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S Corp vs. Partnership S Corporation 1.

inflexible Partnerships

1. flexible 2. basis includes share of all 2. basis does not include share of liabilities liabilities 3. may pay tax 3. does not pay tax 4. liquidation is costly (regular corp. rules apply) 4. liquidation is tax free 5. no special allocations 5. special allocations are possible 6. losses are deductible to the extent of basis in stock 6. losses are deductible to the extent and loans to corp. of basis Qualification for S Status Definition of small business corporation

Shareholders are all: Individuals Estates, or Certain trusts and tax-exempt organizations Less than or equal to 100 shareholders H & W treated as one shareholder and an election can be made to treat all family members as a single shareholder One class of stock different voting rights o.k. Only eligible corps. No nonresident aliens Domestic corps only
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Making the Election All shareholders must consent both H & W must consent if stock jointly owned. 2- month deadline to be effective for current year Reasonable cause exception applies Premature election of a new corp. is ineffective The S election can be lost in a number of ways:

A new majority shareholder affirmatively refuses to consent Shareholders owning a majority of the stock voluntarily revoke the election 2 month rule applies as to timing to be effective for the current tax year The S Corp ceases to qualify as a small business corporation Passive income limitation is exceeded (former C Corps only) Reelection after termination is possible 5 year waiting period normally applies (exceptions exist)

Income and Losses

S corp.s taxable income (No special allocations) determined in a manner that is similar to tax rules in sec. 703 that apply to partnerships. Income, losses, deductions, and credits which could affect the tax liability of any shareholder are separated, and each shareholder reports pro rata portion (daily allocation) of each item. Shareholder rendering services must be paid a reasonable salary Sec. 1366(e) Residue of nonseparately computed items is aggregated in arriving at Sec. 1366(a) (1)(B) taxable income. Even if such income is not distributed, each shareholder reports pro rata portion of this amount based upon the ownership & # of days stock held. All items retain their character as they pass through to each shareholder. For example, tax-exempt income at the corporate level will be tax-exempt income at the shareholder level. Losses may flow through, but are only deductible to the extent of shareholders stock and loan basis (loans by shareholder to corp.). Any such unused loss may be carried forward, may be deducted by the same shareholder in subsequent years as increases in basis occur (unlimited pro rata C/F of losses) Following the termination of an election, any unused loss may be deducted, deduction is limited to the stock (not loan) basis at end of such year. Loss rules, At-risk rules, and passive loss rules are applied at shareholder level (Sec. 465 & 469) In the case of the transfer of stock during the year, income or loss is allocated among the shareholders on a per share, per day basis. Carry out this allocation process using the pro rata method or the per books method. (note the impact on basis and gain in the event of sales)

Use the pro-rata method unless complete termination of shareholders interest and election to use interim closing of the books method is made.

Operational Rules Dividend Distributions:

The tax treatment of a dividend distribution depends on whether an electing corporation has accumulated earning and profits from a C tax year. A constructive pass-through of net income items for the year increases a shareholders stock basis (where there is no accumulated earnings and profits). Distributions are tax free to the extent of stock basis excess is taxed as capital gain. As for a corporation with accumulated earnings and profits, the constructive dividend increases the shareholders Accumulated adjustments account (AAA). Any future distribution of cash or property reduces the shareholders stock basis or the AAA, respectively.

AAA reflects the cumulative income and losses AAA is corporate level account, distributions from an S Corps AAA are generally not affected by stock transfers. The selling shareholders share of income and loss is generally determined using year-end totals. The seller should include a provision in the sales contract to compensate the seller for any income allocated to him or her for operations after the sale date Distributions are applied to stock basis before the basis is reduced for current year losses and deductions. Thus, a shareholder receiving a distribution no longer must wait until the close of the year to determine the tax treatment of the distribution. Following the termination of an election, any cash dividends made within an approximately one-year, post-termination period will reduce the shareholders basis (i.e. not taxable) A distribution of appreciated property results in a corporate gain which is passed through to shareholders. Shareholder has distribution and basis equal to FMV loss is not recognized (basis = FMV) Any C corporation that makes an S election after 1986 is subject to a corporatelevel tax on any built-in gains recognized during the 10-year period following the conversionNeed appraisal. Built-in gains equal gains on the corporate assets at the time of conversion to S status (all regular corp. rules apply 35% ratecan deduct NOL C/Fs) Built in gains recognized cant exceed the corp.s taxable income computed on a C corp. basis C/F of gain applies. Passive investment income penalty tax can also apply to a former C corporation (but election not lost for 3 years) Any tax applied at the corporate level reduces the amount of the income to be passed through to the shareholders S Corp is placed on the cash method for purposes of deducting related party expenses (> 50% shareholders) Several states do not recognize an S election, so the corp. may incur state corporate income tax, as well
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Stock Basis Initial Basis (cost, FMV @ DOD or DOG) + Additional purchases or contributions + Share of income (overall plus separately stated includes tax-exempt income) - Share of loss (overall plus separately stated) - Non-deductible corporate expenses - Cash or property distributions (@ FMV) not basis Comparison of Entity Characteristics




COMPANY Limited liability for Limited members even Liability if they participate in management By all members, Management unless managers appointed No maximum, Number of usually members requires at least two Restricted; requires Transferability consent of at of interests least majority of other members Different classes of Permitted interests

Limited liability Limited liability for for limited partners shareholders even if who do not Same as C corp. they participate in participate in management management

By general partner

By board of directors

By board of directors 100 maximum; no corporate or nonresident-alien shareholders

No maximum, requires at least two Restricted unless authorized by partnership agreement

No maximum

No restriction

No restriction, but see above



Only one class of stock permitted

Federal Income None at LLC None at Tax level partnership level State Income Tax Usually none None at at LLC level partnership level

35% on corporation plus tax on Usually no distributions to corporate-level tax shareholders Usually a corporate-Usually no level tax corporate-level tax