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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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. 11-11 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 11-21 Taxable Year Permitted Tax Years  A year ending on December 31,  Including a 52-53 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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

36. 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

37. 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

38. 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

39. 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

40. 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

41. 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

42. 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

43. 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

44. 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

45. 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

46. 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

47. 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

48. 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

49. 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

50. 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

51. 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

52. 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

53. 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

54. 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

55. 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

56. Comments or questions about PowerPoint Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business richard.newmark@PhDuh.com 11-56 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall