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1 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Corporations, Partnerships, Estates & Trusts 1 Chapter 12 S Corporations

2 The Big Picture (slide 1 of 2) Cane, Inc., has been a C corp. for a number of years, earning taxable income of less than $100,000 per year. –Thus, the business has been subject to the lower C corporation tax rates. Due to cheap imports from China, Cane’s two owners, Smith and Jones, expect operating losses for the next two or three years. –They hope to outsource some of the manufacturing to Vietnam and turn the company around. How can they deduct these anticipated future losses?

3 The Big Picture (slide 2 of 2) The corp. receives some tax-exempt income, generates a small domestic production activities deduction (DPAD), and holds some C corp. E&P. Each owner draws a salary of $92,000. Cane has two classes of stock, voting and non-voting common stock. –Cane is located in Texarkana, Texas. –Smith lives in Texas, and Jones lives in Arkansas. Both are married to nonresident aliens. Should Smith and Jones elect to be taxed as an S corporation? –Do they need to liquidate or go through some type of reorganization to do so? Read the chapter and formulate your response.

4 Subchapter S Issues (slide 1 of 6) S corporations provide many of the benefits of partnership taxation –Also gives the owners limited liability protection from creditors S corporation status is obtained through an election by a qualifying corporation with the consent of its shareholders

5 Subchapter S Issues (slide 2 of 6) S corporations are still corporations for legal purposes –Owners receive the benefits of limited liability, ability to raise capital (within limits), etc...

6 Subchapter S Issues (slide 3 of 6) Taxation resembles partnership taxation –Certain items (primarily business income and certain expenses) are accumulated and passed through to shareholders –Other items are “separately stated” and each item is passed through to shareholders

7 Subchapter S Issues (slide 4 of 6) An S corporation is a reporting (rather than tax-paying) entity Tax liability may still arise at the entity level for: –Built-in gains tax, or –Passive investment income penalty tax

8 Subchapter S Issues (slide 5 of 6) An S corporation is not subject to the following taxes: –Corporate income tax –Accumulated earnings tax –Personal holding company tax –Corporate alternative minimum tax

9 Subchapter S Issues (slide 6 of 6) Entity is subject to Subchapter C rules for a transaction unless Subchapter S provides alternate rules

10 When to Elect S Corp Status Following factors should be considered: –If shareholders have high marginal tax rates vs C corp rates –If NOLs are anticipated –If currently C corp, any NOL carryovers from prior years can’t be used during S corp years Still reduces 20 year carryover period –Character of anticipated flow-through items –State and local tax laws –A variety of other factors

11 S Corp Qualification Requirements (slide 1 of 3) To elect under Subchapter S, a corporation must meet the following requirements: –Must be a domestic corporation –Must not otherwise be “ineligible” Ineligible corporations include certain banks, insurance companies and foreign corporations Any domestic corp. that is not an ineligible corp. can be a qualified Subchapter S Subsidiary (QSSS) if: –S corp owns 100% of its stock, and –Elects to treat the subsidiary as a QSSS

12 S Corp Qualification Requirements (slide 2 of 3) Corporation may have only one class of stock –Can have stock with differences in voting rights but not in distribution or liquidation rights –It is possible for debt to be reclassified as stock Results in unexpected loss of S corp status Safe harbor provisions mitigate concern over reclassification of debt

13 The Big Picture – Example 3 One Class of Stock Return to the facts of The Big Picture on p. 12–1. Cane, Inc., could elect to be an S corp. as long as the 2 classes of common stock are identical except that one class is voting and the other class is nonvoting. You learn that both shareholders have binding employment contracts with Cane, Inc. –The amount paid to Jones under her employment contract is reasonable –The amount paid to Smith is excessive, resulting in a constructive dividend. Smith’s employment contract was not prepared to circumvent the one-class-of-stock requirement. –Because employment contracts are not considered governing provisions, Cane still is treated as though it has only one class of stock if an S election is made.

14 S Corp Qualification Requirements (slide 3 of 3) Must have 100 or less shareholders –Family members may be treated as one shareholder Shareholders may include resident individuals, estates, certain trusts, and certain tax-exempt organizations –Charitable organizations, employee benefit trusts exempt from taxation, and a one-person LLC classified as a disregarded entity also can qualify as shareholders of an S corporation –Partnerships, Corps, LLPs, most LLCs and most IRAs cannot own S corp stock, but S corps can be partners in a partnership or shareholders in a corporation Shareholders cannot include any nonresident aliens

15 The Big Picture – Example 6 Nonresident Aliens Return to the facts of The Big Picture on p. 12–1. Jones lives in Arkansas, a common law property state. –Being married to a nonresident alien spouse would not affect an S election. However, Smith lives in Texas, a community property state. –His nonresident alien spouse would be treated as owning half of his community property stock. Consequently, an S election would not be allowed. To qualify for S status, Smith could move to Arkansas or his spouse could move to Texas (becoming a resident alien).

16 Making the Election (slide 1 of 3) To become an S corp, must make a valid election that is: –Filed timely –All shareholders must consent to the election

17 Making the Election (slide 2 of 3) To be effective for current year –Make election by 15th day of third month of current tax year, or –File in previous year

18 Making the Election (slide 3 of 3) Shareholder Consent –Each shareholder owning stock during election year must sign consent for election (even if stock is no longer owned at election date) –May be able to obtain extension of time for filing consent from IRS Available only if Form 2553 is filed on a timely basis, reasonable cause is given, and the interests of the government are not jeopardized

19 The Big Picture – Example 7 Making The Election Return to the facts of The Big Picture on p. 12–1. Suppose that in 2012, shareholders Smith and Jones decide to become an S corp. beginning January 1, 2013. Since the C corp. uses a calendar tax year, the S election can be made at any time in 2012 or by March 15, 2013. –An election after March 15, 2013, will not be effective until the 2014 calendar tax year.

20 Termination of Election (slide 1 of 4) An S election remains in force until revoked or lost, however, an S election can terminate if: 1.Shareholders owning a majority of shares voluntarily revoke the election –Revocation must be filed by 15th day of third month of tax year to be effective for entire year –Otherwise, it is effective for first day of following year, or any other specified future date A revocation that designates a future effective date splits the corp’s tax year into a short S corp. year and a short C corp. year

21 Termination of Election (slide 2 of 4) 2. New shareholder owning > 50% of entity affirmatively refuses to consent to election 3. Entity no longer qualifies as S corp –If an S corp. fails to qualify as a small business corp. at any time after the election has become effective, its status as an S corp. ends e.g., The entity has > 100 shareholders or a nonresident alien shareholder, a second class of stock exists, etc. –Election is terminated on date disqualification occurs

22 Termination of Election (slide 3 of 4) 4.The corp. does not meet the passive investment income limitation –If an S corp. has C corp. E & P and passive income > 25% of its gross receipts for three consecutive taxable years The S election is terminated as of the beginning of the fourth year –Applies to S corps. that were previously C corps. or for S corps. that have merged with C corps.

23 Termination of Election (slide 4 of 4) A new S election normally cannot be made within 5 years after termination of a prior election –Five year waiting period is waived if: There is a > 50% change in ownership after first year termination is applicable Event causing termination was not reasonably within control of the S corp or its majority shareholders

24 Computation of Taxable Income (slide 1 of 2) Determined in a manner similar to partnerships except –S corp. amortizes organizational costs under the C corp. rules –S corp. must recognize gains (but not losses) on distributions of appreciated property to shareholders –Certain other special C corp. provisions do not extend to S corps. e.g., Dividends received deduction

25 Computation of Taxable Income (slide 2 of 2) S corp items are divided into: –Nonseparately stated income or loss Essentially, constitutes Subchapter S ordinary income or loss –Separately stated income, losses, deductions and credits that could affect tax liability of shareholders in a different manner Identical to separately stated items for partnerships

26 Flow-Through of S Corporation Items

27 Separately Stated Items Examples include: –Tax-exempt income –Gains/losses from disposal of business property and capital assets –Charitable contributions –Income/loss from rental of real estate –Interest, dividend, or royalty income –Tax preference items

28 Allocation of Income and Loss (slide 1 of 2) Each shareholder is allocated a pro rata portion of nonseparately stated income (loss) and all separately stated items –If stock holdings change during year, shareholder is allocated a pro rata share of each item for each day stock is owned On the date of transfer, the transferor (and not the transferee) is considered to own the stock

29 Allocation of Income and Loss (slide 2 of 2) –Short-year election is available if a shareholder’s interest is completely terminated (through disposition or death) Allows tax year to be treated as two tax years –Results in interim closing of books on date of termination –Shareholders report their shares of S corp items as they occurred during year

30 S Corporation Distributions (slide 1 of 7) Amount of distribution to shareholder –Cash + FMV of any other property distributed Taxation of distribution depends on whether the S corp has accumulated E&P from C corp years

31 S Corporation Distributions (slide 2 of 7) Where no Earnings and Profits exist 1. Nontaxable to the extent of adjusted basis in stock 2. Excess treated as gain from the sale or exchange of stock Capital gain in most cases

32 S Corporation Distributions (slide 3 of 7) Where Earnings and Profits exist –1. Tax-free to the extent of accumulated adjustments account –2. Distributions from AEP constitute dividend income. ** –3. Tax-free to extent of Other Adjustments Account –4. Tax-free reduction in basis of stock* –5. Excess treated as gain from the sale or exchange of stock (capital gain in most cases) –* Once stock basis reaches zero, any distribution from AAA is treated as a gain from sale or exchange of stock. “Basis” is the maximum tax- free distribution a shareholder can receive. –** AAA bypass election is available

33 S Corporation Distributions (slide 4 of 7) Accumulated Adjustments Account (AAA) –Represents cumulative total undistributed nonseparately and separately stated items –Mechanism to ensure that earnings of an S corp are taxed to shareholders only once

34 S Corporation Distributions (slide 5 of 7)

35 S Corporation Distributions (slide 6 of 7) Other issues regarding distributions: –Distributions of cash during a one-year period following S election termination receive special treatment Treated as a tax-free recovery of stock basis to the extent it does not exceed AAA account Since only cash distributions receive this special treatment, the corp should not distribute property during this postelection termination period

36 S Corporation Distributions (slide 7 of 7) Other issues regarding distributions: –If E & P exists, the entity may elect to first distribute E & P before reducing AAA Called an AAA bypass election

37 Distributions of Property If the entity distributes appreciated property –Gain must be recognized Treated as if property sold to shareholder for FMV Gain is allocated to shareholders and increases their basis in stock before considering the distribution Basis of asset distributed = FMV –Loss is not recognized Basis of asset distributed = FMV Essentially, loss property receives a stepdown in basis without any loss recognition by the S corp. –Thus. distributions of loss property should be avoided

38 Shareholder’s Basis (slide 1 of 4) Determination of initial basis is similar to that of basis of stock in C corp –Depends on manner stock was acquired e.g., gift, inheritance, purchase, exchange –Basis is increased by: Stock purchases Capital contributions Nonseparately computed income Separately stated income items Depletion in excess of basis

39 Shareholder’s Basis (slide 2 of 4) –Basis is decreased by: Distributions not reported as income by shareholders (e.g., from AAA) Nondeductible expenses (e.g., fines, penalties) Nonseparately computed loss Separately stated loss and deduction items –Similar to partnership basis rules First increase basis by income items Then decrease it by distributions and finally losses

40 Shareholder’s Basis (slide 3 of 4) Shareholder’s basis cannot be negative –Once basis is reduced to zero, any additional reductions (losses or deductions, but not distributions) decrease (but not below zero) basis in loans made to S corp –Any excess losses or deductions are suspended –Once basis of debt is reduced, it is increased by subsequent net increases from all positive and negative adjustments

41 Shareholder’s Basis (slide 4 of 4) Basis rules are similar to partnership rules except: –Partner’s basis in partnership interest includes direct investment plus a ratable share of partnership liabilities –Except for loans from a shareholder to the S Corp, corporate borrowing does not affect shareholder’s basis

42 Treatment of Losses (slide 1 of 2) Step 1.Allocate total loss to the shareholder on a daily basis, based upon stock ownership Step 2.If shareholder’s loss exceeds stock basis, apply any excess to adjusted basis of indebtedness to the shareholder. Distributions do not reduce debt basis. Step 3.Where loss > debt basis, excess is suspended and carried over to future tax years. If the shareholder’s basis is insufficient to allow a full flow through and there is more than one type of loss, the flow- through amounts are determined on a pro rata basis –e.g., The S corp. incurs both a passive loss and a net capital loss in the same year

43 Treatment of Losses (slide 2 of 2) Step 4.In future tax years, any net increase in basis adjustment restores debt basis first, up to its original amount. Step 5. Once debt basis is restored, remaining net increase is used to increase stock basis. Step 6. Suspended loss from a previous year now reduces stock basis first and debt basis second. Step 7.If S election terminates, any loss carryover remaining at the end of the post-termination transition period is lost forever.

44 The Big Picture – Example 35 Net Operating Loss Return to the facts of The Big Picture on p. 12–1. If Smith and Jones make the S election for Cane, Inc., they will be able to pass through any NOLs to the extent of the shareholder’s adjusted stock basis. If the new S corp. incurs an NOL of $84,000 during 2012, both shareholders are entitled to deduct $42,000 against other income for the tax year in which Cane’s tax year ends. Any NOL incurred before the S election is in effect does not flow through to the two shareholders.

45 At-Risk Rules S corp. shareholders are limited in the amount of loss they may deduct by their “at-risk” amounts –Rules for determining at-risk amounts are similar, but not identical, to the partner at-risk rules At-risk rules apply to the shareholders, but not to the corp. –Amount at risk is determined separately for each shareholder The amount of the corporate losses that are passed through and deductible by the shareholders is not affected by the amount the corp. has at risk

46 Passive Losses and Credits An S corp is not directly subject to the passive loss rules –If the corporation is involved in rental activities or shareholders do not materially participate Passive losses and credits flow through to shareholders Shareholder’s stock basis is reduced even if passive losses are not currently deductible

47 Built-in Gains Tax (slide 1 of 4) Generally applies to C corps. converting to S corp. status after 1986 –Corporate-level tax on built-in gain recognized in a taxable disposition within 10 calendar years after the effective date of the S corp election The 10-year holding period is reduced to –7 years for tax years beginning in 2009 and 2010, and –5 years for 2011

48 Built-in Gains Tax (slide 2 of 4) Tax base includes unrealized gain on appreciated assets held on date of S corp election –Highest corporate tax rates apply (currently 35%) –This gain passes through to shareholders as taxable gain Maximum built-in gain recognized over the required (5-,7- or 10-year) holding period is limited to aggregate net built-in gain at time corp. converted to S status

49 Built-in Gains Tax (slide 3 of 4) Amount of built-in gain recognized in any year is limited to an “as if” taxable income, computed as if the corp were a C corp –Any gain that escapes taxation under this limit is carried forward and recognized in future years S corp can offset built-in gains with unexpired NOLs or capital losses from corp. years

50 Built-in Gains Tax (slide 4 of 4) LIFO recapture tax –Any LIFO recapture amount at time of S corp election is subject to a corporate-level tax –Taxable LIFO recapture amount = excess of inventory’s value under FIFO over the LIFO value –Resulting tax is payable in four annual installments First payment is due on or before due date of last C corp tax return

51 Computation of Built-in Gains Tax (slide 1 of 2) Step 1.Select the smaller of built-in gains or taxable income.* Step 2.Deduct unexpired NOLs and capital losses from C corporation tax years. Step 3.Multiply the tax base from step 2 by the top corporate tax rate. *Any net recognized built-in gain > taxable income is carried forward to the next year, as long as the next year is within the 5-, 7-, or 10-year recognition period.

52 Computation of Built-in Gains Tax (slide 2 of 2) Step 4.Deduct business credit carryforwards and AMT credit carryovers from a C corporation tax year from the amount obtained in step 3. Step 5.The corporation pays any tax resulting from step 4.

53 The Big Picture – Example 42 Built-in Gains Tax Return to the facts of The Big Picture on p. 12–1. If Cane, Inc., becomes an S corp., a built-in gain may be recognized. Assume that Cane reports a $50,000 built-in gain on conversion. –It holds a $20,000 NOL carryforward from C corp. years before the S election. The NOL carryforward is applied against the built-in gain. –Cane’s built-in gains tax applies only to $30,000.

54 Passive Investment Income Penalty Tax (slide 1 of 3) If an S corp has accumulated E&P (AEP) from C corp years –A tax is imposed on excess net passive income (ENPI) calculated as follows: Passive investment income Net passive ENPI = > 25% of gross receipts × investment Passive investment income income for for the year the year

55 Passive Investment Income Penalty Tax (slide 2 of 3) Passive investment income includes royalties, rents, dividends, interest, annuities –Only net gain from disposition of capital assets is included Net passive income is passive income less directly related deductions

56 Passive Investment Income Penalty Tax (slide 3 of 3) Excess net passive income cannot exceed C corp. taxable income before considering any NOL or other special deductions Tax rate applied is the highest corporate tax rate for the year

57 The Big Picture – Example 48 Salary Vs. Distribution Return to the facts of The Big Picture on p. 12–1. The two shareholders should consider reducing their $92,000 salary and instead receiving a larger undistributed share of the S corp. income. –A shareholder’s share of pass-through S corp. income is not treated as self-employment income, whereas compensation is subject to a 12.4% Social Security tax and 2.9% Medicare tax. –By receiving the $92,000 as a distribution rather than salary, each shareholder saves $14,076 ($92,000 × 15.3%). But Watson might lead Cane to allow each shareholder a mix of pass-through income and salary.

58 Refocus On The Big Picture (slide 1 of 3) As long as Smith and Jones, the owners of Cane, Inc., maintain C corp. status, they cannot deduct any NOLs that the business incurs on their individual tax returns. –For the owners to deduct any future NOLs on their Forms 1040, Cane needs to be operated as a flow-through entity. –The most logical alternatives are to make an S election or to become a limited liability company. An S election may be appropriate for Cane. –Cane should make a timely election on Form 2553. –Both shareholders must consent to the election. The owners should make the election on or before the fifteenth day of the third month of the current year.

59 Refocus On The Big Picture (slide 2 of 3) Normally, an S corp. does not pay any income tax. – A C corp. making an S election may be required to pay a built-in gains tax or a LIFO recapture tax. –The base for the built-in gains tax includes any unrealized gain on appreciated assets held by Cane on the day the owners elect S status. –The highest corporate rate is applied to the unrealized gain when any of the built-in gain assets are sold. –If the corporation uses the LIFO inventory method, any LIFO recapture amount at the time of the S election is subject to a corporate-level tax.

60 Refocus On The Big Picture (slide 3 of 3) Cane does not need to liquidate or engage in a tax- deferred reorganization when converting to an S corp. –An S corp. can have voting and nonvoting common stock, provided that all shares have the same economic rights to corporate income or loss. –Data used to compute a DPAD flows through to the shareholders. Cane might get rid of the tax-exempt income, which will not be reflected in AAA. –Although it is reflected in stock basis, tax-exempt income (as part of OAA) is distributed to the shareholders only after the S corporation has distributed all of its C corporation E&P.

61 © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 61 If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA SUNY Oneonta

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