1. 1 Subchapter S (Day 2) Robert R. Oliva, Ph.D., LL.M., J.D., CPA University of Arkansas at Little Rock

2. 2 Introduction l Tax effect of S election l Subchapter S taxes »BIG/PII »Recapture l Shareholder taxes: Pass Throughs: »Separately stated » Not separately stated

3. 3 Tax Effect of S Election on S l Information return l No federal income taxes paid, except »BIG »PII »Recapture: LIFO reserve; ITC

4. 4 Tax Effect of S Election on Shareholders l Introduction l Separately stated items l Nonseparately stated items

5. 5 Introduction l S v. partnerships l S v. corporations

6. 6 S Corp v. partnerships l Similar in income computation: »Separately and non-separately stated items. l However, »S measures property distributions at FMV –Partnerships distributions measured at AB »S debt does not affect shareholders’ AB. –Partnership’s debt affects partners’ AB »Disproportional distributions permitted in partnerships –But could cause the S termination b/c creates second class of stock

7. 7 S Corp v. C Corp l Unless otherwise stated follow Sub C rules »Like C Corps, S Corps –allowed IRC 248 org. exp. Amortization –Recognize gain on distributions of appreciated property l However, while gain is passed through but shareholder does not report it as dividend. »But unlike C Corps, –S Corps are not allowed to an IRC 243 or IRC 291 deductions –S Corps separately report items that may have different treatments at shareholder level.

8. 8 Separately Stated Items l charitable contributions (no 10% limit) l foreign/possessions taxes »Shareholder to elect deduction or credit l tax exempt income »Passes through as increases to AB l income/loss/deduction/credit requiring separate treatment »Capital gains & losses »IRC 1231 gains & losses »Interest and dividends received by an S, e.g., portfolio income

9. 9 Separately Stated Deductions l IRC 179 l Nonbusiness bad debt (IRC 166(d): STCL)

10. 10 Non-separately Stated Items l Gross income less deductions l Deductions: IRC 248, 291, depreciation (not 179). l Disallowed deductions: sep. stated; personal;

11. 11 Computation of shareholders’ share l Pro rata: daily/per share l Daily: Yearly income(loss) / days in taxable year l Per share: Daily income(loss) / # shares outstanding

12. 12 Example 1: Pro rata l A and B equal owners of S »w/ O.I. of $146,000 »and LTCG of $36,500. l How much do A and B report?

13. 13 Answer to Example 1: l A and B each report 50%.

14. 14 Example 2:Pro rata l Now B sells 50% on 90th day. »B owned 50% for 89 days and 25% for 276 days »C owned 25% for 276 days l How much do B and C report?

15. 15 Answer to Example 2: Ordinary Income: l B: $146K(.5)(89/365) + $146K(.25)(276/365) = $45,400 l C: $146K(.25)(276/365) = $27,600

16. 16 Answer to Example 2: LTCG l B: $36500(.5)(89/365) + $36500(.25)(276/365)=$11350 l C:$36500(.25)(276/365) = $6900

17. 17 Example 3: pro rata l A owns 10% through the year; nonseparately stated = $36500 l How much does he report?

18. 18 Answer to Example 3: l.10(36500) = $3650 l Or: »Daily: $36500/365= $100/day »Prorata:$100(.10)=$10/day »Yearly share: $10/day(365)=$3650

19. 19 Example 4: prorata l Same as 3 but now A buys another 10% on the 201st day: l How much does he report?

20. 20 Answer to Example 4: l 10% for 200 days:$100/day(.10)(200)=$2000 l 20% for 165 days:$100/day(.20)(165)=$3300

21. 21 Effect of cessation of ownership: l If no election: compute as above l If election: compute as if two years l Why relevant?

22. 22 Relevancy of no election: l If income is NOT earned evenly throughout year, shareholders will not report their fair share l Similar election available when S terminates.

23. 23 Distributions: irc 1368 l An extension of the IRC 301 water faucet analogy in Subchapter C. l But 4 buckets or tiers instead of 3 buckets »Tier 1: From AAA: Tax free –Simultaneously reduce l AAA and AB –Recognize gain after AB. »Tier 2: In excess of AAA: dividend up to AEP »Tier 3: Remainder of AB tax free »Tier 4: Balance in excess of AB = gain

24. 24 Therefore, l an S distribution has no impact on shareholders’ TI unless »After elimination of AAA, distribution is sourced from EP »Distribution > Adjusted Basis

25. 25 AAA: Accumulated Adjustments Account l Rationale: Tracks the source of distributions l Two sources of distributions »Undistributed and untaxed C’s EP = AEP »Undistributed but taxed S’s operations = post-1982 undistributed earnings

26. 26 AAA: Adjustments l Beginning balance on day 1 of S = 0 »AAA = 0 »AEP = $500 (leftover from C years) l Increase AAA by results of operations »If S has $100 earnings, then –AAA= $100 –AEP = $500

27. 27 AAA adjustments: l Increase AAA »Results of operations l Reduce AAA by »Pass through losses/deductions »Nondeductible expenses, not charged to capital account

28. 28 Examples of nonded exp/not charged to cap. l expenses for tax free income l illegal bribes, nondeductible fines & penalties l losses between related parties l federal taxes during C years l disallowed meal and entertainment expenses

29. 29 Treatment l Redemptions, distributions and operating results »Sub S corporations with C’s EP. »Sub S corporations (never were C corporations)

30. 30 Sub S corporations with C’s EP. l Dealing with the AAA

31. 31 AAA Adjustments: Redemption l 25% stock redemption; AAA = $160 l Adjust AAA by 25%: $160 -.25(160) = $120

32. 32 AAA adjustments: Distributions l Timing Issue: »Which should be accounted for first? –Results of operations? –Results of distributions?

33. 33 General rule: l (1) Adjust S Corp’s balances (AAA, EP, AB) by the results of operations l (2) Adjust S Corp’s balances to account for the distribution.

34. 34 Exception: l The order of adjustments is changed when there is an operating loss at EOY. »(1) Adjust for the distribution »(2) Adjust for the results of operations

35. 35 Example 5: Operating Loss l Assume one owner l EOY balance before adjustments for the results of operations and distributions »AAA=400; »AEP=1000; »AB=2000; l EOY operating results: »LTCG=400; »Operating loss=(1800)

36. 36 Order of Adjustments (the exception) l First: Distributions l Then: LTCG and ordinary loss.

37. 37 Recalling treatment for distributions: l Tier 1: From AAA: Tax free »Simultaneously reduce –AAA and AB »Recognize gain after AB. l Tier 2: In excess of AAA: dividend up to AEP l Tier 3: Remainder of AB tax free l Tier 4: Balance in excess of AB = gain

38. 38 Example 6: Same facts as #5 but w/$1200 dist. l EOY balance before adjustments for the results of operations and distributions »AAA=400 (from past results of S operations); »AEP=1000 (from results when business was conducted as a C Corp); »AB=2000; l EOY results: »LTCG=400; »Operating Loss=(1800) »Distribution during the year: $1200

39. 39 Effect on Tier 1: AAA l AAA = 400 - 400 = 0 »Note that $800 of the $1200 distribution has not been accounted for as of this time. l Simultaneous reduction of AB »EOY AB before adjustments = 2000 - 400 AAA reduction = 1600 AB balance l Results after dealing with 1st tier: »AB balance = $1600 »ROC = $400

40. 40 The balance of the $1200, e.g., the $800: l Effect on Tier 2: In excess of AAA, div. up to AEP. »AEP=1000-800 = 200 l Results after Tier 2: »AEP balance= $200 »$800 dividend

41. 41 Results of the $1200 distribution: l ROC = $400; l Dividend = $800 l Balances »AEP balance = $200 »AAA balance = 0 »AB balance = $1600

42. 42 After treatment of the $1200 distribution, l proceed to account for the results of operations, »$400 LTCG »$1800 ordinary loss

43. 43 Example 7: l AAA = Beginning balance $400 - $400 (because of distribution) + $400 LTCG - $1800 ordinary loss = - $1400 AAA negative balance l AB = Beginning balance $2000 - $400 (b/c of distribution) + $400 LTCG - $1800 loss = $200 ending balance

44. 44 Note: l Even if AB not enough to reflect loss, AAA will reflect it. l Distribution is greater than AB but the distribution is not taxable.

45. 45 Distributions under the “general rule” l (1) Adjust for results of operations l (2) Adjust for distributions.

46. 46 Example 8: Facts:

47. 47 Results from operations l Non-separately stated income and deductions »$30K l Separately stated income and deductions »LTCG: 15 »Municipal interest: 5 »Dividend income: 3 »Charitable contribution: -8

48. 48 Example 8: Balances at BOY l AB60 l AAA 40 l OAA 0 l AEP 25

49. 49 Example 8: l First question »What is the effect of operations on the following accounts? – AB; AAA; OAA; AEP l Second question »What will be the effect of two $50K distributions, one in June 1 and the other one in December 1?

50. 50 SubSExample8.xls

51. 51 Example 9: AEP and no AAA l Facts: After accounting for the results from operations Sub S Corp has the following balances: AEP=$10; AAA=0; and AB=$25. What is the effect of $50 distribution? l Effect on Tiers: »Tier 1: AAA: None »Tier 2: Div up to AEP = $10 »Tier 3: Reduce AB = $25 »Tier 4: Balance above AB = gain = $15

52. 52 Distributions where there is no AAA nor EP l Tier 1: AAA: None l Tier 2: EP : None l Tier 3: Reduce AB l Tier 4: Balance above AB = gain from s/e.

53. 53 Example 10: l Facts: Results from operations: OI=30; LTCL=(5). Sole shareholder has AB=20 at BOY and receives $35 in distributions during the year.

54. 54 First compute EOY AB and before distributions : l AB BOY 20 + 30 OI -5 LTCL = 45 AB before distributions

55. 55 Second: Compute effect of distributions: l Tier 1: AAA: None l Tier 2: EP : None l Tier 3: Reduce AB: 45 - 35 distribution = 10 AB balance at EOY l Tier 4: Balance above AB = gain from s/e = $0

56. 56 Example 11: l Facts: Same as 10 but now assume that OI=5, and no LTCL.

57. 57 First compute EOY AB and before distributions : l AB BOY 20 + 5 OI = 25

58. 58 Second: Compute effect of distributions: l Tier 1: AAA: None l Tier 2: EP : None l Tier 3: Reduce AB: 25 - 25 distribution = 0 AB balance at EOY »Additional $10 has to be accounted as gain l Tier 4: Balance above AB = gain from s/e = $10

59. 59 Example 12: l Facts: Same as 10 but now OI= (5), and no LTCL l First compute ending AB=20-5=15 l Then 1st Tier: 15-15= 0 AB, 20 LTCG l Is this correct?

60. 60 NOT! l Operating loss (exception of general rule). »It requires a net negative adjustment l First: reduce BOY AB by dist of 35: 20- 20=0 AB l Excess of dist. over AB= 15 LTCG gain; NOT 20.

61. 61 AB Positive Adjustments: rationale l If earnings are up, stock value should be up. l If shdr sells, then substantial gain l But as shdr pays for P/T, AB increases to avoid double tax.

62. 62 AB Negative Adjustments: rationale l If earnings are down, stock value should decrease. l If shdr sells,then substantial loss l But b/c P/T losses reduce other income, losses reduce AB to avoid a double benefit.

63. 63 AB Adjustments done at EOY l NOTE: If shareholder sells during the year, gain/loss not determined until EOY.

64. 64 Pecking Order for AB Adjustments l 1. Increase for income items l 2. Decrease for nondeductible, noncapital expenses l 3. Decrease for losses and deductions (could precede 2) l 4. Decrease for distributions

65. 65 Example 13: AB adjustments: l Note: Previous examples involved a 100% shareholder l S reports $50 profit and distributes $20K to 50% shareholder who has $10 AB at BOY »AB BOY 10 + 25 (50% of profits) - 20 distribution = 15 AB EOY and after distributions

66. 66 Example 14: AB Adjustments l Multiple years; equity and debt: »S reports 15K loss in Yr1 and 25K profit in Yr2. »At BOY YR 1: Stock AB=5; Debt AB = 5K (material participation) »S distributes $8K in Yr2 to 50% shareholder l Tax effect of distribution?

67. 67 Answer to Example 15: Year 1 l Yr1: $15K loss: Reduce shareholder’s AB by 50% of $15K »Decrease AB stock: BOY 5 - 5 = 0 EOY 1 (Stock AB cannot fall below 0) »Decrease AB of debt: BOY 5 - 2.5 (bal. not used by stock AB) = 2.5 EOY Yr 1

68. 68 Answer to Example 15: Year 2 l Yr.2: $25K profit; Increase shareholder’s AB by 50% of $25K »Restore debt AB: BOY Yr 2: 2.5 + 2.5 (Debt AB cannot go over original AB) = 5K at EOY 2 and before distributions »Restore stock AB: BOY Yr 2: $0 + $10K = $10 EOY Yr 2 AB before distributions

69. 69 Answer to Example 15: Effect of $8K distribution in Yr 2: l Stock AB EOY Yr 2 10 - 8 dist = 2 ending AB after dist. l As distribution did not exceed stock AB, it is a tax free distribution.

70. 70 Example 16: l A, B, and C equal owners. A’s AB=25 l OI=36.5; muni=14.6; A sells on 1/31 for $30K l Compute A’s gain/loss.

71. 71 Answer Example 16: l AB= 25 + [36.5(1/3)(30/365)] + [14.6(1/3)(30/365)=26.4 l Gain from sale of stock: 30 - 26.4 = $3.6

72. 72 Debt Basis l Use stock AB first, then debt’s AB, not below 0. l Eligible “debt”: B/E fn 115, 116. l Unused loss/deduction carried forward indefinitely l Upward adjustments in reverse

73. 73 Example 17: Debt AB l 1/1/00: 50% shdr, AB stock=40K, secured debt AB=20K l 2000: S reports (100K). Thus ABs=0, ABd=10K l 2001: S reports 10K. ABdebt=15K. l S pays $20K note. Shdr reports $5K gain on debt. l Unsecured note would have resulted in $5K OI.

74. 74 ENPI: Example 18 l ENPI = NPI [ (PII-.25 GR) / PII ] l Nonpassive= 35K; PII=65K; exp for PII=10K; other exp=25 »NPI = 65-10 = 55 l ENPI= 65-10 [(65-.25(35+65) / 65 = $33,486 l $33486 at highest rate (assume 35%) = $11,486

75. 75 Built-In Gains Tax l Recognizes any C’s BIG during 10 years after S election. l Taxes gain at highest rate, e.g., 35% l If BIG imposed, it is treated as a loss for the year. l Character of loss: look at the asset causing BIG

76. 76 Definitions l NUBIG: Excess of FMV over AB on Day 1 of S l NRBIG: Lesser of net of BIG and BIL or TI l Recognized BIG: gain from sale of any asset. l Exceptions: » Asset sold not held in Day1, or »if held on Day 1, actual gain exceeded NUBIG

77. 77 Additional Limitations l NRBIG < NUBIG-NRBIG to date: top = NUBIG l C’s NOL carryforwards used v. BIG

78. 78 Example 19: BIG l 1/1/96:FMV/AB: Inv(FIFO)=75/60;Mach1(1245:18/11, Mach2 (1231):15/19 l Inv sold for 85: 85-60=25 OI, but 15 is BIG l Mach 1 sold for 19: 19-11=8 OI, but 7 is BIG. l Mach 2 (1231) sold or 16: 16-19=3 1231 loss PT, and 3 BIG l Yearly: 15+7-3=19 at 35% = $6,650 in BIG taxes