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Chapter 11: S Corporations

Chapter 11: S Corporations. Chapter 11: S Corporations. S CORPORATIONS (1 of 2). Should an S election be made? S corporation requirements S corporation election Termination of S election Tax year Ordinary income/loss and separately stated items. S CORPORATIONS (2 of 2).

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Chapter 11: S Corporations

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  1. Chapter 11:S Corporations Chapter 11: S Corporations

  2. S CORPORATIONS(1 of 2) • Should an S election be made? • S corporation requirements • S corporation election • Termination of S election • Tax year • Ordinary income/loss and separately stated items

  3. S CORPORATIONS(2 of 2) • Special S corporation taxes • Shareholder allocations • Loss limitations • Additional limitations • Family S corporations • Basis adjustments • S corporation distributions

  4. Should an S ElectionBe Made (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 ElectionBe Made (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 ElectionBe Made (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 ElectionBe Made (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 ElectionBe Made (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 Requirements (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 Requirements (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 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 Election(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 Election(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 Election(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 Year(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 Year(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 & Separately Stated Items (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 & Separately Stated Items (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 & Separately Stated Items (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 Taxes • 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 recognized • Built-in gains tax applies to dispositions during 10-year period after S election is made • See 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 Allocations(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 Allocations(2 of 2) • Divide item by # of days in tax year • Daily amount for each item • Divide daily amount by # of shares o/s • Daily amount per share for each item • Total daily allocations for a share • Multiply amount per share times # of shares held by owner

  28. Loss 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 Limitations(1 of 2) • §465 at-risk rules applied at s/h level • Passive 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 Limitations(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 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 Adjustments(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 Adjustments(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 Distributions (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 Distributions (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 Distributions (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 Distributions (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 Rules(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 Rules(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. End of Chapter 11 Comments or questions about PowerPoint Slides?Contact Dr. Richard Newmark atUniversity of Northern Colorado’sKenneth W. Monfort College of Businessrichard.newmark@PhDuh.com

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