S Corporations

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Chapter 11
S Corporations
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Advantages of S Corp

• No corporate level taxation
• Taxed directly to shareholders
• Losses can be used to reduce s/h other income
• All items retain character in s/hs hands
• Splitting S corps income between family members
  is possible (w/ restrictions)
• Earnings not subject to SE tax

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Disadvantages of S Corp(1 of 2)

• Earnings retained by C corp taxed at rates
  generally lower than s/hs marginal tax rate
• Earnings taxed to s/h even if no distributions
  are made
• Subject to excess net passive income tax,
  built-in gains tax, and LIFO recapture tax
• No dividends received deduction

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Disadvantages of S Corp(2 of 2)

• No special allocations allowed
• Income based on ownership
• Liabilities do not increase loss limits
• Except for s/h loan to S corp
• Subject to at-risk rules, passive activity
  limits, and hobby loss rules
• Restricted in type and number of s/hs
• Generally must use calendar year

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S Corporation Requirements (1 of 2)

• Shareholder related requirements
• No more than 75 shareholders
• Shareholders must be individuals, estates,
  certain tax-exempt org., and certain types of
  trusts (including QSSTs)
• U.S. citizens or resident aliens

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S Corporation Requirements (2 of 2)

• Corporation related requirements
• Domestic corporation
• Must not be an ineligible corporation
• Only one class of stock
• May be a Qualified Subchapter S Subsidiary (QSub)
• QSub is 100 owned by an S corp
• Assets, liabilities, income deductions, etc.
  considered owned by S corp parent

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S Corporation Election

• Form 2553 must be filed within first 2½ months of
  tax year for election to be effective for that
  tax year
• A new corporations tax year begins on first day
  it acquires assets, has shareholders or begins
  business
• All shareholders must consent to election

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Termination of S Election(1 of 3)

• Voluntary S election termination
• Owners of more than 50 of the corporations
  stock must agree
• Revocation made within 1st 2½ months of tax year
  can be retroactive to beginning of year
• Otherwise, election effective for 1st day of next
  taxable year

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Termination of S Election(2 of 3)

• Involuntary S election termination
• Occurs when corporation ceases to meet S
  corporation requirements
• If termination occurs during tax year
• Portion of year prior to termination date is a
  short S corp year and
• Portion of year after termination date is a short
  C corp year

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Termination of S Election(3 of 3)

• Inadvertent termination can be undone
• If termination due to failure to be a small
  business or
• Failing the passive income test for three
  consecutive years
• New S corp election cannot be made for 5 tax
  years after termination
• Unless inadvertent termination

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Tax Year(1 of 2)

• Permitted tax years
• A year ending on December 31, or
• Any fiscal year where a business purpose has been
  established
• Natural business year

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Tax Year(2 of 2)

• Other tax years may be elected
• Ownership year - same year as shareholders owning
  50 of stock
• Facts and circumstances year
• 444 allows S corp to elect a fiscal year end of
  9/30 or later w/o satisfying business purpose
  exception
• Advance payments required to eliminate benefit of
  income deferral

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Ordinary Income/Loss Separately Stated Items (1
of 3)

• Income is divided between ordinary and separately
  stated items
• Separately stated items same as for partnerships

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Ordinary Income/Loss Separately Stated Items (2
of 3)

• Deductions that cannot be claimed
• Dividends-received deduction
• Personal or dependency exemption
• Personal itemized deductions
• Taxes paid/accrued to foreign country
• Charitable contributions
• Oil gas depletion or
• NOL carryback/forward

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Ordinary Income/Loss Separately Stated Items (3
of 3)

• Net operating losses
• NOLs created when a C corp cannot be carried
  back/forward to S corp years
• NOLs created when an S corp cannot be carried
  back/forward to C corp years
• NOLs created from S corp pass through to the
  shareholder and can create NOL carry back/forward
  for shareholder

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Special S Corporation Taxes

• Excess net passive income tax
• Built-in gains tax
• LIFO recapture tax

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Excessive Net Passive Income Tax

• S corp has passive income in excess of 25 of
  gross receipts and has C corp EP
• Excess net passive income taxed at 35
• Limited to corps taxable income, which is
  defined as a C corps taxable income excluding
  NOL deduction or dividends received deduction

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Built-in Gains Tax(1 of 4)

• Imposed on income/gain that would have been
  included in gross income while a C corp if corp
  had used accrual accounting
• Tax applies to dispositions during 10-year period
  starting on the date the S election took effect
  (recognition period)

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Built-in Gains Tax(2 of 4)

• Built-in losses reduce the amount of recognized
  built-in gains in determining tax liability
• Tax is 35 on net built-in gains recognized
  during tax year
• Subject to limitations

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Built-in Gains Tax(3 of 4)

• Built-in gains include
• Sales or exchanges
• Collection of A/R by cash method taxpayer
• Collection of installment sale obligation
• Completion of L-T contract by taxpayer using
  completed contract method
• Cannot exceed excess of FMV over basis on 1st day
  of recog. period

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Built-in Gains Tax(4 of 4)

• Built-in losses include
• Sales or exchanges
• Deductions claimed during recog. Period that are
  attributable to periods before 1st S corps tax
  year
• Built-in losses do NOT include
• Any loss, deduction, or carryforward originating
  from disposition of any asset acquired before or
  during recog. period where principal purpose of
  acquisition was to avoid this tax
• Cannot exceed excess of basis over FMV on 1st day
  of recog. period

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LIFO Recapture Tax(1 of 2)

• Applies to C corps using LIFO inventory method
  who make an S election
• LIFO recapture amount is excess of inventory
  basis using FIFO over inventory basis using LIFO
  at close of final C corp tax year

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LIFO Recapture Tax(2 of 2)

• LIFO recapture amount included in taxable income
  of corps final C corp tax year
• Any tax increase incurred in final C corps tax
  return can be paid in four annual installments

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Shareholder Allocations(1 of 2)

• Shareholders report pro rata share of ordinary
  income/loss separately stated items
• Known as per day/per share method

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Shareholder Allocations(2 of 2)

• Divide item by of days in tax year
• Daily amount for each item
• Divide daily amount by of shares outstanding
• Daily amount per share for each item
• Total daily allocations for a share
• Multiply amount per share times of shares held
  by owner

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General Loss Limitation

• Ordinary separately stated loss amounts
  passed through to s/h
• S/hs deduction limited to adjusted basis in
  stock plus adjusted basis of debt owed directly
  by corp to s/h

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Additional Loss Limitations (1 of 2)

• 465 at-risk rules applied at s/h level
• Passive activity rules
• S/h must meet material participation std. to
  avoid passive activity limitation
• 183 hobby loss rules apply at s/h level

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Additional Loss Limitations (2 of 2)

• Post termination loss carryovers
• Unused S corp losses due to basis limitations
• Carried over up to 1 yr after termination
• Depending on reason for termination
• Unused loss carryovers after post termination
  period are lost

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Family S Corporations

• Donee or purchaser of stock in S corp not
  considered a s/h unless
• Such stock acquired in bona fide transaction AND
• Donee or purchaser is the real owner of stock
• IRS can adjust income, loss, deduction, or credit
  items allocated to a family member to reflect the
  value of services rendered or capital provided to
  the corporation

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Basis Adjustments (1 of 3)

• Initial investment
• Additional contributions
• Share of income/separate items
• - Distribs excluded from s/h gross inc.
• - Non-deductible expenses not chargeable to
  capital
• - Share of losses/distributions
• Ending basis (but not below zero)

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Basis Adjustments (2 of 3)

• Basis adjustment made at end of tax year
• Because of daily pro-ration

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Basis Adjustments (3 of 3)

• Basis adjustments to s/h debt
• After stock basis reduced to zero, basis
  reduction applies to indebtedness based on
  relative adjusted basis for each loan
• Loss/deduction not currently deductible is
  suspended until s/h has basis in debt or stock
• Ordinary income and separately stated positive
  items in subsequent tax years first added to
  outstanding debt and then to the stock.

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S Corporation Distributions (1 of 3)

• Distributions for S Corp w/o AEP
• Money distributions tax-free and reduce s/h
  basis, but not below zero
• Distributions in excess of basis treated as gain
  from sale of stock
• Corporation recognizes gain on distribution of
  appreciated property

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S Corporation Distributions (2 of 3)

• Distributions for S Corp w/ AEP
• Distributions based on tiers of earnings
• Distributions from AAA are tax-free
• Distributions from AEP are taxable
• Distributions that reduce basis in S corp stock
  are tax-free
• Distributions over stock basis are taxable as
  capital gain

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S Corporation Distributions (3 of 3)

• AAA balance at beginning of year
• Taxable income/separate items
• - Distribs made from AAA
• - Non-deductible expenses not chargeable to
  capital
• - Losses/separate items (except ones related to
  production of tax-exempt income)
• AAA Balance EOY

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Other S Corp Rules (1 of 2)

• Alternative minimum tax
• No S corp AMT
• AMT items pass through to s/h
• Related party transactions
• 267 related party rules apply between s/h and S
  corp
• 267 applies to S corp and another entity if gt50
  owned by persons

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Other S Corp Rules (2 of 2)

• Fringe benefits paid to s/h-employee
• For less than 2, shareholders treated as
  ordinary employees
• Benefits deductible to corp and nontaxable to
  employee
• For 2 (or more) s/h, S corp treated like a
  partnership
• Benefits are deductible to corp and taxable to
  employee

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End of Chapter 11