SUBCHAPTER S CORPORATIONS Unless otherwise noted, these notes are based on Froth, Edward C. 2010. CCH Federal Tax Study

1. SUBCHAPTER S CORPORATIONSUnless otherwise noted, these notes are based on Froth, Edward C. 2010. CCH Federal Tax Study ManualChapter 21 Rutgers University School of Business Camden David E. Vance, MBA, CPA, JD 1

2. Sub-Chapter S Corporations 1. Sub-Chapter S Corporations generally pay no tax. Income, losses, deductions, credits, and so forth are passed through to shareholders and become part of shareholders income. 2. A �small� business may elect Sub-Chapter S treatment. All other corporations are C Corporations, subject to tax provisions previously discussed. 3. An S-Corp may own any percentage of stock in a C-corp. and may own 100% of a Qualified Subchapter S Subsidiary (see qualifications for S-corp. election.) 4. An S-corp. may NOT file a consolidated return with a C-corp. 2

3. 5. Eligibility for Sub-Chapter S status Domestic corporation One class of stock outstanding (voting and non-voting stock will not destroy the one class designation.) Shareholders must be individuals, trusts created by will (for 2 yrs), an certain other trusts. No non-resident alien shareholders Number of shareholders limited to 100 a) husband and wife are counted as one shareholder, b) each beneficiary of a trust is considered a shareholder, c) all members of a family may be treated as one shareholder. 6. An S-corp. election made on or before the 15th day of the third month of the year it is to be effective, otherwise it is considered effective for the following tax year. 7. All shareholders must consent to the S-corp. election. 3

4. 8. A valid election is valid for all subsequent years until revoked or destroyed by violating one of the conditions for an S-corp. The IRS may elect to overlook technical violations. 9. LIFO recapture � If a C-corp. using LIFO basis for valuing inventory, elects to be treated as an S-corp. it must recapture as income the value of inventory stated on a FIFO basis. One quarter of the recapture is due when the corp. files its last C-corp. tax return. The remainging recapture may be spread over three years of S-corp. returns. 10. Taxable Year � An S-corp. must generally file on a calendar year unless it can show that the �natural year� for the business is something different. This can be shown if 25% of income occurs within the last three months of a twelve month year. 11. An S-corp. must file a Form 1120 within 3 months, 15 days of yr. end. 4

5. 12. S-Corp. Election may be terminated by: a. Shareholder holding more than 50% of stock consent to revocation, b. An election to terminate made by the 15th day of the third month is effective from the first day of the tax year. Later elections to terminate are effective for following years. c. The S-corp. ceases to qualify. The termination is effective on the date the S-corp. fails to qualify. In that event, the corporation must file a short S-corp. year return and a short C-corp. year return. Items of income and loss are allocated to the short year based on the number of days in the short year. d. Passive income exceeding 25% of gross receipts for 3 consecutive years may cause termination if the S-corp. has C-corp. earnings and profits. 13. Once terminated, an S-corp. election can only be made again after five non-S-corp. years. 5

6. 14. An S-corp. generally pays for no gain or loss. However, it must pay for built in gains and taxes on excessive passive income. 15. A C-corp. which elects to become an S-corp. may have a built in gain to the extent that the FMV of assets at the conversion exceeds the basis of assets in the hands of the C-corp. AND the gain is recognized within ten years after the S-corp. election. For S-corp. elections made in 2009 and 2010 the period is seven years. A corp. that was never a C-corp. is exempt from this provision. 16. Built-in gain is not recognized on property acquired after the S-corp. election. 17. If the built-in gain is partly the result of pre-S-corp. holding and partly the result of post-S-corp. holding, only the gain pre-S-corp. election is taxable. 6

7. 18. Passive Income Tax � An S-corp. may have passive income tax if its passive income is > 25% of income AND it has C-corp. earnings and profits. (Since an S-corp. can own shares in a C-corp., the C-corp. earnings and profits test would seem to be fairly easy to meet.) 19. The Passive Income Tax is the lesser of 35% of Excess Net Passive Income (ENPI) OR net income. ENPI = Net Passive Income x Passive Income >25% Gross Receipts Total Passive Income The tax paid reduces the total passive income passed through to investors. 20. An S-corp. election will not trigger recapture of business tax credits, unless, property is disposed of prior to the time indicated in a particular tax credit. (There are so many credits with their own rules, each must be analyzed individually. 7

8. 21. An S-corp. must make estimated tax payments for built-in gain, excessive passive income tax and business tax credit recapture. 22. An S-corp. distributing appreciated property to its shareholders must recognize gain on the distribution as though the property were sold to the distributee at FMV. 23. When a shareholder in an S-corp. terminates his or her interest, ordinary income or loss, passive income or loss, capital gain or loss, tax exempt income, expenses and credits are allocated on a per-share per-day basis. Items are allocated based on the shareholder�s stock, not debt. (Recall the basis of stock may include debt assumed.) 24. Losses are limited to capital at risk (the basis of stock plus debt.) The excess of losses over basis plus debt can be carried forward indefinitely until there is sufficient basis to absorb it. 8

9. 25. Passive activity loss limitations apply to passive losses passed through from an S-corp. to individuals. (Passive activity losses are generated by businesses in which an �individual� does not actively participate, or rental activity. Here the �individual� would seem to be the S-corp.) 26. A shareholder�s basis in S-corp. stock is adjusted as follows: + All income (including tax exempt income) Distributions Non-deductible, non-capital expenses (ex. 50% of business meals, expenses to produce non-taxable income, etc.) Deductible expenses and losses. Example: An S-corp. shareholder purchased stock for $20,000, her share of income was $5,000; non-deductible, non-capital losses were $1,000, and deductible expenses and losses were $2,000. Shareholder�s Basis is $22,000 ($20,000+$5,000-$1,000-$2,000) 9

10. 27. Distributions to shareholders are generally NOT taxable to the extent of Accumulated Adjustments Account (AAA) and are applied to reduce AAA and stock basis. 28. The AAA is the sum of income, expenses and losses not previously distributed to shareholders. AAA may be negative. Generally, AAA is increased by income and decreased by expenses. However, no adjustments are made for Tax Exempt income and related expenses. These accumulate in an Other Adjustments Account (OAA). 29. Distributions from AAA that exceed stock basis are treated as capital gain. 30. Distributions in excess of AAA are treated as dividends to the extent of accumulated Earnings and Profits (AE&P), which are Earnings and Profits accumulated when the company was a C-corp. and never taxes to shareholders. 10

11. 31. Distributions are next NON-taxable to the extent of the remaining stock basis and are used to reduce OAA and paid-in capital. 32. Distributions in excess of stock basis are generally treated as capital gains. 33. Fringe benefits for a more than 2% shareholder are treated by an expense to the S-corp. and treated as W-2 wage income to the employee. 34. Amounts paid for health insurance for a more than 2% employee may be 100% deducted in the computation of AGI. 11

12. THE ENDSub-Chapter S CorporationsChapter 21 Rutgers University School of Business Camden David E. Vance, MBA, CPA, JD 12