1. 11-1 ©2010 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 ©2010 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 ©2010 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% (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

5. 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

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 ©2010 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 ©2010 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 ©2010 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

10. 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. 11-11 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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

36. 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

37. 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. 5. - Nondeductible, noncapital expenditures Basis available to absorb S corp loss ©2010 Pearson Education, Inc. Publishing as Prentice Hall

38. 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

39. 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

40. 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

41. 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

42. 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

43. 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

44. 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

45. 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

46. 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

47. 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

48. 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

49. 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

50. 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

51. 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

52. 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

53. 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 11-53 ©2010 Pearson Education, Inc. Publishing as Prentice Hall