1

Chapter 11:S Corporations

2

S CORPORATIONSS CORPORATIONS(1 of 2)(1 of 2)

Should an S election be made?S corporation requirementsS corporation electionTermination of S electionTax yearOrdinary income/loss and separately stated

items

3

S CORPORATIONSS CORPORATIONS(2 of 2)(2 of 2)

Special S corporation taxesShareholder allocationsLoss limitationsAdditional limitationsFamily S corporationsBasis adjustmentsS corporation distributions

4

Should an S ElectionShould an S ElectionBe Made Be Made (1 of 5)(1 of 5)

Advantages of S corp– No corporate level taxation

» Income taxed directly to shareholders• Benefit reduced because dividends are generally taxed to

individuals at 15%

– All items retain character in s/h’s hands »E.g., tax-exempt income earned by S corp is tax-exempt

to s/h»Limitations are computed at s/h level

5

Should an S ElectionShould an S ElectionBe Made Be Made (2 of 5)(2 of 5)

Advantages of S corp (continued)– S corp losses can be used to offset

s/h’s other income

– Allowed to split S corp income between family members (with restrictions)

– S corp earnings not subject to SE tax

6

Should an S ElectionShould an S ElectionBe Made Be Made (3 of 5)(3 of 5)

Disadvantages of S corp– Earnings retained by C corp taxed at rates

generally lower than s/h’s marginal tax rates– S corp earnings taxed to s/h even if no

distributions are made– S corps subject to excess net passive

income tax & built-in gains tax

7

Should an S ElectionShould an S ElectionBe Made Be Made (4 of 5)(4 of 5)

Disadvantages of S corp (continued)– No dividends-received deduction– No special allocations allowed

» Income allocated based on ownership

– S corp liabilities do not increase loss limits»Except for s/h loan to S corp

8

Should an S ElectionShould an S ElectionBe Made Be Made (5 of 5)(5 of 5)

Disadvantages of S corp (continued)– S corps and s/hs subject to at-risk rules,

passive activity limits, and hobby loss rules

– S corp restricted in type & number of s/hs

– S corps generally must use calendar year

9

S Corporation S Corporation RequirementsRequirements (1 of 2) (1 of 2)

Shareholder requirements– No more than 75 shareholders– Individuals, estates, and certain types of

trusts (including QSSTs)»QSSTs may be complex trusts

– U.S. citizens or resident aliens– Tax-exempt public charity or private

foundation may be a shareholder

10

S Corporation S Corporation RequirementsRequirements (2 of 2) (2 of 2)

Corporation-related requirements– Domestic corporation– Must not be an “ineligible” corporation– Only one class of stock– May be a Qualified Subchapter S Subsidiary

(QSSS)»QSSS is 100% owned by an S corp»Assets, liabilities, income deductions, etc.

considered owned by S corp parent

11

S Corporation ElectionS Corporation Election

Form 2553 must be filed no later than 15th day of third month for year election is to be effective– A new corporation’s tax year begins on first

day it acquires assets, has shareholders or begins business

All shareholders must consent to election

12

Termination of S ElectionTermination of S Election(1 of 3)(1 of 3)

Voluntary S election termination– Owners of more than 50% of the

corporation’s stock must agree– Revocation made w/in 1st 2-1/2 can be

retroactive to beginning of year»Otherwise, election effective for 1st day of

next taxable year

13

Termination of S ElectionTermination of S Election(2 of 3)(2 of 3)

Involuntary S election termination– Occurs when corporation ceases to meet S

corporation requirements

If termination occurs during tax year– Portion of year prior to termination is a short S

corp year and– Portion of year after termination is a short C corp

year

14

Termination of S ElectionTermination of S Election(3 of 3)(3 of 3)

Inadvertent termination can be undone

New S corp election cannot be made for 5 tax years after termination– Unless inadvertent termination

15

Tax YearTax Year(1 of 2)(1 of 2)

Permitted tax years– A year ending on December 31, or

– Any fiscal year where a business purpose has been established including a natural business year

16

Tax YearTax Year(2 of 2)(2 of 2)

Other tax years may be elected– Ownership year - same year as shareholders

owning 50% of stock– Facts and circumstances year– §444 allows S corp to elect a fiscal year end of

9/30 or later w/o satisfying business purpose exception»Advance payments required to eliminate benefit of

income deferral

17

Ordinary Income/Loss & Ordinary Income/Loss & Separately Stated ItemsSeparately Stated Items (1 of 3) (1 of 3)

Income is divided between ordinary and separately stated items

Separately stated items same as for partnerships, including passive activities and portfolio activities– Refer to Form 1120S Schedule K in

Appendix B for a complete listing

18

Ordinary Income/Loss & Ordinary Income/Loss & Separately Stated ItemsSeparately Stated Items (2 of 3) (2 of 3)

S corps cannot deduct– Dividends-received deduction– Personal or dependency exemption– “Personal” itemized deductions– Taxes paid/accrued to foreign country– Charitable contributions– Oil & gas depletion or NOL carrybacks

19

Ordinary Income/Loss & Ordinary Income/Loss & Separately Stated ItemsSeparately Stated Items (3 of 3) (3 of 3)

Net operating losses– NOLs created when a C corp cannot be

carried back/forward to S corp years– NOLs created when an S corp cannot

be carried back/forward to C corp years

20

Special S Corporation Special S Corporation TaxesTaxes

Special levies apply to S corps– Excess net passive income tax

– Built-in gains tax

– LIFO recapture tax

21

Excess Net Passive IncomeTax

S corp has passive income in excess of 25% of S corp gross receipts and has C corp E&P

Excess net passive income taxed at highest corporate tax rate (35%)

See Example C11-11

22

Built-in Gains Tax(1 of 2)

Imposed on income/gain that would have been included in gross income while a C corp if corp had used accrual accounting– E.g., property with a FMV in excess of

basis on day S election was made

23

Built-in Gains Tax(2 of 2)

Tax is 35% (top corp rate) on net built-in gains recognized during tax year– Built-in gains recognized less any built-in losses

recognizedBuilt-in gains tax applies to dispositions during

10-year period after S election is madeSee Example C11-13

24

LIFO Recapture Tax(1 of 2)

Applies to C corps using LIFO inventory method who make an S election

LIFO recapture amount is excess of inventory basis using FIFO over inventory basis using LIFO at close of final C corp tax year

25

LIFO Recapture Tax(2 of 2)

LIFO recapture amount included in taxable income of corp’s final C corp tax year– Additional tax can be paid in four annual

installments– S corp’s basis in inventory increased by LIFO

recapture amount

See example C11-14

26

Shareholder AllocationsShareholder Allocations(1 of 2)(1 of 2)

S/hs report pro rata share of ordinary income & separately stated items

– Known as per day/per share method See Example C11-16

27

Shareholder AllocationsShareholder Allocations(2 of 2)(2 of 2)

1. Divide item by # of days in tax year» Daily amount for each item

2. Divide daily amount by # of shares o/s» Daily amount per share for each item

3. Total daily allocations for a share4. Multiply amount per share times # of

shares held by owner

28

Loss LimitationsLoss Limitations

Ordinary & separately stated loss amounts “passed” through to s/h

S/h’s deduction limited to adjusted basis in stock plus adjusted basis of debt owed directly by corp to s/h

29

Additional LimitationsAdditional Limitations(1 of 2)(1 of 2)

§465 at-risk rules applied at s/h levelPassive activity rules

– S/h must meet material participation std. to avoid passive activity limitation

§183 “hobby loss” rules apply at s/h level

30

Additional LimitationsAdditional Limitations(2 of 2)(2 of 2)

Post termination loss carryovers– Unused S corp losses due to basis

limitations– Carried over up to 1 yr after termination

»Depending on reason for termination

– Unused loss carryovers after post termination period are lost

31

Family S CorporationsFamily S Corporations

Donee or purchaser of stock in S corp not considered a s/h unless– Such stock acquired in bona fide

transaction AND

– Donee or purchaser is the real owner of stock

32

Basis AdjustmentsBasis Adjustments(1 of 2)(1 of 2)

Initial investment+ Additional contributions+ Share of income/separate items- Distrib’s excluded from s/h gross inc.- Non-deductible expenses not chargeable to

capital- Share of losses/distributions= Ending basis (but not below zero)

33

Basis AdjustmentsBasis Adjustments(2 of 2)(2 of 2)

Basis adjustments to s/h debt– After stock basis reduced to zero, basis

reduction applies to indebtedness based on relative adjusted basis for each loan

Loss/deduction not currently deductible is suspended until s/h has basis in debt or stock

34

S Corporation S Corporation DistributionsDistributions (1 of 4) (1 of 4)

Distributions for S Corp w/o AE&P – Money distributions tax-free and

reduce s/h basis, but not below zero

– When s/h has a zero basis, distributions received treated as gain from sale of stock

35

S Corporation S Corporation DistributionsDistributions (2 of 4) (2 of 4)

Distributions for S Corp w/o AE&P (continued)– Corporation recognizes gain on

distribution of appreciated property»No loss reported when corp distributes

property that has declined in value

36

S Corporation S Corporation DistributionsDistributions (3 of 4) (3 of 4)

Distributions for S Corp w/ AE&P – Distributions based on tiers of earnings

»Distributions from AAA are tax-free»Distributions from AE&P are taxable»Distributions that reduce basis in S corp stock are tax-

free»Distributions over stock basis are taxable

– See Table C11-1 and Example C11-27

37

S Corporation S Corporation DistributionsDistributions (4 of 4) (4 of 4)

Distributions for S Corp w/ AE&P (continued) – S corp can elect to skip over AAA in

determining source of distributions»May be advantageous for s/hs who want to

recognize dividend income before 15% rate expires after 2008

38

Other S Corp RulesOther S Corp Rules(1 of 2)(1 of 2)

Alternative minimum tax– No S corp AMT

»AMT items pass through to s/h

Related party transactions– §267 related party rules apply between s/h and

S corp– §267 applies to S corp and another entity if

>50% of both entities owned by same persons

39

Other S Corp RulesOther S Corp Rules(2 of 2)(2 of 2)

Fringe benefits paid to s/h-employee– For 2% (or more) s/h, S corp treated

like a partnership»Many benefits tax-free to C corp s/h-

employees are taxable to S corp s/h-employees

40

Comments or questions about PowerPoint Slides?Contact Dr. Richard Newmark atUniversity of Northern Colorado’s

Kenneth W. Monfort College of Businessrichard.newmark@PhDuh.com