2016 S CORPORATION TAXATION PART I 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 I 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 1-70 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 tax considerations of electing S Corporation status, the S Corporation election, operational rules that affect the S Corporation, and operational rules that affect the S Corporation s shareholders. 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 - D).

3 2016 QUIZ INSTRUCTIONS 2016 S CORPORATION TAXATION PART I 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 I 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 ANSWER SHEET TO BE SUBMITTED 2016 S CORPORATION TAXATION PART I 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) 2016 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 NEWSLETTER 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 I Recommended CPE Credit: 6 HRS [B] TABLE OF CONTENTS A. TAX CONSIDERATIONS OF ELECTING S CORPORATION STATUS A.1 Tax Rates 1 A.2 Income Taxed at Only One Level 3 A.3 Passthrough of Operating Losses to Shareholders 5 A.4 Penalty Taxes 6 A.5 Reasonable Compensation Issues 6 A.6 Corporate Tax on Liquidation and Asset Sales 7 A.7 Alternative Minimum Tax 8 A.8 Self-Employment Tax 8 B. THE S CORPORATION ELECTION B.1 Eligibility Requirements 10 B.2 Making the S Election 25 B.3 Terminating the Election 28 C. OPERATIONAL RULES: THE S CORPORATION C.1 In General 42 C.2 Elections Affecting S Corporation Taxable Income 43 C.3 Taxable Income 45 C.4 Filing the S Corporation Tax Return 57 D. OPERATIONAL RULES: S CORPORATION SHAREHOLDERS D.1 Tax Consequences of Current Income (Loss) 62 D.2 General Determination of the S Corporation Shareholder's Stock Basis 67 E. CONCLUDING REMARKS 69 INDEX 70 QUIZ QUESTIONS 71 ENDNOTES 77 -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 I The primary objective of this course is to provide an explanation of the following items: (1) considerations in being an S Corporation, (2) requirements and election to be an S Corporation, (3) elections and operations, (4) shareholder basis issues, and (5) reporting and compliance. 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. TAX CONSIDERATIONS OF ELECTING S CORPORATION STATUS LEARNING OBJECTIVES: 1. Identify the treatment to an S Corporation shareholder of amounts paid the shareholder by the S Corporation. 2. Compute the amount of income tax that an S Corporation must pay. 3. Determine the treatment of losses of an S Corporation. 4. Identify taxes that are imposed on an S Corporation. A.1 Tax Rates Consider the 2016 income tax rate schedules for individual taxpayers Tax Rate Schedules Tax Taxable Income Bracket Ranges by Filing Status Rate Joint Separate Hd Household Single 10% 0-18, , , ,275 15% 18,551-75,300 9,276-37,650 13,251-50,400 9,276-37,650 25% 75, ,900 37,651-75,950 50, ,150 37,651-91,150 28% 151, ,450 75, , , ,800 91, ,150-1-

8 2015 Tax Rate Schedules Continued Tax Taxable Income Bracket Ranges by Filing Status % 231, , , , , , , ,350 35% 413, , , , , , , % Over 466,950 Over 233,475 Over 441,000 Over 415,050 Now consider the 2016 income tax rate schedule for a regular C Corporation Tax Rate Schedule C Corporation Tax Rate $ Taxable Income % 0-50,000 25% 50,001-75,000 34% 75, ,000 39% 100, ,000 34% 335,001-10,000,000 35% 10,000,001-15,000,000 38% 15,000,001-18,333,333 35% over 18,333,333 The tax-rate attractiveness of S Corporation status depends on the marginal tax rates of a regular C Corporation and the marginal tax rates of the corporation s owners. At very low amounts of taxable income, the marginal rate for individuals often is lower than the marginal rate for a C Corporation. When you consider that the S Corporation s earnings generally are not taxed at the entity level, this consideration alone appears to make the S Corporation a more desirable choice than the regular C Corporation. While S Corporation earnings are not taxed twice (entity and owners), -2-

9 some distributions from an S Corporation may be considered to be a dividend. Dividends are taxed at the preferential 0%/15% rate through 2012, depending on the owner s top marginal income tax rate. For 2013 and later, a 20% capital gain tax rate is added for higher-income taxpayers. 2 Also, higher-income taxpayers may have to pay the 3.8% net investment income tax that started in Though an S Corporation s earnings are not taxed twice, a shareholder s share of S Corporation taxable income is taxed, whether actually distributed or not. Considering the rate issue alone, the C Corporation generally is preferred over the regular S Corporation at relatively lower levels of company taxable income at taxable income, unless the shareholder s marginal tax rate is 15%. Once taxable income exceeds $75,000, which entity the rate issue favors depends on the shareholder s marginal tax rate. Example 1 For 2016 Bev Smart and Harriet James file joint returns with their spouses. Assume that Bev s and Harriet s other income (not net investment income) equals the sum of their personal exemptions and standard deduction. They are equal shareholders in Mix Company, a calendar-year corporation. Mix's ordinary taxable income for 2016 is $500,000. Ignoring compensation paid Bev and Harriet were they employees of the corporation, if Mix were a regular corporation its federal income tax liability would be $170,000. If Mix were an S Corporation, it would pay no federal income taxes. If Bev and Harriet each includes one-half of Mix's taxable income on her tax return, each would have total federal income tax liability of $57,913, for total liability of $115,826. Assuming Mix makes no dividend distributions were it a regular corporation, Bev and Harriet save $54,174 of federal income taxes by doing business as an S Corporation. The difference is greater if Mix were a regular corporation and made dividend distributions to Bev and Harriet. A.2 Income Taxed at Only One Level Another federal income tax consideration is the effect of double taxation. If the regular C Corporation is used to conduct business, the corporation pays an income tax, and the shareholders pay income tax on dividend distributions. Since the S Corporation generally pays no income tax, 3-3-

10 the only income tax paid by the company and its owners is what the shareholders pay currently on their pro rata shares of the S Corporation's income. Example 2 Refer back to Example 1, and assume that the regular C Corporation evenly distributes the income remaining after federal income taxes are paid, i.e., $330,000 ($500,000 taxable income - $170,000 corporate income tax), between Bev and Harriet. Each would pay individual income tax of $24,750 in 2016 (reflecting the 15% dividend rate for taxpayers beyond the 15% marginal bracket, but not in the top bracket), for a total tax bill of $49,500 at the individual level. The total federal income tax liability from operating as a regular corporation is $219,500 ($170,000 + $49,500) versus $115,826 of income tax liability from operating as an S Corporation. Thus, there is an incremental tax cost of $103,674, when the regular C Corporation is used and all of the corporation's after-tax earnings are distributed. The tax increase is due to the disadvantage of double taxation. It may be, however, that not all after-tax earnings are distributed by the C Corporation. Tax-wise, it is prudent to consider the amount of income of the corporation, the expected dividends, other income earned by the corporation s owners, and the owners s marginal tax rates before the type of entity is chosen. Example 3 Jason McCarty, a single taxpayer, plans to start a new business in Jason will operate his business as a single-owner company. Unlike many startups, Jason expects his company to be profitable immediately. Jason expects his 2016 net profit to be $100,000. With an eye to continual expansion, Jason will be plowing as much of his profits as possible back into his business. He believes that $50,000 of his profit will sustain his personal needs. If Jason operates as a sole proprietorship, he must consider his 28% marginal rate (without regard to personal deductions), the 15.3% self-employment tax, and the 50% deduction for the self-employment tax that he pays. On the other hand, if he operates as a C Corporation, and likely must pay himself a salary (reasonable compensation law), he must consider the corporation s 25% rate on its taxable income in the 50,000-75,000 range, and 34% in the 75, ,000 range, payroll taxes on any salary he pays himself, and the 15% rate on income above $37,650 paid out as dividends. -4-

11 A.3 Passthrough of Operating Losses to Shareholders Losses from an active business at the S Corporation level pass through to shareholders. The amount of the passthrough is limited to the sum of the basis which the shareholder has in his stock and any loans the shareholder has made to the corporation. 4 Also, the at-risk and passive activity loss rules limit a shareholder s ability to use his share of S Corporation losses on his individual tax return. Example 4 Simmons Corporation is a calendar-year S Corporation with two equal owners, Doug and Gene. For its current taxable year, Simmons has a $100,000 loss. Doug has a $25,000 basis in his Simmons stock, and he has made $12,000 in direct loans to Simmons. Gene has a $62,000 basis in his Simmons stock, and he has not made any loans to Simmons. Each may take his $50,000 share of Simmons Corporation s loss up to his stock basis plus direct loans made to Simmons. Doug may use $37,000 of his loss share ($25,000 stock basis plus $12,000 loan to Simmons). Since Gene s stock basis exceeds his $50,000 loss share, he may take his entire loss share. The loss passthrough provision for S Corporations may be significant in a corporation s start-up years, when losses may have no immediate tax benefit to a regular C Corporation because it has no history of income. Example 5 Smith Corporation begins business on March 11, Smith is a calendaryear corporation. Smith's two owners, Mel and Sol, each contributes $50,000 to Smith solely for Smith's stock. Smith Corporation, primarily because of material start-up costs and relatively small sales due to its initial entry into the market, incurs a $40,000 net operating loss for If Smith is a regular corporation, its loss must be carried over and used within the next 20 years. If Smith is an S Corporation and the at-risk and passive activity loss rules do not apply, Mel and Sol each will be able to use $20,000 of the loss to reduce his 2016 taxable income TAX SAVER!! If an S Corporation has losses which the shareholder otherwise would not be able to use currently because of insufficient stock basis, he can make year-end loans to his S Corporation. This strategy increases the amount of the loss which the shareholder can use currently, generating immediate tax savings. Shareholder loans should be characterized by a formal agreement between the shareholder and the S Corporation

12 A.4 Penalty Taxes Corporate penalty taxes for unreasonably accumulating earnings 5 and using the corporation as an "incorporated pocketbook" 6 potentially apply to a C Corporation. Neither the accumulated earnings tax nor the personal holding company tax applies to an S Corporation. Thus, an S Corporation faces no penalty tax for earnings accumulation. Also, unless an S Corporation has C Corporation earnings and profits, it faces no income tax consequences from being involved in passive investment activities TAX SAVER!! An S Corporation that might face potential liability issues because of insufficient or inadequate insurance needs to be aware of the potential exposure its earnings and profits have to an injured party. Earnings and profits that are not paid out as salary or distributions could be available to an injured party that sues the corporation A.5 Reasonable Compensation Issues An S Corporation, unlike a regular C Corporation, generally does not face a reasonable compensation issue for paying excessive compensation to an owner / employee. The reason is that shareholders of an S Corporation are taxed on all of the corporation's income, regardless of whether it is distributed. Even though an S Corporation may pay its owner / employee a salary, reducing the company s income that is taxed, the full amount of the company s income is taxed (company income reduced by salary, plus salary taxed to owner / employee). Usually there are no taxable dividends from an S Corporation to its owners. Dividends are distributions from a corporation's earnings and profits. Payments from an S Corporation to its owners that are considered as dividends were subject to the preferential 0 / 15% rates through 2012, and 0/15/20% for 2013 and later taxable years. An S Corporation does not have earnings and profits unless (1) previously it was a C Corporation, (2) it was an S Corporation prior to 1983 and generated earnings and profits under the pre-1983 rules for S Corporations, or (3) it acquired C Corporation -6-

13 earnings and profits in a tax-free reorganization. So, an S Corporation with a C History, either because it previously was a C Corporation or because it acquired another C Corporation, might have earnings and profits that can cause payments to owners to be considered and taxed as dividends. An S Corporation potentially does face a reasonable compensation issue for not paying enough salary to an owner / employee. Salaries paid an owner / employee are subject to social security taxes and other payroll taxes, and withholding. In contrast, earnings of an S Corporation that are paid out as distributions to owners are not subject to these taxes and withholding. An S Corporation may try to lower or eliminate its payroll tax and withholding obligation by underpaying owner / employee salary, or not paying an owner / employee salary at all. Because of some court decisions, S Corporations must pay at least a reasonable salary to an owner / employee. 7 It is not well-established what a reasonable salary is. The corporation should be able to use amounts paid similar employees / owners for the same type and same size company as a gauge to determine how much is a reasonable salary. A.6 Corporate Tax on Liquidation and Asset Sales Regular C Corporations must recognize gain and pay income tax on the distribution of appreciated property to its shareholders pursuant to a complete liquidation. 8 Thus, all gains realized at the corporate level, whether they are realized from regular operations or property distributions to its shareholders, are taxed to a C Corporation. On the other hand, if an S Corporation is liquidated, gain from the liquidation of appreciated assets would be taxed at only one level unless the built-in gains tax applies. 9 When an S Corporation sells business assets that are appreciated, there is tax liability only at the shareholder level. Unlike for a regular C Corporation, where the corporation pays tax on the sale, and the shareholders pay tax when related net distributions from earnings and profits are paid -7-

14 to them, the tax on sale of assets by an S Corporation is paid only at the shareholder level (again, unless the built-in gains tax applies). A.7 Alternative Minimum Tax Unlike a regular C Corporation, an S Corporation is not subject to the alternative minimum tax. A regular C Corporation that is subject to the alternative minimum tax files Form 4626 with its Form 1120 tax return. An S Corporation must determine any alternative minimum tax adjustments and preferences that it has (Adjusted Current Earnings adjustment excluded), and pass these items down to its shareholders. The corporation reports the items on Schedule K of Form 1120S, and allocates the amounts on Schedule K pro rata to the owners on their Schedules K-1. The corporation s alternative minimum tax items are put on Lines 15a - 15f of Schedule K. A.8 Self-Employment Tax Self-employment earnings and the associated self-employment tax are an issue between the S Corporation and the other popular flowthrough business entity form, partnerships. Limited liability partnerships and many two or more owner limited liability companies are treated as partnerships for federal income tax purposes. A general partner and an active limited liability partner and limited liability company owner s share of the entity s ordinary income is self-employment earnings, subject to the self-employment tax (Form 1065, Schedule K, line 14a). In contrast, an S Corporation shareholder s share of the corporation s ordinary income is not self-employment earnings. Salary the S Corporation pays to its owner-employee is subject to the corporation s and employee s share of social security taxes. B. THE S CORPORATION ELECTION Key Terms in This Section: Small business corporation: A corporation which, if it meets certain requirements (e.g., is a domestic corporation, and has a limited number and certain types of shareholders), is permitted to elect to be treated as an S Corporation for federal income tax purposes.. -8-

15 Governing provisions: The provisions that the IRS will examine to determine if a corporation s stock confers identical rights to distribution and liquidation proceeds to owners. A requirement to be an S Corporation is that it issues only one class of stock which confers such identical rights on its owners. Straight debt: Debt which, because it meets certain requirements, will not be classified as a second type of stock. Some types of debt which have equity features, e.g., debt which can be converted to stock, risk being classified as a second type of stock. Such reclassification could cause an S Corporation to lose its S election. Natural business year: An S Corporation must use a permitted year. The IRS states that one of the tax years available to an S Corporation is a natural business year. A natural business year can be satisfied by any of three tests: (1) annual business cycle test, (2) seasonal business test, or (3) 25% gross receipts test. Revocation: An S election is terminated in one of three ways. One way is by revocation. Revocation occurs when shareholders who own more than one-half of the corporation's shares formally consent to the revocation of the corporation s S election. Inadvertent termination: An S Corporation can lose its election in one of three ways: (1) revocation, (2) ceasing to be a small business corporation, e.g., issuing shares to more than 100 shareholders, and (3) having excessive passive investment income. If required conditions are met, the corporation can restore the S election if it is lost inadvertently. An inadvertent termination occurs from loss of the S election through items 2 and 3. S termination year: If an S Corporation loses its S election through revocation or its ceasing to be a small business corporation, the result can be that the corporation has a two-part taxable year: an S short year, and a C short year. The two-part taxable year is referred to as an S Termination Year. Interim-closing-of-the-books: When an S Termination Year occurs, items of income, gain, deduction, and loss must be allocated between the S and C short years. While generally the allocation is done on a pro rata basis, the corporation may elect to allocate using an interim-closingof-the-books method. In applying this method, the corporation uses its normal tax accounting rules to effect the allocation. Accumulated adjustments account: An account maintained by the S Corporation. The account generally reflects the accumulated undistributed net income of the corporation for its post-1982 years. The account is used to determine the tax effect of distributions of the S Corporation during its years as an S Corporation, and during the post-termination transition period. Separately stated: This describes the items of an S Corporation s income, gain, deduction, and loss, which are segregated from its nonseparately stated items (ordinary income and loss). Separately stated items are stated on Form 1120S, Schedule K. -9-

16 LEARNING OBJECTIVES: 1. Recognize the requirements that a corporation must satisfy to be permitted to make an S Corporation election. 2. Identify documents that the IRS will review to determine if an S Corporation has only one class of stock which has identical distribution and liquidation rights. 3. Recognize the tax years that an S Corporation may have. 4. Determine how a corporation elects to be treated as an S Corporation. 5. Identify when a corporation must file to be treated as an S Corporation. 6. Identify the relief provisions available to an S Corporation that makes a defective S election. 7. Recognize the ways in which an S Corporation terminates its S election. 8. Determine the implications to an S Corporation when it terminates its S election. B.1 Eligibility Requirements The federal tax election to be treated as an S Corporation is made on Form The election may be made at any time during the tax year that precedes the tax year in which the election is to take effect, or no more than two months and 15 days after the beginning of the tax year in which the election is to take effect (see Section B.2 below). It must be signed by all who are shareholders on the day the election is made. 10 A corporation must be a "small business corporation" to make the election. A corporation that has not made the federal tax election on Form 2553 to be treated as an S Corporation is treated as a regular C Corporation. Example 6 Seslar, Inc. is formed on March 19, Seslar and its owners use a calendar-year. The owners of Seslar claim to have filed Form 2553 timely before June 3, However, on audit in 2017 the corporation is unable to prove that it filed Form Seslar will be treated as a regular C Corporation for its 2016 taxable year. Start-up losses that Seslar incurred in 2016 will remain inside the C Corporation, and will be unable to be used by Seslar s owners for their 2016 taxable year. -10-

17 There are a number of characteristics that a corporation must possess to be treated as a small business corporation. 11 B.11 Domestic Corporation The corporation must be a domestic corporation. Domestic refers to where the corporation is created or organized, not where it operates geographically. Whether the corporation does business only in the United States or internationally, its S election is unaffected as long as it is created or organized under United States law or any state law. So, a corporation created or organized in the United States and in a foreign jurisdiction is a domestic entity. 12 Example 7 Focus Corporation is organized under a foreign country s laws as a public limited company. Also, Focus is organized as a limited liability company under South Carolina state law. Focus files Form 8832, Entity Classification Election, and elects to be treated as a corporation for federal income tax purposes. Focus is a domestic corporation because it is an entity that is classified as a corporation and it is organized as an entity under a state law. 13 An unincorporated association taxable as a corporation may elect to be treated as an S Corporation. 14 As illustrated in Example 7 above, an entity formed as a limited liability company under state law may elect to be treated as an S Corporation under federal income tax law. A limited liability company might make this election to circumvent the more complex legal issues that a regular C Corporation faces under a state s corporation law, in contrast to issues it would face under a state s limited liability company law. A limited liability company that timely files Form 2553 to be treated as an S Corporation is treated as having made the election under the check-the-box regulations to be treated as a corporation. The company would not also have to file Form B.12 Ineligible Corporation The corporation can not be an ineligible corporation, which is any of the following: (1) a financial institution (a bank or thrift institution) which uses the bad debt reserve method a bank is a bank or trust company that is incorporated and doing business under United States laws, where -11-

18 a substantial part of its business consists of receiving deposits and making loans and discounts; 16 (2) an insurance company that is subject to tax under Subchapter L of the Internal Revenue Code; (3) a corporation that has elected to be treated as a possessions tax credit corporation under IRC Section 936; and, (4) an entity that is a Domestic International Sales Corporation (DISC) or that formerly was a DISC. B.13 One Hundred or Fewer Shareholders The corporation must have 100 or fewer shareholders. 17 A husband and wife (and their estates) and all members of a family (and their estates) are treated as one shareholder. 18 A family member is a common ancestor, any lineal descendant of that common ancestor, and any spouse or former spouse of that common ancestor or any lineal descendant. However, a common ancestor is not included if that ancestor is more than six generations removed from the youngest generation of shareholders who would be treated as a member of the family on the latest of the following: (1) the date the S Corporation election is made; (2) the earliest date that a family member first holds stock in the S Corporation; or, (3) October 22, A spouse or former spouse is treated as being of the same generation as the individual to whom that spouse is (or was) married. Any legally adopted child and any eligible foster child of an individual is treated as that individual s child. 19 B.14 Only Certain Types of Shareholders The S Corporation may have only individuals, estates, certain trusts, and certain tax-exempt organizations as shareholders. 20 Estates include an individual s bankruptcy estate. 21 Partnerships and corporations may not be a shareholder in an S Corporation. The following trusts may be an S Corporation shareholder: (1) grantor trust a non-foreign grantor trust may be an S Corporation shareholder through the two-year period which begins with the death of the deemed owner; (2) testamentary trust a testamentary trust which receives stock pursuant to the terms of a will may own S Corporation stock during the two-year period that begins -12-

19 on the day the S Corporation stock is transferred to it 22 ; (3) voting trust; (4) electing small business trust (ESBT); (5) qualified subchapter S trust (QSST); and, (6) for a bank corporation, a trust for an individual retirement account (whether traditional or Roth). 23 Examples of trusts that may not be an S Corporation shareholder are a foreign trust or a trust for an individual retirement account that is a shareholder in a non-bank corporation. Some tax-exempt entities may be S Corporation shareholders: included are certain taxexempt qualified pension, profit-sharing, and stock bonus plans retirement trusts, IRC Section 501(c)(3) tax-exempt organizations, and tax-exempt religious and apostolic organizations. 24 The Tax Court and the Ninth Circuit Court of Appeals have agreed that a Roth IRA is not an eligible S Corporation shareholder TAX SAVER!! An individual can donate S Corporation stock to a charitable organization and receive a charitable contribution deduction for the donation. The charitable organization must be a qualified tax-exempt shareholder. The deduction equals the fair market value of the stock. Note: The charitable organization counts as one shareholder for purposes of the 100-shareholder limitation B.141 ESBTs A charitable remainder unitrust and a charitable remainder annuity trust can not be an ESBT. 26 A QSST and a tax-exempt trust can not be an ESBT (although if an existing QSST meets certain requirements, it may be converted to an ESBT). Generally, all beneficiaries of an ESBT must be individuals or estates eligible to be S Corporation shareholders, or certain charitable organizations. A state or local government may be a beneficiary if it holds a contingent interest and it is not a potential current beneficiary. These restrictions do not apply to other charitable organizations. 27 An election must be made for a trust to be an ESBT. Generally, only one ESBT election is made for the trust, regardless of the number of S Corporations whose stock is held by the ESBT. 28 The trustee -13-

20 of the trust makes the ESBT election by filing a statement with the IRS Service Center where the S Corporation files its return. 29 An interest in an ESBT must be acquired by gift, bequest, or some means other than by purchase. Each potential current beneficiary of the ESBT is counted as a shareholder in determining if the 100 shareholder limit is satisfied. 30 If a nonresident alien is a potential current income beneficiary of the ESBT, the corporation will lose its S election because a nonresident alien is not a permitted S Corporation shareholder (see Section B.15 below). 31 However, if the nonresident alien holds a contingent beneficiary interest that is not vested, the S election is not lost. The portion of the ESBT which consists of stock in all S Corporations is treated as a separate trust for purposes of computing the income tax attributable to the S Corporation stock held by the ESBT. The ESBT pays income tax on its share of S Corporation income at the highest marginal income tax rate (for 2016, 39.6% on ordinary income, 20% on net capital gain). In computing the ESBT's share of S Corporation taxable income, no deduction is allowed for amounts distributed to beneficiaries. If the ESBT is subject to the alternative minimum tax, it is not allowed an alternative minimum tax exemption. 32 An ESBT may convert to a QSST if it meets four requirements that are specified in Treasury regulations. 33 B.142 QSSTs The QSST is treated as a grantor trust. The QSST income beneficiary is treated as the owner of the part of the trust which consists of S Corporation stock for which a QSST election has been made. The QSST income beneficiary who makes the irrevocable election is treated as the shareholder of the S Corporation with respect to the S Corporation stock held by the trust. The terms of a QSST must require the following: (1) during the life of the current income beneficiary, there is only one income beneficiary of the trust; (2) any corpus distributed during the life of the current income beneficiary may be distributed only to the current income beneficiary; (3) the income interest -14-

21 of the current income beneficiary must terminate on the earlier of the beneficiary s death or the termination of the trust; and, (4) when the trust terminates during the life of the current income beneficiary, the trust must distribute all of its assets to the beneficiary. Trust income that is distributed must be distributed to an individual who is a United States citizen or resident. 34 A QSST may be converted to an ESBT if four requirements are met. 35 Example 8 Mort establishes a trust and transfers to the trust his shares of stock of Mortco, Inc., an S Corporation. Mort has the power to revoke the entire trust. Trust terms require that all income be paid to Mort s son, Mortson. The trust meets all of the requirements for a QSST. The trust will continue in existence after Mort s death. During Mort s life, the trust is a grantor trust, and with respect to the trust and Mortco, Inc., Mort is treated as the S Corporation shareholder for purposes of the corporation s income, gain, deduction, loss, and credit items, stock basis adjustments, and distributions. 36 B.15 No Nonresident Alien Shareholders The S Corporation may not have a nonresident alien as a shareholder. 37 A nonresident alien is a person who is neither a United States citizen nor a United States resident. 38 So, a resident alien or a nonresident citizen is a permissible S Corporation shareholder. Special attention needs to be paid to residency status. An alien individual may be considered to be a United States resident and hence a permissible S Corporation shareholder in three instances: 39 (1) the individual is a lawful permanent resident of the United States at any time during the calendar year; (2) the individual meets a substantial presence test 40 ; or, (3) the individual makes a special election (only available for the first year that the individual is in the United States) to be treated as a resident of the United States. 41 If a U.S. shareholder s spouse is a nonresident alien who has a current ownership interest in the corporation s stock because of applicable law, the corporation is not permitted to be an S Corporation, or the corporation would lose its S election were there an election in effect. It would -15-

22 be okay for the nonresident alien spouse to have a survivorship interest. Examples of applicable law are a state community property law or a foreign country s law. 42 Example 9 Bill is a United States citizen. Bill marries Heike who always has been a German citizen living in Germany. Under German law, all property acquired by husband and wife during their marriage is community property that is jointly owned by husband and wife. Several years after their marriage, while residing together in Germany, Bill forms a United States corporation and files an S election on Form All of the corporation s stock is issued in Bill s name. Since under German law the corporation s stock becomes the community property of and is owned jointly by Bill and Heike, Bill has not filed a valid S Corporation election. Example 10 Assume that Bill and Heike in Example 9 are married in 2015, and in 2016 they file an election under IRC Section 6013(g) that allows them to file a joint federal income tax return and causes Heike to be treated as a United States resident. The election applies to 2016 and all subsequent years until the election is terminated. Assume further that Bill makes an S election on Form 2553 for a corporation he forms in Because Heike is treated as a United States resident under Section 6013(g), the election for the corporation to be treated as an S Corporation for federal income tax purposes is valid. 43 B.16 Only One Class of Stock is Permitted An S Corporation may not have more than one class of stock. All of the corporation s outstanding shares of stock must confer identical rights to distribution and liquidation proceeds. There may be differences in voting rights among common shares. 44 In none of the following situations will an S Corporation violate the one-class-of-stock requirement: (1) having voting and nonvoting common stock; (2) having a class of stock that may vote only on certain issues; (3) having irrevocable proxy agreements; and, (4) having groups of shares that differ with respect to rights to elect members of the company s board of directors TAX SAVER!! The S Corporation should have in its minutes, as well as on its stock certificates, that distribution and liquidation proceeds are identical among all shares of stock. Stock which is outstanding should differ only as to voting rights, if there are differences. Otherwise, the S Corporation risks losing its S election

23 The IRS will consider the facts and circumstances, and it will look at the corporation s governing provisions in determining if the identical rights requirement for the company s stock shares is met. Governing provisions include: (1) corporate charter; (2) articles of incorporation; (3) bylaws; (4) applicable state law; and, (5) binding agreements that relate to distribution and liquidation proceeds. The governing provisions collectively must provide for identical distribution and liquidation rights. S Corporations must be careful to avoid distributions that differ in timing or amount, as the tax effect of non-identical distributions will be examined for their full tax effect. 46 Any distributions (including actual, constructive, or deemed distributions) that differ in timing or amount are to be given appropriate tax effect in accordance with the facts and circumstances. 47 Example 11 Rich and Tom are equal shareholders in RT Corporation, Inc., an S Corporation. Under RT s bylaws, Rich and Tom are entitled to equal distributions. Late in 2015, RT distributes $50,000 to Rich. RT does not distribute $50,000 to Tom until one year later in Circumstances show that the timing difference as to the distributions was not the result of a binding agreement relating to distribution or liquidation proceeds. The timing difference does not cause RT to have more than one class of stock. However, IRC Section 7872, relating to the treatment of loans at below-market interest rates, or similar recharacterization provisions may be used by the IRS to determine the appropriate tax consequences of the distributions. 48 When a person performs services in exchange for S Corporation stock, and the stock that the service provider receives is substantially nonvested, the person generally is not treated as a shareholder, and the stock is not treated as outstanding stock. However, if an election is made under IRC Section 83(b), then the person is treated as a shareholder, and the stock is treated as outstanding stock. 49 The stock then must be examined to determine if is treated as a second class of stock. If an employee or an independent contractor performs services for an S Corporation and receives an instrument, obligation, or other arrangement, the property received is not treated as outstanding stock if three requirements are satisfied: (1) the property does not convey the right to vote to the individual; (2) the property contains an unfunded and unsecured promise to pay money -17-

24 or property in the future; and, (3) the employee or independent contractor is not taxed currently on the instrument, obligation, or other arrangement which is received. 50 A commercial contractual agreement such as a lease, employment agreement, or loan agreement is not a binding agreement relating to distribution and liquidation proceeds, and thus is not a governing provision if the agreement is not struck to avoid the one-class-of-stock requirement. 51 Example 12 Bob and Sam are the sole shareholders of Global Corporation, Inc., an S Corporation. Bob and Sam have employment agreements with Global which specify the compensation to be paid them for the services which they perform for Global. For the taxable year, part of Bob's compensation is found to be unreasonably excessive; none of Sam's compensation is found to be excessive. The facts and circumstances do not show that a principal purpose of Bob s employment agreement is to circumvent the one-class-of-stock requirement. Although the corporation will be denied a deduction for the part of Bob's compensation which is excessive, it will not cause two classes of stock to exist, and hence a termination of Global's S election. 52 Agreements to pay fringe benefits are not governing provisions provided the agreements are not made for the purpose of avoiding the one-class-of-stock requirement. Example 13 Mel and Will are employee-shareholders of Universal Corporation, Inc., an S Corporation. Binding agreements require Universal to pay the cost of fringe benefits for Mel and Will. The agreements are not entered into to avoid the oneclass-of-stock requirement. The fringe benefit premium costs are different for Mel and Will. The agreement is not a governing provision, Universal does not have more than one class of stock because it pays different premium amounts, and Universal will not lose its S election because of the agreements TAX SAVER!! Beware of state laws which may cause two classes of stock to exist. Consider the instance where state law requires that if some shareholders contribute cash and other shareholders contribute non-cash property in exchange for S Corporation shares, then shareholders who contribute non-cash property must waive all rights to receive distributions until the shareholders who contributed cash for stock have received distributions in the amount of their cash contributions. In this instance, the rights to distribution and liquidation proceeds are altered, and are not identical for all shareholders. Therefore, the corporation is treated as having a second class of stock, and the corporation will not be able to make or to retain an S election

25 If there are binding agreements to adjust distributions based on different state tax burdens, where the intent is to give shareholders equal after-tax distributions, the rights of shareholders will not be considered to be identical, and the one-class-of-stock requirement is violated. 54 Example 14 Bandy Corporation, Inc., is an S Corporation, owned equally by Doug and Ned. Doug lives in California, and Ned lives in Connecticut. Bandy has a binding agreement to adjust distributions to Doug and Ned based on their different state tax burdens. Doug s effective state tax rate is 10%, and Ned s effective state tax rate is 5%. Here is the reason that Bandy Corporation has the agreement. Say that for the current tax year, $20,000 would be available for distribution. Under the binding agreement, $10,270 would be distributed to Doug, and $9,730 would be distributed to Ned. As a consequence, Doug and Ned each would net $9,244, taking into account the different state tax burden that each has. The binding agreement relates to distribution proceeds. The agreement is a governing provision which alters the rights conferred by Bandy's outstanding stock to distribution proceeds, so that the rights are not identical. Bandy is treated as having more than one class of stock, and its S election will be terminated. The election probably should be terminated as of the date the binding agreement was struck. This result is not clear from the Treasury regulations, so it could be that the election is not terminated until the distributions actually are made. State laws which require a corporation to pay and withhold income tax for a shareholder are disregarded in determining if all outstanding shares confer identical rights to distribution and liquidation proceeds. However, when the constructive distributions that result from the tax withholding or payments are taken into account, the corporation s outstanding shares must confer identical rights to distributions and liquidation proceeds. Just because there is a timing difference between such constructive distributions and actual distributions to other shareholders, the corporation is not considered to have more than one class of stock. 55 Example 15 The laws of a state require that a corporation pay state income taxes on behalf of nonresident shareholders. The corporation does not have to pay state income taxes on behalf of resident shareholders. Under the corporation's bylaws, resident -19-

26 shareholders have the right to distributions which take into account the state income tax payments which the corporation makes with respect to nonresident shareholders. The corporation's shares are deemed to confer identical rights to distribution proceeds. So, the corporation will not be in violation of the one-class-of-stock requirement. Generally, buy-sell agreements and redemption agreements are not to be regarded in determining if a corporation's shares confer identical distribution and liquidation rights. 56 However, they may not be disregarded if there is a redemption agreement the purpose of which is to circumvent the one-class-of-stock requirement and the price under the agreement is significantly in excess of or below the fair market value of the stock when the agreement is entered into by the parties. 57 There is a safe harbor provision for short-term unwritten advances. Unwritten shareholder advances which (1) do not exceed $10,000 in the aggregate at any time, (2) are treated as debt by the shareholder and the S Corporation, and (3) are expected to be repaid within a reasonable time, are not treated as a second class of stock even if the advances are considered equity under general principles of federal tax law TAX SAVER!! This aspect of the regulations actually provides for a second kind of debt which will not be reclassified by the IRS as stock, potentially creating a second class of stock, and thereby terminating a corporation s S election. Straight debt (IRC Section 1361(c)(5)) discussed below in Section B.161 also will not be reclassified as stock. Tax advisers should advise their S Corporation clients that if loans from shareholders to the corporation are anticipated, provisions should be incorporated into the corporation's formal agreements which require that the debt be either straight debt or in the nature of short-term unwritten advances which have the three characteristics in the prior paragraph Obligations which are considered to be equity under general principles of federal income tax law will not cause the S Corporation to violate the one-class-of-stock requirement as long as the obligations are owned solely by the owners of the corporation, and in the same proportion as the outstanding stock of the corporation. 59 An obligation or obligations owned by the sole shareholder of a corporation always are held proportionately to the corporation's outstanding stock. -20-