1. © 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. Taxation of Business Entities 1 Chapter 12 S Corporations

2. The Big Picture (slide 1 of 2) Fowle, 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. The corp. receives some tax-exempt income, generates a small domestic production activities deduction (DPAD), and holds about $200,000 of C corp. E&P. David, the company’s sole owner, draws a salary of $92,000. Fowle has two classes of stock, voting and non- voting common stock.

3. The Big Picture (slide 2 of 2) Due to cheap imports from China, Fowle’s owner, David, expects operating losses for the next few years. David would like to know if he can deduct these anticipated future losses? 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

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. S Corp Qualification Requirements (slide 3 of 3) Must have 100 or less shareholders –Family members may be treated as one shareholder Shareholders can only include individuals, estates, certain trusts, and certain tax-exempt organizations –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

14. 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

15. 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

16. 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

17. The Big Picture – Example 5 Making The Election Return to the facts of The Big Picture on p. 12–2. Suppose that in 2011, David decides to elect that Fowle, Inc. become an S corp. beginning January 1, 2012. Since the C corporation uses a calendar tax year, the S election can be made at any time in 2011 or by March 15, 2012. An election after March 15, 2012, will not be effective until the 2013 calendar tax year.

18. Termination of Election (slide 1 of 4) The S election is lost in any of the following ways: 1.Shareholders owning a majority of shares voluntarily revoke the election –Revocation must be filed by 15th day of third month to be effective for entire year –Otherwise, it is effective for first day of following year, or any other specified future date

19. 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 –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

20. Termination of Election (slide 3 of 4) 4.The corporation does not meet the passive investment income limitation –Passive investment income limitation If passive income > 25% of gross receipts for 3 consecutive taxable years –S election is terminated as of the beginning of the fourth year –Only applies if an S corp. has C corp. E & P

21. Termination of Election (slide 4 of 4) A new 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

22. Computation of Taxable Income (slide 1 of 2) Determined in a manner similar to partnerships except –S corp amortizes organizational costs under the corporate rules –S corp must recognize gains (but not losses) on distributions of appreciated property to shareholders

23. 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

24. Flow-Through of S Corporation Items

25. 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

26. 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

27. 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

28. 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

29. 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 property (capital gain in most cases)

30. S Corporation Distributions (slide 3 of 7) Where Earnings and Profits exist –1. Tax-free to the extent of accumulated adjustments account* –2. Any PTI from pre-1983 tax years can be distributed tax-free –3. Remaining distribution is ordinary dividend from AEP** –4. Tax-free to extent of Other Adjustments Account –5. Tax-free reduction in basis of stock –6. 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

31. 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

32. S Corporation Distributions (slide 5 of 7) Accumulated Adjustments Account (AAA) is adjusted as follows: –Increased by: Nonseparately computed income and Schedule K items other than tax-exempt income Depletion in excess of basis in property –Decreased by: Negative Schedule K adjustments other than distributions Portion of distribution treated as tax-free from AAA (but not below zero)

33. 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

34. The Big Picture – Example 20 Postelection Termination Period Return to the facts of The Big Picture on p. 12–2. Assume that Fowle has operated as an S corp. for many years. –David decides to terminate the S election at the end of 2011. On December 31, 2011, Fowle’s AAA balance totals $1.3 million. David can receive a nontaxable distribution of cash during Fowle’s 2012 post-termination period, to the full extent of the entity’s AAA balance. –Any cash distributions so received reduce the basis of David’s Fowle stock, but not below zero.

35. 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

36. 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 shareholders’ basis in stock in the entity, before considering the effect of the distribution Basis of asset distributed = FMV

37. 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

38. Shareholder’s Basis (slide 2 of 4) –Basis is decreased by: Distributions not reported as income by shareholders (e.g., from AAA or PTI) 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

39. 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

40. 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

41. The Big Picture – Example 26 Shareholder’s Basis (slide 1 of 2) Return to the facts of The Big Picture on p. 12–2. Assume that Fowle has made an S election and that David, its sole shareholder, consented. At the beginning of 2011, David’s basis in his Fowle stock was $90,000. During 2011, he made a $40,000 loan to the corporation, using a written debt instrument and market interest rates.

42. The Big Picture – Example 26 Shareholder’s Basis (slide 2 of 2) Fowle generated a $93,000 taxable loss for 2011. –Thus, at the beginning of 2012, David’s stock basis was zero, and the basis in his loan to Fowle was $37,000. Fowle repaid the loan in full on March 1, 2012. –David recognizes a $3,000 capital gain on the repayment.

43. The Big Picture – Example 27 Shareholder’s Basis (slide 1 of 2) Continue with the facts of Example 26 except that Fowle’s loss cannot be deducted by David because of the lack of basis. David purchases $5,000 of additional stock in Fowle. –David gets an immediate deduction for his investment, due to his $93,000 in suspended losses.

44. The Big Picture – Example 27 Shareholder’s Basis (slide 2 of 2) Alternatively, if Fowle shows a $5,000 profit for the year, –David pays no tax on the flow-through income, as it is offset by the suspended losses. However, if Fowle distributes $5,000 to David in 2012 without earning any profit for the year, and prior to any capital contribution by him, –David recognizes a $5,000 capital gain, because his stock basis is zero.

45. 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

46. 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.

47. At-Risk Rules Generally apply to S corp shareholders –At-risk amounts include: Cash and adjusted basis of property contributed to corp Any amount borrowed for use in the activity for which the shareholder is personally liable Net FMV of personal assets that secure nonrecourse borrowing –Losses suspended under at-risk rules are carried forward and are available during post-termination transition period

48. 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

49. Built-in Gains Tax (slide 1 of 4) Generally applies to C corporations 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.

50. Built-in Gains Tax (slide 2 of 4) Tax base includes unrealized gain on 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

51. 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

52. 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

53. 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.

54. 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.

55. 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

56. 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

57. 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

58. Refocus On The Big Picture (slide 1 of 5) As long as Fowle, Inc., maintains C corp. status, David cannot deduct any NOLs that the business incurs on his individual tax returns. –However, the corp. can carry any NOLs back and claim refunds for prior taxes paid and carry any remaining NOLs forward to reduce taxes paid if the company becomes profitable again. If David wants to deduct any future NOLs on his individual return, Fowle needs to be operated as a flow-through entity. An S election may be appropriate for Fowle. –Fowle should make a timely election on Form 2553. –David must consent to the election in writing. David should make the election on or before the fifteenth day of the third month of the current year to be effective this year.

59. Refocus On The Big Picture (slide 2 of 5) What if? What if David expects the loss years to be followed by years of increased profitability? –In this case, David expects that the corporation will make significant distributions to him. How might this affect David’s decision about whether the corporation should make an S election? David should be aware of several rules that may result in income tax being paid by the S corporation or by him as the shareholder.

60. Refocus On The Big Picture (slide 3 of 5) What if? First, distributions from an S corp. may be treated as taxable dividends to a shareholder to the extent of E&P dating to its years as a C corp. –While distributions are deemed to be made first from accumulated net S corp. earnings, distributions in excess of that amount may be treated as a taxable dividend, being paid from AEP.

61. Refocus On The Big Picture (slide 4 of 5) What if? The S corporation’s DPAD computations flow through to David, as does Fowle’s tax-exempt interest income. –The entity may want to reconsider its salary and fringe benefits levels for David, so as to minimize the creation of a payroll tax burden, and to manage the restrictions on deductions for fringe benefits provided to an S shareholder. Fowle’s tax-exempt interest can be distributed to David tax-free only after all of the entity’s AEP has been accounted for.

62. Refocus On The Big Picture (slide 5 of 5) In addition, David should be aware that an S corp. that has been a C corp. in the past may be required to pay a built-in gains tax or LIFO recapture tax. –The base for the built-in gains tax includes any unrealized gain on appreciated assets held by Fowle, Inc., on the day the company becomes an S corp. –The highest Federal corporate income tax rate is applied to the unrealized gains when any of the assets are sold within a specified number of years. –If Fowle uses the LIFO inventory method, any LIFO recapture amount at the time of the S election also is subject to a corporate-level tax.

63. © 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. 63 If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA trippedr@oneonta.edu SUNY Oneonta