hope is that everyone will abide by the new deadlines as best as possible, and the Treasury can count on the majority of their tax revenue coming on April 15 of each year.