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1 Chapter 11: S Corporations
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2 S CORPORATIONS (1 of 2) Should an S election be made? S corporation requirements S corporation election Termination of S election Tax year Ordinary income/loss and separately stated items
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3 S CORPORATIONS (2 of 2) Special S corporation taxes Shareholder allocations Loss limitations Additional limitations Family S corporations Basis adjustments S corporation distributions
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4 Should an S Election Be Made (1 of 5) Advantages of S corp No corporate level taxation Income taxed directly to shareholders Benefit reduced because dividends are generally taxed to individuals at 15% (through 2008) 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
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5 Should an S Election Be Made (2 of 5) Advantages of S corp (continued) S corp losses can be used to offset s/h’s other income Allowed to split S corp income between family members (with restrictions) S corp earnings not subject to SE tax
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6 Should an S Election Be Made (3 of 5) Disadvantages of S corp Earnings retained by C corp taxed at rates generally lower than s/h’s marginal tax rates 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
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7 Should an S Election Be Made (4 of 5) Disadvantages of S corp (continued) No dividends-received deduction No special allocations allowed Income allocated based on ownership S corp liabilities do not increase loss limits Except for s/h loan to S corp
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8 Should an S Election Be Made (5 of 5) Disadvantages of S corp (continued) 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
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9 S Corporation Requirements (1 of 3) Shareholder requirements No more than 100 shareholders Husband and wife counted as one s/h May elect to include all members of a family as a single shareholder Individuals, estates, and certain types of trusts (including QSSTs) QSSTs may be complex trusts
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10 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 Must not be an “ineligible” corporation
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11 S Corporation Requirements (3 of 3) Corporation-related requirements (continued) 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
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12 S Corporation 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
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13 Termination of S 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 can be retroactive to beginning of year Otherwise, election effective for 1 st day of next taxable year
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14 Termination of S 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
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15 Termination of S 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
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16 Tax 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
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17 Tax 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
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18 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 or pages C11-14 & C11-15
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19 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
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20 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
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21 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% of the qualified production activities income allocated to the s/h
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22 Special S Corporation Taxes Special levies apply to S corps Excess net passive income tax Built-in gains tax LIFO recapture tax
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23 Excess Net Passive Income Tax 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 C11-11
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24 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
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25 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 C11-13
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26 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
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27 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 C11-14
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28 Shareholder Allocations (1 of 2) S/hs report pro rata share of ordinary income & separately stated items Known as per day/per share method See Example C11-16
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29 Shareholder 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
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30 Loss Limitations (1 of 2) Ordinary & separately stated loss amounts “passed” through to s/h S/h’s deduction limited to adjusted basis in stock plus adjusted basis of debt owed directly by corp to s/h
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31 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
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32 Additional Limitations (1 of 2) §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 to new owner unless to spouse incident to divorce
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33 Additional Limitations (2 of 2) 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
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34 Family S Corporations 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
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35 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)
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36 Basis Adjustments (2 of 2) 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 Loss/deduction not currently deductible is suspended until s/h has basis in debt or stock
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37 S Corporation Distributions (1 of 4) 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
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38 S Corporation Distributions (2 of 4) Distributions for S Corp w/o AE&P (continued) Corporation recognizes gain on distribution of appreciated property No loss reported when corp distributes property that has declined in value
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39 S Corporation Distributions (3 of 4) 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
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40 S Corporation Distributions (4 of 4) Distributions for S Corp w/ AE&P (continued) S corp can elect to skip over AAA in determining source of distributions May be advantageous for s/hs who want to recognize dividend income before 15% rate expires after 2008
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41 Other S Corp 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
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42 Other S Corp Rules (2 of 2) Fringe benefits paid to s/h-employee For 2% (or more) s/h, S corp treated like a partnership Many benefits tax-free to C corp s/h- employees are taxable to S corp s/h- employees
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43 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
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