Chapter 11 - S Corporations I. General Characteristics and Considerations A. S corporations are largely taxreporting rather than tax-paying enterprises. 1.

Taxable income flows through to shareholders regardless of whether there are distributions. 2. Each shareholder gets a pro-rata share of S Corporation income and losses based on the prorated number of days during the S Corp. year that the shareholder held the stock. 3. S Corporations are generally not subject to corporate income taxes. 4. S Corporations may be subject to a pre-election built-in gains tax, excessive passive investment income tax, and LIFO recapture tax.

B. S Corporation status is elective. Compliance with applicable code requirements is required.

II. Qualification for S Corporation Status A. Domestic Corporation. B. Not a bank (limited exceptions exist), insurance company, Possessions Corporation, or DISC.
C.

100 or fewer shareholders (with husband and wife treated as one shareholder).

D. Beginning in 2005, family units may elect to be treated as a single shareholder. E. Shareholders must be individuals, estates, certain trusts (including electing small business trust), charitable organizations, pension trusts, and employee stock ownership plans. F. No nonresident alien shareholders.

G. The S Corporation may own stock of a Corporation.

H.

Only one class of stock may be issued

1. Voting and nonvoting common stock are allowed. 2. Straight debt that meets certain conditions is allowed.

III.

Making the Election

A. The election is made with Form 2553 and all shareholders must sign and consent to the election (including spouses in a community property State). B. To be effective for the current tax year the election must be made on or before the 15th day of the 3rd month of the current year. C. For a newly created corporation, the two and one-half month election period begins at the earlier of when the corp. has shareholders, acquires assets, or begins doing business. D. Under current law the IRS may accept late elections if there is a reasonable cause. E. Elections made after the first two months and 15 days of the current tax year are effective for the following tax year.

F. Eligibility requirements must be met for the entire taxable year. G. All shareholders for the entire taxable year, even those that are no longer shareholders on the election date, must consent to the election.

IV. Loss of the Election A. Any of the above eligibility requirements are no longer met. B. A new shareholder owning more than one-half of the stock affirmatively refuses to consent to the election. C. Shareholders owning a majority of shares voluntarily revoke the election. D. For S Corporations with accumulated E&P from prior C Corporation years, the corporation has passive investment income > 25 percent of gross receipts for 3 consecutive tax years. E. If the termination is inadvertent, the corporation can request relief by applying to the IRS National Office and paying a user fee for a letter ruling. V. Reelection after Termination A. The general rule is that after an election has terminated five

years must pass before a new Corporation election can be made.

B. The five-year waiting period may be waived under certain circumstances.

VI. Operational Rules A. Tax Year generally conforms to the tax year of the shareholders (e.g., a calendar year). B. The ordinary income (loss) computation is similar to that of a partnership. A primary difference is that gains (but not losses) are recognized on distributions of property to shareholders. C. As compared to C Corporation taxable income: 1. No dividends received deduction. 2. No charitable contribution limit. D. Each shareholder is allocated a prorata portion of ordinary income (losses) and separately stated items. No special allocations are allowed. E. Allocation Methods 1. An equal amount of each S item is assigned to each day of the year. Shareholder allocations are then

based on per-day stock ownership. 2. If a shareholder's interest is completely terminated during the tax year, an election may be made to "close the books" on the date of termination.

VII. Tax Treatment of Distributions to Shareholders A. The distribution amount equals cash plus FMV of property distributed. B. One of two sets of distribution rules apply, depending on whether the S Corporation has accumulated E&P from C Corporation years. C. No Accumulated E&P: 1. Distributions extent of 2. Distributions trigger a are nontaxable to the adjusted basis in stock. in excess of stock basis gain (usually capital).

D. With Accumulated E&P (AEP), distributions are treated as follows: 1. Tax-free distribution of accumulated adjustments account (AAA). 2. Ordinary dividend to extent of AEP. 3. Return of capital for remaining stock basis. 4. Capital gain for excess over stock basis. Note: Distributions under (1) reduce stock

basis and are only tax-free to the extent of stock basis.

E. Features of the AAA: 1. The AAA is essentially the cumulative total of undistributed net income items for S Corporation tax years beginning after 1982. 2. The AAA is adjusted similar to shareholder's stock basis except no adjustment for tax-exempt income and related expenses, and no increase for shareholder contributions. 3. The AAA can not go negative from distributions. F. An AAA bypass election is available to pay out AEP before reducing the AAA. G. Property distributions trigger recognized gains, but not losses. Loss properties should not be distributed because there is no recognized loss and the shareholders basis equals the lower FMV. VIII. Shareholder Stock Basis

A. Acquisition basis is calculated similar to basis in C Corporation stock. B. Subsequent adjustments are similar to partnership basis adjustments, except that S Corporation shareholders generally do not receive basis for corporate borrowings other than direct loans made by the shareholder to the corporation.

IX. Treatment of Losses A. NOLs are allocated on a daily basis. B. Once a shareholder's adjusted stock basis has been eliminated by an NOL, any excess NOL is used to reduce the shareholder's basis for loans made to the corporation. C. NOLs from C Corporation years cannot be utilized, but C Corporation carryover period continues to run during S Corporation years. D. Unused losses are carried forward. If the S election terminates, loss carryovers can be used to the extent of stock basis. E. At-risk and passive loss rules also limit deductibility of losses. X. Tax on Preelection Built-In Gains A. For a C Corporation converting to S status, a corporate-level tax is imposed on built-in gains when the S Corporation disposes of an asset in a

taxable transaction within ten calendar years. B. All gains are presumed built-in unless proved that asset not held on date of conversion or that the gain had not accrued at the date of the S election.

C. The tax is the highest corporate tax rate applied to the lesser of the recognized built-in gain or the amount that would be taxable income in that year if it were a C Corporation. D. Any built-in gain that escapes taxation due to the taxable income limitation is carried forward. E. C Corporation NOL carryovers and capital loss carryovers can be used to offset built-in gains.

XI. LIFO Recapture Tax A. Required upon S Corporation election. B. Income results to C Corporation for amount that FIFO inventory would exceed LIFO inventory.

XII. Passive Investment Income Penalty Tax A. Tax imposed on excess passive income of S Corporations that possess accumulated earnings and profits from C Corporation years.

B. Tax rate equals highest corporate tax rate. C. Three consecutive years of excess passive investment income terminates S election.

XIII. Shareholder-Employees A. Fringe benefits for shareholderemployees owning more than 2 percent of S Corporation stock are generally taxed to the shareholder as compensation. B. A shareholder's portion of S Corporation income is not classified as self-employment income.