1120-S S Corp Return Preparation Tips. Presented by Tony Nitti, CPA, MT National Tax Services Group

Transcription

1 S S Corp Return Preparation Tips Presented by Tony Nitti, CPA, MT National Tax Services Group

2 A QUICK PRIMER 1 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 distribution is generally tax free.

3 A QUICK PRIMER 2 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.

4 PAGE 1, BOX A: WHAT CAN WE LEARN? 3 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.

5 ELIGIBILITY 4 1.Qualification 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 3.Must have only one class of stock

6 INELIGIBLE SHAREHOLDERS 5 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)

7 PAGE 1, BOX A: MAKING THE ELECTION 6 Form 2553 Due dates: 1. Newly formed corporation: 15 th day of 3 rd 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 15 th of a month. Ex: S Co. is incorporated on March 9, S Co. has until May 24, 2014 to make an S election effective for If the election is made after that date but during 2014, it will be effective

8 PAGE 1, BOX A: MAKING THE ELECTION 7 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 ) 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.

9 LATE ELECTIONS 8 IRS consolidated all prior late relief options during Rev. Proc superseded Rev. Procs and 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 Must have reasonable cause 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 to file its 2553 and elect S status any time before March 15, 2014.

10 LATE ELECTIONS 9 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.

11 LATE ELECTIONS 10 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.

12 COMPARE BOX A TO BOX E: WHAT CAN WE 11 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 Built-in-Gains Tax does not apply

13 COMPARE BOX A TO BOX E: WHAT CAN WE 12 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 Built-in-Gains Tax may apply

14 PAGE 1, TAX YEAR 13 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 year end, the income from through would be included in your 2013 tax return, allowing you to defer 11 months of income earned during 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 ) 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.

15 PAGE 1, LINE 7: REASONABLE COMPENSATION 14 Too high or too low? C corporations: Too high. Reduce corporate level tax. S corporations: Too low. Avoid SE tax. Revenue Ruling , S corporation flowthrough 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.

16 REASONABLE COMPENSATION 15 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.

17 REASONABLE COMPENSATION 16 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 combined $15,300 in payroll taxes.

18 REASONABLE COMPENSATION 17 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.

19 REASONABLE COMPENSATION 18 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. IRS determined that his services were worth $92K per year.

20 REASONABLE COMPENSATION 19 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 nonshareholder, 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?

21 PAGE 1: FRINGE BENEFITS AND HEALTH 20 INSURANCE PREMIUMS Revenue Ruling 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. 20

22 HEALTH INSURANCE PREMIUMS 21 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) Using the attribution rules of Section 318

23 HEALTH INSURANCE PREMIUMS 22 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.

24 BALANCE SHEET: ACCRUED LIABILITIES 23 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.

25 PAGE 2: SCHEDULE B, BOX 1 24 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 (gross receipts less than $1M) RP (gross receipts less than $10M) These two are automatic changes from accrual cash.

26 SCHEDULE B, LINE 4A: OWNERSHIP OF SUBSIDIARIES 25 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.

27 OWNERSHIP OF SUBSIDIARIES 26 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. Late relief is available under RP

28 SCHEDULE B, LINE 8: BUILT-IN GAINS TAX 27 BASIC FACTS X Co. 100% INDIVIDUAL ASSETS 30% FMV $ 3,000,000 A/B 1,000,000 TAX RATE 40% A A/B $600,000 CORPORATE What result in each of the following situations?

29 C CORPORATION LIQUIDATION 28 Bb. X Company is a C corporation and liquidates in 2010 (4/21/10). X Co. A 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 x 40% x 30% Tax Liability $800,000 Tax Liability $ 480,000 TOTAL TAX - $1,280,000

30 S CORPORATION LIQUIDATION 29 Cc. X Company is an always S corporation and liquidates in X Co. A 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 x 30% $720,000

31 WHY THE BIG TAX? 30 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.

32 HOW DOES IT WORK 31 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.

33 MUST DETERMINE NUBIG 32 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.

34 COMPARISON TO C CORPORATION 33 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?

35 BIG EXAMPLE 34 BASIC FACTS X Co. 100% INDIVIDUAL ASSETS 30% FMV $ 3,000,000 A/B 1,000,000 TAX RATE 40% A A/B $600,000 CORPORATE

36 HOW DO WE COMPUTE NUBIG? 35 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).

37 STEP 1: COMPUTE NUBIG 36 FMV of assets: $3,000,000 Less: tax basis ($1,000,000) Unrealized BIG $2,000,000 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.

38 BIG EXAMPLE 37 Cc. X Company converts to S status and immediately liquidates in X Co. A 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

39 ADDITIONAL LIMITATIONS 38 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 taxable income, then no BIG!

40 QUESTION 1 BIG TAX 39 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?

41 STEP 1: DETERMINE NET UNREALIZED BUILT-IN 40 GAIN Reg. Section 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

42 STEP 2: DETERMINE RECOGNIZED BUILIT-IN 41 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.

43 STEP 2: DETERMINE RECOGNIZED BUILT-IN GAIN 42 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 $250,000.

44 QUESTION 1(B): MAXIMUM BIG 43 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 corporation.

45 STEP 2: DETERMINE RECOGNIZED BUILT-IN GAIN 44 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.

46 STEP 2: DETERMINE RECOGNIZED BUILT-IN GAIN 45 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, Or taxable income of $400,000 Thus, recognized built-in gains is limited to $100,000. Easy to mess this up and recognize too much ($150,000) as built-in gain.

47 SCHEDULE B, LINE 9: PRESENCE OF CORPORATE E&P 46 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 S election may terminate under Section 1362 if corporation has excess net passive income for three straight years. Must know if corporation has AEP on date of S election.

48 TAXABILITY OF DISTRIBUTIONS 47 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?

49 USING STOCK BASIS TO DETERMINE TAXABILITY 48 OF DISTRIBUTIONS General Rule for distributions if no AEP 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. 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.

50 SHAREHOLDER BASIS 49 A A invests $500 into a wholly owned S corporation. S Co. uses the $500 to generate $100 of taxable income. FORM 1040 The $100 of income is allocated to A on Schedule K 1; A pays tax on the $100 on Form 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.

51 SHAREHOLDER BASIS AND SINGLE LEVEL OF 50 TAX STOCK BASIS 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. A s basis goes from: $500 to $600 Thus, a sale of the S Co. stock for $600 would generate no further gain or loss. $600 $600 INCREASE BASIS By increasing A s basis, the singlelevel of taxation has been preserved.

52 BASIS ADJUSTMENTS: 1367(A)(1) 51 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 5. Add depletion item

53 BASIS ADJUSTMENTS: 1367(A)(2) 52 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 4. Non-deductible expenses (ex: M&E M-1)

54 ORDER OF ADJUSTMENTS TO STOCK BASIS 53 Normally made at end of the tax year IMPORTANT-Under (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 deduction

55 PROBLEM 1: ORDERING RULES 54 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:

56 SOLUTION: 1A 55 + $5,000 $2,000 - $7,000 $0 - $7,000 $7,000 $7,000 $7,000 $0

57 SOLUTION: 1B 56 + $5,000 $2,000 - $7,000 $5,000 - $2,000 $2,000 $7,000 $2,000 $0

58 SOLUTION: 1C 57 + $5,000 $2,000 - $7,000 $7,000 $7,000 $0

59 STOCK BASIS VERSUS ACCUMULATED 58 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.

60 DOES THE CORPORATION HAVE AEP? 59 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.

61 S CORP WITH AEP 1368(C) 60 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 3: Distributions in excess of AEP are treated as if made by S corp without AEP. (i.e., same as Step 1)

62 PAGE 5: SCHEDULE M-1: WHAT IS AAA? 61 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.

63 HOW AND WHEN DO YOU ADJUST AAA? 62 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.

64 HOW AND WHEN DO YOU ADJUST AAA? 63 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 basis rather than a taxable dividend.

65 NET POSITIVE ADJ. 64 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: Non-separately stated income $9000 Capital loss: ($2000) Distributions $11,000 Determine the taxability of the distributions

66 NET POSITIVE 65 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.

67 SOLUTION 66 AAA E&P S Corp. Dist. Starting $2,500 $7,500 C Corp Dist. Increase AAA: net positive adjustment $7,000 AAA balance before $9,500 distribution Decrease: distribution ($9,500) $9,500 Ending AAA $0 Distribution from E&P ($1,500) $1,500 Ending E&P $6,000

68 SOLUTION 67 Basis Starting $10,000 Increase for income $9,000 Basis before distribution $19,000 Decrease for distribution not taxed as ($9,500) dividend Decrease for losses ($2,000) Ending basis $7,500

69 EXAMPLE 8 WHAT S THE LESSON? 68 AAA (bottom of Page 5) is the dividing line between distributions made from S corporation income (which are nondividends and tax free to extent of shareholder basis) and those made from C corporation E&P (which must be taxed as a dividend).

70 ELECTIONS 69 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 (f)(2) Can also elect to make a deemed dividend under Treas. Reg (f)(3) if no cash is available.

71 PAGE 5, SCHEDULE M-2: PTI AND OAA 70 Almost unanimously misunderstood. Previously taxed income: Was AAA before AAA came to be in 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).

72 SCHEDULE K-1 : ALLOCATION OF INCOME AND LOSS TO SHAREHOLDERS 71 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/perday basis.

73 PER-SHARE/PER-DAY 72 How do you compute per share per day? STEP 1 Take the income or loss for the year and divide by the number of days in the tax year. STEP 2 Divide the income for each day by the number of shares owned on that day. STEP 3 Multiply the result from Step 2 by the total number of shares the shareholder held on that day. STEP 4 Multiply the result from Step 3 by the number of days the shareholder owned that number of shares.

74 PER-SHARE/PER-DAY EXAMPLE 73 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). X earns $720,000 of income during 2012.

75 PER-SHARE/PER-DAY EXAMPLE 74 To allocate its income among the shareholders: Step 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) Step 2 There are 200 shares outstanding all year, so divide $2,000 by 200 shares = $100 per share/per day. Step 3 and 4 A owned 100 shares for the entire year. A is allocated $360,000 ($100 pershare/per-day * 100 shares * 360 days). 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/perday * 50 shares * 160 days).

76 CLOSING THE BOOKS 75 Assume A and B own 50% each of S corporation X from January 1 through June 30, 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?

77 CLOSING THE BOOKS 76 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.

78 CLOSING THE BOOKS 77 Little known fact: Regulations at Section (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.

79 DISTRIBUTIONS 78 Do S corporation distributions also have to be made on a strict pershare/per-day basis? General rule, yes, but there is more flexibility than people realize.

80 ONE CLASS OF STOCK REQUIREMENT 79 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.

81 SECOND CLASS OF STOCK EXAMPLE 80 A calendar year S corporation has two equal shareholders Art and Bill. Bill sells 50% of his stock to Carl on January 1, 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, 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.

82 WHAT TYPES OF FORM 1120S ARE LIKELY TO BE AUDITED? 81 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)?

83 WHEN A FORM 1120S IS SELECTED FOR AUDIT, THE IRS WILL RECONCILE THE FOLLOWING ITEMS: 82 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

84 FORM 1120S AUDIT ISSUES INCLUDE: 83 ISSUE AUDIT ISSUE GTP_CORPTAX Losses claimed in excess of stock and debt basis (Proof) (d) 2 Losses claimed in excess of the at-risk rules 3 Losses claimed in excess of passive activity loss rules (IRS) Taxable gain on loan repayments to shareholders Loans to shareholder with loans from shareholder (economic outlay doctrine = Poorer) - See Kerzner, T.C. Memo )

85 FORM 1120S AUDIT ISSUES INCLUDE: 84 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 (d) Tax on excessive net passive investment income Recapture of prior year business credits (d) GTP_CORPTAX3.10

86 FORM 1120S AUDIT ISSUES INCLUDE: 85 ISSUE AUDIT ISSUE 9 Officer compensation vs. distribution Inadequate compensation - Too little Excessive compensation - Too much 10 Fringe benefits 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? GTP_CORPTAX3.10