Chapter 11 S Corporations

Basis Limitation for Losses

Slide 7-3 Basis Limitation for Losses [IRC §1366(d)(1)] Deductions for losses from S corporations are limited to: The shareholder’s basis in the stock plus The shareholder’s basis in any indebtedness of the corporation to the shareholder

Slide 7-4 Basis Limitation for Losses [IRC §1366(d)(1)(A)] To determine the basis limit, stock basis is adjusted for current year items in IRC §1367(a)(1) and (a)(2)(A) only

Slide 7-5 Basis Limitation for Losses [IRC §1367(a)(2)] Basis is reduced by losses but not below zero [IRC §1367(b)(2)(A)] Deductible losses reduce the basis of the stock first (but not below zero) and then reduce the basis of debt

Slide 7-6 Basis Limitation for Losses [IRC §1367(b)(2)(B)] Restoration of basis: Basis in debt obligations are restored first before restoring stock basis [Rev. Rul ] If the corporation pays off the debt to the shareholder/creditor before the basis is restored, he/she must recognize a gain If the debt was evidence by a security, the gain is a capital gain (otherwise, the gain is an ordinary gain)

Slide 7-7 Basis Limitation for Losses [IRC §1366(d)(2)] Excess losses carry forward indefinitely and are deductible when the S corporation stock basis is restored

Slide 7-8 Basis Limitations See Examples 2 & 3

S Corporations Penalty Taxes or “Sting Taxes” Built-In Gains

Slide 7-10 Built-In Gains Tax Enacted to keep C corporations from avoiding paying taxes on liquidating distributions by electing S corporation status just before liquidating the corporation or selling its assets Tax is imposed directly on the S corporation [IRC §1374(a)] Tax applies only to S corporations that were formerly C corporations [IRC §1374(c)(1)]

Slide 7-11 Built-In Gains Tax [IRC §1374(d)(1)] The net unrealized built-in gain equals: The corporation’s aggregate asset FMV at the beginning of its first year as an S corporation less The corporation’s aggregate asset adjusted basis at the beginning of its first year as an S corporation

Slide 7-12 Built-In Gains Tax [IRC §1374(d)(3)] Recognized built-in gain means any gain recognized during the recognition period on the disposition of any asset except to the extent that: The asset was acquired after the election of S corporation status, or The gain exceeds the FMV less the asset’s adjusted basis at the time the S election was made

Slide 7-13 Built-In Gains Tax [IRC §1374(d)(3)] Recognized built-in loss means any loss recognized during the recognition period on the disposition of any asset to the extent that: The asset was held at the time S corporation status was elected, and The loss does not exceed the asset’s adjusted basis less the FMV at the time the S election was made

Slide 7-14 Built-In Gains Tax [IRC §1374(d)(7)] The recognition period means the first 10 years after the corporation becomes an S corporation

Slide 7-15 Built-In Gains Tax [IRC §1374(d)(2)] The net recognized built-in gain means the lesser of: The amount that would be taxable income for the year if only recognized built-in gains and recognized built in losses were taken into account, or The corporation’s taxable income for the year under IRC §1375(b)(1)(B) Items of taxable gross income less deductible expenses (without DRD or NOL carryovers)

Slide 7-16 Built-In Gains Tax [IRC §1374(c)(2)] The amount of net recognized built-in gain taken into account for any year shall not exceed: The net unrealized built-in gain less The net recognized built-in gains for prior years

Slide 7-17 Built-In Gains Tax [IRC §1374(b)] A 35% tax is imposed on the net recognized built-in gain for the year The tax imposed is treated as a loss sustained by the corporation [IRC §1366(f)(2)] The character of the loss depends on the character of the recognized built-in gain that gave rise to the tax [IRC §1366(f)(2)]

Slide 7-18 Built-In Gains Tax See Examples 4 & 5