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Chapter 12 S Corporations
The Big Picture  (slide 1 of 2) <ul><li>Cane, Inc., has been a C corp. for a number of years, earning taxable income of le...
The Big Picture  (slide 2 of 2) <ul><li>The corp. receives some tax-exempt income, generates a small domestic production a...
Subchapter S Issues (slide 1 of 6) <ul><li>S corporations provide many of the benefits of partnership taxation  </li></ul>...
Subchapter S Issues  (slide 2 of 6) <ul><li>S corporations are still corporations for legal purposes </li></ul><ul><ul><li...
Subchapter S Issues  (slide 3 of 6) <ul><li>Taxation resembles partnership taxation </li></ul><ul><ul><li>Certain items (p...
Subchapter S Issues  (slide 4 of 6) <ul><li>An S corporation is a reporting (rather than tax-paying) entity </li></ul><ul>...
Subchapter S Issues  (slide 5 of 6) <ul><li>An S corporation is not subject to the following taxes: </li></ul><ul><ul><li>...
Subchapter S Issues  (slide 6 of 6) <ul><li>Entity is subject to Subchapter C rules for a transaction unless Subchapter S ...
When to Elect S Corp Status <ul><li>Following factors should be considered: </li></ul><ul><ul><li>If shareholders have hig...
S Corp Qualification  Requirements  (slide 1 of 3) <ul><li>To elect under Subchapter S, a corporation must meet the follow...
S Corp Qualification  Requirements  (slide 2 of 3) <ul><li>Corporation may have only one class of stock </li></ul><ul><ul>...
S Corp Qualification  Requirements  (slide 3 of 3) <ul><li>Must have 100 or less shareholders </li></ul><ul><ul><li>Family...
The Big Picture – Example 3 One Class of Stock <ul><li>Return to the facts of The Big Picture on p. 12–2.  </li></ul><ul><...
Making the Election  (slide 1 of 3) <ul><li>To become an S corp, must make a valid election that is: </li></ul><ul><ul><li...
Making the Election  (slide 2 of 3) <ul><li>To be effective for current year </li></ul><ul><ul><li>Make election by 15th d...
Making the Election  (slide 3 of 3) <ul><li>Shareholder Consent </li></ul><ul><ul><li>Each shareholder owning stock during...
The Big Picture – Example 6 Making The Election <ul><li>Return to the facts of The Big Picture on p. 12–2.   </li></ul><ul...
Termination of Election (slide 1 of 4) <ul><li>The S election is lost in any of the following ways: </li></ul><ul><li>1. S...
Termination of Election   (slide 2 of 4) <ul><li>2.New shareholder owning > 50% of entity  affirmatively refuses to consen...
Termination of Election  (slide 3 of 4) <ul><li>4. The corporation does not meet the passive investment income limitation ...
Termination of Election   (slide 4 of 4) <ul><li>A new election normally cannot be made within 5 years after termination o...
Computation of Taxable Income (slide 1 of 2) <ul><li>Determined in a manner similar to partnerships except </li></ul><ul><...
Computation of Taxable Income (slide 2 of 2) <ul><li>S corp items are divided into: </li></ul><ul><ul><li>Nonseparately st...
Flow-Through of S Corporation Items
Separately Stated Items <ul><li>Examples include: </li></ul><ul><ul><li>Tax-exempt income </li></ul></ul><ul><ul><li>Gains...
Allocation of Income and Loss   (slide 1 of 2) <ul><li>Each shareholder is allocated a pro rata portion of nonseparately s...
Allocation of Income and Loss (slide 2 of 2) <ul><ul><li>Short-year election is available if a shareholder’s interest is c...
S Corporation Distributions (slide 1 of 7) <ul><li>Amount of distribution to shareholder = cash + FMV of any other propert...
S Corporation Distributions  (slide 2 of 7) <ul><li>Where no Earnings and Profits exist </li></ul><ul><li>1.  Nontaxable t...
S Corporation Distributions (slide 3 of 7) <ul><li>Where Earnings and Profits exist </li></ul><ul><ul><li>1.  Tax-free to ...
S Corporation Distributions   (slide 4 of 7) <ul><li>Accumulated Adjustments Account (AAA) </li></ul><ul><ul><li>Represent...
S Corporation Distributions  (slide 5 of 7) <ul><li>Accumulated Adjustments Account (AAA) is adjusted as follows: </li></u...
S Corporation Distributions   (slide 6 of 7) <ul><li>Other issues regarding distributions: </li></ul><ul><ul><li>Distribut...
S Corporation Distributions   (slide 7 of 7) <ul><li>Other issues regarding distributions: </li></ul><ul><ul><li>If E & P ...
Distributions of Property   <ul><li>If the entity distributes appreciated property  </li></ul><ul><ul><li>Gain must be rec...
Shareholder’s Basis (slide 1 of 4)   <ul><li>Determination of initial basis is similar to that of basis of stock in C corp...
Shareholder’s Basis (slide 2 of 4)   <ul><ul><li>Basis is decreased by: </li></ul></ul><ul><ul><ul><li>Distributions not r...
Shareholder’s Basis  (slide 3 of 4)   <ul><li>Shareholder’s basis cannot be negative </li></ul><ul><ul><li>Once basis is r...
Shareholder’s Basis  (slide 4 of 4)   <ul><li>Basis rules are similar to partnership rules except: </li></ul><ul><ul><li>P...
Treatment of Losses (slide 1 of 2) <ul><li>Step 1. Allocate total loss to the shareholder on a daily basis,  based upon st...
Treatment of Losses  (slide 2 of 2) <ul><li>Step 4. In future tax years, any net increase in basis  adjustment restores de...
The Big Picture – Example 34 Net Operating Loss <ul><li>Return to the facts of The Big Picture on p. 12–2.   </li></ul><ul...
At-Risk Rules <ul><li>Generally apply to S corp shareholders </li></ul><ul><ul><li>At-risk amounts include: </li></ul></ul...
Passive Losses and Credits <ul><li>An S corp is not directly subject to the passive loss rules </li></ul><ul><ul><li>If th...
Built-in Gains Tax   (slide 1 of 4) <ul><li>Generally applies to C corporations converting to S corp status after 1986 </l...
Built-in Gains Tax  (slide 2 of 4) <ul><li>Tax base includes unrealized gain on assets held on date of S corp election </l...
Built-in Gains Tax   (slide 3 of 4) <ul><li>Amount of built-in gain recognized in any year is limited to an “as if” taxabl...
Built-in Gains Tax  (slide 4 of 4) <ul><li>LIFO recapture tax </li></ul><ul><ul><li>Any LIFO recapture amount at time of S...
Computation of Built-in  Gains Tax   (slide 1 of 2) <ul><li>Step 1. Select the smaller of built-in gains or taxable income...
Computation of Built-in  Gains Tax   (slide 2 of 2) <ul><li>Step 4. Deduct business credit carryforwards and AMT credit ca...
The Big Picture – Example 41 Built-in Gains Tax <ul><li>Return to the facts of The Big Picture on p. 12–2.   </li></ul><ul...
Passive Investment Income Penalty Tax  (slide 1 of 3) <ul><li>If an S corp has accumulated E&P (AEP) from C corp years </l...
Passive Investment Income Penalty Tax  (slide 2 of 3) <ul><li>Passive investment income includes royalties, rents, dividen...
Passive Investment Income Penalty Tax  (slide 3 of 3) <ul><li>Excess net passive income cannot exceed C corp. taxable inco...
Refocus On The Big Picture  (slide 1 of 3) <ul><li>As long as Smith and Jones, the owners of Cane, Inc., maintain C corpor...
Refocus On The Big Picture  (slide 2 of 3) <ul><li>Normally, an S corp. does not pay any income tax. </li></ul><ul><ul><li...
Refocus On The Big Picture  (slide 3 of 3) <ul><li>Cane does not need to liquidate or engage in a tax-deferred reorganizat...
<ul><li>If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation...
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Chapter 12 presenatation

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Transcript of "Chapter 12 presenatation"

  1. 1. Chapter 12 S Corporations
  2. 2. The Big Picture (slide 1 of 2) <ul><li>Cane, Inc., has been a C corp. for a number of years, earning taxable income of less than $100,000 per year. </li></ul><ul><ul><li>Thus, the business has been subject to the lower C corporation tax rates. </li></ul></ul><ul><li>Due to cheap imports from China, Cane’s two owners, Smith and Jones, expect operating losses for the next two or three years. </li></ul><ul><ul><li>They hope to outsource some of the manufacturing to Vietnam and turn the company around. </li></ul></ul><ul><li>How can they deduct these anticipated future losses? </li></ul>
  3. 3. The Big Picture (slide 2 of 2) <ul><li>The corp. receives some tax-exempt income, generates a small domestic production activities deduction (DPAD), and holds some C corp. E&P. </li></ul><ul><li>Each owner draws a salary of $92,000. </li></ul><ul><li>Cane has two classes of stock, voting and non-voting common stock. </li></ul><ul><li>Should Smith and Jones elect to be taxed as an S corporation? </li></ul><ul><ul><li>Do they need to liquidate or go through some type of reorganization to do so? </li></ul></ul><ul><li>Read the chapter and formulate your response. </li></ul>
  4. 4. Subchapter S Issues (slide 1 of 6) <ul><li>S corporations provide many of the benefits of partnership taxation </li></ul><ul><ul><li>Also gives the owners limited liability protection from creditors </li></ul></ul><ul><li>S corporation status is obtained through an election by a qualifying corporation with the consent of its shareholders </li></ul>
  5. 5. Subchapter S Issues (slide 2 of 6) <ul><li>S corporations are still corporations for legal purposes </li></ul><ul><ul><li>Owners receive the benefits of limited liability, ability to raise capital (within limits), etc... </li></ul></ul>
  6. 6. Subchapter S Issues (slide 3 of 6) <ul><li>Taxation resembles partnership taxation </li></ul><ul><ul><li>Certain items (primarily business income and certain expenses) are accumulated and passed through to shareholders </li></ul></ul><ul><ul><li>Other items are “separately stated” and each item is passed through to shareholders </li></ul></ul>
  7. 7. Subchapter S Issues (slide 4 of 6) <ul><li>An S corporation is a reporting (rather than tax-paying) entity </li></ul><ul><li>Tax liability may still arise at the entity level for: </li></ul><ul><ul><li>Built-in gains tax, or </li></ul></ul><ul><ul><li>Passive investment income penalty tax </li></ul></ul>
  8. 8. Subchapter S Issues (slide 5 of 6) <ul><li>An S corporation is not subject to the following taxes: </li></ul><ul><ul><li>Corporate income tax </li></ul></ul><ul><ul><li>Accumulated earnings tax </li></ul></ul><ul><ul><li>Personal holding company tax </li></ul></ul><ul><ul><li>Corporate alternative minimum tax </li></ul></ul>
  9. 9. Subchapter S Issues (slide 6 of 6) <ul><li>Entity is subject to Subchapter C rules for a transaction unless Subchapter S provides alternate rules </li></ul>
  10. 10. When to Elect S Corp Status <ul><li>Following factors should be considered: </li></ul><ul><ul><li>If shareholders have high marginal tax rates vs C corp rates </li></ul></ul><ul><ul><li>If NOLs are anticipated </li></ul></ul><ul><ul><li>If currently C corp, any NOL carryovers from prior years can’t be used during S corp years </li></ul></ul><ul><ul><ul><li>Still reduces 20 year carryover period </li></ul></ul></ul><ul><ul><li>Character of anticipated flow-through items </li></ul></ul>
  11. 11. S Corp Qualification Requirements (slide 1 of 3) <ul><li>To elect under Subchapter S, a corporation must meet the following requirements: </li></ul><ul><ul><li>Must be a domestic corporation </li></ul></ul><ul><ul><li>Must not otherwise be “ineligible” </li></ul></ul><ul><ul><ul><li>Ineligible corporations include certain banks, insurance companies and foreign corporations </li></ul></ul></ul><ul><ul><ul><li>Any domestic corp. that is not an ineligible corp. can be a qualified Subchapter S Subsidiary (QSSS) if: </li></ul></ul></ul><ul><ul><ul><ul><li>S corp owns 100% of its stock, and </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Elects to treat the subsidiary as a QSSS </li></ul></ul></ul></ul>
  12. 12. S Corp Qualification Requirements (slide 2 of 3) <ul><li>Corporation may have only one class of stock </li></ul><ul><ul><li>Can have stock with differences in voting rights but not in distribution or liquidation rights </li></ul></ul><ul><ul><li>It is possible for debt to be reclassified as stock </li></ul></ul><ul><ul><ul><li>Results in unexpected loss of S corp status </li></ul></ul></ul><ul><ul><ul><li>Safe harbor provisions mitigate concern over reclassification of debt </li></ul></ul></ul>
  13. 13. S Corp Qualification Requirements (slide 3 of 3) <ul><li>Must have 100 or less shareholders </li></ul><ul><ul><li>Family members may be treated as one shareholder </li></ul></ul><ul><li>Shareholders can only include individuals, estates, certain trusts, and certain tax-exempt organizations </li></ul><ul><ul><li>Partnerships, Corps, LLPs, most LLCs and most IRAs cannot own S corp stock, but S corps can be partners in a partnership or shareholders in a corporation </li></ul></ul><ul><li>Shareholders cannot include any nonresident aliens </li></ul>
  14. 14. The Big Picture – Example 3 One Class of Stock <ul><li>Return to the facts of The Big Picture on p. 12–2. </li></ul><ul><li>Cane, Inc., could elect to be an S corp. as long as the 2 classes of common stock are identical except that one class is voting and the other class is nonvoting. </li></ul><ul><li>You learn that both shareholders have binding employment contracts with Cane, Inc. </li></ul><ul><ul><li>The amount paid to Jones under her employment contract is reasonable </li></ul></ul><ul><ul><li>The amount paid to Smith is excessive, resulting in a constructive dividend. </li></ul></ul><ul><li>Smith’s employment contract was not prepared to circumvent the one-class-of-stock requirement. </li></ul><ul><ul><li>Because employment contracts are not considered governing provisions, Cane still is treated as though it has only one class of stock if an S election is made. </li></ul></ul>
  15. 15. Making the Election (slide 1 of 3) <ul><li>To become an S corp, must make a valid election that is: </li></ul><ul><ul><li>Filed timely </li></ul></ul><ul><ul><li>All shareholders must consent to the election </li></ul></ul>
  16. 16. Making the Election (slide 2 of 3) <ul><li>To be effective for current year </li></ul><ul><ul><li>Make election by 15th day of third month of current tax year, or </li></ul></ul><ul><ul><li>File in previous year </li></ul></ul>
  17. 17. Making the Election (slide 3 of 3) <ul><li>Shareholder Consent </li></ul><ul><ul><li>Each shareholder owning stock during election year must sign consent for election (even if stock is no longer owned at election date) </li></ul></ul><ul><ul><li>May be able to obtain extension of time for filing consent from IRS </li></ul></ul><ul><ul><ul><li>Available only if Form 2553 is filed on a timely basis, reasonable cause is given, and the interests of the government are not jeopardized </li></ul></ul></ul>
  18. 18. The Big Picture – Example 6 Making The Election <ul><li>Return to the facts of The Big Picture on p. 12–2. </li></ul><ul><li>Suppose that in 2011, shareholders Smith and Jones decide to become an S corp. beginning January 1, 2012. </li></ul><ul><li>Since the C corporation uses a calendar tax year, the S election can be made at any time in 2011 or by March 15, 2012. </li></ul><ul><li>An election after March 15, 2012, will not be effective until the 2013 calendar tax year. </li></ul>
  19. 19. Termination of Election (slide 1 of 4) <ul><li>The S election is lost in any of the following ways: </li></ul><ul><li>1. Shareholders owning a majority of shares voluntarily revoke the election </li></ul><ul><ul><li>Revocation must be filed by 15th day of third month to be effective for entire year </li></ul></ul><ul><ul><li>Otherwise, it is effective for first day of following year, or any other specified future date </li></ul></ul>
  20. 20. Termination of Election (slide 2 of 4) <ul><li>2.New shareholder owning > 50% of entity affirmatively refuses to consent to election </li></ul><ul><li>3. Entity no longer qualifies as S corp </li></ul><ul><ul><li>e.g., The entity has > 100 shareholders or a nonresident alien shareholder, a second class of stock exists, etc. </li></ul></ul><ul><ul><li>Election is terminated on date disqualification occurs </li></ul></ul>
  21. 21. Termination of Election (slide 3 of 4) <ul><li>4. The corporation does not meet the passive investment income limitation </li></ul><ul><ul><li>Passive investment income limitation </li></ul></ul><ul><ul><ul><li>If passive income > 25% of gross receipts for 3 consecutive taxable years </li></ul></ul></ul><ul><ul><ul><ul><li>S election is terminated as of the beginning of the fourth year </li></ul></ul></ul></ul><ul><ul><li>Only applies if an S corp. has C corp. E & P </li></ul></ul>
  22. 22. Termination of Election (slide 4 of 4) <ul><li>A new election normally cannot be made within 5 years after termination of a prior election </li></ul><ul><ul><li>Five year waiting period is waived if: </li></ul></ul><ul><ul><ul><li>There is a > 50% change in ownership after first year termination is applicable </li></ul></ul></ul><ul><ul><ul><li>Event causing termination was not reasonably within control of the S corp or its majority shareholders </li></ul></ul></ul>
  23. 23. Computation of Taxable Income (slide 1 of 2) <ul><li>Determined in a manner similar to partnerships except </li></ul><ul><ul><li>S corp amortizes organizational costs under the corporate rules </li></ul></ul><ul><ul><li>S corp must recognize gains (but not losses) on distributions of appreciated property to shareholders </li></ul></ul>
  24. 24. Computation of Taxable Income (slide 2 of 2) <ul><li>S corp items are divided into: </li></ul><ul><ul><li>Nonseparately stated income or loss </li></ul></ul><ul><ul><ul><li>Essentially, constitutes Subchapter S ordinary income or loss </li></ul></ul></ul><ul><ul><li>Separately stated income, losses, deductions and credits that could affect tax liability of shareholders in a different manner </li></ul></ul><ul><ul><ul><li>Identical to separately stated items for partnerships </li></ul></ul></ul>
  25. 25. Flow-Through of S Corporation Items
  26. 26. Separately Stated Items <ul><li>Examples include: </li></ul><ul><ul><li>Tax-exempt income </li></ul></ul><ul><ul><li>Gains/losses from disposal of business property and capital assets </li></ul></ul><ul><ul><li>Charitable contributions </li></ul></ul><ul><ul><li>Income/loss from rental of real estate </li></ul></ul><ul><ul><li>Interest, dividend, or royalty income </li></ul></ul><ul><ul><li>Tax preference items </li></ul></ul>
  27. 27. Allocation of Income and Loss (slide 1 of 2) <ul><li>Each shareholder is allocated a pro rata portion of nonseparately stated income (loss) and all separately stated items </li></ul><ul><ul><li>If stock holdings change during year, shareholder is allocated a pro rata share of each item for each day stock is owned </li></ul></ul>
  28. 28. Allocation of Income and Loss (slide 2 of 2) <ul><ul><li>Short-year election is available if a shareholder’s interest is completely terminated (through disposition or death) </li></ul></ul><ul><ul><ul><li>Allows tax year to be treated as two tax years </li></ul></ul></ul><ul><ul><ul><ul><li>Results in interim closing of books on date of termination </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Shareholders report their shares of S corp items as they occurred during year </li></ul></ul></ul></ul>
  29. 29. S Corporation Distributions (slide 1 of 7) <ul><li>Amount of distribution to shareholder = cash + FMV of any other property distributed </li></ul><ul><li>Taxation of distribution depends on whether the S corp has accumulated E&P from C corp years </li></ul>
  30. 30. S Corporation Distributions (slide 2 of 7) <ul><li>Where no Earnings and Profits exist </li></ul><ul><li>1. Nontaxable to the extent of adjusted basis in stock </li></ul><ul><li>2. Excess treated as gain from the sale or exchange of property (capital gain in most cases) </li></ul>
  31. 31. S Corporation Distributions (slide 3 of 7) <ul><li>Where Earnings and Profits exist </li></ul><ul><ul><li>1. Tax-free to the extent of accumulated adjustments account* </li></ul></ul><ul><ul><li>2. Any PTI from pre-1983 tax years can be distributed tax-free </li></ul></ul><ul><ul><li>3. Remaining distribution is ordinary dividend from AEP** </li></ul></ul><ul><ul><li>4. Tax-free to extent of Other Adjustments Account </li></ul></ul><ul><ul><li>5. Tax-free reduction in basis of stock </li></ul></ul><ul><ul><li>6. Excess treated as gain from the sale or exchange of stock (capital gain in most cases) </li></ul></ul><ul><ul><li>* Once stock basis reaches zero, any distribution from AAA is treated as a gain from sale or exchange of stock. “Basis” is the maximum tax-free distribution a shareholder can receive. </li></ul></ul><ul><ul><li>** AAA bypass election is available </li></ul></ul>
  32. 32. S Corporation Distributions (slide 4 of 7) <ul><li>Accumulated Adjustments Account (AAA) </li></ul><ul><ul><li>Represents cumulative total undistributed nonseparately and separately stated items </li></ul></ul><ul><ul><li>Mechanism to ensure that earnings of an S corp are taxed to shareholders only once </li></ul></ul>
  33. 33. S Corporation Distributions (slide 5 of 7) <ul><li>Accumulated Adjustments Account (AAA) is adjusted as follows: </li></ul><ul><ul><li>Increased by: </li></ul></ul><ul><ul><ul><li>Nonseparately computed income and Schedule K items other than tax-exempt income </li></ul></ul></ul><ul><ul><ul><li>Depletion in excess of basis in property </li></ul></ul></ul><ul><ul><li>Decreased by: </li></ul></ul><ul><ul><ul><li>Negative Schedule K adjustments other than distributions </li></ul></ul></ul><ul><ul><ul><li>Portion of distribution treated as tax-free from AAA (but not below zero) </li></ul></ul></ul>
  34. 34. S Corporation Distributions (slide 6 of 7) <ul><li>Other issues regarding distributions: </li></ul><ul><ul><li>Distributions of cash during a one-year period following S election termination receive special treatment </li></ul></ul><ul><ul><ul><li>Treated as a tax-free recovery of stock basis to the extent it does not exceed AAA account </li></ul></ul></ul><ul><ul><ul><li>Since only cash distributions receive this special treatment, the corp should not distribute property during this postelection termination period </li></ul></ul></ul>
  35. 35. S Corporation Distributions (slide 7 of 7) <ul><li>Other issues regarding distributions: </li></ul><ul><ul><li>If E & P exists, the entity may elect to first distribute E & P before reducing AAA </li></ul></ul><ul><ul><ul><li>Called an AAA bypass election </li></ul></ul></ul>
  36. 36. Distributions of Property <ul><li>If the entity distributes appreciated property </li></ul><ul><ul><li>Gain must be recognized </li></ul></ul><ul><ul><ul><li>Treated as if property sold to shareholder for FMV </li></ul></ul></ul><ul><ul><ul><li>Gain is allocated to shareholders and increases shareholders’ basis in stock in the entity, before considering the effect of the distribution </li></ul></ul></ul><ul><ul><ul><li>Basis of asset distributed = FMV </li></ul></ul></ul>
  37. 37. Shareholder’s Basis (slide 1 of 4) <ul><li>Determination of initial basis is similar to that of basis of stock in C corp </li></ul><ul><ul><li>Depends on manner stock was acquired </li></ul></ul><ul><ul><ul><li>e.g., gift, inheritance, purchase, exchange </li></ul></ul></ul><ul><ul><li>Basis is increased by: </li></ul></ul><ul><ul><ul><li>Stock purchases </li></ul></ul></ul><ul><ul><ul><li>Capital contributions </li></ul></ul></ul><ul><ul><ul><li>Nonseparately computed income </li></ul></ul></ul><ul><ul><ul><li>Separately stated income items </li></ul></ul></ul><ul><ul><ul><li>Depletion in excess of basis </li></ul></ul></ul>
  38. 38. Shareholder’s Basis (slide 2 of 4) <ul><ul><li>Basis is decreased by: </li></ul></ul><ul><ul><ul><li>Distributions not reported as income by shareholders (e.g., from AAA or PTI) </li></ul></ul></ul><ul><ul><ul><li>Nondeductible expenses (e.g., fines, penalties) </li></ul></ul></ul><ul><ul><ul><li>Nonseparately computed loss </li></ul></ul></ul><ul><ul><ul><li>Separately stated loss and deduction items </li></ul></ul></ul><ul><ul><li>Similar to partnership basis rules </li></ul></ul><ul><ul><ul><li>First increase basis by income items </li></ul></ul></ul><ul><ul><ul><li>Then decrease it by distributions and finally losses </li></ul></ul></ul><ul><ul><li>Noncapital, nondeductible expenditures reduce stock basis before losses or deductible items unless taxpayer elects to have deductible items pass through before any noncapital, nondeductible items </li></ul></ul>
  39. 39. Shareholder’s Basis (slide 3 of 4) <ul><li>Shareholder’s basis cannot be negative </li></ul><ul><ul><li>Once basis is reduced to zero, any additional reductions (losses or deductions, but not distributions) decrease (but not below zero) basis in loans made to S corp </li></ul></ul><ul><ul><li>Any excess losses or deductions are suspended </li></ul></ul><ul><ul><li>Once basis of debt is reduced, it is increased by subsequent net increases from all positive and negative adjustments </li></ul></ul>
  40. 40. Shareholder’s Basis (slide 4 of 4) <ul><li>Basis rules are similar to partnership rules except: </li></ul><ul><ul><li>Partner’s basis in partnership interest includes direct investment plus a ratable share of partnership liabilities </li></ul></ul><ul><ul><li>Except for loans from a shareholder to the S Corp, corporate borrowing does not affect shareholder’s basis </li></ul></ul>
  41. 41. Treatment of Losses (slide 1 of 2) <ul><li>Step 1. Allocate total loss to the shareholder on a daily basis, based upon stock ownership </li></ul><ul><li>Step 2. If shareholder’s loss exceeds stock basis, apply any excess to adjusted basis of indebtedness to the shareholder. Distributions do not reduce debt basis. </li></ul><ul><li>Step 3. Where loss > debt basis, excess is suspended and carried over to future tax years. </li></ul><ul><li>If the shareholder’s basis is insufficient to allow a full flow through and there is more than one type of loss, the flow-through amounts are determined on a pro rata basis </li></ul><ul><ul><li>e.g., The S corp. incurs both a passive loss and a net capital loss in the same year </li></ul></ul>
  42. 42. Treatment of Losses (slide 2 of 2) <ul><li>Step 4. In future tax years, any net increase in basis adjustment restores debt basis first, up to its original amount. </li></ul><ul><li>Step 5. Once debt basis is restored, remaining net increase is used to increase stock basis. </li></ul><ul><li>Step 6. Suspended loss from a previous year now reduces stock basis first and debt basis second. </li></ul><ul><li>Step 7. If S election terminates, any loss carryover remaining at the end of the post-termination transition period is lost forever. </li></ul>
  43. 43. The Big Picture – Example 34 Net Operating Loss <ul><li>Return to the facts of The Big Picture on p. 12–2. </li></ul><ul><li>If Smith and Jones make the S election for Cane, Inc., they will be able to pass through any NOLs to the extent of the shareholder’s adjusted stock basis. </li></ul><ul><li>If the new S corporation incurs an NOL of $84,000 during 2012, both shareholders are entitled to deduct $42,000 against other income for the tax year in which Cane’s tax year ends. </li></ul><ul><li>Any NOL incurred before the S election is in effect does not flow through to the two shareholders. </li></ul>
  44. 44. At-Risk Rules <ul><li>Generally apply to S corp shareholders </li></ul><ul><ul><li>At-risk amounts include: </li></ul></ul><ul><ul><ul><li>Cash and adjusted basis of property contributed to corp </li></ul></ul></ul><ul><ul><ul><li>Any amount borrowed for use in the activity for which the shareholder is personally liable </li></ul></ul></ul><ul><ul><ul><li>Net FMV of personal assets that secure nonrecourse borrowing </li></ul></ul></ul><ul><ul><li>Losses suspended under at-risk rules are carried forward and are available during post-termination transition period </li></ul></ul>
  45. 45. Passive Losses and Credits <ul><li>An S corp is not directly subject to the passive loss rules </li></ul><ul><ul><li>If the corporation is involved in rental activities or shareholders do not materially participate </li></ul></ul><ul><ul><ul><li>Passive losses and credits flow through to shareholders </li></ul></ul></ul><ul><ul><ul><li>Shareholder’s stock basis is reduced even if passive losses are not currently deductible </li></ul></ul></ul>
  46. 46. Built-in Gains Tax (slide 1 of 4) <ul><li>Generally applies to C corporations converting to S corp status after 1986 </li></ul><ul><ul><li>Corporate-level tax on built-in gain recognized in a taxable disposition within 10 calendar years after the effective date of the S corp election </li></ul></ul><ul><ul><ul><li>The 10-year holding period is reduced to </li></ul></ul></ul><ul><ul><ul><ul><li>7 years for tax years beginning in 2009 and 2010, and </li></ul></ul></ul></ul><ul><ul><ul><ul><li>5 years for 2011. </li></ul></ul></ul></ul>
  47. 47. Built-in Gains Tax (slide 2 of 4) <ul><li>Tax base includes unrealized gain on assets held on date of S corp election </li></ul><ul><ul><li>Highest corporate tax rates apply (currently 35%) </li></ul></ul><ul><ul><li>This gain passes through to shareholders as taxable gain </li></ul></ul><ul><li>Maximum built-in gain recognized over the required (5-,7- or 10-year) holding period is limited to aggregate net built-in gain at time corp. converted to S status </li></ul>
  48. 48. Built-in Gains Tax (slide 3 of 4) <ul><li>Amount of built-in gain recognized in any year is limited to an “as if” taxable income, computed as if the corp were a C corp </li></ul><ul><ul><li>Any gain that escapes taxation under this limit is carried forward and recognized in future years </li></ul></ul><ul><li>S corp can offset built-in gains with unexpired NOLs or capital losses from corp. years </li></ul>
  49. 49. Built-in Gains Tax (slide 4 of 4) <ul><li>LIFO recapture tax </li></ul><ul><ul><li>Any LIFO recapture amount at time of S corp election is subject to a corporate-level tax </li></ul></ul><ul><ul><li>Taxable LIFO recapture amount = excess of inventory’s value under FIFO over the LIFO value </li></ul></ul><ul><ul><li>Resulting tax is payable in four annual installments </li></ul></ul><ul><ul><ul><li>First payment is due on or before due date of last C corp tax return </li></ul></ul></ul>
  50. 50. Computation of Built-in Gains Tax (slide 1 of 2) <ul><li>Step 1. Select the smaller of built-in gains or taxable income.* </li></ul><ul><li>Step 2. Deduct unexpired NOLs and capital losses from C corporation tax years. </li></ul><ul><li>Step 3. Multiply the tax base from step 2 by the top corporate tax rate. </li></ul><ul><li>*Any net recognized built-in gain > taxable income is carried forward to the next year, as long as the next year is within the 5-, 7-, or 10-year recognition period. </li></ul>
  51. 51. Computation of Built-in Gains Tax (slide 2 of 2) <ul><li>Step 4. Deduct business credit carryforwards and AMT credit carryovers from a C corporation tax year from the amount obtained in step 3. </li></ul><ul><li>Step 5. The corporation pays any tax resulting from step 4. </li></ul>
  52. 52. The Big Picture – Example 41 Built-in Gains Tax <ul><li>Return to the facts of The Big Picture on p. 12–2. </li></ul><ul><li>If Cane, Inc., becomes an S corp., a built-in gain may be recognized. </li></ul><ul><li>Assume that Cane reports a $50,000 built-in gain on conversion. </li></ul><ul><ul><li>It holds a $20,000 NOL carryforward from C corporation years before the S election. </li></ul></ul><ul><li>The NOL carryforward is applied against the built-in gain. </li></ul><ul><ul><li>Cane’s built-in gains tax applies only to $30,000. </li></ul></ul>
  53. 53. Passive Investment Income Penalty Tax (slide 1 of 3) <ul><li>If an S corp has accumulated E&P (AEP) from C corp years </li></ul><ul><ul><li>A tax is imposed on excess net passive income (ENPI) calculated as follows: </li></ul></ul><ul><ul><li>Passive investment income Net passive </li></ul></ul><ul><ul><li>ENPI = > 25% of gross receipts × investment </li></ul></ul><ul><ul><li> Passive investment income income for </li></ul></ul><ul><ul><li> for the year the year </li></ul></ul>
  54. 54. Passive Investment Income Penalty Tax (slide 2 of 3) <ul><li>Passive investment income includes royalties, rents, dividends, interest, annuities </li></ul><ul><ul><li>Only net gain from disposition of capital assets is included </li></ul></ul><ul><li>Net passive income is passive income less directly related deductions </li></ul>
  55. 55. Passive Investment Income Penalty Tax (slide 3 of 3) <ul><li>Excess net passive income cannot exceed C corp. taxable income before considering any NOL or other special deductions </li></ul><ul><li>Tax rate applied is the highest corporate tax rate for the year </li></ul>
  56. 56. Refocus On The Big Picture (slide 1 of 3) <ul><li>As long as Smith and Jones, the owners of Cane, Inc., maintain C corporation status, they cannot deduct any NOLs that the business incurs on their individual tax returns. </li></ul><ul><ul><li>For the owners to deduct any future NOLs on their Forms 1040, Cane needs to be operated as a flow-through entity. </li></ul></ul><ul><ul><li>The most logical alternatives are to make an S election or to become a limited liability company. </li></ul></ul><ul><li>An S election may be appropriate for Cane. </li></ul><ul><ul><li>Cane should make a timely election on Form 2553. </li></ul></ul><ul><ul><li>Both shareholders must consent to the election. </li></ul></ul><ul><li>The owners should make the election on or before the fifteenth day of the third month of the current year. </li></ul>
  57. 57. Refocus On The Big Picture (slide 2 of 3) <ul><li>Normally, an S corp. does not pay any income tax. </li></ul><ul><ul><li>A C corp. making an S election may be required to pay a built-in gains tax or a LIFO recapture tax. </li></ul></ul><ul><ul><li>The base for the built-in gains tax includes any unrealized gain on appreciated assets held by Cane on the day the owners elect S status. </li></ul></ul><ul><ul><li>The highest corporate rate is applied to the unrealized gain when any of the built-in gain assets are sold. </li></ul></ul><ul><ul><li>If the corporation uses the LIFO inventory method, any LIFO recapture amount at the time of the S election is subject to a corporate-level tax. </li></ul></ul>
  58. 58. Refocus On The Big Picture (slide 3 of 3) <ul><li>Cane does not need to liquidate or engage in a tax-deferred reorganization when converting to an S corporation. </li></ul><ul><ul><li>An S corporation can have voting and nonvoting common stock, provided that all shares have the same economic rights to corporate income or loss. </li></ul></ul><ul><ul><li>Data used to compute a DPAD flows through to the shareholders. </li></ul></ul><ul><li>Cane might get rid of the tax-exempt income, which will not be reflected in AAA. </li></ul><ul><ul><li>Although it is reflected in stock basis, tax-exempt income (as part of OAA) is distributed to the shareholders only after the S corporation has distributed all of its C corporation E&P. </li></ul></ul>
  59. 59. <ul><li>If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: </li></ul><ul><li>Dr. Donald R. Trippeer, CPA </li></ul><ul><li>[email_address] </li></ul><ul><li>SUNY Oneonta </li></ul>
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