11-1 ©2010 pearson education, inc. publishing as prentice hall

11-2

S CORPORATIONSS CORPORATIONS(1 of 2)(1 of 2)

Should an S election be made?S corporation requirementsElection of S corporation statusS corporation operations Taxation of the Shareholder

©2010 Pearson Education, Inc. Publishing as Prentice Hall

11-3

S CORPORATIONSS CORPORATIONS(2 of 2)(2 of 2)

Basis adjustmentsS corporation distributionsOther rulesTax planning considerationsCompliance and procedural

considerations


11-4

Should an S Election Be Should an S Election Be Made?Made?

Advantages (1 of 3)Advantages (1 of 3)

No corporate level taxationIncome taxed directly to shareholders

Benefit reduced because dividends are generally taxed to individuals at 15% (through 2009)

All items retain character in s/h’s hands E.g., tax-exempt income earned by S corp is

tax-exempt to s/hLimitations are computed at s/h level


11-5

Should an S Election Be Should an S Election Be Made? Made?


S corp losses can be used to offset shareholders’ other income

Allowed to split S corp income between family membersWith restrictions

S corp earnings not subject to SE tax


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S corp not subject to personal holding company or accumulated earnings taxes

LLCs and partnerships may make S election


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Disadvantages (1 of 3)Disadvantages (1 of 3)

Earnings retained by C corp taxed at rates generally lower than shareholders’ marginal tax rates

S corp earnings taxed to shareholders even if no distributions are made

S corps subject to excess net passive income tax & built-in gains tax


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No dividends-received deductionNo special allocations allowed

Income allocated based on ownershipS corp liabilities do not increase loss

limitsExcept for shareholder loan to S corp


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S corps and shareholders subject to at-risk rules, passive activity limits, and hobby loss rules

S corp restricted in type & number of shareholders

S corps generally must use calendar year


11-10

S Corporation S Corporation RequirementsRequirements

(1 of 3)(1 of 3)

Shareholder requirementsNo more than 100 shareholders

Family members count as one shareholderInclude common ancestor, spouses of

common ancestor or lineal descendents, and estates of family members

Individuals, estates, and certain types of trusts (including QSSTs)QSSTs may be complex trusts


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(2 of 3)(2 of 3)

Shareholder requirements (continued)U.S. citizens or resident aliensTax-exempt public charity or private

foundation may be a shareholderCorporation-related requirements

Domestic corporationOr unincorporated entity electing to be

treated as a corp under check-the-box Regs


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(3 of 3)(3 of 3)

Corporation-related requirements (continued)Must not be an “ineligible” corporationOnly one class of stockMay be a Qualified Subchapter S

Subsidiary (QSSS)QSSS is 100% owned by an S corpAssets, liabilities, income deductions, etc.

considered owned by S corp parent


11-13

Election of S Corporation Election of S Corporation StatusStatus

Taxes Applicable to S CorporationsTaxes Applicable to S Corporations

S election exempts corps from all taxes imposed by IRC Chapter 1 except§1374 built-in gains tax§1375 excess net passive income

tax§1363(d) LIFO recapture tax


11-14

Election of S Corporation Election of S Corporation Status Status

Making the ElectionMaking the Election

Form 2553 must be filed no later than 15th day of third month for year election is to be effectiveA new corporation’s tax year begins

on first day it acquires assets, has shareholders or begins business

All shareholders must consent to election


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Terminating the Election (1 of 3)Terminating the Election (1 of 3)

Voluntary S election terminationOwners of more than 50% of the

corporation’s stock must agreeRevocation made w/in 1st 2-1/2

months can be retroactive to beginning of yearOtherwise, election effective for 1st

day of next taxable year


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Involuntary S election terminationOccurs when corporation ceases to

meet S corporation requirementsIf termination occurs during tax year

Portion of year prior to termination is a short S corp year and

Portion of year after termination is a short C corp year


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Inadvertent termination can be undone

New S corp election cannot be made for 5 tax years after terminationUnless inadvertent termination


11-18

S Corporation OperationsS Corporation Operations

Taxable yearAccounting method electionsOrdinary income and separately

stated itemsU.S. production activities

deductionSpecial S corporation taxes


11-19

Taxable Year(1 of 2)

Permitted tax yearsA year ending on December 31,

Including a 52-53 week year, ORAny fiscal year where a business

purpose has been established including a natural business year


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Taxable Year(2 of 2)

Other tax years may be electedOwnership year - same year as

shareholders owning 50% of stockFacts and circumstances year§444 allows S corp to elect a fiscal year

end of 9/30 or later w/o satisfying business purpose exceptionAdvance payments required to eliminate

benefit of income deferral


11-21

Ordinary Income/Loss &Separately Stated Items (1 of

4)

Income is divided between ordinary and separately stated items

Separately stated items same as for partnerships, including passive activities and portfolio activitiesRefer to Form 1120S Schedule K in

Appendix B for a complete listing


11-22


4)

S corps cannot deductDividends-received deductionPersonal or dependency exemption“Personal” itemized deductionsTaxes paid/accrued to foreign countryCharitable contributionsOil & gas depletion NOL carryovers from C corp years


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4)

Net operating lossesNOLs created when a C corp

cannot be carried back/forward to S corp years

NOLs created when an S corp cannot be carried back/forward to C corp years


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4)

U.S. production activities deductionDetermined at s/h level50% salary limitation

Each s/h is allocated a share of S corp’s W-2 wages equal to lesser of

S/h’s allocable share of W-2 wages OR6% (in 2009) of the qualified production

activities income allocated to the s/h


11-25

Special S Corporation Taxes

Special levies apply to S corpsExcess net passive income taxBuilt-in gains taxLIFO recapture tax


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Excess Net Passive Income Tax(1 of 2)

S corp has passive income in excess of 25% of S corp gross receipts and has C corp E&P

Excess net passive income taxed at highest corporate tax rate (35%)

See Example 11


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Excess Net Passive Income Tax(2 of 2)


[Passive investment

income] – [25% of gross receipts]__________________

Passive investment

income

Net passive income

X =

Excess net

passive income

11-28

Built-in Gains Tax(1 of 2)

Imposed on income/gain that would have been included in gross income while a C corp if corp had used accrual accountingE.g., property with a FMV in excess

of basis on day S election was made


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Built-in Gains Tax(2 of 2)

Tax is 35% (top corp rate) on net built-in gains recognized during tax yearBuilt-in gains recognized less any built-in

losses recognizedBuilt-in gains tax applies to

dispositions during 10-year period after S election is made

See Example 13


11-30

LIFO Recapture Tax(1 of 2)

Applies to C corps using LIFO inventory method who make an S election

LIFO recapture amount is excess of inventory basis using FIFO over inventory basis using LIFO at close of final C corp tax year


11-31

LIFO Recapture Tax(2 of 2)

LIFO recapture amount included in taxable income of corp’s final C corp tax yearAdditional tax can be paid in four

annual installmentsS corp’s basis in inventory increased

by LIFO recapture amountSee example 14


11-32

Taxation of the Taxation of the ShareholderShareholder

Income allocation procedures Loss and deduction pass-through

to shareholders Family S corporations


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Income Allocations(1 of 2)

Shareholders report pro rata share of ordinary income & separately stated items

Known as per day/per share method

See Example 16


11-34

Income Allocations(2 of 2)

1. Divide item by # of days in tax year Daily amount for each item

2. Divide daily amount by # of shares o/s

Daily amount per share for each item

3. Total daily allocations for a share4. Multiply amount per share times #

of shares held by owner


11-35

Loss & Deduction Pass-through

to Shareholders

Allocating the lossPer share per day allocation same

as for incomeShareholder limitationsSpecial shareholder loss and

deduction limitationsPost-termination loss carryovers


11-36

Shareholder Loss Limitations(1 of 2)

Ordinary & separately stated loss amounts “passed” through to shareholders

Shareholder’s deduction limited to adjusted basis in stock plus adjusted basis of debt owed directly by corp to shareholder


11-37

Shareholder Loss Limitations(2 of 2)

Sequence for stock basis limitation 1. Beginning basis2. + Capital contributions3. + Share of ordinary income and

separately stated items4. - Distributions not included in s/h inc.5. - Nondeductible, noncapital

expenditures Basis available to absorb S corp loss


11-38

Special Shareholder Loss and Deduction Limitations

§465 at-risk rules applied at s/h levelPassive activity rules

S/h must meet material participation std. to avoid passive activity limitation

§183 hobby loss rules apply at s/h levelSuspended losses do not transfer

Unless transfer to spouse incident to divorce


11-39

Post-Termination Loss Carryovers

Unused S corp losses due to basis limitations

Carried over up to 1 yr after termination Depending on reason for termination

Unused loss carryovers after post termination period are lost


11-40

Family S Corporations

Donee or purchaser of stock in S corp not considered a shareholder unlessSuch stock acquired in bona fide

transaction ANDDonee or purchaser is the real

owner of stock


11-41

Basis AdjustmentsBasis Adjustments(1 of 2)(1 of 2)

Initial investment+ Additional contributions+ Share of income/separate items- Distrib’s excluded from s/h gross inc.- Non-deductible expenses not

chargeable to capital- Share of losses/distributions= Ending basis (but not below zero)


11-42

Basis AdjustmentsBasis Adjustments(2 of 2)(2 of 2)

Basis adjustments to shareholder debtAfter stock basis reduced to zero, basis

reduction applies to indebtedness based on relative adjusted basis for each loan

Loss/deduction not currently deductible is suspended until shareholder has basis in debt or stock


11-43

S Corporation S Corporation DistributionsDistributions

Without AE&P (1 of 2)Without AE&P (1 of 2)

Money distributions tax-free and reduce shareholder basis, but not below zero

When shareholder has a zero basis, distributions received treated as gain from sale of stock


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Without AE&P (2 of 2)Without AE&P (2 of 2)

Corporation recognizes gain on distribution of appreciated property

No loss reported when corp distributes property that has declined in value


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With AE&P (1 of 3)With AE&P (1 of 3)

Distributions based on tiers of earningsDistributions from AAA are tax-freeDistributions from AE&P are taxableDistributions that reduce basis in S

corp stock are tax-freeDistributions over stock basis are

taxable


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Beginning AAA balance+ Ordinary income+ Separately stated inc/gain items- Ordinary loss- Separately stated loss deductions- Non-deductible expenses not

chargeable to capital accountEnding AAA balance


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S corp can elect to skip over AAA in determining source of distributionsCould be used to avoid excess net

passive income tax and termination of S election


11-48

Other RulesOther Rules(1 of 2)(1 of 2)

Alternative minimum taxNo S corp AMT

AMT items pass through to s/hRelated party transactions

§267 related party rules apply between s/h and S corp

§267 applies to S corp and another entity if >50% of both entities owned by same persons


11-49

Other RulesOther Rules(2 of 2)(2 of 2)

Fringe benefits paid to shareholder-employeeFor 2% (or more) shareholder, S

corp treated like a partnershipMany benefits tax-free to C corp

shareholder-employees are taxable to S corp shareholder-employees


11-50

Tax Planning Tax Planning ConsiderationsConsiderations

(1 of 2)(1 of 2)

Election to allocate income based on the S corp’s accounting methodsAvailable when S election terminates or

s/h terminates or substantially reduces ownership

May use per-share-per-day method ORClosing-of-the-books method


11-51

Tax Planning Tax Planning ConsiderationsConsiderations

(2 of 2)(2 of 2)

Increasing benefits from S corp lossesConsider basis-increasing transactions

Passive income requirementsS corp can earn unlimited passive

income if no AE&P from C corp yearsIf AE&P exist, S corp can elect to have

distributions come from AE&P before AAA to avoid excess net passive income tax


11-52

Compliance and Compliance and Procedural Procedural

ConsiderationsConsiderations

Making the electionForm 2553

§444 electionAttach Form 8716 to Form 1120S for

first yearTax return filed using Form 1120S


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11-53©2010 Pearson Education, Inc. Publishing as Prentice Hall

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