The right entity choice can make a difference in the tax bill you owe for your business. Although S corporations can provide substantial tax advantages over C corporations in some circumstances, there are plenty of potentially expensive tax problems that you should assess before making the decision to convert from a C corporation to an S corporation.

Here’s a quick rundown of four issues to consider:

LIFO inventories. C corporations that use last-in, first-out (LIFO) inventories must pay tax on the benefits they derived by using LIFO if they convert to S corporations. The tax can be spread over four years. This cost must be weighed against the potential tax gains from converting to S status.

Built-in gains tax. Although S corporations generally aren’t subject to tax, those that were formerly C corporations are taxed on built-in gains (such as appreciated property) that the C corporation has when the S election becomes effective, if those gains are recognized within five years after the conversion. This is generally unfavorable, although there are situations where the S election still can produce a better tax result despite the built-in gains tax.

Passive income. S corporations that were formerly C corporations are subject to a special tax. That tax kicks in if their passive investment income (including dividends, interest, rents, royalties, and stock sale gains) exceeds 25% of their gross receipts, and the S corporation has accumulated earnings and profits carried over from its C corporation years. If that tax is owed for three consecutive years, the corporation’s election to be an S corporation terminates. You can avoid the tax by distributing the accumulated earnings and profits, which would be taxable to shareholders. Or you might want to avoid the tax by limiting the amount of passive income.

Unused losses. If your C corporation has unused net operating losses, they can’t be used to offset its income as an S corporation and can’t be passed through to shareholders. If the losses can’t be carried back to an earlier C corporation year, it will be necessary to weigh the cost of giving up the losses against the tax savings expected to be generated by the switch to S status.

Additional factors

These are only some of the factors to consider when a business switches from C to S status. For example, shareholder-employees of S corporations can’t get all of the tax-free fringe benefits that are available with a C corporation. And there may be issues for shareholders who have outstanding loans from their qualified plans. These factors have to be taken into account in order to understand the implications of converting from C to S status.

Contact us. We can explain how these factors will affect your company’s situation and come up with strategies to minimize taxes.

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Given the escalating cost of employee health care benefits, your business may be interested in providing some of these benefits through an employer-sponsored Health Savings Account (HSA). For eligible individuals, HSAs offer a tax-advantaged way to set aside funds (or have their employers do so) to meet future medical needs. Here are the key tax benefits:

• Contributions that participants make to an HSA are deductible, within limits.
• Contributions that employers make aren’t taxed to participants.
• Earnings on the funds within an HSA aren’t taxed, so the money can accumulate year after year tax free.
• HSA distributions to cover qualified medical expenses aren’t taxed.
• Employers don’t have to pay payroll taxes on HSA contributions made by employees through payroll deductions.

Who is eligible?

To be eligible for an HSA, an individual must be covered by a “high deductible health plan.” For 2019, a “high deductible health plan” is one with an annual deductible of at least $1,350 for self-only coverage, or at least $2,700 for family coverage. For self-only coverage, the 2019 limit on deductible contributions is $3,500. For family coverage, the 2019 limit on deductible contributions is $7,000. Additionally, annual out-of-pocket expenses required to be paid (other than for premiums) for covered benefits cannot exceed $6,750 for self-only coverage or $13,500 for family coverage.

An individual (and the individual’s covered spouse, as well) who has reached age 55 before the close of the tax year (and is an eligible HSA contributor) may make additional “catch-up” contributions for 2019 of up to $1,000.

Employer contributions

If an employer contributes to the HSA of an eligible individual, the employer’s contribution is treated as employer-provided coverage for medical expenses under an accident or health plan and is excludable from an employee’s gross income up to the deduction limitation. There’s no “use-it-or-lose-it” provision, so funds can be built up for years. An employer that decides to make contributions on its employees’ behalf must generally make comparable contributions to the HSAs of all comparable participating employees for that calendar year. If the employer doesn’t make comparable contributions, the employer is subject to a 35% tax on the aggregate amount contributed by the employer to HSAs for that period.

Distributions

HSA distributions can be made to pay for qualified medical expenses, which generally mean those expenses that would qualify for the medical expense itemized deduction. They include expenses such as doctors’ visits, prescriptions, chiropractic care and premiums for long-term care insurance.

If funds are withdrawn from the HSA for other reasons, the withdrawal is taxable. Additionally, an extra 20% tax will apply to the withdrawal, unless it’s made after reaching age 65, or in the event of death or disability.

As you can see, HSAs offer a flexible option for providing health care coverage, but the rules are somewhat complex. Contact us if you’d like to discuss offering this benefit to your employees.

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Many business owners ask: How can I avoid an IRS audit? The good news is that the odds against being audited are in your favor. In fiscal year 2018, the IRS audited approximately 0.6% of individuals. Businesses, large corporations and high-income individuals are more likely to be audited but, overall, audit rates are historically low.

There’s no 100% guarantee that you won’t be picked for an audit, because some tax returns are chosen randomly. However, completing your returns in a timely and accurate fashion with our firm certainly works in your favor. And it helps to know what might catch the attention of the IRS.

Audit red flags

A variety of tax-return entries may raise red flags with the IRS and may lead to an audit. Here are a few examples:

• Significant inconsistencies between previous years’ filings and your most current filing,
• Gross profit margin or expenses markedly different from those of other businesses in your industry, and
• Miscalculated or unusually high deductions.

Certain types of deductions may be questioned by the IRS because there are strict recordkeeping requirements for them ― for example, auto and travel expense deductions. In addition, an owner-employee salary that’s inordinately higher or lower than those in similar companies in his or her location can catch the IRS’s eye, especially if the business is structured as a corporation.

How to respond

If you’re selected for an audit, you’ll be notified by letter. Generally, the IRS won’t make initial contact by phone. But if there’s no response to the letter, the agency may follow up with a call.

Many audits simply request that you mail in documentation to support certain deductions you’ve taken. Others may ask you to take receipts and other documents to a local IRS office. Only the harshest version, the field audit, requires meeting with one or more IRS auditors. (Note: Ignore unsolicited email messages about an audit. The IRS doesn’t contact people in this manner. These are scams.)

Keep in mind that the tax agency won’t demand an immediate response to a mailed notice. You’ll be informed of the discrepancies in question and given time to prepare. You’ll need to collect and organize all relevant income and expense records. If any records are missing, you’ll have to reconstruct the information as accurately as possible based on other documentation.

If the IRS chooses you for an audit, our firm can help you:

• Understand what the IRS is disputing (it’s not always crystal clear),
• Gather the specific documents and information needed, and
• •Respond to the auditor’s inquiries in the most expedient and effective manner.

Don’t panic if you’re contacted by the IRS. Many audits are routine. By taking a meticulous, proactive approach to how you track, document and file your company’s tax-related information, you’ll make an audit much less painful and even decrease the chances that one will happen in the first place.

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Some of your not-for-profit’s communications are of interest only to a select group of your supporters. But your organization’s annual report is for all stakeholders — donors, grantmakers, clients, volunteers, watchdog groups and the government.

Some report elements are nonnegotiable, such as financial statements. But you also have plenty of creative license to make your report engaging and memorable for its wide-ranging audience.

First things first

Most nonprofit annual reports consist of several standard sections, starting with the Chairman of the Board’s letter. This executive summary should provide an overview of your nonprofit’s activities, accomplishments and anything else worth highlighting. Next is the directors and officers list. The biggest task here is to make sure all names, professional affiliations and designations are accurate and spelled correctly.

Then there’s the financial information section, which generally is subdivided into three sections:

1. Independent auditor’s report. This is a professional auditor’s opinion about whether your nonprofit’s financial statements have been prepared in accordance with Generally Accepted Accounting Principles.
2. Financial statements.You’ll want to include a Statement of Financial Position(assets, liabilities and net asset categories as of the last day of the fiscal year), Statement of Activities(revenues earned and expenses incurred during the year) and Statement of Cash Flows (changes, sources and uses of cash for the year).
3. Footnotes. Use these toexpand on financial statement items regarding such subjects as leasing arrangements and debt.

You can make your financial statements easier to understand by creating an abbreviated version with a synopsis that quickly gets to the heart of the matter. Where applicable, use simple graphs, diagrams and other visual aids to highlight specific points.

Meat of the matter

A “Description” is the other major section in a typical annual report, and it’s where you can — and should — get creative. First, explain your organization’s mission, goals and strategies for reaching those goals. Then, describe who benefits from your organization’s services and how they contribute to the community.

So that your report does justice to this work, include client testimonials where those you’ve helped tell their own story in a personal way. Or create a timeline that enables readers to see the progress you’ve made toward a long-term goal.

Your annual report should be as visually exciting as it is interesting to read, with engaging photos, arresting graphics and innovative layouts. Make sure your graphic designer has experience with annual reports — preferably those of nonprofits — and understands the brand, values and image your organization wants to convey.

Continuous improvement

Even if you’re proud of the finished product, make sure you survey stakeholders. Or convene a small focus group to find out what your report’s readers liked — and what they didn’t find as effective. Then apply these insights to next year’s effort.

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It’s no secret that this is a challenging time for charitable fundraising. In its annual Giving USA 2019 report, the Giving USA Foundation noted a decrease in individual and household giving, blaming such impersonal factors as tax law changes and a wobbly stock market.

So why not fight back by making personal appeals to supporters? Requests from friends or family members have traditionally been significant donation drivers. Even in the age of social media “influencers,” prospective donors are more likely to contribute to the causes championed by people they actually know and trust.

Success strategies

The dedicated members of your board can be particularly effective fundraisers. But make sure they have the information and training necessary to be successful when reaching out to their networks.

When making a personal appeal to prospective donors, your board members should:

Meet in person. Letters and email can help save time, but face-to-face appeals are more effective. This is especially true if your nonprofit offers donors something in exchange for their attention. For instance, they’re more likely to be swayed at an informal coffee hour or after-work cocktail gathering hosted by a board member.

Humanize the cause. Say that your charity raises money for cancer treatment. If board members have been impacted by the disease, they might want to relate their personal experiences as a means of illustrating why they support the organization’s work.

Highlight benefits. Even when appealing to potential donors’ philanthropic instincts, it’s important to mention other possible benefits. For example, if your organization is trying to encourage local business owners to attend a charity event, board members should promote the event’s networking opportunities and public recognition (if applicable).

Wish list

Consider equipping board members with a wish list of specific items or services your nonprofit needs. Some of their friends or family members may not be able to support your cause with a monetary donation but can contribute goods (such as auction items) or in-kind services (such as technology expertise).

If you’re concerned about declining donations and need help finding new revenue streams, contact us for ideas.

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