FOR LIVE PROGRAM ONLY Calculating S Corp Stock and Debt Basis: Avoiding Loss Limitations and Excess Distributions WEDNESDAY, AUGUST 16, 2017, 1:00-2:50 pm Eastern IMPORTANT INFORMATION FOR THE LIVE PROGRAM This program is approved for 2 CPE credit hours. To earn credit you must: Participate in the program on your own computer connection (no sharing) if you need to register additional people, please call customer service at 1-800-926-7926 x10 (or 404-881-1141 x10). Strafford accepts American Express, Visa, MasterCard, Discover. Listen on-line via your computer speakers. Respond to five prompts during the program plus a single verification code. You will have to write down only the final verification code on the attestation form, which will be emailed to registered attendees. To earn full credit, you must remain connected for the entire program. WHO TO CONTACT DURING THE LIVE EVENT For Additional Registrations: -Call Strafford Customer Service 1-800-926-7926 x10 (or 404-881-1141 x10) For Assistance During the Live Program: -On the web, use the chat box at the bottom left of the screen If you get disconnected during the program, you can simply log in using your original instructions and PIN.
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Calculating S Corp Stock and Debt Basis Aug. 16, 2017 Robert S. Barnett, Partner Capell Barnett Matalon & Schoenfeld, Jericho, N.Y. rbarnett@cbmslaw.com Darren J. Mills, Esq., CPA Mills Estate & Tax Law, Red Bank, N.J. djmills1267@gmail.com
Notice ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.
DARREN J MILLS, ESQ., CPA Mills Estate & Tax Law LLC Stock Basis: Mechanics; Loss Limitations; & Sale Transactions
DISCLAIMER The views/content, typos, errors, etc. expressed herein are solely those of the presenter. The content herein is based on the Internal Revenue Code of 1986 (as amended) and the regulations thereunder. This material will not be updated for any changes in law and does not address and foreign or state and local tax issues. Please consult your individual advisor regarding any tax, legal or accounting advice with respect to your personal situation. 6
CONTENTS Stock Basis: Mechanics Stock Basis: Loss Limitations Stock Basis: Sales Transactions Bio 7
STOCK BASIS: MECHANICS 8
STOCK BASIS: MECHANICS It is important that a shareholder know his/her stock basis when: The S corporation allocates a loss and/or deduction item to the shareholder. In order for the shareholder to claim a loss, they need to demonstrate they have adequate stock and or debt basis. The S corporation makes a non-dividend distribution to the shareholder. In order for the shareholder to determine whether or not the distribution is a non-taxable they need to have adequate stock basis. The shareholder disposes of their stock. As with any asset, including C corporation stock, when the assets is sold or disposed of, basis needs to be established in order to reflect the proper gain or loss on the disposition. Since shareholder stock basis is an S corporation changes every year, it must be computed every year. Increase Basis. Ordinary Income Separately Stated Income Items. Tax Exempt Income Excess Depletion the excess of the deductions for depletion over the basis of the property subject to depletion Decreases Basis Ordinary Loss Separately State Loss Items Nondeductible Expenses Non-Dividend Distributions In no event may a shareholder s stock basis be reduced below zero 9
STOCK BASIS: MECHANICS CONT D Staring point: Substituted basis Sec. 358 Cost basis Sec. 1012 Gift/inheritance Sec. 1014/1015 Substituted basis Incorporation of either a sole proprietorship or partnership (including an LLC taxed as a partnership) The basis of the stock received (or deemed received in a meaningless gesture transaction) is the same as the adjusted basis of the property transferred. If money (including as assumed liability) or other property is received by the transferor then special basis adjustment rules apply. Such basis is first decreased by the amount of money received, the fair market value of any other property received, and any loss recognized on the exchange. The basis is then increased by any amount that is treated as a dividend and by the amount of any gain recognized as a result of the exchange (excluding that portion of the gain that is treated as a dividend). 10
STOCK BASIS: MECHANICS CONT D Holding Period In a sec. 351 transaction, the holding period generally tacks Loss Duplication Issues Policy A single economic loss should not give rise to two tax deductions. This result can occur as a result the mechanical application of the substituted basis rules. Generally, under Sec. 362, the transferee (e.g., an S Corporation) would take a carryover basis in the assets transferred to it. As such, if a shareholder transferred built-in loss assets in a Sec. 351 transaction, the S/H would take a substituted basis in the stock received under Sec. 358 and the Corporation would take a carryover basis under Sec. 362; therefore, as a result of the mechanical application of the basis rules two built-in losses arose from the same economic loss. According, with the AJCA Congress rectified this result with the enactment of Sec. 362(e)(2). If aggregate AB > aggregate FMV then basis is limited to aggregated FMV. Election available to reduce stock basis in lieu of the transferee s basis in the built-in loss asset. See Sec. 362(e)(2)9C) and the regulations thereunder. 11
STOCK BASIS: MECHANICS CONT D Loss Duplication Issues cont d A, an individual, owns Asset 1 (basis $90, value $60) and Asset 2 (basis $110, value $120). In a transaction to which Code Sec. 351 applies, A transfers Asset 1 and Asset 2 to X, a domestic corporation, in exchange for a single outstanding share of X stock representing all the outstanding X stock immediately after the transaction. A s transfer of Asset 1 and Asset 2 is a Code Sec. 362(a) transaction. For purposes of Code Sec. 362(e)(2), X s aggregate basis in those assets would be $200 ($90 + $110), which would exceed the aggregate value of the assets $180 ($60 + $120) immediately after the transaction. Accordingly, the transfer is a loss duplication transaction and A has a net built-in loss of $20 ($200 - $180). Asset 1 is loss duplication property since X s basis in Asset 1 would be $90, which would exceed Asset 1 s $60 value immediately after the transaction. X s basis in Asset 2 would be $110, which would not exceed Asset 2 s $120 value immediately after the transaction, so Asset 2 is not loss duplication property. X s basis in Asset 1 is $70, computed as its $90 basis under Code Sec. 362(a), reduced by A s $20 net built-in loss. X has transferred basis of $110 in Asset 2. Under Code Sec. 358(a). A has exchanged basis of $200 in the X stock it received in the transaction. Treas. Reg. 1.362-4(h). Example 1(i). 12
STOCK BASIS: MECHANICS CONT D Timing Adjustments are made as of the close of the corporation s tax year If a S/H disposes of stock during the year, the adjustments are effective immediately before the disposition (but note election) Ordering Rules for calculating basis post August 18, 1998 (Treas. Reg. 1.1367-1(f)) First, basis is increased for both separately stated and non-separately stated income items an the excess of the deductions for depletion; Next, basis is decreased by items that are noncapital, nondeductible expenses and the oil and gas depletion; and Finally, any decrease attributable to separately stated loss, deduction or credit items as well as non-separately computed loss items Separate Basis Rule Under this rule, stock basis is computed on a share-by-share basis in the same manner as that of a S/H in a C corporation The basis of a share of stock is decreased by an amount equal to the S/H s pro rata portion of the items described in 1367(a)(1) or (a)(2) that is attributable to that share 13
STOCK BASIS: MECHANICS CONT D Other Considerations A distribution ay be tax free to the S/H, but Sec. 311(b) continues to apply to a distribution of appreciated property (i.e., any gain recognized in the deemed sale under Sec. 311(b) will pass through to all S/Hs) A S/H s stock basis at the time of a distribution is irrelevant in determining the tax treatment of the distribution: Basis at the close of the tax year determines the tax treatment of the distribution Under the stock basis adjustment rules, distributions made during a tax year are taken into account before applying any loss limitation for the year Note that, under Sec. 1367(b)(2)(A), basis from indebtedness may ply be used to deduct losses; it may not be used to receive tax-free distributions (cash received in connection with such loans must take the form of a loan repayment) S corporation rules adopt a separate basis approach for determining the basis adjustments in S stock, computing stock basis on a share-by-share basis in the same manner as stock basis is computed doe a S/H in a C corporation 14
STOCK BASIS: LOSS LIMITATIONS 15
STOCK BASIS: LOSS LIMITATIONS Amount of losses that can be deducted by the S/H is limited to his/her adjusted basis in the stock A loss that cannot be deducted due to a lack of basis is a suspended loss A suspended loss is an attribute of the individual S/H and cannot be used by other S/Hs If a shareholder transfers some but not all of the shareholder s stock in the corporation, the amount of any disallowed loss of deduction under this section is not reduced and the transferee does not acquire any portion of the disallowed loss or deduction. If a shareholder transfers all of the shareholder s stock in the corporation, any disallowed loss or deduction 1.366-2(a)(6) No basis obtained in debt simply by guaranteeing a loan, etc. Payment on the loan must be made by the S/H to get basis. 16
STOCK BASIS: LOSS LIMITATIONS CONT D Example: T is the sole shareholder of X, an S corporation. During 2005, X incurred and passed through to T $6,000 in nonseparately stated loss and $4,000 in capital loss. However, T was unable to deduct any of the losses due to a lack of basis. In this situation, both losses are suspended, carry forward to 2006, and pass through again with respect to T. In 2006, X incurred and passed through $5,000 in nonseparately stated income and $2,000 in capital gain. This means that T is deemed to have $1,000 in ordinary loss ($6,000 $5,000) and $2,000 in capital loss ($4,000 $2,000) from X in 2006. These amounts must be compared with T s basis at the end of 2006 to determine if any of these amounts may be deducted. If not deductible, those amounts again carry forward and are combined with 2007 s passthrough results. Starr and Sobol, 731-2nd T.M., S Corporations: Operations Example: T is the sole shareholder of X, an S corporation. During X s first three years of operations, it incurred losses totaling $100,000 that passed through to T. However, because T only had basis of $20,000 in X, $80,000 of the losses were suspended. In the fourth year of operations, T sold his stock to B. In this situation, T s suspended losses are lost forever (nor are they available to offset any gain from the sale of X stock). Id. 17
STOCK BASIS: SALES TRANSACTION 18
THE SEC. 338(H)(10) ELECTION Introduction When Available Available to any corporation that makes a Qualified Stock Purchase (QSP) of a Target Corporation Target is an S Corporation or an 80% or greater corporate subsidiary member of a consolidated group Also, Sec. 336(e) may be a viable alternative as it does not require a corporate purchaser in a qualified stock disposition ( QSD ) Requirements Corporate Purchaser QSP: at least 80% (vote and value) must be acquired Joint election by buyer and seller: filed by the 15 th day of the 9 th month following the month in which the acquisition occurs 19
THE SEC. 338(H)(10) ELECTION Mechanics Treatment of Target Corporation: Target Corporation is deemed to sell all of its assets for an amount equal to the Aggregated Deemed Sales Price Target Corporation reports gain or loss from deemed sale on its final tax return In the S Corporation context, gain or loss flows-through to selling shareholders (generally no federal entity-;level tax is imposed on S corporations). Seller is responsible for any tax due on the deemed asset sale. 20
THE SEC. 338(H)(10) ELECTION Mechanics Treatment of Target Corporation (continued): Target Corporation is deemed to liquidate at the end of the acquisition date If Target S Corporation is deemed to engage in a taxable liquidation. See Sec. 331 and 336. However, the gain or loss from the deemed asset sale flows through to the selling shareholders, increasing or decreasing their tax basis in their stock, respectively. As such, there generally is no incremental taxable gain upon the deemed liquidation of Target Corporation. At the beginning of the day after the acquisition date, Target Corporation is deemed to reconstitute itself as a new corporation and purchase the assets. Target Corporation receives a tax basis in the assets equal to the Adjusted Grossed Up Basis. Target Corporation uses the Residual Method to allocate the Adjusted Grossed Up Basis. 21
THE SEC. 338(H)(10) ELECTION Mechanics Treatment of Buyer Receives a cost basis in the stock of Target Corporation. Tax basis step up in target assets Increase in after-tax cash flow Takes the form of a stock sale for non-tax reasons Note: historical business & tax exposures carryover 22
THE SEC. 338(H)(10) ELECTION Mechanics Treatment of Sellers The stock sale is ignored for federal income tax purposes Single level of tax (no shareholder level gain). The gain or loss from the deemed sale of the Target Corporation s assets flows through to the shareholders and is reported on their federal income tax returns. May be additional taxes (federal + state) for which seller may require gross ups Complications in rolling shareholders rollover is taxable as if stock was sold 23
THE SEC. 338(H)(10) ELECTION Summary Note that in the case of a Sec. 338(h)(10) election, there is only one level of tax. Because the deemed asset sale generally results in ordinary income, while the sale of stock results in capital gain or loss, the sellers may, in certain cases, pay more tax under a Sec. 338(h)(10) election than under a stock sale. Individual capital gain tax rates vs. ordinary income tax rates (23.8% vs. 39.6%), although, see Sec. 1231. State taxes (including entity-level taxes), Sec. 1374 BIG tax, etc. In order to make the sellers whole, the purchaser can Gross Up the sellers by increasing the purchase price to accommodate for the incremental tax that the sellers must suffer as a result of making the Sec. 338(h)(10) election. The Gross Up Payment is included in the computations for Aggregate Deemed Sales Price and Adjusted Grossed Up Basis. May result in additional depreciation or amortization deductions. 24 A Sec. 338(h)(10) election generally makes sense if the present value of the additional depreciation and amortization deductions that result from making the election exceed the amount of the Gross Up Payment.
THE SEC. 338(H)(10) ELECTION Summary $300 Corporate Buyer ( B ) New T (C Corp) ACTUAL Stock Step 1 Assets (basis=$200) DEEMED $300 + $100 Assumption of Debt Seller ( S ) OLD T (S Corp) Step 2 Old T Liquidaes DEEMED Assumptions Seller s outside stock basis = $100 T s inside asset basis = $200 T s liabilities = $100 Buyer Pays $300 for stock Stock Sale 338(h)(10) Buyer B Seller S Target T Cost Basis in T Stock = $300 Capital Gain = $200 No Gain; Carryover Basis up to $400 Cost Basis in T Stock = $300 Capital / Ordinary Gain = $200 ($300 + $100 - $200) on deemed sales is passed through from Target; No gain on liquidation Gain passed through to S; Basis is stepped 25
THE SEC. 338(H)(10) ELECTION The Malpractice Transaction PE Historical S/H PE Historical S/H Cash Holdco Holdco Target (S Corp) Stock Buyer Buyer Target Buyer purchases the stock of Target from Historical S/H for cash, and both parties make a Sec.338(h)(10) election. Historical S/H rolls part of his proceeds (7%) into Holdco, such that after the transaction is consummated he is a partner in Holdco along with PE. The Sec. 338(h)(10) election was invalid because Historical S/H would be viewed as a related party, and you can t do a Sec. 338(h)(10) election with a related party. 26 A very harsh and unfair result. Had Historical S/H rolled his interest into Buyer, it would not have been a problem. The Sec. 336(e) rules partially address this issue.
THE SEC. 338(H)(10) ELECTION Other Considerations Rollovers where the Seller ends up with more than 20% are not good QSPs S Corp status must be valid as a 338(h)(10) can t be made on a stand-alone C corp. Gross-up for Incremental taxes Built-in gains taxes (S corporations State Taxes Character of taxable gains (ordinary versus capital) 27
BIO: DARREN J MILLS 28
DARREN J MILLS, ESQ., CPA Darren is an attorney licensed in the State of New Jersey and the Commonwealth of Pennsylvania. He is also a licensed CPA in the States of New Jersey and Florida. He has taught numerous graduated level tax classes as well as professional continuing education. Darren earned his undergraduate and law degree from Seton Hall University. He also has a Masters in Taxation from Fairleigh Dickinson University where he was inducted into the tax honor society. Finally, Darren has authored articles on various tax and elder law issues. He can be reached at djmills@millstaxlaw.com 29
S CORPORATION LOSS UTILIZATION By Robert S. Barnett CPA, JD, MS (TAXATION) CAPELL BARNETT MATALON & SCHOENFELD, LLP. ATTORNEYS AT LAW (516) 931-8100 rbarnett@cbmslaw.com
LOSS UTILIZATION IRC 1366(d)(1): S Corp losses and deductions limited to extent of SH s basis in stock PLUS corporate debt to SH. Basis determines: Deductibility of losses and deductions Taxability of distributions Gain/Loss on sale of stock Contribution to Capital raises Stock Basis WATCH AT RISK REQUIREMENTS 32
LOSS ORDERING First apply At-Risk Rules & Basis If Limited by 465 not a PAL If Insufficient Basis not a PAL for year When Limitations Removed PAL applies Therefore, must pass Basis & At- Risk Tests 33
RATABLE SHARE If part of S loss is disallowed 1366(d) Ratable portion of each S loss item is disallowed Permitted to compute limitations on net loss Unless individual item taxed differently Ex. Part of Passive Rental Activity 34
HOW IS BASIS CREATED? Purchase / Gift / Inheritance Contribute cash or property (less liability assumed) KEEP RECORDS & RETURNS Accumulated and undistributed income Tax-exempt income Reduced by distributions losses and nondeductible expenses 35
INHERITANCE 1367(b)(4)(B) Reduction of FMV Basis By portion of value of stock attributable to IRD 36
EXAMPLE Inherit 20% S Corp. S Corp. fmv $1 million Including $500k cash A/R Basis = $100k 37
REG. 1.1367-1 BASIS Stock Basis purchase/ gift / inheritance Increase by K-1 income items & tax free Pro rata per share per day Decrease (not below 0) k-1 losses & distributions Compute at end of year (or before disposition) 38
BASIS CONTINUED Contribute property basis less liability assumed, WATCH 357(c) EXAMPLE: Property Basis $40,000, Value $100,000 and mortgage of $30,000 is contributed: STOCK BASIS $10,000 Special Estate Considerations reduction for IRD type items Ordering Rules will be discussed 39
BASIS DETERMINES Deductibility of losses and deductions Taxability of distributions Gain/Loss on sale of stock 40
LOSS UTILIZATION IRC 1366(d)(1) LIMITS use of S Corp losses and deductions to extent of shareholder s basis in stock PLUS Corporate debt to shareholder. 41
LOSSES - UTILIZATION 1. First 1366(d)(1) Stock Basis 2. Then reduces Basis in debt to Corp 3. Remainder carried forward REMEMBER basis does not include guarantees or circular loans Back-to-Back must be bona fide See 1.1366-2(a)(2)(i) & (iii),ex. 2 42
BASIS Barnes v. Comm., 111 AFTR 2d 2013 (DC Cir) Affirmed Tax Court, TCM 2012-80 reduce basis even if fail to deduct the loss S SHs inadequate basis Unable to deduct losses limited to basis Basis not increased by prior losses not claimed Taxpayer failed to deduct suspended losses Statute of limitations expired 43
LOSS UTILIZATION Gleason v. Commissioner, TCM 2006-191 (9/11/06) Taxpayer won as borrower on a $6m loan IRS re-characterized loan properly made by taxpayer because loan payments paid by Corp and stock was pledged as collateral Kerzener, TCM 2009-76 CIRCULAR LOAN from p ship to S SH to S corp did not create basis. S Corp paid equivalent rent back to the p ship. Transaction lacked economic substance MERE CONDUIT No sufficient risk Court distinguished Ruckriegel and Culnen Nathel, 105 AFTR 2 2010-927 (2nd Cir. 6/2/10) Equity and debt are distinguishable Contribution of equity increases basis of stock but does not restore loan basis CONTRIBUTIONS TO CAPITAL ARE NOT INCOME! 44
NATHEL Attempted to restore or increase loan basis Corp. repaid shareholder loans with reduced basis (from losses) Recognized Ordinary Income on repayment of loan Capital contributions do not create exempt income (income increases loan basis) Supreme court denied cert. 45
Culnen, TCM 2000-139 Distributions from profitable S to loss S added to basis > $3 Mil: i. amounts came out of S earnings, ii. always shown on books as loans to/from shareholder, and iii. all bank financing statements showed the loans as personal, not corporate. IRS permits Back to Back loans (bona fide) 46
BACK TO BACK LOANS Prop. Reg. 1.1366-2 Bona fide indebtedness All facts & circumstances considered General tax principles MAGUIRE, TCM 2012-160 Auto dealer and finance company Finance A/R distributed then contributed 47
BONA FIDE DEBT Watch Second Class of Stock Rules Straight Debt Safe Harbor Reg. 1.1361-1(l)(5) 48
DEBT v. EQUITY Transfers to Corp generally equity, not loan Capital contribution Corp s payment of personal expenses = dividends Not repayment of loan No debtor/creditor indicia ACM Environmental Services, TCM 2012-335 Proper documentation missing 49
NOT BONA FIDE DEBT No Bad Debt Deduction Herrera v. Comm r, 112 AFTR2d 2013-6858 (5th Cir.) LLC (partnership) Loans to related steel corp. No written promissory notes No definite maturity No repayment schedule No security no payments 50
OPEN ACCOUNT DEBT INTRODUCTION Brooks v. Commissioner TCM 2005-204 (August 25, 2005) Final Regulations 51
LOANS Assume Stock Basis $100 If X $200 loss, shareholder deducts only $100 1366(d)(1) deductions limited to Basis Basis can never be negative So shareholder loans $100 to Corp on 12/31 Stock Basis & Loan Basis is $0 Later income first restores Loan Basis 52
OPEN ACCOUNT DEBT Shareholder loans/advances not evidenced by written instrument New Regulations advances 10/20/08 and thereafter Limit $25,000 per Shareholder EXAMPLE Each Sh. can have up to $25,000 of Open Account Debt 53
BE CAREFUL No Shareholder exceeds limit Keep records per Shareholder Not day/day END OF S YEAR Unless debt disposed or Shareholder terminated 54
WHAT HAPPENS When $25,000 limit exceeded Debt at end of year treated AS IF evidenced by separate written agreement No longer Open Account Debt Debt existing on 10/20/2008 is not subject to new rules and is treated as a separate loan Identification issues exist 55
LOSSES ORDERING RULES Losses first absorb Stock Basis Then reduce Debt Basis NOT BELOW ZERO Multiple indebtedness Loss Allocated Based upon aggregate Basis Intricate record keeping required 56
RESTORATION Distinction between Stock & Debt Basis Net Income restores Debt Basis first Net Increase is 1367(a)(1) income items New contribution(s) - increase Stock Basis (Nathel) Computations generally determined at end of the year 57
COMPUTATION Advances and Repayments are netted At close of S Corp year Net Advance or Repayment is combined with Principal balance of Open Account Debt Carried to next year (unless > $25,000) IF > $25,000 no longer Open Account Debt Treated as if separate debt. 58
EXAMPLE ONE A s Stock Basis is $0 6/1/09 A loans S $16,000 (no note) 12/31/09 Open Account Debt = $16,000 59
EXAMPLE TWO 2009 STOCK BASIS $0 A lends $16,000 6/1/09 12/31/09 Loss <$8,000> A s BASIS in Open Account Debt is $8,000 Principal Loan amount remains $16,000 60
EXAMPLE THREE 2010 A Stock Basis = $0 Loan Basis = $8,000 (principal $16,000) 4/1/10 S Repays to A $4,000 9/1/10 A Advances $1,000 (net $3,000) 12/31/10 Debt Principal $13,000 Still open Account Debt 61
EXAMPLE THREE CONTINUED A Ordinary Income $1,500 (8/16 x $3,000 Net Repayment) IF evidenced by note Capital Gain Debt treated as if evidenced by note, tax effect not addressed 12/31/10 Open Account Debt Principal $13,000 Carried to 2011 62
EXAMPLE FOUR (ex. 3 FACTS) 2/1/11 S Repays A $5,000 3/1/11 A Advances $20,000 Not evidenced by a written agreement 2011 Net Advance $15,000 Debt $28,000 (> $25,000 not Open Account Debt) Treated as if evidenced by a separate written agreement maintain records 63
REPORTING REQUIREMENTS Must keep records per shareholder IF hold more than one indebtedness at close of year Basis is reduced proportionately to aggregate Basis Net increase is applied to first restore debt basis before stock basis First restore Basis of any debt which is repaid during year 64
WHO CARES? The IRS & the Treasury $25,000 limitation eliminates Year End Repayments Mixed blessing Gain on Repayment of Debt evidenced by notes is CAPITAL GAIN Repayment of Open Account Debt with reduced basis = ORDINARY INCOME 66
NATHEL Attempted to restore or increase loan basis Corp. repaid shareholder loans with reduced basis (from losses) Recognized Ordinary Income Capital contributions do not create exempt income (income increases loan basis) Supreme court denied cert. 67
PLANNING Reduce YE Balance < $25,000 Use Note Capital Gain Do Not Repay Identify Debt Repaid Contribute to Capital 68
SCOTT SINGER INSTALLATIONS INC. TCM 2016-161 IRS payment of personal expenses WAGES TP Advanced $ to Corp. Corp. paid TP s expenses TP Loan repayment not wages No Notes or Debt Acknowledgement 69
SHAREHOLDER LOAN SUFFICENT? Court Said Yes In years Co. was profitable In other years No! Look at all factors Need Debtor/Creditor Relationship 70
S CORP DISTRIBUTIONS Goals: 1. Avoid/Defer taxation 2. Avoid C corp taxation 3. Preserve S election 4. Maximize tax-free $ 71
BASIS DETERMINES Deductibility of losses and deductions Taxability of distributions Gain/Loss on sale of stock 72
S CORP DISTRIBUTIONS Initial question: Does S corp have AEP? Accumulated Earnings & Profits Next compute Basis 73
EARNINGS AND PROFITS (E & P) Measures ability to pay Dividends Net profits after SH Dividends Special adjustments Cumulative computations 74
Example Accumulated deficit of $20,000 Current E & P of $10,000 Distribution of $10,000 Taxable Dividend Wait until next year 75
C Corp w/ AEP S Election C corp has $100 AEP C corp makes S election C corp becomes S corp S corp has $100 AEP 76
STOCK BASIS DECREASE Deductions and Losses NOT below zero Distributions Nondeductible expenses 77
BASIS ADJUSTMENTS Per share, per day At year end, generally First increases, then decreases Special election to close books 78
S Corp Distribution No AEP No tax to extent of Basis Distribution Decrease Basis Yearly adjustment Distributions > Basis capital gain AAA Irrelevant 79
NO AEP EXAMPLE Bob owns all S corp stock Basis = $10K on 1/1/2015 During 2015: $30K ordinary loss $10K distribution 80
NO AEP EXAMPLE Distribution = Basis Bob not taxed on distribution Decrease Basis to $0 No Basis $30K loss suspended 81
DISTRIBUTIONS IF AEP 4 Tiers: 1. Tax free to AAA (Accumulated Adjustments Account, Up to Basis) 2. Dividend to AEP 3. Return of capital Basis 4. Excess: Gain sale or exchange 82
AAA (1982) Previously Taxed Income 1368(e)(1)(A) corp. attribute Computed similar to Basis, except: No adjustment for exempt income No adjustment for C level taxes CAN BE LESS THAN ZERO But not by distributions 83
AAA Adjustments INCREASE Non-separately stated income Separately stated income DECREASE Non-separately stated loss Separately stated loss Distributions 84
AAA Stock Sale/Redemption Stock sale to 3 rd party: AAA unaffected AAA affects transferee s distributions Redemption: Reduces AAA Based on ratio of shares redeemed 85
1 ST : Net Positive or Net Negative? Net Positive: (income + gain) > (loss + deduction) NOT including distribution(s) Net Negative: (loss + deduction) > (income + gain) NOT including distribution(s) 86
2 ND : Timing Net Positive AAA Adjustment: Adjust AAA BEFORE taxing distribution Net Negative AAA Adjustment : Adjust AAA AFTER taxing distribution Allows more tax-free basis return 87
3 RD : Default Order 1. To extent AAA, Capital Return 2. Then Dividend to AEP 3. Then Capital Return to Basis 4. Excess is Capital Gain 88
S Corp w/ AEP Example 1 Joan owns 100% S Corp: Basis = $10K on 1/1/2015 AAA = $2.5K AEP = $8.5K In 2015: $10K income $3K loss $12K distribution 89
Example 1 (Net Positive) AAA AEP S Corp Dist. Starting $2,500 $8,500 Increase AAA: net positive $7,000 C Corp Dist. AAA balance before Dist. $9,500 Decease: distribution $9,500 $9,500 Ending AAA $0 Distribution from AEP $2,500 $2,500 Ending AEP $6,000 Dividend $2500 90
Example 1 Basis Basis Starting $10,000 Increase for income $10,000 Basis before distribution $20,000 Decease for dist. not taxed as dividend ($9,500) Decrease for losses ($3,000) Ending Basis $7,500 Return of capital $9500 91
Example 1 $10K Pos. Adj. > $3K Neg. Adj. $10K - $3K = $7K Net Positive Adjustment Adjust AAA BEFORE taxing distribution AAA increased by $7K $9.5K First: Capital return to extent of AAA AAA = $9.5K; Capital Return of $9.5K AAA decreased by $9.5K $0 92
Example 1 Distribution $12K $9.5K AAA = $2.5K Second: Dividend to extent of AEP Remaining $2.5K < 8.5K AEP Dividend of $2.5K AEP Adjustment $8.5K - $2.5K dividend = $6K 93
Example 1 Basis Adjustment $10K at start Increase $10K income $20K Decrease $9.5K capital return $10.5K Decrease $3K loss $7.5K (AAA = 0) 94
Example 2 (Net Negative) Sally owns 100% S Corp: Basis = $2,000 on 1/1/2015 AAA = $300 AEP = $500 In 2015: $200 capital gain $1,000 loss $2,000 distribution 95
Example 2 AAA AEP S Corp Dist. Starting $300 $500 Decrease: distribution ($300) $300 (not below zero) AAA Balance after dist. $0 C Corp Dist. Decease AAA: net ($800) negative adjustment Ending AAA ($800) Distribution from AEP ($500) $500 Ending AEP $0 Dist. in excess of AAA/AEP $1200 96
Example 2 Basis Starting $2,000 Increase for Income $200 Decease for Dist. not taxed as dividend ($1,500) Basis after distributions $700 Decrease for losses ($700) Ending Basis $0 Suspended losses $300 97
Example 2 $1,000 Neg. Adj. > $200 Pos. Adj. $1,000 - $200 = $800 Net Negative Adjustment Adjust AAA AFTER distribution 1. Beginning AAA $300 distributed TAX FREE! 2. AAA negative (not Basis) 3. AAA reduced by full net negative adj. 98
Example 2 First: Capital Return to extent of AAA AAA = $300 capital return AAA decreases by $300 $0 THEN apply Net Negative Adjustment $800 Net Negative Adjustment Decreases AAA by $800 AAA = -800 99
Example 2 Second: Dividend to extent of AEP $500 of remaining distribution Dividend of $500 AEP 0 Third: Adjust Basis Capital Return Remaining $1,200 of $2,000 distribution Capital Return of $1,200 + $300 100
Example 2 Basis Adjustment & Suspended Loss Basis = $2,000 at start Increase for $200 income $2,200 Decrease for $1,500 Capital Return $700 ($300 AAA + $1,200 remaining distribution) Decrease for $700 loss $0 Basis cannot be < zero Remaining $300 suspended loss 101
Property Distribution Similar rules apply Distribution = FMV Gain as if sold 311(b) Gain to extent FMV exceeds basis Gain passes to SH, increases stock basis Property Basis = FMV SH Basis decreased by property FMV 102
Depreciated Property Distribution Generally no loss allowed, 311(a) Value of dist. is FMV of property SH Basis in property is FMV Treated as non-deductible, non-capital expense. CCA 201421015. AAA & SH Basis reduced by loss Sell Property! 103