2016 S CORPORATION TAXATION PART II Recommended CPE Credit: 6 HRS [B] PREPARED BY. CPElite T.M. In a Class By Yourself T.M.

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1 2016 S CORPORATION TAXATION PART II Recommended CPE Credit: 6 HRS [B] PREPARED BY CPElite T.M. In a Class By Yourself T.M. (800) 9500-CPE P.O. BOX 1059, CLEMSON, SC & P.O. BOX 721, WHITE ROCK, SC

2 INSTRUCTIONS Read the content of this course on pages 1-59 and answer the review questions at the end of each course section. Then read the quiz instructions on page I and the 30 quiz questions on pages Select the best answer for each quiz question and record your answers either on the answer sheet on page ii, or on-line at if you are an online test-taker. COURSE COMPONENTS, CONTENT LEVEL, AND LEARNING OBJECTIVES The components of this course include detailed coverage of S Corporation shareholder basis, loss limitations, S Corporation distributions to owners, S Corporation shareholder changes, S Corporation income taxes, and planning considerations. The table of contents on page iii provides a more detailed description of the course components. Also where applicable, key terms are listed and defined at the beginning of the section in which they are found. The content level of this course is basic. The learning objectives of the course are provided at the beginning of each section (see Sections A - F).

3 QUIZ INSTRUCTIONS S CORPORATION TAXATION PART II There are 30 multiple-choice questions at the end of the course. Choose the best answer based on the limited facts of each question, and record your answer on the enclosed answer sheets. An extra answer sheet below is enclosed for your personal records. The answer sheet to be turned in is on the next page. To test on-line, go to and log in to your account page. If your account has not yet been created at our website, please contact us for assistance [ cpeliteinc@aol.com; phone or fax: ]. You must score 70% to receive continuing professional education credit for this course. You may take the quiz two additional times without incurring additional expense. If your zip code is below 56000, please return your completed answer sheet to CPElite, T.M P. O. Box 721, White Rock, SC If your zip code is above 55999, please return your completed answer sheet to CPElite, T.M P.O. Box 1059, Clemson, SC After you successfully complete the quiz, your quiz results, a complete set of solutions, and a certificate of completion will be mailed to you within 10 working days of our receipt of your answer sheet. The completion date on your answer sheet will be the date designated on your certificate. The latest recommended completion date is within one year of purchase. ANSWER SHEET FOR YOUR RECORDS 2016 S CORPORATION TAXATION PART II 6 HOURS OF CPE (Based on 50 Minutes of Average Completion Time Per Hour) Delivery Method Self Study (Latest Recommended Completion Date: Within one year of purchase) Please record your answers below and retain this copy for your records We appreciate your business and hope that you were satisfied with the course. COMPLETION DATE i

4 2016 ANSWER SHEET TO BE SUBMITTED 2016 S CORPORATION TAXATION PART II 6 HOURS OF CPE (Based on 50 Minutes of Average Completion Time Per Hour) Delivery Method Self Study (Latest Recommended Completion Date: Within one year of purchase) To test on-line, go to and log in to your account page. If your account has not yet been created at our website, please contact us for assistance [ cpeliteinc@aol.com; phone or fax: ]. Otherwise, please record your answers below and mail your solutions to: ZIP CODE BELOW ZIP CODE ABOVE CPElite CPElite T.M. T.M. P.O. Box 721 P. O. Box 1059 White Rock, SC Clemson, SC We appreciate your business and hope that you were satisfied with the course. Please express below your comments on course quality, other topics you would like, or our other products and services NAME ADDRESS [PLEASE PRINT] ADDRESS (Note: We do not share or sell addresses) PHONE NUMBER SIGNATURE COMPLETION DATE PURPOSE OF CPE PTIN (if applicable) (Indicate whether credit is for enrolled agent, CPA, or other purpose. For CPA's and other licensed accountants, please indicate state licensed. For CFPs, please provide either the last four digits of your social security number or your certificant/cfp Board ID number). COURSE EVALUATION (Answer Yes, No, or N/A) 1. The stated learning objective was met. 2. Handout or advance preparation materials were satisfactory. 3. The materials were accurate. 4. The materials were relevant and contributed to the achievement of the learning objective. 5. If applicable, prerequisite requirements were appropriate. 6. The time allotted to the learning activity was appropriate. 7. Additional Comments. ii

5 2016 S CORPORATION TAXATION PART II TABLE OF CONTENTS A. DETERMINING THE S CORPORATION SHAREHOLDER S BASIS A.1 Initial Stock Basis 2 A.2 Subsequent Effects on the Initial Stock Basis 5 A.3 Computing Stock Basis for Specific Shares 9 A.4 Direct Shareholder Loans Made to the S Corporation 9 A.5 Special Stock and Loan Basis Issues 12 B. LOSS LIMITATIONS B.1 Introduction 16 B.2 At-Risk Limitations 17 B.3 Passive Activity Loss Limitations 19 C. DISTRIBUTIONS C.1 Distributions Generally 23 C.2 S Corporations with no Earnings and Profits 24 C.3 S Corporations with Earnings and Profits 26 C.4 Post-Termination Transition Period 32 D. S CORPORATION SHAREHOLDER CHANGES D.1 Sale of Owner Stock 37 D.2 Sale of Company Assets 39 E. INCOME TAX LIABILITY E.1 Introduction 40 E.2 Built-in Gains from C Corporation Years 41 E.3 Excessive Passive Investment Income 45 E.4 LIFO Recapture Tax 48 E.5 Estimated Tax Payments 50 F. PLANNING ISSUES WITH S CORPORATIONS F.1 Formation 53 F.2 Election 55 F.3 Transactions and Operations 56 F.4 Distributions 57 F.5 Relief Provisions 57 G. CONCLUDING REMARKS 59 INDEX 60 QUIZ QUESTIONS 61 ENDNOTES 67 iii

6 ONGOING DEVELOPMENTS CPElite T.M. CONTINUES TO MONITOR LEGISLATIVE, ADMINISTRATIVE, AND JUDICIAL DEVELOPMENTS AS THEY OCCUR, AND OUR COURSES ARE UPDATED TO REFLECT TAX LAW CHANGES. ALL RIGHTS RESERVED. THE REPRODUCTION OR TRANSLATION OF THESE MATERIALS IS PROHIBITED WITHOUT THE WRITTEN PERMISSION OF CPElite. T.M. iv

7 2016 S CORPORATION TAXATION PART II The primary objective of this course is to provide an explanation of the following items: (1) detailed coverage of S Corporation shareholder basis issues; (2) loss limitation issues; (3) distributions made by an S Corporation to its owners; (4) S Corporation shareholder changes; (5) S Corporation income taxes; and, (6) planning considerations. This course reflects legislative changes made through the Protecting Americans from Tax Hikes Act of 2015, the PATH Act, signed by President Obama on December 18, The level of knowledge expected to be imparted by this course is basic. Our courses comply with the enhanced standards required of providers of continuing professional education (the Statement of Standards for Continuing Professional Education (CPE) Programs, issued jointly by the AICPA and NASBA) and the QAS requirements. Also, we are an IRS-Approved Continuing Education Provider. A. DETERMINING THE S CORPORATION SHAREHOLDER S BASIS Key Terms in This Section: Accumulated adjustments account: An account that an S Corporation must maintain if it has accumulated earnings and profits. The account is not apportioned among shareholders. The account is used to determine the effect of distributions. It generally is adjusted in a manner similar to adjustments to the basis of a shareholder s stock. However, it is not adjusted for tax-exempt income and related expenses, and federal taxes the S Corporation pays that are attributable to years that the corporation was a C Corporation. Other adjustments account: An S Corporation account that consists of tax-exempt income and related expenses, and federal taxes the S Corporation pays that are attributable to years that the corporation was a C Corporation. Spillover rule: A special shareholder stock basis calculation rule that is used where a shareholder's share of losses and deductions exceeds the basis of a share of stock to which the losses and deductions are attributable. The rule allows the shareholder to apply the excess ("spillover") to the remaining basis of all other shares. The rule applies to basis adjustments for distributions as well as to adjustments for pro rata shares of passthrough items of loss or deduction. Section 1244 stock: Stock that may be issued by a corporation for which a shareholder loss on disposition of the stock receives favorable tax treatment. On a joint return, up to $100,000 of loss from Section 1244 stock in a tax year is treated as an ordinary loss ($50,000 on all other individual returns). Certain requirements must be met when the stock is issued in order for it to be classified as Section 1244 stock. An S Corporation may issue Section 1244 stock. Qualified small business stock: Stock that may be issued by a corporation for which a shareholder gain on sale of the stock receives favorable tax treatment part of the gain on the sale of the stock may be excluded from gross income. Certain requirements must be met when the stock is issued 1

8 in order for it to be classified as qualified small business stock. Only a C Corporation may issue qualified small business stock (thus this stock may not be issued by an S Corporation). LEARNING OBJECTIVES: 1. Determine the initial basis that an S Corporation shareholder has in his or her stock. 2. Determine the effects of income in respect of a decedent on an individual who inherits S Corporation stock. 3. Determine the effect that an S Corporation s operations and transactions have on the basis of the S Corporation shareholder s stock. 4. Compute the basis that an S Corporation shareholder has in his or her S Corporation stock. 5. Compute the basis that an S Corporation shareholder has in loans that he or she has made to the S Corporation. 6. Recognize basis, character, and loan repayment consequences of shareholder loans to an S Corporation. 7. Identify the treatment of worthless S Corporation stock. 8. Determine if an S Corporation can issue Section 1244 and Section 1202 stock. A.1 Initial Stock Basis The shareholder s basis in his S Corporation stock is important for three reasons: (1) basis is the starting point to determine how much of a shareholder s current share of the corporation s loss the shareholder may use on his current income tax return; (2) basis affects, in part, how a distribution from the S Corporation to the owner is treated; and, (3) basis is used in computing the amount of realized gain or loss that the owner has when he sells his S Corporation stock. The shareholder s initial basis in his S Corporation stock depends on how the shareholder acquires his S Corporation stock. The shareholder may acquire shares in the S Corporation in a number of ways: (1) contributing property in exchange for shares; (2) performing services in exchange for shares; (3) receiving shares as a gift; (4) inheriting shares; or, (5) purchasing shares directly from an existing owner. The rules of Internal Revenue Code Subchapter C 2 are used to determine initial stock basis when the owner acquires his shares by contributing property to the corporation or performs services 3 for the corporation in exchange for the stock. The shareholder substitutes his basis in contributed property for stock received in the corporation. He reduces his stock basis for any liabilities on 2

9 property that is transferred to the corporation in exchange for stock, and for any property other than stock that the shareholder receives on the transfer. If the shareholder must recognize gain on the transfer of property, he increases the basis in his stock for any gain recognized. Realized gain must be recognized if the shareholder receives property in addition to stock on the transfer. Gain must be recognized if total liabilities transferred to the corporation on the transfer exceed the basis in the properties that are contributed to the corporation. If the shareholder performs services in exchange for stock in a corporation, the shareholder recognizes compensation income equal to the fair market value of the services, and he increases the basis in the corporation s stock equal to the amount of income recognized. Example 1 Tom and Rich form an S Corporation as equal owners. Tom performs services related to organizing the corporation and perfecting the title of various assets that the corporation purchases. He receives 500 shares of the corporation s stock, valued at $50 a share, equal to the $25,000 value of the services that he performs. Rich transfers $10,000 cash and a business asset worth $15,000 in exchange for 500 of the corporation s shares. Rich s basis in the business asset is $7,000. Tom recognizes $25,000 of compensation income, and takes a $25,000 basis in the corporation stock that he receives (value of services he performs). Rich takes a $17,000 basis in the stock that he receives ($10,000 of cash transferred + $7,000 basis in the business asset that he transfers). Example 2 Assume in Example 1 that Rich transfers no cash, the business asset is worth $34,000, the asset is encumbered by a $9,000 liability taken out for a business purpose, and the corporation takes over the liability. Rich recognizes $2,000 of gain (excess of $9,000 liability over $7,000 basis in the property). Rich s basis for his stock is $0 ($7,000 basis in property transferred + $2,000 of gain recognized - $9,000 liability transferred to the corporation). Example 3 Return to Example 1. Assume that Rich receives 400 shares of stock and a $5,000 note from the corporation. Of the $8,000 of realized gain on the business asset ($15,000 value - $7,000 basis), Rich must recognize gain of $5,000, the value of the property other than stock that he receives. Rich s basis for his stock is $17,000 ($10,000 of cash transferred + $7,000 basis in property transferred + $5,000 gain recognized - $5,000 value of property other than stock that he receives). The taxpayer may receive shares in a corporation as a gift. Generally, the donee takes a carryover basis from the donor. However, if the donor s basis in the shares received is more than the fair market value of the stock, the donee s basis depends on the amount for which he subsequently sells the shares: if the shares later are sold for less than the fair market value on the gift 3

10 date, the fair market value is used as the basis in determining the loss on the shares sold; if the shares later are sold for more than the donor s basis, the donor s basis is used as the basis in determining the gain on the shares sold; if the shares later are sold for an amount between the donor s basis and the lower fair market value on the gift date, there is no gain or loss on the shares when they are sold. 4 Example 4 Megan gives shares in Missy Corporation, Inc., an S Corporation, to Nicole. At the gift date, Megan s basis in the shares is $50,000, and the fair market value of the shares is $30,000. If Nicole later sells the shares for more than $50,000, she uses $50,000 as her basis to compute her gain on the sale. If Nicole later sells the shares for less than $30,000, she uses $30,000 as her basis to compute her loss on the sale. If Nicole later sells the shares for an amount between $30,000 and $50,000, she reports no gain or loss from the sale of the shares. Note: Apparently, the basis to be used to compute gain or loss would be Nicole s initial basis in the S Corporation shares adjusted for her share of the S Corporation s items of income, gain, loss, and deduction after the gift date. The taxpayer may receive shares in an S Corporation as an inheritance. Generally, the heir who receives the shares takes a basis equal to the fair market value of the shares on the date of the decedent s death. 5 However, special rules apply. 6 The S Corporation basis rule is similar to the partnership basis rule where a person acquires the right to receive income in respect of a decedent (IRD). Generally, IRD is an item that has been realized but not yet reported by a cash-basis taxpayer, for example cash-basis accounts receivable. Specifically, the following three rules apply to a person who inherits S Corporation stock: 7 1. The heir treats as IRD his or her pro rata share of any item of income of the S Corporation that would have been IRD if that item had been acquired directly from the decedent. The character of the income is the character that it would have been to the decedent. 2. If an item is treated as IRD, Internal Revenue Code Section 691(c) generally permits the heir a deduction for the estate tax attributable to the item. 3. The stepped-up basis which the heir receives in S Corporation stock inherited from the decedent is reduced by the extent to which the value of the stock is attributable to items consisting of IRD. Example 5 Bill owns a 30% interest in an S Corporation. The corporation s business is providing architectural services, and it uses the cash method of tax accounting. Bill dies and leaves his interest to his son Seth. At the time of Bill s death, the fair market value of his shares is $500,000, and the corporation has $200,000 of unrealized receivables. Seth s basis for the inherited shares is $440,000 ($500,000 fair market value less Bill s 30% share of the unrealized receivables of $60,000). The $60,000 is IRD and, under the S Corporation s cash method, Seth will report his $60,000 share of the unrealized receivables as ordinary income. 4

11 The taxpayer may acquire his S Corporation shares through purchase directly from an existing shareholder. In this case, the purchaser takes a cost basis in the shares purchased. Unlike with the purchase of shares from a partner, cost does not include the purchaser s share of the S Corporation s liabilities. Example 6 Mel buys all of Ray s shares in an S Corporation. At the time of purchase, the corporation has $50,000 of debt owed to a local bank. Mel pays Ray $30,000 for Ray s shares. Mel s basis in the shares is his $30,000 cost he includes none of the S Corporation debt in his stock basis. A.2 Subsequent Effects on the Initial Stock Basis Various items increase or decrease a shareholder s basis in his S Corporation stock. 8 Shareholders increase their S Corporation stock basis for their share of income, whether includible or excludable from gross income, and reduce their basis for their share of expenses, whether deductible or nondeductible. 9 The items are applied in a specified order to affect the basis. A shareholder s basis in his S Corporation stock can not go below zero. 10 Both separately stated and nonseparately stated items of income increase a shareholder's basis in his stock. Also, any excess of percentage depletion taken by the corporation over the related property's basis is added to the shareholder's basis in his stock. Example 7 AB Corporation is an S Corporation. One of AB Corporation's shareholders, X, has a basis of $300 in his stock before the current calendar year. For the current calendar year, X's separately stated share of long-term capital gain is $50, and his share of nonseparately computed income is $150. X's percentage depletion on AB Corporation depletable property is $90; his allocated share of the property's basis at the beginning of the current calendar year is $40. There are no other items affecting X's stock basis. X's adjusted basis in his AB Corporation stock at the end of the current calendar year is $550 [$300 + $50 + $150 + ($90 - $40)]. Here is the order in which the shareholder s basis in his S Corporation stock is affected by the S Corporation s items Increase stock basis for stock purchases and capital contributions. Increase stock basis for income items that are separately stated, that is income items that could affect owners differently, and nonseparately stated income ( ordinary business income (loss) ) from line 21 of page 1 of Form 1120S). Separately stated income includes net rental real estate income, other gross rental income, interest, dividends, royalties, net short-term capital gain, net long-term capital gain, net Section 1231 gain, and tax-exempt income. The increase in stock basis for tax-exempt income preserves the nontaxable status of the income. If shareholders were not allowed to 5

12 increase their basis for their share of tax-exempt income, the net effect on their basis after the tax-exempt income is distributed to the shareholders would be a downward basis adjustment or gain recognition (if the cash distributed exceeded the stock basis). Also, increase stock basis for the excess of depletion deductions over the basis of property that is subject to depletion. 2. Decrease stock basis for distributions that are not treated as income, for example distributions from the corporation s Accumulated Adjustments Account, Previously Taxed Income, and Other Adjustments Account. 12 Thus, distributions treated as a dividend because they are made from C Corporation earnings and profits that the S Corporation has would not affect stock basis. C Corporation earnings and profits could exist because the S Corporation previously was a C Corporation before making the S election, or because the S Corporation acquired a C Corporation in which the tax attributes that carried over from the C Corporation included its earnings and profits. The adjustments for distributions that an S Corporation makes during a tax year are taken into account before applying the loss limitation for the year. In other words, distributions made during a year reduce the shareholder's adjusted basis for his or her S Corporation stock before determining the allowable loss for the year. The ordering treatment for S Corporation distributions is the same as that for partnership distributions. Example 8 On January 1, 2016, Herm Stankey, a shareholder in an S Corporation, has a basis of $15,000 in his S Corporation stock. Herm has made no loans to the corporation. During 2016, Herm receives $13,000 in distributions from the S Corporation. Herm's share of the S Corporation's operating loss for 2016 is $6,000. Herm is able to use only $2,000 of the loss under the stock basis loss limitation rule which applies to S Corporation shareholders ($15,000 - $13,000). The $4,000 currently unused portion of the loss is carried over to 2017 and future years until Herm has sufficient basis to absorb the carryover and to enable him to use the loss. Example 9 A shareholder's basis in his S Corporation stock is reduced by all distributions. For property distributions, the shareholder's basis is reduced by the fair market value of the property distributed (but not below zero). Gain is recognized by the shareholder to the extent the money or fair market value of the property distributed exceeds the shareholder's stock basis. In addition, the property's basis in the shareholder s hands after the distribution equals its fair market value. 13 As for a C Corporation, if an S Corporation distributes appreciated property, the corporation recognizes the gain in the property, and it allocates each shareholder his/her portion of the gain (the shareholder pays tax on his/her share of the gain allocated). If the gain is built-in gain (Section E.2 below), the S Corporation pays tax on the gain and the tax it pays reduces the amount of gain allocated to the shareholder. An S Corporation distributes property worth $150,000 and in which it has a $90,000 basis to its sole shareholder. The shareholder has a $200,000 basis in his S Corporation stock. The $60,000 of gain in the property ($150,000 - $90,000) is not built-in gain. The corporation recognizes $60,000 of gain. It allocates the $60,000 of gain to its shareholder, who includes the $60,000 of gain in his gross income, and pays tax on it. The shareholder reduces the basis in his S Corporation stock to $50,000 ($200,000 - $150,000). The shareholder recognizes go gain from the distribution, as the fair market value of the property distributed is less than his stock basis before the property distribution. If the shareholder s stock basis were less than the $150,000 value of the property distributed, the shareholder would recognize gain 6

13 in the amount of the property value / stock basis difference, and the basis of his S Corporation stock would be reduced to zero. The shareholder takes a basis of $150,000 in the property distributed. 3. Decrease stock basis for noncapital, nondeductible expenses, for example fines, penalties, illegal kickbacks, and charitable contributions. Stock basis also is reduced for loss on distributed property, where Section 311 that applies to regular C Corporations does not permit the corporation to recognize the loss. 14 The shareholder reduces his/her stock basis for his/her share of the S Corporation s basis of non-cash charitable contributions that the S Corporation makes. 15 Also, decrease stock basis for the shareholder s depletion deduction for oil and gas property held by the S Corporation, to the extent that the deduction does not exceed the proportionate share of the adjusted basis of the property that is allocated to the shareholder. 16 With respect to oil and gas property, each S Corporation shareholder computes cost or percentage depletion for each oil and gas property. The S Corporation does not compute depletion. The S Corporation allocates to each shareholder his or her pro rata share of the basis of oil or gas property. If the corporation distributes oil or gas property to shareholders, the adjusted basis of the property distributed equals the sum of the collective shareholders' adjusted bases in the property TAX SAVER!! Because depletion is figured at the shareholder level, it is important for each shareholder to keep careful records of the adjusted basis of oil and gas property which is allocated to him or her by the S Corporation, and to adjust the basis each year for depletion taken. The shareholder's gain or loss, thus, is computed easily should the corporation dispose of the property. Also, it would be prudent for each shareholder annually to provide the corporation copies of his or her records with respect to the basis of oil or gas property of the S Corporation. This procedure would facilitate the S Corporation's calculating potential built-in gains tax and the basis of the property should it distribute an oil or gas property to one of its shareholders Decrease stock basis for separately stated items of loss and deduction, and for nonseparately computed loss ( ordinary business loss from line 21 of page 1 of Form 1120S). Separately stated items of loss and deduction include net rental real estate loss, other gross rental loss, net short-term capital loss, net long-term capital loss, and net Section 1231 loss. Stock basis is reduced for separately stated items before ordinary business loss. Example 10 Ashley is a 30% owner of Simmons Corporation, Inc., an S Corporation, both calendar-year taxpayers. At the beginning of 2016, basis for her Simmons stock was $20,000. For her 2016 tax year, Ashley receives a Schedule K-1 from Simmons, containing the following items: ordinary business loss (Box 1), ($30,000); interest income (Box 4), $4,500; ordinary dividends and qualified dividends (Boxes 5a and 5b), $3,000; net short-term capital gain (Box 7), $1,500; net long-term capital loss (Box 8a), ($9,000); cash charitable contributions subject to the 50% limitation (Box 12, Code A), $1,500; tax-exempt interest income (Box 16, Code A), $600; fines (Box 16, Code C), $150; and, cash distributions (Box 16, Code D) from the corporation s accumulated adjustments account, $15,000. Ashley computes her 2016 year-end basis in her Simmons stock as follows: Stock basis, beginning of $20,000 Interest income... 4,500 Dividend income... 3,000 7

14 Net short-term capital gain... 1,500 Tax-exempt interest income Stock basis before distributions... $29,600 Cash distributions... (15,000) Stock basis before noncapital, nondeductible items... $14,600 Fines... ( 150) Cash charitable contributions... ( 1,500) Stock basis before separately stated items of loss and deduction, and nonseparately compute loss (orbusiness loss)... $12,950 Net long-term capital loss... ( 9,000) Ordinary business loss... (30,000) Stock basis, end of $ -0- Ashley is only permitted to use $12,950 of net long-term capital loss and ordinary business loss, because the basis of her stock can not go below zero. Since the total $39,000 of losses ($9,000 + $30,000) exceeds her $12,950 of stock basis before considering availability of losses, only $12,950 of the net long-term capital and ordinary business losses may be used currently, as her stock basis can not go below zero. A pro rata share of each loss is permitted currently, with the balance being carried over to future years when there is ample stock basis. 17 The amount of each loss which can be used currently is calculated as follows: net long-term capital loss $2,988 (($9,000 / $39,000) x $12,950); and, ordinary loss $9,962 (($30,000 / $39,000) x $12,950); The $6,012 of net long-term capital loss and $20,038 of ordinary business loss Ashley is unable to use currently due to the stock basis limitation are carried over to future years. She will be permitted to use the losses carried over to the extent of net positive adjustments to her stock basis (and direct loan basis see Section A.4 below) in future years. There is an elective ordering rule. Under the elective rule, the shareholder may reduce stock basis for deductible items before reducing stock basis for nondeductible expenditures. 18 The shareholder makes the election by attaching a statement to his timely filed original or amended return that states that he agrees to a required carryover rule. The carryover rule is that the shareholder must agree to carry forward any disallowed expenses that are more than basis and to reduce basis in future years. The election is irrevocable TAX SAVER!! The elective ordering rule should be considered if a shareholder s share of total deductible and nondeductible losses and expenses exceeds his stock basis: the shareholder would be permitted a current rather than a deferred deduction. On the other hand, the general ordering rule would be advantageous if the shareholder s stock basis is less than the amount of the disallowed losses and deductions, and the tax benefit of a future deduction might be greater, say because of expected future marginal tax rates that are greater than the marginal tax rate for the current year in which the losses and deductions are sustained. Also, the irrevocability of the election is a risk that must be considered TAX SAVER!! The importance of basis to the shareholder and the fact that most items that affect basis are on the Schedule K-1 that the shareholder receives each year 8

15 point up the importance of having the Schedule K-1 readily available for each year the taxpayer is a shareholder in the S Corporation. It is a good idea to communicate regularly to clients the importance of keeping Schedule K-1s in the investment folder Where debt discharge income is excluded from the S Corporation's income, the amount of the income does not increase a shareholder's S Corporation stock basis. Generally, this rule applies to S Corporation debt discharges after October 11, A.3 Computing Stock Basis for Specific Shares A separate basis approach is used to compute the basis of a shareholder's S Corporation stock. 20 Example 11 At December 31, 2015, Sally Mills owns 100 shares of stock in an S Corporation. Her per share basis is $8. Sally buys an additional 100 shares for $1,200 on December 31, 2015, giving her a per share basis in her new shares of $12. Sally owns the 200 shares throughout the corporation's 2016 taxable year. Sally's share of the corporation's 2016 items is as follows: (1) ordinary income -- $600; and, (2) capital losses -- $900. During 2016 the corporation makes a $300 distribution to Sally. Sally increases the basis of each share by $3 ($600 / 200 shares) for ordinary income, decreases the basis of each share by $4.50 ($900 / 200 shares) for capital losses, and decreases the basis of each share by $1.50 ($300 / 200 shares) for the distribution. Thus, there is a net $3 decrease in each share ($3 -$ $1.50). Sally owns 100 shares with a per share basis of $5 ($8 - $3) and 100 shares with a per share basis of $9 ($12 - $3). A "spillover rule" is used where a shareholder's share of losses and deductions exceeds the basis of a share of stock to which the losses and deductions are attributable. The "spillover rule" allows the shareholder to apply the excess ("spillover") to the remaining basis of all other shares. The "spillover rule" applies to basis adjustments for distributions as well as to adjustments for pro rata shares of passthrough items of loss or deduction. 21 A.4 Direct Shareholder Loans Made to the S Corporation Unlike the federal income tax treatment for a for a business entity that is treated as a partnership, S Corporation shareholders are unable to increase their basis for taking losses from the corporation for their share of the corporation s debt. However, S Corporation shareholders may deduct their share of the corporation s losses up to the basis that they have in direct loans that they have made to the S Corporation. 22 As with stock basis, the deduction is tested against the at-risk and 9

16 passive activity loss rules for current deductibility. Losses first reduce the S Corporation shareholder s basis in his S Corporation stock. Also as with stock basis, the loan basis may not go below zero. If a shareholder guarantees S Corporation debt, there is no effect on shareholder loans or stock in the S Corporation. However, after the shareholder actually performs on the guarantee, the shareholder increases the basis in his S Corporation stock for the amount of performance. 23 If current net decreases exceed the shareholder's basis in the S Corporation's stock, the excess is applied to reduce the basis of any loans made directly by the shareholder to the corporation. Any subsequent net increases first go to restore the reduction in the basis of loans before increasing the basis of the shareholder's S Corporation stock. If the shareholder holds more than one debt, the basis reduction is made proportionately. The reduction is based on the basis which each item of debt bears to the aggregate basis of debt owed by the S Corporation to the shareholder. 24 Example 12 Wilson has a zero basis in his S Corporation stock. At December 31, 2015, Wilson had made the following two loans to the S Corporation: Loan # Type Original Amount Basis - 12/31/ year promissory note $1, Demand promissory note $5,000 $1,000 On January 1, 2016, Wilson loans $4,000 to his S Corporation (Loan # 3), evidenced by a demand promissory note. During 2016, the losses allocated to Wilson exceed by $4,000 the income allocated to Wilson. Wilson's S Corporation makes no 2016 distributions. Since Loan # 1 has a zero basis, none of the $4,000 net loss is allocated to it. Since Loan # 2's basis is 20% of the aggregate basis of loans made by Wilson to his S Corporation ($1,000 / $1,000 + $4,000), $800 of the net loss (20% x $4,000 loss) is allocated to Loan # 2, giving it a basis of $200 ($1,000 - $800). Loan # 3 is allocated 80% of the loss, or $3,200. Wilson's basis in Loan # 3 after the allocation is $800 ($4,000 - $3,200). A special rule applies to "open account debt." "Open account debt" is advances to an S Corporation by a shareholder, where the advances are not represented by separate written instruments and they typically are treated as one account by the S Corporation. Under the special rule, all "open account debt" held by a shareholder is treated as a single debt for purposes of reducing and restoring basis of debt

17 Basis in reduced debt is restored when the S Corporation subsequently earns income. Any net income in subsequent years goes first to restore reduced loan basis, and then to restore the S Corporation shareholder s stock basis. 26 Example 13 Tim has a zero basis in his S Corporation stock. A loan he has made to his S Corporation has a face value of $10,000, and its current basis is $3,000 (having previously been reduced by $7,000 of losses that he used). Tim s share of the corporation s current net income is $4,000. Tim increases the basis in his loan to $7,000. His stock basis remains at zero. If the shareholder loan is evidenced by a note, the note is a capital asset. If the shareholder loan is not evidenced by a note, it is not treated as a capital asset. All unwritten loans are treated as a single note for basis purposes. If the S Corporation repays reduced-basis shareholder loans before basis is restored, the federal income tax consequences depend on whether the loan is evidenced by a note. If the corporation repays a shareholder loan before basis is restored, there is capital gain if the loan is evidenced by a note, ordinary income if it is not. Example 14 Refer back to Example 13. If the S Corporation repays Tim the $10,000 face value of the loan before its basis is increased again, Tim has $3,000 of income. The income is capital gain if the loan is supported by a note, $3,000 of ordinary income if it is not, for example if Tim lent the money to the corporation on open account TAX SAVER!! Given the tax rate differential between ordinary income (39.6% top rate) and residual capital gain (0%, 15%, and 20% after 2012), it is important that all shareholder loans to the S Corporation be documented with notes. This strategy ensures that repayment of a reduced basis loan before basis is restored results in capital gain rather than ordinary income TAX SAVER!! If the prospects are not good that the S Corporation will repay the shareholder a reduced-basis loan, and the shareholder wishes to avoid income recognition, the shareholder may consider gifting the loan. For example, a genuine gifting of the loan to a family member in a lower marginal tax bracket will result in lower income tax upon loan repayment. Also, a gift of a note to a qualified charitable organization permits the shareholder to claim a charitable deduction equal to the fair market value of the note

18 A.5 Special Stock and Loan Basis Issues A.51 Worthless Stock and Bad Debt There are special rules for S Corporation stock which becomes worthless, and for loans the shareholder has made to the S Corporation which go bad. The shareholder's basis in his stock and loans is to be adjusted for his share of S Corporation items for the period in question before a loss for worthless securities or bad debts may be taken. 27 After the shareholder adjusts the basis in the S Corporation stock and loans made to the corporation, the loss on the worthless stock or registered loans is treated as a capital loss. With respect to the stock, the stock is treated as if it were sold on the last day of the tax year in which it becomes worthless. A loss on a worthless unregistered loan is treated as a short-term capital loss. Example 15 An S Corporation calendar-year shareholder has no basis in her S Corporation stock which she acquired three years ago. She has a $7,000 basis in a $12,000 unregistered loan she made to the S Corporation two years ago. For the current year, her share of the S Corporation's loss (all ordinary) is $5,000. The corporation goes bankrupt in the current year, and her stock and debt owed to her by the S Corporation are worthless. She reports a $5,000 ordinary loss and a $2,000 ($7,000 - $5,000) short-term capital loss on her return for the current year. Example 16 An S Corporation shareholder acquires stock on December 15, 2015, in exchange for a $25,000 cash contribution. The stock becomes worthless on November 19, The stock is treated as if were sold on December 31, The shareholder has a $25,000 long-term capital loss from the worthlessness of the stock. A.52 Section 1244 Stock An S Corporation may issue Section 1244 stock. It is important that shareholders who receive Section 1244 stock are aware of it, since a loss on Section 1244 stock receives favorable tax treatment. On a joint return, up to $100,000 of loss from Section 1244 stock in a tax year is treated as an ordinary loss ($50,000 on all other individual returns). 28 There are several requirements for stock to be Section 1244 stock. There are separate requirements for both the issuing corporation and the shareholder. With respect to the issuing corporation, the corporation must (1) be a domestic corporation, (2) have issued the stock for money or property other than stock and securities, (3) for its most recent five taxable years derived more than 50% of its gross receipts from non-passive sources (sources other than royalties, rents, 12

19 dividends, interest, annuities, sales or exchanges of stock or securities, and other types of investment income), and (4) meet capitalization requirements. With respect to the capitalization requirements, the corporation s aggregate amount of money and other property received as contributed capital must be $1 million or less. 29 The shareholder must be an individual. 30 Example 17 An S Corporation issues stock to a shareholder in exchange for cash of $60,000 and a Section 1231 asset in which the shareholder has a $90,000 basis. The stock is Section 1244 stock. The corporation breaks even for several years, then it has several loss years in which the shareholder s share of the corporation s losses is $20,000. The shareholder sells his stock for $10,000, and files a joint return. Based only on these facts, the shareholder sustains a long-term capital loss of $120,000 from the stock s worthlessness. On a joint return, the shareholder claims a $100,000 Section 1244 ordinary loss, $3,000 of long-term capital loss that may be taken against non-capital gain income, and $17,000 of long-term capital loss that may be taken against capital gain income TAX SAVER!! In the previous example, if the shareholder has no current capital gain income, and does not anticipate capital gain income in the near future, he should consider selling part of his stock in the current tax year, and the balance of his stock in the next tax year. For example, if he sells $8,000 of his stock in the current year, and the remaining $2,000 in his next tax year, all of the loss on sale will be able to be taken as ordinary loss in the two tax years: $96,000 of ordinary loss is claimed in the current tax year, and $24,000 of ordinary loss is claimed in the next tax year. The reduced value of unused capital loss that must be carried over to future tax years is avoided While an S Corporation may issue Section 1244 stock, it may not issue Section 1202 qualified small business stock, which permits a partial exclusion of gain on the sale of qualified stock qualified small business stock may only be issued by a regular C Corporation. 31 So, while S Corporation owners receive preferential treatment for some or all of the loss the shareholder sustains if the company is not successful, there is no preferential treatment beyond capital gain treatment if the company is successful. **REVIEW QUESTIONS AND SOLUTIONS** 1. Art and Sam form AS, Inc., an S Corporation. Art transfers $25,000 cash and unrealized receivables (zero basis, $30,000 fair market value), and performs services valued at $15,000 for 700 shares. Sam transfers depreciable business property ($20,000 basis, $30,000 fair market value) for 300 shares. What are Art and Sam s bases in their AS, Inc. stock? a. Art $70,000; Sam $30,000. b. Art $25,000; Sam $30,000. c. Art $40,000; Sam $20,

20 2. With respect to a shareholder s initial S Corporation stock basis, which one of the following statements is true? a. A transferring shareholder reduces his stock basis for any liabilities that he transfers to the corporation in exchange for his stock. b. If the shareholder recognizes gain when he transfers property to the corporation in exchange for stock, he reduces the basis in his stock in the amount of any gain recognized. c. If a person receives S Corporation shares as a gift, the donor s basis in the shares is $19,000 and they are worth $13,000 when gifted, if the donee later sells the shares for $21,000, he recognizes $8,000 of gain on the sale. 3. An S Corporation distribution from which one of the following sources does not reduce the shareholder s basis in her S Corporation stock? a. The corporation s earnings and profits. b. The corporation s accumulated adjustments account. c. The corporation s other adjustments account. 4. Under an elective ordering rule for affecting an S Corporation shareholder s stock basis, the shareholder may reduce stock basis for deductible items before she reduces stock basis for nondeductible expenditures. With respect to the rule, which one of the following statements is false? a. The election is irrevocable. b. The corporation must make the election. c. The shareholder must agree to carry forward any disallowed expenses that are more than stock basis and to reduce stock basis in future years. 5. A sole owner of an S Corporation loans $25,000 to her corporation in The loan was formal, and evidenced by a note. In 2015, the shareholder used the loan to absorb $11,000 of losses that she had from the corporation. In 2016 the corporation breaks even in its operations, and it repays the $25,000 loan to the shareholder. How much and what type of income does the shareholder have from the repayment? Solutions a. $11,000 ordinary income. b. $25,000 capital gain. c. $11,000 capital gain. 1. C is the correct response. Art s stock basis is the sum of the $25,000 cash, the zero basis in the receivables, and the $15,000 of compensation income that he recognizes from the services that he performs. Sam s basis equals the $20,000 basis in the contributed depreciable business property. 14

21 A is an incorrect response. The transferring shareholder substitutes the basis for property contributed and the value of services he performs for the basis in the stock that he receives in the exchange. B is an incorrect response. Art must include the compensation income he recognizes in the basis for his stock. Section A A is the correct response. Shareholder liabilities taken over by the corporation are treated as if the transferring shareholder received boot in the exchange. B is an incorrect response. The shareholder increases the basis in his stock in the amount of any gain recognized. C is an incorrect response. When the gifted property s value is less than the donor s basis, the basis is used on sale of the shares by the donee to compute gain. The person has $2,000 of gain on the sale ($21,000 - $19,000). Section A A is the correct response. Stock basis is reduced for distributions that are not treated as income. A distribution from earnings and profits is treated as dividend income, and so it does not reduce stock basis. B is an incorrect response. A distribution from the corporation s accumulated adjustments account is not treated as income, and it reduces stock basis. C is an incorrect response. A distribution from the corporation s other adjustments account is not treated as income, and it reduces stock basis. Section A B is the correct response. The shareholder makes the election by attaching a statement to his return. A is an incorrect response. The shareholder must exercise caution in making the election, as the election is irrevocable. C is an incorrect response. Part of the election is the shareholder statement that she agrees to carry forward any disallowed expenses that are more than stock basis and to reduce stock basis in future years. Section A C is the correct response. The shareholder has income to the extent that the $25,000 repayment exceeds her $14,000 loan basis ($25,000 loan - $11,000 loss share in 2015) in the loan. The $11,000 of income is capital gain, as the loan is evidenced by a note. A is an incorrect response. The income would be ordinary income were the loan open account debt that was not formal and evidenced by a note. B is an incorrect response. The shareholder recovers the $14,000 basis in the note taxfree, and recognizes gain in the amount of the excess of the repayment over the basis in the note. Section A.4. B. LOSS LIMITATIONS Key Term in This Section: Qualified nonrecourse debt: While generally nonrecourse debt is not included in the calculation of one s at-risk amount in an activity, qualified nonrecourse debt represents the lone exception. An S Corporation shareholder s share of an amount borrowed for use in an activity that is qualified nonrecourse debt (financing borrowed for an activity of holding real property that meets certain Internal Revenue Code requirements) may be included in the shareholder s at-risk amount for the activity. 15