S CORPORATIONS INTRODUCTION AND STUDY OBJECTIVES. In studying the rules of S corporations, the student should have these objectives: STUDY HIGHLIGHTS

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1 H Chapter Eeven H S CORPORATIONS INTRODUCTION AND STUDY OBJECTIVES Certain sma business corporations may eect to be taxed under Subchapter S instead of under the reguar rues for taxation of corporations. If the eection is made, the corporation becomes an S corporation, and with some exceptions, its income is not taxed at the corporate eve. Instead, a of an S corporation s items of income, oss, deduction, and credit are passed through to, and taken into account by, the corporation s sharehoders in computing their own taxabe income. Specific items are passed through separatey if their separate treatment coud affect the tax iabiity of the sharehoder. In studying the rues of S corporations, the student shoud have these objectives: 1. To be famiiar with the eigibiity requirements of an S corporation and how the eection to be taxed under Subchapter S is made. 2. To understand how an S corporation operates and the reationship between the entity and its sharehoders. 3. To earn how the distribution of taxabe income or oss to the sharehoders is determined and which taxes are imposed on the S corporation. S CORPORATION ELIGIBILITY REQUIREMENTS STUDY HIGHLIGHTS 1. The Sma Business Job Protection Act, which was signed into aw in 1996, iberaized the S corporation s eigibiity requirements. The new aw incuded severa changes to the S corporation rues, which, in genera, are effective for tax years beginning after The more common of the 17 changes incude the foowing: The maximum number of sharehoders was expanded from 75 to 100 for 2005 (The New Jobs Act). The new aw expands the rues to incude eecting sma business trusts as permissibe trusts eigibe to hod S corporation stock. Each beneficiary is counted toward the 75 sharehoder imit. An S corporation may own 80 percent or more of the stock of a C corporation. The C corporation subsidiary can eect to be incuded in a consoidated tax return of affiiated C corporations, but the S corporation parent must fie a separate return. Distributions by the C corporation from earnings and profits to the parent S corporation, to the extent reated to an active trade or business, wi not be passive investment income under Subchapter S rues. S corporations may own quaified subchapter S subsidiaries. The subsidiary must meet S corporation eigibiity requirements and the parent must (1) own 100 percent and (2) eect treatment as a quaified subchapter S subsidiary. The IRS has the authority to waive an inadvertent faiure to quaify as a sma business corporation or to obtain the required sharehoder consents. Thus, a ate Subchapter S eection coud be considered as timey if there was reasonabe cause for the faiure to make the eection timey. The new aw provides that the eection to cose the books of the S corporation upon the termination of a sharehoder s interest wi be made by and appy to, a affected sharehoders and the corporation, rather than a sharehoders. 11-1

2 11-2 S Corporations The aw provided that adjustments for distributions made by an S corporation during a tax year are taken into account before appying osses for the year. Determinations of the accumuated adjustment account, for purposes of determining the tax treatment of distributions made during a tax year by an S corporation having accumuated earnings and profits, wi disregard net negative adjustments for that tax year. Losses of an S corporation that are suspended under the at-risk rues wi be carried forward to the S corporation s post-termination period. For purposes of the five-year re-eection rue, any termination in effect immediatey before the date of enactment of this provision wi not be taken into account. Any sma business corporation that was subject to waiting five years before re-eecting S status may re-eect upon enactment of this provision without IRS consent. 2. Ony domestic corporations are eigibe for specia treatment under Subchapter S and then ony if the corporation is a sma business corporation (SBC) and a of its sharehoders consent. The term SBC refers to the restriction on the number of sharehoders and not to the doar vaue of the corporate assets or capitaization. A corporation is an SBC if it is eigibe, has no more than 75 sharehoders, and has ony one cass of stock. 3. Foreign corporations and certain other domestic corporations are ineigibe corporations and may not eect S corporation treatment. These ineigibe corporations incude members of an affiiated group, financia institutions, insurance companies, foreign service corporations, and corporations eecting the 936 possessions tax credit. A specia rue aows an S corporation to own the stock of an inactive subsidiary without vioating the affiiated group prohibition. 4. The stock of an S corporation may ony be owned by individua U.S. citizens and residents, estates, and certain trusts. In addition, the number of sharehoders is imited to 75. For counting purposes, husband and wife are treated as a singe sharehoder whether the stock is owned jointy or separatey. Nonresident aiens, corporations, partnerships and many trusts are not aowed to hod stock in an S corporation. Those permitted are grantor trusts, quaified subchapter S trusts, certain testamentary trusts, and voting trusts. Exampe. A corporation in which the stock is hed by 75 married coupes (150 individuas) wi quaify for the eection because each married coupe is counted as one person, even though a 150 individuas must fie a consent eection. In the event that one of the coupes shoud obtain a divorce, the eection to be an S corporation woud terminate. 5. In determining the number of sharehoders, the aw currenty aows a husband and wife to be treated as one sharehoder. The 2004 Jobs Act extends this approach by aowing a famiy to eect under 1361 (c) to treat the entire famiy as one sharehoder. For purposes of this eection, a famiy is defined to incude the common ancestor (within 6 generations), inea descendants of the common ancestor, and the spouses (or former spouses) of the inea descendants or common ancestor. 6. In an effort to avoid aocation of income probems, Congress aowed for ony one cass of stock, athough differences in voting rights are expressy authorized. Prior to the Subchapter S Revision Act of 1982, purported debt obigations that actuay represented stock (see thin capitaizations in Chapter 2) were considered a second cass of stock and woud therefore terminate an S corporation eection. The 1982 Act attempted to aeviate some of these probems by creating a safe harbor for debt that met certain requirements. These requirements ensure that the obigations do not possess the characteristics of stock. ELECTION OF S CORPORATION STATUS 7. In order to be taxed as an S corporation, an eection must be fied that requires the unanimous consent of a sharehoders hoding stock at any time during the taxabe year. In order to make the eection effective for the current year, the eection must be fied by the 15th day of the third month of the corporation s tax year. Eections made after the first 2 and one-haf month period become effective for the foowing year.

3 Study Highights 11-3 Exampe. In 2008 RST, a caendar year C corporation, decides to become an S corporation January 1, This objective wi be achieved if a vaid eection is made at any time during 2008 or up through March 15, If the eection is made at any time after March 15, 2009, RST wi not become an S corporation unti Once an S corporation eection is made, it remains effective unti it is terminated. Termination may occur when the corporation fais to satisfy the SBC requirements or vountariy revokes the eection. Faiure to satisfy the SBC requirements terminates the eection on the date the disquaifying event occurred. A vountary revocation occurs when sharehoders owning more than 50 percent of the stock fie to terminate the eection. If the revocation is fied by the 15th day of the third month of the tax year, it is effective for the entire year. If the revocation is fied after the 2 and one-haf month period, it usuay becomes effective for the foowing tax year. In either situation of a vountary revocation, the corporation can specify a termination date on or after the date of revocation. 9. A subchapter S eection wi aso terminate if an S corporation has E&P and excessive passive investment income (EPII) at the end of each of the three consecutive years it was a C corporation. EPII is gross receipts from passive sources (royaties, rents where substantia services are not provided to tenants, dividends, interest, annuities, and gains from the sae of capita assets, stocks, and securities) in excess of 25 percent of tota gross receipts. The termination is effective for the year foowing the third successive year. 10. Once termination of an S eection occurs, a corporation normay may not make a new eection unti the fifth taxabe year foowing the year in which the termination is effective. The five-year waiting period can be waived where the IRS consents or determines that the termination was inadvertent. Termination aso requires that the income or oss of a corporation be apportioned to a short S year and a short C year, possiby requiring two tax returns. Exampe. A caendar year S corporation terminates its eection effective Juy 1. For the period January 1 to June 30, it shows revenues of $50,000 and expenses of $30,000; for the period Juy 1 to December 31, its revenue is $100,000 with associated expenses of $90,000. The annua revenues amount to $150,000 and the annua expenses amount to $130,000. Since no eection is made to aocate income and expenses on an actua accounting basis, the short S period wi report revenues of $74,385 ($150, /365) and expenses of $59,508 ($120, /365). The short C corporation wi report the remaining revenues and expenses of $75,615 and $60,492, respectivey. OPERATING THE S CORPORATION 11. As a resut of the Subchapter S revision Act of 1982, computing the net income of an S corporation is very simiar to that of a partnership (i.e., it is taxed as a conduit). There are, however, four important exceptions. First, organizationa expenditures can be amortized over a 60-month period in an S corporation. Second, an S corporation s sharehoders may quaify as empoyees. Third, certain empoyee-stockhoder fringe benefits may be deducted by an S corporation. Fourth, S corporations must recognize gain on a distributions of appreciated property to sharehoders. Consistent with the partnership provisions, most specia eections are to be made at the S corporation and not by each sharehoder. Each item of income that wi be given specia treatment or be subject to specia imitations wi be passed through separatey. A other items of income or oss wi be aggregated and passed through as ordinary income or oss. Exampe. W Corporation, an S corporation for the past eight years, distributes a tract of and hed as an investment to N, a majority sharehoder. The and was purchased for $44,000 severa years ago and has a current FMV of $66,000. W Corporation must recognize a capita gain of $22,000.

4 11-4 S Corporations 12. A S corporation items passed through to sharehoders are based upon their pro rata ownership and the number of days they owned the shares during the year. The aocation between days is normay based upon a per day aocation method. This method aocates an equa amount of the S items to each day of the year. Aternativey, if there is a compete termination of a sharehoder s interest, an eection may be made by a sharehoders (incuding the terminating sharehoder) to aocate income and osses on an interim cosing of the books. 13. S corporation osses pass through to the sharehoders to be offset against their other income. This is a common reason why S corporation status is eected. Unike net income, the amount of oss deductibe is imited to the sharehoder s basis in the stock pus any debt owed by the corporation to the sharehoder. Any osses that exceed these amounts may be carried forward indefinitey to be distributed when the sharehoder s basis is increased. If an eection is terminated and osses are sti being carried forward, they may be deducted against basis increases during a post-termination transition period. Loss carryovers from a C corporation may not be used during years the corporation is taxed as an S corporation. However, the S years are counted in determining the expiration period of the carryover. RELATIONSHIP BETWEEN AN S CORPORATION AND ITS SHAREHOLDERS 14. A sharehoder s basis in the S corporation is computed in much the same manner as a partner s basis in the partnership. See Exhibit 11-3 in the textbook. Contributions of property for stock foow the C corporation rues and can create gain if the provisions of 351 are not met. When a sharehoder ses an interest in the S corporation, any gain or oss reported by the seer has no effect on the business of the purchaser. Unike partnership taxation, no provision exists to refect the inequities that can arise from the sae of an S corporation with appreciated assets. 15. S corporations, as a resut of the Tax Reform Act of 1986, are restricted to three methods for seecting a taxabe year. First, any S corporation may choose a caendar year. Second, a fisca year may be adopted if it is identica to that of owners hoding a majority of the stock. Third, under specia requirements, a natura business year may be used. Prior to 1987, a fisca year coud be seected that did not defer more than three months of income for a majority of the sharehoders. Once a tax year is seected, sharehoders report their share of income deductions, gains, osses, or credits in their taxabe year with or within which the corporate taxabe year ends. FAMILY OWNERSHIP 16. Operating an S corporation in a famiy business offers many benefits for income spitting. In addition, parents can retain management contro because sharehoders are not required to participate in management and corporate stock may have different voting rights. Care shoud be exercised when famiy members own stock because, in many cases, the IRS may reaocate income to refect the vaue of services or the use of capita of the famiy members. Essentiay, reasonabe compensation must be paid to members of the famiy for services rendered and the use of capita. CURRENT DISTRIBUTIONS OF CORPORATE ASSETS 17. The distribution rues that appy depend upon whether the eecting corporation has accumuated E&P. The amount of any distribution to a sharehoder is measured by the amount of cash pus the fair market vaue of any property rendered. Distributions by S corporations with no E&P are tax-free uness they exceed the sharehoder s basis in the stock. Excess distributions are treated as gain from the sae or exchange of property (i.e., capita gain).

5 Study Highights Distributions from S corporations with accumuated E&P are treated in the foowing order: a. Tax-free to the extent of the accumuated adjustments account (AAA). The AAA is an account that consists of post-1982 accumuated gross income ess deductibe expenses not previousy distributed. b. Tax-free to the extent of any previousy taxed income (PTI) from years before PTI is persona to the sharehoder and represents earnings taxed to the sharehoders that have never been distributed. c. A distribution in excess of the AAA is treated as a dividend to the extent of accumuated E&P. d. A return of capita to the extent of the sharehoder s basis in the stock. e. Distributions that exceed the stockhoder s basis are treated as capita gains. 19. When an S corporation terminates, the business is taxed as a C corporation and any unused osses from the S years wi expire. In order to mitigate the harshness of osing these deductions, Congress aowed for a post-termination transaction period. During this period, which is generay one year, nontaxabe cash (nonproperty) distribution may be made from the AAA. TAXES IMPOSED ON THE S CORPORATION 20. Even though S corporations are generay exempt from taxation, they may be required to pay a specia tax. One such tax is that imposed upon excess net passive income (ENPI). The tax on ENPI is assessed at the highest rate of tax on reguar corporations, 34 percent (the tax rate prior to 1987 was 46 percent). Net passive investment income is passive investment income ess directy reated expenses. Excess net passive income can be defined as foows: Net Passive Income EPII ENPI ¼ Passive Investment Income This tax does not appy to S corporations with no E&P or to corporations formed after A corporation may eect to have distributions first made from E&P in order to eiminate it. Exampe. A current-year S corporation with prior C corporation E&P has tota gross receipts of $120,000. Incuded in this amount are dividends of $10,000 and gross rentas of $40,000. Expenses reated to the renta income amount to $15,000 and the corporation s taxabe income for the year is $16,000. Taxabe income is computed as foows: PII ¼ $50,000 (dividends and rentas) Excess PII ¼ $20,000 ($50,000 [25% of $120,000]) NPII ¼ $35,000 ($50,000 $15,000 renta expenses) ENPI ¼ $14,000 ($35,000 $20,000/$50,000) ENPI tax ¼ $4,760 (34% esser of taxabe income [$16,000] or ENPI [$14,000]) 21. Congress aso imposed an S corporation tax on ong-term capita gains in order to prevent one shot eections of S status to secure the tax benefits of the 60 percent deduction at the individua eve prior to Athough the Tax Reform Act of 1986 eiminated the 60 percent deduction, the capita gains tax sti appies where the corporate and individua margina tax rates vary. The capita gains tax is imposed if taxabe income exceeds $25,000 net ong-term capita gains exceeds $25,000 net ong-term capita gains exceeds 50 percent of the corporation s taxabe income the year is one of the first three years foowing C corporation status

6 11-6 S Corporations The tax is the esser of a. the aternative capita gains tax of 35 percent on the net capita gain in excess of $25,000, or b. the reguar tax computed on the corporation s tota taxabe income without regard to the NOL and dividends-received deduction. When the income fows through, the tax first reduces the ong-term capita gains passing from the corporation and then reduces any 1231 gains passing through. 22. When an S corporation is subject to the capita gains tax, the capita gains are aso subject to the add-on minimum tax. In addition to the minimum taxes, for years beginning after 1983, an S corporation may be iabe for the recapture of investment tax credits from non-s corporation years. Exampe. An S corporation with four equa sharehoders has taxabe income of $90,000. The corporation aso has a $100,000 net ong-term capita gain with an associated tax of $26,250 ([$100,000 $25,000 exemption] 35%). The amount that woud fow through to the sharehoders to be reported as ong-term capita gain woud be reduced by this corporate tax. Therefore, each sharehoder woud report a ongterm capita gain in the amount of $18, ([$100,000 $26,250]/4). MISCELLANEOUS RULES 23. Four other rues affecting S corporations shoud be considered: Hobby oss provisions of 183 are appicabe to S corporations. The at-risk rues generay appy to S corporations. The provisions governing iquidations and reorganizations for C corporations are appicabe to S corporations. The S corporation eection is fied on Form 2553 and shows evidence of sharehoder consents.

7 Study Questions 11-7 True or Fase STUDY QUESTIONS 1. A partnership made up of ony a husband and wife can be a sharehoder in an S corporation. 2. An S corporation does not get the dividends-received deduction for dividends paid by other domestic corporations in which it owns stock. 3. S corporations are not aowed to exist in every state. 4. If a C corporation, with a capita oss carryover, eects S corporation status for two years and then reverts to a C corporation again, those two years must be considered in computing the carryover expiration period. 5. An S corporation, athough a conduit, may have to pay tax on excess ong-term capita gains. 6. A corporation wi not quaify as a sma business corporation if one of its sharehoders is a resident aien. 7. An S eection can be ost when a new sharehoder with a minority interest affirmativey refuses to consent to the eection. 8. An S corporation formed in 1985 that has never been a C corporation wi not have an accumuated adjustments account (AAA). 9. In an S corporation, osses are passed through to whomever owns the stock on the ast day of the corporation s tax year. 10. A sharehoder s basis in an S corporation is increased for any taxabe income recognized by the sharehoder but not actuay received. 11. Once an S corporation eection is ost, the corporation may not make a new eection within five years of the termination. 12. After 1982, a sharehoder in an S corporation sti retains his previousy taxed income (PTI) account and can receive tax-free distribution. Mutipe Choice 1. In what manner may an S corporation ose its status and become terminated? a. At the IRS s discretion. b. If the sharehoder dies and his estate owns the stock. c. If the corporation has an NOL for three consecutive years. d. If a sharehoder transfers his stock to a grantor trust. e. None of the above.

8 11-8 S Corporations 2. A of the foowing are deductibe in computing the taxabe income of an S corporation except a. Dividends-received deduction. b. Amortization of organizationa expenditures. c. Investment interest. d. Saaries of sharehoder-empoyees. e. Charitabe contributions. 3. T Inc., a caendar year S corporation, was organized on January 2, 2009, with two equa sharehoders. Each sharehoder invested $5,000 and oaned the corporation $15,000. In addition to the $30,000 from the sharehoders, T Inc. borrowed $60,000 from a bank for working capita. T Inc. sustained an operating oss of $90,000 for the year. How much of this oss can each sharehoder caim on his 2009 tax return? a. $0. b. $5,000. c. $20,000. d. $45,000. e. $65, T Corporation, a caendar year corporation, is owned by individua R from January 1, 2009, unti October 1, 2009, at which time R ses her entire interest to individua M. During 2009, T Corporation reported taxabe income of $146,000 and made a $30,000 cash distribution to R on Juy 20, How much must R and M report on their respective tax returns? a. R, $30,000 M, $116,000. b. R, $ 3,000 M, $146,000. c. R, $139,200 M, $6,800. d. R, $109,100 M, $36,800. e. None of the above. 5. Which of the foowing wi retain its tax characteristics as it is passed through from an S corporation to the sharehoder? a. Investment credit. b. Capita gains. c. Tax preference items. d. Foreign tax credits. e. A of the above. 6. An S corporation eection heps a corporation avoid which of the foowing? a. The tax on unreasonabe accumuations. b. Doube taxation. c. Unused net operating osses. d. A of the above. e. None of the above.

9 Study Questions T Corporation vountariy terminates its S eection for When wi T once again be eigibe to re-eect S status (ignoring specia IRS approva)? a b c d e. Never. 8. Individua T buys a 20 percent interest in X Corporation, a caendar year S corporation, on October 31, If T fies an affirmative refusa to consent to S corporation status on November 31, 2009, the S eection: a. Does not terminate. b. Terminates January 1, c. Terminates October 31, d. Terminates November 31, e. Terminates December 31, R Corporation has been in existence for five tax years with the past two years as an S corporation. On its 2009 tax return, R reports a net ong-term capita gain of $30,000. If taxabe income for the year was $40,000, on what amount does R compute its capita gain tax? a. $0. b. $5,000. c. $15,000. d. $30,000. e. $40, The S corporation status can ony be revoked if the sharehoders who coectivey own more than what percentage of the outstanding stock consent to the revocation? a. 50% b % c. 75% d. 80% e. None of the above. 11. An S corporation has correcty determined that it is iabe for a tax on its excess net passive income of $100,000. What is the amount of tax? a. $28,000. b. $34,000. c. $46,000. d. $50,000. e. $60,000.

10 11-10 S Corporations 12. Stock of an S corporation may be owned by a of the foowing except a. An individua who is a resident aien of the United States. b. An estate. c. A domestic partnership. d. A voting trust. e. $60, An S corporation has C corporation accumuated earnings and profits. To guard against termination of S status, the corporation might a. Capitaize the C corporation AE&P. b. Eect to treat the C corporation AE&P as S corporation AE&P at the time it fies Form c. Distribute the C corporation AE&P and remove any threat of termination due to passive investment income, whether significant or not. d. None of the above. e. A of the above 14. Z owns five of an S corporation s 100 shares of common stock outstanding. After hoding the stock 73 days during the taxabe year, Z ses a five shares. S corporate records for the year show taxabe income to be $200,000. If no specia eection is made, Z s incudibe share of taxabe income from the S corporation is a. $0 b. $2,000. c. $10,000. d. Not abe to be determined from the information provided in the probem because the interim cosing of books method must be used. e. Not abe to be determined from the information provided in the probem because the per-day aocation method must be used. 15. An S corporation incurs a net operating oss of $25,000 in the current year and makes no distributions. Its soe sharehoder, K, has a basis in the stock of $30,000 and in a note receivabe from the corporation of $20,000. The $25,000 has the foowing impact: a. None, since no distributions were made. b. Reduces the stock basis by $25,000. c. Reduces the note basis by $20,000 and the stock basis by $5,000. d. Reduces the note basis by $10,000 and the stock basis by $15,000. e. Reduces the stock basis by $45,000. Fi In the Banks 1. Ony corporations are eigibe for treatment as S corporations. 2. The stock owned is imited to sharehoders, with husband and wife counting as sharehoder. 3. The eection to be an S corporation must be made on the 15th day of the month of the tax year.

11 Study Questions A vountary revocation occurs when sharehoders owning percent eect to terminate the S corporation. 5. Once terminated, a corporation cannot eect S status unti the year foowing the year the termination is effective. 6. A specia tax may be evied against the corporation on its. 7. Distributions from an S corporation are tax-free to the extent of the. Code Section Recognition For each of the foowing Code sections, try to match the response that most propery identifies the underying provision a. effect of eection on the corporation b. pass-through of items to sharehodersg c. definition of S corporation d. taxabe year of S corporation e. terminating the eection

12 11-12 S Corporations SOLUTIONS TO STUDY QUESTIONS True or Fase 1. Fase. Partnerships cannot be sharehoders. 2. True. 3. Fase. Federa aw governs S corporation status. 4. True. 5. True. 6. Fase. The prohibition ony appies to nonresident aiens. 7. Fase. Terminating the eection requires a majority of the sharehoders. 8. True. 9. Fase. Losses are prorated on a daiy basis. 10. True. 11. Fase. The eection can be regained with the permission of the IRS. 12. True. Mutipe Choice 1. e. 2. a. 3. c. $5,000 basis þ $15,000 share of debt. 4. d. ($146,000 / 365 days) 273 days. 5. e. 6. d. 7. d. A five-year waiting period. 8. a. To terminate requires a majority refusa. 9. b. $30,000 ess the $25,000 statutory base.

13 Soutions to Study Questions a. 11. b. Excess net passive income is taxed at a rate of 34 percent. 12. c. 13. c. 14. a. [$20,000 5%] ¼ 20% ¼ $2, b. Losses must reduce the basis in stock. Fi In the Banks 1. Domestic ; third; corporation s. 4. more than fifth. 6. Excess net passive income. 7. Accumuated adjustments account. Code Section Recognition 1. c. 2. e. 3. a. 4. b. 5. d.

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