Essentials of taxation 2016 cengage chapter 15

S Corp Qualification Requirements slide 2 of 3• Corporation may have only one class of stock but not in distribution or liquidation rights • Results in unexpected loss of S corp status •

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Essentials of Taxation

1

Chapter 15

S Corporations

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

– The company has accumulated its earnings for a variety of

business needs and has not paid dividends to date.

• Thus, the corporation has been able to

– Take advantage of lower C corp tax rates, and

– Avoid double taxation problems so far.

• 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

The Big Picture (slide 2 of 2)

$92,000

non-voting common stock

operating losses for the next few years

anticipated future losses?

• S corporation status is obtained through an

election by a qualifying corporation with the consent of its shareholders

Subchapter S Issues

(slide 2 of 6)

• S corporations are still corporations for legal

purposes

ability to raise capital (within limits), etc

Subchapter S Issues

(slide 3 of 6)

• Taxation resembles partnership taxation

certain expenses) are accumulated and passed

through to shareholders

is passed through to shareholders

Subchapter S Issues

(slide 5 of 6)

• An S corporation is not subject to the

following taxes:

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:

corp rates

prior years can’t be used during S corp years

• Still reduces 20 year carryover period

S Corp Qualification Requirements (slide 1 of 3)

• To elect under Subchapter S, a corporation

must meet the following requirements:

• 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

S Corp Qualification Requirements (slide 2 of 3)

• Corporation may have only one class of stock

but not in distribution or liquidation rights

• 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 15–1

• Fowle, Inc., could elect to be an S corporation, except that one

class of stock is voting common and the other class is

nonvoting preferred

• If S status is desired, a recapitalization of the Fowle stock is

required, perhaps issuing nonvoting common in place of the preferred stock, which would satisfy the one-class-of-stock

requirement.

S Corp Qualification Requirements (slide 3 of 3)

– Family members may be treated as one shareholder

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

Making the Election

(slide 1 of 3)

• To become an S corp, must make a valid

election that is:

Making the Election

(slide 2 of 3)

• To be effective for current year

current tax year, or

Making the Election

(slide 3 of 3)

• Shareholder Consent

year must sign consent for election (even if stock

is no longer owned at election date)

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

The Big Picture – Example 6

Making The Election

• Return to the facts of The Big Picture on p 15-1.

• Suppose that in 2016, David decides to elect

that Fowle, Inc become an S corp beginning January 1, 2017

• Fowle’s S election can be made at any time in

2016 or by March 15, 2017

• An election after March 15, 2017, will not be

effective until the 2018 calendar tax year.

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

month to be effective for entire year

year, or any other specified future date

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

Termination of Election

(slide 3 of 4)

4.The corporation does not meet the passive

investment income limitation

> 25% of its gross receipts for three consecutive taxable years

• The S election is terminated as of the beginning of the

fourth year

or for S corps that have merged with C corps

Termination of Election

(slide 4 of 4)

• A new election normally cannot be made

within 5 years after termination of a prior

election

• 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)

• Determined in a manner similar to partnerships

except

distributions of appreciated property to

Computation of Taxable Income

(slide 2 of 2)

• S corp items are divided into:

• Essentially, constitutes Subchapter S ordinary income or

loss

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

• Examples include:

and capital assets

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

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)

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

(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

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)

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 free distribution a shareholder can receive.

tax-– ** AAA bypass election is available

S Corporation Distributions

(slide 4 of 7)

• Accumulated Adjustments Account (AAA)

nonseparately and separately stated items

taxed to shareholders only once

S Corporation Distributions

(slide 5 of 7)

S Corporation Distributions

(slide 6 of 7)

• Other issues regarding distributions:

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

The Big Picture – Example 20

Postelection Termination Period

• Return to the facts of The Big Picture on p 15-1.

during the next year, 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

S Corporation Distributions

(slide 7 of 7)

• Other issues regarding distributions:

distribute E & P before reducing AAA

• Called an AAA bypass election

Distributions of Property

• If the entity distributes appreciated property

• 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

• 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

• e.g., gift, inheritance, purchase, exchange

• Stock purchases

• Capital contributions

• Nonseparately computed income

• Separately stated income items

• Depletion in excess of basis

Shareholder’s Basis

(slide 2 of 4)

• 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

• First increase basis by income items

• Then decrease it by distributions and finally losses

Shareholder’s Basis

(slide 3 of 4)

• Shareholder’s basis cannot be negative

reductions (losses or deductions, but not

distributions) decrease (but not below zero) basis

in loans made to S corp

subsequent net increases from all positive and

negative adjustments

Shareholder’s Basis

(slide 4 of 4)

• Basis rules are similar to partnership rules

except:

direct investment plus a ratable share of

partnership liabilities

corporate borrowing does not affect shareholder’s basis

The Big Picture – Example 26

Shareholder’s Basis (slide 1 of 2)

• Assume that Fowle has made an S election

• At the beginning of 2016, David’s basis in his

Fowle stock was $90,000.

• During the year, he made a $40,000 loan to the

corporation, using a written debt instrument

and market interest rates.

The Big Picture – Example 26

Shareholder’s Basis (slide 2 of 2)

• Fowle generated a $93,000 taxable loss for

2016

was zero, and the basis in his loan to Fowle was

The Big Picture – Example 27

Shareholder’s Basis (slide 1 of 2)

that Fowle’s loss cannot be deducted by David because he has a zero basis in both the stock

and debt of the entity.

Fowle.

– David gets an immediate deduction for his

investment, due to his $93,000 in suspended losses

The Big Picture – Example 27

Shareholder’s Basis (slide 2 of 2)

• Alternatively, if Fowle shows a $5,000 profit

for the year,

it is offset by the suspended losses

• However, if Fowle distributes $5,000 to David

in 2015 without earning any profit for the year, and prior to any capital contribution by him,

his stock basis is zero

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.

At-Risk Rules

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

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

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 corporations converting

to S corp status after 1986

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 assets

held on date of S corp election

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

carried forward and recognized in future years

• S corp can offset built-in gains with unexpired

NOLs or capital losses from corp years

Built-in Gains Tax

(slide 4 of 4)

• LIFO recapture tax

election is subject to a corporate-level tax

inventory’s value under FIFO over the LIFO value

• 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