I.
Overview
A. An eligible corporation that elects to
avoid the corporate level income tax by reporting their income in a manner similar to a
partnership.
B. S Corporation=Flow through
entity.
1. Income/loss
flows through the corporation and the tax
consequences
occur at the shareholder level.
2. Shareholders are taxed annually on
their pro rata share of S Corp. income regardless of whether the income is distributed.
3. S Corporation is simply a C-corp. that
has made an election under Subchapter S of the IRC. If
a tax situation is not covered by the S rules, then the rules pertaining to C-corps apply.
4. Some states do not recognize the S
election.
5. S Corporations remain a corporation in
all other matters except federal tax
6. S-Corps are generally subject to only
the “BIG” Tax & Passive Investment Income Tax.
A. Small Business Corporation
1. Domestic corp. (a US corp)
2. Not ineligible, i.e. bank, insurance
co’s
3. No more than 75 shareholders
(a) 35 before 1997
(b) Husband and wife=one shareholder. Beware of divorce.
4. All sh’s must be individuals,
estates, or certain trusts.
5. No shareholder can be a nonresident
alien.
6. Only one class of stock can be issued
and outstanding.
B. Valid election required to obtain
S-corp status.
1. File Form 2553
2. All
shareholders must consent to election.
3. Timing of election:
(a) For following year-anytime in current
year as long as eligibility requirements are met.
(b) For current year-On or before 15th
day of third month of year.
i.e. by March 15th for
calendar year entity.
(c) New corporation-w/I 2 ½ months of
doing business.
C. Terminating or Losing the Election
1. Valid election remains in effect until
lost or terminated.
2. Voluntary Revocation:
(a) if before 15th day of
3rd month, effective for current year, otherwise effective
on any prospective date specified or beginning of next tax year
(b) by shareholders owning majority
of shares of stock, including a new majority shareholder.
(c) May result in a partial S year & C
year
(1) Income allocated on a pro rata basis,
unless
(2) Interim closing of books election made,
then income/loss allocated on basis of corporate records.
3. Involuntary Loss of Election-effective
on date of action
1. Corp ceases to qualify as small
business corp. i.e. too many sh’s.
2. Termination due to Passive Investment
Income Limitation
(a) S corp. has passive investment income
exceeding 25% of its gross receipts for 3 consecutive taxable years, AND
(b) Corp. has Accumulated E&P from C
corp years at the end of each of the 3 consecutive taxable years.
(c) Termination effective at beginning of 4th
year.
(d) E & P can be acquired in years
before making S election or by merger, as an S corp does not have Accum E & P.
(e) What is Passive Investment Income? Rents (unless significant services provided to
tenants, ie. Hotels, motels), dividends, all interest (including tax exempt), dividends,
LTCG or STCG from sale of stock.
3. General rule: 5 year waiting period before new election can be
made, however, IRS can consent to earlier election.
III.
Operational Rules
A. Income and losses of S corp flow through the entity and are reported by the
shareholders, whether actually distributed or not.
Some items flow thru separately, others are grouped and flow through as S-income or
S-loss
1. Generally a calendar year
2. Fiscal Year can be elected, if
(a) Business Purpose-If for more than 3
consecutive periods 25% or more of corporationss gross receipts recognized in last 2
months of 12 month period, or
(b) Tax deferral payment made.
C. Computation of S-Corporation Income Categorys
1. Separately
Stated Items-these items are set out seperately on the Schedule K-1 for each
shareholder. Basically, these items uniquely
affect the shareholders income [other than merely increasing or decreasing it].
2. Listed on Page 21-14.
3. Non
Separately Stated Income/Loss-all other items, eg sales, phone, rent
4. Per day method must be used unless a
shareholder disposes of her entire interest, in which case, if all affected shareholders
consent, a “closing of the books method” is used.
This method results in two tax years: an
S-corp year and a C-corp year.
5. Both separately and non-separately
income/losses are reported during the year in which the S corporation year ends.
D. Distributions
to Shareholders
1. S-Corp. has no Accum E&P:
Distrib. is
(a) ROC to extend of stock basis
(b) Excess above stock basis = CG
2. S-Corp has Accum E & P:
Distrib is
(a) non taxable to extent of AAA
(b) Dividend to the extent of E & P
{AAA Bypass election available}
(c) ROC to extent of stock basis {Reduce
basis of stock by FMV of dist}
(d) Capital Gain
3. Accumulated Adjustments Account – AAA-S corps with E & P.
(a) mechanism for insuring income of S-corp
is taxed only once
(b) Cumulative total of S year income
taxed to the shareholders but not distributed
(c) Corporate level account, determined at
year end. Since it is not shareholder
specific, whoever gets to it first, uses it. If
distributions during year at same time, pro rata share to each shareholder.
(d) AAA can be negative, however
distributions to shareholders cannot cause it to be negative.
(e) Adjustments to AAA are same as
adjustments to stock basis except no adjustment is made for tax exempt income or related
expenses.
4. Distributions of Appreciated Property by S-corp.
(a) Results in Recognized gain to Corp. [FMV asset – Adj. Basis]
(b) Gain & character pass through to
shareholders
(c) SH basis = FMV
5. Distributions of Depreciated Property by S-corp.
(a) No loss recognized by S-corp.
(b) SH basis
= FMV {therefore loss is postponed until sh disposes of property in a taxable
transaction}
E. Shareholders
Basis in Stock
1. Initial Stock Basis – How was
stock acquired?
2. Annual PlusAdjustments to Stock Basis
(a) Additional stock purchases
(b) Capital contributions
3. Annual Plus Adjustments to Stock Basis from S operations
(a) share of S corps Ordinary Income
(b) share of S corps. Separately stated
items.
4. Annual Negative
Adjustments to Stock Basis from S operations
(a) Nontaxable Distributions from AAA
(b) Nondeductible expenses of corp.
(c) Share of S corps. Ordinary loss
(d) Share of S corps. Separately stated
loss & deduction items:
5. Basis Increased by income items, reduced by distributions, by loss items.
6. Stock
Basis cannot go below –0-.
7. In
certain circumstances, can reduce basis of loans made to corp.
F. Net Operating Losses
1. Passed through to shareholders based on
stock ownership, on
a daily basis
2. Deduction for AGI, Reported on Schedule
E
3. Reduce basis in stock and reduce AAA
4. Excess NOL carried forward and cannot
be deducted by shareholder until stock basis increased above zero.
5. Generally, must use any carryover NOL
w/I one year after an S corporation termination.
6. NOL’s from C-years generally
cannot be used by s/h’s or corp.
G. Passive Loss Rules & At-Risk rules
1. Passive loss rules apply at the
shareholder level. Thus, a shareholder cannot deduct a loss from an
S-corp. against active or portfolio income, unless
they materially participate in the corporation.
2. At risk rules also apply at the
shareholder level
H. Tax on Preelection Built-In Gains (BIG Tax)
1. Effective for C-Corps that elect S
status after 1986
2. In general-S corp. must recog. Gain and
incurs a corporate level tax on any asset that had appreciated
gain built in as of the date of conversion to S status if such asset is disposed of by
S-corp within 10 yrs of S election.
3. Tax = highest corporate tax rate (39%).
4. Presumption that gains are built in. Burden on t/p to show appreciation occurred after
S election or that asset acquired after S election.
5. Tax paid under this provision is
treated as a corporate loss and passes through to the shareholders.
I. Passive Investment Income Tax
1. Must have Accum E & P from C years
2. Recall-If subject to this tax for 3
consecutive years, then S election is terminated in 4th year.
J. Fringe Benefit Rules
1. S corporation treated like a
partnership.
2. In general, if corp provides a sh who owns greater than 2% of stock with fringe benefits, those benefits will be treated as compensation paid to the shareholder. Corp. will deduct the amt as an expense, sh will pick it up as income.
K.Other
1. S corp can own stock in another corp,
but no DRD.
2. S income is not self employment income
subject to self employment taxes, however, a shareholder who provides services to an S
corp. must be paid reasonable compensation for those services. Such services are subject to FICA taxes.
3. S election not recognized in several
states. Thus, in these states would have to
pay a corporate level state income tax.
4. If related party (SH owns more than 50%
stock of S corp) is on cash basis and receives income or rent from the corporation, then
the S corp is also placed on the cash basis with respect to these business expenses.