When a corporation confers an economic benefit upon a shareholder, in his capacity as such, without an expectation of reimbursement, that economic benefit becomes a constructive dividend, taxable as such. See INTERNAL REVENUE SERVICE NATIONAL OFFICE FIELD SERVICE ADVICE MEMORANDUM FOR DISTRICT COUNSEL, Number 200011003 dated October 27, 1999; specifically Page 4, 3rd paragraph.
The first Form 1040 in 1914 was a mere 5 lines of information. Today, the Internal Revenue Code spans 5 volumes with over 700 pages each in 8 point font. This doesn’t include the associated regulations. This section covers income tax and how the small business entrepreneur deals with proper filing and the associated deadlines.
In the world of big business corporate earnings are taxed twice under the Internal Revenue Code. The first layer of taxation occurs with the traditional corporate income tax. The second tier of taxation happens when dividends are issued to shareholders. The shareholder pays an income tax at their personal rate.
The American Benefits Council estimates that about 80% of all American workers have access to an employer sponsored retirement plan. This means that 20% of the workforce has no access to a formal retirement plan. To alleviate this issue, Congress created laws allowing those with earned income access to a retirement via Individual Retirement Accounts or more commonly called IRA’s.
One of the more significant expenses for the small business owners is income taxes. Since most small businesses are tax pass through entities, it is beneficial to the business to have the least amount of net income in order to reduce the tax obligations of the owner(s). This is achieved by making sure every dollar expensed is deductible for tax purposes.
In the normal taxpayer relationship with the Internal Revenue Service, the taxpayer is an employee and via withholding, taxes are paid the U.S. Government by the employer. Basically the employer pays the tax after each payroll run on behalf of all the employees and the corresponding mandated matching taxes (Social Security and Medicare). But in the small business world, this is not the normal relationship.
Code Section 465 of the Internal Revenue Code defines ‘At-Risk’ as the financial value the taxpayer has in jeopardy related to the business activity the taxpayer is invested in as some form of an owner. Effectively, the taxpayer may only take losses on his tax return contingent on the loss being directly tied to invested dollars with some form of tax basis.
Those small businesses using partnership or S-Corporation formats issue Form K-1 to the respective owners. When income is assigned to the owner and there is no corresponding cash related to that income, then this income is referred to as ‘Phantom Income’. In effect, it is assigned income for tax purposes without the corresponding cash to pay the tax liability.