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Comprehensive Volume

Chapter 22

S Corporations

The Big Picture (slide 1 of 2)

Cane, Inc., has been a C corp. for a number of years, earning taxable income of less than $100,000 per year.
Thus, the business has been subject to the lower C corporation tax rates.
Due to cheap imports from China, Cane’s two owners, Smith and Jones, expect operating losses for the next two or three years.
They hope to outsource some of the manufacturing to Vietnam and turn the company around.
How can they deduct these anticipated future losses?

The Big Picture

Cane, Inc. a C corporation, has been in the manufacturing business for a number of years. It has two types of stock outstanding, voting and nonvoting common. All the stock is owned equally by two individual shareholders, one a resident of Texas and the other a resident of Arkansas. Each shareholder is married to a nonresident alien.

The Big Picture (slide 2 of 2)

The corp. receives some tax-exempt income, generates a small domestic production activities deduction (DPAD), and holds some C corp. E&P.
Each owner draws a salary of $92,000.
Cane has two classes of stock, voting and non-voting common stock.
Cane is located in Texarkana, Texas.
Smith lives in Texas, and Jones lives in Arkansas.
Both are married to nonresident aliens.
Should Smith and Jones elect to be taxed as an S corporation?
Do they need to liquidate or go through some type of reorganization to do so?
Read the chapter and formulate your response.

Cane pays each shareholder a salary of $92,000. After considering the shareholders’ salaries, the corporation has generated modest profits in the recent past, most subject to tax at the lower corporate rates. The owners anticipate that the company will generate losses in the next few years before returning to profitability.

Can/Should the owners make an election to have Cane taxed under Subchapter S? If they do, must the corporation liquidate to make the election?

Subchapter S Issues
(slide 1 of 6)

S corporations provide many of the benefits of partnership taxation
Also gives the owners limited liability protection from creditors
S corporation status is obtained through an election by a qualifying corporation with the consent of its shareholders

. Introduction

1. Subchapter S of the IRC (§§ 1361–1379), allowing shareholders of qualifying corporations the ability to avoid the double taxation ordinarily associated with corporate status while retaining liability protection, was added to the tax law long before the evolution of LLCs and LLPs. Taxation under Subchapter S includes many of the benefits of partnership taxation as applied to operating income. However, many of the other provisions covering corporations remain relevant to S corporations, making certain transactions involving the entity and its owners that might be tax deferred in the partnership setting taxable

Subchapter S Issues
(slide 2 of 6)

S corporations are still corporations for legal purposes
Owners receive the benefits of limited liability, ability to raise capital (within limits), etc...

2. As LLCs and LLPs became more popular and the twin benefits of flow-through taxation and limited liability were more generally available, several of the barriers to qualification for S status, especially those related to ownership, were eased. However, many differences in the taxation of S corporations and partnerships remain, making the choice between the two a significant one for the owners of many business entities.

Subchapter S Issues
(slide 3 of 6)

Taxation resembles partnership taxation
Certain items (primarily business income and certain expenses) are accumulated and passed through to shareholders
Other items are “separately stated” and each item is passed through to shareholders

3. S Corporation status provides many of the benefits of partnership taxation plus limited liability for the owners similar to a C corporation. Thus, an S corporation is a hybrid of partnerships and C corporations.

4. S corporations are treated as corporations under state legal systems.

Subchapter S Issues
(slide 4 of 6)

An S corporation is a reporting (rather than tax-paying) entity
Tax liability may still arise at the entity level for:
Built-in gains tax, or
Passive investment income penalty tax

5. Since the IRS ruled that a limited liability company (LLC) may be taxed as a partnership, the choice of organization form for owners of many closely-held businesses is often between an LLC and an S Corporation. The differences between these entities are highlighted throughout the chapter and summarized in Concept Summary 22-1. The differences include the following.

S Corporations lack the flexibility in allocating items of income, loss and deductions afforded by LLCs.
S status imposes several restrictions on the number and type of owners the entity may have.
Many transactions that escape current taxation under Subchapter K (e.g., distributions of appreciate property) are taxable to an S Corporation.
The aggregate ordinary income allocated to shareholders of an S Corporation, even those who are actively involved in the management of the corporation, are not subject to payroll or self-employment tax.
Subchapter S contains no provision analogous to § 751 that will re-characterize a gain on the sale of corporate stock as ordinary due to the nature of assets held by the corporation.

6. Changing from an S Corporation to an LLC will require liquidation of the S Corporation, triggering recognition of any gain related to any appreciated assets. Therefore, existing S Corporations will often choose to remain S Corporations regardless of any advantages an LLC or LLP may provide with respect to the taxation of current income.

Subchapter S Issues
(slide 5 of 6)

An S corporation is not subject to the following taxes:
Corporate income tax
Accumulated earnings tax
Personal holding company tax
Corporate alternative minimum tax

Subchapter S Issues
(slide 6 of 6)

Entity is subject to Subchapter C rules for a transaction unless Subchapter S provides alternate rules

7. S corporation popularity has waxed and waned with the changes in the tax laws. However, S corporations are currently popular with 60% reporting positive income.

ADDITIONAL LECTURE RESOURCE

The Small Business Corporation provision was first introduced in Congress in 1954, but it did not become law until 1958. A Subchapter R option in § 1351 was passed in 1954 to allow a partnership to be taxed as a corporation, but that provision was quickly deleted from the Code.

When to Elect S Corp Status

Following factors should be considered:
If shareholders have high marginal tax rates vs C corp rates
If NOLs are anticipated
If currently C corp, any NOL carryovers from prior years can’t be used during S corp years
Still reduces 20 year carryover period
Character of anticipated flow-through items
State and local tax laws
A variety of other factors

When to Elect S Corporation Status

8. The following factors should be considered when considering electing S status.

The marginal rates of shareholders.
The usefulness of pass-through losses to shareholders.
The effect of the S election on C corporation NOL carryovers.
The character of income and expenses that will flow through to shareholders.
The eligibility requirements imposed on the entity to retain its S status.
Whether the S status is recognized for state and local tax purposes.
The effect S status may have on other tax factors such as the Alternative Minimum Tax (AMT).

S Corp Qualification
Requirements (slide 1 of 3)

To elect under Subchapter S, a corporation must meet the following requirements:
Must be a domestic corporation
Must not otherwise be “ineligible”
Ineligible corporations include certain banks, insurance companies and foreign corporations
Any domestic corp. that is not an ineligible corp. can be a qualified Subchapter S Subsidiary (QSSS) if:
S corp owns 100% of its stock, and
Elects to treat the subsidiary as a QSSS

QUALIFYING FOR S CORPORATION STATUS

Definition of a Small Business Corporation

9. Each of these requirements must be met for an entity to qualify as an S corporation.

The entity must be a domestic corporation.
The entity must be an eligible corporation.
Only one class of stock can be issued.
The number of shareholders cannot exceed the theoretical 100 maximum.
Shareholders may only include individuals, estates, trusts, and exempt organizations.
Shareholders may not include nonresident aliens.

10. There is no maximum or minimum dollar capitalization or sales restrictions. Thus, the “business” does not have to be “small.”

11. Ineligible Corporations

a. Non-U.S. corporations, banks or insurance companies are ineligible.

b. The entity cannot be a subsidiary of another corporation.

c. An S corporation may have a subsidiary called a qualified Subchapter S subsidiary (QSSS). This subsidiary must be owned 100% by the S corporation.

S Corp Qualification
Requirements (slide 2 of 3)

Corporation may have only one class of stock
Can have stock with differences in voting rights but not in distribution or liquidation rights
It is possible for debt to be reclassified as stock
Results in unexpected loss of S corp status
Safe harbor provisions mitigate concern over reclassification of debt

12. One class of stock

a. While the one-class-of-stock requirement seems straightforward, debt can be reclassified as stock by the IRS, thus creating another class of stock. To mitigate unexpected repercussions from debt reclassification, a safe-harbor provision treats the “debt stock” as the same class of stock as the stock already outstanding.

Differences in voting rights among the shares of common stock do not result in a second class of stock.

ADDITIONAL LECTURE RESOURCE

The one-class-of-stock requirement severely restricts the selective sharing of tax items among S corporation shareholders. To obtain special allocation type benefits, an S corporation could use a variety of tools including options and straight debt, or set up partnerships that have S corporations as their partners.

The Big Picture – Example 3
One Class of Stock

Return to the facts of The Big Picture on p. 22-1.
Cane, Inc., could elect to be an S corp. as long as the 2 classes of common stock are identical except that one class is voting and the other class is nonvoting.
You learn that both shareholders have binding employment contracts with Cane, Inc.
The amount paid to Jones under her employment contract is reasonable
The amount paid to Smith is excessive, resulting in a constructive dividend.
Smith’s employment contract was not prepared to circumvent the one-class-of-stock requirement.
Because employment contracts are not considered governing provisions, Cane still is treated as though it has only one class of stock if an S election is made.

Return to the Big Picture

(Example 3) Cane, Inc. has both voting and nonvoting common stock outstanding. As long as these differ only with respect to voting power, Cane will be considered to have only one class of stock outstanding for purposes of qualification for S status.

You find that both shareholders have binding employment contracts with the company. Further, the compensation in one of the contracts is found to be unreasonable, with part of the payments reclassified as a constructive dividend. Employment contracts are not generally considered a governing provision that might be taken into account in determining whether another class of stock exists. Unless the contract was intended to circumvent the one-class-of stock requirement (unlikely if it existed prior to the consideration of S status), it will not be considered a separate class of stock even if a portion of the payments is treated as a constructive dividend.

S Corp Qualification
Requirements (slide 3 of 3)

Must have 100 or less shareholders
Family members may be treated as one shareholder
Shareholders may include resident individuals, estates, certain trusts, and certain tax-exempt organizations
Charitable organizations, employee benefit trusts exempt from taxation, and a one-person LLC classified as a disregarded entity also can qualify as shareholders of an S corporation
Partnerships, Corps, LLPs, most LLCs and most IRAs cannot own S corp stock, but S corps can be partners in a partnership or shareholders in a corporation
Shareholders cannot include any nonresident aliens

13. Limitations on shareholders.

a. The number of shareholders is theoretically limited to 100. However, family members may be treated as one shareholder. Family members include the following.

Those with a common ancestor.
Lineal decedents of a common ancestor.
Spouses and former spouses of lineal decedents.
Spouses and former spouses of common ancestor.
Estates of family members.

b. Charitable organizations and one-person LLCs classified as sole proprietorships can be S corporation shareholders.

c. An individual who is not a U.S. citizen or resident alien cannot be a shareholder.

S Corp Qualification
Requirements (slide 3 of 3)

Must have 100 or less shareholders
Family members may be treated as one shareholder
Shareholders may include resident individuals, estates, certain trusts, and certain tax-exempt organizations
Charitable organizations, employee benefit trusts exempt from taxation, and a one-person LLC classified as a disregarded entity also can qualify as shareholders of an S corporation
Partnerships, Corps, LLPs, most LLCs and most IRAs cannot own S corp stock, but S corps can be partners in a partnership or shareholders in a corporation
Shareholders cannot include any nonresident aliens

ADDITIONAL LECTURE RESOURCE

Only the following trusts may be shareholders in an S corporation.

Voting trust.
Shareholder or beneficiary’s grantor trust.
Trust to which stock is transferred pursuant to the terms of a will (testamentary trust) but only for 2 years beginning on the date of transfer from the estate to the trust.
Electing small business trust (ESBT) such as an employee stock ownership plan trust.
Qualified Subchapter S Trust (QSST).
Trusts owned by beneficiary.

The Big Picture – Example 6
Nonresident Aliens

Return to the facts of The Big Picture on p. 22-1.
Jones lives in Arkansas, a common law property state.
Being married to a nonresident alien spouse would not affect an S election.
However, Smith lives in Texas, a community property state.
His nonresident alien spouse would be treated as owning half of his community property stock.
Consequently, an S election would not be allowed.
To qualify for S status, Smith could move to Arkansas or his spouse could move to Texas (becoming a resident alien).

Return to the Big Picture

(Example 6) Recall both shareholders of Cain, Inc. are married to nonresident aliens. One shareholder lives in Arkansas, a common law state. Because the stock owned by the shareholder’s spouse is not property of the shareholder, this poses no problem. However, since the other shareholder lives in Texas, a community property state, the nonresident alien spouse will be treated as owning half of the shareholder’s stock in violation of the restriction on nonresident alien shareholders.

Making the Election
(slide 1 of 3)

To become an S corp, must make a valid election that is:
Filed timely
All shareholders must consent to the election

Making the Election

14. The timing in making the S election can be of crucial significance when a newly formed corporation is involved.

a. For the S election to apply to the current tax year, it must be filed either in a prior year or on or before the fifteenth day of the third month of the current year.

b. A corporation must meet the eligibility requirements for the entire year including the days before the election was made.

c. An election cannot be made for a corporation that is not in existence. Thus, a new corporation with a premature election will not be valid. A new corporation comes into existence at the earlier of the following.

When the corporation has shareholders.
When it acquires assets.
When it begins doing business.

d. An LLC can make a valid election to be classified as an S corporation.

e. To obtain a 24-month extension of time to file Form 2553, use Form 8869.

Making the Election
(slide 2 of 3)

To be effective for current year
Make election by 15th day of third month of current tax year, or
File in previous year

15. A corporation should obtain and retain proof of a timely filed Form 2553. Instructions to Form 2553 indicate the following acceptable proof of filing.

Timely filed certified receipt.
Form 2553 with “accepted” stamp from an IRS Service Center.
Form 2553 stamped with the date of receipt by the IRS.
Letter from the IRS stating that Form 2553 has been accepted.

16. The IRS can correct errors in the S election in certain situations.

a. The errors were inadvertent.

b. The election was not filed by the deadline. A simplified method of requesting relief for late election exists. The reason for failure to timely file must be provided.

Making the Election
(slide 3 of 3)

Shareholder Consent
Each shareholder owning stock during election year must sign consent for election (even if stock is no longer owned at election date)
May be able to obtain extension of time for filing consent from IRS
Available only if Form 2553 is filed on a timely basis, reasonable cause is given, and the interests of the government are not jeopardized

Shareholder Consent

17. All shareholders must consent in writing to the S election. A consent extension is available only if Form 2553 is filed on a timely basis, reasonable cause is given, and the interests of the government are not jeopardized.

a. Husbands and wives must each consent if they own stock jointly.

b. All individuals that were shareholders for any part of the year (even before the election was made) must consent to the S election.

The Big Picture – Example 7
Making The Election

Return to the facts of The Big Picture on p. 22-1.
Suppose that in 2015, shareholders Smith and Jones decide to become an S corp. beginning January 1, 2016.
Since the C corp. uses a calendar tax year, the S election can be made at any time in 2015 or by March 15, 2016.
An election after March 15, 2016, will not be effective until the 2017 calendar tax year.

Return to the Big Picture

(Example 7) Assume the shareholders of Cane, Inc. want to elect S status for 2016. The shareholders must make the election by March 15, 2016.

Termination of Election
(slide 1 of 4)

An S election remains in force until revoked or lost, however, an S election can terminate if:

1. Shareholders owning a majority of shares voluntarily revoke the election

Revocation must be filed by 15th day of third month of tax year to be effective for entire year
Otherwise, it is effective for first day of following year, or any other specified future date
A revocation that designates a future effective date splits the corp’s tax year into a short S corp. year and a short C corp. year

Loss of the Election

18. The S election can be lost in a number of ways.

a. New majority shareholders affirmatively refuse to consent to the election.

b. Shareholders owning a majority of the stock voluntarily revoke the election.

c. The S corporation ceases to qualify as a small business corporation.

d. The S corporation (having accumulated E&P from prior Subchapter C years) derives too much passive investment income in three consecutive years.

(1) Passive income (dividends, interest, investment gains, and sometimes rents and royalties) is in excess of 25% of gross receipts is considered excessive.

(2) The S election is terminated as of the beginning of the fourth year.

Termination of Election
(slide 2 of 4)

2. New shareholder owning > 50% of entity affirmatively refuses to consent to election

3. Entity no longer qualifies as S corp

If an S corp. fails to qualify as a small business corp. at any time after the election has become effective, its status as an S corp. ends
e.g., The entity has > 100 shareholders or a nonresident alien shareholder, a second class of stock exists, etc.
Election is terminated on date disqualification occurs

19. Voluntary revocation of the S election requires consent of the shareholders holding a majority of the stock.

a. Revocations filed by the fifteenth day of the third month of the tax year can be effective for the entire year. Revocation can also be made prospectively.

b. The day the revocation occurs is treated as the first day of the C corporation year.

c. After termination, the corporation generally must wait five years before reelecting S status. The waiting period can be waived in certain situations.

(1) There is more than a 50% change in ownership after the first year in which the election was made.

(2) The event causing the termination was not within the control of the S corporation or its majority shareholders.

Termination of Election
(slide 3 of 4)

4. The corp. does not meet the passive investment income limitation

If an S corp. has C corp. E & P and passive income > 25% of its gross receipts for three consecutive taxable years
The S election is terminated as of the beginning of the fourth year
Applies to S corps. that were previously C corps. or for S corps. that have merged with C corps.

Termination of Election
(slide 4 of 4)

A new S election normally cannot be made within 5 years after termination of a prior election
Five year waiting period is waived if:
There is a > 50% change in ownership after first year termination is applicable
Event causing termination was not reasonably within control of the S corp or its majority shareholders

Computation of Taxable Income
(slide 1 of 2)

Determined in a manner similar to partnerships except
S corp. amortizes organizational costs under the C corp. rules
S corp. must recognize gains (but not losses) on distributions of appreciated property to shareholders
Certain other special C corp. provisions do not extend to S corps.
e.g., Dividends received deduction

OPERATIONAL RULES

20. The taxable income of S corporations is determined much the same as that of partnerships. Accounting method and other elections are made at the entity level. The amount and nature of income, deductions, losses and credits are determined at the entity level and allocated to shareholders as of the last day of the corporation’s tax year.

Computation of Taxable Income

21. The S corporation’s taxable income or loss computation is similar to that of partnerships, except that S corporations amortize organizational expenditures under the corporate rules and must recognize gains, but not losses, on distributions of appreciated property to shareholders. Other provisions unique to C corporations (e.g., the DRD, § 291 recapture) do not extend to S corporations.

Computation of Taxable Income
(slide 2 of 2)

S corp items are divided into:
Nonseparately stated income or loss
Essentially, constitutes Subchapter S ordinary income or loss
Separately stated income, losses, deductions and credits that could affect tax liability of shareholders in a different manner
Identical to separately stated items for partnerships

22. Income and expense items are divided into two types for reporting.

a. Nonseparately stated income or loss.

b. Income, losses, deductions, and credits that could affect any shareholder differently must be separately stated.

(1) Separately stated items are identical to those of partnerships. For a list of the specific items see page 22-10 in the text.

(2) Separately stated items are listed on Schedule K of the 1120S.

(3) Separately stated items are determined first. The aggregated residual income and expenses becomes the nonseparately-stated income.

23. All items of income and loss retain their character as they pass through to each shareholder. For example, tax-exempt income at the corporate level will be tax-exempt income at the shareholder level.

Flow-Through of S Corporation Items

Separately Stated Items

Examples include:
Tax-exempt income
Gains/losses from disposal of business property and capital assets
Charitable contributions
Income/loss from rental of real estate
Interest, dividend, or royalty income
Tax preference items

Allocation of Income and Loss
(slide 1 of 2)

Each shareholder is allocated a pro rata portion of nonseparately stated income (loss) and all separately stated items
If stock holdings change during year, shareholder is allocated a pro rata share of each item for each day stock is owned
On the date of transfer, the transferor (and not the transferee) is considered to own the stock

24. Each shareholder is allocated a pro rata portion, on a per share per day basis, of both the separately and nonseparately items even if there is no distribution during the year.

a. In case of the transfer of stock during the year, this method may result in a shareholder being allocated items of income, deduction, etc. from periods in which they did not own stock, or being allocated much more or less than what they would have been allocated if the allocation had been based on their ownership at the time the item was earned, incurred, etc.

Allocation of Income and Loss
(slide 2 of 2)

Short-year election is available if a shareholder’s interest is completely terminated (through disposition or death)
Allows tax year to be treated as two tax years
Results in interim closing of books on date of termination
Shareholders report their shares of S corp items as they occurred during year

b. If a shareholder’s interest is completely terminated, an election may be made to split the taxable year into two with the first ending on the date of termination.

(1) A pro rata allocation within each short year will result in a closer matching of income, loss, etc to the shareholders who held stock at the time the income, loss etc was generated. Pro rata per day allocation must be used unless the shareholder disposes of the entire interest.

(2) All shareholders and the corporation must join in the election to treat the S taxable year as two taxable years.

c. When a shareholder disposes of stock during the year, the transferor (seller) is considered to own the stock on the date of transfer, not the transferee (buyer).

S Corporation Distributions
(slide 1 of 7)

Amount of distribution to shareholder
Cash + FMV of any other property distributed
Taxation of distribution depends on whether the S corp has accumulated E&P from C corp years

Tax Treatment of Distributions to Shareholders

25. Distributions to shareholders equal the cash plus the value of other property distributed. The taxation of distributions depends on whether the S corporation has C corporation accumulated earnings and profits (AE&P).

S Corporation Distributions
(slide 2 of 7)

Where no Earnings and Profits exist
1. Nontaxable to the extent of adjusted basis in stock
2. Excess treated as gain from the sale or exchange of stock
Capital gain in most cases

26. If the S corporation was never a C corporation, or has no C corporation AE&P

a. A distribution is a tax-free recovery of capital to the extent of the shareholder’s adjusted basis.

Any distribution in excess of adjusted basis is treated as a gain from the sale or exchange of property (capital gain in most cases).

27. If the S corporation has C corporation AE&P, the treatment is a blend of the entity and conduit approaches.

a. Distributions of S earnings are tax-free to the extent of the shareholder’s adjusted basis in the stock.

b. Distributions of C corporation AE&P are taxed as dividends (0 or 15% rate).

S Corporation Distributions
(slide 3 of 7)

Where Earnings and Profits exist
1. Tax-free to the extent of accumulated adjustments account
2. Distributions from AEP constitute dividend income. **
3. Tax-free to extent of Other Adjustments Account
4. Tax-free reduction in basis of stock*
5. Excess treated as gain from the sale or exchange of stock (capital gain in most cases)

* Once stock basis reaches zero, any distribution from AAA is treated as a gain from sale or exchange of stock. “Basis” is the maximum tax-free distribution a shareholder can receive.
** AAA bypass election is available

28. To determine whether a distribution comes from S corporation earnings, a special account, the Accumulated Adjustment Account (AAA), is required.

a. AAA is a corporate-level account and reflects the cumulative income and losses for all of the S years. In this respect it is similar to the C corporation AE&P.

Where distributions during a tax year exceed the amount in AAA at the close of the tax year, the AAA is allocated proportionately among the distributions. See § 1368(c)(3).

c. Except in the case of a stock redemption, there is no adjustment to AAA when a shareholder transfers stock to another shareholder. Thus, a selling shareholder should obtain a distribution from AAA before a stock transfer or at least consider the AAA in determining the selling price.

d. Tax exempt income and related expenses are excluded in computing the AAA, but are included in the Other Adjustments Account (OAA).

e. AAA can have a negative balance at the end of the taxable year (accumulated operating losses) unlike stock basis, which cannot be reduced below zero. However, distributions to the shareholders cannot cause or add to a negative balance.

S Corporation Distributions
(slide 4 of 7)

Accumulated Adjustments Account (AAA)
Represents cumulative total undistributed nonseparately and separately stated items
Mechanism to ensure that earnings of an S corp are taxed to shareholders only once

29. Distributions are first considered to come from the AAA account, then from C corporation AE&P, and lastly from OAA. Shareholders can elect to have distributions first out of AE&P. This is known as the AAA bypass election.

S Corporation Distributions
(slide 5 of 7)

31. Schedule M-2 of Form 1120S reports changes in the AAA account.

a. The column labeled “Other Adjustment Account” (OAA) is where items that affect basis but not AAA are entered. This is usually tax-exempt income and its related expense.

b. Distributions come from OAA only after A E&P and AAA are reduced to zero. These distributions are generally tax free.

32. Schedule M-3 is the Net Income or Loss Reconciliation for corporations with total assets on Schedule L of at least $10 million. This is filed in lieu of Schedule M-1.

a. Part I of the schedule asks questions regarding the corporation’s financial statement and derives the net income (loss) per income statement.

b. Part II and III reconcile the financial statement net income (loss) with the total income (loss) per tax return.

(1) Differences must be categorized as temporary or permanent differences.

(2) Part II is the income reconciliation and part III is the expense/deduction reconciliation.

S Corporation Distributions
(slide 6 of 7)

Other issues regarding distributions:
Distributions of cash during a one-year period following S election termination receive special treatment
Treated as a tax-free recovery of stock basis to the extent it does not exceed AAA account
Since only cash distributions receive this special treatment, the corp should not distribute property during this postelection termination period

S corporation cash distributions made to shareholders during a one-year period after terminating the S election receive special treatment.

a. They are treated as a tax-free recovery of stock basis if not in excess of AAA.

b. Since only cash distributions reduce the AAA during this post election termination period, a corporation should not make property distributions during this time.

c. To take advantage of this benefit, an S corporation should maintain both AAA and OAA accounts, although S corporations without A E&P are not required to keep track of these accounts.

S Corporation Distributions
(slide 7 of 7)

Other issues regarding distributions:
If E & P exists, the entity may elect to first distribute E & P before reducing AAA
Called an AAA bypass election

Distributions of Property

If the entity distributes appreciated property
Gain must be recognized
Treated as if property sold to shareholder for FMV
Gain is allocated to shareholders and increases their basis in stock before considering the distribution
Basis of asset distributed = FMV
Loss is not recognized
Basis of asset distributed = FMV
Essentially, loss property receives a stepdown in basis without any loss recognition by the S corp.
Thus. distributions of loss property should be avoided

S corporations recognize gain (but not loss) on any distribution of appreciated property in the same manner as if it sold the asset to the shareholder.

a. Gains pass through to the shareholders. Their character, ordinary or capital, depends on the property distributed.

b. A shareholder’s basis in the distributed property is the property’s fair market value.

Shareholder’s Basis (slide 1 of 4)

Determination of initial basis is similar to that of basis of stock in C corp
Depends on manner stock was acquired
e.g., gift, inheritance, purchase, exchange
Basis is increased by:
Stock purchases
Capital contributions
Nonseparately computed income
Separately stated income items
Depletion in excess of basis

Shareholder’s Basis

35. The calculation of a shareholder’s initial tax basis in S corporation stock is similar to that for C corporation stock because § 351 applies to the creation of S corporations. A shareholder’s basis will be affected by the following items.

a. First, increased by operating items.

(1) Separately and nonseparately stated income items including nontaxable income.

(2) Depletion in excess of basis in the property.

(3) Additional contributions.

Shareholder’s Basis (slide 2 of 4)

Basis is decreased by:
Distributions not reported as income by shareholders (e.g., from AAA)
Nondeductible expenses (e.g., fines, penalties)
Nonseparately computed loss
Separately stated loss and deduction items
Similar to partnership basis rules
First increase basis by income items
Then decrease it by distributions and finally losses

b. Next, decreased by these items in following order.

(1) Distributions.

(2) Separately and nonseparately stated losses and deduction items including nondeductible expenses.

Shareholder’s Basis (slide 3 of 4)

Shareholder’s basis cannot be negative
Once basis is reduced to zero, any additional reductions (losses or deductions, but not distributions) decrease (but not below zero) basis in loans made to S corp
Any excess losses or deductions are suspended
Once basis of debt is reduced, it is increased by subsequent net increases from all positive and negative adjustments

Shareholder’s Basis (slide 4 of 4)

Basis rules are similar to partnership rules except:
Partner’s basis in partnership interest includes direct investment plus a ratable share of partnership liabilities
Except for loans from a shareholder to the S Corp, corporate borrowing does not affect shareholder’s basis

c. A shareholder’s stock basis can never be reduced below zero. Once the stock basis is zero, losses and deduction (but not distributions) reduce the shareholder’s basis in loans s/he has specifically made to the corporation. This basis also cannot be reduced below zero.

(1) When the corporation subsequently generates income or other net basis increases, the basis in the loan is increased to its original amount before the stock basis is increased. That is, loan basis is the last to be decreased and the first to be increased.

(2) If a loan’s basis is reduced and repaid before it is restored, the shareholder will recognize gain on the repayment to the extent the amount received is in excess of the basis in the loan.

Treatment of Losses
(slide 1 of 2)

Step 1. Allocate total loss to the shareholder on a daily basis, based upon stock ownership

Step 2. If shareholder’s loss exceeds stock basis, apply any excess to adjusted basis of indebtedness to the shareholder. Distributions do not reduce debt basis.

Step 3. Where loss > debt basis, excess is suspended and carried over to future tax years.

If the shareholder’s basis is insufficient to allow a full flow through and there is more than one type of loss, the flow-through amounts are determined on a pro rata basis
e.g., The S corp. incurs both a passive loss and a net capital loss in the same year

Treatment of Losses

36. Losses may flow through, but are only recognizable to the extent of the shareholder’s stock and loan basis.

a. When the full amount o flosses flowing through are limited because of basis, the amount of each type of loss currently recognizable is determined on a pro rata basis.

b. Although any unused loss may be carried forward, this carryover may be deducted in subsequent years only by the same shareholder.

c. Distributions reduce stock basis before the basis is reduced for current year losses and deductions.

d. Following the termination of an S election by the corporation, any unused losses are deductible only in the next year and are limited to the stock (not loan) basis as of the end of such year. If not deductible within this year, the benefits are lost forever.

e. C corporation NOLs occurring before the S election cannot be utilized by the S corporation.

Treatment of Losses
(slide 2 of 2)

Step 4. In future tax years, any net increase in basis adjustment restores debt basis first, up to its original amount.

Step 5. Once debt basis is restored, remaining net increase is used to increase stock basis.

Step 6. Suspended loss from a previous year now reduces stock basis first and debt basis second.

Step 7. If S election terminates, any loss carryover remaining at the end of the post-termination transition period is lost forever.

The Big Picture – Example 35
Net Operating Loss

Return to the facts of The Big Picture on p. 22-1.
If Smith and Jones make the S election for Cane, Inc., they will be able to pass through any NOLs to the extent of the shareholder’s adjusted stock basis.
If the new S corp. incurs an NOL of $84,000 during 2015, both shareholders are entitled to deduct $42,000 against other income for the tax year in which Cane’s tax year ends.
Any NOL incurred before the S election is in effect does not flow through to the two shareholders.

Return to the Big Picture

(Example 35) If the owners of Cane, Inc. make an S election, they can recognize any of the corporation’s subsequent losses to the extent of their basis in their stock. For example, if the corporation generates an $84,000 NOL, each shareholder can recognize $42,000 to offset other taxable income they may have. Any unused NOL may be carried backward or forward by the shareholders.

At-Risk Rules

S corp. shareholders are limited in the amount of loss they may deduct by their “at-risk” amounts
Rules for determining at-risk amounts are similar, but not identical, to the partner at-risk rules
At-risk rules apply to the shareholders, but not to the corp.
Amount at risk is determined separately for each shareholder
The amount of the corporate losses that are passed through and deductible by the shareholders is not affected by the amount the corp. has at risk

Passive Losses and Credits

An S corp is not directly subject to the passive loss rules
If the corporation is involved in rental activities or shareholders do not materially participate
Passive losses and credits flow through to shareholders
Shareholder’s stock basis is reduced even if passive losses are not currently deductible

Built-in Gains Tax
(slide 1 of 4)

Generally applies to C corps. converting to S corp. status after 1986
Corporate-level tax on built-in gain recognized in a taxable disposition within 10 calendar years after the effective date of the S corp election
The 10-year holding period is reduced to
7 years for tax years beginning in 2009 and 2010, and
5 years for 2011 through 2013

Tax on Pre-Election Built-in Gain

37. Any C corporation making an S election is subject to a corporate-level tax on any built-in gains (BIG) recognized during the 10-year period (7 years for tax years beginning in 2009 and 2010; 5 years for 2011 through 2013) following the conversion. These built-in gains equal the aggregate of the net unrealized gains on all of the corporate assets at the time of the conversion to S status.

a. Without this provision, C corporations could avoid double taxation at liquidation by switching to S corporations and then liquidating.

b. Any tax applied at the corporate level reduces the amount of the income to be passed through to the shareholders. A capital gain at the corporate level flows through to the shareholders as capital gain.

c. The amount of gain recognized in any one year is limited to the taxable income that the S corporation would have computed as if it was a C corporation. The amount of BIG escaping taxation because of this limitation is carried forward and taxed in future years.

Built-in Gains Tax
(slide 2 of 4)

Tax base includes unrealized gain on appreciated assets held on date of S corp election
Highest corporate tax rates apply (currently 35%)
This gain passes through to shareholders as taxable gain
Maximum built-in gain recognized over the required (5-,7- or 10-year) holding period is limited to aggregate net built-in gain at time corp. converted to S status

d. Any gain on a sale of property held by a C corporation prior to its conversion to an S corporation will be presumed to be a BIG unless the taxpayer can show otherwise.

e. Unexpired tax attributes of the former C corporation such as NOLs and capital losses can be used to offset the BIG.

f. Any LIFO recapture (excess value of inventory under FIFO over LIFO value) is recognized at the time of the S election and is subject to corporate-level taxes. The tax is payable in four equal installments.

Built-in Gains Tax
(slide 3 of 4)

Amount of built-in gain recognized in any year is limited to an “as if” taxable income, computed as if the corp were a C corp
Any gain that escapes taxation under this limit is carried forward and recognized in future years
S corp can offset built-in gains with unexpired NOLs or capital losses from C corp. years

Built-in Gains Tax
(slide 4 of 4)

LIFO recapture tax
Any LIFO recapture amount at time of S corp election is subject to a corporate-level tax
Taxable LIFO recapture amount = excess of inventory’s value under FIFO over the LIFO value
Resulting tax is payable in four annual installments
First payment is due on or before due date of last C corp tax return

ADDITIONAL LECTURE RESOURCE

No Avoidance of LIFO Recapture on S Conversion. When a C corporation elects S status, the tax law requires that it recapture any LIFO reserve it has accumulated to date. The recapture must be included in the income of the corporation’s final C corporation return. The additional tax resulting from the LIFO recapture is payable in four equal annual installments, beginning with the tax payment for the final C corporation year.

A LIFO reserve is essentially the amount by which LIFO has reduced taxable income during the years of its use. When a company has used LIFO for many years, and there has been a fair amount of cost inflation during that time, the LIFO reserve can be quite a substantial number. This LIFO recapture provision was Congress’s way of making sure that corporations with LIFO inventories did not avoid the tax that FIFO (first-in, first-out) corporations have to pay on the built-in gains in their inventories.

Computation of Built-in
Gains Tax (slide 1 of 2)

Step 1. Select the smaller of built-in gains or taxable income.*

Step 2. Deduct unexpired NOLs and capital losses from C corporation tax years.

Step 3. Multiply the tax base from step 2 by the top corporate tax rate.

*Any net recognized built-in gain > taxable income is carried forward to the next year, as long as the next year is within the 5-, 7-, or 10-year recognition period.

ADDITIONAL LECTURE RESOURCE

S Corporations Pay Taxes, Too. S corporations, like partnerships and limited liability entities, are pass-through entities, and are supposed to pay zero entity-level Federal income tax. But certain penalty taxes apply to S corporations and their shareholders. And when there is a tax liability, there are potential audit adjustments.

Here are some approximate amounts of tax payments by and for S corporations in recent years. Less than one-half of 1 percent of all Forms 1120S reflect a liability for one or more of these taxes.

Computation of Built-in
Gains Tax (slide 2 of 2)

Step 4. Deduct business credit carryforwards and AMT credit carryovers from a C corporation tax year from the amount obtained in step 3.

Step 5. The corporation pays any tax resulting from step 4.

The Big Picture – Example 41
Built-in Gains Tax

Return to the facts of The Big Picture on p. 22-1.
If Cane, Inc., becomes an S corp., a built-in gain may be recognized.
Assume that Cane reports a $50,000 built-in gain on conversion.
It holds a $20,000 NOL carryforward from C corp. years before the S election.
The NOL carryforward is applied against the built-in gain.
Cane’s built-in gains tax applies only to $30,000.

Return to the Big Picture

(Example 41) Since Cane, Inc. operated as a C corporation, it may be potentially subject to the BIG tax should its owners decide to convert to an S corporation. This may be particularly relevant if it subsequently disposes of any of its equipment on which it has used any accelerated cost recovery methods (e.g., Sec,. 179 expense, or bonus depreciation).

However, as a tax on its C-corp earnings, Cane would be able to use any NOLs or capital losses to offset the BIG tax.

Passive Investment Income Penalty Tax (slide 1 of 3)

If an S corp has accumulated E&P (AEP) from C corp years
A tax is imposed on excess net passive income (ENPI) calculated as follows:

Passive investment income Net passive

ENPI = > 25% of gross receipts × investment

Passive investment income income for

for the year the year

Passive Investment Income Penalty Tax

38. Passive investment income (PII) tax is imposed on S corporations that possess A E&P from C corporation years and have gross receipts from the following.

Royalties.
Passive rents.
Interest.
Dividends.
Not included is built-in gains (or losses).

39. The tax rate for PII is at the highest corporate tax rate for the year (currently 35%).

a. The tax rate is applied to the excess net passive income (ENPI). For the year, this is equal to the following.

PII in excess of 25% of gross receipts X Net PII = ENPI

PII

b. ENPI cannot exceed income the S corporation would have had if it were taxed as a C corporation.

Passive Investment Income Penalty Tax (slide 2 of 3)

Passive investment income includes royalties, rents, dividends, interest, annuities
Only net gain from disposition of capital assets is included
Net passive income is passive income less directly related deductions

Other Operational Rules

40. Other points about possible effects of Code provisions on S corporations.

a. S corporations make estimated payments for BIG and PII taxes.

b. S corporations may have subsidiaries but S corporations cannot be subsidiaries of C corporations.

c. Although S corporation income flows through to shareholders, this income is not payment for services. Therefore, it is not self-employment income and is not subject to the FICA taxes. Thus, any family member that provides services must be paid reasonable compensation so as not to avoid FICA taxes. See Examples 43 and 44 in the text.

d. Any person who owns, directly or indirectly, any stock of an S corporation is considered a related party under § 267. Therefore, expenses accrued to any shareholder are not deductible by the corporation until the shareholder includes the amount in their income. Similarly, losses on sales to any shareholder are not recognizable.

Passive Investment Income Penalty Tax (slide 3 of 3)

Excess net passive income cannot exceed C corp. taxable income before considering any NOL or other special deductions
Tax rate applied is the highest corporate tax rate for the year

Other Operational Rules (Continued)

e. Several states and the District of Columbia do not recognize the S election, so the corporation may incur a state corporate income tax.

f. S corporation stock can qualify as § 1244 stock but does not qualify for the § 1202 small business stock exclusion of gains on disposition.

g. Hobby loss rules may be applied to extended losses of S corporations.

h. Penalties are imposed for the failure to file the S corporation return on a timely basis. The penalty is $195 per month X the number of shareholders.

i. Partnership limitations on fringe benefits apply to shareholder-employees owning more than 2% of the corporation.

j. Cancellation of debt (COD) income excluded by an S corporation reduces its tax attributes.

The Big Picture – Example 46
Salary Vs. Distribution

Return to the facts of The Big Picture on p. 22-1.
The two shareholders should consider reducing their $92,000 salary and instead receiving a larger undistributed share of the S corp. income.
A shareholder’s share of pass-through S corp. income is not treated as self-employment income, whereas compensation is subject to a 12.4% Social Security tax and 2.9% Medicare tax.

Return to the Big Picture

(Example 46) The shareholders of Cane, Inc. are each currently paid $92,000 salaries. These salaries are subject to self-employment tax as well as income tax. The shareholders may save 15.3 percent of any amounts they can reclassify as dividends.

Of course, a reasonable salary should be paid for services provided. However, the shareholders should reconsider the level of services actually provided to determine whether a lower salary might be justified.

Refocus On The Big Picture (slide 1 of 3)

As long as Smith and Jones, the owners of Cane, Inc., maintain C corp. status, they cannot deduct any NOLs that the business incurs on their individual tax returns.
For the owners to deduct any future NOLs on their Forms 1040, Cane needs to be operated as a flow-through entity.
The most logical alternatives are to make an S election or to become a limited liability company.
An S election may be appropriate for Cane.
Cane should make a timely election on Form 2553.
Both shareholders must consent to the election.
The owners should make the election on or before the fifteenth day of the third month of the current year.

Refocus on the Big Picture

If Cane, Inc. remains a C corporation, its losses may only be carried back or forward to offset other C income. The fact that prior C income has been taxed at relatively low rates reduces any benefit of future NOL carrybacks. Even if income earned after the anticipated losses is subject to tax at higher rates, the value of a carryforward is reduced in present value terms.

An S election will make the anticipated losses immediately available to the owners to offset wages as well as income they may be generating from other sources. The owners may also be able to use the losses to carry back against prior income. Any election should be made prior to the fifteenth day of the third month of the year for which losses are anticipated.

Refocus On The Big Picture (slide 2 of 3)

Normally, an S corp. does not pay any income tax.
A C corp. making an S election may be required to pay a built-in gains tax or a LIFO recapture tax.
Cane does not need to liquidate or engage in a tax-deferred reorganization when converting to an S corp.
An S corp. can have voting and nonvoting common stock, provided that all shares have the same economic rights to corporate income or loss.

Cane may have trouble qualifying for S status. It appears to meet the one-class-of-stock requirement provided its common stock differs only with respect to voting rights. Further, the stock is owned by fewer than 100 individuals. However, the fact that one of the owners resides in a community property state and is married to a nonresident alien may pose a problem.

Refocus On The Big Picture (slide 3 of 3)

Cane might get rid of the tax-exempt income, which will not be reflected in AAA.
Although it is reflected in stock basis, tax-exempt income (as part of OAA) is distributed to the shareholders only after the S corporation has distributed all of its C corporation E&P.
What If?
Nonresident aliens cannot own S stock, so if joint ownership of the shares is desired among all of the spouses, a change in the spouses’ residency must occur.
When Cane begins to turn a profit, the S election will be less attractive, and termination of the S election should be considered by the parties.

The S election itself will not constitute a liquidation and is not, therefore, inherently a taxable event. As Cane is currently a C corporation, however, it may be subject to the BIG tax if it disposes of, within ten years of the election, any assets (including inventory) that were appreciated at the time of the election. The shareholders may consider having the assets appraised to determine the amount of any net built-in gain and, therefore, BIG tax exposure existing at the time of the election. Of course, as the corporation is expected to generate losses, any BIG tax that might otherwise be due in the near future will likely be deferred. Further, any such tax would have been due without the S election and is not, therefore, an additional cost. If Cane currently uses the LIFO method for determining its inventories, it may also be subject to the LIFO recapture tax.

Finally, it is worth ensuring that the state in which Cane is organized and operates recognizes S corporations for state tax purposes.

If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:

Dr. Donald R. Trippeer, CPA

[email protected]

SUNY Oneonta

The Big Picture

Can/Should the owners make an election to have Cane taxed under Subchapter S? If they do, must the corporation liquidate to make the election?

. Introduction

4. S corporations are treated as corporations under state legal systems.

S Corporations lack the flexibility in allocating items of income, loss and deductions afforded by LLCs.
S status imposes several restrictions on the number and type of owners the entity may have.
Many transactions that escape current taxation under Subchapter K (e.g., distributions of appreciate property) are taxable to an S Corporation.
The aggregate ordinary income allocated to shareholders of an S Corporation, even those who are actively involved in the management of the corporation, are not subject to payroll or self-employment tax.
Subchapter S contains no provision analogous to § 751 that will re-characterize a gain on the sale of corporate stock as ordinary due to the nature of assets held by the corporation.

7. S corporation popularity has waxed and waned with the changes in the tax laws. However, S corporations are currently popular with 60% reporting positive income.

ADDITIONAL LECTURE RESOURCE

When to Elect S Corporation Status

8. The following factors should be considered when considering electing S status.

The marginal rates of shareholders.
The usefulness of pass-through losses to shareholders.
The effect of the S election on C corporation NOL carryovers.
The character of income and expenses that will flow through to shareholders.
The eligibility requirements imposed on the entity to retain its S status.
Whether the S status is recognized for state and local tax purposes.
The effect S status may have on other tax factors such as the Alternative Minimum Tax (AMT).

QUALIFYING FOR S CORPORATION STATUS

Definition of a Small Business Corporation

9. Each of these requirements must be met for an entity to qualify as an S corporation.

The entity must be a domestic corporation.
The entity must be an eligible corporation.
Only one class of stock can be issued.
The number of shareholders cannot exceed the theoretical 100 maximum.
Shareholders may only include individuals, estates, trusts, and exempt organizations.
Shareholders may not include nonresident aliens.

10. There is no maximum or minimum dollar capitalization or sales restrictions. Thus, the “business” does not have to be “small.”

11. Ineligible Corporations

a. Non-U.S. corporations, banks or insurance companies are ineligible.

b. The entity cannot be a subsidiary of another corporation.

c. An S corporation may have a subsidiary called a qualified Subchapter S subsidiary (QSSS). This subsidiary must be owned 100% by the S corporation.

12. One class of stock

Differences in voting rights among the shares of common stock do not result in a second class of stock.

ADDITIONAL LECTURE RESOURCE

Return to the Big Picture

13. Limitations on shareholders.

a. The number of shareholders is theoretically limited to 100. However, family members may be treated as one shareholder. Family members include the following.

Those with a common ancestor.
Lineal decedents of a common ancestor.
Spouses and former spouses of lineal decedents.
Spouses and former spouses of common ancestor.
Estates of family members.

b. Charitable organizations and one-person LLCs classified as sole proprietorships can be S corporation shareholders.

c. An individual who is not a U.S. citizen or resident alien cannot be a shareholder.

ADDITIONAL LECTURE RESOURCE

Only the following trusts may be shareholders in an S corporation.

Voting trust.
Shareholder or beneficiary’s grantor trust.
Trust to which stock is transferred pursuant to the terms of a will (testamentary trust) but only for 2 years beginning on the date of transfer from the estate to the trust.
Electing small business trust (ESBT) such as an employee stock ownership plan trust.
Qualified Subchapter S Trust (QSST).
Trusts owned by beneficiary.

Return to the Big Picture

Making the Election

14. The timing in making the S election can be of crucial significance when a newly formed corporation is involved.

a. For the S election to apply to the current tax year, it must be filed either in a prior year or on or before the fifteenth day of the third month of the current year.

b. A corporation must meet the eligibility requirements for the entire year including the days before the election was made.

When the corporation has shareholders.
When it acquires assets.
When it begins doing business.

d. An LLC can make a valid election to be classified as an S corporation.

e. To obtain a 24-month extension of time to file Form 2553, use Form 8869.

15. A corporation should obtain and retain proof of a timely filed Form 2553. Instructions to Form 2553 indicate the following acceptable proof of filing.

Timely filed certified receipt.
Form 2553 with “accepted” stamp from an IRS Service Center.
Form 2553 stamped with the date of receipt by the IRS.
Letter from the IRS stating that Form 2553 has been accepted.