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Presented by Tony Nitti, CPA, MT National Tax Services Group
• 1120-S S Corp Return
Preparation Tips
11
A QUICK PRIMER
S Corporations generally do not pay tax at
the entity level.
Instead, the income or loss of the S
corporation is computed at the entity level,
but then is allocated among the shareholders
on Schedule K-1.
The income or loss is then reported – and tax
paid – at the individual shareholder level.
Upon the distribution of income, the
2
A QUICK PRIMER
Thus, the defining characteristic of S corporations is:
• S Corporations and their shareholders generally pay a
single level of taxation. Stated in another way, the same
$100 of income would only be taxed once – at the
shareholder level – as opposed to the double taxation that
is the defining characteristic of C corporations.
3
PAGE 1, BOX A: WHAT CAN WE LEARN?
Being treated
as an S
corporation
requires a
CHOICE.
Being treated
as an S
corporation
requires a
CHOICE.
Default “entity
classification
regulations:”
• An entity that is incorporated under state law is treated as a C
corporation.
• An entity with one member that is not incorporated under state law defaults to a disregarded entity.
• An entity with more than one member defaults to a partnership.
Default “entity
classification
regulations:”
• An entity that is incorporated under state law is treated as a C
corporation.
• An entity with one member that is not incorporated under state law defaults to a disregarded entity.
• An entity with more than one member defaults to a partnership.
4
ELIGIBILITY
1.Qualification - § 1361
a. Domestic Corporation
b. Less than 100 shareholders (husband and wife, all family members treated as one shareholder. See Section 1361(c))
2.Who are eligible shareholders?
a. Individuals who are citizens or residents of U.S.
b. Single Member LLC provided sole member is eligible c. ESOPs
d. Estates (decedent and bankrupt)
e. Certain types of trusts (voting trusts, grantor trusts, call us!)
f. Certain tax-exempt organizations (Section 501(c)(3) organizations, but see Section 512, which says S corporation income is UBTI
5
INELIGIBLE SHAREHOLDERS
C corporation
S corporation (unless own 100%
percent and elect QSSS status)
LLC/LLP – Tax Partnership
Nonresident alien
IRA or self-directed IRA (Including
Roth IRA - Taproot)
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PAGE 1, BOX A: MAKING THE ELECTION
Form 2553
Due dates:
1. Newly formed corporation:
15th day of 3rd month after start of corporation (first date it has
shareholders, starts business or acquires assets) to be effective in year 1.
Definition of month is strange under Section 1362; it is really 75 days rather than always the 15th of a month.
Ex: S Co. is incorporated on March 9, 2014. S Co. has until May 24, 2014 to make an S election effective for 2014. If the election is made after that date but during 2014, it will be effective 1.1.2015.
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PAGE 1, BOX A: MAKING THE ELECTION
Form 2553
Due dates:
1. Existing C corporation:
Within the first 2 ½ months of the tax year you wish the election to become effective (by March 15, 2013 to be effective 1.1. 2013)
If you make it after that date, it will be effective on the first day of the next tax year. (you can make election in late 2012 for 2013)
Who must consent to election?
1. All shareholders, including any shareholder who owned stock in the corporation at any time from the start of the tax year until the date of the election.
8
LATE ELECTIONS
IRS consolidated all prior late relief options during 2013.
Rev. Proc. 2013-30 superseded Rev. Procs. 2003-43 and 2007-62.
2553 can be filed within 3 years and 75 of the date it wished the S
election to be effective for the first S year if following conditions are met: • Failed to qualify as S corp solely due to failure to make timely election
• All shareholders must include statements that they properly reported the S corporation income
• Form 2553 must be state at the top “FILED PURUSANT TO REV. PROC. 2013-30”
• Must have reasonable cause
8
Example: X Co intended to file a Form 2553 to be treated as an S corporation for 2011, but failed to do so. Assuming X Co. was eligible for S status throughout 2011 and beyond, X Co. may use RP 2013-30 to file its 2553 and elect S status any time before March 15, 2014.
99
LATE ELECTIONS
If all Forms 1120S have been filed from the year of the effective date through the year the failed election is discovered:
• Form 2553 can be attached to the current year Form 1120S as long as filed within 3 yrs 75 days. (Thus, an extension to file the 2015 tax return would doom the previous example!)
In the previous example, if S Co. discovers in 2015 that the election it intended to be effective on 1/1/2011 was not filed, it may file Form 2553 requesting late relief by 3/15/2014 with its 2013 tax return. If S Co. extends its 2013 return until September 15, 2014, however, S Co. will miss the opportunity for late relief.
If all Forms 1120S have not been filed from the effective date through the year of discovery:
• Form 2553 can be attached to the late 1120S for the year of the effective date on two conditions:
– The Form 1120S for the year of the effective date is filed within 3 years and 75 days of the effective date, and
– All other delinquent Forms 1120S are filed simultaneously.
Ex: S Co. intended to be taxed as an S corporation on 1/1/2012 but failed to file Form 2553 and also failed
to file its 2012 and 2013 tax returns. S Co. can obtain late relief provided it files its 2012 return with a Form 2553 before 3/15/2015 AND files its late 2013 return at the same time.
10 10
LATE ELECTIONS
You can file a late election EVEN AFTER 3 years and 75 days have passed, if:
- The corporation is not also seeking a late entity classification (i.e., an LLC electing to concurrently be treated as a corporation and making an S election) - At least six months have passed since the date on which the corporation filed
its tax return for the first year the corporation wanted to be treated as an S corporation, and
- Neither the corporation nor any of its shareholders were notified by the IRS of any problem regarding the S corporation status within six months of the date on which the Form 1120S for the first year was timely filed.
Example: X Co. wanted to be taxed as an S corporation effective 1/1/2009. It filed its
2009, 2010, 2011 and 2012 tax return timely each year of Form 1120S. In 2013, X Co. discovers that its S election was never filed. Even though more than 3 years and 75 days have passed since the date the S election was to be effective, X Co. can file a late 2553 provided the above conditions are met.
11
COMPARE BOX A TO BOX E: WHAT CAN WE
LEARN?
Date in Box A is same as Box E
Has been an S corporation since inception.
This means that generally:
• S Corporation has no C corporation E&P
– Section 1362 termination for ENPI does not apply
– Section 1375 entity-level tax on ENPI does not apply
– Distributions cannot be dividends; AAA irrelevant
12
COMPARE BOX A TO BOX E: WHAT CAN WE
LEARN?
Date in Box A is later than Box E
Was previously a C corporation
Must know if we still have C corporation E&P.
IF so:
• Section 1362 termination for ENPI could apply • Section 1375 entity-level tax on ENPI could apply • Distributions can be dividends; must use AAA
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PAGE 1, TAX YEAR
Tax Years
99 times out of 100 will be calendar year (Section 1378)
Why? Allowing a fiscal year would allow S corporation shareholders to defer income. For example, if you elected a 1.31.2013 year end, the income from 2.1.2012 through 1.31.2013 would be included in your 2013 tax return, allowing you to defer 11 months of income earned during 2012.
Exceptions
• Natural business year end (CPA firms in May) at least 25% of the corporation's annual gross receipts must be earned during a consistent two-month period. The corporation must pass the test for three consecutive years. (RP 2006-46)
• Business purpose
• Section 444 election (might get you Sept/Oct/Nov), have to pay estimated tax on deferral
When a fiscal year C corporation elects S status, must generally switch to calendar year, creating short period return.
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PAGE 1, LINE 7: REASONABLE COMPENSATION
Too high or too low?
C corporations: Too high. Reduce corporate level tax.
S corporations: Too low. Avoid SE tax.
Revenue Ruling 59-221, S corporation
flow-through income is NOT subject to SE tax.
Creates an opportunity for shareholders to
forego compensation in exchange for
distributions, saving on payroll taxes as the
increased flow-through income is not subject
to SE tax.
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REASONABLE COMPENSATION
Example 1: A owns 100% of the stock of S Co. A is also S Co.’s president and only employee.
S Co. generates $100,000 of taxable income in 2013,
before considering A’s compensation. If A draws a $100,000 salary, S Co.’s taxable income will be reduced to zero.
A will report $100,000 of wage income on his individual income tax return, and S Co. and A will be liable for the necessary payroll taxes.
S Co. will be required to pay $7,650 (7.65% of $100,000) as its share of payroll tax, and S Co. will withhold $7,650 (7.65% of $100,000) from A’s salary towards A’s payroll obligation, resulting in a total payroll tax bill of $15,300.
16
REASONABLE COMPENSATION
Example 2: Alternatively, A may choose to withdraw $100,000 from S Co. as a distribution rather than a salary.
S Co.’s taxable income will remain at $100,000 and will be passed through to A and reported on his
individual income tax return, where it is not subject to self-employment tax.
The $100,000 distribution is also not taxable to A, as it represents a return of basis.
By choosing to take a $100,000 distribution rather than a $100,000 salary, S Co. and A have saved a
17
REASONABLE COMPENSATION
The IRS isn’t stupid. It has challenged
the compensation of S corporation
shareholder/employees as being
unreasonably low for a half decade.
Under Section 3121 and more cases
than imaginable, a shareholder/employee
who renders “significant services” to the
S corporation MUST take a reasonable
salary.
18
REASONABLE COMPENSATION
The IRS has moved to a quantitative approach. See Watson. Partner in CPA firm paid himself only $24K in salary, took out
distributions of over $200K.
IRS brought in an expert:
Compared the health of Watson’s firm to other firms.
• Used RMA (Risk Management Association) ratios to get comparison to other accounting firm. (profit/sales, compensation/sales)
Based on profitability, looked at what Watson earned compared to other peers, subordinates at his own firm.
• Looked at Management of an Accounting Practice survey (conducted by AICPA) and Robert Half info.
19
REASONABLE COMPENSATION
Lessons from Watson
Don’t allow shareholder to pay himself less than an inexperienced new hire.
If shareholder provides more services than the highest paid non-shareholder, his compensation must be higher.
Manufacturers/Distributors can justify lower salary to
shareholder/employees. Not so for personal service corporations.
Do your homework! Look at comparison data, Robert Half, salary.com, etc…
Note, no court case has EVER reclassified salary to a
shareholder/employee in excess of the Social Security wage base ($117,000 in 2014). Coincidence or not worth the effort to collect 2.9% (Medicare taxes) of excess?
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PAGE 1: FRINGE BENEFITS AND HEALTH
INSURANCE PREMIUMS
Revenue Ruling 91-26 provides
guidance on the appropriate way
for S corporations and
shareholders to treat health
insurance premiums paid by the S
corporation on behalf of the
shareholders.
21
HEALTH INSURANCE PREMIUMS
S Corporations: Payments made on behalf of > 2% shareholder
S corporation is required to treat the health insurance premiums paid
on behalf of the shareholder as wages.
To S corporation: Tax deduction for amounts paid for shareholder
health insurance premiums as compensation expense.
To the shareholders from Form 1120S: Reported as wages to the
respective shareholders on Form W-2. (generally not treated as wages for Social Security and Medicare purposes)
To the shareholders on Form 1040: Shareholders may deduct the
premiums on page 1 of Form1040, subject to the limits of Section 162(l)
22
HEALTH INSURANCE PREMIUMS
S Corporations: Payments made on behalf of < 2% shareholder
S corporation is not required to treat the health insurance premiums paid on behalf of the shareholder as wages.
To S corporation: Tax deduction for amounts paid for shareholder health insurance premiums as
fringe benefits.
To the shareholders from Form 1120S: Not reported as wages to the respective shareholders on
Form W-2.
To the shareholders on Form 1040: Shareholders may exclude from income the premiums paid
on their behalf by the S corporation as tax-free fringe benefits.
Unlike partnerships, S corporations cannot treat the health insurance premiums paid on behalf of > 2% shareholders as distributions, as S corporation flow-through income is not subject to SE tax.
23
BALANCE SHEET: ACCRUED LIABILITIES
Amounts accrued to shareholders
Under Section 267(e), no amount accrued to
an S corporation shareholder may be
deducted until it is paid.
Example: S Co. accrues a deduction for a
$100,000 bonus to be paid to A, a 10%
shareholder. Under Section 267(e), the bonus
may not be deducted until paid.
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PAGE 2: SCHEDULE B, BOX 1
Method of Accounting
Common Mistake: An S corporation is NOT subject to
Section 448, thus, it may be on the cash method even if it has receipts in excess of $5M.
However, it is required to maintain inventory under Section 471, the S corporation is required to use the accrual
method.
Two exceptions:
• RP 2001-10 (gross receipts less than $1M) • RP 2002-28 (gross receipts less than $10M)
25
SCHEDULE B, LINE 4A: OWNERSHIP OF SUBSIDIARIES
S corporation may own any
percentage of another C corporation
or an LLC.
An S corporation may only own
another S corporation if it owns 100%
of the subsidiary corporation and
elects to treat the subsidiary as a
‘qualified subchapter S subsidiary.”
26
OWNERSHIP OF SUBSIDIARIES
Effect of QSSS election
Deemed tax-free liquidation of subsidiary under Section 332/337.
Subsidiary is disregarded as separate from its S corporation parent.
QSSS must pay own employment taxes.
May force change in parent’s method of accounting (inventory?)
Mechanics of QSSS election: Form 8869
Can be made any time during year, but cannot be effective more than 2 months and 15 days prior to election date, or more than 12 months from the date the election is filed.
27
BASIC FACTS
SCHEDULE B, LINE 8: BUILT-IN GAINS TAX
40% 30%
TAX RATE
CORPORATE INDIVIDUAL
What result in each of the following situations? ASSETS FMV $ 3,000,000 A/B 1,000,000 X Co. 100%
A/B $600,000
A
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C CORPORATION LIQUIDATION
b. X Company is a C corporation and liquidates in 2010 (4/21/10).
B
X Co. A - § 331 A/R $3,000,000 A/R $2,200,000 A/B 1,000,000 A/B $600,000 Tax Gain $2,000,000 LT $ 1,600,000 40% 30%Tax Liability $800,000 Tax Liability $ 480,000
TOTAL TAX - $1,280,000
x x
29
S CORPORATION LIQUIDATION
c. X Company is an always S corporation and liquidates in 2010.
C
X Co. A - § 331
A/R $3,000,000 A/R $3,000,000
A/B 1,000,000 A/B $2,600,000
Tax Gain $2,000,000 LTCG $ 400,000
Tax Liability S Corporation
Flow-through Gain $ 2,000,000 Total Gain $2,400,000
30% $ 720,000
30
WHY THE BIG TAX?
The reason the BIG tax of §1374 was
added was to prevent C corporations from
electing S status and then immediately
liquidating to avoid GU repeal.
For a 10-year period after the S election,
an S corporation that disposes of assets
that were held on the final day it was a C
corporation will pay corporate level tax on
the gain inherent in the assets at the time
of the S election.
31
HOW DOES IT WORK
Take a picture of the C corporation on the
day it makes the S election.
Determine the FMV of all the C
corporation’s assets and determine the
net appreciation inherent in the assets.
This appreciation, if recognized during
the first 10 years as an S corporation, will
be subject to corporate level tax.
32
MUST DETERMINE NUBIG
Net unrealized built in gains: total gain
less total loss inherent in the company’s
assets at the time of the S election.
This is the maximum BIG an S
corporation will ever pay corporate level
tax on.
If net unrealized built in gains is zero at
the time of the S election, the company
will never recognize BIG, and never pay
BIG tax.
33
COMPARISON TO C CORPORATION
If subject to BIG tax, is total tax
liability greater than, equal to, or less
than the total tax of $1,280,000 that
would have been imposed on a C
corporation? In other words, is a
corporation worse off by making an S
election?
34
BIG EXAMPLE
BASIC FACTS
40% 30% TAX RATE CORPORATE INDIVIDUAL ASSETS FMV $ 3,000,000 A/B 1,000,000 X Co. 100%A/B $600,000
A
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HOW DO WE COMPUTE NUBIG?
Unrealized built-in gains
Excess of FMV over tax basis of any asset.
Includes intangibles.
Includes cash basis accounts receivables.
Unrealized built-in loss
Excess of tax basis over FMV of any asset
Liabilities that would be deductible upon payment (cash basis liabilities)
Accrual basis liabilities that would be deductible only upon payment (related party liabilities subject to Section 267).
36
STEP 1: COMPUTE NUBIG
Net Unrealized Built In Gain = $2,000,000
The corporation will never pay tax on more than
$2,000,000 of BIG
BIG tax paid by S corporation passes through to
shareholder as a loss with same character of
BIG.
FMV of assets:
$3,000,000Less: tax basis
($1,000,000)37
BIG EXAMPLE
c. X Company converts to S status and immediately liquidates in 2010.
C
X Co. A - § 331
A/R $3,000,000 A/R $2,200,000
A/B 1,000,000 A/B $1,800,000 ($600K + $1.2M)
Tax Gain $2,000,000 LT $ 400,000
BIG Tax Liability $800,000 S Corporation’s Tax Income ($2M BIG- $800K BIG TAX
$1,200,000
Total Gain $1,600,000
30%
Tax Liability $ 480,000
38
ADDITIONAL LIMITATIONS
Limited to the actual appreciation inherent
in each particular asset at the time of the
S election (realized built in gain.)
Thus, any future appreciation inherent in
the asset escapes BIG tax.
Also, BIG is limited to taxable income. If
limited, it carries forward to the next year.
If you make it through all 10 years with no
39
QUESTION 1– BIG TAX
X Co. was formed in 2006 as a C corporation. The shareholders of X Co. elected S status effective as of January 1, 2014, when it had the following assets:
Asset Adjusted Basis Fair Market Value
Land $250,000 $200,000
Building $100,000 $350,000
Machinery $150,000 $300,000
Total $500,000 $850,000
X Co. sells the building for $500,000 in 2014 when the basis is
$90,000. Its taxable income for 2014 if it were not an S corporation would be $750,000. How much gain is subject to the BIG tax?
40
STEP 1: DETERMINE NET UNREALIZED BUILT-IN
GAIN
Reg. Section 1.1374-3
Amount that would be realized if the corporation
had sold all of its assets for FMV: $850,000
Less: accrued liabilities deductible when paid: $0
Less: tax basis of assets: ($500,000)
Plus/minus: Section 481 adjustment ($0)
Total net unrealized built-in gain: $350,000
41
STEP 2: DETERMINE RECOGNIZED BUILIT-IN
GAIN
Recognized built-in gain is the gain
recognized on the sale, limited to
the amount of appreciation
inherent in the asset at the time of
the S election.
42
STEP 2: DETERMINE RECOGNIZED BUILT-IN GAIN
Recognized built-in gain is the lesser
of:
1.
The recognized built-in gain of $250,000;
2.
The excess of the net unrealized built-in gains
of $350,000 less all previous recognized built-in
gains ($0), or $350,000, or
3.
Taxable income of $750,000
Thus, recognized built-in gains is
43
QUESTION 1(B): MAXIMUM BIG
X Co. was formed in 2006 as a C corporation. The shareholders of X Co. elected S corporation status effective as of January 1, 20014, when it had no sub-C earnings and profits and the following assets:
Asset Adjusted Basis Fair Market Value
Land $250,000 $200,000
Building $100,000 $350,000
Machinery $150,000 $300,000
Total $500,000 $850,000
Continuing along the first variation, X Co. also sells the machinery for $400,000 in 2015 when it has a basis of $100,000, when it would have $400,000 of taxable income if it were not an S
44
STEP 2: DETERMINE RECOGNIZED BUILT-IN GAIN
Recognized built-in gain is the gain
recognized on the sale, limited to
the amount of appreciation
inherent in the asset at the time of
the S election.
45
STEP 2: DETERMINE RECOGNIZED BUILT-IN GAIN
Recognized built-in gain is the lesser of:
1. The recognized built-in gain of $150,000;
2. The excess of the net unrealized built-in gains of $350,000 less all previous recognized built-in gains ($250,000), or $100,000
3. Or taxable income of $400,000
Thus, recognized built-in gains is limited to
$100,000.
Easy to mess this up and recognize too
46
SCHEDULE B, LINE 9: PRESENCE OF CORPORATE E&P
Earnings and Profits is a subchapter C concept.
If a C corporation with accumulated E&P makes an S
election, the accumulated E&P survives the S election and will continue on in the S corporation.
E&P hurts an S corporation in three ways:
May convert a portion of an S corporation’s distribution into a taxable dividend.
May result in corporate level gain if S corporation has “excess net passive income” under Section 1375.
S election may terminate under Section 1362 if corporation has “excess net passive income” for three straight years.
47
TAXABILITY OF DISTRIBUTIONS
Must ask two questions FIRST:
Was the S corporation ever a C corporation?
If so, does the S corporation still have C
corporation “earnings and profits?”
48
USING STOCK BASIS TO DETERMINE TAXABILITY
OF DISTRIBUTIONS
General Rule for distributions if no AEP
If no AEP, you DO NOT CARE ABOUT AAA!!!!!!!!!
Distributions only reduce stock basis, not debt basis. (§1368)
Ex: Joe has stock basis of $3,000 after all adjustments for the year except a $5,000 distribution. $3,000 is tax free, reducing basis to zero. $2,000 is capital gain to Joe.
STEP ONE
Distributions are tax-free to the extent of stock basis.
STEP TWO
Distributions in excess of basis generate capital gain to the s/h.
49 FORM 1040
SHAREHOLDER BASIS
A
A invests $500 into a wholly‐owned S corporation. S Co. uses the $500 to generate $100 of taxable income. The $100 of income is allocated to A on Schedule K‐1; A pays tax on the $100 on Form 1040. Presumably, the value of S Co. is now $600. If A did NOT adjust his initial $500 basis to reflect the $100 of income earned, a sale of the stock for $600 would generate $100 of gain ($600 ‐ $500 basis) Thus, A would effectively be taxed twice on the SAME $100 of income earned by S Co.50
SHAREHOLDER BASIS AND SINGLE LEVEL OF
TAX
By increasing A’s basis, the single‐ level of taxation has been preserved. Thus, a sale of the S Co. stock for $600 would generate no further gain or loss. A’s basis goes from:$500
to
$600
To avoid this result, Section 1367 requires A to increase his stock basis to reflect the $100 of income allocated to him from S Co. STOCK BASIS INCREASE BASIS$600
$600
51
BASIS ADJUSTMENTS: §1367(A)(1)
Basis is increased by:
1.
Capital contributions (cash and adjusted
basis of property contributed)
2.
Non-separately stated income (ex: Line 1
of K-1)
3.
Separately stated income
4.
Tax-Exempt income
52
BASIS ADJUSTMENTS: §1367(A)(2)
After increases, basis is decreased by:
1.
Distributions (cash and FMV of property)
2.
Non-separately stated loss
3.
Separately stated items of loss or
deduction
53
ORDER OF ADJUSTMENTS TO STOCK BASIS
Normally made at end of the tax year
IMPORTANT-Under §1.1367-1(f), stock
basis is adjusted in the following
order:
FIRST: Increase for income items
SECOND: Decrease for distributions
THIRD: Decrease by nondeductible expenses
FOURTH: Decrease for items of loss and
54
PROBLEM 1: ORDERING RULES
A owns 100% of S Co. S Co. has been an S corporation for four years and has no AEP. Assume that the following three different factual situations apply:
55
SOLUTION: 1A
$5,000 $2,000 $7,000 + $7,000 $0 $7,000 -$7,000 $7,000 $0-56
SOLUTION: 1B
$5,000 $2,000 $7,000 + $5,000$7,000 $2,000 - $2,000 $2,000 $0-57
SOLUTION: 1C
$5,000 $2,000 $7,000 + $7,000 $7,000 $0-58
STOCK BASIS VERSUS ACCUMULATED
ADJUSTMENTS ACCOUNT
Note, stock basis and AAA may not be the same thing.
AAA is a corporate attribute.
Stock basis is personal to a shareholder.
Stock basis is increased for tax‐exempt income and decreased for expenses attributable to tax‐exempt expenses, AAA is NOT.AAA can go negative, stock basis cannot.
If a shareholder buys an interest in an S corporation for a
premium, it has no effect on AAA.
59
DOES THE CORPORATION HAVE AEP?
Only applies to prior C corporations.
Accumulated earnings and profits are the
“economic income” available for a C
corporation to distribute to its
shareholders.
If a C corporation had accumulated
earnings and profits at the time of the S
election, those earnings and profits
remain with the S corporation, to
eventually be taxed as dividends.
60
S CORP WITH AEP §1368(C)
Tier 1: To the extent of
Accumulated
Adjustment Account (AAA), the distribution is treated as if made by a S corp WITHOUT AEP.
Tier 1: To the extent of
Accumulated
Adjustment Account (AAA), the distribution is treated as if made by a S corp WITHOUT AEP.
Tier 2: Distributions
in excess of AAA are treated as a dividend up to AEP.
Tier 2: Distributions
in excess of AAA are treated as a dividend up to AEP.
Tier 3: Distributions
in excess of AEP are treated as if made by S corp without AEP. (i.e., same as Step 1)
Tier 3: Distributions
in excess of AEP are treated as if made by S corp without AEP. (i.e., same as Step 1)
61
PAGE 5: SCHEDULE M-1: WHAT IS AAA?
An account of the S corp (not the s/h)
that is increased or decreased similar to
adjustments made to basis. §1368(e)(1)
No increase for tax-exempt income.
AAA, unlike basis, can be reduced below
zero, but NOT by distributions.
The purpose of AAA is to measure
previously taxed but undistributed
income of the S corporation.
62
HOW AND WHEN DO YOU ADJUST AAA?
Depends on if you have a net positive
or net negative adjustment.
Net positive: income and gain
exceeds loss and deduction (not
distribution) items.
Net negative: loss and deduction
items exceed the income and gain
items.
63
HOW AND WHEN DO YOU ADJUST AAA?
If you have a net positive adjustment,
adjust AAA BEFORE figuring out
taxability of distribution.
If you have a net negative adjustment,
DO NOT adjust AAA before figuring out
taxability of distribution.
This keeps AAA higher and allows more
distribution to be a tax-free return of
64
NET POSITIVE ADJ.
EXAMPLE: PROBLEM 4
Tom owns 100% of S Co. S Co. has AAA
of $2,500 and AEP of $7,500. Tom’s
stock basis on 1/1 is $10,000. During the
year, S Co. has the following:
Determine the taxability of the distributions
Non-separately stated income
$9000
Capital loss:
($2000)
65
NET POSITIVE
EXAMPLE, SOLUTION
First, adjust AAA, because there is a net positive adjustment. ($9000 inc - $2000 loss).
AAA starts at $2500, increases by $9000 income, then
decreases by $(2000) loss. Unlike basis, you reduce AAA by loss before the distribution. AAA is $9500 before distribution. Since $11,000 is distributed, the first $9,500 comes out of
AAA and is not taxed as a dividend.
The remaining $1,500 distribution comes from the E&P of $7,500, and is thus a taxable dividend.
To determine if the $9,500 distribution made under the S corporation rules is taxable, we must adjust stock basis.
66
SOLUTION
AAA E&P S Corp. Dist. C Corp Dist. Starting $2,500 $7,500 Increase AAA: net positive adjustment $7,000 AAA balance before distribution $9,500 Decrease: distribution ($9,500) $9,500 Ending AAA $0 Distribution from E&P ($1,500) $1,500 Ending E&P $6,000
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SOLUTION
Basis
Starting
$10,000
Increase for income
$9,000
Basis before distribution
$19,000
Decrease for distribution not taxed as
dividend
($9,500)
Decrease for losses
($2,000)
Ending basis
$7,500
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EXAMPLE 8
WHAT’S THE LESSON?
AAA (bottom of Page 5) is the dividing
line between distributions made from
S corporation income (which are non‐
dividends and tax‐free to extent of
shareholder basis) and those made
from C corporation E&P (which must
be taxed as a dividend).
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ELECTIONS
An S corporation that wants to get rid of
its C corp AEP (perhaps to avoid §1375
or take advantage of the 15% current
rate on dividends) can elect to bypass
AAA and distribute E&P first. Treas. Reg.
§1.1368-1(f)(2)
Can also elect to make a deemed
dividend under Treas. Reg.
§1.1368-1(f)(3) if no cash is available.
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PAGE 5, SCHEDULE M-2: PTI AND OAA
Almost unanimously misunderstood. Previously taxed income:
Was AAA before AAA came to be in 1983.
Was specific to a shareholder. Can be distributed tax-free before AAA.
Must be maintained for distribution purposes.
Other adjustment account:
Doesn’t exist in Code or Regulations.
Simply a reconciling item. Meant to measure differences
between stock basis and AAA (tax-exempt income and related expenses).
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SCHEDULE K-1 : ALLOCATION OF INCOME AND LOSS TO
SHAREHOLDERS
Once the S corporation computes its taxable
income, it must allocate it among shareholders.
As opposed to partnerships, special allocations
of income and loss is not permitted.
Under Section 1366, each shareholder must be
allocated his “pro-rata share” of the various
items of income and loss for the year.
Under Section 1377, the shareholder’s pro-rata
share” is determined on a strict
per-share/per-day basis.
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PER-SHARE/PER-DAY
How do you compute per share per day?
STEP 1STEP 1
Take the
income or loss for the year and divide by the number of days in the tax year. Take the
income or loss for the year and divide by the number of days in the tax year.
STEP 2STEP 2
Divide the
income for each day by the
number of shares owned on that day. Divide the
income for each day by the number of shares owned on that day. STEP 3STEP 3 Multiply the
result from Step 2 by the total number of shares the shareholder held on that day. Multiply the
result from Step 2 by the total number of shares the shareholder held on that day. STEP 4STEP 4 Multiply the
result from Step 3 by the number of days the shareholder owned that number of shares. Multiply the
result from Step 3 by the number of days the shareholder owned that number of shares.
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PER-SHARE/PER-DAY
EXAMPLE
On January 6, 2012, A and B form a new corporation, X. On the same day, X issues 100 shares of stock to each of A and B. X elects to be an S corporation and uses the calendar taxable year.
On July 24, 2012, B sells fifty shares of stock to C. As a result, B owns 50 percent of the X stock from January 6 to July 24 (200 days), and 25 percent for the balance of the year (160 days). C owns 25 percent of the stock from July 25 to December 31 (160 days).
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PER-SHARE/PER-DAY
EXAMPLE
To allocate its income among the shareholders:
B owned 100 shares for 200 days and 50 shares for 160 days. B is allocated
$200,000 ($100 per-share/per-day * 100 shares * 200 days) + $80,000 ($100 per-share/per-day * 50 shares * 160 days) for a total of $280,000.
C owned 50 shares for 160 days. C is allocated $80,000 ($100
per-share/per-day * 50 shares * 160 per-share/per-days).
Step 1Step 1
Divide income for the year ($720,000) by the number of days in the tax year (360) to get income per day. ($2,000) Divide income for the year ($720,000) by the number of days in the tax year (360) to get income per day. ($2,000)
Step 2Step 2
There are 200
shares outstanding all year, so divide $2,000 by 200
shares = $100 per share/per day.
There are 200
shares outstanding all year, so divide $2,000 by 200
shares = $100 per share/per day.
Step 3 and 4Step 3 and 4
A owned 100 shares for the entire year. A is allocated $360,000 ($100 per-share/per-day * 100 shares * 360 days). A owned 100 shares for the entire year. A is allocated $360,000 ($100 per-share/per-day * 100 shares * 360 days).
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CLOSING THE BOOKS
Assume A and B own 50% each of S corporation
X from January 1 through June 30, 2012. During
May, X sells an asset for a $1,000,000 gain.
On July 1, 2012, B sells his entire interest to C.
From July 1 through December 31, 2012, X
breaks even.
Is C allocated 25% of the $1,000,000 gain even
though he was not a shareholder at the time it
was generated?
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CLOSING THE BOOKS
Under the general rule, yes.
However, there are two exceptions:
Under Section 1377(a)(2), if a shareholder sells his entire interest, as B did, the S corporation can elect to “close the books” on the transfer date.
This does NOT close the S corporation’s tax year. It is just a hypothetical close so an interim income can be
computed and allocated only to the shareholders based on their pre-sale ownership percentages.
In the example above, A and B would split the $1,000,000 gain 50/50 and C would not be allocated any of the gain, since he was not a shareholder.
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CLOSING THE BOOKS
Little known fact: Regulations at
Section 1.1368-1(g) allow for a
closing of the books if a shareholder
disposes of 20% or more of the
corporation’s (not the shareholder’s)
stock during a 30-day period.
For either “close the books” election,
an affirmative election must be made.
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DISTRIBUTIONS
Do S corporation distributions also
have to be made on a strict
per-share/per-day basis?
General rule, yes, but there is more
flexibility than people realize.
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ONE CLASS OF STOCK REQUIREMENT
Often an area of confusion
In general, S corporations MUST allocate distributions on a per-share/per-day basis. If not, the corporation may have two classes of stock which would terminate the S election.
Differences in voting rights not a problem.
The stock must offer the same distribution and liquidation rights based on the governing provisions.
Key Point: as long as the stock has the same distribution and liquidation rights, the occasional disproportionate distributions can be made. They should be corrected ASAP, however.
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SECOND CLASS OF STOCK
EXAMPLE
A calendar year S corporation has two equal shareholders—Art and Bill. Bill sells 50% of his stock to Carl on January 1, 2012.
The corporation's income for 2011 is $60,000, which is allocated $30,000 to Art and $30,000 to Bill.
Because of the abnormally slow collection of its receivables, the corporation delays distributing its net income until January 20, 2012.
This is unfair from Bill's perspective, because he must report $30,000 of income on his 2011 return but will receive a distribution on January 20 of only $15,000 because he is a 25% shareholder on the date of the distribution.
The regulations solve this problem by allowing the corporation to make
distributions based on the shareholders' varying interests in the corporation during the current year or the immediately preceding tax year. Therefore, if the distribution on January 20, 2012, is based on the preceding year's stock
ownership (2011 under the facts of this example), Bill and Art can each receive a distribution of $30,000.
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WHAT TYPES OF FORM 1120S’
ARE LIKELY TO BE AUDITED?
See Line 7 on page 1 of Form 1120S and
Line 16(d) on Schedule K
No compensation and lots of
distributions or increase in loan
accounts.
See Schedule B of Form 1120S, Line 8
Did a C corporation make an S election
(BIG tax)?
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WHEN A FORM 1120S IS SELECTED FOR AUDIT, THE
IRS WILL RECONCILE THE FOLLOWING ITEMS:
Book income to the corporate tax return
Current year retained earnings
Current year retained earnings, AAA & OAA
change
K-1s to Schedule K
AAA equals retained earnings & S
corporation was once C corporation - Why?
Fixed assets & accumulated depreciation
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ISSUE AUDIT ISSUE
1 Losses claimed in excess of stock and debt basis (Proof) - § 1366(d) 2 Losses claimed in excess of the at-risk rules
3 Losses claimed in excess of passive activity loss rules (IRS) - § 469 4 Taxable gain on loan repayments to shareholders - § 1271
5 Loans to shareholder with loans from shareholder(economic outlay doctrine = Poorer) -
See Kerzner
, T.C. Memo 2009-76)FORM 1120S AUDIT ISSUES INCLUDE:
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ISSUE AUDIT ISSUE
6 Taxable distributions (
see
§ 1368) - L.16(d) - See § 301 No E&P With E&P - See L.17(c) Capital gain
Tax return reporting
Distributions with debt basis
7 Built-in gains tax on sale of assets and inventory (§1374) 8 S corporation taxes:
12 LLC and S corporation
LIFO reserve recapture tax - § 1363(d)
Tax on excessive net passive investment income - § 1375 Recapture of prior year business credits - § 1371(d)
FORM 1120S AUDIT ISSUES INCLUDE:
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ISSUE AUDIT ISSUE
9 Officer compensation vs. distribution Inadequate compensation - Too little Excessive compensation - Too much 10 Fringe benefits - § 1372
11 Accrued expenses to shareholder (
see
§ 267(e) & § 267(a)(2)) 12 LLC and S corporation LLC: An S corporation shareholder? LLC: An S corporation?
S corporation convert to LLC – tax free?
S corporation transfer assets tax free in exchange for LLC interest?