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    2013 cch basic principles ch16 piv 2013 cch basic principles ch16 piv Presentation Transcript

    • Chapter 16 Partnerships, Corporations, and S Corporations Part IV: S Corporations©2012 CCH. All Rights Reserved.4025 W. Peterson Ave.Chicago, IL 60646-60851 800 248 3248www.CCHGroup.com
    • Chapter 16 Contents 1. S Corporations—Treatment of Tax and Nontax Matters 2. S Corporations—Tax Years 3. S Corporations—Accounting Methods 4. S Corporations—Tax Model 5. S Corporations—Eligibility and Election 6. S Corporations—Revoking S Status 7. S Corporation Basis Accounts—Overview 8. S Corporation Basis Accounts—Outside Basis 9. S Corporation Basis Accounts—At-Risk Basis 10. S Corporation Basis Accounts—Accumulated Adjustment Account (AAA) 11. S Corporation Basis Accounts—Other Adjustment Account (OAA)Chapter 16, Exhibit Contents A CCH Federal Taxation Basic Principles2 of 60
    • Chapter 16 Contents 12. S Corporation Basis Accounts—Previously Taxed Income Account (PTI) 13. S Corporation Basis Accounts—Shareholder Loans to S Corporations 14. S Corporation Basis Accounts—Example on Effect of Operating Results on Basis 15. S Corporation Distributions 16. S Corporation Distributions—Effect on Shareholder 17. S Corporation Distributions—Example 18. S Corporation Penalty Taxes—Code Sec. 1374 Tax on Built-in Gains 19. S Corporation Penalty Taxes—Code Sec. 1374 Tax Example 20. S Corporation Penalty Taxes—Code Sec. 1375 Tax on Excess Net Passive Income 21. Code Sec. 1375 Tax on Excess Net Passive Income—ExampleChapter 16, Exhibit Contents B CCH Federal Taxation Basic Principles3 of 60
    • S Corporations—Treatment of Tax and Nontax Matters The Conduit Concept. For most tax matters, S corporations are treated like partnerships. As in the partnership conduit concept, the taxable income of an S corporation flows through to the owners on a per- day and per-share basis. Income and losses are reported on Form 1120-S, allocated to each shareholder on a supporting K-1 schedule, and then transferred, via the K-1, to the individual owners’ 1040 returns. There, at the individual level, income is taxed and losses are deducted.Chapter 16, Exhibit 1a CCH Federal Taxation Basic Principles4 of 60
    • S Corporations—Treatment of Tax and Nontax Matters The Entity Concept. The character of income and losses is determined at the entity level, not at the shareholder level. For example, a long-term capital gain reported by the S corporation remains long- term to the shareholder, even if his ownership in the S corporation had been held for a short-term period.Chapter 16, Exhibit 1b CCH Federal Taxation Basic Principles5 of 60
    • S Corporations—Treatment of Tax and Nontax Matters Distributions of Cash or Property. Actual distributions of cash or property are generally not income to its shareholders. Two notable differences with partnerships are:  Owner salaries and payroll taxes. Deductible by S corporations, not by partnerships.  Gain on distribution of property. S corps must recognize gains (but not losses) on distributions of appreciated property to shareholders; partnerships escape this gain recognition.Chapter 16, Exhibit 1c CCH Federal Taxation Basic Principles6 of 60
    • S Corporations—Treatment of Tax and Nontax Matters Nontax matters. For most structural matters (e.g., formation, redemptions and terminations), S corporations are treated in much the same manner as C corporations.Chapter 16, Exhibit 1d CCH Federal Taxation Basic Principles7 of 60
    • S Corporations—Tax Years An S corporation must generally use a calendar year end. However, it may elect a fiscal tax year under any of the following three conditions:  Three-Month Deferral OK. A fiscal tax year would result in income deferral of not more than three months and the shareholder-employee’s salary earned between fiscal year end and December 31 is both:  Paid during that period; and,  Proportionate to the salary paid during the preceding fiscal year.  Business Purpose. A business purpose can be demonstrated.  1987 FYE. The S corporation retains the same fiscal tax year as was used in 1987, if in existence at that time.Chapter 16, Exhibit 2 CCH Federal Taxation Basic Principles8 of 60
    • S Corporations—Accounting Methods The accrual, cash and hybrid methods are available regardless of the size of the S corporation.Chapter 16, Exhibit 3 CCH Federal Taxation Basic Principles9 of 60
    • S Corporations—Tax Model Code Sec. 702(a)(8) Income Definition. As with partnerships, items that are always subject to ordinary treatment are lumped together in an amount called Code Sec. 702(a)(8) income or loss. Shareholders recognize Code Sec. 702(a)(8) income even if no cash is actually distributed. Accordingly, shareholders are generally not taxed on distributions.Chapter 16, Exhibit 4a CCH Federal Taxation Basic Principles10 of 60
    • S Corporations—Tax Model Code Sec. 702(a)(8) Income Computation. Sec. 702(a)(8) is generally operating income or loss computed as follows:  Ordinary Income “From Whatever Source Derived” (including Code Sec. 1245 recapture)  Less: Exclusions  Less: Cost of Goods Sold (resulting in gross income from business operations)  Less: Operating ExpensesChapter 16, Exhibit 4b CCH Federal Taxation Basic Principles11 of 60
    • S Corporations—Tax Model Rationale. Each shareholder of an S corporation reports her share of corporate net income based on her stock ownership. Any income, loss, deduction, or credit which could uniquely affect the tax liability of a shareholder is separately stated in the K-1 to the shareholder.Chapter 16, Exhibit 4c CCH Federal Taxation Basic Principles12 of 60
    • S Corporations—Tax Model Separately Stated Items  Passive income and losses from rental and other non-operating activities  Investment income and related expenses (e.g., dividends, investment interest, ad valorem tax on stock, investment counseling fees, etc.)  Code Sec. 1231 gain and loss  Capital gains and losses  Dividends eligible for a dividends-received deduction  Charitable contributions  Taxes paid to a foreign country or to a U.S. possession  Code Sec. 179 deduction  Recovery items (e.g., tax refunds, recovery of bad debts)  Tax-exempt income and related expense  Tax credits  Deductions disallowed in computing S corporation incomeChapter 16, Exhibit 4d CCH Federal Taxation Basic Principles13 of 60
    • S Corporations—Eligibility and Election A corporation is treated as an S corporation only for those days for which each specific eligibility requirement is met and the required election is effective. Eligibility and election rules include: Unanimous Consent. 100% of the shareholders must consent to the S election. Deadline For Filing S Election. If a calendar year C corporation makes an S election by 3/15/x1, it is retroactive to 1/1/x1. If made after 3/15/x1, but before 3/15/x2, it is effective 1/1/x2. One Class of Stock. Only one class of stock is permitted.  Rights to profits and assets on liquidation must be identical.  Debt may be treated as a disqualifying second class of stock.Chapter 16, Exhibit 5a CCH Federal Taxation Basic Principles14 of 60
    • S Corporations—Eligibility and Election Maximum 100 Shareholders. The number of shareholders may not exceed 100.  A nonresident alien may not own shares.  Each shareholder must be an individual, an estate, or a qualified trust.  Related taxpayers can elect to be treated as one shareholder.Chapter 16, Exhibit 5b CCH Federal Taxation Basic Principles15 of 60
    • S Corporations—Eligibility and Election Ineligible Corporations. The corporation must be domestic but not a bank or insurance company. Eligible Subsidiaries.  S corporations can own C corporations, but C corporations cannot own S corporations.  S corporations can own qualified subchapter S subsidiaries (QSubs). A QSub is an electing domestic corporation that qualifies as an S corporation and is 100% owned by an S corporation parent.Chapter 16, Exhibit 5c CCH Federal Taxation Basic Principles16 of 60
    • S Corporations—Revoking S Status The S election will be terminated upon one of the following events: 1. Over 50% consent. Over 50% of the shareholders agree to the revocation. The deadline for revoking S status is the same as the deadline for electing it. 2. Prior C life AND passive investment income over 25%. If an S corporation had a prior life as a C corporation and its passive investment income is over 25% of its total income for three consecutive years, it loses the S election at the start of the fourth year.Chapter 16, Exhibit 6a CCH Federal Taxation Basic Principles17 of 60
    • S Corporations—Revoking S Status 3. Violation of qualifications. If any of the qualifications mentioned above are violated (e.g., stock is sold to a C corporation, or a second class of stock is issued), the S election is terminated on the date of violation, and the period before the violation is considered a “short-year.” 4. Majority shareholder revocation. If a new shareholder owning more than 50% takes affirmative action to terminate the election, the election dies as of the date of action. After revocation or termination of an election, a new election cannot be effectively made for 5 years without IRS consent.Chapter 16, Exhibit 6b CCH Federal Taxation Basic Principles18 of 60
    • S Corporation Basis Accounts—Overview Outside (Stock) Basis At Risk Basis AAA Basis Primary To determine gain or To determine how To determine Purpose: loss when the stock is much of how much of ultimately sold. [Also shareholder’s cash and will limit tax-free allocations of Sec. property distributions if stock 702(a)(8) losses and distributions are basis is lower than separately stated tax-free. AAA basis.] expenses are deductible.Chapter 16, Exhibit 7a CCH Federal Taxation Basic Principles19 of 60
    • S Corporation Basis Accounts—Overview (“Yes” means the item to the left is used in the computation of basis): Outside (Stock) At Risk Basis AAA Basis Basis + Original basis (e.g., purchase, Yes Yes No inheritance, gift) ± Sec. 702(a)(8) TI or Loss Yes Yes ± Separately stated items that are taxable Yes Yes Yes or deductible to s/h ± Tax-exempt income and non- Yes Yes No deductible exp. + Company debt for which s/h is No Yes No personally liableChapter 16, Exhibit 7b CCH Federal Taxation Basic Principles20 of 60
    • S Corporation Basis Accounts—Overview (“Yes” means the item to the left is used in the computation of basis): Outside (Stock) At Risk Basis AAA Basis Basis + Non-recourse No No No financing from (unlike the qualified lenders normal at-risk rules for individuals) + Shareholder (S/H) No Yes No loans to S Corp (unlike (unlike partnerships, partnerships debt debt basis is held basis is held separately from separately from equity basis.) equity basis.)Chapter 16, Exhibit 7c CCH Federal Taxation Basic Principles21 of 60
    • S Corporation Basis Accounts—Overview (“Yes” means the item to the left is used in the computation of basis): Outside (Stock) At Risk Basis AAA Basis Basis - Fair market value Yes Yes Yes (FMV) of distributions (distributions (distributions (distributions reduce reduce basis reduce at risk AAA before current before current amount before year losses) year losses) current year losses)Chapter 16, Exhibit 7d CCH Federal Taxation Basic Principles22 of 60
    • S Corporation Basis Accounts—Outside Basis General Rule. A shareholder’s outside basis is his/her stock basis. Outside basis is computed in much the same manner as a partner’s outside basis in a partnership interest. Exception. One notable exception is that the basis of stock in an S corporation is not affected by the corporation’s liabilities. This seems reasonable because, unlike a general partner, an S corporation shareholder is not personally liable for the debts of the corporation.Chapter 16, Exhibit 8 CCH Federal Taxation Basic Principles23 of 60
    • S Corporation Basis Accounts—At-Risk Basis General Rule. At-risk rules are applied at the shareholder level. The amount of S corporation losses that the shareholder can deduct may not exceed the lesser of:  At-risk amount or  Sum of a shareholder’s stock basis and debt basis.Chapter 16, Exhibit 9a CCH Federal Taxation Basic Principles24 of 60
    • S Corporation Basis Accounts—At-Risk Basis Computation of At-Risk Basis. At-risk basis is equal to the sum of:  Cash and basis of property contributed to the S corporation (to the extent unencumbered)  Outstanding shareholder loans to the S corporation  Loans for which the shareholder has personal liability or has pledged as security for repayment property not used in the activity of the corporation. (However, this does not include other debts of the corporation to third parties, even if the repayment is guaranteed by the shareholder.)  Allocated portion of income  Less: Allocated portion of losses  Less: Distributions at fair market value (not at partnership basis)Chapter 16, Exhibit 9b CCH Federal Taxation Basic Principles25 of 60
    • S Corporation Basis Accounts— Accumulated Adjustment Account (AAA) Purpose. Records and information pertaining to each shareholder’s accumulated adjustment account (AAA) are needed by S corporations only for purposes of helping shareholders determine taxability of distributions when the S corporation has earnings and profits (E&P).  The C corporation connection. An S corporation has E&P only if it was classified as a C corporation in the past or acquired a C corporation. Tax effect of distributions. The fair market value (FMV) of distributions to shareholders are tax-free to the extent of the lesser of (1) AAA balance and (2) stock basis.Chapter 16, Exhibit 10a CCH Federal Taxation Basic Principles26 of 60
    • S Corporation Basis Accounts— Accumulated Adjustment Account (AAA) Computation. A shareholder’s AAA balance is INCREASED only by taxable income. It is REDUCED by all deductible losses/expenses, by cash distributions and by the fair market value (FMV) of property distributions.  Same-year losses and distributions. Shareholders are allowed to reduce the AAA basis by the amount of current year distributions BEFORE applying current year losses against bases. This rule enables tax-free distributions to the extent of AAA, BEFORE AAA is reduced by the amount of losses. While the effect is favorable for tax-free distributions, it can also result in higher suspended losses, since distributions reduce all bases, dollar for dollar, thus lowering the limits of loss deductions and increasing suspended losses.  Tax–exempt income. No adjustment to the AAA account is made for tax-exempt income such as municipal bond interest and life insurance proceeds (reduced by related expenses).Chapter 16, Exhibit 10b CCH Federal Taxation Basic Principles27 of 60
    • S Corporation Basis Accounts— Accumulated Adjustment Account (AAA) Negative AAA balance OK. The AAA basis (unlike the stock basis) can have a negative balance. However only losses, (not distributions) can make the AAA negative or increase a negative balance. Transferability of AAA account. If the shareholder disposes of stock, the AAA associated with the stock passes to the new owner.Chapter 16, Exhibit 10c CCH Federal Taxation Basic Principles28 of 60
    • S Corporation Basis Accounts— Other Adjustment Account (OAA) Other Adjustments Account (OAA). The OAA represents another form of accumulated adjustments account (AAA) in that:  The OAA is a balance sheet account in the capital section.  The OAA is needed by S corporations only for purposes of helping shareholders determine taxability of distributions when the S corporation has earnings and profits (E&P).  Any distributions from OAA are tax-free to shareholders.Chapter 16, Exhibit 11a CCH Federal Taxation Basic Principles29 of 60
    • S Corporation Basis Accounts— Other Adjustment Account (OAA) Timing of distributions. Tax-free distributions from OAA cannot be made until after all accumulated E&P are paid out. Computation. The OAA balance is increased for tax-exempt income or decreased for nondeductible expenditures not properly chargeable to the AAA.Chapter 16, Exhibit 11b CCH Federal Taxation Basic Principles30 of 60
    • S Corporation Basis Accounts— Previously Taxed Income Account (PTI) Timing of distributions. Tax-free distributions from the PTI account are made after tax-free distributions reduce the OAA balance to zero. Computation. The PTI account represents a balance of undistributed net income on which the shareholders were already taxed prior to 1983.Chapter 16, Exhibit 12 CCH Federal Taxation Basic Principles31 of 60
    • S Corporation Basis Accounts— Shareholder Loans to S Corporations Using loan basis for deductions. Once stock basis is zero, any additional basis reductions (losses or deductions, but NOT distributions), decrease (but not below zero) the shareholder’s basis in loans made to the S corporation. Suspended losses/deduction. Any excess of losses or deductions over both stock and debt bases is suspended until subsequent items of income or contributions arise to restore basis in debt. Restoring debt basis. Once the basis of any debt is reduced, it is later increased (only up to the original face amount of the loan) by the subsequent net increase resulting from all positive and negative basis adjustments. The debt basis is adjusted before any increase is made in the stock basis.Chapter 16, Exhibit 13a CCH Federal Taxation Basic Principles32 of 60
    • S Corporation Basis Accounts— Shareholder Loans to S Corporations Distributions. A distribution in excess of stock basis does not reduce any debt basis. Same-year losses and distributions. If a loss and a distribution occur in the same year, the loss reduces the debt basis before the distribution. (This rule favors the taxpayer.) Repayment of shareholder loan with reduced basis. If an S corporation repays a shareholder loan when the debt basis is below the loan amount, the difference is treated as a capital gain. An allocation is required for partial repayments.Chapter 16, Exhibit 13b CCH Federal Taxation Basic Principles33 of 60
    • S Corporation Basis Accounts— Shareholder Loans to S Corporations Example: A shareholder lends an S corporation $100,000. Subsequent losses eliminate the shareholder’s stock basis and reduce a portion of the debt basis. The S corporation repays $20,000 of the $100,000 loan when the shareholder’s basis in the loan is $75,000. The shareholder must report a capital gain in the amount of $5,000 on the receipt of $20,000, since 25% of the face value was not supported by debt basis [$20,000 x ($100,000 – $75,000) ÷ $100,000].Chapter 16, Exhibit 13c CCH Federal Taxation Basic Principles34 of 60
    • S Corporation Basis Accounts— Example on Effect of Operating Results on Basis FACTS: David, an individual, owns all of the shares of an S corporation throughout 20x1. The corporate books show the information for 20x1 on the following slides. QUESTION: (1) Compute 20x1 Code Sec. 702(a)(8) taxable income (2) Compute David’s stock basis at 12/31/x1. (3) Compute David’s “at risk” amount at 12/31/x1. (4) Compute David’s AAA balance at 12/31/x1. (5) Compute David’s debt basis at 12/31/x1.Chapter 16, Exhibit 14a CCH Federal Taxation Basic Principles35 of 60
    • S Corporation Basis Accounts— Example on Effect of Operating Results on Basis Facts Solution Corp. Books: (1) (2) (3) (4) (5) Sec. 702(a) Stock At Risk AAA Debt (8) TI Basis Basis Basis Basis Initial bases, from 10,000 10,000 10,000 0 0 $10m stock purchase on 1/1/x1 Net sales 200,000 200,000 200,000 200,000 200,000 Cost of goods sold (100,000) (100,000) (100,000) (100,000) (100,000) Overhead expenses (10,000) (10,000) (10,000) (10,000) (10,000) Sec. 1245 gain 10,000 10,000 10,000 10,000 10,000Chapter 16, Exhibit 14b CCH Federal Taxation Basic Principles36 of 60
    • S Corporation Basis Accounts— Example on Effect of Operating Results on Basis Facts Solution Corp. (1) (2) (3) (4) (5) Books: Sec. 702(a)(8) TI Stock Basis At Risk AAA Debt Basis Basis Basis Sec. 1231 loss (10,000) (sep’ly. stated) (10,000) (10,000) (10,000) Charitable (10,000) (sep’ly. stated) (10,000) (10,000) (10,000) contributions Short-term (10,000) (sep’ly. stated) (10,000) (10,000) (10,000) capital loss Long-term 10,000 (sep’ly. stated) 10,000 10,000 10,000 capital gain Tax-exempt 15,000 (sep’ly. stated) 15,000 15,000 interest incomeChapter 16, Exhibit 14c CCH Federal Taxation Basic Principles37 of 60
    • S Corporation Basis Accounts— Example on Effect of Operating Results on Basis Facts Solution Corp. (1) (2) (3) (4) (5) Books: Sec. 702(a)(8) TI Stock Basis At Risk AAA Debt Basis Basis Basis Lobbying (10,000) (sep’ly. stated) (10,000) (10,000) expense - state officials (not deductible) David’s loan to 10,000 10,000 10,000 S corp. S corp 10,000 10,000 borrowings from banks— recourse to DavidChapter 16, Exhibit 14d CCH Federal Taxation Basic Principles38 of 60
    • S Corporation Basis Accounts— Example on Effect of Operating Results on Basis Facts Solution Corp. (1) (2) (3) (4) (5) Books: Sec. 702(a)(8) Stock Basis At Risk AAA Debt TI Basis Basis Basis S corp borrowings 10,000 from banks— NONrecourse to David. David’s additional 10,000 10,000 10,000 10,000 stock purchases of S corp. stock Cash distribution to (10,000) (10,000) (10,000) (10,000) David Balances, 12/31/x1 125,000 100,000 95,000 115,000 80,000 10,000Chapter 16, Exhibit 14e CCH Federal Taxation Basic Principles39 of 60
    • S Corporation Distributions Does an S corporation recognize gain or loss on the distribution of cash to shareholders? No, never. Does an S corporation recognize gain or loss on the distribution of other property (other than its own stock)?  Gains: Yes (compute gain in the same way as if the property were sold)  Losses: No (except in complete liquidation).Chapter 16, Exhibit 15a CCH Federal Taxation Basic Principles40 of 60
    • S Corporation Distributions What is the character of the entity’s gain on distribution of property to owners?  If a shareholder owns no more than 50% of the S corporation, then the character of the entity’s gain is the same as the character of the property distributed.  If a shareholder owns more than 50%, then the entity’s gain is ordinary.Chapter 16, Exhibit 15b CCH Federal Taxation Basic Principles41 of 60
    • S Corporation Distributions—Effect on Shareholder S Corporation Without C Corporation E&P Shareholder Distribution Tax Result To extent of stock basis Tax-free; reduces stock basis In excess of stock basis Taxed as a capital gainChapter 16, Exhibit 16a CCH Federal Taxation Basic Principles42 of 60
    • S Corporation Distributions—Effect on Shareholder S Corporation With C Corporation E&P Shareholder Distribution Tax Result To extent of accumulated Tax-free; reduces AAA and stock adjustments account (AAA) basis To extent of C corporation E&P Taxed as an ordinary dividend; does not reduce stock basis To extent of other adjustments Tax-free; reduces OAA, PTI, and account (OAA) and previously taxed stock basis income (PTI) account To extent of any remaining stock Tax-free; reduces stock basis. basis In excess of stock basis Taxed as a capital gainChapter 16, Exhibit 16b CCH Federal Taxation Basic Principles43 of 60
    • S Corporation Distributions—Example FACTS: An S corporation reports the following balances for its sole shareholder as of 1/1/x1:  Capital balance per corporate books: $125,000  Stock basis: $95,000  At-risk basis: $115,000  AAA basis: $80,000  Shareholder loan to S corporation: $10,000 (basis also $10,000) The S corporation reports a ($200,000) ordinary loss in 20x1.Chapter 16, Exhibit 17a CCH Federal Taxation Basic Principles44 of 60
    • S Corporation Distributions—Example QUESTIONS: (a) What is the maximum tax-free nonstock distribution the shareholder can receive in 20x1? (Hint: The tax-free distribution is not affected by the 20x1 loss. Use the 1/1/x1 balance in AAA and any excess stock basis. Answer: $95,000 = $80,000 AAA + $15,000 excess stock basis) (b) Assuming that a $95,000 cash distribution is made to the sole shareholder in 20x1, what are the 12/31/x1 balances in stock basis, at-risk basis, AAA and debt basis? (c) What portion of the ($200,000) loss is deductible in 20x1 under the at-risk rules? (d) What portion of the $200,000 loss is suspended in 20x1 under the at-risk rules?Chapter 16, Exhibit 17b CCH Federal Taxation Basic Principles45 of 60
    • S Corporation Distributions—Example QUESTION: If the S corporation repays the $10,000 shareholder debt in year 20x2, what are the tax consequences if:  S corporation has income of $10,000 in year 20x2?  (If the S corporation has income in year 20x2, the first $10,000 must restore the debt basis back to $10,000. Any income in excess of $10,000 increases the following simultaneously: (a) the stock basis, (b) at-risk basis, and (c) AAA balance. A subsequent repayment of the $10,000 shareholder loan does not result in capital gain.)  S corporation has a loss in year 20x2?  (Answer: A $10,000 capital gain passes through to the shareholder since the debt basis is zero.)Chapter 16, Exhibit 17c CCH Federal Taxation Basic Principles46 of 60
    • S Corporation Distributions—Example SOLUTION: Tax Effect of a $200,000 loss and a $95,000 distribution in 20x1 Cap. Sec. 702(a) Stock Basis At Risk AAA Debt Bal. per (8) income Basis Basis Basis Books (loss) Balances, 1/1/x1 125m 95m 115m 80m 10m 1st: Apply dist’n. (80m) (80m) (80m) (80m) 0 against bases: [tax-free] [tax-free] [tax-free] [Debt Tier 1 Distribution: basis is (i.e., Tax free: never Lesser of, reduced by (1) $80m AAA distributio balance, or ns] (2) $95m stock basis)Chapter 16, Exhibit 17d CCH Federal Taxation Basic Principles47 of 60
    • S Corporation Distributions—Example SOLUTION: Tax Effect of a $200,000 loss and a $95,000 distribution in 20x1 Cap. Bal. Sec. 702(a)(8) Stock Basis At Risk AAA Debt per income (loss) Basis Basis Basis Books Balances, 1/1/x1 125m 95m 115m 80m 10m Tier 2 Distribution: 0 0 0 0 (i.e., taxable to extent of accumulated E & P from prior life as a C corp. None here.)Chapter 16, Exhibit 17e CCH Federal Taxation Basic Principles48 of 60
    • S Corporation Distributions—Example SOLUTION: Tax Effect of a $200,000 loss and a $95,000 distribution in 20x1 Cap. Sec. 702(a) Stock At Risk AAA Basis Debt Basis Bal. per (8) income Basis Basis Books (loss) Balances, 1/1/x1 125m 95m 115m 80m 10m Tier 3 Distribution: (15m) (15m) (15m) 0 0 (i.e. tax free to extent [tax-free] [tax-free] [Dist’ns [Debt basis is of any stock basis cannot never reduced surviving the 1st tier create neg. by distribution AAA bal.] distributions] (15m = 95m - 80m) Subtotals 30m 0 0 20m 0 10mChapter 16, Exhibit 17f CCH Federal Taxation Basic Principles49 of 60
    • S Corporation Distributions—Example SOLUTION: Tax Effect of a $200,000 loss and a $95,000 distribution in 20x1 Cap. Sec. 702(a)(8) Stock At Risk AAA Debt Basis Bal. per income (loss) Basis Basis Basis Books Subtotals 30m 0 0 20m 0 10m 20x1 DEDUCTIBLE (200m) (10m) 0 (20m) (200m) (10m) LOSSES UNDER [Note: Only (10m) is AT-RISK RULES deductible, because [Apply 200m Sec. loss deductions are 702(a)(8) loss limited to the lesser against bases and of determine the 1. $10m (i.e., stock amount deductible basis of $0, + debt under the at-risk basis of $10m); or rules.] $20m at risk basis]Chapter 16, Exhibit 17g CCH Federal Taxation Basic Principles50 of 60
    • S Corporation Distributions—Example SOLUTION: Tax Effect of a $200,000 loss and a $95,000 distribution in 20x1 Cap. Sec. 702(a) Stock At Risk AAA Debt Basis Bal. per (8) income Basis Basis Basis Books (loss) BASES, 12/31/x2 (170m) 0 0 (40m) 0 [can’t be [can’t be [CAN be [can’t be neg.] neg.] neg.] neg.] 20X2B (190m)      SUSPENDED [200m- (180m) (10m) LOSS UNDER AT- 10m] or [190m RISK RULES [180m + nondeduct ($190m total) 10m] ible loss - 10m debt basis]Chapter 16, Exhibit 17h CCH Federal Taxation Basic Principles51 of 60
    • S Corporation Penalty Taxes— Code Sec. 1374 Tax on Built-in Gains All four conditions listed below must be present to subject an S corp. to the 35% Code Sec. 1374 tax: 1. Prior life as a C corporation; 2. S-corporation election occurs after 1/1/87; 3. Asset sale with pre-election built-in gain (but not built-in loss). [If the asset is purchased after the election, Code Sec. 1374 would not apply.] 4. Asset sale within 10 years of election date, not effective date of election. (e.g., if an election is made on 3/15/x1, it is retroactively effective to 1/1/x1. The 10 year toll begins in 3/15/x1, not 1/1/x1.)Chapter 16, Exhibit 18a CCH Federal Taxation Basic Principles52 of 60
    • S Corporation Penalty Taxes— Code Sec. 1374 Tax on Built-in Gains Computation. At the time that an asset is sold, the corporation will recognize (and pay tax) on the difference between the fair market value of the asset at the time of the election. The tax rate is the highest corporate effective rate of 35%.Chapter 16, Exhibit 18b CCH Federal Taxation Basic Principles53 of 60
    • S Corporation Penalty Taxes— Code Sec. 1374 Tax Example FACTS: On 3/15/x0, a C corporation makes an election to become an S corporation. At the time of the election, the corporation had the following assets: Asset Fair Market Value at Adjusted Basis at Built-In Gain Election Date Election Date Office Building $600,000 $500,000 $100,000 Land $400,000 $300,000 $100,000Chapter 16, Exhibit 19a CCH Federal Taxation Basic Principles54 of 60
    • S Corporation Penalty Taxes— Code Sec. 1374 Tax Example QUESTION: Determine the tax effect to the corporation and to the shareholder of the following transactions:  One year after the election date, the corporation sells the building at a sales price of $700,000 when the adjusted basis is $450,000.  Twelve years after the election date, the corporation sells the land at a sales price of $500,000. (a) (b) (c) (d)= (b) – (c) (e) = [Lesser of: (a) or (d)] x 35% Asset Built-in Gain Sales Price Basis at Realized Gain Sec. 1374 at Election Sales Date Tax Building $100,000 $700,000 $450,000 $250,000 $35,000 Land $100,000 $500,000 $300,000 $200,000 0**Chapter 16, Exhibit 19b CCH Federal Taxation Basic Principles55 of 60
    • S Corporation Penalty Taxes— Code Sec. 1374 Tax Example COMPUTATIONS Tax effect of 20x1 sale of building:  S corporation: The corporation itself pays the $35,000 tax to the IRS. (35% x [the lesser of 100,000 or 250,000])  Shareholders: The shareholders are allowed a deduction for that tax. The S corporation’s K-1 would show: Code Sec. 1231 gain/Code Sec. 1245 recapture ($700,000 - 450,000) $250,000 Code Sec. 1374 tax deduction $ (35,000)Chapter 16, Exhibit 19c CCH Federal Taxation Basic Principles56 of 60
    • S Corporation Penalty Taxes— Code Sec. 1374 Tax Example COMPUTATIONS Tax effect of selling land over 10 years after the election date:  No Code Sec. 1374 tax would be imposed since the 10-year post-election period had lapsed. Only the $200,000 Code Sec. 1231 gain would be reported by the S corporation on the shareholder’s K-1.Chapter 16, Exhibit 19d CCH Federal Taxation Basic Principles57 of 60
    • S Corporation Penalty Taxes— Code Sec. 1375 Tax on Excess Net Passive Income This tax applies to any S corporation with accumulated E&P that has more than 25% of its gross receipts derived from passive sources.Chapter 16, Exhibit 20a CCH Federal Taxation Basic Principles58 of 60
    • S Corporation Penalty Taxes— Code Sec. 1375 Tax on Excess Net Passive Income Computations  Excess Net Passive Income = [(a) – {25% x (c)}] ÷ [(a) x (b)]  Code Sec. 1375 Tax = 35% x Excess Net Passive Income, where (a) = Gross passive investment income (e.g., royalties, rents, dividends, interest, annuities, and gain on sales of securities) (b) = Net passive investment income (i.e., gross amount net of investment expenses (c) = Gross receipts (i.e., receipts from all sources including active and passive sources)  Note that Excess Net Passive Investment Income can never be more than taxable income computed as if the S corporation had been a C corporation.Chapter 16, Exhibit 20b CCH Federal Taxation Basic Principles59 of 60
    • Code Sec. 1375 Tax on Excess Net Passive Income —Example FACTS: 1. S corporation has gross receipts of $300,000 in 20x1. 2. Included in the $300,000 is $100,000 of royalties. 3. Expenses directly connected with the production royalties are $30,000. 4. The S corporation has accumulated E & P from its prior life as a C corporation. QUESTION: Compute the Code Sec. 1375 tax. SOLUTION: Excess Net Passive Investment Income: $17,500 =[100,000 – {25% x (300,000)}] ÷ [100,000 x 70,000] Code Sec. 1375 tax: $6,125 = 35% x 17,500.Chapter 16, Exhibit 21 CCH Federal Taxation Basic Principles60 of 60