UCF School of AccountingTax 5015 S Corporations Chapter Twelve
Learning Objectives • Explain the requirements for being taxed under Subchapter S • Calculate ordinary income or loss • Calculate amount of any special S tax levies • Calculate S/H allocable share of ordinary income/loss and separately stated items • Determine limitations on a S/H deduction of S corp losses • Calculate a S/H basis in S Corp Stock and Debt • Determine taxability of S Corp distributions to S/H
Sub S Requirements • The shareholders - • must number no more than 75 (100 after 12/31/2004); • After 12/31/2004, family members treated as 1 shareholder • Members of family defined as: common ancestor, lineal descendants of common ancestor, and spouses of lineal descendants or common ancestor. Maximum of 6 generations. • must be individuals, estates, certain types of trusts, and certain types of tax-exempt organizations; • must be U.S. citizens or resident aliens.
Sub S Requirements • The corporation - • must be a domestic corporation; • Unincorporated entities that “check the box” to be treated as corporation are also eligible. • must not be an “ineligible” corporation; • Corporations that have special status can not be S corp (e.g. financial institutions, insurance companies) • Corporations that have elected special Puerto Rico and US possession tax credit or special Domestic International Sales Corp tax exemption • must have only one class of stock • This provision may get complicated for unincorporated “check the box” entities
The Election • Form 2553 must be filed no later than the 15th day of the 3rd month for year election is to be effective. • Tax year begins on the first day on which it acquires assets, has shareholders or begins business. • Each shareholder of a new corp must consent. • S election exempts corp from all federal income taxes except: • built-in gains tax • excess net passive income tax • LIFO recapture tax • Recapture of previously claimed ITC
Termination of the Election • The election is terminated when: • the corporation either voluntarily revokes the election • Filed during first 2 1/2 months of taxable year • Consented to by a majority of shareholders • The corporation ceases to meet the small business corporation requirements: • exceeding 75 (100) shareholder limit • having an ineligible shareholder own stock • second class of stock • retaining a prohibited tax year • failing the passive investment income test for 3 consec. years
Passive Income Test • IF S Corp’s Passive Income exceeds 25% of total gross receipts for 3 consecutive years; AND • S Corp has C Corp E&P; • THEN S Corp election terminated beginning of 4th year. • Passive Income: gains from sale of securities, royalties, rents, dividends, interest, and annuities.
S Corp. Operations • S Corp.’s make same accounting period and accounting method elections as C Corp’s. • Tax Year - usually calendar year • Although business purpose exception is allowed • Accounting Methods • Most elections made by S Corp • Exceptions: same as partnership’s - discharge of indebtedness, mining exploration expenditures, FTC
Reporting of S Corp. Income • Ordinary Income or Loss • Separately stated items (same as partnership) • Special Rules • Amortization of organizational expenditures allowed • No Dividends Received Deduction • Accrued expenses owed to S. Corp S/H not deductible by S Corp until S/H reports income • S/H’s may be employees, however those owning more than 2% of stock are not eligible for tax-free fringe benefits • Generally, no Carryback or Carryover of losses or deductions between an S Corp and a C Corp • Sec 291 Recapture applies ONLY if S Corp had been C Corp in any of its three preceding tax years.
Shareholder’s AllocationsPer Day/Per Share • Each shareholder is allocated a pro rata portion of ordinary income (loss) and all separately stated items • If stock holdings change during year, shareholder is allocated a pro rata share of each item for each day • No special allocations are allowed • No pre-contribution gain rules apply
Loss Limitations • Both ordinary and separately stated loss amounts are “passed” through to the shareholders. • The shareholder’s deduction is limited to: • s/h’s adjusted basis in the stock • plus the adjusted basis of debt owed by the corporation to the shareholder. • Additional Limitations: • The Sec. 465 at-risk rules are applied at the shareholder level. • Passive activity rules apply. The shareholder must personally meet the material participation standard to avoid the passive activity limitation. • The Sec. 183 “hobby loss” rules apply
Basis Adjustments • Stock • Initial investment (or basis at beginning of year) • Plus: • Additional contributions • Share of ordinary and sep.stated income and gains • Minus (in order): • S Corp Distributions (not out of C Corp E&P) • Non-deductible expenses not chargeable to capital • Share of ordinary and separately stated losses • Equals: Adjusted Basis of S Corp stock • Debt • decrease for losses if stock basis reduced to zero • increase for ord inc and/or sep. stated. gains up to original basis
S Corp Distributions:no C Corp E&P present • Consequences to Shareholder • Reduce Basis in Stock • Distributions in Excess of Basis are Capital Gain • S/H takes FMV basis in distributed property • Consequences to S Corp • Must recognize gain on distribution of appreciated property • Can not recognize losses
S Corp Distributions:S Corps with C Corp E&P • Cash Distribution: • AAA (Tax Free up to S/H’s Basis in Stock) • PTI (Tax Free up to S/H’s Basis in Stock) • Accumulated E & P (Taxable) • Other Adjustments Account (Tax-Free up to S/H’s Basis in Stock) • Basis of Stock (Tax Free) • Capital Gain on Sale of Stock Once Basis Reduced to Zero • Property Distribution: same rules as for cash distributions except: • Gain recognized by S Corp on distribution of appreciated property • Shareholder takes a FMV basis in distributed property
AAA Account • Accumulated Adjustments Account: represents cumulative income/loss recognized in post-1982 S Corp years. • Computed as follows: • Beginning of Year AAA Balance • Plus: • ordinary income • separately stated income items (not tax-exempts) • Minus (IN ORDER): • expenses that are not deductible in determining ord. Income • Ordinary loss • separately stated deduction and loss items (not tax-exempt) • distributions made during year from AAA • Equals: End of Year AAA Balance • Note: if net adjustments (not including distributions) is negative, then distributions are deducted first (before any other adjustments).
OAA Account • Other Adjustments Account (OAA) maintained only by corps having accumulated E&P at year end • Computed as follows: • Beginning of year OAA Balance • Plus:Tax Exempt Income Received • Minus: • Expenses incurred in earning tax-exempt interest • Distributions from OAA • Federal taxes paid by S Corp that are attributable to C Corp tax years • Equals: End of year OAA Balance
Excess Net Passive Income Tax • If S Corp’s Passive Investment Income exceeds 25% of its gross receipts AND • it has C Corp E & P at close of tax year • THEN S Corp pays tax on excess net passive income at 35% • Recall that Passive income was defined previously as: gains from sale of securities, royalties, rents, dividends, interest, and annuities • Net Passive Income = Total passive income less deductions directly connected • Excess Net Passive Income = • Net Passive Income x [(Passive Investment Income - 25% of gross receipts)]/Passive Investment Income • Income passed through to shareholders is reduced by the amount of the tax
Built-in Gains Tax • C Corp Converting to an S Corp incurs corporate level tax on any built-in gains when asset disposed of at a gain within 10 years of conversion. • Tax applies to any asset disposition (e.g. accounts receivable, inventory, real estate, etc). • Tax levied at 35% on the lesser of: • Built-in gains recognized for tax year • Taxable income (computed as if C corp, ignoring DRD and NOL) • Net unrealized Built-in gains at conversion less total recognized built-in gain for prior tax years • Tax not levied if asset acquired after 1st day of S status • Built-in Gains Tax reduces amount of regular gain pass through to S Corp S/H’s from sale of assets