Chapter 22.ppt

Chapter 1© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Comprehensive Volume
Chapter 22
S Corporations
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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?
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.
Subchapter S Issues
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
Subchapter S Issues
S corporations are still corporations for legal purposes
Owners receive the benefits of limited liability, ability to raise capital (within limits), etc...
Subchapter S Issues
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
Subchapter S Issues
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
Subchapter S Issues
An S corporation is not subject to the following taxes:
Corporate income tax
Accumulated earnings tax
Personal holding company tax
Corporate alternative minimum tax
Subchapter S Issues
(slide 6 of 6)
Entity is subject to Subchapter C rules for a transaction unless Subchapter S provides alternate rules
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
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
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
The Big Picture – Example 3
One Class of Stock
Return to the facts of The Big Picture on p. 22–1.
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.
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
Nonresident Aliens
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).
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
Making the Election
To be effective for current year
Make election by 15th day of third month of current tax year, or
File in previous year
Making the Election
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
Making The Election
Suppose that in 2013, shareholders Smith and Jones decide to become an S corp. beginning January 1, 2014.
Since the C corp. uses a calendar tax year, the S election can be made at any time in 2013 or by March 15, 2014.
An election after March 15, 2014, will not be effective until the 2015 calendar tax year.
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
(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
(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.
(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
Computation of Taxable Income
(slide 1 of 2)
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
Computation of Taxable Income
(slide 2 of 2)
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
Flow-Through of S Corporation Items
Separately Stated Items
Charitable contributions
Interest, dividend, or royalty income
Tax preference items
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
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
S Corporation Distributions
Cash + FMV of any other property distributed
Taxation of distribution depends on whether the S corp has accumulated E&P from C corp years
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
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
Represents cumulative total undistributed nonseparately and separately stated items
Mechanism to ensure that earnings of an S corp are taxed to shareholders only once
(slide 5 of 7)
(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
(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
Distributions of 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
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:
Depletion in excess of basis
Basis is decreased by:
Distributions not reported as income by shareholders (e.g., from AAA)
Nondeductible expenses (e.g., fines, penalties)
Nonseparately computed loss
Similar to partnership basis rules
First increase basis by income items
Then decrease it by distributions and finally losses
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
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
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
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.
Net Operating Loss
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 2013, 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.
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
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
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 through 2013
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
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 C corp. years
Built-in Gains Tax
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
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.
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.
Built-in Gains Tax
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.
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
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
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
Salary Vs. Distribution
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%).
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.
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.
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.
*
If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:
Dr. Donald R. Trippeer, CPA
[email protected]

Chapter 22.ppt

Documents