11-1 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-2 S CORPORATIONS (1 of 2)  Should an S election be made?  S corporation requirements  Election of S corporation status  S corporation operations  Taxation of the shareholder Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-3 S CORPORATIONS (2 of 2)  Basis adjustments  S corporation distributions  Other rules  Tax planning considerations  Compliance and procedural considerations Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-4 Should an S Election Be Made? Advantages (1 of 3)  No corporate level taxation  Income taxed directly to shareholders  Benefit reduced because dividends are generally taxed to individuals at 15%  S corp losses can be used to offset shareholders’ other income  Undistributed income previously taxed not taxed again when distributed Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-5 Should an S Election Be Made? Advantages (2 of 3)  All items retain character in s/h’s hands  Including tax-exempt income and capital gains, deductions, losses, and credits  Limitations are computed at s/h level  Allowed to split S corp income between family members w/restrictions  S corp earnings not subject to SE tax Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-6 Should an S Election Be Made? Advantages (3 of 3)  S corp not subject to personal holding company or accumulated earnings taxes  LLCs and partnerships may make S election Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-7 Should an S Election Be Made? Disadvantages (1 of 3)  Earnings retained by C corp taxed at rates generally lower than shareholders’ marginal tax rates  S corp earnings taxed to shareholders even if no distributions are made  S corps subject to excess net passive income tax & built-in gains tax Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-8 Should an S Election Be Made? Disadvantages (2 of 3)  No dividends-received deduction  No special allocations allowed  Income allocated based on ownership  S corp liabilities do not increase loss limits  Except for shareholder loan to S corp Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-9 Should an S Election Be Made? Disadvantages (3 of 3)  S corps and shareholders subject to at- risk rules, passive activity limits, and hobby loss rules  S corp restricted in type & number of shareholders  S corps generally must use calendar year Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-10 S Corporation Requirements Shareholder Requirements (1 of 2)  No more than 100 shareholders  Family members count as one shareholder  Include common ancestor, spouses of common ancestor or lineal descendants, and estates of family members Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-11 S Corporation Requirements Shareholder Requirements (2 of 2)  Other included shareholders  U.S. citizens or resident aliens  Tax-exempt public charity or private foundation may be a shareholder Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-12 S Corporation Requirements Corporation-Related Requirements (1 of 2)  Domestic corporation  Or unincorporated entity electing to be treated as corp under check-the-box Regs  Must not be an “ineligible” corporation  Only one class of stock Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-13 S Corporation Requirements Corporation-Related Requirements (2 of 2)  May be a Qualified Subchapter S Subsidiary (QSSS)  QSSS is 100% owned by an S corp  Assets, liabilities, income deductions, etc. considered owned by S corp parent Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-14 Election of S Corporation Status Taxes Applicable to S Corporations  S election exempts corps from all taxes imposed by IRC Chapter 1 except  §1374 built-in gains tax  §1375 excess net passive income tax  §1363(d) LIFO recapture tax Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-15 Election of S Corporation Status Making the Election  Form 2553 must be filed no later than 15th day of third month for year election is to be effective  New corp’s tax year begins on 1 st day it acquires assets, has s/h’s or begins business  All shareholders must consent to election Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-16 Election of S Corporation Status Voluntarily Terminating S Election  Owners of more than 50% of the corporation’s stock must agree  Revocation made w/in 1 st 2-1/2 months can be retroactive to beginning of year  Otherwise, election effective for 1 st day of next taxable year Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-17 Election of S Corporation Status Involuntarily Terminating S Election  Occurs when corporation ceases to meet S corporation requirements  Examples  Exceeding 100-shareholder limit  Creating 2 nd class of stock  Failing passive investment income test for three consecutive years Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-18 Election of S Corporation Status Other Termination Rules (1 of 2)  If termination occurs during tax year  Portion of year prior to termination is a short S corp year and  Portion of year after termination is a short C corp year Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-19 Election of S Corporation Status Other Termination Rules (2 of 2)  Inadvertent termination can be undone  New S corp election cannot be made for 5 tax years after termination  Unless inadvertent termination Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-20 S Corporation Operations  Taxable year  Accounting method elections  Ordinary income and separately stated items  U.S. production activities deduction  Special S corporation taxes Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-21 Taxable Year Permitted Tax Years  A year ending on December 31,  Including a week year, OR  Any fiscal year where a business purpose has been established including a natural business year Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-22 Taxable Year Other Tax Year Elections  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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-23 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, including passive activities and portfolio activities  Refer to Form 1120S Schedule K in Appendix B for a complete listing Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-24 Ordinary Income/Loss & Separately Stated Items (2 of 3)  S corp disallowed deductions include  Dividends-received deduction  U.S. production activities deduction  Personal or dependency exemption  Taxes paid/accrued to foreign country  Charitable contributions  Oil & gas depletion  NOL carryovers from C corp years Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-25 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-26 U.S. Production Activities Deduction  Determined at s/h level  50% salary limitation  Each s/h is allocated a share of S corp’s W-2 wages equal to lesser of  S/h’s allocable share of W-2 wages OR  9% of the qualified production activities income allocated to the s/h Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-27 Special S Corporation Taxes  Special levies apply to S corps  Excess net passive income tax  Built-in gains tax  LIFO recapture tax Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-28 Excess Net Passive Income Tax Basic Concepts  S corp has passive income in excess of 25% of S corp gross receipts and has C corp E&P  Excess net passive income taxed at highest corporate tax rate (35%)  See Example 11 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-29 Excess Net Passive Income Tax Computation Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall [Passive investment income] – [25% of gross receipts] __________________ Passive investment income Net passive income X = Excess net passive income

11-30 Built-In Gains Tax (1 of 2)  Imposed on income/gain that would have been included in gross income while a C corp if corp had used accrual accounting  E.g., property with a FMV in excess of basis on day S election was made Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-31 Built-In Gains Tax (2 of 2)  Tax is 35% (top corp rate) on net built- in gains recognized during tax year  Built-in gains recognized less any built-in losses recognized  Built-in gains tax applies to dispositions during 10-year period after S election is made  See Example 13 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-32 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-33 LIFO Recapture Tax (2 of 2)  LIFO recapture amount included in taxable income of corp’s final C corp tax year  Additional tax can be paid in four annual installments  S corp’s basis in inventory increased by LIFO recapture amount  See Example 14 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-34 Taxation of the Shareholder  Income allocation procedures  Loss and deduction pass-through to shareholders  Family S corporations Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-35 Income Allocation Procedures Basic Concepts  Shareholders report pro rata share of ordinary income & separately stated items  Known as per day/per share method  See Example 16 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-36 Income Allocations Computation 1. Divide item by # of days in tax year  Daily amount for each item 2. Divide daily amount by # of shares o/s  Daily amount per share for each item 3. Total daily allocations for a share 4. Multiply amount per share times # of shares held by owner Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-37 Loss & Deduction Pass-Through to Shareholders  Allocating the loss  Per share per day allocation same as for income  Shareholder limitations  Special shareholder loss and deduction limitations  Post-termination loss carryovers Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-38 Shareholder Loss Limitations Basic Concepts  Ordinary & separately stated loss amounts “passed” through to shareholders  Shareholder’s deduction limited to adjusted basis in stock plus adjusted basis of debt owed directly by corp to shareholder Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-39 Shareholder Loss Limitations Stock Basis Limitation Computation 1. Beginning basis 2. + Capital contributions 3. + Share of ordinary income and separately stated items 4. - Distributions not included in s/h inc 5. - Nondeductible, noncap. expenditures Basis available to absorb S corp loss Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-40 Special Shareholder Loss and Deduction Limitations  §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  Suspended losses do not transfer  Unless transfer to spouse incident to divorce Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-41 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-42 Family S Corporations  Donee or purchaser of stock in S corp not considered a shareholder unless  Such stock acquired in bona fide transaction AND  Donee or purchaser is the real owner of stock Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-43 Basis Adjustments Computation Initial investment + Additional contributions + Share of income/separate items - Distrib’s excluded from s/h gross inc - Non-deductible expenses not chargeable to capital - Share of losses/deductions Ending basis (but not below zero) Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-44 Basis Adjustments Other Rules  Basis adjustments to shareholder 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 shareholder has basis in debt or stock Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-45 S Corporation Distributions Corporations with No AE&P (1 of 2)  Money distributions tax-free and reduce shareholder basis, but not below zero  When shareholder has a zero basis, distributions received treated as gain from sale of stock Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-46 S Corporation Distributions Corporations with No AE&P (2 of 2)  Corporation recognizes gain on distribution of appreciated property  No loss reported when corp distributes property that has declined in value  Shareholder’s basis in property is FMV Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-47 S Corporation Distributions Corporations with AE&P – Basic Concepts  Distributions based on tiers of earnings  Distributions from AAA are tax-free  Distributions from AE&P are taxable  Distributions that reduce basis in S corp stock are tax-free  Distributions over stock basis are taxable Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-48 S Corporation Distributions Corporations with AE&P – Money Distributions  Distributions based on tiers of earnings  Distributions from AAA (tax-free)  Distributions from AE&P (taxable dividend)  Distributions that reduce basis in S corp stock (tax-free)  Distributions in excess of stock basis (taxable) Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-49 S Corporation Distributions Corporations with AE&P – AAA Computation Beginning AAA balance +Ordinary income +Separately stated inc/gain items -Ordinary loss -Separately stated loss deductions -Non-deductible expenses not chargeable to capital account Ending AAA balance Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-50 S Corporation Distributions Corporations with AE&P – AAA Election  S corp can elect to skip over AAA in determining source of distributions  Could be used to avoid excess net passive income tax and termination of S election Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-51 Other Rules (1 of 2)  No S corp alternative minimum tax  AMT items pass through to shareholder  Related party transactions  §267 related party rules apply between shareholder and S corp  §267 applies to S corp and another entity if >50% of both entities owned by same persons Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-52 Other Rules (2 of 2)  Fringe benefits paid to shareholder- employee  For 2% (or more) shareholder, S corp treated like a partnership  Many benefits tax-free to C corp shareholder-employees are taxable to S corp shareholder-employees Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-53 Tax Planning Considerations (1 of 2)  Election to allocate income based on the S corp’s accounting methods  Available when S election terminates or s/h terminates or substantially reduces ownership  May use per-share-per-day method OR  Closing-of-the-books method Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-54 Tax Planning Considerations (2 of 2)  Increasing benefits from S corp losses  Consider basis-increasing transactions  Passive income requirements  S corp can earn unlimited passive income if no AE&P from C corp years  If AE&P exist, S corp can elect to have distributions come from AE&P before AAA to avoid excess net passive income tax Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11-55 Compliance and Procedural Considerations  Making the election  Form 2553  §444 election  Attach Form 8716 to Form 1120S for first year  Tax return filed using Form 1120S Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

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