Form 1120S Challenges
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Form 1120S Challenges Amanda Wilson June 27, 2013. I.Adjustments to Accumulated Adjustment Accounts. Accumulated Adjustment Accounts.

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Form 1120s challenges amanda wilson june 27 2013

Form 1120S Challenges

Amanda Wilson

June 27, 2013


Form 1120s challenges amanda wilson june 27 2013

I.Adjustments to Accumulated Adjustment Accounts


Accumulated adjustment accounts

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.


Accumulated adjustment accounts1

Accumulated Adjustment Accounts

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.


Accumulated adjustment accounts2

Accumulated Adjustment Accounts

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.

  • Current rules

  • Rules for taxable years beginning before 1/1/1997


Current aaa rules

Current AAA rules

AAA is:

  • Increased for separately and nonseparately stated income (excluding tax-exempt income) and certain depletion deductions;

  • Decreased by separately and nonseparately stated loss, nondeductible expenses (other than federal taxes attributable to any C corporation taxable years or tax-exempt income related expenses), and depletion deductions (capped by the amount of the increase in (1));

  • Decreased (but not below zero) for tax-free distributions under Section 1368(b) or (c)(1) (i.e., distributions that reduce basis);


Current aaa rules1

Current AAA rules

  • Decreased by the amount of separately and nonseparately stated loss, nondeductible expenses (other than federal taxes attributable to any C corporation taxable years or tax-exempt income related expenses), and depletion deductions to the extent that they exceed the amount of the increase in (1) (i.e., the amount that was not allowed under (2) because of the cap); and

  • Decreased or increased (as appropriate) for any redemption distributions qualifying under Section 302(a) or 303(a).


Example

Example

XYZ Inc. is a new S corporation formed as of January 1. In Year 1, XYZ has $20,000 in losses and no distributions.

  • XYZ’s AAA as of December 31, Year 1 is negative $20,000.

    In Year 2, XYZ has $60,000 of income and makes a $15,000 distribution.

  • XYZ’s AAA as of December 31, Year 2 is $25,000 [-$20,000 + $60,000 - $15,000]


Example1

Example

In Year 3, XYZ has $30,000 of separately stated income, $40,000 of nonseparetely stated loss, and makes a $5,000 distribution.

  • XYZ’s AAA as of December 31, Year 3 is $10,000

    • First, increase $25,000 starting AAA balance by $30,000 of income

    • Second, decrease by $30,000 loss ($10,000 is not taken under this step because loss is capped by amount of income)

    • Third, decrease (but not below zero) by $5,000 distribution

    • Fourth, decrease by $10,000 remaining loss


Pre 1997 aaa rules

Pre-1997 AAA rules

AAA is:

  • Increased for separately and nonseparately stated income (excluding tax-exempt income) and certain depletion deductions;

  • Decreased by separately and nonseparately stated loss, nondeductible expenses (other than federal taxes attributable to any C corporation taxable years or tax-exempt income related expenses), and depletion deductions;

  • Decreased (but not below zero) for tax-free distributions under Section 1368(b) or (c)(1); and

  • Decreased or increased (as appropriate) for any redemption distributions qualifying under Section 302(a) or 303(a).


Difference between the rules

Difference between the Rules

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 adjustments

AAA Adjustments

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.


Form 1120s challenges amanda wilson june 27 2013

  • Character and Treatment of Distributions and Dividends


Distributions

Distributions

Tax treatment of distributions from S corporation is governed by Section 1368.

If S corporation has no E&P, Section 1368(b) applies.

  • Distribution is tax-free to extent of shareholder’s basis, and

  • Remaining distribution treated as gain from the sale or exchange of property (i.e., capital gain).


Distributions1

Distributions

If S corporation has E&P, Section 1368(c) applies:

  • Distribution is treated as provided for under Section 1368(b) to the extent of E&P (Treas. Reg. sec. 1.1368-1(d)(2) expands this to include previously taxed income) [i.e., tax-free to extent of shareholder’s basis, capital gain for amount in excess of basis].

  • Treated as a dividend to extent of accumulated E&P [note that dividend income is subject to net investment income tax under Section 1411], then

  • Any remainder is treated as provided for under Section 1368(b) [i.e., tax-free to extent of shareholder’s basis, capital gain for amount in excess of basis].

    Dividend income will be reported by the S corporation on 1099-Div, not Schedule K-1.


Example2

Example

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.

  • $25,000 (AAA balance) treated under Section 1368(b). Shareholder has $30,000 basis so distribution is tax-free.

  • $2,000 treated as dividend because of $2,000 accumulated E&P.

  • Remaining $3,000 treated under Section 1368(b). Shareholder has $5,000 remaining basis so distribution is tax-free.

  • Shareholder’s basis is reduced to $2,000 after distribution.


Fringe benefits

Fringe Benefits

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.


Special rule for s corporations

Special Rule for S Corporations

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

  • An S corporation is treated as a partnership, and

  • any 2% or more shareholder is treated as a partner of the partnership.


Special rule for s corporations1

Special Rule for S Corporations

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.

  • For example, Father owns 5% of stock in Y. Son works for Y but holds no stock. Under Section 318, stock ownership is attributed between members of a family (spouses, children, grandchildren and parents). Son is treated as a 2% shareholder because the stock of Father is attributed to Son.


What does this mean

What Does This Mean?

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.


What fringe benefits are covered

What Fringe Benefits Are Covered?

Section 1372 does not specifically define what fringe benefits are covered. What does appear to be covered based on legislative history:

  • Exclusion from income amounts received under accident and health plans (Section 105) (See Part V).

  • Exclusion from an employee’s income employer-provided coverage under an accident and health plan (Section 106) (See Part V).

  • Exclusion from employee’s taxable income of the cost (up to $50,000) of group term life insurance provided by an employer on employee’s life. (Section 79).

  • Exclusion from employee’s taxable income of meals or lodging provided by an employer to an employee for the convenience of the employer (Section 119).


What fringe benefits are not covered impacted

What Fringe Benefits Are Not Covered/Impacted

The following benefits are generally not covered/impacted, as these provisions specifically define employees to include self-employed individuals (including partners).

  • Defined contribution plans and defined benefit plans, including employee stock ownership plans (Sections 401-417).

  • Qualified group legal services plans (Section 120).

  • Dependent care assistance programs (Section 129).


Cafeteria plans

Cafeteria Plans

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.


Health related fringe benefits

Health Related Fringe benefits

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:

  • The employee fringe benefits paid or furnished for the benefit of 2% shareholder employees were to be treated like a guaranteed payment under Section 707(c).

  • The 2% shareholders had to include cost of the premiums in their gross income.

  • The less than 2% shareholder employee could exclude the cost from income under Section 106.


Revenue ruling 91 29

Revenue Ruling 91-29

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).


Announcement 92 16

Announcement 92-16

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.


Notice 2008 1

Notice 2008-1

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:

  • Deduction shall not be allowed to the extent the deduction exceeds the individual’s earned income from the trade or business with respect to which the plan providing the medical care coverage is established.

  • Deduction is not allowed for amounts during a month in which the individual is eligible to participate in any subsidized health plan maintained by an employer of the individual or their spouse.


Notice 2008 1 requirements

Notice 2008-1 Requirements

In addition to the Section 162(l) requirements, Notice 2008-1 requires:

  • Plan providing medical coverage must be established by the S corporation. Either

    • S corporation makes the premium payments for the accident and health insurance policy in the current taxable year, or

    • 2% shareholder makes the premium payments and furnishes proof of payment to the S corporation and S corporation then reimburses the 2% shareholder in the current taxable year.

      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.

  • S corporation must report the accident and health insurance premiums paid or reimbursed as wages on the 2% shareholder’s Form W-2.


Earned income

Earned Income

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.


Health savings account

Health Savings Account

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.


In short

In Short

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.


Form 1120s challenges amanda wilson june 27 2013

IV.Recent Legislative and Administrative Developments


Section 179 expensing

Section 179 Expensing

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.


Section 179 expensing1

Section 179 Expensing

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.

  • An S corporation cannot allocate an expense deduction to its shareholders in excess of the S corporation’s taxable income for that year.

  • Shareholder cannot take an expense deduction for any tax year more than the shareholder’s taxable income limitation for that year.


Section 179 expensing2

Section 179 Expensing

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).


Limitations on losses and deductions

Limitations on Losses and Deductions

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.


Stock basis

Stock Basis

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

  • Additional capital contributions

  • Share of S corporation income (including exempt income)

  • Excess of depletion deductions over basis

    Basis decreased by

  • Share of S corporation losses, deductions, and depletion

  • Share of noncapital, nondeductible expenses (e.g. penalties or bribes).

  • Certain distributions


Debt basis

Debt Basis

Debt basis – General rule

  • Initial basis equals the cost of the debt.

  • Decreased by the repayment of principal.

  • Reduced to zero if the debt becomes worthless.

    Adjustments are first made to reduce stock basis (down to zero), and then debt basis.


Proposed regulations on basis

Proposed Regulations on 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.


Proposed regulations on basis1

Proposed Regulations on Basis

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.


Inadvertent termination relief

Inadvertent Termination Relief

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 Secretary must determine that the circumstances were inadvertent.

  • Corrective steps must be taken within a reasonable period of time after discovery.

  • S corporation and all people who were shareholders during relevant period must agree to make adjustments required by the Secretary.


Inadvertent termination relief1

Inadvertent Termination Relief

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).


Inadvertent termination relief2

Inadvertent Termination Relief

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:

  • person signing S election was not authorized to sign on behalf of shareholder,

  • ineligible shareholders (including failure to file QSST or QSBT election),

  • excessive passive income


Circular 230

Circular 230

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing or recommending to another party any transaction, arrangement, or other matter.


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