Section 3 S Corporations Entity Tax Classification

Transcription

1 Section 3 S Corporations Entity Tax Classification Business entities classification for tax purposes Check the box regulations Taxpaying entities Flow-through entities Corporations are C corporations unless they make a valid S election; needs 100% (unanimous) vote. Unincorporated entities taxed as partnerships if they have more than one owner taxed as sole proprietorships if owned by an individual or as disregarded entities if held by some other entity may elect to be taxed as C corporations

2 S Corporation Elections Formation 351 Qualification requirements (Small & Simple): Shareholders must be individuals (or certain estate or trusts for the benefit of individuals; no corp, partnerships or big trusts) Shareholder number: = or < 100; (residents or citizens; married couple is treated as a single shareholder; you, your grandfather & grandma (i.e., family members with a common ancestor = or < 6 generations plus their spouses) are one shareholder) Corporation type (must be domestic & eligible; financial institutions such as banks & insurance Cos not eligible) S corps can own C corps stock or qualified S Subs; C can t own S. 1 class of stock Filing the election: Election made within 1 st 2 ½ months of the beginning of the Corp s tax year is retroactively effective from the 1 st date of that tax year. Tax return, 1120-S, is due 3/15 with 6 month extension if calendar year. The IRS can treat a late-filed election as timely filed if it determines that reasonable cause existed.

3 S Corporation Election? Example: Suppose CCS was formed with Nicole Johnson, Sarah Walker, and Chan Inc., a corporation owned by Chan Armstrong, as shareholders. Would CCS be eligible to elect S corporation status? (No. Because one of its shareholders is a corporation (Chan Inc.), CCS would not be eligible to elect S corporation status) Suppose Nicole, Sarah, and Chance recruited 97 U.S. residents to become shareholders of CCS. Meanwhile, Nicole gave several of her CCS shares to her grandfather and his bride as a wedding gift. After the transfer, CCS had 102 shareholders. Can CCS elect S corporation status? Yes. Nicole (descendant of common ancestor), her grandfather (common ancestor), and her grandfather s wife (spouse of common ancestor) are treated as one shareholder for purposes of the 100-shareholder limit

4 Formation Similar to a C Corp Cash or property may be transferred to a S corp. in exchange for the firm s stock at any time. Control: if immediately after transfer, the transferor gain 80% or more of stock (voting or nonvoting stock = or > 80%), it is tax free exchange, ie., the transaction is non-taxable and will not have to recognize any gain when property is transferred. Services rendered for stock or < 80%: taxable (ordinary income) at FMV

5 S Corporation Operation Initial contribution +/- % income/loss - Distrib received = Net basis (basis) muni bond inter Separately stated items $10 6 (=60 NI x 10% owned) (7) partially 9 taxed when earned taxed already because taxed when earned, not when received 1,550* 1,556 * Allocate your income on average daily basis, meaning how many stocks you owned on a daily basis (5/100 for 31 days). e.g., An S corp has 100 shares outstanding and has $365,000 NI. You purchased 5 shares on 11/30 (31 days). $365,000 / 365 days = $1,000 avg NI / 100 shares = $10 per share per day x31 days = 10 x 5 shares x 31 days = 1,550 NI allocated to you, which increase your basis.

6 Separately Stated Items 1/4 Items subject to certain limitations on shareholder s individual return, i.e., will go over to individual return separately. S Corp doesn t pay income taxes, but files info returns(1120-s) reporting income & telling how that income is allocated to the various shareholders. Shareholders must separately state items to allow any special treatment on individual tax returns to be applied. Corporate: prepares Schedule K summarizing the ordinary income. also prepares Sch K-1 for each shareholder showing that shareholder s allocated share of items on Sch K. These items include: Capital gains & losses (see Sec 2, slide 15) Deductibility limit (3,000 NL) Section 1231 gains & losses Noncurrent bus assets; Gaincap, Loss- Ordinary Dividends & interest Investment Interest- Net out income/exp Passive activities (Pub 925) <25,000 Charitable contributions Must itemize to deduct/50% AGI Section 179 depreciation $ limit, must elect per yr Tax credits (see Sec 2, slide 19 ) Limit to tax liab

7 Separately Stated Items 2/4

8 Separately Stated Items, example 3/4 Your individual return already has $2,490 cap loss. You now have $1,000 capital loss distribution from an S Co. (2,490) (1,000) (3,490) 3,000 cap loss limitation 490 carry over indefinitely

9 Schedule K and Schedule K-1, 4/4 Example S Corp (Sch K) Sch K-1 Corp Level Items Sales 200 COGS (1125-A) (60) Rent (25) G&A ( 5) Sal (comp) (10) 10 Sch E Sep Items Interest Income ( 0) B Charity (30) 3 A Cap Loss (10) 1 D Net Income 60 (6 = 10%) 6 Distribution to shareholder: See slide 5 ( = 9 shareholder s net basis)

10 Limit on Investment Interest Deduction Generally, your deduction for investment interest expense is limited to your net investment income. You can carry over the amount of investment interest you could not deduct because of this limit to the next tax year. The interest carried over is treated as investment interest paid or accrued in that next year.

11 Operating Distributions 1/3 S Corporations with AAA, E & P and AEP Distributions come from (1) Accumulated Adjustments Account (AAA; money earned as an S Corp but not paid out; not taxable), (2) E & P (current; dividend; taxable), and then (3) AEP (taxable) (4) any remaining shareholder stock basis (not taxable) AAA represents the current cumulative balance of the S corp. Total distributions to shareholders > (1)+(2)+(3), excess is capital gain

12 Operating Distributions 2/3 AAA account calculation Beginning of year AAA balance + Separately stated income/gain items (excluding tax exempt income) + Ordinary income - Separately stated losses and deductions - Ordinary losses - Nondeductible expenses that are not capital expenditures (except deductions related to generating tax-exempt income) - Distributions out of AAA = End of year AAA balance AAA may have a negative balance but distributions may not cause the AAA to go negative or become more negative

13 Accumulated Earnings & Profits (AEP; for C Corp) 3/3 C Corp (AEP) S Corp (AAA) earned, not paid Taxed when earned; no taxes to shareholders when S Corp pays: 1 st : comes out of AAA not taxed to SH 2 nd : extra goes against AEP 3 rd : if pay out > 1 + 2, the extra is a basis reduction (not taxable)

14 Operating Distributions Before considering distributions, CCS s AAA was $24,000 and its accumulated E&P from 2012 was $40,000. Also assume Nicole s basis in her CCS stock is $80,000. If CCS distributes $60,000 on July 1 ($20,000 to each shareholder), what is the amount and character Nicole (a 1/3 shareholder) must recognize on her $20,000 distribution, and what is her stock basis in CCS after the distribution?

15 S Corp Termination 1/2 The election to be an S corp must be unanimously (100%) Voluntary Terminations - Elected by shareholders, = or > 50% stock Effective date Involuntary Terminations (S status revoked) Failing S corporation requirements (no longer small & simple), e.g., issued > 100 shares, issued pref stocks, or nonresident SH Passive investment income (dividends, interests, royalties) > 25 percent of gross receipts for 3 years Restricted to S corporations with earnings and profits Passive investment income; Gross receipts Effective date

16 S Corp Termination 2/2 Short tax years Allocation of income across S and C corporation years. Daily method (see slide 19) Specific identification method Tax return due dates S corporation reelections Generally available at the beginning of the 5 th year after year of termination (i.e., Termin, yr1, 2, 3, 4, 1/1/5) Early IRS consent

17 Income and loss allocations 1/2 Allocate profit and loss pro rata, based on shares owned each day of the year If sell shares during the year, pro rata, per day allocations If all shareholders with changing ownership percentages agree, the S corporation can use its normal accounting rules to allocate income and loss to the specific periods in which it realized income and losses

18 Income and Loss Allocations 2/2 - Daily Method Assume CCS was formed as a calendar-year S corporation with Nicole Johnson, Sarah Walker, and Chance Armstrong as equal (one-third) shareholders (has 100 shares outstanding). On 6/14/2013, Chance sold his CCS shares to Nicole. CCS reported business income for 2013 as follows: January 1 through June 14 (165 days) $100,000 June 14 through December 31 (200 days) 265,000 January 1 through December 31, 2013 (365 days) $365,000 How much 2013 income is allocated to each shareholder if CCS uses the daily method of allocating income? Nicole = 188,333=100,000/100*200/ ,000/3 Sarah = 121,667 = 365,000 x 1/3 Chance = 55,000=100,000/100 x (165/3)

19 Built-in Gains (BIG) A C corp elects S corp status; and the FMV of the corp assets > the adjusted basis of corp assets on the election date. The difference (i.e., appreciated amount) is a net unrealized built-in gain. A distribution or sale of an S corp s assets in 5 years* (counting from the beginning of the year of which S corp status is elected) may result in a tax on any built-in gain at the corp-level. Calculation of Tax: 35% (the highest corp tax rate) X net gain recognized. In summary, recognized built-in gain for the current year (the year assets are sold or distributed) is subject to 35% on net gain recognized (up to the amount of BIG gain on conversion). *Note: before 2009, it was 10 years , 7 years; 2011: 5 years The excess of a corporation s net recognized built-in gain in excess of its taxable income: is treated as recognized built-in gain in the succeeding tax year subject to that succeeding year s limitations. If the succeeding year is a year after the recognition period has expired, the gain escapes the BIG tax.

20 LIFO Recapture Tax A C corp that owns LIFO inventory and that elects to be taxed as an S corp must include in its gross income for its final tax year as a C corp the LIFO recapture amount which is the excess of the FIFO inventory value over the LIFO inventory at the close of the last tax year of C corp status. Basis of the inventory is increased by the amount on which the recapture tax is imposed. The recapture income is spread over 4 years: the last C corp year and the first 3 years of the S corp.

21 Shareholder s Basis Initial basis: Exchange: Tax basis of property transferred, less any liabilities assumed by the corporation on the property contributed (substituted basis) Increased by any gain recognized; Reduced by the fair market value of any property received other than stock Purchase: Purchase price of the stock

22 Shareholder s Basis Annual basis adjustments: Increase for: Contributions Shareholder s share of income/gain items (including tax-exempt income Decrease for: Distributions Shareholder s share of nondeductible expenses Shareholder s share of expense/loss items Basis can never be < 0

23 Shareholder s Basis Example Assume that Nicole s beginning of year basis in CCS is $115,000. This year, her allocated share of S corporation items are: $80,000 business income; $2,000 interest income; $1,000 dividends; $400 tax-exempt interest income. What is Nicole s basis at the end of 2013?

24 Loss Limitations - Summary Losses are limited to amount invested & amount loaned to the Corp. (i.e., amount at risk). Shareholder s basis in their stock is decreased by: their share of losses (including non-deductable expenses) dividends received (all dividends are treated as return of capital; not taxable, it was taxed when earned) Basis can t go below 0, if below 0, loss is suspended & carry over until more money is put in or there is a profit (gain). (note: municipal bond interest received increases basis, but not taxable)

25 Loss Limitations - Details Tax Basis Limitation: Losses limited first to the shareholder s tax basis in stock shares and then to any basis in any direct loans made to their S corporations. In subsequent years, any net increase in basis for the year first restores the shareholder s debt basis and then the shareholder s stock basis Any loan repayment in excess of the shareholder s debt basis triggers a taxable gain to the shareholder

26 Loss Limitations Details Tax Basis Limitation (cont d): Losses not deductible due to the tax basis limitation are suspended until the shareholder generates additional basis If the shareholder sells the stock before creating additional basis, the suspended loss disappears unused At risk Limitation shareholders may deduct S corporation losses only to the extent of their at-risk amount ( 465)

27 Loss Limitations - Details At risk Limitation (cont d): S corporation shareholders are deemed at risk only for direct loans they make to S corporations S corporation shareholder s at-risk amount is generally the same as stock basis Losses limited under the at-risk rules are carried forward indefinitely until the shareholder generates additional at-risk amounts to utilize them or sells the S corporation stock

28 Loss limitations- Examples Suppose at the beginning of 2014, Nicole s basis in her CCS stock was $14,000. During 2014, Nicole loaned $8,000 to CCS and CCS reported a $60,000 ordinary business loss and no separately stated items. How much of the $20,000 ordinary loss allocated to Nicole clears the tax basis hurdle for deductibility in 2014? All $20,000. The first $14,000 of the loss reduces her stock basis to $0, and the remaining $6,000 reduces her debt basis to $2,000 ($8,000 $6,000). Suppose in 2015, CCS allocated $9,000 of ordinary business income to Nicole and no separately stated items. What are Nicole s CCS stock basis and debt basis at the end of 2015? Her stock basis is $3,000; her debt basis is $8,000. The income first restores debt basis to its original amount and then increases her stock basis.

29 Self-Employment Income S corporation shareholder s allocable share of ordinary business income (loss) is not classified as selfemployment income Shareholder salary as employees is subject to social security taxes Tax planning incentives

30 Fringe Benefits For shareholder who owns 2 percent or less of the S corporation, the S corporation gets a tax deduction and the benefit is nontaxable to shareholder-employee For shareholder who owns > 2 percent of the S corporation on any day during its tax year is not considered an employee entitled to employee benefits, the S corporation gets a tax deduction but many benefits are taxable to the shareholder-employee

31 Property Distributions S corporation consequences: recognizes gain on distribution of appreciated property does not recognize loss on distribution of property whose value has declined Shareholder consequences: recognizes distributive share of the deemed gain and increase stock basis accordingly the property distribution is the FMV of the property received taxability of distribution is determined based on distribution rules discussed previously basis is FMV of property

32 Liquidating Distributions S corporation rules follow C corporation rules S corporations generally recognize gain or loss on each asset they distribute in liquidation These gains and losses are allocated to the S corporation shareholders, increasing or decreasing their stock basis In general, shareholders recognize gain on the distribution if the value of the property exceeds their stock basis; they recognize loss if their stock basis exceeds the value of the property

33 S Corporation Taxes Excess net passive income tax Only applies to S corporations with C corporation E&P Levied on excess net passive income calculated as: Net Passive Income x [(Passive Investment Income (25% x Gross Receipts)) / Passive Investment Income] Limit on excess net passive income Applicable tax rate Allocation of excess net passive income tax to shareholders S corporation termination if tax applies three consecutive years

34 Estimated Taxes & Filing Requirements Estimated taxes Generally follow C corporation rules: S corporations with a federal income tax liability of $500 or more due must make quarterly estimated tax payments Not required to make estimated tax payments for the LIFO recapture tax Filing requirements Form 1120S due by the 15th day of the third month after the S corporation s year end Automatic, six-month extension by filing Form 7004

35 Comparing C and S Corporations and Partnerships

36 Comparing C and S Corporations and Partnerships

37 Comparing C and S Corporations and Partnerships

38 Comparing C and S Corporations and Partnerships

39 Comparing C and S Corporations and Partnerships