11-1 ©2010 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 ©2010 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 ©2010 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% (through 2009)  All items retain character in s/h’s hands  E.g., tax-exempt income earned by S corp is tax-exempt to s/h  Limitations are computed at s/h level ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-5 Should an S Election Be Made? Advantages (2 of 3)  S corp losses can be used to offset shareholders’ other income  Allowed to split S corp income between family members  With restrictions  S corp earnings not subject to SE tax ©2010 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 ©2010 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 ©2010 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 ©2010 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-10 S Corporation Requirements (1 of 3)  Shareholder requirements  No more than 100 shareholders  Family members count as one shareholder  Include common ancestor, spouses of common ancestor or lineal descendents, and estates of family members  Individuals, estates, and certain types of trusts (including QSSTs)  QSSTs may be complex trusts ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-11 S Corporation Requirements (2 of 3)  Shareholder requirements (continued)  U.S. citizens or resident aliens  Tax-exempt public charity or private foundation may be a shareholder  Corporation-related requirements  Domestic corporation  Or unincorporated entity electing to be treated as a corp under check-the-box Regs ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-12 S Corporation Requirements (3 of 3)  Corporation-related requirements (continued)  Must not be an “ineligible” corporation  Only one class of stock  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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-13 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-14 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  A new corporation’s tax year begins on first day it acquires assets, has shareholders or begins business  All shareholders must consent to election ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-15 Election of S Corporation Status Terminating the Election (1 of 3)  Voluntary S election termination  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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-16 Election of S Corporation Status Terminating the 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 is a short S corp year and  Portion of year after termination is a short C corp year ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-17 Election of S Corporation Status Terminating the Election (3 of 3)  Inadvertent termination can be undone  New S corp election cannot be made for 5 tax years after termination  Unless inadvertent termination ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-18 S Corporation Operations  Taxable year  Accounting method elections  Ordinary income and separately stated items  U.S. production activities deduction  Special S corporation taxes ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-19 Taxable Year (1 of 2)  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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-20 Taxable 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-21 Ordinary Income/Loss & Separately Stated Items (1 of 4)  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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-22 Ordinary Income/Loss & Separately Stated Items (2 of 4)  S corps cannot deduct  Dividends-received deduction  Personal or dependency exemption  “Personal” itemized deductions  Taxes paid/accrued to foreign country  Charitable contributions  Oil & gas depletion  NOL carryovers from C corp years ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-23 Ordinary Income/Loss & Separately Stated Items (3 of 4)  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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-24 Ordinary Income/Loss & Separately Stated Items (4 of 4)  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  6% (in 2009) of the qualified production activities income allocated to the s/h ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-25 Special S Corporation Taxes  Special levies apply to S corps  Excess net passive income tax  Built-in gains tax  LIFO recapture tax ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-26 Excess Net Passive Income Tax (1 of 2)  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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-27 Excess Net Passive Income Tax (2 of 2) ©2010 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

11-28 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-29 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-30 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-31 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-32 Taxation of the Shareholder  Income allocation procedures  Loss and deduction pass-through to shareholders  Family S corporations ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-33 Income Allocations (1 of 2)  Shareholders report pro rata share of ordinary income & separately stated items  Known as per day/per share method  See Example 16 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-34 Income Allocations (2 of 2) 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-35 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-36 Shareholder Loss Limitations (1 of 2)  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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-37 Shareholder Loss Limitations (2 of 2)  Sequence for stock basis limitation 1. Beginning basis 2. + Capital contributions 3. + Share of ordinary income and separately stated items 4. - Distributions not included in s/h inc Nondeductible, noncapital expenditures Basis available to absorb S corp loss ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-38 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-39 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-40 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-41 Basis Adjustments (1 of 2) 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/distributions = Ending basis (but not below zero) ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-42 Basis Adjustments (2 of 2)  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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-43 S Corporation Distributions Without 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-44 S Corporation Distributions Without 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-45 S Corporation Distributions With AE&P (1 of 3)  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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-46 S Corporation Distributions With AE&P (2 of 3) 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-47 S Corporation Distributions With AE&P (3 of 3)  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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-48 Other 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 >50% of both entities owned by same persons ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-49 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-50 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-51 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-52 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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