My article “Tax Tips for S Corporate Structure” that ran on May 20 spurred numerous e-mails from CPAs all over the country stating that I had made an error with regard to the ability to write off rental losses against Sub S income all of which are declared on Schedule E of a person’s individual income tax return. The main concern is that rental losses are treated as passive losses, whereas Sub S income is non-passive income. You can’t mix apples and oranges: You can’t net passive losses against non-passive income.
To explain the concept simplistically: Passive income is income you receive while sitting around, such as interest from a savings account, dividends from stock holdings, or rents from apartment buildings. (Can’t resist the aside, you also can’t write off rental losses against dividend or interest income even though they are in the same class of income.)
For those of you who get up every day and go to work at your Sub S Corporate business where you sweat and struggle to claw your way to the top, you’re not thinking that it’s “sitting around income.” This has got to be non-passive income, right?
Well… Please note: this is one of the advantages of incorporating as a Sub S Corporation. Sub S corporation income and losses are treated as passive for tax purposes. Yes, this is counterintuitive, especially if the shareholder in question also has W2 wages and material participation in the entity. Material participation – that pretty much means you go to work every day.
No one ever said the IRS is always logical.
But still, I wondered if I had missed something in my research. And because tax law is so complicated, I decided to get to the bottom of it. I discussed my findings with an IRS auditor, a tax attorney, my office mate who is also an enrolled agent, as well as with an individual in the Tax Law Department at the IRS. They all agreed with me.
But the biggest tipoff is Schedule E itself. Note that rental losses are listed on page 1, line 26; Sub S income is listed on page 2, line 32. What happens next? These two totals are combined and netted out (along with several other line items on the form) on line 42 and transferred to line 17 of Form 1040. This function alone (without any reference to work-sheeting) demonstrates that the principle I outlined is in fact correct. Don’t believe me? Go to www.irs.gov, bring up Schedule E and try it yourself.
So when you, as a Sub S Shareholder, lose $25,000 on your apartment building rentals but earn $200,000 from your Sub S Corporation, you will pay taxes on $175,000. You will not have to carry forward the $25,000 loss on the apartment building and pay taxes on $200,000, after all. You’re going to save a lot of money in taxes because of this provision.
This is a useful tool for the self employed. Once income levels for sole proprietors and partners in a partnership reach the point where rental losses will no longer be allowed (or phased out) and it is otherwise time to incorporate, the Sub S election will be quite the tax-saving device. This device also comes in handy if rental losses exceed the $25,000 maximum allowed under current tax law for passive activities at lower income levels.
But before deciding to incorporate as a Sub S, check all aspects to determine if the structure will suit your needs and psychological temperament. In other words, can you keep up with the rules and the paperwork requirements? Also check with your attorney to make sure this structure is the best form to protect you legally. And check with your tax pro to determine what your tax savings will be.
Other items about Sub S Corporations not included previously:
1. Income and losses must be allocated to shareholders according to their percentage of ownership;
2. You cannot deduct losses in excess of your investment;
3. You cannot have more than 100 shareholders;
4. Each shareholder must be a permanent U.S. resident;
5. Fringe benefits for more than 2% owners are not deductible at the corporate level – you may take the appropriate deductions for fringe benefits, such as retirement plan contributions and health insurance as an adjustment to income on your individual income tax return;
6. Not all fringe benefits are deductible like they would be if the entity was a C Corporation, e.g. life insurance and disability insurance;
7. As an owner, you must take payroll before you take a distribution of profits.
Speaking of complexities with the tax law, here’s a tid bit for you regarding my recent column about casualty losses: Beginning in 2010, you may take a casualty loss deduction for drywall corrosion. This just makes me shake my head and roll my eyes.
The implementation of this exception defeats the entire premise of no deduction for slow acting damage such as corrosion, dry rot, rust, termite damage, etc. Per IRS regulations, a deductible casualty loss is caused by a sudden and unexpected occurrence. Why the hell should drywall corrosion suddenly become an exception? It doesn’t make sense and it further complicates a tax code that has become far too burdensome and complicated for the average human to comprehend.
Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know,” available at all major booksellers. Follow Bonnie Lee on Twitter at BLTaxpertise and at http://www.facebook.com/taxpertise.bonnielee.