S Corp Case Study Part II –Tax Problems Resulting from Deficit Equity

 In Part I, we discussed that owners of small companies live and breathe their businesses. Cash to fund operations often comes from the owner, and most owners also take cash out of the company as distributions.  It is common to see both cash inflows and outflows on a frequent basis throughout the year.  Part I focused on various methods of tracking this activity as it relates to an S Corp in a QuickBooks file.  

In Part II we promised to discuss some of the “bad news” that comes with the flexibility of S Corporations.  In particular, we will be discussing one of the most common tax problems for an S Corporation: “Distributions in excess of basis”.  This is a fancy phrase that means there are distributions paid to the owner during the year, and there is an ending deficit in the total equity balance. 

As in Part I, we are limiting this discussion to one-owner S corporations.  The tax treatment of owner distributions for partnerships and LLC’s have several important differences than discussed below, so it is important not­ to apply this discussion to a partnership situation.  Please remember also that the discussion below is general in nature, and numerous variations and exceptions exist that change the outcome – so, please discuss each specific situation with the tax preparer before arriving at any conclusions.  They have the ultimate responsibility, so you should not be making tax decisions.

However, as a QuickBooks consultantyou have the unique opportunity to act as the first line of defense.  Since you are involved in processing client financial data throughout the year, you are in position to notice when owner distributions run the risk of creating a deficit equity balance.  If you see this developing, notify the client and/or tax preparer immediately so that appropriate action can be taken as quickly as possible.  Prompt action makes almost any problem easier to solve. 

In addition to tax problems, deficit equity can be an indication the business is heading into financial trouble.  While this may seem obvious to you as a financial professional, the client may be unaware of what is happening.  Early identification allows the owner more time to determine alternative courses of action – before the problem grows too large to remedy successfully.

And remember - when it comes to taxes, after December 31st it is often too late to do anything about what may have just become an expensive problem. Savvy QuickBooks consultants are always looking to provide exceptional value, and early identification of this situation is one easy way to become a hero to your client.

Distributions in Excess of Basis - A Basic Case Study

2007 – A Developing Problem

In the example below, 2007 owner distributions of $48,552 exceed current year net income of $25,441 by $23,111. Total equity of $4,666 is still positive so no tax problem has occurred yet.  However, the warning signs of a developing problem are evident; equity is shrinking, and distributions exceed net income.  The savvy QuickBooks consultant will have already discussed the situation with the client and tax preparer during 2007. 

2008 – Deficit Equity, and “Distributions in Excess of Basis”

In the example below, 2008 owner distributions of $37,445 now significantly exceed net income of $1,993 by $35,452.  More importantly, total equity is now a deficit of $(30,786).  Owner distributions are what pushed equity into a deficit, as equity would have been positive had the owner not taken any 2008 distributions.  Generally, the owner’s “basis” for tax purposes is equal to the ending total equity balance.  Hence, 2008 activity resulted in the tax problem we are discussing – Distributions in Excess of Basis of $30,786. 

Author's note: The above explanation of “basis” is only a general rule and numerous other possibilities and exceptions exist, including differences in tax vs. book treatment of income or expenses, and owner basis in stock created outside the company.  It is possible for book equity to be positive yet still have a negative tax basis, and vice versa.  Assumptions about tax basis should not be made, so please consult with the tax preparer in all cases.   

Variation with Distributions Exceeding Net Income but No Tax Problem

As we see in the next example, had the owner limited distributions in the previous example to $6,659 or less there would have been no tax problem created since there was no ending deficit equity created.  This illustrates the point that prompt discovery on the part of the QuickBooks consultant can alert the owner to the need for prompt corrective action. 

Variation with Deficit Equity but No Tax Problem

I would like to make the point again: The tax problem of distributions in excess of basis occurs when there are both owner distributions and an ending deficit equity balance.  In the variation below, there is an ending deficit equity balance of $(19,783).  However, there were no owner distributions, so there could be no “distributions in excess of basis”.   

Authors note:  One exception to the above rule is when there is 1) positive beginning equity, 2) a net loss for the year, and 3) owner distributions for the year do not exceed beginning positive equity.  Rather than demonstrate by example how you can identify this technical exception, I instead suggest you stick with the general rule that owner distributions and ending deficit equity indicate the potential for a tax problem.  Let the tax preparer diagnose.  Our job is to be on the alert for our clients.

Conclusion

As we have seen in Parts I and II, there are a wide variety of transactions with owners and each requires separate treatment and understanding.  Additionally, the equity section of the S Corporation balance sheet often provides clues into developing tax and financial problems. 

The savvy QuickBooks consultant educates themselves with important basic tax and financial knowledge, they become familiar with the types of transactions they will encounter for each business, they remain alert for developing financial issues throughout the year, and they coordinate QuickBooks accounting with the owner and tax preparer to ensure owner transactions are properly identified, classified, and understood by all parties involved.

2 Comments

• Michael L says:
  May 21, 2009 09:21

  "... please discuss each specific situation with the tax preparer before arriving at any conclusions. They have the ultimate responsibility, so you should not be making tax decisions."

  Business owners, regardless of business structure, are responsible for all tax decisions. It is the responsibility of the tax preparer to inform the owners of alternatives and tax consequences. It is also the preparer's responsibility to prepare an accurate return from the information provided. The IRS and state departments of revenue will always hold business owners responsibile for accuracy, timeliness, completeness, and payment of all taxes.

  Ultimate responsibility for tax decisions rests with owners, not preparers.

• Donald L says:
  May 21, 2009 17:20

  Thanks for the comment, Michael. The business owner does bear the ultimate responsibility for the tax return. As a CPA who prepares tax returns, the reality in my practice is that the owners rely on me to inform them of the appropriate tax law in matters such as these. We can take this opportunity to re-emphasize the last sentence in the above conclusion: "... coordinate QuickBooks accounting with the owner and tax preparer...."