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Subchapter S (Day 2)

Subchapter S (Day 2). Robert R. Oliva, Ph.D., LL.M., J.D., CPA. University of Arkansas at Little Rock. Introduction. Tax effect of S election Subchapter S taxes BIG/PII Recapture Shareholder taxes: Pass Throughs: Separately stated Not separately stated. Tax Effect of S Election on S.

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Subchapter S (Day 2)

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  1. Subchapter S (Day 2) Robert R. Oliva, Ph.D., LL.M., J.D., CPA University of Arkansas at Little Rock

  2. Introduction • Tax effect of S election • Subchapter S taxes • BIG/PII • Recapture • Shareholder taxes: Pass Throughs: • Separately stated • Not separately stated

  3. Tax Effect of S Election on S • Information return • No federal income taxes paid, except • BIG • PII • Recapture: LIFO reserve; ITC

  4. Tax Effect of S Election on Shareholders • Introduction • Separately stated items • Nonseparately stated items

  5. Introduction • S v. partnerships • S v. corporations

  6. S Corp v. partnerships • Similar in income computation: • Separately and non-separately stated items. • However, • S measures property distributions at FMV • Partnerships distributions measured at AB • S debt does not affect shareholders’ AB. • Partnership’s debt affects partners’ AB • Disproportional distributions permitted in partnerships • But could cause the S termination b/c creates second class of stock

  7. S Corp v. C Corp • Unless otherwise stated follow Sub C rules • Like C Corps, S Corps • allowed IRC 248 org. exp. Amortization • Recognize gain on distributions of appreciated property • However, while gain is passed through but shareholder does not report it as dividend. • But unlike C Corps, • S Corps are not allowed to an IRC 243 or IRC 291 deductions • S Corps separately report items that may have different treatments at shareholder level.

  8. Separately Stated Items • charitable contributions (no 10% limit) • foreign/possessions taxes • Shareholder to elect deduction or credit • tax exempt income • Passes through as increases to AB • income/loss/deduction/credit requiring separate treatment • Capital gains & losses • IRC 1231 gains & losses • Interest and dividends received by an S, e.g., portfolio income

  9. Separately Stated Deductions • IRC 179 • Nonbusiness bad debt (IRC 166(d): STCL)

  10. Non-separately Stated Items • Gross income less deductions • Deductions: IRC 248, 291, depreciation (not 179). • Disallowed deductions: sep. stated; personal;

  11. Computation of shareholders’ share • Pro rata: daily/per share • Daily: Yearly income(loss) / days in taxable year • Per share: Daily income(loss) / # shares outstanding

  12. Example 1: Pro rata • A and B equal owners of S • w/ O.I. of $146,000 • and LTCG of $36,500. • How much do A and B report?

  13. Answer to Example 1: • A and B each report 50%.

  14. Example 2:Pro rata • Now B sells 50% on 90th day. • B owned 50% for 89 days and 25% for 276 days • C owned 25% for 276 days • How much do B and C report?

  15. Answer to Example 2: Ordinary Income: • B: $146K(.5)(89/365) + $146K(.25)(276/365) = $45,400 • C: $146K(.25)(276/365) = $27,600

  16. Answer to Example 2: LTCG • B: $36500(.5)(89/365) + $36500(.25)(276/365)=$11350 • C:$36500(.25)(276/365) = $6900

  17. Example 3: pro rata • A owns 10% through the year; nonseparately stated = $36500 • How much does he report?

  18. Answer to Example 3: • .10(36500) = $3650 • Or: • Daily: $36500/365= $100/day • Prorata:$100(.10)=$10/day • Yearly share: $10/day(365)=$3650

  19. Example 4: prorata • Same as 3 but now A buys another 10% on the 201st day: • How much does he report?

  20. Answer to Example 4: • 10% for 200 days:$100/day(.10)(200)=$2000 • 20% for 165 days:$100/day(.20)(165)=$3300

  21. Effect of cessation of ownership: • If no election: compute as above • If election: compute as if two years • Why relevant?

  22. Relevancy of no election: • If income is NOT earned evenly throughout year, shareholders will not report their fair share • Similar election available when S terminates.

  23. Distributions: irc 1368 • An extension of the IRC 301 water faucet analogy in Subchapter C. • But 4 buckets or tiers instead of 3 buckets • Tier 1: From AAA: Tax free • Simultaneously reduce • AAA and AB • Recognize gain after AB. • Tier 2: In excess of AAA: dividend up to AEP • Tier 3: Remainder of AB tax free • Tier 4: Balance in excess of AB = gain

  24. Therefore, • an S distribution has no impact on shareholders’ TI unless • After elimination of AAA, distribution is sourced from EP • Distribution > Adjusted Basis

  25. AAA: Accumulated Adjustments Account • Rationale: Tracks the source of distributions • Two sources of distributions • Undistributed and untaxed C’s EP = AEP • Undistributed but taxed S’s operations = post-1982 undistributed earnings

  26. AAA: Adjustments • Beginning balance on day 1 of S = 0 • AAA = 0 • AEP = $500 (leftover from C years) • Increase AAA by results of operations • If S has $100 earnings, then • AAA= $100 • AEP = $500

  27. AAA adjustments: • Increase AAA • Results of operations • Reduce AAA by • Pass through losses/deductions • Nondeductible expenses, not charged to capital account

  28. Examples of nonded exp/not charged to cap. • expenses for tax free income • illegal bribes, nondeductible fines & penalties • losses between related parties • federal taxes during C years • disallowed meal and entertainment expenses

  29. Treatment • Redemptions, distributions and operating results • Sub S corporations with C’s EP. • Sub S corporations (never were C corporations)

  30. Sub S corporations with C’s EP. • Dealing with the AAA

  31. AAA Adjustments: Redemption • 25% stock redemption; AAA = $160 • Adjust AAA by 25%: $160 - .25(160) = $120

  32. AAA adjustments: Distributions • Timing Issue: • Which should be accounted for first? • Results of operations? • Results of distributions?

  33. General rule: • (1) Adjust S Corp’s balances (AAA, EP, AB) by the results of operations • (2) Adjust S Corp’s balances to account for the distribution.

  34. Exception: • The order of adjustments is changed when there is an operating loss at EOY. • (1) Adjust for the distribution • (2) Adjust for the results of operations

  35. Example 5: Operating Loss • Assume one owner • EOY balance before adjustments for the results of operations and distributions • AAA=400; • AEP=1000; • AB=2000; • EOY operating results: • LTCG=400; • Operating loss=(1800)

  36. Order of Adjustments (the exception) • First: Distributions • Then: LTCG and ordinary loss.

  37. Recalling treatment for distributions: • Tier 1: From AAA: Tax free • Simultaneously reduce • AAA and AB • Recognize gain after AB. • Tier 2: In excess of AAA: dividend up to AEP • Tier 3: Remainder of AB tax free • Tier 4: Balance in excess of AB = gain

  38. Example 6: Same facts as #5 but w/$1200 dist. • EOY balance before adjustments for the results of operations and distributions • AAA=400 (from past results of S operations); • AEP=1000 (from results when business was conducted as a C Corp); • AB=2000; • EOY results: • LTCG=400; • Operating Loss=(1800) • Distribution during the year: $1200

  39. Effect on Tier 1: AAA • AAA = 400 - 400 = 0 • Note that $800 of the $1200 distribution has not been accounted for as of this time. • Simultaneous reduction of AB • EOY AB before adjustments = 2000 - 400 AAA reduction = 1600 AB balance • Results after dealing with 1st tier: • AB balance = $1600 • ROC = $400

  40. The balance of the $1200, e.g., the $800: • Effect on Tier 2: In excess of AAA, div. up to AEP. • AEP=1000-800 = 200 • Results after Tier 2: • AEP balance= $200 • $800 dividend

  41. Results of the $1200 distribution: • ROC = $400; • Dividend = $800 • Balances • AEP balance = $200 • AAA balance = 0 • AB balance = $1600

  42. After treatment of the $1200 distribution, • proceed to account for the results of operations, • $400 LTCG • $1800 ordinary loss

  43. Example 7: • AAA = Beginning balance $400 - $400 (because of distribution) + $400 LTCG - $1800 ordinary loss = - $1400 AAA negative balance • AB = Beginning balance $2000 - $400 (b/c of distribution) + $400 LTCG - $1800 loss = $200 ending balance

  44. Note: • Even if AB not enough to reflect loss, AAA will reflect it. • Distribution is greater than AB but the distribution is not taxable.

  45. Distributions under the “general rule” • (1) Adjust for results of operations • (2) Adjust for distributions.

  46. Example 8: Facts:

  47. Results from operations • Non-separately stated income and deductions • $30K • Separately stated income and deductions • LTCG: 15 • Municipal interest: 5 • Dividend income: 3 • Charitable contribution: -8

  48. Example 8: Balances at BOY • AB 60 • AAA 40 • OAA 0 • AEP 25

  49. Example 8: • First question • What is the effect of operations on the following accounts? • AB; AAA; OAA; AEP • Second question • What will be the effect of two $50K distributions, one in June 1 and the other one in December 1?

  50. SubSExample8.xls

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