Case Study-Tax Implications
Florida Tropical Landscaping (FTL) is a calendar-year Accrual Basis Cooperation founded in September 2018. The company, however, registered losses in the first years of its operations. The first taxable year for the company ended on December 31, 2018, after the shareholders made their S Election in 2018.
In 2018, Matt, the leading shareholder of the company, borrowed $50,000 from a local bank. He used the certificate of deposit as collateral for the loan. The certificate of deposit is a savings product that earns interest on a lump sum basis after a specific period. The loan was used as follows:
- FTL Stock purchases: $30,000
- Loan to FTL: $20,000
To date, Matt has not paid any amount against the principal of the loan. However, he made the interest payments on time. Between 2018 and 2020, FTL Company made losses of $62,000, and all the losses were appropriately allocated to Matt. Matt deducted $50,000 from these losses as of the beginning of 2021. The remaining $12,000 was a carry forward into 2021. These deductions reduced FTL’s debt to zero.
Matt has also served as FTL’s president since the company’s incorporation and, therefore, has received a total of $150,000 annual salary from the company. In 2021, FTL made a taxable income of $250,000. The first principal repayment of $10,000 to Matt was made in 2021. The company did not make cash or property distributions to stakeholders in 2021.
In 2021, Vanessa, an FTL investor, gave a gift of 75 shares to an irrevocable trust. This gift brought forth the element of fiduciary accounting income that the company will make quarterly to support her grandmother and children. On the other hand, the reaming of Vanessa’s income after making the distributions to her three children should be distributed and made to a Democratic party. The trust will be terminated upon Vanessa’s grandmother’s death, and all the accumulated income will be distributed among her three children.
All these aspects will significantly impact the taxation of the 2021 taxable year for the company. Matt, as the leading shareholder of the company, draws the most financial resources from the company due to his shares and employment. Therefore, these are the major considerations when analyzing FTL and Matt’s tax implications.
ISSUES AND CONCLUSION
Issue: What are the tax implications for FTL when it was making profits and when it did not have any profits?
Conclusion: The Company will not be entitled to income tax because it made no profits during the first years. However, it will have other tax obligations such as employment taxes, excise, wage, and salary taxation for the years it did not make profits (Internal Revenue Service). On the other hand, the company will have to pay taxes in the 2021 financial year as it made a capital gain and increased the values of shares. The tax will be charged based on the shareholder’s equity in the company as it will increase due to the retained earnings in the company.
As presented in the company details, the $10,000 payment for the principal to Matt is not taxable for either the company or Matt. This is because it is a loan repayment, and they are not taxable. This aspect presents that the taxable income for the company will be $250,000 – $10,000 = $240,000. Therefore, $240,000 will be the company’s taxable income for 2021. This shows that the company will have some tax obligations in 2021. However, these obligations will be moved to the shareholders. They will be liable to taxation based on their shares in the company.
Additionally, the loan used for the investment in the company also raises some significant aspects due to the collateral that Matt used. Loans and interests on loans, including loans offered by banks, cannot be taxed; therefore, Matt’s loan was not taxable (Mooij). However, the interests received in the certificate of deposit are entitled to taxes as long as they exceed $10. This will, therefore, cause increased tax consequences for Matt and not the organization. On the other hand, S Corporations do not have income tax obligations. The profits and losses of the companies are instead allocated to the shareholders, who in turn pay the taxes on them. This shows that the shares bought and the loan to FTL are not subject to taxation. However, Matt will be taxed on the income gained through his shares in the corporation (Internal Revenue Service).
Issue: What are the tax implications of the shares offered as gifts by Vanessa?
Conclusion: Shares offered to trust funds as gifts would be taxable under the head income from capital gains. This means that the capital gained from the trust fund to support Vanessa’s children and grandmother is taxable. This is an important aspect as the taxation will affect the company as Vanessa is a company shareholder. On the other hand, the details about the company present that despite making profits, FTL did not pay any cash or property distributions to its shareholders. This shows that the values of their shares increased in the company. This is a capital gain for the shares; therefore, Vanessa’s gifting part of her shares in the irrevocable trust fund shows that Matt will have to pay a tax on the capital gain on Vanessa’s shares. Therefore, it is evident that this aspect has to be considered for the taxation of the company in 2021, as it made profits that increased the share value of each shareholder. Vanessa’s gift of shares to the irrevocable trust account means that the company will have to pay taxes on the 70 shares for the 2021 taxable year, depending on the capital gains on the shares.
DISCUSSION OF REASONING AND AUTHORITIES
The S Corporation does not pay federal income tax like most other companies. Rather, the company’s shareholders are responsible for paying these taxes. In other words, the business goes through the tax authorities for registration to move the tax liabilities to the owners. Everyone who owns stock in a small business that is currently an S Corporation must pay corporate tax annually. Matt can make money as a shareholder in the S Corporation in two ways: through distributions or payroll. As a result, as an active employer, the company is responsible for paying taxes accumulated through its operations that led to the development of the business. Compared to other businesses, the company pays both federal and employment taxes, which is not the case in S Corporations.
Most businesses typically use corporation income, losses, discounts, and loans for federal tax calculations. S Corporations are not subject to this as all these aspects are passed to the shareholders. Shareholders of S Corporations assess and report income gains and losses and are assessed for tax obligations individually. They are, therefore, supposed to file tax returns based on their shares in the company’s stakes. This saves the business from having to pay double taxes on business income. Taxes on specific connected income and passive income at the institutional level are the responsibility of the company. Therefore, the business is not entitled to pay taxes because the tax burden is transferred to the shareholders of the S Corporation. Because FTL Company was not profitable in its first years of operations, shareholders did not pay taxes. However, the business is required to pay other taxes, such as employment and excise duty taxes.
Excise taxes are often applied to transactions involving the purchase of goods and services used in the operations of businesses. Many of them are paid by the merchants, who then pass the tax obligations to the S Corporate. After paying taxes, businesses transfer the cost to shareholders. Retail prices go up overall as a result of merchants paying consumption tax to suppliers and taking the product’s price into account. Customers may or may not directly evaluate the consumption tax that was paid as a result. However, consumers have to pay some consumption taxes directly, such as property taxes and various interactions between taxes and retirement savings. Excise tax is crucial to the operations of all businesses, including FTL. The company’s actions show that it must make restitution for the goods and services rendered and the operations conducted during the years of its operations, regardless of whether it made profits.
The power to impose excise taxes rests with the federal, state, and local governments. Consumption tax revenue makes up a minor portion of total income for the federal and state governments, even though income tax is their primary source of income. The majority of excess tax comes from company tax settlements. S Corporations, unlike other businesses, are not required to pay income tax. Companies must include excise tax payments and fill them in the file form 720 federal excise tax return as a result of collecting and accepting excise taxes. Merchants who collect consumption tax are required to transfer it to state and local governments when necessary. Traders can subtract or exclude the cost of paying consumption tax from their yearly income tax return. The business manages and operates materials; thus, it must make tax payments. Therefore, these excise taxes raise the tax obligations of the company.
FTL has passive investors who do not take part in the daily operations of the business. On the other hand, the business also has Matt as its active investor, who participates in the operations and receives a taxable salary. Both active and passive investors are likely to receive returns based on the profits of the organization. Distribution can be broken down into several areas: regular business income, income from real estate rentals, regular dividends, and royalties. All these distributions from the company are capital gains for the shareholders. They are, therefore, taxable. Although no income tax is imposed on the business, the distribution is nevertheless taxable regardless of the type. This means that while the shareholders will owe taxes on the earnings they receive from the S Corporation, the company will have taxes to pay on the employment activities. Each year, taxes are imposed on each of these aspects, that is, from the shareholder’s capital gains and the operations of the companies.
Matt is not just a passive investor but also active in running the business. The IRS will consider Matt as a worker for the business and a taxpayer from two different perspectives. Matt will receive at least a portion of the company profits in the form of compensation. This compensation is taxable by IRS regulations. The taxation of employee compensation that Matt will receive is taxable from the organizational level. The same is true for any corporate executives and staff who are also shareholders in the company.
Given that it is typical to conduct a company in cramped spaces, it is crucial to comprehend the shareholders’ obligations to pay their taxes. Unlike distributors, employees who own stocks are subject to both federal employment tax and personal income tax on their pay. Due to the nature of Matt’s involvement in the business, the income tax can be deducted, and he will only pay employment taxes.
People utilize irrevocable trust accounts to safeguard property. This is the same aspect for Vanessa. After the property is given to the trust management, getting it back to the original owner is challenging if there is no irrevocable trust. The trust has its taxpayer identification number and is a separate legal organization. Until the trustee distributes the assets among the individuals specified by name or their heirs, the trustee permanently resides in the assets transferred to the trust. Usually, irrevocable beliefs are employed to shield property from legal action.
Capital gains are tax liabilities incurred as a result of the sale of tax assets. Stocks, homes, businesses, and collectibles are common assets subject to capital gains tax. Capital gains taxes are typically lower than income taxes. For example, the highest federal income tax rate is 37%, while the highest capital gains tax rate is 20%. If the investor’s taxable income is $41,675 or less, he will not be subject to capital gains tax. Vanessa’s case is unique. Her role in the trust fund is to provide financial assistance to her children and grandmother.
An irrevocable trust owns the property entrusted to it until the assets, including the income received, are divided. An irrevocable trust account must pay taxes on income received from the shares in the trust account. If an irrevocable trust must distribute income to consumers yearly, this will make the trust transfer easier. Beneficiaries must pay taxes on their anticipated earnings. This means that Vanessa must pay taxes on the income that the trust funds gain. This is a tax obligation that FTL Company will cover because the funds in the trust fund are meant to manage Vanessa’s personal needs.
Capital gains from irrevocable trusts are not considered income. Any capital gain, on the other hand, is considered a contribution to fixed capital. As a result, when the trust sells assets and realizes that the profits are not distributed to consumers, the trust pays capital gains taxes. This is a viable aspect for the 70 shares that Vanessa gifted to the irrevocable trust account. The increase in the value of the company’s shares meant that the trust fund shares value increased; therefore, Matt had to consider the tax implications of the shares. This is a critical factor in Vanessa’s situation. The company received some capital gains, resulting in a change in the value of 70 shares, which was labeled as an irrevocable trust.
On the other hand, an irrevocable trust is typically treated as a separate tax element because, when a person transfers ownership of the property to him, he provides an opportunity to control and restore the property. Profits or losses will thus not be reported on the settler’s tax return. Unfortunately, the capital tax analysis does not stop there. A person must still consider their unshakeable beliefs.
Each tax year, a simple irrevocable trust must terminate all income received by the trust. Consumers are taxed on these expenses as income. Some irreversible beliefs, however, are more complicated, and the law allows for income to be generated. This irrevocable trust can only distribute a portion of its earnings to users’ trusted individuals. On the other hand, capital gains are not considered income from a revocable trust. On the contrary, the capital benefit is regarded as a contribution to fixed capital. As a result, if the property is sold and a profit is realized, the profit cannot be distributed, implying that the trust must pay income tax.
An irrevocable trust is not liable for the sale of property or the distribution of profits. It is not liable for paying taxes to the beneficiary if it can distribute or transfer the property to the beneficiary. Although the initial distribution is tax-free, capital gains tax must be paid if the user sells the property along the way. In this case, the capital gains tax is usually calculated based on the value of the property when it was transferred to the user rather than the value of the previous purchase. This means that Vanessa’s irrevocable trust funds are liable for taxation, especially in 2021, since the company made profits showing evidence of capital gain.
Based on the case of FTL, the company did not pay cash or property distributions to its shareholders. This means that the company withheld all its profits in 2021, thus increasing the assets. However, the shareholders own the assets, and therefore, each of their portion of the shares in the organization increases in value. However, Vanessa’s gifting part of her shares to the irrevocable trust shows that the value of the shares will be taxable for the amount they gain. This means that Matt will have to pay the amount of the tax based on the capital gain that the 70 shares had in the company by 2021. Therefore, this shows that gifting the shares to the irrevocable trust fund has significant tax implications for the organization.
METHODS OF MINIMIZING TAX CONSEQUENCES
The company has no owner’s wages. This is one of the most reliable ways of reducing tax liabilities in the company. From the details of the corporation, the only tax liability of the company was on the 70 shares that Vanessa gifted to an irrevocable trust account. The company did not pay the shareholders’ wages, showing that they did not have tax obligations. Employment taxes for self-employment are always 15.3% of the salaries. This amount is payable in half by the employee and the other half by the employer. However, this is different for Matt, considering that he is one of the shareholders and also an employee of the company. His salary is considered under employment taxes and not self-employment. Therefore, the company can deduct the wages, salaries, and other fringe benefits that it uses from the taxable income. However, the company has to pay employment taxes.
Tax planning has been a concept of significant attention recently. It is very important in reducing the tax obligations of individuals and organizations. The organization can adopt different methods of reducing its tax obligations. Moving the shares to irrevocable trust accounts shows that the value of the shares will have to be registered under taxable assets. This means that it will increase the taxable income of the company, and therefore, this will increase the tax obligations of the organization. However, the tax will be paid with Vanessa and the FTL Company because the trust that she chose is not a grantor trust. This means that it will not be liable for tax liabilities of the assets as the ownership of the shares does not change when the gift is made. This will significantly increase the tax liability registered in the company.
In general, the payments received by Matt present the aspect of self-employment where the corporation will have half of the tax obligation, and he will be liable for the other half of taxation on his income from the operations of the company. According to the Internal Revenue Service (IRS), self-employment income is an income that arises from the performance of personal services. Matt is one of FTL’s major co-founders; therefore, drawing a salary from his operations in the development and performance of the company shows that he was employed in the company. Therefore, his $150,000 salary is taxable (Tyson and Sack). The salary paid to Matt is of fair value, as seen in the company details. The amount is liable for employment taxes.
IRREVOCABLE TRUST ACCOUNT AND THE TAX RATE
Unauthorized alteration, modification, or termination of the collateral by the beneficiary or designated user of an irrevocable trust is prohibited. The beneficiary has no additional rights in such a case since the grantor lawfully transfers the rights to them. However, the associated trust is not a grantor, showing that Vanessa’s decision has not changed the tax obligations. Therefore, the Agreement may not be amended by anybody other than the beneficiary or beneficiaries. The opposite of an irrevocable trust revocation is trust management. A revocable trust’s grantor has the authority to alter the trust’s provisions, but doing so forfeits some advantages, such as creditor protection. Trust is crucial to resolving disputes and fostering smooth development in real estate planning. This is an important aspect for most people.
Property and taxation are generally viewed with suspicion due to the tax obligations that the owners can get, especially if their assets are gifted to an irrevocable trust account. This kind of trust has the benefit of omitting all ownership scenarios; thus, the guarantee provider is not taxed on the assets. As a result, the grantor will not be impacted by any taxes levied on such an inheritance. Additionally, the irrevocable trust cancels any tax debts or arrears from any income derived from the grantor’s assets. In most circumstances, if entrusted, the grantor is prohibited from obtaining this benefit. It differs by jurisdiction, though, since some people take it a step further. Vanessa uses an irrevocable trust designation to safeguard the futures of her children and her grandmother. This attracts a different type of tax obligation, as analyzed in this memo. Since the assets are in share form, the organization must consider the shares for tax calculations.
Investments, life insurance, and money can all be included in a trust’s assets. Customers can also be trusted for certain traits. A lawyer must be involved since creating trust is a challenging process. It is sometimes true that the wealthiest citizens of the nation use this form of trust as an investment or investment strategy. The irrevocable trust charges the maximum installation fee set by the lawyer. Although there are many different kinds of trusts, it’s vital to remember that even those who plan their inheritance and property modestly need trusts.
People who have low-paying occupations typically find irrevocable beliefs to be highly helpful. Two outstanding examples of these professions are medicine and law. Trust is built in the so-called user or users when an asset is handed to such trust management. As a result, any issues the grantor encounters do not affect the trust because the grantor has been legally transferred from the defender to the user’s trust. Therefore, any legal action conducted against the trustee’s property after it has been transferred from them will have no bearing on it. This shows that while the gift to the irrevocable trust was important for Vanessa, she could have waited till the company increased profits and started to distribute returns on investment for such an action.
In the contemporary period, irrevocable trusts have several benefits that were not available when the equipment was originally utilized. The growth of the trust system enhances trust administration and asset allocation while increasing flexibility. The trust system is a crucial addition to the existing irrevocable trust system because it enables the transfer of trusts, the creation of more up-to-date trusts, and the creation of more significant laws. Breathing makes the present better and makes managing trust in the future simpler. One can change the dominion’s status by using additional supplements that can provide tax discounts and higher savings. These are some options Vanessa could have considered to reduce the tax obligations acquired through her irrevocable trust accounts.
STRATEGIES FOR REDUCING TAX OBLIGATIONS
The company can use different methods to lower its tax obligations. One of the most prominent methods the company can use is the owner-employee healthcare reimbursement method. Matt can use healthcare reimbursement for his salary, thus reducing the amount that can be taxed under the employment taxes by the company (Preskitt). This method will allow the company to reduce its taxable income while increasing its financial gains of Matt. It is, therefore, one of the most important methods of consideration for the taxation of the company.
On the other hand, tax obligations can be avoided by the use of deductions in S companies. This is a viable element for FTL Company. There are numerous forms of deductions that Matt can consider for the operations of FTL. These deductions are important in reducing the company’s taxable income. Some of these deductions include home office appliances, depreciation, vehicle expenses, travel expenses, and cell phone expenses. All these deductions are important in the company’s overall operations. This means that they are deductible from the final taxable income.
In the case of the company, one of the causes of increased tax consequences for FTL is the shares that Vanessa gifted to the irrevocable trust account for the management of her family. According to past studies and sources, a shareholder of any company is liable for their shares after they buy them. This makes them owners of the shares they purchase and a part of the organization. However, the organization does not control its actions regarding its shares. They are, therefore, allowed to sell them or gift them at any time. This raised a significant issue for the company because despite making profits in 2022, none of the shareholders received any cash or property distributions. This means that the profits made by the company did not have a tax liability.
The actions Vanessa took had significant consequences on the amount of tax. Matt should consider telling the shareholders to communicate before making such decisions to make effective decisions on methods of handling the tax obligations. Such methods can include offering specific distributions to shareholders to take care of their tax obligations and maintain a steady improvement of the company’s value.
Bad debt is another method of increasing deductions in S Corporations. This is an evident aspect of FTL, as shown in the company’s financial performance details. In 2021, the company’s taxable income was reduced from $250,000 to $140,000 due to the debt that Matt took and funded the company’s operations. This is because most debts are not taxed. Therefore, the company can fund most of its operations with debt, deducting them from the tax on the shares of shareholders. Subsequently, this will reduce the company’s tax obligations.
S Corporations generally report taxes, but the owners hold the tax liabilities. The owners pay and file the taxes and income gained in the companies at an individual level. Therefore, the tax obligations at the corporate level are not based on the income gained but on other aspects such as excise tax and employment tax. This is an imminent element, as seen in the taxation parameters of FTL. The company made an income gain but did not pay the shareholders any returns in 2021. This increased the assets of the company and, therefore, reduced the tax obligations by the shareholders as in that year. However, the 70 shares gifted to an irrevocable trust account by Vanessa were subjected to taxation, which meant that the company had to pay the tax on the value gain of Vanessa’s shares. Therefore, it is evident that Vanessa’s actions had significant impacts on the tax consequences for the company.
In general, Vanessa’s gift of share to the irrevocable trust account does not change the ownership as the trust is not a grantor. Therefore, Vanessa and the FTL organization are still liable for any tax imposed on the shares because assets in an irrevocable trust fund are taxable as per federal law. On the other hand, loans are not taxed, meaning that Matt’s action of taking a bank loan to purchase his shares and loaning part of it to the company was a smart move for reducing the company’s tax obligations. Matt also worked for the organization and presented some tax obligations for the company. However, Matt can use different methods, such as deductions, to reduce the company’s taxable income.
Additionally, shareholders should consider other methods of savings and operating to minimize tax obligations. Vanessa could use revocable trust accounts that can be canceled when needed. Notably, this would be important in solving higher tax consequences for the company and its shareholders.
Bennett, S.J. “Preserve your assets by using irrevocable life insurance trusts.” 2005, https://www.researchgate.net/publication/294185081_Preserve_your_assets_by_using_irrevocable_life_insurance_trusts.
Internal Revenue Service. “S Corporation Stock and Debt Basis.” 2022. https://www.irs.gov/businesses/small-businesses-self-employed/s-corporation-stock-and-debt-basis
Internal Revenue Service. “S Corporation.” 2022. https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations
Mooij, Ruud, A., “Tax Biases to Debt Finance: Assessing the Problem, Finding Solutions.” International Monetary Fund (IMF) staff Discussion Note. 2011. https://www.imf.org/external/pubs/ft/sdn/2011/sdn1111.pdf
Preskitt, John, T., “Health care reimbursement: Clemens to Clinton.” Baylor University Medical Center Proceedings, vol. 21, no. 1, 2008, pp. 40 – 44. https://doi.org/10.1080%2F08998280.2008.11928358
Tyson, Toussaint, and Sack, Gerald, V., “IRC 7701 – General Discussion.” 1992, EO CPE Text. https://www.irs.gov/pub/irs-tege/eotopici92.pdf
We’ll write everything from scratch
Assume that it is March 1, 2022, and you are working on the 2021 tax return for Florida Tropical Landscaping (FTL). FTL is a calendar-year, accrual-basis corporation that was formed in September 2018 and made a valid S election for its first taxable year ending on December 31, 2018. Although the business generated operating losses for its first several years, the shareholders are confident that the long-term prospects for the business are excellent.
Matt owns 100 percent (300 shares) of the outstanding voting stock in FTL (and he is in the top marginal tax bracket). Nine individual investors, who are Matt’s friends and business associates, own another 700 shares of nonvoting common stock (issued at the end of 2020). In 2018, Matt borrowed $50,000 from a local bank, using a Certificate of Deposit with the bank as collateral for the loan. He used $30,000 of the loan proceeds to purchase his FTL stock. He loaned the remaining $20,000 to FTL and received a properly drafted note from the corporation that stipulated the applicable federal interest rate and provided for repayment of principal beginning in 2021. To date, Matt has made no payments against the principal of his bank loan; however, the interest payments were made in a timely manner.
From 2018 through 2020, FTL’s operating losses of $62,000 were properly allocated to Matt. There were no other items of separately computed income, gain, or loss during these years. As of the beginniMatt’s2021, Matt’s basis in his FTL stock and FTL debt were reduced to zero because of his deduction of $50,000 of these losses. The $12,000 non-deductible portion of the allocated losses is a carryforward into 2021.
Matt has served as President of FTL since its incorporation, drawing a $150,000 annual salary. This amount of salary is reasonable considering the time and effort he has devoted to the corporate business.
FTL generated a taxable operating income of $250,000 during its 2021 taxable year. In late 2021, FTL made the first $10,000 principal repayment on its note held by Matt. FTL made no cash or property distributions to its shareholders during 2021.
Two days ago, Matt discovered that one of his co-investors in FTL, Vanessa, had made a completed gift of 75 shares of FTL stock into an irrevocable trust. The date of the gift was April 22, 2021. The trust instrument provides that fiduciary accounting income is to be distributed to Vanessa’s elderly grandmother in an amount sufficient for her support and maintenance. The trustee has the discretion to distribute any additional trust into Vanessa’ sus to Vanessa’s three adult children. Any trust income remaining after making these distributions will be distributed to the Democratic Party’s grandmother’s death, the trust will terminate, and the trust corpus and any accumulated income will be distributed in equal shares to the three adult children. This trust is not a grantor trust.
Assume that it is March 1, 2022, and you are now working on the 2021 tax return for Matt’s as well as Matt’s tax return, and you need to determine the exact amounts that should be reported. Matt is concerned about any unforeseen tax consequences of the transfer of FTL stock into the trust. He needs a full explanation of any specific consequences to FTL for its 2021 tax year, along with the computations to support your explanation.
You are to provide detailed computations showing the specific tax impMatt’s FTL and Matt’s tax returns if they are filed now before the extension and after the extension.
Matt also wants to know if there is any way to avoid or negate any unexpected or undesirable vVanessa’s generous gift and recommendations as to what should be done in the future. You have told him that it is possible to file an extension for the tax returns.
Provide specific details of what can potentially be done to minimize any adverse tax consequences, assuming extension requests are filed, and any recommendations of what should be done to minimize future problems.
Instructions: Identify the issues, research them, reach conclusions, and then prepare a memo to file and a client letter for a sophisticated client. Be sure to include any relevant computations in your memo to file.