Form 1120S Challenges Amanda Wilson June 27, 2013. I.Adjustments to Accumulated Adjustment Accounts. Accumulated Adjustment Accounts.
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Form 1120S Challenges
June 27, 2013
I.Adjustments to Accumulated Adjustment Accounts
An accumulated adjustment account (AAA) generally reflects the accumulated undistributed net income of the corporation for the S corporation's post-1982 years.
More simply, it tracks the S corporation’s ability to make tax-free distributions to shareholders.
The AAA reflects the earnings of the S corporation that have been previously taxed to the shareholders, reduced by any amounts that have already been distributed to the shareholders. To the extent there is a positive AAA balance, distributions can be made tax-free to the shareholders.
AAA is zero as of the start of the S corporation’s first taxable year for which the S election is in effect.
Adjustments to an AAA are similar to the adjustments to the shareholder’s basis provided for under Section 1367, except that an AAA can go negative.
AAA balance disappears following the end of the post termination transition period after termination of S election, even if corporation later re-elects S status.
All S corporations should maintain an AAA in case the S corporation ever engages in a Section 381 transaction with another corporation.
The AAA is an account of the S corporation and is not apportioned to the shareholders in any way.
Adjustments to AAA depend on the taxable year.
XYZ Inc. is a new S corporation formed as of January 1. In Year 1, XYZ has $20,000 in losses and no distributions.
In Year 2, XYZ has $60,000 of income and makes a $15,000 distribution.
In Year 3, XYZ has $30,000 of separately stated income, $40,000 of nonseparetely stated loss, and makes a $5,000 distribution.
The difference between the current and prior AAA adjustment rules relates to when an AAA is measured to determine whether a distribution is tax-free.
Under the old rules, income and losses were taken into account when making the AAA adjustments before distributions were tested.
The current rules provide that distributions be taken into account before any net negative adjustment (i.e., losses in excess of income) are taken into account.
AAA can become negative as a result of loss and deductions items.
If this occurs, S corporation must generate future income to overcome this negative balance before the S corporation can once again distribute cash tax-free.
Negative adjustments to AAA are made by deduction items, even if the shareholders allocated the deduction items are unable to deduct such items currently (i.e., because they lack sufficient basis). When the shareholders are later able to utilize the deduction, there is no adjustment to AAA.
AAA is generally determined as of the close of the S corporation’s tax year.
Tax treatment of distributions from S corporation is governed by Section 1368.
If S corporation has no E&P, Section 1368(b) applies.
If S corporation has E&P, Section 1368(c) applies:
Dividend income will be reported by the S corporation on 1099-Div, not Schedule K-1.
ABC Inc. has $25,000 AAA balance and $2,000 accumulated E&P. Shareholder has basis in stock of $30,000. ABC Inc. distributes $30,000 to Shareholder.
ABC Inc. has E&P so Section 1368(c) applies.
One of the tax benefits of a C corporation is that an owner/shareholder can be treated/respected as an employee of the corporation. This contrasts to the partnership area which does not allow an owner/partner to be treated as an employee.
As a result, an owner/shareholder can participate in certain fringe benefits offered to employees. The C corporation can generally deduct the cost of fringe benefits provided to employee owners without the employee owner having to include the value of the fringe benefits in taxable income.
While the rules applicable to C corporations generally apply to S corporations as well, Section 1372 provides that, in applying the rules applicable to employee fringe benefits
A 2% shareholder is any person who on any day of the corporate year owns more than 2% of the outstanding stock or more than 2% of the voting power of all of the stock.
The constructive ownership rules of Section 318 apply. As a result, a person can be a 2% shareholder even if he does not own any stock directly.
2% shareholders generally do not get the benefit of excluding fringe benefits from income, since the fringe benefit exclusion provisions generally only apply to “employees”.
Note that this rule is for 2% shareholders only. Less than 2% shareholders are caught by Section 1372.
Section 1372 does not specifically define what fringe benefits are covered. What does appear to be covered based on legislative history:
The following benefits are generally not covered/impacted, as these provisions specifically define employees to include self-employed individuals (including partners).
A cafeteria plan allows employees to pay certain qualified expenses on a pre-tax basis (i.e., flexible spending accounts).
Section 125 provides that employee benefits provided under a cafeteria plan are not included in an employee’s income merely because the employee had the chance, before the cash became available, to chose to receive the cash or nontaxable benefits under the cafeteria plan.
Section 125 requires that all participants in the cafeteria plan be employees. Based on Section 1372, the IRS has issued proposed regulations under Section 125 stating that 2% shareholders are not employees and thus cannot participate in cafeteria plans.
The IRS addressed how to apply Section 1372 to payments of health insurance premiums by an S corporation in Revenue Ruling 91-29.
In that ruling, the S corporation paid accident and health insurance premiums for both 2% shareholder employees and a less than 2% shareholder employee. The IRS held:
In addition, the IRS held that the S corporation could deduct the cost of providing the employee fringe benefits if the requirements under Section 162(a) were satisfied (i.e., if the cost was an ordinary and necessary expense paid or incurred in carrying on trade or business).
The IRS also stated that the 2% shareholders could deduct the cost of the insurance premiums if they satisfied the requirements of Section 162(l).
In Announcement 92-16, the IRS reiterated its holding in Revenue Ruling 91-29.
It then stated that while the premium payments by the S corporation are included in the 2% shareholder’s wages for income tax withholding purposes (i.e., listed on the W-2), they are not wages subject to the Social Security and Medicare taxes.
The IRS provided rules regarding when a 2% shareholder is entitled to deduct accident and health insurance premiums under Section 162(l) in Notice 2008-1.
Section 162(l) provides that an employee (including a self-employed individual such as a partner) may deduct amounts paid for medical care insurance subject to the following limitations:
In addition to the Section 162(l) requirements, Notice 2008-1 requires:
If premiums are not paid or reimbursed by S corporation and included in 2% shareholder’s gross income, requirement is not satisfied and no deduction.
Section 162(l) provides that the deduction is limited to the amount of the individual’s earned income from the trade or business with respect to which the plan providing the medical care coverage is established.
Wages paid to a 2% shareholder are deemed to be earned income for purposes of this Section 162(l) limitation.
An individual can generally, under Section 223, deduct contributions made to a health savings account (HSA) established to pay for qualified medical expenses. If the employer makes the contribution, the contribution is generally excluded from income and wages under Section 106(d).
In Notice 2005-8, the IRS stated that an S corporation’s contribution to HSA of 2% shareholder is treated as a guaranteed payment under Section 707(c). The S corporation can deduct the contribution under Section 162 and the 2% shareholder must include it in gross income.
The deduction must be included in wages on W-2, but not subject to Social Security or Medicare tax.
2% shareholders often do not get the benefit of excluding fringe benefits from income, since the fringe benefit exclusion provisions generally only apply to “employees”.
The 2% shareholders must generally include the fringe benefit in gross income. A deduction may be available in some cases (e.g., Section 162(l)).
The S corporation should issue the 2% shareholder a W-2 with respect to the fringe benefits, although Social Security and Medicare generally do not apply.
The S corporation may be able to deduct the cost of the fringe benefits as a business expense under Section 162.
IV.Recent Legislative and Administrative Developments
Section 179 allows taxpayers to elect to deduct as an expense certain types of property and computer software.
Expense limitation on the amount deductible was set to be reduced from $139,000 (with phaseout threshold of $560,000) in 2010 and 2011 to $25,000 (with phaseout threshold is $200,000) in 2012.
American Taxpayer Relief Act of 2012 increased dollar expensing limitation for 2012 and 2013 to $500,000 (with phaseout threshold of $2 million) and extended 50% first-year additional bonus depreciation to 2013.
Expensing deduction is limited to the aggregate amount of taxable income that the taxpayer has from an active trade or business. Expense deductions above this amount can be carried forward.
For an S corporation, the limitations on taking an expensing deduction (phase-out threshold and taxable income limitation) are applied at the S corporation and the shareholder level.
For purposes of the expensing deduction limitation, all component members of a controlled group shall be treated as one taxpayer.
Definition of members of a controlled as provided under Section 1563(a) except that the test is more than 50% instead of at least 80%.
However, an S corporation is generally not a component member of a controlled group by virtue of Treasury Regulation section 1.1563-1(b)(2).
Under section 1366(d)(1), a shareholder is limited in the amount of losses and deductions that it can take in any taxable year to the sum of the shareholder’s adjusted basis in stock and adjusted basis of any indebtedness of the S corporation to that shareholder.
Generally, initial basis equals the cost paid for the stock. If property was contributed for stock, then basis equals basis of property contributed, adjusted for gain recognized and boot distributed.
Basis increased by
Basis decreased by
Debt basis – General rule
Adjustments are first made to reduce stock basis (down to zero), and then debt basis.
Proposed Regulation section 1.1366-2(a)(2) was issued October 2012.
It provides that:
The term basis of any indebtedness of the S corporation to the shareholder means the shareholder's adjusted basis (as defined in §1.1011-1 and as specifically provided in section 1367(b)(2)) in any bona fide indebtedness of the S corporation that runs directly to the shareholder. Whether indebtedness is bona fide indebtedness to a shareholder is determined under general Federal tax principles and depends upon all of the facts and circumstances.
In addition, the proposed regulation provides that a shareholder does not obtain basis in indebtedness of an S corporation merely by guaranteeing a loan or acting as a surety. A shareholder that makes a payment on bona fide indebtedness for which the shareholder has acted as a guarantor, the shareholder may increase its basis in the indebtedness by the amount of the payment. Treas. Reg. sec. 1.1366-2(a)(2)(ii).
Contrasts from treatment of partners in a partnership.
Section 1362(f) provides relief where an S election was not effective (because the S corporation was not a small business corporation or all shareholders did not consent) or where such election was terminated (because the S corporation ceased to be a small business corporation or had too much passive investment income).
The corporation has the burden of establishing that under the relevant facts and circumstances the Commissioner should determine that the termination or invalid election was inadvertent.
“The fact that the terminating event or invalidity of the election was not reasonably within the control of the corporation and, in the case of a termination, was not part of a plan to terminate the election, or the fact that the terminating event or circumstance took place without the knowledge of the corporation, notwithstanding its due diligence to safeguard itself against such an event or circumstance, tends to establish that the termination or invalidity of the election was inadvertent.” Treasury Regulation section 1.1362-4(b).
The corporation seeks relief by requesting a private letter ruling from the IRS.
The IRS grants a substantial number of ruling requests. For example, for the period between January 1, 2012 and the date of this webinar, approximately 113 requests have been released.
Situations where relief was granted include:
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