Placing an S corporation on the cash basis for certain expenses paid to shareholders.

• Author: Ellentuck, Albert B.

A special rule applies to expenses paid by an accrual-method S corporation to a cash-method shareholder, if paid after the end of the corporation's tax year. According to Sec. 267(a)(2), the corporation cannot deduct such expenses until they are includible in the shareholder's income; in other words, the corporation is placed on the cash basis for these expenses. (As illustrated in the final example, this rule does not cause a problem if the S corporation and shareholder use the same tax year.) Under Sec. 267 (e)(1) (B) (ii), this rule applies to an expense paid to a person who owns (directly or indirectly) any of the S corporation's stock.

Example

Jancorp is an accrual-method S corporation with a September 30 yearend. On Sept. 30, 2005, it owes $1,500 in equipment rent to Janet, its sole shareholder, and pays her on Oct. 1, 2005. When does Jancorp take the deduction for the rent? When is the income taxable to Janet?

Even though the rent is properly accruable on September 30, Jancorp cannot take the deduction until it pays it. Thus, the corporation shows the expense on its return for the year ended Sept. 30, 2006. Janet, however, must report the income on her 2005 return.

To summarize, Jancorp takes the deduction when the expense is paid, instead of when accrued, and will show the expense on its return for the year ended Sept. 30, 2006. Janet must report the income in the year before the year in which Jancorp is allowed the deduction.

Strategy

Planning is needed to ensure that the corporate deduction and the inclusion in shareholder income occur in the same tax year. To prevent mismatching, Jancorp could have paid the expense on Sept. 30, 2005. It would then show the deduction on its return for the year ended Sept. 30, 2005; Janet would show the income on her 2005 return. Alternatively, Jancorp could have waited until Jan. 1, 2006, to make the payment; in such case, both the corporation's expense and Janet's income would be reported in...