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CCH Federal Taxation Basic Principles Chapter 16 Partnerships, Corporations, and S Corporations ©2004 , CCH INCORPORATED 4025 W. Peterson Ave. Chicago, IL 60646-6085 800 248 3248 http://tax.cchgroup.com Part IV: S Corporations Chapter 16 Contents

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Cch federal taxation basic principles chapter 16 partnerships corporations and s corporations l.jpg

CCH Federal TaxationBasic PrinciplesChapter 16Partnerships, Corporations, and S Corporations

©2004, CCH INCORPORATED

4025 W. Peterson Ave.

Chicago, IL 60646-6085

800 248 3248

http://tax.cchgroup.com

Part IV: S Corporations


Chapter 16 contents l.jpg
Chapter 16 Contents

1. S Corporations—Treatment of Tax and Nontax Matters

2. S Corporations—Tax Years

3. S Corporations—Accounting Methods

4. S Corporations—Tax Model

5. S Corporations—Eligibility and Election

6. S Corporations—Revoking S Status

7. S Corporation Basis Accounts—Overview

8. S Corporation Basis Accounts—Outside Basis

9. S Corporation Basis Accounts—At-Risk Basis

10. S Corporation Basis Accounts—Accumulated Adjustment Account (AAA)

11. S Corporation Basis Accounts—Other Adjustment Account (OAA)

Chapter 16, Exhibit Contents A

CCH Federal Taxation Basic Principles


Chapter 16 contents3 l.jpg
Chapter 16 Contents

12. S Corporation Basis Accounts—Previously Taxed Income Account (PTI)

13. S Corporation Basis Accounts—Shareholder Loans to S Corporations

14. S Corporation Basis Accounts—Example on Effect of Operating Results on Basis

15. S Corporation Distributions

16. S Corporation Distributions—Effect on Shareholder

17. S Corporation Distributions—Example

18. S Corporation Penalty Taxes—Code Sec. 1374 Tax on Built-in Gains

19. S Corporation Penalty Taxes—Code Sec. 1374 Tax Example

20. S Corporation Penalty Taxes—Code Sec. 1375 Tax on Excess Net Passive Income

21. Code Sec. 1375 Tax on Excess Net Passive Income—Example

Chapter 16, Exhibit Contents B

CCH Federal Taxation Basic Principles


S corporations treatment of tax and nontax matters l.jpg
S Corporations—Treatment of Tax and Nontax Matters

The Conduit Concept. For most tax matters, S corporations are treated like partnerships. As in the partnership conduit concept, the taxable income of an S corporation flows through to the owners on a per-day and per-share basis. Income and losses are reported on Form 1120-S, allocated to each shareholder on a supporting K-1 schedule, and then transferred, via the K-1, to the individual owners’ 1040 returns. There, at the individual level, income is taxed and losses are deducted.

Chapter 16, Exhibit 1a

CCH Federal Taxation Basic Principles


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S Corporations—Treatment of Tax and Nontax Matters

The Entity Concept. The character of income and losses is determined at the entity level, not at the shareholder level. For example, a long-term capital gain reported by the S corporation remains long-term to the shareholder, even if his ownership in the S corporation had been held for a short-term period.

Chapter 16, Exhibit 1b

CCH Federal Taxation Basic Principles


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S Corporations—Treatment of Tax and Nontax Matters

Distributions of Cash or Property. Actual distributions of cash or property are generally not income to its shareholders. Two notable differences with partnerships are:

  • Owner salaries and payroll taxes. Deductible by S corporations, not by partnerships.

  • Gain on distribution of property. S corps must recognize gains (but not losses) on distributions of appreciated property to shareholders; partnerships escape this gain recognition.

Chapter 16, Exhibit 1c

CCH Federal Taxation Basic Principles


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S Corporations—Treatment of Tax and Nontax Matters

Nontax matters. For most structural matters (e.g., formation, redemptions and terminations), S corporations are treated in much the same manner as C corporations.

Chapter 16, Exhibit 1d

CCH Federal Taxation Basic Principles


S corporations tax years l.jpg
S Corporations—Tax Years

An S corporation must generally use a calendar year end. However, it may elect a fiscal tax year under any of the following three conditions:

  • Three-Month Deferral OK. A fiscal tax year would result in income deferral of not more than three months and the shareholder-employee’s salary earned between fiscal year end and December 31 is both:

    • Paid during that period; and,

    • Proportionate to the salary paid during the preceding fiscal year.

  • Business Purpose. A business purpose can be demonstrated.

  • 1987 FYE. The S corporation retains the same fiscal tax year as was used in 1987, if in existence at that time.

Chapter 16, Exhibit 2

CCH Federal Taxation Basic Principles


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S Corporations—Accounting Methods

The accrual, cash and hybrid methods are available regardless of the size of the S corporation.

Chapter 16, Exhibit 3

CCH Federal Taxation Basic Principles


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S Corporations—Tax Model

Code Sec. 702(a)(8) Income

Definition.As with partnerships, items that are always subject to ordinary treatment are lumped together in an amount called Code Sec. 702(a)(8) income or loss. Shareholders recognize Code Sec. 702(a)(8) income even if no cash is actually distributed. Accordingly, shareholders are generally not taxed on distributions.

Chapter 16, Exhibit 4a

CCH Federal Taxation Basic Principles


S corporations tax model11 l.jpg
S Corporations—Tax Model

Code Sec. 702(a)(8) Income

Computation. Sec. 702(a)(8) is generally operating income or loss computed as follows:

  • Ordinary Income “From Whatever Source Derived” (including Code Sec. 1245 recapture)

  • Less: Exclusions

  • Less: Cost of Goods Sold (resulting in gross income from business operations)

  • Less: Operating Expenses

Chapter 16, Exhibit 4b

CCH Federal Taxation Basic Principles


S corporations tax model12 l.jpg
S Corporations—Tax Model

Rationale.Each shareholder of an S corporation reports her share of corporate net income based on her stock ownership. Any income, loss, deduction, or credit which could uniquely affect the tax liability of a shareholder is separately stated in the K-1 to the shareholder.

Chapter 16, Exhibit 4c

CCH Federal Taxation Basic Principles


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S Corporations—Tax Model

Separately Stated Items

  • Passive income and losses from rental and other non-operating activities

  • Investment income and related expenses (e.g., dividends, investment interest, ad valorem tax on stock, investment counseling fees, etc.)

  • Code Sec. 1231 gain and loss

  • Capital gains and losses

  • Dividends eligible for a dividends-received deduction

  • Charitable contributions

  • Taxes paid to a foreign country or to a U.S. possession

  • Code Sec. 179 deduction

  • Recovery items (e.g., tax refunds, recovery of bad debts)

  • Tax-exempt income and related expense

  • Tax credits

  • Deductions disallowed in computing S corporation income

Chapter 16, Exhibit 4d

CCH Federal Taxation Basic Principles


S corporations eligibility and election l.jpg
S Corporations—Eligibility and Election

A corporation is treated as an S corporation only for those days for which each specific eligibility requirement is met and the required election is effective. Eligibility and election rules include:

Unanimous Consent. 100% of the shareholders must consent to the S election.

Deadline For Filing S Election. If a calendar year C corporation makes an S election by 3/15/x1, it is retroactive to 1/1/x1. If made after 3/15/x1, but before 3/15/x2, it is effective 1/1/x2.

One Class of Stock.Only one class of stock is permitted.

  • Rights to profits and assets on liquidation must be identical.

  • Debt may be treated as a disqualifying second class of stock.

Chapter 16, Exhibit 5a

CCH Federal Taxation Basic Principles


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S Corporations—Eligibility and Election

Maximum 75 Shareholders. The number of shareholders may not exceed 75.

  • A nonresident alien may not own shares.

  • Each shareholder must be an individual, an estate, or a qualified trust.

  • A husband and wife count as one shareholder; however, if they divorce, they count as two if they each own stock.

Chapter 16, Exhibit 5b

CCH Federal Taxation Basic Principles


S corporations eligibility and election16 l.jpg
S Corporations—Eligibility and Election

Ineligible Corporations. The corporation must be domestic but not a bank or insurance company.

Eligible Subsidiaries.

  • S corporations can own C corporations, but C corporations cannot own S corporations.

  • S corporations can own qualified subchapter S subsidiaries (QSubs). A QSub is an electing domestic corporation that qualifies as an S corporation and is 100% owned by an S corporation parent.

Chapter 16, Exhibit 5c

CCH Federal Taxation Basic Principles


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S Corporations—Revoking S Status

The S election will be terminated upon one of the following events:

1.Over 50% consent. Over 50% of the shareholders agree to the revocation. The deadline for revoking S status is the same as the deadline for electing it.

2. Prior C life AND passive investment income over 25%. If an S corporation had a prior life as a C corporation and its passive investment income is over 25% of its total income for three consecutive years, it loses the S election at the start of the fourth year.

Chapter 16, Exhibit 6a

CCH Federal Taxation Basic Principles


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S Corporations—Revoking S Status

3. Violation of qualifications. If any of the qualifications mentioned above are violated (e.g., stock is sold to a C corporation, or a second class of stock is issued), the S election is terminated on the date of violation, and the period before the violation is considered a “short-year.”

4.Majority shareholder revocation. If a new shareholder owning more than 50% takes affirmative action to terminate the election, the election dies as of the date of action.

After revocation or termination of an election, a new election cannot be effectively made for 5 years without IRS consent.

Chapter 16, Exhibit 6b

CCH Federal Taxation Basic Principles


S corporation basis accounts overview l.jpg

Outside (Stock) Basis

At Risk Basis

AAA Basis

To determine gain or loss when the stock is ultimately sold. [Also will limit tax-free distributions if stock basis is lower than AAA basis.]

To determine how much of shareholder’s allocations of Sec. 702(a)(8) losses and separately stated expenses are deductible.

To determine how much of cash and property distributions are tax-free.

Primary Purpose:

S Corporation Basis Accounts—Overview

Chapter 16, Exhibit 7a

CCH Federal Taxation Basic Principles


S corporation basis accounts overview20 l.jpg

(“Yes” means the item to the left is used in the computation of basis):

Outside (Stock) Basis

At Risk Basis

AAA Basis

+ Original basis (e.g., purchase, inheritance, gift)

Yes

Yes

No

 Sec. 702(a)(8) TI or Loss

Yes

Yes

Yes

 Separately stated items that are taxable or deductible to s/h

Yes

Yes

Yes

 Tax-exempt income and non-deductible exp.

Yes

Yes

No

+ Company debt for which s/h is personally liable

No

Yes

No

S Corporation Basis Accounts—Overview

Chapter 16, Exhibit 7b

CCH Federal Taxation Basic Principles


S corporation basis accounts overview21 l.jpg

(“Yes” means the item to the left is used in the computation of basis):

Outside (Stock) Basis

At Risk Basis

AAA Basis

+ Non-recourse financing from qualified lenders

No

No

(unlike the normal at-risk rules for individuals)

No

+ Shareholder (S/H) loans to S Corp

No

(unlike partnerships debt basis is held separately from equity basis.)

Yes

No

(unlike partnerships, debt basis is held separately from equity basis.)

S Corporation Basis Accounts—Overview

Chapter 16, Exhibit 7c

CCH Federal Taxation Basic Principles


S corporation basis accounts overview22 l.jpg

(“Yes” means the item to the left is used in the computation of basis):

Outside (Stock) Basis

At Risk Basis

AAA Basis

- Fair market value (FMV) of distributions

Yes

(distributions reduce basis before current year losses)

Yes

(distributions reduce at risk amount before current year losses)

Yes

(distributions reduce AAA before current year losses)

S Corporation Basis Accounts—Overview

Chapter 16, Exhibit 7d

CCH Federal Taxation Basic Principles


S corporation basis accounts outside basis l.jpg
S Corporation Basis Accounts—Outside Basis computation of basis):

General Rule. A shareholder’s outside basis is his/her stock basis. Outside basis is computed in much the same manner as a partner’s outside basis in a partnership interest.

Exception. One notable exception is that the basis of stock in an S corporation is not affected by the corporation’s liabilities. This seems reasonable because, unlike a general partner, an S corporation shareholder is not personally liable for the debts of the corporation.

Chapter 16, Exhibit 8

CCH Federal Taxation Basic Principles


S corporation basis accounts at risk basis l.jpg
S Corporation Basis Accounts—At-Risk Basis computation of basis):

General Rule. At-risk rules are applied at the shareholder level. The amount of S corporation losses that the shareholder can deduct may not exceed the lesser of:

  • At-risk amount or

  • Sum of a shareholder’s stock basis and debt basis.

Chapter 16, Exhibit 9a

CCH Federal Taxation Basic Principles


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S Corporation Basis Accounts—At-Risk Basis computation of basis):

Computation of At-Risk Basis. At-risk basis is equal to the sum of:

  • Cash and basis of property contributed to the S corporation (to the extent unencumbered)

  • Outstanding shareholder loans to the S corporation

  • Loans for which the shareholder has personal liability or has pledged as security for repayment property not used in the activity of the corporation. (However, this does not include other debts of the corporation to third parties, even if the repayment is guaranteed by the shareholder.)

  • Allocated portion of income

  • Less: Allocated portion of losses

  • Less: Distributions at fair market value (not at partnership basis)

Chapter 16, Exhibit 9b

CCH Federal Taxation Basic Principles


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S Corporation Basis Accounts— computation of basis):Accumulated Adjustment Account (AAA)

Purpose.Records and information pertaining to each shareholder’s accumulated adjustment account (AAA) are needed by S corporations only for purposes of helping shareholders determine taxability of distributions when the S corporation has earnings and profits (E&P).

  • The C corporation connection.An S corporation has E&P only if it was classified as a C corporation in the past or acquired a C corporation.

    Tax effect of distributions. The fair market value (FMV) of distributions to shareholders are tax-free to the extent of the lesser of (1) AAA balance and (2) stock basis.

Chapter 16, Exhibit 10a

CCH Federal Taxation Basic Principles


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S Corporation Basis Accounts— computation of basis):Accumulated Adjustment Account (AAA)

Computation.A shareholder’s AAA balance is INCREASED only by taxable income. It is REDUCED by all deductible losses/expenses, by cash distributions and by the fair market value (FMV) of property distributions.

  • Same-year losses and distributions. Shareholders are allowed to reduce the AAA basis by the amount of current year distributions BEFORE applying current year losses against bases. This rule enables tax-free distributions to the extent of AAA, BEFORE AAA is reduced by the amount of losses. While the effect is favorable for tax-free distributions, it can also result in higher suspended losses, since distributions reduce all bases, dollar for dollar, thus lowering the limits of loss deductions and increasing suspended losses.

  • Tax–exempt income. No adjustment to the AAA account is made for tax-exempt income such as municipal bond interest and life insurance proceeds (reduced by related expenses).

Chapter 16, Exhibit 10b

CCH Federal Taxation Basic Principles


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S Corporation Basis Accounts— computation of basis):Accumulated Adjustment Account (AAA)

Negative AAA balance OK. The AAA basis (unlike the stock basis) can have a negative balance. However only losses, (not distributions) can make the AAA negative or increase a negative balance.

Transferability of AAA account.If the shareholder disposes of stock, the AAA associated with the stock passes to the new owner.

Chapter 16, Exhibit 10c

CCH Federal Taxation Basic Principles


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S Corporation Basis Accounts— computation of basis):Other Adjustment Account (OAA)

Other Adjustments Account (OAA).The OAA represents another form of accumulated adjustments account (AAA) in that:

  • The OAA is a balance sheet account in the capital section.

  • The OAA is needed by S corporations only for purposes of helping shareholders determine taxability of distributions when the S corporation has earnings and profits (E&P).

  • Any distributions from OAA are tax-free to shareholders.

Chapter 16, Exhibit 11a

CCH Federal Taxation Basic Principles


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S Corporation Basis Accounts— computation of basis):Other Adjustment Account (OAA)

Timing of distributions. Tax-free distributions from OAA cannot be made until after all accumulated E&P are paid out.

Computation.The OAA balance is increased for tax-exempt income or decreased for nondeductible expenditures not properly chargeable to the AAA.

Chapter 16, Exhibit 11b

CCH Federal Taxation Basic Principles


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S Corporation Basis Accounts— computation of basis):Previously Taxed Income Account (PTI)

Timing of distributions. Tax-free distributions from the PTI account are made after tax-free distributions reduce the OAA balance to zero.

Computation.The PTI account represents a balance of undistributed net income on which the shareholders were already taxed prior to 1983.

Chapter 16, Exhibit 12

CCH Federal Taxation Basic Principles


S corporation basis accounts shareholder loans to s corporations l.jpg
S Corporation Basis Accounts— computation of basis):Shareholder Loans to S Corporations

Using loan basis for deductions.Once stock basis is zero, any additional basis reductions (losses or deductions, but NOT distributions), decrease (but not below zero) the shareholder’s basis in loans made to the S corporation.

Suspended losses/deduction.Any excess of losses or deductions over both stock and debt bases is suspended until subsequent items of income or contributions arise to restore basis in debt.

Restoring debt basis. Once the basis of any debt is reduced, it is later increased (only up to the original face amount of the loan) by the subsequent net increase resulting from all positive and negative basis adjustments. The debt basis is adjusted before any increase is made in the stock basis.

Chapter 16, Exhibit 13a

CCH Federal Taxation Basic Principles


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S Corporation Basis Accounts— computation of basis):Shareholder Loans to S Corporations

Distributions. A distribution in excess of stock basis does not reduce any debt basis.

Same-year losses and distributions. If a loss and a distribution occur in the same year, the loss reduces the debt basis before the distribution. (This rule favors the taxpayer.)

Repayment of shareholder loan with reduced basis. If an S corporation repays a shareholder loan when the debt basis is below the loan amount, the difference is treated as a capital gain. An allocation is required for partial repayments.

Chapter 16, Exhibit 13b

CCH Federal Taxation Basic Principles


S corporation basis accounts shareholder loans to s corporations34 l.jpg
S Corporation Basis Accounts— computation of basis):Shareholder Loans to S Corporations

Example: A shareholder lends an S corporation $100,000. Subsequent losses eliminate the shareholder’s stock basis and reduce a portion of the debt basis. The S corporation repays $20,000 of the $100,000 loan when the shareholder’s basis in the loan is $75,000. The shareholder must report a capital gain in the amount of $5,000 on the receipt of $20,000, since 25% of the face value was not supported by debt basis [$20,000 x ($100,000 – $75,000)  $100,000].

Chapter 16, Exhibit 13c

CCH Federal Taxation Basic Principles


S corporation basis accounts example on effect of operating results on basis l.jpg
S Corporation Basis Accounts— computation of basis):Example on Effect of Operating Results on Basis

FACTS: David, an individual, owns all of the shares of an S corporation throughout 20x1. The corporate books show the information for 20x1 on the following slides.

QUESTION:

(1) Compute 20x1 Code Sec. 702(a)(8) taxable income

(2) Compute David’s stock basis at 12/31/x1.

(3) Compute David’s “at risk” amount at 12/31/x1.

(4) Compute David’s AAA balance at 12/31/x1.

(5) Compute David’s debt basis at 12/31/x1.

Chapter 16, Exhibit 14a

CCH Federal Taxation Basic Principles


S corporation basis accounts example on effect of operating results on basis36 l.jpg

Facts computation of basis):

Solution

Corp. Books:

(1)

Sec. 702(a)(8) TI

(2)

Stock Basis

(3)

At Risk Basis

(4)

AAA Basis

(5)

Debt Basis

Initial bases, from $10m stock purchase on 1/1/x1

10,000

10,000

10,000

0

0

200,000

200,000

200,000

200,000

200,000

Net sales

Cost of goods sold

(100,000)

(100,000)

(100,000)

(100,000)

(100,000)

Overhead expenses

(10,000)

(10,000)

(10,000)

(10,000)

(10,000)

Sec. 1245 gain

10,000

10,000

10,000

10,000

10,000

S Corporation Basis Accounts—Example on Effect of Operating Results on Basis

Chapter 16, Exhibit 14b

CCH Federal Taxation Basic Principles


S corporation basis accounts example on effect of operating results on basis37 l.jpg

Facts computation of basis):

Solution

Corp. Books:

(1)

Sec. 702(a)(8) TI

(2)

Stock Basis

(3)

At Risk Basis

(4)

AAA Basis

(5)

Debt Basis

Sec. 1231 loss

(10,000)

(sep’ly. stated)

(10,000)

(10,000)

(10,000)

Charitable contributions

(10,000)

(sep’ly. stated)

(10,000)

(10,000)

(10,000)

Short-term capital loss

(10,000)

(sep’ly. stated)

(10,000)

(10,000)

(10,000)

Long-term capital gain

10,000

(sep’ly. stated)

10,000

10,000

10,000

Tax-exempt interest income

15,000

(sep’ly. stated)

15,000

15,000

S Corporation Basis Accounts—Example on Effect of Operating Results on Basis

Chapter 16, Exhibit 14c

CCH Federal Taxation Basic Principles


S corporation basis accounts example on effect of operating results on basis38 l.jpg

Facts computation of basis):

Solution

Corp. Books:

(1)

Sec. 702(a)(8) TI

(2)

Stock Basis

(3)

At Risk Basis

(4)

AAA Basis

(5)

Debt Basis

Lobbying expense - state officials (not deductible)

(10,000)

(sep’ly. stated)

(10,000)

(10,000)

David’s loan to S corp.

10,000

10,000

10,000

S corp borrowings from banks— recourse to David

10,000

10,000

S Corporation Basis Accounts—Example on Effect of Operating Results on Basis

Chapter 16, Exhibit 14d

CCH Federal Taxation Basic Principles


S corporation basis accounts example on effect of operating results on basis39 l.jpg

Facts computation of basis):

Solution

Corp. Books:

(1)

Sec. 702(a)(8) TI

(2)

Stock Basis

(3)

At Risk Basis

(4)

AAA Basis

(5)

Debt Basis

S corp borrowings from banks— NONrecourse to David.

10,000

David’s additional stock purchases of S corp. stock

10,000

10,000

10,000

10,000

Cash distribution to David

(10,000)

(10,000)

(10,000)

(10,000)

Balances, 12/31/x1

125,000

100,000

95,000

115,000

80,000

10,000

S Corporation Basis Accounts—Example on Effect of Operating Results on Basis

Chapter 16, Exhibit 14e

CCH Federal Taxation Basic Principles


S corporation distributions l.jpg
S Corporation Distributions computation of basis):

Does an S corporation recognize gain or loss on the distribution of cash to shareholders?

No, never.

Does an S corporation recognize gain or loss on the distribution of other property (other than its own stock)?

  • Gains: Yes (compute gain in the same way as if the property were sold)

  • Losses: No (except in complete liquidation).

Chapter 16, Exhibit 15a

CCH Federal Taxation Basic Principles


S corporation distributions41 l.jpg
S Corporation Distributions computation of basis):

What is the character of the entity’s gain on distribution of property to owners?

  • If a shareholder owns no more than 50% of the S corporation, then the character of the entity’s gain is the same as the character of the property distributed.

  • If a shareholder owns more than 50%, then the entity’s gain is ordinary.

Chapter 16, Exhibit 15b

CCH Federal Taxation Basic Principles


S corporation distributions effect on shareholder l.jpg

S Corporation computation of basis):Without C Corporation E&P

Shareholder Distribution

Tax Result

To extent of stock basis

Tax-free; reduces stock basis

In excess of stock basis

Taxed as a capital gain

S Corporation Distributions—Effect on Shareholder

Chapter 16, Exhibit 16a

CCH Federal Taxation Basic Principles


S corporation distributions effect on shareholder43 l.jpg

S Corporation computation of basis):With C Corporation E&P

Shareholder Distribution

Tax Result

To extent of accumulated adjustments account (AAA)

Tax-free; reduces AAA and stock basis

To extent of C corporation E&P

Taxed as an ordinary dividend; does not reduce stock basis

To extent of other adjustments account (OAA) and previously taxed income (PTI) account

Tax-free; reduces OAA, PTI, and stock basis

To extent of any remaining stock basis

Tax-free; reduces stock basis.

In excess of stock basis

Taxed as a capital gain

S Corporation Distributions—Effect on Shareholder

Chapter 16, Exhibit 16b

CCH Federal Taxation Basic Principles


S corporation distributions example l.jpg
S Corporation Distributions—Example computation of basis):

FACTS:

An S corporation reports the following balances for its sole shareholder as of 1/1/x1:

  • Capital balance per corporate books: $125,000

  • Stock basis: $95,000

  • At-risk basis: $115,000

  • AAA basis: $80,000

  • Shareholder loan to S corporation: $10,000 (basis also $10,000)

    The S corporation reports a ($200,000) ordinary loss in 20x1.

Chapter 16, Exhibit 17a

CCH Federal Taxation Basic Principles


S corporation distributions example45 l.jpg
S Corporation Distributions—Example computation of basis):

QUESTIONS:

(a) What is the maximum tax-free nonstock distribution the shareholder can receive in 20x1? (Hint: The tax-free distribution is not affected by the 20x1 loss. Use the 1/1/x1 balance in AAA and any excess stock basis. Answer: $95,000 = $80,000 AAA + $15,000 excess stock basis)

(b) Assuming that a $95,000 cash distribution is made to the sole shareholder in 20x1, what are the 12/31/x1 balances in stock basis, at-risk basis, AAA and debt basis?

(c) What portion of the ($200,000) loss is deductible in 20x1 under the at-risk rules?

(d) What portion of the $200,000 loss is suspended in 20x1 under the at-risk rules?

Chapter 16, Exhibit 17b

CCH Federal Taxation Basic Principles


Slide46 l.jpg

S Corporation Distributions—Example computation of basis):

QUESTION:

If the S corporation repays the $10,000 shareholder debt in year 20x2, what are the tax consequences if:

  • S corporation has income of $10,000 in year 20x2?

    (If the S corporation has income in year 20x2, the first $10,000 must restore the debt basis back to $10,000. Any income in excess of $10,000 increases the following simultaneously: (a) the stock basis, (b) at-risk basis, and (c) AAA balance. A subsequent repayment of the $10,000 shareholder loan does not result in capital gain.)

  • S corporation has a loss in year 20x2?

    (Answer: A $10,000 capital gain passes through to the shareholder since the debt basis is zero.)

Chapter 16, Exhibit 17c

CCH Federal Taxation Basic Principles


S corporation distributions example47 l.jpg

SOLUTION: Tax Effect of a $200,000 loss and a $95,000 distribution in 20x1

Cap. Bal. per Books

Sec. 702(a)(8) income (loss)

Stock Basis

At Risk Basis

AAA Basis

Debt Basis

Balances, 1/1/x1

125m

95m

115m

80m

10m

1st: Apply dist’n. against bases:

Tier 1 Distribution:

(i.e., Tax free: Lesser of,

(1) $80m AAA balance, or

(2) $95m stock basis)

(80m)

(80m)

[tax-free]

(80m)

[tax-free]

(80m)

[tax-free]

0

[Debt basis is never reduced by distributions]

S Corporation Distributions—Example

Chapter 16, Exhibit 17d

CCH Federal Taxation Basic Principles


S corporation distributions example48 l.jpg

SOLUTION: Tax Effect of a $200,000 loss and a $95,000 distribution in 20x1

Cap. Bal. per Books

Sec. 702(a)(8) income (loss)

Stock Basis

At Risk Basis

AAA Basis

Debt Basis

Balances, 1/1/x1

125m

95m

115m

80m

10m

Tier 2 Distribution:

(i.e., taxable to extent of accumulated E & P from prior life as a C corp. None here.)

0

0

0

0

S Corporation Distributions—Example

Chapter 16, Exhibit 17e

CCH Federal Taxation Basic Principles


S corporation distributions example49 l.jpg

SOLUTION: Tax Effect of a $200,000 loss and a $95,000 distribution in 20x1

Cap. Bal. per Books

Sec. 702(a)(8) income (loss)

Stock Basis

At Risk Basis

AAA Basis

Debt Basis

Balances, 1/1/x1

125m

95m

115m

80m

10m

Tier 3 Distribution:

(i.e. tax free to extent of any stock basis surviving the 1st tier distribution

(15m = 95m - 80m)

(15m)

(15m)

[tax-free]

(15m)

[tax-free]

0

[Dist’ns cannot create neg. AAA bal.]

0

[Debt basis is never reduced by distributions]

Subtotals

30m

0

0

20m

0

10m

S Corporation Distributions—Example

Chapter 16, Exhibit 17f

CCH Federal Taxation Basic Principles


S corporation distributions example50 l.jpg

SOLUTION: Tax Effect of a $200,000 loss and a $95,000 distribution in 20x1

Cap. Bal. per Books

Sec. 702(a)(8) income (loss)

Stock Basis

At Risk Basis

AAA Basis

Debt Basis

Subtotals

30m

0

0

20m

0

10m

20x1 DEDUCTIBLE LOSSES UNDER AT-RISK RULES

[Apply 200m Sec. 702(a)(8) loss against bases and determine the amount deductible under the at-risk rules.]

(200m)

(10m)

[Note: Only (10m) is deductible, because loss deductions are limited to the lesser of

1. $10m (i.e., stock basis of $0, + debt basis of $10m); or

$20m at risk basis]

0

(20m)

(200m)

(10m)

S Corporation Distributions—Example

Chapter 16, Exhibit 17g

CCH Federal Taxation Basic Principles


S corporation distributions example51 l.jpg

SOLUTION: Tax Effect of a $200,000 loss and a $95,000 distribution in 20x1

Cap. Bal. per Books

Sec. 702(a)(8) income (loss)

Stock Basis

At Risk Basis

AAA Basis

Debt Basis

BASES, 12/31/x2

(170m)

0

[can’t be neg.]

0

[can’t be neg.]

(40m) [CAN be neg.]

0

[can’t be neg.]

20X2B SUSPENDED LOSS UNDER AT-RISK RULES ($190m total)

(190m) 

[200m-10m] or [180m + 10m]



(180m)

[190m nondeductible loss - 10m debt basis]





(10m)

S Corporation Distributions—Example

Chapter 16, Exhibit 17h

CCH Federal Taxation Basic Principles


S corporation penalty taxes code sec 1374 tax on built in gains l.jpg
S Corporation Penalty Taxes— distribution in 20x1Code Sec. 1374 Tax on Built-in Gains

All four conditions listed below must be present to subject an S corp. to the 35% Code Sec. 1374 tax:

1. Prior life as a C corporation;

2.  S-corporation election occurs after 1/1/87;

3.  Asset sale with pre-election built-in gain (but not built-in loss). [If the asset is purchased after the election, Code Sec. 1374 would not apply.]

4.  Asset sale within 10 years of election date, not effective date of election. (e.g., if an election is made on 3/15/x1, it is retroactively effective to 1/1/x1. The 10 year toll begins in 3/15/x1, not 1/1/x1.)

Chapter 16, Exhibit 18a

CCH Federal Taxation Basic Principles


S corporation penalty taxes code sec 1374 tax on built in gains53 l.jpg
S Corporation Penalty Taxes— distribution in 20x1Code Sec. 1374 Tax on Built-in Gains

Computation. At the time that an asset is sold, the corporation will recognize (and pay tax) on the difference between the fair market value of the asset at the time of the election. The tax rate is the highest corporate effective rate of 35%.

Chapter 16, Exhibit 18b

CCH Federal Taxation Basic Principles


S corporation penalty taxes code sec 1374 tax example l.jpg

FACTS: On 3/15/x0, a C corporation makes an election to become an S corporation. At the time of the election, the corporation had the following assets:

Asset

Fair Market Value at Election Date

Adjusted Basis at Election Date

Built-In Gain

Office Building

$600,000

$500,000

$100,000

Land

$400,000

$300,000

$100,000

S Corporation Penalty Taxes—Code Sec. 1374 Tax Example

Chapter 16, Exhibit 19a

CCH Federal Taxation Basic Principles


S corporation penalty taxes code sec 1374 tax example55 l.jpg

QUESTION: Determine the tax effect to the corporation and to the shareholder of the following transactions:

  • One year after the election date, the corporation sells the building at a sales price of $700,000 when the adjusted basis is $450,000.

  • Twelve years after the election date, the corporation sells the land at a sales price of $500,000.

(a)

(b)

(c)

(d)= (b) – (c)

(e) =

[Lesser of: (a) or (d)] x 35%

Asset

Sales Price

Basis at Sales Date

Realized Gain

Sec. 1374 Tax

Built-in Gain at Election

Building

$100,000

$700,000

$450,000

$250,000

$35,000

Land

$100,000

$500,000

$300,000

$200,000

0**

S Corporation Penalty Taxes—Code Sec. 1374 Tax Example

Chapter 16, Exhibit 19b

CCH Federal Taxation Basic Principles


S corporation penalty taxes code sec 1374 tax example56 l.jpg
S Corporation Penalty Taxes— to the shareholder of the following transactions:Code Sec. 1374 Tax Example

COMPUTATIONS

Tax effect of 20x1 sale of building:

  • S corporation: The corporation itself pays the $35,000 tax to the IRS. (35% x [the lesser of 100,000 or 250,000])

  • Shareholders: The shareholders are allowed a deduction for that tax. The S corporation’s K-1 would show:

    Code Sec. 1231 gain/Code Sec. 1245 recapture

    ($700,000 - 450,000) $250,000

    Code Sec. 1374 tax deduction $ (35,000)

Chapter 16, Exhibit 19c

CCH Federal Taxation Basic Principles


S corporation penalty taxes code sec 1374 tax example57 l.jpg
S Corporation Penalty Taxes— to the shareholder of the following transactions:Code Sec. 1374 Tax Example

COMPUTATIONS

Tax effect of selling land over 10 years after the election date:

  • No Code Sec. 1374 tax would be imposed since the 10-year post-election period had lapsed. Only the $200,000 Code Sec. 1231 gain would be reported by the S corporation on the shareholder’s K-1.

Chapter 16, Exhibit 19d

CCH Federal Taxation Basic Principles


S corporation penalty taxes code sec 1375 tax on excess net passive income l.jpg
S Corporation Penalty Taxes— to the shareholder of the following transactions:Code Sec. 1375 Tax on Excess Net Passive Income

This tax applies to any S corporation with accumulated E&P that has more than 25% of its gross receipts derived from passive sources.

Chapter 16, Exhibit 20a

CCH Federal Taxation Basic Principles


S corporation penalty taxes code sec 1375 tax on excess net passive income59 l.jpg
S Corporation Penalty Taxes— to the shareholder of the following transactions:Code Sec. 1375 Tax on Excess Net Passive Income

Computations

  • Excess Net Passive Income = [(a) – {25% x (c)}]  [(a) x (b)]

  • Code Sec. 1375 Tax = 35% x Excess Net Passive Income, where

    (a) = Gross passive investment income (e.g., royalties, rents, dividends, interest, annuities, and gain on sales of securities)

    (b) = Net passive investment income (i.e., gross amount net of investment expenses

    (c) = Gross receipts (i.e., receipts from all sources including active and passive sources)

  • Note that Excess Net Passive Investment Income can never be more than taxable income computed as if the S corporation had been a C corporation.

Chapter 16, Exhibit 20b

CCH Federal Taxation Basic Principles


Code sec 1375 tax on excess net passive income example l.jpg

FACTS: to the shareholder of the following transactions:

1. S corporation has gross receipts of $300,000 in 20x1.

2.  Included in the $300,000 is $100,000 of royalties.

3.  Expenses directly connected with the production royalties are $30,000.

4.  The S corporation has accumulated E & P from its prior life as a C corporation.

QUESTION:

Compute the Code Sec. 1375 tax.

SOLUTION:

Excess Net Passive Investment Income:

$17,500 =[100,000 – {25% x (300,000)}]  [100,000 x 70,000]

Code Sec. 1375 tax:

$6,125 = 35% x 17,500.

Code Sec. 1375 Tax on Excess Net Passive Income—Example

Chapter 16, Exhibit 21

CCH Federal Taxation Basic Principles


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