Last fall I was meeting with a prospective client who was starting a small business. The business had just $10,000 of income in 2018, and would maybe have $30,000 of income in 2019.
She was thinking about making her business an S-corporation because her dentist had told her about “these great tax strategies where you put money into the corporation and then get all these benefits from it.”
She wanted to know what this great strategy was, so she too could employ it.
I said that the dentist’s words were too vague to know what he meant (as is usually the case with people who aren’t tax professionals but who opine on some “strategy” they use to “pay no taxes”); I said I would need to see the dentist’s tax return or talk to his accountant to know what he was doing.
I went on to talk about how maybe he was referring to shareholder loans, as a way of getting money back from the corporation without calling it a distribution or without blowing the S election if there are multiple shareholders.
But as always in these situations, I was getting into things she didn’t understand. So I closed by telling her that until her income increased, an S-corp wasn’t a great option for her anyway.
I could tell she wasn’t happy with my response, because I suppose it seemed like the dentist had some “secret sauce” that the tax pro didn’t know about.
S-Corporation Loans (What the Dentist was [Probably] Talking About)
I think the dentist was probably talking about making a shareholder loan to the S-corp. The shareholder puts money into the corporation, and then gets paid back from the corporation in a way where the payback is not a distribution and would not be taxable to the shareholder.
Again, I have no idea if that’s the “strategy” the dentist was talking about, but it’s what seems to fit.
Shareholder loans can be useful for situations where the shareholder is fronting losses, in particular where the corporation has multiple shareholders.
The S-Corp Problem with Multiple Shareholders
Let’s say there’s an S-corp with Dad and Sonny as 50/50 owners. The corporation needs an infusion of cash to pay expenses right now, so Dad puts in $20,000. The intention is to pay back that $20,000 to Dad.
If Dad was the only shareholder, then no problem. You’d probably call it a capital contribution by Dad, and the payback would just be a distribution.
(NOTE: this assumes that Dad is paying himself a reasonable salary. If he’s not paying himself a reasonable salary [COUGHandhe’sprobablynotCOUGH — sorry, there goes my “tax field cynicism” again], then getting a distribution would be a problem.)
But since Sonny is also a shareholder, the distribution idea for Dad is problematic because S-corp distributions must be paid pro rata. Meaning, if Dad gets paid back, say $5,000 this year and it’s called a distribution then Sonny also must get a $5,000 distribution or else the S-election is blown and that’s a bad thing.
And so Dad calls the $20,000 a loan. Paybacks need to include an interest portion, which Dad will claim as interest income.
Losses and Loans
Dad has an added benefit with his contribution — if the corporation suffers a loss, Dad can use than $20,000 as basis and take the loss even if his “regular” basis is not enough to take a full loss.
You do have to be careful here though, because if the loan basis gets drawn down by losses and Dad continues to get paybacks on the loan, those paybacks may become taxable, and the payback may be ordinary income (depending on how the loan was set up).
Closing Thoughts on Getting Tax Advice from Your Dentist
I am amazed at how, in the tax field, there are so many “experts” who are not tax professionals. This field is HARD, there are no easy answers and there is no pot of gold “magical tax strategy. I work with this junk every day (there goes my cynicism again) and I learn new things EVERY SINGLE DAY. And yet a person who doesn’t work with taxes at all is going to spout off about some grand strategy?
I mean, I don’t talk to my clients about their teeth, because I am not a dentist. So why does the dentist feel inclined to talk about taxes to his patients????