When an S Corporation Pays Tax

Transcription

1 When an S Corporation Pays Tax The Business Entity Series Vicki L Mulak, EA, CFP September 21, 2016

2 Vicki is an Enrolled Agent and Certified Financial Planner (CFP ). She is insurance and securities licensed. Vicki is the owner of American Financial and Tax, a tax preparation, planning and representation firm, which was founded in Tustin, California in 1985, when Vicki became both a resident and a business owner. She frequently testifies before the Franchise Tax Board meetings in Sacramento, CA and stays involved in California tax legislation sponsored by the California Society of Enrolled Agents (CSEA), attending Assembly and Senate committee hearings as necessary. Vicki testified with Senator Mimi Walters before the California Labor Committee assisting in the passage of SB1244 (CH ) and SB 1131 (CH ) which now conform California employment tax law affecting LLCs to federal. She chairs CSEA s annual State Tax Agency Liaison Meeting, and the Advocacy Partnership Subcommittee, which is a committee of likeminded individuals and professional organizations that partner with CSEA, as needed, on California legislation and tax matters of mutual interest and concern. In addition to her private practice, Vicki serves on two of the three California state tax agency advisory boards: The California Franchise Tax Board (FTB) Advisory Board, since 2010 and the Employment Development Department's (EDD) Small Business Employer s Advisory Committee (SBEAC) since Vicki is a well-known presenter on federal and California tax law and update with audiences at continuing education events hosted by the National Association of Enrolled Agents (NAEA) and its state affiliates, CSEA s Super Seminar, and the various CSEA chapters. She is also a frequent presenter for Society of California Accountants (SCA). She is author of numerous articles that have appeared in NAEA s EA Journal, and CSEA s California Enrolled Agent. Vicki was honored in August 2012 with NAEA s Bill Payne Advocacy Award in recognition of her commitment to advocacy on behalf of Enrolled Agents. In 2011, Vicki was awarded the Distinguished Service Award for enhancement of CSEA s reputation. In 2006, she received CSEA s prestigious Thomas P Hess Award in recognition of her contributions to CSEA s educational goals. She appeared in December 2004 on the IRS web cast Tax Talk Today. Vicki L Mulak, EA, CFP Page i When an S Corporation Pays Tax

3 From , Vicki worked to prepare students for the partnership and corporation section of the Special Enrollment Exam Class hosted by CSEA s Orange County Chapter. She has been an Extended Education instructor for California State University at Fullerton for their Financial Planning Certificate Program from , and has worked as an editor for Thomson Reuters Practitioner Publishing Company s Accounting Quickfinder from Vicki was honored for her excellent support of the local business community in 1996 as the recipient of the U.S. Small Business Administration s Accountant Advocate of the Year award. She received her Bachelor of Science in Business Administration degree from Thomas Edison State University in Camden, New Jersey and resides with her husband, George, in Tustin, CA. Vicki L Mulak, EA, CFP Page ii When an S Corporation Pays Tax

4 TABLE OF CONTENTS S Election Form 2553: Page A Natural Business YEAR (Item P1)... 3 Section 444 Election (Item R)... 3 Tax Deferral Comes with a Cost... 5 Contrast Schedule H and Form Form 8752 Required Payment or Refund... 9 Two Retained Earnings Accounts Accumulated Adjustments Account (AAA) Accumulated Earnings and Profits (AE&P) Tax Return Form Design Issues AAA: Annual Adjustments and Distributions Stock Basis Ordering Rules AAA Ordering Rules Distributions Distributions from S Corporations without AE&P Distributions from S Corporations with AE&P EXAMPLE--Distribution when AE&P is Present Calculate AAA First, Calculate Stock Basis Second Schedule K and Form 1099-DIV EXAMPLE--Calculating Distributions from AAA & AE&P Net Negative Adjustment Ordering Rules EXAMPLE--Net Negative Adjustment Ordering Rule Election to Distribute AE&P before the AAA Tax on Built-In Gains (The BIG Tax) Vicki L Mulak, EA, CFP Page iii When an S Corporation Pays Tax

5 Purpose of the Built-in Gains Tax Valuing Inventory EXAMPLE BIG Tax from Inventory Built-in Gains Built-in Losses Losses and Credits from C Corporation Tax Years Carryover Years EXAMPLE--Carryforwards from C Years Built-in Gain Tax Traps Cash Method Accounts Receivable Goodwill and Intangible Assets EXAMPLE-- Built-in Gains Tax from Goodwill Transferred Pass-Through of Built-In Gains Tax on the K BIG Tax Limitations EXAMPLE--Taxable Income Limit Effect on Future BIG Tax Computing Taxable Income as a C Corporation EXAMPLE--BIG Recognition & Tax in Same Tax Year IRC 1374(b)(2) Deduction EXAMPLE-Built-in Gain & Tax in Different Tax Years Built-In Gain Reducers and Minimizers Tax on Excess Net Passive Income Distribute AE&P First Calculation of the Tax Planning Strategies to Avoid the Tax on ENPI K-1 Pass-Through of Excess Net Passive Income Tax Vicki L Mulak, EA, CFP Page iv When an S Corporation Pays Tax

6 Possible Termination of S Election Waivers Available Coordinating the Passive Investment and BIG Taxes EXAMPLE -Coordination with BIG Tax Practitioner Awareness of Potential for the Tax Recapture of General Business Credits EXAMPLE-Investment Credit Recapture LIFO Recapture Calculating the LIFO Recapture Tax Recapture Tax Paid in Four Installments EXAMPLE-LIFO Recapture Tax Tax only Affects C Corporations using LIFO Method Vicki L Mulak, EA, CFP Page v When an S Corporation Pays Tax

7 WHEN AN S CORPORATION PAYS TAX The S corporation is a very popular entity-type today. This session will analyze relevant topics and concerns affecting C corporations that convert to S corporations in order to understand hidden traps and avoid or minimize unwanted negative outcomes, including: The required tax deposit when using an IRC 444 election; The undistributed C corporation earnings at the date of the S election. A good understanding of stock basis, ordering rules and treatment of the corporation s two retained earnings account is crucial; What happens to C corporation carryovers; The appraisals and valuations needed at date of the S election; and The corporate-level taxes that could impact the conversion corporation. S ELECTION FORM 2553: PAGE 3 Page 3 consists of two parts. Part II is for selection of a fiscal year, and Part III is for an income beneficiary (or legal representative of the income beneficiary) to make a Qualified Subchapter S Trust (QSST) election for a trust shareholder of the corporation making the S election on the front of Page One. Page 3 does not need to be completed unless: 1. The corporation is selecting a fiscal year; or 2. There is a simultaneous QSST election being made with the corporation s S election. The calendar year is the required year for an S corporation, but there are also permitted tax years. Some opportunity exists for securing a fiscal year. A fiscal-year C corporation is not automatically entitled to retain its fiscal year when it elects S status. But, the corporation may be able to retain a fiscal year that is its natural year under Rev-Proc or its existing year under a Section 444 election. A Vicki L Mulak, EA, CFP Page 1 When an S Corporation Pays Tax

8 C corporation electing S status cannot make a Section 444 election that results in a deferral period greater than its present fiscal year. Vicki L Mulak, EA, CFP Page 2 When an S Corporation Pays Tax

9 A NATURAL BUSINESS YEAR (ITEM P1) This is one of the most viable option for a fiscal year, and one that should be used if the corporation or entity making the election qualifies. Automatic approval provisions of Rev-Proc apply, if the business can demonstrate on the basis of its previous 47 months (bank statements) that 25% of gross receipts are earned in two months of the year. If so, automatic consent to end the tax year at the end of this normal two-month peak is automatically granted, without a user fee. Box 1 in Item P is checked, and a statement is attached to Form 2553 which shows the computation. SECTION 444 ELECTION (ITEM R) This method only allows for a 3-month deferral of income, which generally provides 3 other alternatives to a December 31 year-end, which are September 30, October 31 or November 30. Two features of the election can make it less desirable: 1. The year-end of the corporation can only be September 30, October 31 or November 30. Additionally, a C corporation election g S status cannot make an IRC 444 election that results in a deferral period greater than its present tax year; and 2. The corporation is required to make payments to the IRS for the tax benefit received from the income deferral. If a Section 444 election is required, an electing corporation can check Box 1 in Item R on page 3 of Form Additionally, Form 8716 Election to Have a Tax Year Other than a Required Year is filed. It must be filed by the earlier of: The 15 th day of the 5 th month following the month that includes the 1 st day of the tax year the election will be effective; or The due date (not including extensions) of the income tax return for the tax year resulting from the IRC 444 election. Vicki L Mulak, EA, CFP Page 3 When an S Corporation Pays Tax

10 This form is only used by partnerships, S corporations, and personal service corporations (PSC) to elect a tax year other than the required year. A PSC is a C corporation whose principal activity is the performance of personal services in the fields of health (including veterinarians), law, engineering, architecture, accounting, actuarial science, performing arts, and consulting. The corporation s services are substantially performed by employee-owners and these employee-owners own more than 10% of the FMV of the outstanding stock [Reg ]. A special rule applies to personal service corporations (PSCs) that have an existing Section 444 election in effect at the time of the S election. The PSC can retain the Section 444 election, make required payments, and continue to use the PSC s fiscal year [Temp Reg T(a)(5)]. IRS automatically grants a 12-month extension to make the election. If Form 8716 is filed late, but within 12 months of the original due date, the words Filed Pursuant to Section should be typed at the top of the form. A copy of the Form 8716 should be attached to the S corporation s tax return for the first year that the IRC 444 election is effective. Then, every year, the corporation completes Form 8752 Required Payment or Refund under Section 7519 by May 15 th following the calendar year that the original election was made. The required payment is intended to be approximately equal to the amount of additional tax that would be paid by the corporation's owners if it had used the required tax year instead of the one elected. Thus, the required payment calculation is cumulative in nature. That is, the actual payment for a given year is the current year's calculation of the tax deferred as a result of the fiscal-year election, less the cumulative amount of the required payments made in prior years. A completed Form 8752 is included below. Vicki L Mulak, EA, CFP Page 4 When an S Corporation Pays Tax

11 TAX DEFERRAL COMES WITH A COST Anytime a corporation, particularly a closely-held corporation, has a different tax year from its shareholders, there is a potential for the shareholders to defer tax. This deferral can be achieved by paying larger salaries, bonuses, rents, etc to the shareholders after their year-ends (usually December 31 st ), but before the corporate year-end. Without certain restrictions, the corporation would have a tax advantage from taking a currentyear deduction is while the shareholder s recognition of income is deferred for at least a year. CONTRAST SCHEDULE H AND FORM 8752 A C corporation with an IRC 444 election (usually a PSC) is required each year to file a Schedule H (Section 280H Limitations for a Personal Service Corporation) with its Form 1120 to test whether there has been a significant deferral of income to the shareholders by testing to see if a minimum distribution requirement has been met. The PSC filing as a C corporation could be denied a full deduction for wages paid to the shareholderemployees. The excess functions as a carryover. Schedule H must be attached to the tax return of the PSC for each tax year the PSC does not meet the minimum distribution requirements. Two tests are used to determine whether the minimum distribution requirements have been met, and these tests are calculated on Schedule H: 1. The first test compares applicable amounts paid during the current year s deferral period with applicable amounts paid during the previous year s deferral period. 2. The second test compares an average of the amounts paid during the previous three years to make the same comparison. If the applicable amounts paid during the deferral period of the current year exceed either of these two tests, there is no limit on the amounts deductible by the corporation for the current period. If both tests are failed, the deduction of the amounts paid for the current year is limited. Vicki L Mulak, EA, CFP Page 5 When an S Corporation Pays Tax

12 If the minimum distribution requirements are not met, a separate computation determines the PSC s maximum deductible amount for the current year. Any amounts not allowed as a deduction during the current year are treated as being paid in the succeeding year [IRC 280H(b)]. However, when this occurs, these amounts are excluded in calculating the minimum distribution requirements for that year [IRC 280H(c)(1)]. Also, because of the shifting of income between years required by these provisions, IRC 280H specifically disallows the carryback of any NOL to or from a year to which an IRC 444 election applies. The maximum deductible amount is computed on Schedule H and deducted on Page 1 of Form EXAMPLE Medical Practice Inc (MPI), a PSC, has one shareholder. The corporation made an IRC 444 election in its first tax year to use a September 30 year-end. MPI s officer wages (applicable amounts) paid to the sole-shareholder are as follows: 9/30/12 9/30/13 9/30/14 Total Applicable Amounts $ 120,000 $ 140,000 $ 190,000 $ 450,000 Adjusted Taxable Income $ 170,000 $ 210,000 $ 270,000 $ 650,000 Applicable amounts and taxable income for tax year ending September 30, 2015 are: Deferral Period 3 Months Remaining 9 Months Total Applicable Amounts $ 35,000 $ 195,000 $ 230,000 Adjusted Taxable Income $ 70,000 $ 280,000 $ 350,000 Vicki L Mulak, EA, CFP Page 6 When an S Corporation Pays Tax

13 MPI s distribution of applicable amounts during the deferral period is $ 35,000, which is less than the smaller of: The amount computed under the preceding year test of $ 47,500 calculated on the first 3 lines of Schedule H; or The three-year average test of $ 48,461 computed on Line 12 of Schedule H. As a result, the minimum distribution requirement for the current tax year has not been met, and MPI reduces its compensation expense by $ 90,000 ($ 230,000 - $ 140,000) in excess of this amount. A corresponding entry is also made on Schedule M-1 (or M-3) of the return. The excess amount is carried over and is available for deduction on the tax return for the year ending September 30, Additionally, this $ 90,000 is excluded in calculating the minimum distribution requirement for the year ending September 30, Vicki L Mulak, EA, CFP Page 7 When an S Corporation Pays Tax

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15 FORM 8752 REQUIRED PAYMENT OR REFUND In contrast, the S corporation with an IRC 444 election, must make required payments for the privilege of deferral. The S corporation is allowed to deduct its wages, but also files Form 8752 Required Payment or Refund Under Section 7519 and maintains a deposit amount on account with the Internal Revenue Service for the privilege of the tax deferral. The required payments are intended to approximate the amount of tax that would be paid by the shareholder if the corporation changed to a calendar year. In most cases, the payments offset the income deferral, negating any positive result from the fiscal year-end. Required payments calculated on Form 8752 are cumulative. No payment is due until the cumulative required payments exceed $ 500. The required payment is generally due by May 15 th following the end of the calendar year in which the applicable IRC 444 election year begins [Reg T(a)(4)(ii)]. Form 8752 is also used to calculate refunds if the required payment for the current year is less than the cumulative required payments previously made. A refund is also allowed when a corporation terminates its election or liquidates. If an IRC 444 election is terminated, it cannot be made again. Required payments are not deductible by the S corporation or by the shareholders. The required payments function as deposits. The corporation does not receive interest on these deposits, but interest is charged on underpayments. Required payments can be subject to underpayment, negligence and fraud penalties. The required payment is equal to: The adjusted highest individual tax rate (adjusted by one percentage point) multiplied by the S corporation s net base year income, less The cumulative amount of the required payments for all preceding Section 444 election years (reduced by the cumulative amount of payments refunded for preceding years). Vicki L Mulak, EA, CFP Page 9 When an S Corporation Pays Tax

16 The adjusted rate is currently 40.6% (39.6% highest individual rate plus 1%). This is one of the highest rates for many years due to the additional 39.6% tax bracket that was added by the American Taxpayer Relief Act of 2012 [ (ATRA 2012) P.L (1/2/2013)]. The required payment functions to discourage S corporations from reducing payments to shareholders during the deferral period so that it will not be taxed until the following year. These payments to shareholders are called applicable payments and include officer compensation and rent paid to the shareholder. The base year is the tax year preceding the election year. If the entity is an S conversion (previously a C corporation), the C corporation s year is the base year. If the entity is unincorporated before electing S status, there is no base year, and payments are not required for the first year, if the corporation makes an IRC 444 election immediately for its first tax year as an S corporation. EXAMPLE The Alpha Corp is a C corporation that has always used a September 30 year-end. Jeff owns 100% of the corporation s stock. For the tax year beginning October 1, 2015, the corporation elects to become an S corporation and makes the IRC 444 election to keep the September 30 fiscal year. For the tax years ending on September 30, 2015, and September 30, 2016, the corporation s books and records reflect the following: FYE 9/30/2015 FYE 9/30/2016 Ordinary income before Jeff s salary $ 110,000 $ 95,000 Jeff s Salary: October 1 through December 31 ($ 9,000) ($ 15,000) January 1 through September 30 ($ 51,000) ($ 45,000) Ordinary Income $ 50,000 $ 35,000 Vicki L Mulak, EA, CFP Page 10 When an S Corporation Pays Tax

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18 In the example above, the applicable payments for the entire base year (10/1/14--9/30/15) are $ 60,000 ($ 9,000 + $ 51,000). The deferral ratio of 25% is calculated by dividing the months in the deferral period by 12 months (3 months divided by 12 months). The applicable payment amount of $ 60,000 is multiplied by the deferral ratio to yield $ 15,000 ($ 60,000 x.25). If actual payments made during the deferral period are less than this amount, the difference is added to the base-period net income when calculating the required payment. In this instance $ 6,000 is added to the base-period income because the actual amount paid during the deferral period ($ 9,000) is less than the $ 15,000 just calculated. EXAMPLE-C Corporation with Existing Section 444 Election ABC Corporation, a C corporation other than a PSC, whose current tax year ends October 31, elects S status. Rather than change to the required calendar year for an S corporation under IRC 1378, ABC wants to make an IRC 444 election to retain its October 31 st year-end for its tax year beginning November 1 st. Since October 31 is a deferral period of only 2 months, ABC may elect to retain its tax year ending October 31 st by filing Form ABC will also file an annual Form ABC Corporation could also elect a November 30 year-end, as a November 30 fiscal year-end is a deferral of only 1 month. The corporation may not elect a fiscal year-end of September 30, because the 3-month deferral period would be longer than the 2 month deferral period being changed. Vicki L Mulak, EA, CFP Page 12 When an S Corporation Pays Tax

19 TWO RETAINED EARNINGS ACCOUNTS One important line on Schedule K, line 17c, does not appear on Schedule K-1 as 17C. Line 17c on Schedule K recaps the S corporation s dividend distributions from undistributed accumulated C corporation earnings and profits (AE&P) from years the S corporation was a C corporation. Dividends from AE&P are reported on Form 1099-DIV, when the dividend is $ 600 or more to any one shareholder. ACCUMULATED ADJUSTMENTS ACCOUNT (AAA) Accumulated, undistributed earnings from S corporation years are retained in an account called the Accumulated Adjustments Account (AAA). S corporations maintain an Accumulated Adjustments Account (AAA) that tracks the amount of undistributed income that has been taxed to the shareholders after The AAA can be distributed to the shareholder free of tax up to the shareholder s basis in his stock. The AAA is a corporate level account and is not allocated to any specific shareholder. If a shareholder sells his shares, the purchaser can receive tax-free distributions of the AAA, even though the AAA arose before the stock purchase occurred. The main purpose of the AAA is to track income that can be distributed tax-free to the shareholders before a distribution is deemed a taxable distribution from Accumulated Earnings and Profits (AE&P) from C corporation years. The AAA represents a cumulative total of flow-through items generated by the S corporation which have been taxed to the individual shareholders, and that remain undistributed by the S corporation for taxable years after The AAA loses most of its significance if the S corporation does not have any AE&P from C corporation years. Unlike stock basis, the AAA can maintain a negative balance as a result of loss and deduction flow-through [Reg (a)(3)(ii)]. Vicki L Mulak, EA, CFP Page 13 When an S Corporation Pays Tax

20 The AAA is reduced by the entire amount of a loss or deduction, even though all or part of the loss or deduction is not allowed to the shareholder due to basis, at-risk or passive rules. An exception to this rule exists for federal income taxes attributable to a prior C corporation period. Under IRC 1368(e)(1)(A), the AAA is not reduced even though the shareholder s basis is reduced. ACCUMULATED EARNINGS AND PROFITS (AE&P) AE&P from C corporation years is frozen on the date the corporation converts to an S corporation. Only a few items will cause an adjustment to the AE&P after the S election: The primary reason the AE&P would ever increase, is if the corporation acquires another corporation with AE&P. The following items would cause the AE&P of an S corporation to decrease: 1. Distributions of AE&P [IRC 1371(c)(3)]; 2. Payment of corporate-level tax due to general business credit recapture [IRC 1371(d)(3)]; 3. Certain redemptions, reorganizations, liquidations, and corporate divisions [IRC 1371(c)(2)]; 4. Payment by the S corporation of tax that relates to the C corporation period [IRC 1371(c)(2)]; and 5. Payment by the S corporation of LIFO recapture [IRC 1363(d)(5)]. TAX RETURN FORM DESIGN ISSUES Unfortunately, the S corporation tax return does not have a place to reflect increases or decreases to AE&P. The most common reasons for a decrease to AE&P during an S year would be: Vicki L Mulak, EA, CFP Page 14 When an S Corporation Pays Tax

21 1. If distributions were deemed to be paid from the AE&P (more on distributions to follow); or, 2. If the corporation were audited, and there was an increase in tax for a C year, that was paid during an S year. It is important that the tax preparer accurately maintain both accounts, i.e., AE&P and AAA, if both accounts exist. Although there is only one line for Retained Earnings, Line 24 on Schedule L, and earnings from both C corporation periods and S corporation periods (AAA) will combine into one total on Schedule L of the tax return, in reality, these accounts are never blended, and separate accounts should be maintained in the accounting records. Most professional software packages will show the detail of the combined total in a statement that accompanies the tax return forms. Practitioners should verify the presence of AE&P, when the date of the S election does not coincide with the date of incorporation, as indicated on Form 1120S, Page 1. AAA: ANNUAL ADJUSTMENTS AND DISTRIBUTIONS The ordering rules for the AAA are not the same as the ordering rules for stock basis. When the S corporation has always been an S corporation, this difference is of no effect. Additionally, if the S corporation had previously been a C corporation, but all C corporation income has been distributed, and the AE&P account is zero, this difference will have no effect, either. The only instance where the difference in annual adjustment order for stock basis versus AAA will matter is when the S corporation has both undistributed C corporation earnings. In other words, the AE&P account has a balance other than zero. STOCK BASIS ORDERING RULES Under the stock basis ordering rules since 1996 (Reg ), distributions reduce basis directly after the adjustment for current period income items and before the adjustment Vicki L Mulak, EA, CFP Page 15 When an S Corporation Pays Tax

22 for current period losses and deductions. This results in more tax-free distributions and more deferred S corporation losses due to a lack of basis. 1. Increased for income items and excess depletion; 2. Decreased for distributions; 3. Decreased for non-deductible, non-capital expenses and depletion; and 4. Decreased for items of loss and deduction. AAA ORDERING RULES The AAA ordering rules are governed by Reg (a)(5). The AAA will be adjusted by the same items that adjust stock basis, but in a different order. The AAA adjustments each year mimic the order of the line items on Schedule M-2: 1. Increased for income items and excess depletion; 2. Decreased for non-deductible, non-capital expenses and depletion; 3. Decreased for items of loss and deduction; and 4. Decreased for distributions. DISTRIBUTIONS When the S corporation has only undistributed S corporation earnings, the tax consequences of a distribution are simplified. When the corporation has combinations of undistributed C corporation earnings and S corporation earnings, it is a little more involved. DISTRIBUTIONS FROM S CORPORATIONS WITHOUT AE&P The treatment of an S corporation shareholder s distributions, where the S corporation does not have any AE&P, is determined under a two-tier system: 1. As a nontaxable return of capital to the extent of the adjusted basis of stock; 2. Capital gain from disposition of stock for amounts in excess of stock basis. Vicki L Mulak, EA, CFP Page 16 When an S Corporation Pays Tax

23 DISTRIBUTIONS FROM S CORPORATIONS WITH AE&P Under IRC 1368(c), 1379(c) and the Form 1120S instructions, a distribution made by an S corporation with AE&P is made using a six-tiered system. The distribution is determined to have been made from the following items in the following order: 1. From the AAA account (tax-free, but still limited to stock basis); 2. From Previously Tax Income (PTI) [also tax-free IRC 1379(c)]; 3. From Accumulated Earnings and Profits (C corporation dividend); 4. From the Other Adjustments Account (OAA also tax-free); 5. As Return of Capital (tax-free); and 6. As Deemed Sale of Stock with No Basis (capital gains). EXAMPLE--DISTRIBUTION WHEN AE&P IS PRESENT Cord, an S corporation, has AE&P of $ 10,000. It distributes $ 80,000 to its only shareholder, Don. Don's basis in his stock is $ 50,000. The AAA before distribution is $ 30,000. What is the order of the distributions and how are they treated by Don for tax purposes? Distribution $ 80,000 Source Type Taxable ($ 30,000) AAA Basis Reduction No ($ 10,000) AE&P C Corp Dividend Yes ($ 20,000) Return of capital Basis Reduction No ($ 20,000) In excess of basis Capital Gain Yes -0- Vicki L Mulak, EA, CFP Page 17 When an S Corporation Pays Tax

24 CALCULATE AAA FIRST, CALCULATE STOCK BASIS SECOND As can be seen from the ordering rules, the correct calculation of AAA is imperative, for accurate calculation of the portion of the distributions to shareholders that is determined first to be from S corporation earnings, either current year or prior. Once distributions have exhausted the AAA (assuming there is no PTI), then the balance of the distribution is deemed to be from the AE&P, until the AE&P is exhausted. Only after the AE&P is exhausted, can any of the distribution be determined to be from the OAA, and then finally from stock basis It is important to note that the $ 30,000 received as part of the AAA in the above example, is indicated as not taxable. This is because it was previously taxed to the shareholder as flow-through income on a K-1. It will not be taxed again when it is distributed. This is how the S corporation avoids the double taxation of the C Corporation. SCHEDULE K AND FORM 1099-DIV The $ 10,000 received as a C corporation dividend is reported on Schedule K and Form 1099-DIV. This $ 10,000 was previously taxed when the corporation was a C corporation, and the shareholder will pay tax when it is distributed. This illustrates the double taxation in the C corporation which will stay in place when an S corporation pays a C corporation dividend. Vicki L Mulak, EA, CFP Page 18 When an S Corporation Pays Tax

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26 EXAMPLE--CALCULATING DISTRIBUTIONS FROM AAA & AE&P Agnes is the sole shareholder of Sample Corporation. On January 1, 2015, her stock basis is $ 25,000. Her original cost is $ 20,000 plus $ 5,000 of prior year, undistributed S corporation income (retained in the AAA account). Sample s 2015 books report: $ 10,000 in current ordinary income; $ 8,000 in current IRC 1231 losses; $ 13,000 in current distributions to Agnes; $ 5,000 beginning AAA; and $ 40,000 in AE&P (from C corporation years). Sample s tax practitioner must first calculate the balance in the AAA before any distribution to Agnes, in order to determine how much of the $ 13,000 in distributions can be received tax-free from the AAA. Step 1: Calculation of AAA AAA 1/1/15 $ 5, ordinary income $ 10,000 AAA before loss and deduction $ 15,000 IRC 1231 losses ($ 8,000) AAA before distributions $ 7,000 Distributions allowed tax-free from AAA ($ 7,000) AAA 12/31/15-0- Step 2: Calculation of Dividend (AE&P) Total distributions $ 13,000 Tax-free from AAA from Step 1 ($ 7,000) Taxable distributions from AE&P $ 6,000 AE&P balance at 12/31/15: $ 34,000 Step 3: Calculation of Stock Basis Stock 1/1/15 $ 25, ordinary income `$ 10,000 Stock basis before distributions $ 35, distribution from AAA ($ 7,000) Stock basis before loss and deduction $ 28, IRC 1231 loss ($ 8,000) Stock 12/31/15 $ 20,000 Vicki L Mulak, EA, CFP Page 20 When an S Corporation Pays Tax

27 NET NEGATIVE ADJUSTMENT ORDERING RULES After 1996, if the S corporation has AE&P, IRC 1368(e)(1)(C) states that net losses are disregarded. Therefore, the amount of loss used in the determination of whether a distribution exceeds the AAA is limited to the amount of current year income. In this situation, the AAA ordering rules are adjusted. First, the beginning AAA is increased by income, next decreased by losses and deductions, but the losses and deductions are limited to the amount of income. There is no net negative adjustment. The AAA is then decreased by any current year distribution. This has the effect of limiting the non-taxable distribution to the amount of the beginning AAA. In other words, there should be no difference to the shareholder whether a prior balance in the AAA is distributed in the current year as it would have been if it were distributed in a prior year. Under the net negative adjustment ordering rules, any distribution in excess of the beginning AAA is taxable as a dividend, up to the AE&P. EXAMPLE--NET NEGATIVE ADJUSTMENT ORDERING RULE ($ 20,000) ordinary loss $ 9,000 IRC 1231 income $ 15,000 distribution $ 2,000 beginning AAA $ 3,000 balance in AE&P $ 4,500 stock basis on 1/1/14 Step 1: Calculation of AAA AAA balance at 1/1/15 $ 2,000 IRC 1231 income $ 9,000 Subtotal $ 11,000 Ordinary loss ($ 20,000, but limited to $ 9,000 under this rule) ($ 9,000) Subtotal $ 2,000 Distribution from AAA ($ 2,000) Subtotal AAA after distribution -0- Balance of 2015 ordinary loss: ($ 11,000) Balance of 12/31/15 ($ 11,000) Vicki L Mulak, EA, CFP Page 21 When an S Corporation Pays Tax

28 Step 2: Determine Amount/Character remaining Distribution Total Distributions $ 15,000 Received tax-free from AAA in Step 1 ($ 2,000) Subtotal $ 13,000 Received as a C corporation dividend from AE&P until exhausted ($ 3,000) Remaining balance--source to be determined in Step 3 $ 10,000 Step 3: Calculation of Stock Basis Stock 1/1/15 $ 4,500 IRC 1231 income $ 9,000 Subtotal $ 13,500 Distribution from AAA from Step 1 ($ 2,000) Subtotal $ 11,500 Remaining balance of distributions from Step 2 $10,000 Subtotal $ 1,500 Portion of current year loss available to 1040, Schedule E ($ 1,500) Stock 12/31/15-0- Step 4: Suspended Losses to Carry to Ordinary Loss ($ 20,000) 2015 Loss allowed up to stock basis $ 1,500 Ordinary loss suspended and carried to 2016 ($ 18,500) ELECTION TO DISTRIBUTE AE&P BEFORE THE AAA Under IRC 1368(e)(3), an S corporation has the option to distribute the AE&P before it makes distribution out of the AAA. The election is effective for one year and applies to all distributions made during the election year. If the S corporation has insufficient cash flow to distribute all of its AE&P, Reg (f)(3) allows the corporation to elect to make a deemed dividend distribution of all or part of its AE&P. The amount of the deemed dividend distribution is considered a cash distribution on the last day of the tax year, with an immediate contribution by the shareholder back to the corporation. Form 1099-DIV would be filed. Vicki L Mulak, EA, CFP Page 22 When an S Corporation Pays Tax

29 CORPORATE- LEVEL TAXES The following are the taxes that apply to an S corporation that was previously a C corporation: 1. The tax on built-in gains (IRC 1374); 2. The tax on excess net passive income [IRC 1375(a)]; 3. The tax on recomputing a prior year s investment credit (ITC Recapture) [IRC 1371(d)]; and 4. LIFO recapture tax ([IRC 1363(d)]. TAX ON BUILT-IN GAINS (THE BIG TAX) The tax on built-in gains is triggered by the recognition of income from C corporation years that are recognized in initial S corporation years. The tax is 35% of the net recognized gain during the recognition period, which is now permanently 5 years. PURPOSE OF THE BUILT-IN GAINS TAX The purpose of the tax is to restrict an S corporation from passing gains, which were generated in C years, to S-shareholder K-1s for taxation on their personal returns with other S corporation income, where it would be taxed at personal rates, rather than at corporate rates. In advance of the S election, C corporations should prepare a built-in gain ledger as of the last day of the last C year. The unrealized built-in gain is the difference between FMV and book value of its assets. Depending on the type and worth of assets on the balance sheet, formal appraisals should be considered. All real estate and high-worth assets should definitely be professionally appraised. The difference between the FMV balance sheet and the accounting balance sheet (historical cost) is the corporation s unrealized built-in gain. Vicki L Mulak, EA, CFP Page 23 When an S Corporation Pays Tax

30 The most common examples of built-in gains for the small business corporation are: Cash-basis Accounts Receivable (generated in a C year, received in S year) Inventory (purchased in a C year, sold in S year); and Sales of fixed assets (purchased in C year, sold in S year). VALUING INVENTORY Reg (a) (which applies to S elections on or after December 27, 1994) clearly indicates that the built-in gains tax applies to inventories. The value of an S corporation s inventory on the day of its S election becomes effective is determined by reference to a hypothetical sale of the entire business. According to the preamble to the regulations, the determined value will generally be less than the inventory s anticipated retail price but greater than its replacement cost. In the case of businesses with fast-moving inventory, the inventory commonly neither appreciates nor depreciates before it is sold. In these circumstances, the inventory will not result in a built-in gains tax. This may not be the case with slower moving inventory. EXAMPLE BIG TAX FROM INVENTORY Diamonds-R-Us, a C corporation is a jewelry store which bought some diamonds for $ 100,000. The corporation elects S status on January 1 st. The diamonds are appraised at $ 150,000. If the diamonds sell in the first 5 years of the S election, the sale will result in the recognition of $ 50,000 in built-in gains. Caution: A cash-basis corporation that renders personal services (like a CPA or EA practice) must consider work-in-process when electing S status. The value of the work-in-process in excess of its basis is subject to the built-in gains rules and is included in net unrealized built-in gain at the date the S election becomes effective. Determining Vicki L Mulak, EA, CFP Page 24 When an S Corporation Pays Tax

31 FMV is not an exact science and can be especially difficult when valuing an intangible asset like work-in-process inventory. BUILT-IN GAINS The following is a nonexclusive list of items that result in built-in gains: Any C corporation accrued income recognized in an S corporation year, including cash basis Accounts Receivable, completed contract method income and installment sale income; Dispositions of appreciated property on hand when the S election became effective, including inventory, work in process inventory, real and personal property, goodwill, and other intangible assets; Dispositions of transferred basis property; Positive IRC 481(a) adjustments, to the extent adjustments relate to items attributable to periods before the S election became effective; Discharge of indebtedness income, if the income arises from a debt owed at the date the S election became effective and the income is recognized during the first year of the recognition period; and Certain income from partnerships. BUILT-IN LOSSES The following is a nonexclusive list of items that result in built-in losses: Any C corporation expense deducted in an S corporation year, including Accounts Payable and accrued compensation, including bonuses; Vicki L Mulak, EA, CFP Page 25 When an S Corporation Pays Tax

32 Dispositions of property on hand when the S election became effective, including inventory, work in process inventory, real and personal property, goodwill and other intangible assets; Losses and credit carryovers from C years; Negative IRC 481(a) adjustments to the extent adjustments relate to items attributable to periods before the S election became effective; and Bad debt deductions, if arising from debt owed to the S corporation at the date the S election became effective and the deduction is taken during the first year of the recognition period. Note: Built-in losses are beneficial because they offset built-in gains and reduce the net unrealized built-in gain. Reminder: The built-in gains tax can cause the S corporation to be liable for estimated tax payments. LOSSES AND CREDITS FROM C CORPORATION TAX YEARS In general, there are no carryforwards and no carrybacks between C and S tax years [IRC 1371(b)]. However, net operation losses (NOLs), capital losses, business credits, and minimum tax credits carried over from C corporation years can be used to reduce the built-in gains tax [IRC 1374(b)(2)]. These carryover items cannot be used to reduce the tax on excess net passive income. Corporate-level carryforwards and carrybacks cannot arise in S years, but are passed through to shareholders. They do not carry forward or carry back to C years. CARRYOVER YEARS Because carryovers may expire, it is necessary to determine which years count in determining a carryforward period. In general, S tax years are counted, in addition to any C years when determining the number of tax years a carryover item can be carried forward [IRC 1371(b)(3)]. A few exceptions: Vicki L Mulak, EA, CFP Page 26 When an S Corporation Pays Tax

33 If the S status is lost in the middle of the tax year, the S short year portion of the S termination year is not counted in determining the number of tax years in the carryforward period. The year which consists of a short S year and a short C year counts as one year for carry forward purposes [IRC 1362 (6)(A)]; and In years where there is a qualifying disposition of stock following a complete termination of a shareholder s interest, and the specific accounting election is used which is an election to treat a tax year as two separate tax years [Reg (g)], only one year is counted for carry forward purposes. EXAMPLE--CARRYFORWARDS FROM C YEARS Sample Corporation elected S status effective January 1 st. As of the end of its last C corporation tax year, Sample had an NOL carryforward of $ 50,000. During any subsequent S corporation tax year, the NOL cannot be used except for built-in gains tax purposes as a deduction against net recognized built-in gain. To the extent Sample Corporation does not use its NOL carryover against any S corporation net recognized built-in gain, the unexpired NOL carryover can offset C corporation income after the S election terminates. Each year the corporation s S election remains in effect counts as a year for purposes of the carryover period for NOLs carried from C corporation tax years [IRC 1371(b)(3)]. BUILT-IN GAIN TAX TRAPS When a C corporation elects S status, it becomes subject to the built-in gains tax during the applicable recognition period following the date the S election takes effect. But, the built-in gains tax may also apply when an S corporation: Vicki L Mulak, EA, CFP Page 27 When an S Corporation Pays Tax

34 Acquires transferred basis assets from a C corporation or an S corporation subject to the built-in gains tax; or Makes a qualified Subchapter S subsidiary (QSub) election for a 100% owned C corporation or S corporation subject to the built-in gains tax before the QSub election. CASH METHOD ACCOUNTS RECEIVABLE Every C corporation using the cash method of accounting with accounts receivable that elects S status faces a built-in gain trap. Receivables earned in C years that are received in S years during the recognition period are subject to the built-in gains tax. GOODWILL AND INTANGIBLE ASSETS A potential tax trap occurs when an S corporation sells assets constituting a trade or business. The corporation may be subject to the built-in gains tax from goodwill, including goodwill that was not purchased, but was generated by the corporation itself when it was in C status. Unless an accurate appraisal is done as of the date the S election becomes effective, the portion of any later gain on the corporation s disposal of the goodwill or any other intangible assets that would be considered built-in gain would be difficult to determine. Worst case scenario would be an IRS challenge on an unreported realized built-in gain subject to the tax. Vicki L Mulak, EA, CFP Page 28 When an S Corporation Pays Tax

35 EXAMPLE-- BUILT-IN GAINS TAX FROM GOODWILL TRANSFERRED California Tax Preparation Services Inc (CTPSI) has operated as a personal service corporation (PSC) for quite a few years. Although subject to a 35% tax on PSCs, CTPSI has not had a problem reducing profits by payment of salary and benefits to its sole-shareholder, John Smith. The practice had grown to a 1,000 return practice through advertising, client referrals and competent preparation services, when John was advised to elect S corporation status effective January 1, In July 2015, John was diagnosed with terminal disease. In order to preserve the value of his business, John decides to sell his practice to a local tax preparer for $ 500,000, of which $ 450,000 represents goodwill from the 1,000 tax clients. CTPSI has no built-in losses. CTPSI s basis in the goodwill is zero. Since CTPSI is still in its recognition period, a built-in gains tax (subject to the limitations explained next) could apply. PASS-THROUGH OF BUILT-IN GAINS TAX ON THE K-1 Taxes imposed at the S corporation level, other than the tax on built-in gains, reduce the pass-through of the item that generated the tax. The built-in gains tax, however, passes through to shareholders as a loss. This is because the year of income recognition and the year the built-in gains tax is due may be different years, due to the taxable income limitation rule. The type of loss (ordinary or capital) is determined by allocating the loss proportionately among the items that caused the tax [IRC 1366(f)(2); Reg (b)]. Assuming a 25% bracket for the shareholders, the shareholder is actually taxed at 51.25% on any recognized built-in gain (35% of the built-in gain at the corporate level, plus 25% of the remaining 65% of the built-in gain at the individual level). Vicki L Mulak, EA, CFP Page 29 When an S Corporation Pays Tax

36 BIG TAX LIMITATIONS The amount of built-in gain subject to tax in any year (i.e., the net recognized built-in gain) is limited to the smallest of: The current recognition limit: The actual recognized built-in gain; The taxable income limit: The corporation s taxable income, computed as if the corporation were a C corporation; or The overall limit: The net unrealized built-in gain reduced by net built-in gain recognized in prior years. If an S corporation has a recognized built-in gain for the year, but is able to reduce the taxable income to zero (calculated as if the corporation were a C corporation), there is no tax. At first glance, this appears as a solution to the recognized built-in gain tax problem. Unfortunately, effective for S corporation elections after 3/30/88, any recognized built-in gain not currently recognized due to the taxable income limitation, carries over to subsequent years. If the S corporation has taxable income at any time within the recognition period, a built-in gains tax is triggered to the extent of taxable income. EXAMPLE--TAXABLE INCOME LIMIT EFFECT ON FUTURE BIG TAX Sample Corporation made an election to be taxed as an S corporation on 3/15/15 for the 2015 year. At the time of the election, Sample had built-in gains of $ 50,000 due to Accounts Receivable. In 2015, the Accounts Receivable was received, and Sample had a gain of $ 50,000. In addition, Sample incurred an overall loss of $ 10,000 for Thus, under the taxable income limitation, Sample is not subject to tax on the recognized built-in gain in However, the potential tax carries over to 2016 and future years in the recognition period. If in 2016, Sample reports a $ 15,000 net income, a corporate level tax of $ 5,250 ($ 15,000 x 35%) is imposed. Sample s suspended built-in gain would be reduced to $ 35,000 ($ 50,000 realized - $ 15,000 recognized). If Sample had a profit in future years, the remaining suspended amount would become subject to tax. Vicki L Mulak, EA, CFP Page 30 When an S Corporation Pays Tax

37 COMPUTING TAXABLE INCOME AS A C CORPORATION An S corporation computes its taxable income in the same manner as an individual [IRC 1363(b)], since the S corporation functions as a conduit for items of income, loss, deduction and credit that will be taxed at the individual shareholder level. However, there are two circumstances when it must compute its income as if it were a C corporation: 1. When calculating the taxable income limitation for purposes of the built-in gains tax [IRC 1374(d)(2)(A)]; and 2. When calculating the taxable income limitation for purposes of the tax on excess net passive income [IRC 1375(b)(1)(B)]. Although this seems pretty straightforward, IRS has issued limited guidance regarding how this is actually done, and many questions will arise when it s actually being calculated, such as: If the cash-basis S corporation would be required to use the accrual method of accounting if it were a C corporation (gross receipts more than $ 5 million), should the income of the S corporation be recalculated using the accrual method? It would seem so. It s clear that certain adjustments would need to be made when moving out of a flowthrough taxation model to developing the taxable income of an entity, but in the absence of a lot of guidance, practitioners will have to use reasonable methods in their calculations. Adjustments will be required to use the 10% of taxable income limit for charitable contribution deductions, and the capital loss limitations applicable to C corporations. The calculation would also include potential carryforwards and carrybacks that would be available if the corporation were a C corporation. Vicki L Mulak, EA, CFP Page 31 When an S Corporation Pays Tax

38 EXAMPLE--BIG RECOGNITION & TAX IN SAME TAX YEAR Sample Corporation, a cash-basis C corporation, elects S corporation status on January 1, 2015 the beginning of the corporation s taxable year. The company balance sheet reflects the following: FMV Adjusted Basis Built-in Gain Cash $ 30,000 $ 30, A/R $ 72, $ 72,500 A/P ($ 21,000) -0- ($ 21,000) Asset A $ 50, $ 50,000 Asset B $ 55,000 $ 25,000 $ 30,000 Asset C $ 60,000 $ 115,000 ($ 55,000) $ 246,500 $ 170,000 $ 76,500 Sample Corporation s taxable income (determined as if the corporation were a C corporation) is $65,000 for 2015 and $70,000 in Sample will collect all of the beginning of the year receivables and pay off all of the beginning of the year Accounts Payable during No asset sales are expected to occur in Unless further action is taken, Sample recognizes $51,500 of net built-in gain in 2015, resulting from the collection of Accounts Receivable of $72,500 offset by the $21,000 of built-in loss from the Accounts Payable. Note: To have successfully reduced the recognized built-in gain to zero, Sample Corporation could have sold Asset C before year-end, and recognized the $ 55,000 loss. In the above example, the amount of built-in gain subject to tax in any year is the lesser of: The actual recognized net built-in gain or $51,500; Vicki L Mulak, EA, CFP Page 32 When an S Corporation Pays Tax

39 The taxable income, computed as if the corporation were a C corporation, which is $65,000; or The net unrealized built-in gain reduced by net built-in gain recognized in prior years or $ 76,500 ($76,500-0 = $ 76,500). Since this is the first S year, no prior years recognition of built-in gains has occurred. Sample recognizes a built-in gain of $51,500. The built-in gains tax is $18,025 (35% of $51,500). The $65,000 of income from operations passes through intact to the shareholders, while the built-in gains tax of $ 18,025 passes through as a loss with the same tax character (ordinary) as the income giving rise to the tax. The ordinary income reported on Line 1 of Schedule K and Schedule K-1 is $ 46,975 ($ 65,000-$ 18,025). IRC 1374(B)(2) DEDUCTION C corporation built-in losses such as an NOL carryover can be deducted on Line 19 of Form 1120S Schedule D, thereby reducing the amount subject to the BIG rate of 35%. Vicki L Mulak, EA, CFP Page 33 When an S Corporation Pays Tax

40 EXAMPLE-BUILT-IN GAIN & TAX IN DIFFERENT TAX YEARS Andrew is sole shareholder in Sample Corporation, an S corporation, in which he materially participates. The corporation has the following to report for 2014: Ordinary income (includes $ 70,000 of built-in gain) $ 90,000 Ordinary expenses ( $ 180,000) Ordinary loss from trade or business ($ 90,000) Long-term capital gain from investments (all built-in gain) $ 60,000 Taxable income if were a C corporation ($ 30,000) Sample Corporation recognized no built-in gain in 2014 because of the taxable income limitation. The corporation passed through $ 90,000 of ordinary income loss and $ 60,000 of long-term capital gain to Andrew. In 2015, Sample Corporation shows the following income and expenses from business operations: Ordinary income $ 290,000 Ordinary expense ($ 125,000) Ordinary income from trade or business $ 165,000 For built-in gains tax purposes, a tax on the 2014 built-in gains is payable in Sample Corporation s 2015 built-in gains tax of $45,500 is calculated as follows: Built-in gains tax from ordinary income ($ 70,000 x 35%) $ 24,500 Built-in gains tax from capital gain income ($ 60,000 35%) $ 21,000 Ordinary income from trade or business ($ 130,000 total x 35%) $ 45,500 The corporation Schedule K and Andrew s 2015 K-1 will reflect: Ordinary income before built-in gains tax consideration $ 165,000 Built-in gains tax attributable to ordinary income ( $ 24,500) Net Ordinary income to Schedule K, Line 1 & K-1, Line 1 $ 140,500 Long-term capital loss to Schedule K, Line 8a & K-1, Line 8a ($ 21,000) Vicki L Mulak, EA, CFP Page 34 When an S Corporation Pays Tax

41 Part III of Schedule D, Form 1120S is used to report built-in gains tax. The $ 21,000 tax on the capital gain income is also reported as a capital loss in Part II of Schedule D, Form 1120S, and is carried as a long-term capital loss to Schedules K and K-1. Vicki L Mulak, EA, CFP Page 35 When an S Corporation Pays Tax

42 Vicki L Mulak, EA, CFP Page 36 When an S Corporation Pays Tax

43 If Andrew (in the previous example) has no capital gains on his personal return, IRC 1211 will limit his capital loss to $3,000, with $ 18,000 to carry to the following year. The foregoing Example illustrates how pass-through of built-in gain items is accomplished when the disposition of various types of assets causes a built-in gains tax. It also illustrates how passing the tax through as a separate loss item as either ordinary or capital, as appropriate, can have undesirable effects on the taxpayer. Important reminder: The net unrealized built-in gain limits the amount of overall builtin gain that can be recognized. This amount functions as a ceiling for the threshold amount of built-in gains that might ever have to be recognized. This amount is the amount tracked each year and reported on Form 1120S, Schedule B, Line 8. BUILT-IN GAIN REDUCERS AND MINIMIZERS Tax planning strategies to avoid or reduce the built-in gains tax generally are: Recognizing built-in losses in years when built-in gains are recognized, to utilize the current recognition limit; Reducing taxable income to utilize the taxable income limit; Reducing net unrealized built-in gain (e.g., by increasing built-in losses) to utilize the overall limit; Declaring bonuses before the S election becomes effective to increase built-in losses; Using C corporation NOL and credit carryovers; Deferring property sales beyond the recognition period; Structuring a tax-deferred transaction, such as a like-kind exchange; Selling Accounts Receivable before the S election becomes effective; Leasing or licensing property, rather than selling it; and Making charitable contributions of appreciated property. Vicki L Mulak, EA, CFP Page 37 When an S Corporation Pays Tax

44 TAX ON EXCESS NET PASSIVE INCOME Passive investment income can be subject to tax at the S corporation level, if the S corporation has accumulated earnings and profits (AE&P) at the end of the tax year, and passive investment income that is more than 25% of its gross receipts for the year. If passive investment income represents more than 25% of the S corporation s gross receipts for three consecutive years, the corporation loses its S corporation status. To be subject to this tax, an S corporation either must have been a C corporation or have acquired a C corporation with AE&P [IRC 1375(a)]. Passive investment income generally includes gross receipts from royalties, rents, dividends, interest (including tax-exempt interest and dividends) and annuities. Gains from the sale or exchange of stocks or securities are no longer considered passive investment income for years after 2007 [IRC 1362(d)(3)(D); Reg (c)(5)]. Gross receipts from other sources (such as gains from sales of real property held for investment) are not passive investment income, even if such amounts are received in the course of holding passive investments (Rev. Rul ). DISTRIBUTE AE&P FIRST The tax can be avoided by distributing AE&P before year-end, which may be appropriate in some cases. To accomplish this, the corporation can elect to distribute AE&P before the accumulated adjustments account (AAA) is distributed. Alternatively, the corporation can make a deemed dividend election under Reg (f)(3). A deemed dividend is a hypothetical distribution of AE&P and may be useful to corporations that lack sufficient liquid assets to make a distribution. Vicki L Mulak, EA, CFP Page 38 When an S Corporation Pays Tax

45 CALCULATION OF THE TAX This corporate level tax (similar to the built-in gains tax) is imposed on the lesser of the taxable income figured as though it were a C corporation, or the excess net passive income (ENPI) multiplied by the highest corporate tax rate. The equation or steps to calculate the tax are: ENPI = Net Passive Investment Income X Passive Inv Income -.25 Gross Receipts Passive Inv Income 1. Multiply gross receipts by 25%. 2. Subtract the amount found in step 1 from the amount of passive investment income. 3. Divide the result of step 2 by the passive investment income. 4. Multiply net passive income by the fraction calculated in step ENPI is the result of step 4 or the taxable income of the S corporation, whichever is less. The tax is calculated using a small worksheet from the Form 1120S instructions, and entering the calculated amount on the front of Form 1120S, page one, Line 22a: In planning for the S corporation conversion client that receives rental income, care should be exercised in determining whether significant services could be provided in Vicki L Mulak, EA, CFP Page 39 When an S Corporation Pays Tax

46 connection with the rental, in an effort to avoid or minimize the tax on passive investment income. PLANNING STRATEGIES TO AVOID THE TAX ON ENPI Several planning options are available to avoid the excess net passive income tax. For example, the S corporation can: Liquidate certain investments. Liquidate investments generating passive investment income and invest the proceeds in assets that generate business income as opposed to investment income. Render significant services. Adjust rental or royalty arrangements so the corporation is rendering significant services. Rents derived in the active conduct of a trade or business and royalties derived in the ordinary course of a trade or business are not included in passive investment income. Reduce or eliminate AE&P. Reduce or eliminate AE&P by electing to distribute AE&P before the accumulated adjustments account (AAA). An S corporation that is short of cash may be able to make a deemed dividend election (the corporation is treated as if it made a distribution of cash or other property) as a means of removing AE&P. Utilize the taxable income limitation. The tax is imposed on the lesser of the taxable income or the excess net passive income. It may be possible to reduce taxable income by selling an asset at a loss, deferring income, or accelerating deductions. Check to see if shareholders salaries can be increased to decrease taxable income. Fail to meet the 25% passive investment income threshold. It may be possible, especially for some cash basis S corporations, to adjust the timing of income recognition so that income from passive investment sources is 25% or less of gross receipts for the year. Another strategy would be to increase gross receipts, which increases the amount of passive income necessary to reach the 25% threshold. For example, the corporation could consider disposing of an Vicki L Mulak, EA, CFP Page 40 When an S Corporation Pays Tax

47 asset other than a capital asset during the year. Proceeds from the sale of depreciable assets and real property used in a trade or business are fully included in gross receipts. Redeem stock in exchange for investment assets. Reduce passive investment income and AE&P by arranging to completely redeem stock held by one or more shareholders in exchange for the assets that generate passive investment income. For example, the corporation could completely redeem stock held by an inactive spouse or child in exchange for certificates of deposit or rental property held by the corporation. Such a sale would remove a source of passive investment income from the corporation (with capital gain treatment at the shareholder level), but the corporation s AE&P would be proportionately reduced. K-1 PASS-THROUGH OF EXCESS NET PASSIVE INCOME TAX Each item of passive investment income passed through to the shareholders is reduced by a pro-rata portion of the tax on excess passive income [IRC Sec. 1366(f)(3); Reg (c)]. The reduction attributable to an item of passive investment income equals the tax multiplied by the ratio of the amount of such item to the total net passive investment income for the tax year. The passive investment income pass-through items are reduced by the tax imposed on those items. Thus, they are reduced in the year the income is recognized, regardless of when the tax is actually paid (unlike the tax on guilt-in gains). It is the items of income that are reduced; the tax does not pass through as a separate deduction. POSSIBLE TERMINATION OF S ELECTION Removing the excess net passive income tax liability does not necessarily eliminate the excess net passive income problem. Even if there is no tax liability, the corporation s S election will terminate under IRC Sec. 1362(d)(3) if the corporation has AE&P and its gross passive investment income exceeds 25% of gross receipts in each of three consecutive tax years. Once the AE&P has been distributed, however, there can be no Vicki L Mulak, EA, CFP Page 41 When an S Corporation Pays Tax

48 excess net passive income tax and the S election will not terminate because of excess passive income. Note: Removing the AE&P through the payment of C corporation dividends can be accomplished more reasonably as compared to prior years, when there is a preferential long-term capital gain rate applied to qualified dividends. WAIVERS AVAILABLE The IRS has the authority to waive the tax on excess net passive income if the following two conditions are met [IRC 1375(d)]: 1) The corporation believed, in good faith, that it had no AE&P for the year in question; and 2) The AE&P was distributed within a reasonable time period after the corporation realized that it had AE&P. User fees are required to request a waiver. A user fees schedule is included in the first revenue procedure of the year, which includes reduced fees for small businesses. COORDINATING THE PASSIVE INVESTMENT AND BIG TAXES If a gain would be subject to both the tax on passive investment income under IRC 1375 and the built-in gains tax under IRC 1374, it will not be subject to taxation under both provisions. The amount treated as passive investment income for the IRC 1375 tax does not include any recognized built-in gain or loss (taxable under the builtin gains tax rules of IRC 1374) for any year during the recognition period. Vicki L Mulak, EA, CFP Page 42 When an S Corporation Pays Tax

49 EXAMPLE -COORDINATION WITH BIG TAX Sample is an S corporation with AE&P from C corporation years. During the current year, Sample has gross receipts of $ 200,000, including $ 105,000 of interest income from investments. Sample has no expenses directly connected with the interest income. Under IRC 1374, $ 60,000 of the interest accrued prior to the date the S election was effective is subject to the built-in gains tax. This recognized built-in gain is not taken into account in determining Sample s passive investment income. Sample s passive investment income is $ 45,000 ($ 105,000 - $ 60,000 recognized for the BIG tax) for purposes of the tax on excess net passive income, which is only 22.5% of the $ 200,000 gross income. Because the passive investment income does not exceed 25% of gross income, Sample has no excess net passive income, and is not subject to the tax on excess passive income. The current year is NOT counted as a year with excess passive investment income for purposes of the three strikes you re out rule for termination of the S status. PRACTITIONER AWARENESS OF POTENTIAL FOR THE TAX The presence of assets that generate passive investment income is an indicator of the current or potential problem with excess net passive income if the S corporation has AE&P. Clues to the potential for this tax from Schedule L are: line 9 (other investments), other clues that an S corporation may have excess net passive income can come from line 5 (tax-exempt securities), line 7 (loans to shareholders), line 8 (mortgage and real estate loans), line 10a (buildings and other depreciable assets) and line 11a (depletable assets). Vicki L Mulak, EA, CFP Page 43 When an S Corporation Pays Tax

50 One of the biggest problems with both the BIG Tax and the Passive Income Tax is the practitioner s lack of recognition the existence of the problem, and omitting the calculation of corporate-level tax from the preparation of the S corporation return. In order for IRS auditors to quickly ascertain an S Corporation s potential for a corporate tax liability, the IRS requests 2 dates on the first page of Form 1120S: 1. Date incorporated; and 2. Date of the S election. RECAPTURE OF GENERAL BUSINESS CREDITS Business credit recapture is the responsibility of the party that claims the credit. Therefore, if a corporation claims the credit (while it was a C corporation), the corporation is responsible for the recapture (regardless of its subsequent S election). If the company is an S corporation when the credit originates, the credit passes through to the shareholders and they must report the recapture. If the credit was taken when the corporation was in S status, the shareholders remain responsible for the recapture even if the S election terminates and the recapture occurs when the corporation is in C status. It is evidently the corporation s responsibility to notify the shareholders of the recapture details so they can report the recapture on Form 4255 Recapture of Investment Credit. The election of S status is not an event that causes the corporation to recapture previously claimed business credits. If the corporation is a C corporation when the credit originates, the election of S status does not result in business credit recapture. However, any subsequent recapture will be paid at the corporate level if the credit was originally claimed by the corporation prior to electing S status (when it was a C corporation). Vicki L Mulak, EA, CFP Page 44 When an S Corporation Pays Tax

51 EXAMPLE-INVESTMENT CREDIT RECAPTURE Sample is an S corporation that is 100% owned by Sam, who files using the calendar year. Prior to 2013, Sample filed as a C corporation and incurred $ 100,000 of expenses to rehabilitate a certified historic structure, which it placed in service on January 31, 2012 in its last C corporation year. Sample claimed a $ 20,000 rehabilitation investment credit (RIC) on the 2012 Form 1120 and reduced the basis of the building by $ 20,000. The RIC is subject to a five-year recapture period. The recapture percentage starts at 100% and is reduced by 20% for each full year the building is held. The building was placed in service on January 31, The corporation elected S status on January 1, 2013, and on February 15, 2015, it sold the building. Since the building was sold more than three full years, but less than four full years, after the qualified rehabilitation expenditures were incurred and the building was placed in service, $ 8,000 (40% of the original $ 20,000 credit) is subject to recapture under IRC 50(a)(1). The $ 8,000 in tax paid by the S corporation passes through to Sam as a separately stated item of nondeductible corporate expense on Schedule K-1 (Line 16 C). The $ 8,000 in the EXAMPLE reduces stock basis as a nondeductible item and also reduces the AE&P. Because the recapture is payment of a federal tax relating to a C corporation year, the AAA account is not reduced. Note: When maintaining two retained earnings accounts for an S corporation conversion client (AE&P and AAA), the practitioner must be careful to adjust the automatic close of Vicki L Mulak, EA, CFP Page 45 When an S Corporation Pays Tax