1. 11-1 ©2008 Prentice Hall, Inc.

2. 11-2 ©2008 Prentice Hall, Inc. S CORPORATIONS (1 of 2)  S election advantages and disadvantages  S corporation requirements  S corporation election  S corporation operations  Shareholder taxation

3. 11-3 ©2008 Prentice Hall, Inc. S CORPORATIONS (2 of 2)  Basis adjustments  Distributions  Other rules

4. 11-4 ©2008 Prentice Hall, Inc. S Corporation 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 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. 11-5 ©2008 Prentice Hall, Inc. S Corporation 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

6. 11-6 ©2008 Prentice Hall, Inc. S Corporation Advantages (3 of 3)  S corp not subject to personal holding company or accumulated earnings taxes  LLCs and partnerships may make S election

7. 11-7 ©2008 Prentice Hall, Inc. S Corporation 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

8. 11-8 ©2008 Prentice Hall, Inc. S Corporation 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

9. 11-9 ©2008 Prentice Hall, Inc. S Corporation 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

10. 11-10 ©2008 Prentice Hall, Inc. 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

11. 11-11 ©2008 Prentice Hall, Inc. 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

12. 11-12 ©2008 Prentice Hall, Inc. 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

13. 11-13 ©2008 Prentice Hall, Inc. S Corporation Election 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

14. 11-14 ©2008 Prentice Hall, Inc. S Corporation Election 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 can be retroactive to beginning of year  Otherwise, election effective for 1 st day of next taxable year

15. 11-15 ©2008 Prentice Hall, Inc. S Corporation Election 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

16. 11-16 ©2008 Prentice Hall, Inc. S Corporation Election 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

17. 11-17 ©2008 Prentice Hall, Inc. S Corporation Operations  Taxable year  Accounting method elections  Ordinary income and separately stated items  U.S. production activities deduction  Special S corporation taxes

18. 11-18 ©2008 Prentice Hall, Inc. 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

19. 11-19 ©2008 Prentice Hall, Inc. 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

20. 11-20 ©2008 Prentice Hall, Inc. 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

21. 11-21 ©2008 Prentice Hall, Inc. 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

22. 11-22 ©2008 Prentice Hall, Inc. 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

23. 11-23 ©2008 Prentice Hall, Inc. 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

24. 11-24 ©2008 Prentice Hall, Inc. Special S Corporation Taxes  Special levies apply to S corps  Excess net passive income tax  Built-in gains tax  LIFO recapture tax

25. 11-25 ©2008 Prentice Hall, Inc. 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

26. 11-26 ©2008 Prentice Hall, Inc. 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

27. 11-27 ©2008 Prentice Hall, Inc. 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

28. 11-28 ©2008 Prentice Hall, Inc. 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

29. 11-29 ©2008 Prentice Hall, Inc. 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

30. 11-30 ©2008 Prentice Hall, Inc. Shareholder Taxation  Income allocation procedures  Loss and deduction pass-through to shareholders  Family S corporations

31. 11-31 ©2008 Prentice Hall, Inc. 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 C11-16

32. 11-32 ©2008 Prentice Hall, Inc. 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

33. 11-33 ©2008 Prentice Hall, Inc. 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

34. 11-34 ©2008 Prentice Hall, Inc. 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

35. 11-35 ©2008 Prentice Hall, Inc. 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

36. 11-36 ©2008 Prentice Hall, Inc. 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

37. 11-37 ©2008 Prentice Hall, Inc. 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

38. 11-38 ©2008 Prentice Hall, Inc. 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

39. 11-39 ©2008 Prentice Hall, Inc. 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)

40. 11-40 ©2008 Prentice Hall, Inc. 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

41. 11-41 ©2008 Prentice Hall, Inc. 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

42. 11-42 ©2008 Prentice Hall, Inc. 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

43. 11-43 ©2008 Prentice Hall, Inc. 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

44. 11-44 ©2008 Prentice Hall, Inc. 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

45. 11-45 ©2008 Prentice Hall, Inc. 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

46. 11-46 ©2008 Prentice Hall, Inc. 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

47. 11-47 ©2008 Prentice Hall, Inc. Other S Corp 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

48. 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 11-48 ©2008 Prentice Hall, Inc.