1 Chapter 11: S Corporations

2 S CORPORATIONS (1 of 2) n Should an S election be made? n S corporation requirements n S corporation election n Termination of S election n Tax year n Ordinary income/loss and separately stated items

3 S CORPORATIONS (2 of 2) n Special S corporation taxes n Shareholder allocations n Loss limitations n Additional limitations n Family S corporations n Basis adjustments n S corporation distributions

4 Should an S Election Be Made (1 of 4) n Advantages of S corp –No corporate level taxation »Income taxed directly to shareholders –S corp losses can be used to offset s/h’s other income –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

5 Should an S Election Be Made (2 of 4) n Advantages of S corp (continued) –Allowed to split S corp income between family members (with restrictions) –S corp earnings not subject to SE tax n Disadvantages of S corp –Earnings retained by C corp taxed at rates generally lower than s/h’s marginal tax rates

6 Should an S Election Be Made (3 of 4) n Disadvantages of S corp (continued) –S corp earnings taxed to s/h even if no distributions are made –S corps subject to excess net passive income tax & built-in gains tax –No dividends-received deduction –No special allocations allowed »Income allocated based on ownership

7 Should an S Election Be Made (4 of 4) n Disadvantages of S corp (continued) –S corp liabilities do not increase loss limits »Except for s/h loan to S corp –S corps and s/hs subject to at-risk rules, passive activity limits, and hobby loss rules –S corp restricted in type & number of s/hs –S corps generally must use calendar year

8 S Corporation Requirements (1 of 2) n Shareholder requirements –No more than 75 shareholders –Individuals, estates or certain types of trusts –U.S. citizens or resident aliens –Tax-exempt public charity or private foundation may be a shareholder as of 1998

9 S Corporation Requirements (2 of 2) n Corporation-related requirements –Domestic corporation –Must not be an “ineligible” corporation –Only one class of stock –May be a Qualified Subchapter S Subsidiary (QSSS)

10 S Corporation Election n 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 n All shareholder must consent to election

11 Termination of S Election (1 of 2) n S election terminated when –Corporation either voluntarily revokes the election (owners of more than 50% of the corporation’s stock must agree) or –Corporation ceases to meet small business corporation (S corp) requirements

12 Termination of S Election (2 of 2) n 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 n Inadvertent termination can be undone n New S corp election cannot be made for 5 tax years after termination

13 Tax Year (1 of 2) n Permitted tax years –A year ending on December 31, or –Any fiscal year where a business purpose has been established including a natural business year

14 Tax Year (2 of 2) n Other tax years may be elected –Ownership year - same year as shareholders owning 50% of stock –Facts and circumstances year –Sec. 444 year - deferral period of 3 months or less with advance payments

15 Ordinary Income/Loss & Separately Stated Items (1 of 3) n Income is divided between ordinary and separately stated items n Separately stated items same as for partnerships plus passive activities and portfolio activities –Refer to Form 1120S Schedule K in Appendix B for a complete listing

16 Ordinary Income/Loss & Separately Stated Items (2 of 3) n 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 or NOL carrybacks

17 Ordinary Income/Loss & Separately Stated Items (3 of 3) n 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

18 Special S Corporation Taxes n Special levies apply to S corps –Excess net passive income tax –Built-in gains tax –LIFO recapture tax

19 Excess Net Passive Income Tax n S corp has passive income in excess of 25% of S corp gross receipts and has C corp E&P n Excess net passive income taxed at 35% n See Example C11-11

20 Built-in Gains Tax (1 of 2) n 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

21 Built-in Gains Tax (2 of 2) n Tax is 35% on net built-in gains recognized during tax year –Built-in gains recognized less any built-in losses recognized n Built-in gains tax applies to dispositions during 10-year period after S election is made n See Example C11-13

22 LIFO Recapture Tax (1 of 2) n Applies to C corps using LIFO inventory method who make an S election n LIFO recapture amount is excess of inventory basis using FIFO over inventory basis using LIFO at close of final C corp tax year

23 LIFO Recapture Tax (2 of 2) n LIFO recapture amount included in taxable income of corp’s final C corp tax year –Additional tax can be paid in four annual installments n See example C11-14

24 Shareholder Allocations n S/hs report pro rata share of ordinary income & separately stated items –1. Divide item by # of days in tax year –2. Divide daily amount by # of shares o/s –3. Total daily allocations for a share –4. Multiply amount per share times # of shares held by owner –See Example C11-16

25 Loss Limitations n Ordinary & separately stated loss amounts “passed” through to s/h n S/h’s deduction limited to adjusted basis in stock plus adjusted basis of debt owed directly by corp to s/h

26 Additional Limitations n §465 at-risk rules applied at s/h level n Passive activity rules –S/h must meet material participation std. to avoid passive activity limitation n §183 “hobby loss” rules apply at s/h level

27 Family S Corporations n 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

28 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)

29 Basis Adjustments (2 of 2) n 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 n Loss/deduction not currently deductible is suspended until s/h has basis in debt or stock

30 S Corporation Distributions (1 of 2) n Distributions for S Corp w/o AE&P –Money distributions tax-free and reduce s/h basis, but not below zero –When s/h has a zero basis, distributions received treated as gain from sale of stock –Corporation recognizes gain on distribution of appreciated property

31 S Corporation Distributions (2 of 2) n Distributions for S Corp w/ AE&P –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 –See Table C11-1 and Example C11-27

32 Other S Corp Rules (1 of 2) n Alternative minimum tax –No S corp AMT »AMT items pass through to s/h n Related party transactions –§267 related party rules apply between s/h and S corp –§267 applies to S corp and another entity if >50% owned by persons

33 Other S Corp Rules (2 of 2) n Fringe benefits paid to s/h-employee –For 2% (or more) s/h, S corp treated like a partnership »Benefits tax-free to C corp s/h-employees are taxable to S corp s/h-employees

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