CHAPTER 12 B S CORPORATIONS
Based on West Federal Taxation, Corporations, Partnerships, Estates, & Trusts, 2001 ed.
1. INTRODUCTION
1. IN GENERAL p.12-2
1. S Corporation status provides a compromise for small businesses.
1. Avoid double taxation and loss limitations inherent in the regular corporate form
2. Enjoy many of the nontax benefits extended to C corporations.
2. State law:
1. S Corporations are treated as corporations under state law. They are recognized as separate legal entities and generally provide shareholders with the same liability protection afforded by C corporations.
2. Some states impose an income or franchise tax on S corporation meaning that the corporation may not owe federal corporate tax but would owe state income tax.
3. S corp status must be elected by a qualifying corporation and consented to by its shareholders.
2. AN OVERVIEW OF S CORPORATIONS p.12-3
1. The growth of S corporations has continued even though the individual income tax rate has remained above the corporate rate. In 1986, only 24.1% of corporations were S corporations, but by 1996 the percentage had grown to 49.8% or 2.3 million S corporations.
2. Two recent developments have affected the popularity of S corporation status.
1. New entities called limited liability companies(LLCs) avoid restrictions that are imposed on S corporations.
2. Small Business Protection Act of 1996 liberalized several S corporation rules which provide greater flexibility in forming, operating, and restructuring S corporations.
3. WHEN TO ELECT S CORPORATION STATUS p.12-4
Consider these factors:
1. Shareholders with high marginal rates relative to C corp. rates may want to avoid S status.
2. S corp. status allows shareholders to realize tax benefits from corporate losses immediately such as the benefits of an NOL used to shelter other income (not available with a C corp).
3. If the entity electing S corporation status is currently a C corporation, any NOL carryovers form prior years cannot be used in an S corporation year.
4. Distributions of earnings from C corporations are usually taxed as ordinary income.
5. S corporation rules impose significant requirements for qualifying as an S corporation.
6. State and local tax laws should also be considered when making the S election.
2. QUALIFYING FOR S CORPORATION STATUS
1. DEFINITION OF A SMALL BUSINESS p.12-5
Corporation must have these characteristics:
1. Ineligible Corporations
1. S corp status only granted to domestic corporations
2. S corp status is not permitted for foreign corporations, certain banks, insurance companies, and Puerto Rico or possessions corporations.
2. One Class of Stock B A small business corporation may have only one class of stock issued and outstanding (does not consider different voting rights as different classes of stock).
Acct 432, Ch 12 Outline, Page 1
3. Number of Shareholders B Maximum of 75 shareholders (35 prior to 1997). Be careful of divorce situations.
4. Type of Shareholder Limitation B Small business corporation shareholders may be resident individuals, estates, certain trusts, and certain tax-exempt organizations.
5. Nonresident Aliens B Nonresident aliens cannot own stock in a small business corporation.
6. Ethical consideration B p.12-8
2. MAKING THE ELECTION p.12-8
To be an S corporation , a small business corporation must file a valid election with the IRS.
1. Use Form 2553
2. For existing corporations B File election either in the previous year or by the 15th day of the third month of the tax year.
3. For new corporations B File election at the earliest of the following dates:
1. 2 2 months from the date corporation has shareholders
2. 2 2 months from the date corporation acquires assets
3. 2 2 months from the date corporation begins doing business.
4. Corp must qualify for S election for entire tax year for which election is made.
5. Obtain consent for S election from all shareholders.
3. SHAREHOLDER CONSENT p.12-9
1. A qualifying election requires the consent of all of the corporation=s shareholders. Consent must be in writing, and must generally be filed by the election deadline.
2. Both husband and wife must consent if they own their stock jointly (as joint tenants, tenants in common, tenants by the entirety, or community property).
3. Shareholders from the year before election for S status is made must also consent to election.
4. LOSS OF THE ELECTION p.12-10
An S election remains in force until it is revoked or lost.
1. Voluntary Revocation
1. Requires the consent of shareholders owning a majority of shares on the day that revocation is to be made.
2. Unless otherwise indicated on the revocation, C corp status will become effective
(1) for the current tax year if filed by March 15th of that year.
(2) for the next tax year if filed after March 15th of that year.
3. Corp can select a future date at which point the C status will become effective. All income for that year would then be allocated between the S corp status and the C corp status depending on the number of days of the year for each status.
2. Loss of Small Business Corporation Status
1. If an S corp fails to qualify at any time after the election has become effective, its status as an S corporation ends.
2. Termination date of the S corp is the date corp failed to qualify as an S corp.
3. Passive Investment Income (PII) Limitation
1. The code provides a PII limitation for:
(1) S corporations that were previously C corporations OR
Acct 432, Ch 12 Outline, Page 1
(2) S corporations that have merged with C corporations.
2. If an S corp has C corp E & P and passive income in excess of 25% of its gross receipts for three consecutive taxable years, the S election is terminated as of the beginning of the fourth year.
3. Passive income includes dividends, interest, rents, gains & losses from sale of securities, etc.
4. Reelection after Termination
After S status is terminated, a corp must wait five years before reelecting S corporation status. The five year waiting period is waived if:
1. there is > 50% change in ownership after the 1st year for which the termination is applicable, or
2. the event causing the termination was not reasonably within the control of the S corporation or its majority shareholders.
3. OPERATIONAL RULES
1. COMPUTATION OF TAXABLE INCOME p.12-12
1. S corporations can amortize organizational expenditures and must recognize gains, but not losses, on distributions of appreciated property to shareholders.
2. Dividends received deduction does not extend to S corporations.
3. In general, S corporation items are divided into
1. nonseparately stated income or loss and
2. separately stated income, losses, deductions, and credits that could affect the tax liability of any shareholder in a different manner and are reported on Schedule K of Form 1065. (See p.12-13 for list of separately stated items.)
PROBLEM 12
2. ALLOCATION OF INCOME AND LOSS p.12-14
1. In general:
1. Each shareholder is allocated a pro rata portion of nonseparately stated income or loss and of all separately stated items. The pro rata allocation method assigns an equal amount of each of the S items to each day of the year. Formula:
S corp item x % of shares owned x % of year shares owned = Amt to be reported
2. If a shareholder=s stock holding changes during the year, this allocation assigns the shareholder a pro rata share of each item for each day the stock is owned. The allocation for the day of transfer is assigned to the transferor (not transferee).
3. The per day allocation must be used, unless the shareholder disposes of his or her entire interest in the entity.
4. If a shareholder dies during the year, his or her share of the pro rata items up to the date of death is reported on the final individual income tax return.
2. The Short-Term Election
1. If a shareholder=s interest is completely terminated by death or disposition before end of the S corp=s year, all shareholders and corp can elect to split the tax year and allocate items as they accrue (per-books method) instead of prorata.
2. Short-term election can help protect the value of the estate of a deceased shareholder.
PROBLEM 14
Acct 432, Ch 12 Outline, Page 1
3. TAX TREATMENT OF DISTRIBUTION TO SHAREHOLDERS p.12-16
Distributions to S corp shareholders equals the cash they receive plus the FMV of the property distributed. Be careful!! The shareholders may be taxed on the distribution if the corporation used to be a C corp.
1. No AEP from C Corporation Years
1. Distributions to S corp shareholders are considered tax-free if:
(1) S corp never was a C corp OR
(2) S corp (that used to be a C corp) has no accumulated earnings and profits (AEP)
2. Distributions in excess of basis are usually treated as capital gains.
2. AEP from C Corporation Years
1. If the S corp (that used to be a C corp) has accumulated earnings and profits, the shareholders must be taxed on the money when it is distributed.
(1) Distributions from AEP are taxed as dividends like they would be if it were still a C corp.
(2) Distributions from income earned by the S corp and taxed on the shareholder=s return is not taxed a second time.
2. All corps (but especially those corps that used to be C corps) must keep an account entitled accumulated adjustments account (AAA) which accumulates the S corp income. This income is eventually passed through tax-free to the shareholders.
(1) AAA is divided among the shareholders based on their proportional interest in the stock (stock basis is irrelevant).
(2) An S corp loss can cause a negative balance in the AAA.
(3) A distribution by an S corp cannot cause a negative balance in the AAA.
3. Distribution Ordering Rules
1. A distribution from an S corp is deemed to come from the following accounts in order:
(1) AAA (limited to the basis in stock)
(2) Previously taxed income (PTI) which is the same type of account as AAA but for S corp formed before 1983.
(3) AEP
(4) Any additional distribution is usually treated as a capital gain.
2. AAA bypass election B If all shareholders consent, S corp can elect to have a distribution come first from AEP instead of AAA.
PROBLEM 22, 25
4. Schedule M-2 B Made up of three columns (AAA, OAA, & PTI)
1. OAA includes items that affect basis but not AAA. Examples include:
(1) tax exempt income
(2) related nondeductible expenses
2. Distributions come from OAA only after AAA and AEP have $0 balances.
3. Distributions from OAA are generally tax free.
5. Effect of Termination the S Election B Be very careful when making distributions the first year after the S election is terminated.
1. Cash distribution? Treated as tax-free recovery of basis if it does not exceed AAA.
2. Property distributions? Do not get the same treatment.
4. TAX TREATMENT OF PROPERTY DISTRIBUTIONS BY THE CORPORATION p.12-20
1. S corp is deemed to have sold the asset to the shareholder for the asset=s FMV
2. Gain?
1. S corp passes the gain through to the shareholders who pay the tax.
2. Gain is taxed as either capital or ordinary (depends on the asset distributed).
3. Loss?
1. S corp does not recognize the loss
2. No pass through of the loss occurs.
4. Shareholder has a basis of the FMV of the property.
Acct 432, Ch 12 Outline, Page 1
5. SHAREHOLDER=S BASIS p.12-22
1. Shareholder basis is increased by the following:
1. Stock purchases
2. Capital contributions
3. Nonseparately computed income
4. Separately stated income items
5. Depletion in excess of basis in the property
2. Shareholder basis is reduced by the following:
1. Distributions not reported as income (e.g. AAA and PTI)
2. Nondeductible expenses of the corporation
3. Nonseparately computed loss
4. Separately stated loss and deduction items
PROBLEM 20, 23
3. To calculate basis, use the following order:
1. Beginning basis
2. Add: Income items
3. Less: Distributions
4. Less: Non-capital, nondeductible expenditures
5. Less: Losses and Deductible expenditures
PROBLEM 21
4. Shareholder=s basis will never fall below zero. Once the zero limit is reached, any additional losses or deductions (but not distributions) impact the shareholder=s basis in any debt owed by the corporation to the shareholder.
1. Any excess losses or deductions over both the stock basis and the debt basis are suspended.
2. Corporate loans from shareholders
(1) Debt basis must be restored to its original amount before the shareholder=s stock basis can be increased.
(2) Get a note or evidence of the debt so that deductions can be substantiated.
3. Corporate loans from third parties
(1) do not affect shareholder=s basis.
(2) do not affect shareholder=s basis even if shareholder personally guarantees the debt.
6. TREATMENT OF LOSSES p.12-24
1. Net Operating Loss
1. NOLs can be passed through to shareholders and used as a deduction on their personal returns in the year in which the S corp. tax year ends.
2. Shareholder=s basis in the stock is reduced to the extent of the NOL. NOL deduction is not allowed on the shareholder=s tax return for an amount exceeding shareholder=s basis in his stock and any debt due to him by the corp.
3. Shareholder=s AAA is reduced by the same deductible amount
4. If S corp incurs more than one type of loss (e.g., NOL, passive loss, capital loss), the loss must be allocated appropriately.
PROBLEM 27
5. Distributions adjustments are made to the shareholder=s stock basis prior to applying any of the loss limitations for the year.
6. Any unused losses (i.e., losses that exceed shareholder=s stock basis and debt basis) can be carried forward and used by that same shareholder when he has restored his debt basis or his stock basis.
PROBLEM 28
7. If the AS@ status is lost or revoked, any unused carried over loss is lost forever after one-year.
2. Passive Losses and Credits B OMIT
3. At-Risk Rules B OMIT
Acct 432, Ch 12 Outline, Page 1
7. TAX ON PRE-ELECTION BUILT-IN GAINS p.12-27
1. S-corporations converting from C-corporation status may be subject to three taxes:
1. Built-in gains tax (' 1374)
2. LIFO recapture tax
3. Passive investment income tax
2. General Rules (for Built-in Gains Tax)
1. Applies to C-corporations converting to S-corp status after 1986.
2. S corp is taxed at corp level on any built-in gain recognized when it disposes of an asset within 10 calendar years after date of S-corp status election.
3. Designed to catch those corporations seeking to avoid double tax on disposition of appreciated property by electing S-corp status.
4. Base for tax includes any unrealized gain on appreciated assets (real estate, cash basis receivables, goodwill).
5. Highest corporate tax rate (now 35%) to unrealized gain when assets are sold.
6. Gain on sale (less the ' 1374 tax) passes through as a taxable gain to shareholders.