STRUCTURE. Schedule K consists of Sales COGS Rent G&A Salary Charity Capital Loss Net Income

Transcription

1 SCORP

2 STRUCTURE Operation and Separately stated items Distributions to shareholders AAA Account Health insurance premiums S Status Termination Built in gains tax Schedule K consists of Sales COGS Rent G&A Salary Charity Capital Loss Net Income

3 FORMATION Eligibility Must be a domestic corporation. Must not consolidate with a C Corp subsidiary If cash or property 80% or more, (control), then tax free to both; carryover basis; carryover holding period. If services or cash+property<80%, then taxable at FMV of stock May own any interest in a C corporation (even 100%), but the S Corporation may not file a consolidated tax return with the C corporation. Would file as one entity with an wholly owned S Corporation subsidiary.an S Corporation may also create a qualified S subsidiary in which it owns 100% of the stock; the two S Corporations would file as one entity for tax purposes. No more than 100 shareholders. Family members may elect to be treated as one shareholder. Family members include common ancestors, lineal descendants of common ancestors, and their current or former spouses. No more than one class of stock outstanding. However, differences in common stock voting rights are allowed. Preferred stock is not permitted Eligible Shareholders: individuals, estates, and Grantor and voting trusts. Qualified retirement plans, trusts, and 501(c)(3) charitable organizations Not Eligible Shareholders: Nonresident alien; Corporations; partnerships

4 FORMATION Election to be an S Corporation Who must consent: 100% of existing shareholders (voting and nonvoting) must consent to a valid election. Effective date of election Election is always effective on the first day of the tax year. In any calendar tax year, if the election is made before March 15, it is effective Jan 1 of the current year. If after March 15, it is Jan 1 of the next year

5 OPERATION Effect of S Corporation Election on the entity Tax form, tax year and tax effect Form to file: S corporations file Form 1120S Tax year: S Corporation must adopt the calendar year, unless a valid business purpose for a different taxable year (fiscal year) is established. Return Due: The return is due by the 15th day of the third month (March 15) after the close of the tax year. Pass through tax effect: Generally, there is no tax at the corporation level; all earnings are passed through to shareholders. There are certain exceptions (see item 0, below).

6 TERMINATION The S corporation status will terminate as a result of any of the following: Holders of a majority of the corporation's stock (any combination of voting and nonvoting common stock) consent to a voluntary revocation; The corporation fails to meet any or all of the eligibility requirements (qualifications) for S corporation status; or More than 25% of the corporation's gross receipts come from passive investment income for three consecutive years and the corporation had C corporation earnings and profits at the end of each year. The S corporation status is terminated as of the beginning of the fourth year.

7 TERMINATION Re-election Once an S corporation election is terminated or revoked, a new election cannot be made for five years unless the IRS consents to an earlier election. If the termination occurs in midyear, the corporation will have two short years, a short S year and a short C year. Earnings are prorated on a daily basis to each of the short years. A special election may be made to "cut off" net income at the exact date of conversion.

8 DISTRIBUTIONS Special Taxes I. Distributions Distributions may trigger corporate gain, but normally represent a return of capital to shareholders. A. Corporate gain -- The corporation generates gains by distributing appreciated property. 1. The gain is passed through to shareholders like other income. Example: S Corporation distributes land to its sole shareholder. If the land has a value of $100 and an adjusted basis of $80 on the date of distribution, then S Corporation will recognize $20 of income on the distribution. No tax will be imposed on S Corporation. Instead, the gain will be passed through to the shareholder.

9 Income related to basis Income comes in and it s either regular income, or separately stated. What s the difference? Regular income gets passed onto the shareholder on the K1, I think, and separately stated items get passed on as that type of income specifically

10 SHAREHOLDER INCOME B. Shareholder income if corporation has no E&P -- A distribution creates a gain to the shareholder if the distribution exceeds the shareholder's adjusted basis in the stock. 1. The amount of a distribution is the amount of cash plus the value of any property distributed. 2. Distributions in excess of adjusted basis are taxed as gains from the sale of stock. 3. Shortcut -- Distributions in excess of adjusted basis will most likely be taxed as capital gains because stock will most likely be a capital asset in the hands of the shareholder (an asset held for investment).

11 SHAREHOLDER INCOME C. Shareholder income if S corporation has E&P -- Shareholders of S corporations with accumulated earnings and profits (E&P) from a previous status as a C corporation are subject to a complex distribution system. 1. Shortcut -- An S corporation that has always been an S electing corporation will not need to use an accumulated adjustments account unless and until the S election is terminated. In addition, an S corporation, that was previously a C corporation, will not need to use an accumulated adjustments account unless the corporation had earnings and profits from this prior period.

12 SHAREHOLDER INCOME EXPLANATION OF AAA Accumulated Adjustments Account and OAA Other Adjustments Account 2. Accumulated undistributed income generated during S status is recorded at the corporate level in the "Accumulated Adjustments Account" (AAA). 3. AAA is adjusted in the same way as stock basis except (1) no adjustment is made for tax exempt income (and related expenses) and (2) AAA can be negative (only losses can reduce AAA below zero; distributions cannot create a deficit in AAA). 4. OAA is the "Other Adjustments Account" that tracks tax exempt income earned by the corporation. 5. Distributions follow this order: first tax-free from AAA (previously taxed to shareholders) and then from E&P (dividend income). All other distributions (including from other adjustments account or OAA) are a return of capital (tax-free up to the remaining stock basis, then capital gain). a. An S corporation can make a "bypass election", which allows the distribution to first come from E&P and then AAA.

13 SHAREHOLDER INCOME 6. Distributions from AAA reduce the balance of AAA (but distributions never reduce AAA below zero - only losses can accomplish this feat). 7. Distributions from AAA and OAA reduce the adjusted basis of the shareholder's stock. Example: At the end of this year, ABC corporation (an electing S corporation) has AAA of $100 and E&P of $50. If ABC makes a distribution of $180 to its sole shareholder, the shareholder will report the first $100 as a return of capital, the next $50 as dividend income, and the final $30 as a return of capital. If SH had a basis in his ABC stock immediately before the distribution of $80, he would report a gain of $50 ($100 + $30 - $80).

14 SHAREHOLDER INCOME D. Distributions of cash during a minimum one-year period following termination of an S corporation election receives special treatment. 1. Treated as a tax-free recovery of stock basis to the extent it does not exceed AAA balance. 2. Since only cash distributions receive this special treatment, the corporation should not distribute property during this post-termination transition period.

15 DISTRIBUTION Because S corporations are only subject to a single level of tax, distributions from an S corporation are generally not subject to taxation for shareholders. The rules for determining the taxability of distributions are presented on the next slide.

16 DISTRIBUTION S Corporation with No C Corporation E&P Distribution Tax Result Treatment 1 st To extent of basis in stock Not subject to tax, reduces basis in stock Return of capital 2 nd In excess of basis stock Taxed as long-term capital gain (if stock held for > year) Capital gain distribution Example Always Corporation, a calendar year S corporation since its formation in 1990, has two equal shareholders, A and W. During 20X5, A received distributions from Always Corporation of $22,000. At December 31, 20X5 after all adjustments to basis had been made, except for distributions, A s basis in his Always stock was $18,000. For 20X5, A will treat $18,000 as a nontaxable return of capital (reduction of basis of stock) and a $4,000 long-term capital gain.

17 DISTRIBUTION Shareholder income if S corporation has C Corporation E&P Accumulated Adjustments Account ("AAA") The tax effects of distributions paid to shareholders of an S corporation that has accumulated earnings and profits since inception (or since the most recent electing of S status) are computed by using the accumulated adjustments account (AAA). The AAA is zero at the inception of the S corporation.

18 DISTRIBUTION Increases to the AAA The AAA is essentially increased by separately and nonseparately stated income and gains (except tax-exempt income and certain life insurance proceeds). Decreases to the AAA The AAA is essentially decreased by corporate distributions (distributions may not reduce the AAA below zero), separately and non-separately stated expense items and losses (except for certain non-deductible items that do not affect the capital account), and non-deductible expenses (except life insurance premiums on a contract that is owned by the corporation and that identifies the corporation as beneficiary) that relate to income other than tax-exempt income.

19 DISTRIBUTION Below are the rules for determining the taxability of distributions for an S Corp that has C Corporation E&P. S corporation with C Corporation E&P Distribution Tax Result Treatment 1 st To extent of AAA Not subject to tax, reduces basis in stock S-Corp (already taxed) profits 2 nd To extent of C corporation E&P 3 rd To extent of basis in stock 4 th In excess of basis in stock Taxed as a dividend, does not reduce basis in stock Not subject to tax, reduces basis in stock Taxed as long-term capital gain Old C-Corp taxable dividend Return of capital Capital gain distribution

20 DISTRIBUTION As previously presented, "AAA" stands for Accumulated Adjustments Account, which essentially means the cumulative amount of S corporation income or loss (separately and nonseparately stated items, excluding tax-exempt income) since the corporation most recently elected S status, less all cumulative distributions. Distributions may not reduce AAA below zero; however, AAA may be negative from S corporation losses.

21 DISTRIBUTION Example The New Elect Corporation, was a C corporation until it elected S status on January 1, New Elect had accumulated E&P of $20,000 at December 31, For the period , New Elect had ordinary income of $100,000 and had made shareholder distributions of $60,000. Thus, New Elect s AAA balance at December 31, 2006 was $40,000. In 2007, New Elect had ordinary income of $40,000 and made distributions to shareholders of $110,000. The tax result of these 2007 items are as follows. (1) To extent of AA ($40,000 + $40,000 = $80,000)..Tax-free (2) To extent of C corporation E&P ($20,000) Dividend (3) Excess ($10,000).Reduces basis in stock, if in excess of basis, LTCG

22 CERTAIN CORPORATION-LEVEL TAXES There are three principal taxes imposed upon S corporations 1. LIFO Recapture Tax C corporations that elect S status must include in taxable income for the last C Corporation year the excess of inventory computed under FIFO over LIFO (cumulative basis). The resulting tax on the C Corporation may be paid in four equal installments, the first of which is due with the final C corporation return. The remaining installments are paid by the S corporation.

23 CERTAIN CORPORATION-LEVEL TAXES 2. Built-In Gains Tax A distribution or sale of an S corporation's assets may result in a tax on any "built-in gain" at the corporate-level. An unrealized "built-in gain" results when the following two conditions occur: (i) A C corporation elects S corporation status, and (ii) The fair market value of the corporate assets exceeds the adjusted basis of corporate assets on the election date. The net unrealized built-in gain is the excess of the fair market value of corporate assets over adjusted basis of corporate assets at the beginning of the year of which S corporation status is elected. The amount of "built-in gain" recognized in any one year is limited to the net unrealized "built-in gain" less any "built-in gain" previously recognized.

24 CERTAIN CORPORATION-LEVEL TAXES Built-In Gains Tax An S corporation can be subject to tax if the corporation sells property that contained a "built-in" gain at the time of the S election. Definition Built-in gain property : For purposes of a tax on an S corporation, is appreciated property (value in excess of adjusted basis) as of the beginning of the first year of the S status. A. Shortcut -- A built-in gains tax is not imposed on a corporation that has always been an S electing corporation. B. The tax is imposed at the highest corporate rate and is limited to the net amount of built-in gain at the time of election.

25 CERTAIN CORPORATION-LEVEL TAXES C. The tax can only be imposed for a period of 10 years after the S election is made. 1. For S corporation years beginning in 2011, the built-in gains tax is not imposed if the 5th tax year in the 10-year period preceded the 2011 tax year (i.e., if S election was made in 2006). D. In the year of the sell, if property is also sold that had built-in losses at the date of the S election, these built-in losses can offset the built-in gains. E. The total built-in gain subject to this tax in any given year is also limited to the S corporation's taxable income for that year. Example: ABC Corporation made an S election this year and, at the time of the election, it held property with a value of $100 and the basis of $80. ABC will be taxed on this $20 built-in gain (at the highest corporate rate) if the property is sold any time during the next 10 years.

26 CERTAIN CORPORATION-LEVEL TAXES Built-in Gains Exemptions from Gain Recognition An S corporation is exempt from a tax on "built-in gains" under any of the following circumstances: (1) The S corporation was never a C corporation. (2) The sale or transfer does not occur within 10 years of the first day of the first year that the S election is made. (3) The S corporation can demonstrate that the appreciation occurred after the S election. (4) The S corporation can demonstrate that the distributed asset was acquired after the S election. (5) The net unrealized built-in gain has been completely recognized in prior tax years. Calculation of Tax The tax is calculated by multiplying 35% (the highest corporate tax rate) by the lesser of the following: (1) Recognized built-in gain for the current year, or (2) The taxable income of the S corporation if it were a C corporation.

27 CERTAIN CORPORATION-LEVEL TAXES 3. Tax on Passive Investment Income (35%) on the lesser of net income or excess passive investment income if the following two tests are met: (1) The S corporation has accumulated C corporation earnings and profits (i.e., accumulated earnings attributable to prior periods in which the corporation was a C corporation), and (2) Passive investment income (e.g., royalties, dividends, interest, rents, and annuities but not gains on sales of securities) exceeds 25% of gross receipts.

28 CERTAIN CORPORATION-LEVEL TAXES Tax on Passive Investment Income Tax An S corporation can be subject to the top corporate tax rate if the corporation reports excessive passive investment income and the corporation has E&P from prior status as a C corporation. Definition Passive income : For purposes of this test includes interest, dividends (except dividends from a subsidiary to the extent the subsidiary is conducting an active trade or business), royalties, and rents (unless substantial extra services are provided). A. Excessive passive income is passive income over 25% of gross receipts. B. The IRS may waive this tax if the corporation establishes that it made distributions within a reasonable time of discovering that E&P existed from a prior year. Example: ABC Corporation made an S election this year and, at the time of the election, it had E&P. This year ABC will be subject to a tax on excessive passive income if it receives interest of $100 and no other revenue. C. Shortcut -- A corporation that has never been a regular "C" corporation or does not have E&P from a prior period as a "C" corporation cannot be subject to the corporate tax on excessive net passive income.

29 INCOME AND BASIS Tax Forms: Form 1120S and Form 1120SK-1 I. Operating Rules A. Required year-end -- Rather than pay the corporate tax, S corporations report income to shareholders on a year-end consistent with that of the shareholders. B. A calendar year-end -- This is generally the default for S corporations. 1. S corporations can elect a fiscal year-end (with IRS permission) if there is a business purpose to the election. The most common business purpose is to elect a "natural" business year. Definition A 'natural' business year : A year in which 25% or more of the gross receipts occur in the last two months of the year (three consecutive years). 2. S corporations may elect a year-end under Section 444 with no more than 3 months of deferral (a deposit with the IRS is required to compensate the government for the deferral benefits to the shareholders if the benefits exceed $500).

30 INCOME AND BASIS SEPARATELY STATED ITEMS Definition Separately stated items : Any tax items (deductions, income, preferences, etc.,) that might affect owners differently. These items retain their character to the owners and must, therefore, be reported separately for each owner. Capital gains and losses Section 1231 gains and losses Dividends and interest Passive activites Charitable contributions Section 179 depreciation election Tax credits

31 INCOME AND BASIS II. Reporting Operations S corporations calculate taxable income (reported on Form 1120S) in a manner similar to partnerships (e.g., no "personal" deductions). A. S corporations may use the cash basis of accounting unless the corporation is a "tax shelter." B. An "S" corporation reports taxable income (ordinary income) and separately stated items for each shareholder on Schedule K-1 whether or not any dividends were declared. C. S corporations are not entitled to most special corporate deductions, such as the dividends-received deduction. D. S corporations do not pay alternative minimum tax, personal holding company tax, or accumulated earnings tax. E. S corporations make most of the tax elections (not shareholders), including the election to amortize organization and start-up costs.

32 INCOME AND BASIS III. Income Flow-Through to Shareholders Each shareholder reports income consistent with the period in which the corporate stock was held. A. Each shareholder reports income and separately stated items according to pro rata share of stock ownership. 1. If relative interests change during the year, each shareholder calculates the share of income on a daily basis. 2. To calculate the daily share of income prior to (or after) the change in shares, divide annual income (and separately stated items) by the number of days in the year. Next, multiply this amount by (1) number of days prior to (after) the change and (2) the percentage ownership interest. Example: As of January 1 of this year, TP1 owned all 100 shares of ABC, a calendar year S corporation. On February 9th (the 40th day of this year), TP1 sold 25 shares to TP2. This year (365 days), ABC reported $73,000 in nonseparately stated income and made no distributions to shareholders. What amount of nonseparately stated income should TP1 report from ABC? TP1 should report income of $56,750 calculated using the daily income ($200 per day) for the 40 days TP1 owned 100% and 75% of the daily income for the 325 days after the sale. Note, that the seller is deemed to own the shares on the day of the sale.

33 INCOME AND BASIS 3. If a shareholder's interest is completely terminated (death or sale), then the share can be calculated by closing the books as of the termination date (an "interim" close). However, all shareholders, including the departing shareholder, must agree to this treatment. Example: As of January 1 of this year, TP1 owned half of the 100 shares of ABC, a calendar year S corporation. On February 10th TP1 sold all of his shares to TP2. This year (365 days) ABC reported $73,000 in ordinary income, that accrued ratably throughout the year, and a capital loss of $3,650, which occurred on June 30. What amount of nonseparately stated income should TP1 report from ABC? Unless the shareholders elect an interim close, TP1 should report ordinary income of $4,000 ($200 per day for the 40 days TP1 owned 50%) and a capital loss of $200 ($10 per day for the 40 days TP1 owned 50%). If all the shareholders elect an interim close, then TP1 still reports the $4,000 of ordinary (it accrued ratably). TP1 cannot, however, report any of the loss because it occurred after he sold his stock.

34 INCOME AND BASIS IV. Shareholders Adjusted Stock Basis Each shareholder has an adjusted basis in his S stock that must be modified by contributions, income, distributions, and expenses. A. First, contributions to capital increase the shareholder's adjusted basis. B. Second, the shareholder's share of income (including exempt income) increases the shareholder's adjusted basis. C. Third, distributions to the shareholder decrease the shareholder's adjusted basis. D. Fourth, the shareholder's share of loss (including nondeductible expenses) decreases the shareholder's adjusted basis.

35 INCOME AND BASIS Calculation of S Shareholder's Basis Initial Basis Plus: Additional Contributions Shareholder's share of: Corporate Income Exempt Income Less: Distributions from AAA: cash inventory and receivables other property Shareholder's share of: Nondeductible Expenses Corporate Loss

36 INCOME AND BASIS V. Loss Limitations Shareholders? Loss deductions are limited in four ways. A. First, the adjusted basis of the stock limits loss deductions because a shareholder's basis cannot be reduced below zero. B. Second, the adjusted basis of loans to the corporation by the shareholder can be used for loss deductions once the adjusted basis of the stock is exhausted. However, later increases in basis are used to restore the basis of the debt before basis of the stock. 1. Debt basis is created when the shareholder loans his or her own funds to the S corporation. C. Third, shareholders may only deduct losses to the extent they are "at risk" for investments in the corporation. D. Fourth, passive loss limits may also limit loss deductions depending upon the nature of the corporate business and the shareholders participation in management activities. E. Unused losses (due to inadequate basis) are carried forward indefinitely (until the adjusted basis of the stock increases or the S election is revoked). F. If an S corporation contributes appreciated property to a charitable organization, the corporation can deduct the fair market value of the property. However, S corporation shareholders can reduce their basis by only the contributed property's basis.

37 INCOME AND BASIS Example: This year S corporation, an S electing corporation, reported the following: Gross income $210,000 Business expenses 283,000 Charitable contributions 14,600 S has two shareholders: PW owns 10% of the stock and M owns 90%. What amount should PW report this year from S? S operated at a $73,000 loss, so PW should report $7,300 of loss and $1,460 of charitable contributions. Suppose that PW sold his stock 60 days after the beginning of the year. If PW sold his stock, then (absent a terminating election) the operating loss would be prorated on a daily basis. Hence, S incurred a daily loss of $200 ($73,000/365) and PW's share would be $1,200 ($200x60x10%). Likewise, the charitable contribution would be $240 ($40x60x10%).

38 INCOME AND BASIS Example: ABC, a calendar year S corporation, had an ordinary loss of $36,500 this year. TP owned 50% of ABC for the first 40 days of the year before selling the stock to an unrelated party. TP's basis in the stock was $10,000 and TP was a full-time employee of the corporation. What is TP's share of the loss this year? The share of the loss is $2, calculated by multiplying TP's share (50%) of the daily loss ($100) times the number of days TP held the stock (40).

39 INCOME AND BASIS Effect of S Corporation Election on the shareholders Pass through Income and/or Losses Types of income/losses Like partnerships, S corporations report both separately and non-separately stated items of income and/or loss. Separately stated income items include dividends, interest, capital gains and losses, Section 1231 gains and losses, etc. Separately stated deductions include charitable contributions, Section 179 expenses, etc.

40 INCOME AND BASIS Allocation of income/losses Allocations to shareholders are made on a per-share, per-day basis. Example The Duffy Corporation, an S corporation, is owned equally by three shareholders, Rick, Tim, and Peter. The corporation is on a calendar year basis. On February 1, 20X5, Peter sold his 1/3 interest in Duffy Corporation to George. For the year ended December 31, 20X5, the corporation had non-separately stated ordinary income of $120,000. For 20X5, the income of the corporation should be allocated as follows: Rick ($120,000 X 1/3) $40,000 Tim ($120,000 X 1/3) 40,000 Peter (31/365 X $40,000) 3,397 George (334/365 X $40,000) 36,603 Total $120,000

41 INCOME AND BASIS Limitation of losses Losses are limited to a shareholder's adjusted basis in S corporation stock plus direct shareholder loans to the corporation. Shareholder guarantees do not increase basis. Any losses disallowed may be carried forward indefinitely and will be deductible as the shareholder's basis is increased.

42 INCOME AND BASIS Special Deduction: Fringe Benefit Deductible Fringe Benefits Fringe benefits are deductible for non-shareholder employees and those employee shareholders owning 2% or less of the S corporation. Non-Deductible Fringe Benefits The cost of fringe benefits for shareholders owning over 2% is not deductible to the S corporation, unless the corporation includes the benefits in the employee/shareholder's W-2 income.

43 INCOME AND BASIS Basis The rules for determining a shareholder's basis in S corporation stock are generally the same as for partnerships, as follows: B Initial Basis A + Income items (separately and non-separately stated items) + Additional shareholder investments in corporation stock S - Distribution to shareholders - Loss or expense items E Ending Basis