CCH Federal Taxation Comprehensive Topics Chapter 21 S Corporations

Chapter 21 Exhibits 1. S Corporations—Tax Model 2. S Corporations—Treatment of Tax and Nontax Matters 3. S Corporations--Eligibility and Election 4. S Corporations—Revoking S Status 5. S Corporations—Tax Years and Accounting Methods 6. Basis Accounts—Overview 7. Basis Accounts—Outside Basis and At-Risk Basis 8. Basis Accounts—Accumulated Adjustment Account. 9. Basis Accounts—Other Adjustment Account and Previously Taxed Income Account 10. Basis Accounts—Shareholder Loans to S Corporations Chapter 21, Exhibit Contents A CCH Federal Taxation Comprehensive Topics

Chapter 21 Exhibits 11. Effect of Operating Results on Basis—Example 12. Distributions—Effect on S Corporation 13. Distributions—Effect on Shareholder 14. Distributions—Example 15. Penalty Taxes—Code Sec. 1374 Tax on Built-In Gains 16. Code Sec. 1374 Tax—Example 17. Penalty Taxes—Code Sec. 1375 Tax on Excess Net Passive Income 18. Code Sec. 1375 Tax on Excess Net Passive Income—Example Chapter 21, Exhibit Contents B CCH Federal Taxation Comprehensive Topics

S Corporations—Tax Model Code Sec. 702(a)(8) income Definition. As with partnerships, items that are always subject to ordinary treatment are lumped together in an amount called Code Sec. 702(a)(8) income or loss. Shareholders recognize Code Sec. 702(a)(8) income even if no cash is actually distributed. Accordingly, shareholders are generally not taxed on distributions. Chapter 21, Exhibit 1a CCH Federal Taxation Comprehensive Topics

S Corporations—Tax Model Computation. Code Sec. 702(a)(8) is generally operating income or loss computed as follows: • Ordinary Income “From Whatever Source Derived” (including Code Sec. 1245 recapture) • Less: Exclusions • Less: Cost of Goods Sold (resulting in gross income from business operations) • Less: Operating Expenses Chapter 21, Exhibit 1b CCH Federal Taxation Comprehensive Topics

S Corporations—Tax Model Separately Stated Items Rationale. Each shareholder of an S corporation reports her share of corporate net income based on her stock ownership. Any income, loss, deduction, or credit which could uniquely affect the tax liability of a shareholder is separately stated in the K-1 to the shareholder. Chapter 21, Exhibit 1c CCH Federal Taxation Comprehensive Topics

S Corporations—Tax Model Separately stated items include: • Passive income and losses from rental and other non-operating activities • Investment income and related expenses (e.g., dividends, investment interest, ad valorem tax on stock, investment counseling fees, etc.) • Code Sec. 1231 gain and loss • Capital gains and losses • Dividends eligible for a dividends-received deduction • Charitable contributions • Taxes paid to a foreign country or to a U.S. possession • Section 179 deduction • Recovery items (e.g., tax refunds, recovery of bad debts) • Tax-exempt income and related expense • Tax credits • Deductions disallowed in computing S corporation income Chapter 21, Exhibit 1d CCH Federal Taxation Comprehensive Topics

S Corporations—Treatment of Tax and Nontax Matters The Conduit Concept. For most tax matters, S corporations are treated like partnerships. As in the partnership conduit concept, the taxable income of an S corporation flows through to the owners on a per-day and per-share basis. Income and losses are reported on Form 1120-S, allocated to each shareholder on a supporting K-1 schedule, and then transferred, via the K-1, to the individual owners’ 1040 returns. There, at the individual level, income is taxed and losses are deducted. Chapter 21, Exhibit 2a CCH Federal Taxation Comprehensive Topics

S Corporations—Treatment of Tax and Nontax Matters The Entity Concept. The character of income and losses is determined at the entity level, not at the shareholder level. For example, a long-term capital gain reported by the S corporation remains long-term to the shareholder, even if his ownership in the S corporation had been held for a short-term period. Chapter 21, Exhibit 2b CCH Federal Taxation Comprehensive Topics

S Corporations—Treatment of Tax and Nontax Matters Distributions of Cash or Property. Actual distributions of cash or property are generally not income to its shareholders. Two notable differences with partnerships are: • Owner salaries and payroll taxes. Deductible by S corporations, not by partnerships. • Gain on distribution of property. S Corps must recognize gains (but not losses) on distributions of appreciated property to shareholders; partnerships escape this gain recognition. Chapter 21, Exhibit 2c CCH Federal Taxation Comprehensive Topics

S Corporations—Treatment of Tax and Nontax Matters Nontax Matters. For most structural matters (e.g., formation, redemptions and terminations), S corporations are treated in much the same manner as C corporations. Chapter 21, Exhibit 2d CCH Federal Taxation Comprehensive Topics

S Corporations—Eligibility and Election A corporation is treated as an S corporation only for those days for which each specific eligibility requirement is met and the required election is effective. Eligibility and election rules include: Unanimous Consent. 100% of the shareholders must consent to the S election. Deadline For Filing S Election. If a calendar year C corporation makes an S election by 3/15/x1, it is retroactive to 1/1/x1. If made after 3/15/x1, but before 3/15/x2, it is effective 1/1/x2. Chapter 21, Exhibit 3a CCH Federal Taxation Comprehensive Topics

S Corporations—Eligibility and Election One Class of Stock. Only one class of stock is permitted. • Rights to profits and assets on liquidation must be identical. • Debt may be treated as a disqualifying second class of stock. Maximum 75 Shareholders. The number of shareholders may not exceed 75. • A nonresident alien may not own shares. • Each shareholder must be an individual, an estate, or a qualified trust. • A husband and wife count as one shareholder; however, if they divorce, they count as two if they each own stock. Chapter 21, Exhibit 3b CCH Federal Taxation Comprehensive Topics

S Corporations—Eligibility and Election Ineligible Corporations. The corporation must be domestic but not a bank or insurance company. Eligible Subsidiaries. • S corporations can own C corporations, but C corporations cannot own S corporations. • S corporations can own qualified subchapter S subsidiaries (QSub). A QSub is an electing domestic corporation that qualifies as an S corporation and is 100% owned by an S corporation parent. Chapter 21, Exhibit 3c CCH Federal Taxation Comprehensive Topics

S Corporations—Revoking S Status The S election will be terminated upon one of the following events: • Over 50% consent. Over 50% of the shareholders agree to the revocation. The deadline for revoking S status is the same as the deadline for electing it. • Prior C life AND passive investment income over 25%. If an S corporation had a prior life as a C corporation and its passive investment income is over 25% of its total income for three consecutive years, it loses the S election at the start of the fourth year. Chapter 21, Exhibit 4a CCH Federal Taxation Comprehensive Topics

S Corporations—Revoking S Status The S election will be terminated upon one of the following events: • Violation of qualifications. If any of the qualifications mentioned above are violated (e.g., stock is sold to a C corporation, or a second class of stock is issued), the S election is terminated on the date of violation, and the period before the violation is considered a “short-year.” • Majority shareholder revocation. If a new shareholder owning more than 50% takes affirmative action to terminate the election, the election dies as of the date of action. After revocation or termination of an election, a new election cannot be effectively made for 5 years without IRS consent. Chapter 21, Exhibit 4b CCH Federal Taxation Comprehensive Topics

S Corporations—Tax Years and Accounting Methods An S corporation must generally use a calendar year end. However, it may elect a fiscal tax year under any of the following three conditions: • Three-Month Deferral OK. A fiscal tax year would result in income deferral of not more than three months and the shareholder-employee’s salary earned between fiscal year end and December 31 is both: • Paid during that period; and, • Proportionate to the salary paid during the preceding fiscal year. Chapter 21, Exhibit 5a CCH Federal Taxation Comprehensive Topics

S Corporations—Tax Years and Accounting Methods Business Purpose. A business purpose can be demonstrated. 1987 FYE. The S corporation retains the same fiscal tax year as was used in 1987, if in existence at that time. Chapter 21, Exhibit 5b CCH Federal Taxation Comprehensive Topics

S Corporations—Tax Years and Accounting Methods The accrual, cash and hybrid methods are available regardless of the size of the S corporation. Chapter 21, Exhibit 5c CCH Federal Taxation Comprehensive Topics

Basis Accounts—Overview Chapter 21, Exhibit 6a CCH Federal Taxation Comprehensive Topics

Basis Accounts—Overview Chapter 21, Exhibit 6b CCH Federal Taxation Comprehensive Topics

Basis Accounts—Overview Chapter 21, Exhibit 6c CCH Federal Taxation Comprehensive Topics

Basis Accounts—Outside Basis and At-Risk Basis Outside Basis General Rule. A shareholder’s outside basis is his/her stock basis. Outside basis is computed in much the same manner as a partner’s outside basis in a partnership interest. Exception. One notable exception is that the basis of stock in an S corporation is not affected by the corporation’s liabilities. This seems reasonable because, unlike a general partner, an S corporation shareholder is not personally liable for the debts of the corporation. Chapter 21, Exhibit 7a CCH Federal Taxation Comprehensive Topics

Basis Accounts—Outside Basis and At-Risk Basis At Risk Basis General Rule. At-risk rules are applied at the shareholder level. The amount of S corporation losses that the shareholder can deduct may not exceed the lesser of: • At-risk amount or • Sum of a shareholder’s stock basis and debt basis. Computation of At-Risk Basis. At-risk basis is equal to the sum of: • Cash and basis of property contributed to the S corporation (to the extent unencumbered) • Outstanding shareholder loans to the S corporation Chapter 21, Exhibit 7b CCH Federal Taxation Comprehensive Topics

Basis Accounts—Outside Basis and At-Risk Basis Computation of At-Risk Basis • Loans for which the shareholder has personal liability or has pledged as security for repayment property not used in the activity of the corporation. • However, this does not include other debts of the corporation to third parties, even if the repayment is guaranteed by the shareholder. • Allocated portion of income • Less: Allocated portion of losses • Less: Distributions at fair market value (not at partnership basis) Chapter 21, Exhibit 7c CCH Federal Taxation Comprehensive Topics

Basis Accounts—Accumulated Adjustment Account Purpose.Records and information pertaining to each shareholder’s accumulated adjustment account (AAA) are needed by S corporations only for purposes of helping shareholders determine taxability of distributions when the S corporation has earnings and profits (E&P). The C corporation connection. An S corporation has E&P only if it was classified as a C corporation in the past or acquired a C corporation. Tax effect of distributions. The fair market value (FMV) of distributions to shareholders are tax-free to the extent of the lesser of (1) AAA balance and (2) stock basis. Chapter 21, Exhibit 8a CCH Federal Taxation Comprehensive Topics

Basis Accounts—Accumulated Adjustment Account Computation.A shareholder’s AAA balance is INCREASED only by taxable income. It is REDUCED by all deductible losses/expenses, by cash distributions and by the fair market value (FMV) of property distributions. Same-year losses and distributions. Shareholders are allowed to reduce the AAA basis by the amount of current year distributions BEFORE applying current year losses against bases. This rule enables tax-free distributions to the extent of AAA, BEFORE AAA is reduced by the amount of losses. While the effect is favorable for tax-free distributions, it can also result in higher suspended losses, since distributions reduce all bases, dollar for dollar, thus lowering the limits of loss deductions and increasing suspended losses. Tax–exempt income.No adjustment to the AAA account is made for tax-exempt income such as municipal bond interest and life insurance proceeds (reduced by related expenses). Chapter 21, Exhibit 8b CCH Federal Taxation Comprehensive Topics

Basis Accounts—Accumulated Adjustment Account Negative AAA balance OK. The AAA basis (unlike the stock basis) can have a negative balance. However only losses, (not distributions) can make the AAA negative or increase a negative balance. Transferability of AAA account.If the shareholder disposes of stock, the AAA associated with the stock passes to the new owner. Chapter 21, Exhibit 8c CCH Federal Taxation Comprehensive Topics

Basis Accounts—Other Adjustment Account and Previously Taxed Income Account Other Adjustments Account (OAA) The OAA represents another form of accumulated adjustments account (AAA) in that: • The OAA is a balance sheet account in the capital section; and • The OAA is needed by S corporations only for purposes of helping shareholders determine taxability of distributions when the S corporation has earnings and profits (E&P). • Any distributions from OAA are tax-free to shareholders. Chapter 21, Exhibit 9a CCH Federal Taxation Comprehensive Topics

Basis Accounts—Other Adjustment Account and Previously Taxed Income Account Timing of distributions. Tax-free distributions from OAA cannot be made until after all accumulated E&P are paid out. Computation.The OAA balance is increased for tax-exempt income or decreased for nondeductible expenditures not properly chargeable to the AAA. Chapter 21, Exhibit 9b CCH Federal Taxation Comprehensive Topics

Basis Accounts—Other Adjustment Account and Previously Taxed Income Account Previously Taxed Income (PTI) Account Timing of distributions. Tax-free distributions from the PTI account are made after tax-free distributions reduce the OAA balance to zero. Computation.The PTI account represents a balance of undistributed net income on which the shareholders were already taxed prior to 1983. Chapter 21, Exhibit 9c CCH Federal Taxation Comprehensive Topics

Basis Accounts—Shareholder Loans to S Corporations Using loan basis for deductions. Once stock basis is zero, any additional basis reductions (losses or deductions, but NOT distributions), decrease (but not below zero) the shareholder’s basis in loans made to the S corporation. Suspended losses/deduction. Any excess of losses or deductions over both stock and debt bases is suspended until subsequent items of income or contributions arise to restore basis in debt. Chapter 21, Exhibit 10a CCH Federal Taxation Comprehensive Topics

Basis Accounts—Shareholder Loans to S Corporations Restoring debt basis. Once the basis of any debt is reduced, it is later increased (only up to the original face amount of the loan) by the subsequent net increase resulting from all positive and negative basis adjustments. The debt basis is adjusted before any increase is made in the stock basis Distributions. A distribution in excess of stock basis does not reduce any debt basis. Chapter 21, Exhibit 10b CCH Federal Taxation Comprehensive Topics

Basis Accounts—Shareholder Loans to S Corporations Same-year losses and distributions. If a loss and a distribution occur in the same year, the loss reduces the debt basis before the distribution. (This rule favors the taxpayer.) Repayment of shareholder loan with reduced basis. If an S corporation repays a shareholder loan when the debt basis is below the loan amount, the difference is treated as a capital gain. An allocation is required for partial repayments. Chapter 21, Exhibit 10c CCH Federal Taxation Comprehensive Topics

Basis Accounts—Shareholder Loans to S Corporations Example: A shareholder lends an S corporation $100,000. Subsequent losses eliminate the shareholder’s stock basis and reduce a portion of the debt basis. The S corporation repays $20,000 of the $100,000 loan when the shareholder’s basis in the loan is $75,000. The shareholder must report a capital gain in the amount of $5,000 on the receipt of $20,000, since 25% of the face value was not supported by debt basis [$20,000 x ($100,00 - $75,000)  $100,000]. Chapter 21, Exhibit 10d CCH Federal Taxation Comprehensive Topics

Effect of Operating Results on Basis—Example Chapter 21, Exhibit 11a CCH Federal Taxation Comprehensive Topics

Effect of Operating Results on Basis—Example Corp. Books: (1) Code Sec. 702(a)(8) TI (2) Stock Basis (3) At Risk Basis (4) AAA Basis (5) Debt Basis Initial bases, from $10m stock purchase on 1/1/x1 $ 10,000 $ 10,000 $ 10,000 $ 0 $ 0 Net sales 200,000 $ 200,000 200,000 200,000 200,000 Cost of goods sold (100,000) (100,000) (100,000) (100,000) (100,000) Overhead expenses (10,000) (10,000) (10,000) (10,000) (10,000) Code Sec. 1245 gain 10,000 $ 10,000 10,000 10,000 10,000 Code Sec. 1231 loss $ (10,000) (sep’ly. stated) $ (10,000) $ (10,000) $ (10,000) Chapter 21, Exhibit 11b CCH Federal Taxation Comprehensive Topics

Corp. Books: (1) Code Sec. 702(a)(8) TI (2) Stock Basis (3) At Risk Basis (4) AAA Basis (5) Debt Basis Charitable contributions $(10,000) (sep’ly. stated) $(10,000) $(10,000) $(10,000) Short-term capital loss (10,000) (sep’ly. stated) (10,000) (10,000) (10,000) Long-term capital gain 10,000 (sep’ly. stated) 10,000 10,000 $10,000 Tax-exempt interest income 15,000 (sep’ly. stated) 15,000 15,000 Lobbying expense - state officials (not deductible) $(10,000) (sep’ly. stated) $(10,000) $(10,000) Effect of Operating Results on Basis—Example Chapter 21, Exhibit 11c CCH Federal Taxation Comprehensive Topics

Effect of Operating Results on Basis—Example Corp. Books: (1) Code Sec. 702(a)(8) TI (2) Stock Basis (3) At Risk Basis (4) AAA Basis (5) Debt Basis David’s loan to S corp. $10,000 $ 10,000 $ 10,000 S corp borrowings from banks—recourse to David 10,000 10,000 S corp borrowings from banks—NONrecourse to David. 10,000 David’s additional stock purchases of S corp. stock 10,000 10,000 10,000 10,000 Cash distribution to David (10,000) (10,000) (10,000) (10,000) Balances, 12/31/x1 $125,000 $100,000 $95,000 $115,000 $80,000 $10,000 Chapter 21, Exhibit 11d CCH Federal Taxation Comprehensive Topics

Distributions—Effect on S Corporation Does an S corporation recognize gain or loss on the distribution of cash to shareholders? No, never. Chapter 21, Exhibit 12a CCH Federal Taxation Comprehensive Topics

Distributions—Effect on S Corporation Does an S corporation recognize gain or loss on the distribution of other property (other than its own stock)? Gains: Yes (compute gain in the same way as if the property were sold) Losses: No (except in complete liquidation). Chapter 21, Exhibit 12b CCH Federal Taxation Comprehensive Topics

Distributions—Effect on S Corporation What is the character of the entity’s gain on distribution of property to owners? If a shareholder owns no more than 50% of the S corporation, then the character of the entity’s gain is the same as the character of the property distributed. If a shareholder owns more than 50%, then the entity’s gain is ordinary. Chapter 21, Exhibit 12c CCH Federal Taxation Comprehensive Topics

Distributions—Effect on Shareholder Chapter 21, Exhibit 13a CCH Federal Taxation Comprehensive Topics

Distributions—Effect on Shareholder Chapter 21, Exhibit 13b CCH Federal Taxation Comprehensive Topics

Distributions—Example FACTS: An S corporation reports the following balances for its sole shareholder as of 1/1/x1: • Capital balance per corporate books: $125,000 • Stock basis: $95,000 • At-risk basis: $115,000 • AAA basis: $80,000 • Shareholder loan to S corporation: $10,000 (basis also $10,000) The S corporation reports a ($200,000) ordinary loss in 20x1. Chapter 21, Exhibit 14a CCH Federal Taxation Comprehensive Topics

Distributions—Example QUESTION: (a) What is the maximum tax-free non-stock distribution the shareholder can receive in 20x1? (Hint: The tax-free distribution is not affected by the 20x1 loss. Use the 1/1/x1 balance in AAA and any excess stock basis. ANSWER: $95,000 = $80,000 AAA + $15,000 excess stock basis) Chapter 21, Exhibit 14b CCH Federal Taxation Comprehensive Topics

Distributions—Example QUESTIONS: (b) Assuming that a $95,000 cash distribution is made to the sole shareholder in 20x1, what are the 12/31/x1 balances in stock basis, at-risk basis, AAA and debt basis? (c) What portion of the ($200,000) loss is deductible in 20x1 under the at-risk rules? (d) What portion of the $200,000 loss is suspended in 20x1 under the at-risk rules? Chapter 21, Exhibit 14c CCH Federal Taxation Comprehensive Topics

Distributions—Example If the S corporation repays the $10,000 shareholder debt in year 20x2, what are the tax consequences if: S corporation has income of $10,000 in year 20x2? (If the S corporation has income in year 20x2, the first $10,000 must restore the debt basis back to $10,000. Any income in excess of $10,000 increases the following simultaneously: (a) the stock basis, (b) at-risk basis, and (c) AAA balance. A subsequent repayment of the $10,000 shareholder loan does not result in capital gain.) S corporation has a loss in year 20x2? (Answer: A $10,000 capital gain passes through to the shareholder since the debt basis is zero.) Chapter 21, Exhibit 14d CCH Federal Taxation Comprehensive Topics

Distributions—Example Chapter 21, Exhibit 14e CCH Federal Taxation Comprehensive Topics

SOLUTION: Tax Effect of a $200,000 loss and a $95,000 distribution in 20x1 Cap. Bal. Per Books Code Sec. 702(a)(8) income (loss) Stock Basis At Risk Basis AAA Basis Debt Basis Tier 3 Distribution: (i.e. tax free to extent of any stock basis surviving the 1st tier distribution (15m = 95m - 80m) $(15,000) (15m) [tax-free] (15m) [tax-free] 0 [Dist’ns cannot create neg. AAA bal.] 0 [Debt basis is never reduced by distributions] Subtotals 30,000 0 0 20,000 0 10,000 20x1 DEDUCTIBLE LOSSES UNDER AT-RISK RULES [Apply 200m Code Sec. 702(a)(8) loss against bases and determine the amount deductible under the at-risk rules.] $(200,000) $(10,000) [Note: Only (10m) is deductible, because loss deductions are limited to the lesser of: 1. $10m (i.e., stock basis of $0, + debt basis of $10m); or 2. $20m at risk basis] 0 $(20,000) $(200,000) $(10,000) Distributions—Example Chapter 21, Exhibit 14f CCH Federal Taxation Comprehensive Topics

CCH Federal Taxation Comprehensive Topics Chapter 21 S Corporations