1. 1 Chapter 11: S Corporations

2. 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

3. 3 S CORPORATIONS (2 of 2)  Special S corporation taxes  Shareholder allocations  Loss limitations  Additional limitations  Family S corporations  Basis adjustments  S corporation distributions

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 22 Special S Corporation Taxes  Special levies apply to S corps  Excess net passive income tax  Built-in gains tax  LIFO recapture tax

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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)

36. 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

37. 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

38. 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

39. 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

40. 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

41. 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

42. 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

43. 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