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The Pitfalls of the At-Risk Rules for the S Corporation Shareholder

  • Written by Lewis Taub, CPA

Taub LewisShareholders of an S Corporation that has a loss from operations are often concerned with whether or not they have basis in the stock and debt in order to use this loss on their tax returns. A critical issue that is often not considered is whether shareholders have a sufficient amount at risk with regard to the loans made to the S Corporation. Both the basis rules and the at-risk rules must be met in order for a shareholder to deduct business losses from an S Corporation. This article will address certain key elements of the at-risk rules which are contained in Section 465 of the Code.

Section 465(c)(3) states that for tax years beginning after December 31, 1978, the rules of the section apply to each activity engaged in by a taxpayer in carrying on a trade or business. Therefore, the rules apply to any S Corporation shareholder engaged in a trade or business. Often practitioners presume that the at-risk rules apply only to partnerships and therefore do not give the application of the rules to S Corporations sufficient consideration.

Contribution of Cash or Other Property

Sec. 465 states that a taxpayer is at-risk in an activity for the amount of money and the adjusted basis of other property contributed to the activity (Section 465(b)(1)(A)). If a shareholder contributes property that is subject to a debt, the amount at-risk depends upon whether the shareholder is personally liable for the repayment of the debt. If the shareholder is personally liable, the amount at risk is increased by the full amount of the property’s adjusted basis. However, if the shareholder is not personally liable, the amount at risk is increased by the adjusted basis of the property contributed and decreased by the nonrecourse debt (Prop. Regs. Sec. 1.465-23(a)).

What About Loans From The Shareholder to the S Corporation?

A very significant difference often arises between a shareholder’s basis and at-risk amount with regard to loans made by a shareholder to an S Corporation. Section 1366 and 1367(b) provide that a shareholder’s basis is increased by loans made to the S Corporation. However, under the at-risk rules of Sec. 465, these loans might not increase the shareholder’s atrisk amount. Section 465(b)(2) states that an S Corporation shareholder is atrisk only with respect to amounts borrowed for use in the corporation to the extent that the shareholder:

A) is personally liable for the repayment of such amounts; or (B) has pledged property, other than property used in such activity, as security for such borrowed amount (to the extent of the fair market value of the taxpayer’s interest in such property).

Under item (A) above, if a shareholder of an S Corporation borrows money from a bank and lends those funds to the S Corporation, the terms of the note between the bank and the shareholder will determine the shareholder’s liability.

Item (B) applies when a shareholder borrows money from an unrelated party, uses as collateral property of an S Corporation as security, and lends the funds to the S Corporation. This loan from the shareholder to the S Corporation gives the shareholder basis in debt but does not increase his or her at-risk amount. Both tests must be met in order for the shareholder to be able to deduct the loss on their personal return.

Company assets are often security for a loan the shareholder takes out in order to loan funds to the S Corporation. The shareholder’s guarantee of a loan made directly from the bank to the S Corporation would not create basis. As a result, the back-to-back loan described above is often used to create basis. However, practitioners often neglect to consider the atrisk issue. In order to avoid the claws of Sec. 465, collateral other than assets used by the activity must be utilized. It must be noted that if the shareholder pledged S Corporation stock as collateral, the shareholder would again not be at-risk.

Exception for Qualified Non-recourse Financing

There is an exception to the at-risk issue discussed in the case of qualified nonrecourse financing under Section. 465(b) (6). A shareholder is at risk with regard to qualified nonrecourse financing that is:

• Borrowed with respect to the activity of holding real property;

• Borrowed from a qualified person;

• Financing for which no person is personally liable for repayment; and

• Not convertible debt.

Borrowing from Persons Having an Interest in the Activity

This is another very significant trap for S Corporation shareholders. Under Section 465(b)(3) a shareholder is not at risk with regard to amounts borrowed from any person who has an interest in the activity or from a person who is related to a person with such an interest. Regs. Sec. 1.465-8, provides that even if an S corporation shareholder is personally liable for repayment of a loan for use in the S corporation, the shareholder will not be considered at risk if the money is borrowed from a person who has a capital interest in the S corporation. A fellow shareholder of the S corporation is considered to have a capital interest in the entity.

Section 465(b)(3) also states that a shareholder is not at risk with regard to money borrowed from an individual who has an interest in the net profits of the entity. Therefore a shareholder would not be at-risk for money borrowed from an employee of the S corporation whose annual bonus was fixed as a percentage of the corporation’s net profits.

Summary

Basis is not enough! Separate considerations must be taken into account to determine the at-risk amount of S corporation shareholders. Section 465 contains many traps that will limit or even prevent S corporation shareholders from deducting their pro-rata share of the company’s losses on their current year tax returns. Practitioners must be fully cognizant of the Section 465 rules in order to properly plan for the impact of the S corporation’s year-end results.


Lewis Taub is a Managing Director in the New York City office of CBIZ MHM, LLC and an active contributor to the S Corporation Technical Resource Committee of the AICPA. Lewis has been an Adjunct Professor at Fordham University’s Graduate School of Business.

A Focus on Write-Up Software

  • Written by Joshua Fluegel

The completion of a client’s taxes incorporates many elements that must be orchestrated with precision. Much of this relies on a CPA’s ability to anticipate problems and variable elements. However, the use of software is a valuable asset that can be used to bring order to the potential chaos of statements, forms and procedures. Write-up software is one of those tools, combing bank and client info to produce accurate financial statements. There are many options available to suit any CPA’s style or skill set. Some of the industry’s leading vendors describe their write-up products and how they could help a CPA during tax season.

“Payroll Relief’s Bank Feeds feature downloads transaction information from thousands of bank and credit card providers to automatically record all journal entries and update the trial balance, which reflects on the financial statements,” said Chandra Bhansali, cofounder and CEO of AccountantsWorld. “This helps keep the financial statements current and accurate with minimal effort.”

“They integrate using our bank reconciliation program and we have another report called the bank report, there are two different reports,” said Terry Gruters, president of PC Software Accounting. “They [CPAs] know for sure they are totally lined up with the bank.”

CheckMark claims to help keep a CPA organized providing easy-to-read displays helping in the comparison to bank records. Such ability could provide relief for the eyes after running through thousands of lines of expenses.

“The program allows CPAs to maintain accounting records for their clients, including sales, purchases, outstanding payables and receivables as well as inventory levels, and keep track of the constantly evolving financial picture of their company,” said Mohammed Ghani, president of CheckMark. “When it comes time to reconcile the books with the bank statement(s), the CPA can view all relevant transactions in a comprehensive and easy-to-read format and confirm that their records are in line with what their bank reports. A client can also use the Bank Reconciliation feature to reconcile other accounts.”

Assuming a CPA’s client portfolio is diversified, a versatile write-up solution would be most helpful. A write-up solution should be serviceable to every industry for which a CPA serves.

“It is important to have the flexibility to present clients with real-time, upto- date financials so that business clients are in a position to make more informed decisions,” said Louie Calvin, product manager - accounting and payroll at Thomson Reuters. “Write-up services are no longer valued after the fact, since clients expect to have access to financial indicators mid-period, or mid-month, in order to adjust strategy as needed. Firms that are positioned to offer clients realtime dashboards, KPIs and alerts can reasonably increase fees for their services and win additional customer satisfaction.”

Those who might be staying with a particular vendor’s write-up solution would be well served to talk to a representative about recent updates. There is no sense in letting last year’s complication reoccur when a patch or update is available to improve your write-up process. Intuit claims to have recently updated their reports feature.

“QuickBooks Online Accountant recently updated its management reports feature,” said Ariege Misherghi, group product manager at Intuit. “This lets accountants easily customize a professional- looking package of reports, complete with cover page, table of contents, preliminary pages, reports, end notes, and other custom content, for clients.”

A CPA works with many technologies when compiling financial statements. It would only seem logical to make sure all software can “talk” to each other. UBCC claims to be able to import information from various locations and platforms.

“UBCC’s write-up allows for direct import of check detail from the bank website and/ or from client supplied electronic sources such as credit cards, Quick- Books data files or Excel spreadsheets,” said Ken Garen, president and co-founder of UBCC. “Cleared check information can be imported from the bank data for automated bank reconciliation. Depending on the client’s needs, direct input of client supplied information can be mixed and matched with electronic imports and predefined client specific financial statement templates to achieve the greatest productivity.”

Of course no process of evaluating write-up software beats trying the products out. A CPA would be prudent to think about testing products months ahead of busy season to make sure they have a strong write-up package to serve clients year round.

Finding Perfection in Payroll Processing

  • Written by Joshua Fluegel

Perfection is a goal only achieved through the painstaking process of determining problems and preventing them from reoccurring. Accordingly, the following payroll processing vendors present problems many of their users have had in the past accompanied with ways to identify and remedy them. For example, maintaining healthy standards of communication and understanding between CPA, client and software is an excellent way to strive for a perfect payroll.

“This lack of understanding [of payroll software] and validation of accuracy can put the CPA at risk as there are several cases where the CPA is responsible for their client’s payroll taxes and possible penalties,” said Chuck Gossett, CEO of Cougar Mountain Software. “We believe the entire accounting department as well as external bookkeepers, auditors, and CPAs should be familiar with the accounting software which is being used…This involvement minimizes the exposure risk for CPAs and other parties.”

“A major obstacle can be the time gap between the payroll specialist (CPA) and the client fulfilling their respective roles,” said Mohammed Ghani, president of CheckMark. “It is important that both the client and the CPA have access to all information either through a web portal or a cloud application.”

Gathering data and maintaining the ability to share data among all software a CPA uses is an essential. A CPA can integrate every piece of software into a practice with all other currently used tools in mind.

“One key potential problem with payroll processing software is with information gathering and management,” said Chandra Bhansali, co-founder and CEO of AccountantsWorld. “Whether it’s obtaining timesheets with hours from employees, locating the correct unemployment rate for each new year from employers, or getting information about third-party payments, these are all significant challenges. CPAs need software that provides visibility into the information they need – for example, enabling them to easily review payroll information for a client’s look-back period to determine whether to change the client’s federal tax deposit frequency – and that helps them to collect information on a timely basis with automatic reminders, and easily-generated custom or batch emails.”

“Since the CPA’s major concern is often preparing his client’s financial statements, his Payroll software must also include write-up integration and/or provide built-in General Ledger summation reports for quick export to the write-up system according to client’s specific chart of accounts,” said Ken Garen, president and co-founder of UBCC.

“One of the most common problems CPAs have with payroll processing software is the seamless integration of their payroll solutions into accounting software,” said Ralph Matlack, director of product management, small business payroll at Intuit. “Not all payroll solutions can perform data sync with accounting software, which can cause manual data entry errors or require more client action.”

“Using inadequate payroll software can now become a problem where it wasn’t before,” said Ray Fazel, president of Paymate Software. “The businesses that do need this kind of detail (and not all do) require a robust system that is flexible and easily capable of integration with accounting, time & attendance, scheduling and other software. The solution to the problem is seemingly simple, but often harder to execute: switch payroll software, or upgrade to the next level of the same software that can handle the required payroll/accounting complexities. Making the switch can be hard, but definitely worth it.”

A CPA must keep the IRS in mind with every step taken. This means knowing tax law and ACA compliance to ensure complete compliance for all clients.

“Learning the compliance rules of a particular industry may be so difficult that the CPA may decide to turn away payroll work rather than invest in learning those rules for only one client,” said Tom Douglass, president of Advanced Micro Solutions. “For this reason, many CPAs decline to perform payroll services for restaurants while other CPAs specialize in that service. Similar situations arise in other industries, such as agriculture or construction.”

“Changes to payroll laws, regulations, rates and forms are ongoing and rapid,” said Jim Paille, director of compliance, myPay solutions at Thomson Reuters. “It is essential to team with a technology vendor that can keep up with the ongoing payroll tax compliance changes that take place on federal, state and local jurisdiction levels.”

“The company needs to make certain all information needed by the CPA is accurate and timely, ensuring that employees can be paid on-time with the deductions and benefits calculated, and all reports and taxes can be filed and paid so no penalties are accrued,” said Ken Hilton, president of Red Wing Software. “Therefore, more important than the software used, is ensuring that a written process is established and followed to the letter by all involved at both ends of the relationship.”

“One of the biggest risks for a CPA offering payroll services to their clients is compliance.  It is important to ensure the payroll processing software they use can help them comply with current federal, state and local regulations,” said Anthony Horton, vice president and general manager – specialty products at ADP. “To mitigate the risk that exists in in this environment it is imperative that CPAs partner with a company who has the expertise and ability to assist them in adapting to these regulatory changes quickly… CPAs should also look for an organization that will file their clients’ payroll taxes and has a team of payroll professionals readily available to offer help.”

By taking this advice a CPA may become a fountain of wisdom and perhaps even perfect at payroll. It’s one thing every employee insists on.

Preventing the Loss of Valuable Time

  • Written by Joshua Fluegel

CPA’s time is valuable. Keeping track of it, especially during tax season, is paramount in order to see a healthy return on investment for months of tireless efforts. Fortunately time and billing software can help a CPA keep track of where his or her day goes.

“Time and billing software provides CPAs with information that supports preparation of federal, state, and local income and/or franchise tax returns - reducing return preparation time and the related fees for such services,” said Curt Finch, CEO of Journyx. “It facilitates the calculation and related accounting for labor costs that must be capitalized for tax purposes, labor costs associated with passive or otherwise separately reportable activities, labor cost components eligible for various tax credits, and payroll apportionment factors required for multistate tax filings.”

“With tax season being so busy it’s easy for things to slide,” said Terence Cummings, vice president, sales at Sage Software. “Especially when it comes to tracking time. A few minutes here or there might not seem like a big deal at the time. But if you do this a few times every day, think about how much time you’re not tracking and billing for by the end of tax season. Be sure you have a solid system in place to help you track all of your billable time.”

“The use of time and billing software provides you the ability to apply a configurable workflow that allows your organization to review and approve the final details before submission for compliance purposes,” said Kevin Sequeira, general manager at Tenrox.

Keeping track of time not only ensures you get paid but proper use of time and billing software also saves valuable minutes.

“It’s helpful to keep the time and billing system open all day during tax season,” said Tom Dawson, president of TPS Software. “Everyone is very busy and working the hardest that they do all year so requiring the extra step of opening the program to record either time spent or stage of the return is counterproductive. Always try to minimize the struggle to record. More will be recorded and the accuracy will be better if effort is kept to a minimum.”

“Excel and Pen/ Paper tracking systems create additional work for you and your staff, and a lot of non-billable hours,” said Shafat Qazi, CEO and founder of BQE Software. “You need a time billing software that completely automates your processes and offers intuitive, easy to use time/expense capture tools.”

Counting and managing time spent with various client tasks not only saves money but it finds the proverbial sweet spot in the revenue/expenditure matrix maximizing profit.

“By tracking your time worked against billed and collected amounts you can see which of your hourly and flat fee clients are profitable over the short and long term,” said Michael Lipps, managing director of business and litigation software solutions at LexisNexis. “Several time and billing software applications have custom reporting options built into the system which can be used to tailor a report to meet a client’s specific needs. This not only helps clients more easily digest the information that is being presented to them, but shows they are a valuable partner to you.”

“Invoicing your services at or close to the time they are provided will enhance cash flows and improve the likelihood that billing disputes are resolved in your favor,” said Fred Lindsley, president of ImagineTime.

Time and billing no longer simply helps a CPA keep track of time spent filing taxes and conducting research but it now can tie all tax processing efforts together for the practice.

“Get online now,” said Brian Saunders, CEO of BigTime. “If you’re thinking of a timesheet as just a history of time, or an invoice as just a vehicle for billing, then you’re missing the true power of cloud-based practice management. It’s more than just an online repository of timesheets, invoices and notes. Big data is on the verge of providing you with the practice management equivalent of “instant replay” (together with a virtual press-booth of data analysts).”

“Automate routine tasks to the greatest extent possible,” said Brett Owens, CEO and co-founder of Chrometa. “Think about the overhead tasks you spent the most time on in previous tax systems. Was it chasing down time entries? Billing customers? Making sure you got paid? There is now software that can automate each of these tasks for you. If one or more was something you spent too much time on previously, look for a product that will reduce your headaches and busywork.”

“As tax season approaches, timesheet data is often a critical source document for so many aspects of the year’s end,” said Chris Vandersluis, CEO of HMS Software. “You may need auditable task-based timesheet data for Research Tax Credits, Sarbanes-Oxley compliance if you are publicly traded, Defense Contract Audit Agency Compliance if you do any work for Homeland Security or numerous other scenarios. Auditable task-level timesheets opens the opportunity for many grant and subsidy programs that require you show how your firm spent its time. Even if you haven’t been gathering task-based timesheet data so far this year, starting now can show good faith that you intend to follow such a practice and that can be a huge factor should you face an audit in the spring.”

Time and billing software is an intricate part of a CPA’s practice. Such an important cog in the machine is worth all the time a CPA can give it.