Module 10 S Corporation/Corporation Study Guide Introduction

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1 Module 10 Study Guide Introduction Running your own business presents many challenges. One of the most difficult is complying with complex and ever-changing tax laws. This small-business tax education program is designed to help you meet this challenge. You will learn about several areas in which your responsibilities as a small-business person are especially complicated. Here you will find a variety of simple checklists and guidelines to help you. These materials put you in the role of a student: either in a classroom setting with the help of an instructor, or on your own -using the materials themselves as your guide and resource. In either case, you will have the chance to select information that directly relates to the challenges you face. There are probably some sections of the program that don't apply to your unique situation. You can ignore these sections or save them for later reference. This means that the small-business tax education program is individualized: it is designed to give you just the information you need. Your small-business tax education materials consist of a study guide and a workbook. The study guide for each module contains a short section called"tax Whys" that explains how that module might fit your needs; a statement of objectives; a lesson covering the tax topic; at least one case study; and a list of key terms. At many points within the study guide, you will be referred to the workbook for an exercise or a case study that will let you "try out" what you have learned. Each workbook contains practice exercises, case studies, multiple choice assessments, and the solutions for all of these. The workbook is designed to be used as you work through the exercises and case studies. The study guide, on the other hand, can be kept for reference. Modules are available to cover the following small-business tax topics: Information for all Businesses 1. Business Assets: Depreciation and Selling Depreciated Property 2. Business Use of the Home 3. Employment Taxes 4. Excise Taxes 5. Starting a Business/Recordkeeping 6. Schedule C and SE, and Form 1040-ES Study Guide 1

2 7. Self-Employed Retirement Plans 8. The Small Business as a Partnership 9. Tip Reporting and Allocation Rules 10. There may be other areas that present special tax-related challenges in your situation. In some cases, a professional tax preparer may be your best source of help. Additional help is available from the IRS's Toll-Free Telephone Tax Assistance at Forms and publications can be ordered by calling (Publication 910, Guide to Free Tax Services, contains a brief description of other types of assistance and can be ordered by calling this number.) Taxpayers who have been unable to resolve their problems through normal channels can be referred to the IRS Problem Resolution Program; call the above Tax Assistance number or write to your local IRS District Director and ask for Problem Resolution assistance. Tax Whys As you learned in Module Five, the form of business you select is one of the first and most important business decisions you will make. In Module Ten, you will learn more details about the corporate form of business. S corporations will be covered in depth. Business owners choose the corporate form of business because it offers limited liability, continuity when shareholders die, ease of transfer of ownership, professional management, and the ability to raise large amounts of money for business use. There are, however, disadvantages to the corporate form of business. For example, corporate income is subject to double taxation, both at the corporate and shareholder levels. Also, corporations have higher legal costs and are subject to heavy regulation. Small corporations may retain the advantages of the corporate form of business while eliminating the disadvantage of double taxation by electing S corporation status. Usually, S corporation income is taxed at the shareholder level only. The S corporation form of business has increased in popularity as a result of the 1986 tax law changes. Now corporate tax rates are higher than individual tax rates. Thus, many business owners believe it is to their advantage to elect S corporation status and pay tax on their business income just once at the lower individual tax rate. Study Guide 2

3 In contrast, regular corporations pay corporate tax (a higher rate) on the business income. Furthermore, regular corporation shareholders pay individual tax on the aftertax profits that the business pays out in the form of dividends. Form 1120S is the tax return for S corporations. This return reports corporation income or loss as well as separately stated items. All of this information is reported to the shareholder on a Schedule K-1 (Form 1120S). A thorough reading of Module Ten will give you an understanding of the tax issues relating to S corporations. You will learn more about the information required to complete an S corporation return. It is important to note, however, the special situations and exceptions regarding S corporations and this module discussed on the next page. Special Situations In general, preparing an S corporation tax return is not complex. However, if any of the situations described below apply to your S corporation, you will need information that is NOT provided in this study guide in order to complete your S corporation tax return. * Your regular corporation made profits and then elected S corporation status. * Your regular corporation claimed the investment tax credit and then elected S corporation status. * Your regular corporation converted to an S corporation after * The S corporation election was made before 1987 and taxable income is more than $25,000 and the corporate net long-term capital gain minus short-term capital loss is $25,000 or more and the corporate net long-term capital gain minus short-term capital loss is more than half of the corporation's taxable income. * Your regular corporation used the LIFO inventory pricing method and elected S corporation status after December 17, Exceptions Module Ten does not cover the following topics: * distributions when the S corporation has earnings and profits * tax on excess net passive investment income * capital gains tax * tax on built-in gains Study Guide 3

4 * tax on recomputing a prior-year investment credit * LIFO recapture tax * estimated tax payments * S corporation required payments or tax payments Objectives At the end of this lesson, you will be able to: 1. Explain the advantages of S corporations. 2. List the requirements for S corporation status. 3. Explain how and when to make the S corporation election. 4. Determine if your situation requires professional assistance. 5. List the due date and penalties for Form 1120S. 6. Compute S corporation loss limitations. 7. Explain S corporation recordkeeping requirements. Lesson About Corporations A corporation is an artificial "being" created by law. When forming a corporation, the owners transfer money, property, or services to the corporation in exchange for shares of stock. The shares of stock represent ownership in the corporation. Each owner is referred to as a shareholder. The managers of a corporation may or may not be shareholders. The shareholders vote to elect a board of directors consisting of either high-ranking employees of the corporation or outside businesspersons. The board's job is to direct corporate affairs, make corporate policies, and hire a president for the corporation, who is called the chief executive officer (CEO). The CEO is responsible for managing the daily operations of the corporation and carrying out the policies established by the board of directors. Corporations can be classified as: * regular corporations, sometimes referred to as C corporations, or * S corporations Study Guide 4

5 REGULAR CORPORATIONS The profits of a regular corporation are taxed at the corporate level as well as at the individual level. Each year a regular corporation must file Form 1120, U.S. Corporation Income Tax Return, and pay tax on the corporation's income. Any profits left after the taxes have been paid may be given to shareholders in the form of dividends. The shareholders pay income tax on the dividends received. EXAMPLE Double Taxation The Heritage Corporation paid tax on its net income of $5,000. Of the income left after taxes, dividends of $2,000 were paid to the shareholders. Pat Seray, owner of 50 percent of the outstanding stock, received one half of the dividends, or $1,000. She paid tax on the $1,000 dividend, which had already been taxed at the corporate level. Advantages of a regular corporation are: * the stockholders have limited liability * the business continues to exist after the death of an owner * the transfer of ownership is easily done by the sale of stock * corporations are able to raise large sums of money for business use * the corporation can hire professional managers to oversee operations Disadvantages of a regular corporation are: * the corporation is subject to double taxation * the costs to organize a corporation are higher than any other form of business * corporations are heavily regulated through state and local laws For more information on regular corporations, see Publication 542, Tax Information on Corporations. S CORPORATIONS An S corporation is a small-business corporation. S corporation income is taxed only once, at the shareholder level. S corporations file tax returns but usually do not pay tax Study Guide 5

6 on the net income. Instead, the income and expenses of the corporation are divided among its shareholders, who report them on their individual tax returns. EXAMPLE S Corporations If the Heritage Corporation had elected S corporation status, it would not pay tax on the net income of $5,000. Pat Seray, however, would report one half of the net income on her personal tax return. She would pay tax on $2,500 regardless of the amount of income distributed to her. Advantages of an S corporation are: * income is taxed only once, at the shareholder level * the shareholders have limited liability * the transfer of ownership is easily done by selling shares of stock * the business continues to exist even after a change in ownership * S corporations may be able to raise large sums of money for business use Disadvantages of an S corporation are: * the start-up costs are higher than those of a sole proprietorship or partnership * corporations are regulated by state and local laws * the corporation must meet the S corporation requirements for the entire year A corporation wishing to elect S corporation status must meet the following requirements: * the business must be a United States corporation * the shareholders must be United States residents or citizens (Nonresident aliens cannot be shareholders) * there cannot be more than 75 shareholders (for this rule, husbands and wives count as one shareholder even if they own the stock separately) * the corporation can have only one class of stock * stock in the S corporation cannot be sold to another corporation or partnership * all shareholders must consent to the election To elect S corporation status, Form 2553, Election by a Small Business Corporation, must be filed on or before the 15th day of the third month of the tax year. If filed after Study Guide 6

7 that date, the election applies for the next tax year, unless the corporation can show that the failure to file on time is due to reasonable cause. The Internal Revenue Service (IRS) will notify the corporation whether or not the S corporation election is accepted. An S corporation does not need IRS approval to choose a December 31st year end. To request a year end other than December 31st, the electing S corporation should complete Part II of Form EXAMPLE S Corporation Election The Heritage Corporation chooses a December 31st year end. Form 2553 was filed on April 15, The IRS accepted the election. S corporation status is effective for 1995 because the election was made after March 15, 1994, the 15th day of the third month of the tax year. Heritage does not require IRS approval to select a December 31st year end. Estimated Tax Payments If an S corporation's tax liability for net recognized built-in gain, excess net passive income, and recapture of investment credit total $500 or more, the S corporation must pay quarterly estimated tax payments. Generally, the quarterly estimated tax payments must equal 25% of the required annual estimated tax. The amount of estimated tax that must be paid annually is the lesser of: % of the tax shown on the return for the tax year (or, if no return is filed, 100% of the tax for that year), or 2. The sum of - 100% of the investment credit recapture and the tax on net recognized built-in gain, (or the tax on certain capital gains) shown on the tax return for the year, (or if no return is filed, 100% of the tax for that year), and 100% of any tax on excess net passive income shown on the corporation's return for the preceding tax year. If the preceding tax year was less than 12 months, the amount of the required annual estimated tax must be determined under A. above. Study Guide 7

8 Reporting S Corporation Income In general, S corporations do not pay federal income tax; S corporation shareholders do. The S corporation return provides information for shareholders to use in reporting their share of the S corporation income on their individual returns. THE S CORPORATION RETURN Form 1120S, U.S. Income Tax Return for an S Corporation, is a four-page return. It shows the S corporation income and expense items and computes ordinary income or loss for the S corporation. It also shows separately stated items. Schedule K, Shareholders' Shares of Income, Credits, Deductions, etc., is part of Form 1120S. Schedule K shows the S corporation's income or loss as well as separately stated items. It shows the total amount of all items to be reported to the shareholders by the S corporation. Schedule K-1 (Form 1120S), Shareholder's Share of Income, Credits, Deductions, etc., is attached to Form 1120S for each shareholder. Also, all shareholders receive a copy of their Schedule K-1. The Schedule K-1 shows each shareholder's portion of the S corporation's income. In addition, it shows the shareholder's portion of other income, deductions, and credits. The shareholders transfer the figures from Schedule K-1 to their individual income tax returns. When all the (shareholder) Schedule K-1 individual lines are added together, they should total the corresponding line amount on (the corporate) Schedule K. This indicates that all the S corporation items of income, deduction, and credit have been reported to the shareholders. S CORPORATION INCOME OR LOSS AND SEPARATELY STATED ITEMS Most business income and expense items are combined to arrive at S corporation income or loss from trade or business activities. This amount is divided among the shareholders according to each shareholder's percentage of ownership of the S corporation for the year. Distributions from an S corporation are not taxable to the shareholder. Some S corporation items, called separately stated items, are not included in S corporation net income. Separately stated items receive special treatment on the Study Guide 8

9 shareholder's individual return. Therefore, Schedule K-1 shows these items separately. Some separately stated items are: * interest, dividend, or royalty income * net income or loss from rental real estate activities * net income or loss from other rental activity * gains and losses from disposal of property * charitable contributions * investment interest expense * tax credits * certain tax preference items An S corporation may deduct health and accident insurance premiums paid on behalf of its shareholder-employee, spouse, and dependents. Generally, the cost of these premiums is not included in the shareholder-employee's gross income. However, the cost is included in the gross income of a shareholder-employee who, on any day during the corporation's tax year, holds more than 2% of the corporation's outstanding stock or combined voting power. For 1995 and 1996, a more than 2% shareholder may be allowed to deduct up to 30% of such amounts on Form The percentage is increased to 40% for 1997 and 45% for DUE DATE AND PENALTIES Form 1120S is due on the 15th day of the third month following the year end. For example, if the year end is December 31st, the return is due on March 15. You may have difficulty in gathering the records to complete Form 1120S. If so, you may request a six-month extension to file Form 1120S by submitting Form 7004, Application for Automatic Extension of Time To File Corporation Income Tax Return. Form 7004 is due by the regular due date of Form 1120S. It is important that you file Form 1120S with the IRS by the due date. If the return is late (including extensions), the S corporation may be subject to a late filing penalty. Also, there is a penalty for failing to give each shareholder a Schedule K-1. This penalty is $50 for each missing, incomplete or incorrect Schedule K-1. If the S corporation can show reasonable cause for failing to meet the requirements, the above penalties may be waived. Complete Fill in the Blank on workbook page 2. Study Guide 9

10 Loss Limitations Schedule K-1, line 1, may show an ordinary loss from trade or business activities. In addition, there may be separately stated deductions and credits. In certain circumstances, you may not deduct the loss and deductions or use the credits. ADJUSTED BASIS Generally, you may not deduct a loss that exceeds your adjusted basis in the corporation's stock and any debt the corporation owes you. Your adjusted basis represents your investment in the S corporation. Your adjusted basis in corporate stock is increased by: * your share of corporation income items, including tax-exempt income, that are separately stated * your share of nonseparately stated income items * your share of the excess of corporation's deduction for depletion once the basis of the property subject to depletion has been recovered Your adjusted basis in corporate stock is decreased by: * your share of nonseparately stated loss * your share of separately stated loss and deductions * distributions not included in the shareholder's income * any expense of the S corporation that is not deductible in figuring taxable income and not properly chargeable to capital account, and * your share of the deduction for depletion of oil and gas property held by the S corporation that does not exceed your share of the adjusted basis of the property There are special basis rules if you make a direct loan to the corporation. EXAMPLE Adjusted Basis Edwin Humphrey's adjusted basis in Valve Co. at December 31, 1994, is $23,828. Study Guide 10

11 Initial investment $15,000 Plus Share of S corporation income 8,941 Share of separately stated interest 412 Less Share of separately stated contribution (25) Distribution (not included in income) (500) Adjusted basis, 12/31/94 $23,828 AT-RISK LIMITATION In addition to the adjusted basis restriction, your loss deduction will be limited to your at-risk amount. You are considered at risk for your: * cash contributions and adjusted basis of other property you make to the S corporation * debt incurred for use in corporation activities that you are personally liable to repay At-risk rules are applied on an activity basis and apply to most activities. However, real estate activities are not subject to at-risk rules if placed in service (ready for use) before If you acquired your S corporation share after 1986, however, at-risk rules apply to real property (land and buildings) no matter when placed in service. For more information on what constitutes an activity, see IRS Publication 925, Passive Activity and At-Risk Rules. PASSIVE ACTIVITY LOSSES If you have losses that come from a passive activity, you may not be able to deduct them. Subject to phase-in rules, passive losses may only be deducted against income from passive activities. A passive activity is one in which you do not materially participate. Material participation means regular, continuous, and substantial involvement in the activity. By definition, all rental activity, regardless of your participation, is passive. However, a special allowance for rental real estate activities with active participation may allow some losses if losses exceed passive income. See IRS Publication 925. Study Guide 11

12 To compute how much, if any, of the passive loss is deductible, complete Form 8582, Passive Activity Loss Limitations. The passive loss limitation is applied after the atrisk limitation. Recordkeeping Like any other business, an S corporation must maintain adequate records. The records verify the amount of gross income, deductions, credits, and other items shown on the tax return. Your S corporation records must be kept as long as necessary to support the amounts on Form 1120S. The minimum time is three years after the return is filed. It is important to keep your corporation and personal records separate. You should set up a separate checking account for your business. Do not pay any personal expenses for the shareholders from the corporate account. When your corporation borrows money, make sure the proceeds are properly identified. For more information on recordkeeping, see IRS Publication 583, Starting a Business and Keeping Records, and Module Five. Key Terms Adjusted basis of an S corporation- The adjusted basis of an S corporation represents the shareholder's investment in the S corporation. Adjusted basis is increased by investments, the shareholder's share of corporation income and separately stated income, and shareholder loans made directly to the corporation. Adjusted basis is decreased by the shareholder's share of corporation loss and separately stated deductions or loss, and distributions to the shareholders. At-risk- The at-risk amount is the amount of corporation debt that a shareholder is personally liable to repay. Shareholders are considered at risk for investments in the S corporation, income retained by the S corporation, and direct loans by the shareholder to the corporation. Board of directors- The board of directors is an elected group of people who determine corporate policy and select the CEO. Study Guide 12

13 C corporation- A regular corporation sometimes is called a C corporation. See regular corporation for more information. Chief executive officer- The chief executive officer (CEO) is responsible for managing the dayto-day activities of a corporation and carrying out the policies set by the board of directors. Corporation- Dividends- Form Form 1120S- Inventory- A corporation is an artificial "being" created by law. Corporations may be classified as regular or S corporations. The after-tax profits of a regular corporation that are distributed to the shareholders. Form 1120, U.S. Corporation Income Tax Return, is the tax return filed by all regular corporations. Form 1120S, U.S. Income Tax Return for an S Corporation, is a fourpage return that shows the corporation's income or loss and separately stated items. Inventory is the goods held for resale in the normal course of business. Material participation- Material participation is regular, continuous, and substantial involvement in the activity. Passive activity- A passive activity is one in which you do not materially participate. Rental activities are passive by definition. Regular corporation- A regular corporation pays income tax on its taxable income. In addition, any profits distributed to the corporation shareholders, in the form of dividends, are taxed again on the shareholders' tax returns. Study Guide 13

14 S corporation- Schedule K- Schedule K-1- An S corporation is a small-business corporation. In general, an S corporation does not pay tax at the corporate level. An S corporation is taxed only once, at the shareholder level. Schedule K, Shareholders' Shares of Income, Credits, Deductions, etc., is part of Form 1120S. It shows the corporation's income or loss and separately stated items. Schedule K-1 (Form 1120S), Shareholder's Share of Income, Credits, Deductions, etc., is attached to Form 1120S. It shows each shareholder's share of the S corporation's income or loss and separately stated items. Separately stated items- Separately stated items are not combined with S corporation income and deductions. These items receive special treatment on the shareholder's individual return. Therefore, they are shown separately on Schedule K-1 (Form 1120S). Shareholder- Stock- Tax shelter- A shareholder is an owner of a corporation. Common stock or shares of stock represent ownership in a corporation. A tax shelter is an investment that offers large tax losses. An S corporation qualifies as a tax shelter if the investment is subject to federal or state securities regulations or federal or state notice requirements or if the total amount of the investment offered exceeds $250,000 and there will be at least five shareholders and an investor can expect a tax loss greater than twice the investment amount in any of the first five years. Tax shelters must be registered using Form Study Guide 14

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