Calculating S Corp Stock and Debt Basis: Avoiding Loss Limitations and Excess Distributions

Transcription

1 Calculating S Corp Stock and Debt Basis: Avoiding Loss Limitations and Excess Distributions WEDNESDAY, JUNE 3, 2015, 1:00-2:50 pm Eastern IMPORTANT INFORMATION This program is approved for 2 CPE credit hours. To earn credit you must: Participate in the program on your own computer connection (no sharing) if you need to register additional people, please call customer service at x10 (or x10). Strafford accepts American Express, Visa, MasterCard, Discover. Listen on-line via your computer speakers. Respond to five prompts during the program plus a single verification code. You will have to write down only the final verification code on the attestation form, which will be ed to registered attendees. To earn full credit, you must remain connected for the entire program. WHOM TO CONTACT For Additional Registrations: -Call Strafford Customer Service x10 (or x10) For Assistance During the Program: -On the web, use the chat box at the bottom left of the screen If you get disconnected during the program, you can simply log in using your original instructions and PIN.

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4 Calculating S Corp Stock and Debt Basis June 3, 2015 Robert S. Barnett Capell Barnett Matalon & Schoenfeld rbarnett@cbmslaw.com Anthony Nitti WithumSmith+Brown anitti@withum.com Darren J. Mills Alvarez & Marsal Taxand dmills@alvarezandmarsal.com

5 Notice ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

6 DARREN J MILLS STOCK BASIS: MECHANICS; LOSS LIMITATIONS; & SALE TRANSACTION

7 DISCLAIMER The views/content, typos, errors, etc. expressed herein are solely those of the presenter and do not necessarily represent the views/content, etc. of Alvarez & Marsal Taxand. The content herein is based on the Internal Revenue Code of 1986 (as amended) and the regulations thereunder. This material will not be updated for any changes in law and does not address any foreign or state and local tax issues. Please consult your individual advisor regarding any tax, legal or accounting advice with respect to your personal situation. 1

8 CONTENTS I. II. III. IV. Stock Basis: Mechanics Stock Basis: Loss Limitations Stock Basis: Sales Transactions Bio

9 STOCK BASIS: MECHANICS

10 STOCK BASIS: MECHANICS It is important that a shareholder know his/her stock basis when: The S corporation allocates a loss and/or deduction item to the shareholder.» In order for the shareholder to claim a loss, they need to demonstrate they have adequate stock and/or debt basis. The S corporation makes a non-dividend distribution to the shareholder.» In order for the shareholder to determine whether or not the distribution is non-taxable they need to demonstrate they have adequate stock basis. The shareholder disposes of their stock.» As with any asset, including C corporation stock, when the asset is sold or disposed of, basis needs established in order to reflect the proper gain or loss on the disposition. to be Since shareholder stock basis in an S Corporation changes every year, it must be computed every year. Increases Basis. Ordinary Income Separately Stated Income Items Tax Exempt Income Excess Depletion - the excess of the deductions for depletion over the basis of the property subject to depletion Decreases Basis Ordinary Loss Separately State Loss Items Nondeductible Expenses Non-Dividend Distributions In no event may a shareholder s stock basis be reduced below zero 4

11 STOCK BASIS: MECHANICS CONT D Starting point: Substituted basis - Sec. 358 Cost basis Sec Gift/inheritance Sec. 1014/1015 Substituted basis Incorporation of either a sole proprietorship or partnership (including an LLC taxed as a partnership) The basis of the stock received (or deemed received in a meaningless gesture transaction) is the same as the adjusted basis of the property transferred. If money (including an assumed liability) or other property is received by the transferor then special basis adjustment rules apply. Such basis is first decreased by the amount of money received, the fair market value of any other property received, and any loss recognized on the exchange. The basis is then increased by any amount that is treated as a dividend and by the amount of any gain recognized as a result of the exchange (excluding that portion of the gain that is treated as a dividend). 5

12 STOCK BASIS: MECHANICS CONT D Holding Period In a Sec. 351 transaction, the holding period generally tacks Loss Duplication Issues Policy A single economic loss should not give rise to two tax deductions. This result can occur as a result the mechanical application of the substituted basis rules. Generally, under Sec. 362, the transferee (e.g., an S Corporation) would take a carryover basis in the assets transferred to it. As such, if a shareholder transferred built-in loss assets in a Sec. 351 transaction, the S/H would take a substituted basis in the stock received under Sec. 358 and the Corporation would take a carryover basis under Sec. 362; therefore, as a result of the mechanical application of the basis rules, two built-in losses arose from the same economic loss. According, with the AJCA Congress rectified this result with the enactment of Sec. 362(e)(2). If aggregate AB > aggregate FMV then basis is limited to aggregated FMV. Election available to reduce stock basis in lieu of the transferee s basis in the built-in loss asset. See Sec. 362(e)(2)(C) and the regulations thereunder. 6

13 STOCK BASIS: MECHANICS CONT D Loss Duplication Issues cont d A, an individual, owns Asset 1 (basis $90, value $60) and Asset 2 (basis $110, value $120). In a transaction to which Code Sec. 351 applies, A transfers Asset 1 and Asset 2 to X, a domestic corporation, in exchange for a single outstanding share of X stock representing all the outstanding X stock immediately after the transaction. A's transfer of Asset 1 and Asset 2 is a Code Sec. 362(a) transaction. For purposes of Code Sec. 362(e)(2), X's aggregate basis in those assets would be $200 ($90 + $110), which would exceed the aggregate value of the assets $180 ($60 + $120) immediately after the transaction. Accordingly, the transfer is a loss duplication transaction and A has a net built-in loss of $20 ($200 - $180). Asset 1 is loss duplication property since X's basis in Asset 1 would be $90, which would exceed Asset 1's $60 value immediately after the transaction. X's basis in Asset 2 would be $110, which would not exceed Asset 2's $120 value immediately after the transaction, so Asset 2 is not loss duplication property. X's basis in Asset 1 is $70, computed as its $90 basis under Code Sec. 362(a), reduced by A's $20 net built-in loss. X has a transferred basis of $110 in Asset 2. Under Code Sec. 358(a), A has an exchanged basis of $200 in the X stock it receives in the transaction. Treas. Reg (h), Example 1(i). 7

14 STOCK BASIS: MECHANICS CONT D Timing Adjustments are made as of the close of the corporation s tax year If a S/H disposes of stock during the year, the adjustments are effective immediately before the disposition (but note election) Ordering Rules for calculating basis post August 18, 1998 (Treas. Reg (f)) First, basis is increased for both separately stated and non-separately stated income items and the excess of the deductions for depletion; Next, basis is decreased with respect to a distribution by the corporation described in 1367(a)(2)(A) (i.e., a distribution that was not includible in the income of the S/H); Next, basis is decreased by items that are noncapital, nondeductible expenses and the oil and gas depletion; and Finally, any decrease attributable to separately stated loss, deduction or credit items as well as non-separately computed loss items Separate Basis Rule Under this rule, stock basis is computed on a share-by-share basis in the same manner as that of a S/H in a C corporation The basis of a share of stock is increased or decreased by an amount equal to the S/H s pro rata portion of the items described in 1367(a)(1) or (a)(2) that is attributable to that share 8

15 STOCK BASIS: MECHANICS CONT D Other Considerations A distribution may be tax free to the S/H, but Sec. 311(b) continues to apply to a distribution of appreciated property (i.e., any gain recognized on the deemed sale under Sec. 311(b) will pass through to all S/Hs) A S/H s stock basis at the time of a distribution is irrelevant in determining the tax treatment of the distribution; Basis at the close of the tax year determines the tax treatment of the distribution Under the stock basis adjustment rules, distributions made during a tax year are taken into account before applying any loss limitation for the year Note that, under Sec. 1367(b)(2)(A), basis from indebtedness may only be used to deduct losses; it may not be used to receive tax-free distributions (cash received in connection with such loans must take the form of a loan repayment) S corporation rules adopt a separate basis approach for determining the basis adjustments in S stock, computing stock basis on a share-by-share basis in the same manner as stock basis is computed for a S/H in a C corporation 9

16 STOCK BASIS: LOSS LIMITATIONS

17 LOSS LIMITATIONS Amount of losses that can be deducted by the S/H is limited to his/her adjusted basis in the stock A loss that cannot be deducted due to a lack of basis is a suspended loss A suspended loss is an attribute of the individual S/H and cannot be used by other S/Hs If a shareholder transfers some but not all of the shareholder's stock in the corporation, the amount of any disallowed loss or deduction under this section is not reduced and the transferee does not acquire any portion of the disallowed loss or deduction. If a shareholder transfers all of the shareholder's stock in the corporation, any disallowed loss or deduction is permanently disallowed. Treas. Reg (a)(6) No basis obtained in debt simply by guaranteeing a loan, etc. made by the S/H to get basis. Payment on the loan must be 11

18 LOSS LIMITATIONS CONT D Example: T is the sole shareholder of X, an S corporation. During 2005, X incurred and passed through to T $6,000 in nonseparately stated loss and $4,000 in capital loss. However, T was unable to deduct any of the losses due to a lack of basis. In this situation, both losses are suspended, carry forward to 2006, and pass through again with respect to T. In 2006, X incurred and passed through $5,000 in nonseparately stated income and $2,000 in capital gain. This means that T is deemed to have $1,000 in ordinary loss ($6,000 $5,000) and $2,000 in capital loss ($4,000 $2,000) from X in These amounts must be compared with T s basis at the end of 2006 to determine if any of these amounts may be deducted. If not deductible, those amounts again carry forward and are combined with 2007 s passthrough results. Starr and Sobol, 731-2nd T.M., S Corporations: Operations Example: T is the sole shareholder of X, an S corporation. During X s first three years of operations, it incurred losses totaling $100,000 that passed through to T. However, because T only had basis of $20,000 in X, $80,000 of the losses were suspended. In the fourth year of operations, T sold his stock to B. In this situation, T s suspended losses are lost forever (nor are they available to offset any gain from the sale of X stock). Id. 12

19 STOCK BASIS: SALES TRANSACTION

20 THE SEC. 338(H)(10) ELECTION Introduction When Available Available to any corporation that makes a Qualified Stock Purchase (QSP) of a Target Corporation Target is an S corporation or an 80% or greater corporate subsidiary member of a consolidated group Also, Sec. 336(e) may be a viable alternative as it does not require a corporate purchaser in a qualified stock disposition ( QSD ) Requirements Corporate Purchaser QSP: at least 80% (vote and value) must be acquired Joint election by buyer and seller: filed by the 15th day of the 9th month following the month in which the acquisition occurs 14

21 THE SEC. 338(H)(10) ELECTION Mechanics Treatment of Target Corporation: Target Corporation is deemed to sell all of its assets for an amount equal to the Aggregate Deemed Sales Price Target Corporation reports gain or loss from deemed sale on its final tax return In the S Corporation context, gain or loss flows-through to selling shareholders (generally no federal entity-level tax is imposed on S corporations). Seller is responsible for any tax due on the deemed asset sale. 15

22 THE SEC. 338(H)(10) ELECTION Mechanics Treatment of Target Corporation (continued): Target Corporation is deemed to liquidate at the end of the acquisition date If Target S Corporation is deemed to engage in a taxable liquidation. See Sec. 331 and 336. However, the gain or loss from the deemed asset sale flows through to the selling shareholders, increasing or decreasing their tax basis in their stock, respectively. As such, there generally is no incremental taxable gain upon the deemed liquidation of Target Corporation. At the beginning of the day after the acquisition date, Target Corporation is deemed to reconstitute itself as a new corporation and purchase the assets. Target Corporation receives a tax basis in the assets equal to the Adjusted Grossed Up Basis. Target Corporation uses the Residual Method to allocate the Adjusted Grossed Up Basis. 16

23 THE SEC. 338(H)(10) ELECTION Mechanics Treatment of Buyer Receives a cost basis in the stock of Target Corporation. Tax basis step up in target assets Increase in after-tax cash flow Takes the form of a stock sale for non-tax reasons Note: historical business & tax exposures carryover 17

24 THE SEC. 338(H)(10) ELECTION Mechanics Treatment of Sellers The stock sale is ignored for federal income tax purposes Single level of tax (no shareholder level gain). The gain or loss from the deemed sale of the Target Corporation s assets flows through to the shareholders and is reported on their federal income tax returns. May be additional taxes (federal + state) for which seller may require gross ups Complications in rolling shareholders rollover is taxable as if stock was sold 18

25 THE SEC. 338(H)(10) ELECTION Summary Note that in the case of a Sec. 338(h)(10) election, there is only one level of tax. Because the deemed asset sale generally results in ordinary income, while the sale of stock results in capital gain or loss, the sellers may, in certain cases, pay more tax under a Sec. 338(h)(10) election than under a stock sale. Individual capital gain tax rates vs. ordinary income tax rates (23.8% vs. 39.6%), although, see Sec State taxes (including entity-level taxes), Sec BIG tax, etc. In order to make the sellers whole, the purchaser can Gross Up the sellers by increasing the purchase price to accommodate for the incremental tax that the sellers must suffer as a result of making the Sec. 338(h)(10) election. The Gross Up Payment is included in the computations for Aggregate Deemed Sales Price and Adjusted Grossed Up Basis. May result in additional depreciation or amortization deductions. A Sec. 338(h)(10) election generally makes sense if the present value of the additional depreciation and amortization deductions that result from making the election exceed the amount of the Gross Up Payment. 19

26 THE SEC. 338(H)(10) ELECTION Summary $300 Corporate Buyer ( B ) ACTUAL Seller ( S ) New T (C Corp) Stock Step 1 Assets (basis=$200) DEEMED $300 + $100 Assumption of Debt OLD T (S Corp) Ste Step 2 Old T Liq uidates DEEMED Assumptions Seller s outside stock basis = $100 T s inside asset basis = $200 T s liabilities = $100 Buyer Pays $300 for stock Stock Sale 338(h)(10) Buyer B Seller S Target T Cost Basis in T Stock = $300 Capital Gain = $200 No Gain; Carryover Basis up to $400 Cost Basis in T Stock = $300 Capital / Ordinary Gain = $200 ($300 + $100 - $200) on deemed sales is passed through from Target; No gain on liquidation Gain passed through to S; Basis is stepped 20

27 THE SEC. 338(H)(10) ELECTION The Malpractice Transaction PE Historical S/H PE Historical S/H Cash Holdco Holdco Target (S Corp) Stock Buyer Buyer Target Buyer purchases the stock of Target from Historical S/H for cash, and both parties make a Sec. 338(h)(10) election. Historical S/H rolls part of his proceeds (7%) into Holdco, such that after the transaction is consummated he is a partner in Holdco along with PE. The Sec. 338(h)(10) election was invalid because Historical S/H would be viewed as a related party, and you can t do a Sec. 338(h)(10) election with a related party. A very harsh and unfair result. Had Historical S/H rolled his interest into Buyer, it would not have been a problem. The Sec. 336(e) rules partially address this issue. 21

28 THE SEC. 338(H)(10) ELECTION Other Considerations Rollovers where the Seller ends up with more than 20% are not good QSPs S Corp status must be valid as a 338(h)(10) can t be made on a stand-alone C corp. Gross-up for Incremental taxes Built-in gains taxes (S corporations) State taxes Character of taxable gains (ordinary versus capital) 22

29 BIO

30 A&M TAX AND PROFESSIONALS Darren J Mills Managing Director Direct: Mobile: dmills@alvarezan Darren J Mills is a Managing Director with Alvarez & Marsal Taxand in New York, with more than 20 years of international tax, M&A and ASC 740 experience. He assists multinational organizations assess and improve their global tax strategies. His most recent leadership experiences include, assisting two large multinationals in implementing the fair market value election and analysis of overall foreign loss/overall domestic loss; successfully assisted a Fortune 500 Company with the integration of a $400 million acquisition; provided both buy side and sell side tax due diligence and structuring to both strategic and financial investors; identification of a missed gain recognition agreement prior the filing of a timely tax return resulting in the preservation of a $500 million gain; identification of a missed tax deduction related to an investment unit and the associated tax implications of a debt restructuring resulting in a $10 million cash refund to the client; and structuring an acquisition to result in a tax-free step-up in inside basis Mr. Mills is frequently involved in helping companies respond to tax demands from boards of directors and shareholders, as well as in fostering cross-functional communication between tax, operations, finance and treasury teams. He has worked closely with CEOs, CFOs and private equity investors. Before A&M, he was the partner responsible for developing the tax advisory practice in both Metro New York and DC for a Top 20 accounting firm. Mr. Mills was also at KPMG LLP where he participated in KPMG s National ASC 740 team as a local resource. He began the early part of his career with Arthur Andersen LLP. Mr. Mills earned a juris doctor from Seton Hall Law School; a Masters of Science in Taxation at Fairleigh Dickinson University and a Bachelor of Science in Accounting, also from Seton Hall University. Mr. Mills is a licensed attorney in the State of New Jersey (inactive in Pennsylvania) and a licensed CPA in the States of New Jersey & Florida as well as the Commonwealth of Virginia. Mr. Mills has served as an Adjunct Professor in the graduate tax programs at both Seton Hall University and the University of Baltimore. He serves as a national speaker, and has written articles and provided comments on proposed regulations and other topics related to corporate and international taxation. NOTE: Alvarez & Marsal employs CPAs but is not a licensed CPA firm. 24

31 31 S CORPORATIONS: Basis and Distribution Ordering Rules WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

32 32 General Rules A distribution of cash or property from an S corporation to a shareholder can result in one of three tax consequences: Tax-free return of capital, Taxable dividend, Capital gain as if the shareholder sold the stock (even though they did not) WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

33 ONE TWO THREE 33 Three Concepts In order to determine the consequences, we must understand three concepts: Shareholder basis in S corporation stock C Corporation Earnings and Profits Accumulated Adjustments Account (AAA, Subchapter S) (Subchapter S) (E&P, Subchapter C) WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

34 34 A Quick Primer Continued The defining characteristic of S corporations is: Distributions of previously taxed S corporation income should not be taxed a second time. In contrast, C corporation income should be taxed twice; once when earned, once when distributed. Distribution rules preserve this difference. WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

35 35 Stock Basis versus Accumulated 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. WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

36 36 Taxability of Distributions 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? Quick hint: If an S corporation: Has been an S corporation since formation; Was formed after 1982, and Has never acquired a C corporation s assets in a Section 381 transaction, Then the S corporation CANNOT have E&P. WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

37 STEP ONE STEP TWO 37 Distributions From an S Corporation With No E&P Taxability of distributions if no E&P (Treas. Reg. Section (c)) Distributions are tax-free to the extent of stock basis. (and basis must be Distributions in excess of basis generate capital gain to the s/h. reduced) WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

38 38 Distributions From an S Corporation With No E&P If an S corporation has no E&P, then all income available for distribution must have been earned while an S corporation. WHY IS THIS THE RULE? If that s the case, because S corporation income should only be taxed ONCE, a distribution of that income should not be taxed a second time. As a result, a distribution is treated first as a taxfree return of basis to preserve the single level of taxation. WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

39 39 What is the Lesson? If an S corporation: Has never been a C corporation and Has never acquired a C corporation in a Section 381 transaction, then it can t have corporate E&P. AAA is irrelevant to determining the taxability of distributions. However, you should still maintain the AAA balance on the return so you can distribute it tax-free during a post-termination transition period. WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

40 40 Example 1 A OWNS ALL THE STOCK OF S CO. A S BASIS IN S CO. STOCK IS $30,000 ON S Co had $10,000 of AAA on S Co. was never a C corporation, has no E&P During 2013, S Co. had: Ordinary income $50,000 LTCL ($5,000) Made a $40,000 distribution to A on WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

41 41 Example 1 Continued Because S Co. has no E&P, AAA is irrelevant. Must look to stock basis: Starting basis: $30,000 Add: income: $50,000 Basis before distribution $80,000 Next: distributions: ($40,000) Remaining basis $40,000 Reduce for losses: ($5,000) End of year basis $35,000 The entire $40,000 distribution is tax free WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

42 42 Example 2 A OWNS ALL THE STOCK OF S CO. A S BASIS IN S CO. STOCK IS $30,000 ON S Co. had $10,000 of AAA on S Co. was never a C corporation, has no E&P During 2013, S Co. had: Ordinary income $20,000 LTCL ($5,000) Made a $60,000 distribution to A on WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

43 43 Example 2 Continued Starting basis: $30,000 Add: income: $20,000 Basis before distributions $50,000 Next: distributions, but not below zero: ($50,000) Remaining basis $0 Reduce for losses: $0 End of year basis $0 Only $50,000 of the $60,000 distribution is tax-free $10,000 results in capital gain The $5,000 loss is suspended WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

44 44 Example 3 BECAUSE OF THE BASIS ORDERING RULES, AN S CORPORATION WILL ALWAYS BE ABLE TO DISTRIBUTE ANY STOCK BASIS THAT EXISTS AT BEGINNING OF YEAR A owns all the stock of S Co. A s basis in S Co. stock is $10,000 on During 2013, S Co. had: Ordinary loss ($30,000) Made a $10,000 distribution to A on WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

45 45 Example 3 Continued Even though S Co. has a net loss of $30,000 for the year, it can still distribute the $10,000 of beginning stock basis to A (this allows for a distribution of cash to cover tax on prior year income): Starting basis: $10,000 Add: income: $0 Next: distributions: ($10,000) Remaining basis $0 Reduce for losses: $0 End of year basis $0 The entire $10,000 distribution is tax-free The $30,000 loss is suspended WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

46 46 S Corporations With E&P Not all S Corporation distributions should only be subject to a single level of tax under the Subchapter S rules. Why? When a C corporation makes a distribution out of E&P, the distribution is taxed a second time as a dividend (Section 317/301) A C corporation should not be able to avoid this result by converting to an S corporation and then distributing the C corporation earnings WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

47 47 S Corporations With E&P If a C corporation with E&P makes an S election, the E&P survives the election and continues on. If the S corporation subsequently distributes the C corporation E&P, it will be taxed as a dividend, just as it would have if distributed while a C corporation. WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

48 48 S Corporations With E&P When will an S corporation have E&P? If it was a prior C corporation and had accumulated E&P on the date of S election If it had no E&P on election date, but subsequently acquired a C corporation in a Section 381 transaction. When will an S corporation never have E&P? Has been an S corporation since formation. Formed after Has never acquired a C corporation in a Section 381 transaction. WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

49 49 S Corporations with E&P Important: An S corporation can have accumulated E&P on the date of an S election, but cannot have current E&P while an S corporation. Effectively, the E&P of the C corporation gets frozen on the S election date and will get reduced when the S corporation distributes the E&P. WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

50 50 Concept #2: What Is E&P? Not defined anywhere in the Code or regulations. Meant to represent the measure of a corporation s ability to make distributions to its shareholders out of earnings rather than by returning contributions to capital. As a result E&P is not concerned with tax policy or financial accounting considerations, rather, it is concerned with quantifying a corporation s economic income. WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

51 51 S Corporations with E&P On S election date, accumulated E&P from prior C corporation years survive. However, the S corporation is still entitled to distribute S corporation earnings tax-free BEFORE it is deemed to distribute C corporation E&P. How do we decide whether an S corporation s distributions are from S corporation earnings or C corporation E&P? WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

52 52 Concept #3: Accumulated Adjustment Account The AAA measures the taxable income that was previously earned by the S corporation. This is income that was previously taxed to shareholders and thus should be permitted to be distributed without a second level of tax. Sales of stock do not impact AAA, because it is a corporate attribute. An account of the S corporation as opposed to basis, which belongs to an individual shareholder. WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

53 Increase for: 53 Accumulated Adjustment Account Account starts at zero on the effective date of an S election. Non-separately stated income Separately stated income Do NOT increase for taxexempt income Non-separately stated loss Separately stated loss Do NOT decrease for expenses attributable to tax-exempt income Distributions Decrease for: AAA, unlike basis, can be reduced below zero, but NOT by distributions. WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

54 54 When and in What Order Do You Adjust AAA? 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. WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

55 55 How and When Do You Adjust AAA? 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. WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

56 56 S Corp with AEP 1368(c) 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) WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

57 57 Example 7 Net Positive Adj. Tom owns 100% of S Co. S Co. has AAA of $2,500 and E&P of $7,500. Tom s stock basis on is $10,000. During the year, S Co. has the following: Loss: $2,000 Income $9,000 Distribution: $11,000 WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

58 58 Solution, Example 8 AAA E&P S Corp. Dist. Starting $2,500 $7,500 C Corp Dist. Increase AAA: net positive adjustment $7,000 AAA balance before distribution $9,500 Decrease: distribution ($9,500) $9,500 Ending AAA $0 Distribution from E&P ($1,500) $1,500 Ending E&P $6,000 WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

59 59 Solution, Example 8 Basis Starting $10,000 Increase for income $9,000 Basis before distribution $19,000 Decrease for distribution not taxed as dividend ($9,500) Decrease for losses ($2,000) Ending basis $7,500 WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

60 60 Example 8 What s the Lesson? AAA is the dividing line between distributions made from S corporation income (which are tax-free to extent of shareholder basis) and those made from C corporation E&P (which must be taxed as a dividend). WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

61 61 Example 9 Net Negative Adj. A X is the sole s/h in S corp. X has basis of $1,000 on 1/1/2013 S corp has $500 of E&P and $200 of AAA on 1/1/2013. During 2013, S corp has $200 of capital gain, has an operating loss of ($900) S corp makes a $1,000 distribution. WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

62 62 Net Negative Example 9, Solution Do you have a net positive or net negative adjustment? THERE IS A NET NEGATIVE ADJUSTMENT. ($200 LTCG - $900 loss). AS A RESULT You determine the taxability of the distribution BEFORE you adjust AAA. This rule means that you can always distribute out the beginning balance in AAA under the S corporation rules, even if the current year is a huge net loss. WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

63 63 Solution, Example 9 AAA E&P S Corp Dist. Starting $200 $500 Decrease: distribution (not below zero) AAA balance after distribution $0 Decrease AAA: net negative adjustment ($200) $200 ($700) Ending AAA ($700) WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com C Corp Dist. Distribution from E&P ($500) $500 Ending E&P $0 Distributions in excess of AAA/E&P $300

64 64 Solution, Example 9 Basis Starting Basis $1,000 Increase for income $200 Decrease for distribution not taxed as dividend ($500) Basis after distributions $700 Decrease for losses ($700) Ending basis $0 Suspended losses $200 WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

65 65 Example 9 What s the lesson? Even though the S corporation had a net loss of $700 for the year, the beginning AAA balance of $200 can be distributed tax free. AAA can go negative from losses; here it ends the year at ($700). Basis CANNOT go negative; any losses that cannot be used carry forward. AAA is reduced by the full loss, even though the loss may be suspended at the shareholder level. VERY IMPORTANT: in this example, we reduced E&P to zero. It will NEVER be a problem again. From this point on, all distributions will simply be tax-free to extent of s/h basis and capital gain for any excess. WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

66 66 Post-Termination Transition Period If a corporation s S election terminates and the corporation reverts to a C corporation, does that mean that all future distributions are taxed as dividends? NO. The corporation may distribute all of its AAA in cash and only cash under the S corporation rules during the posttermination transition period. PERIOD IS LATER OF: One year from date S election terminates, Due date of final S corporation tax return, including extensions Also 120 days from any later determination that S status ended THIS IS WHY We must maintain AAA even when no E&P! WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

67 67 PTTP Example 13 S Co. s S status ended on 1/1/2013. On 1/1/2013, S Co. had: AAA of $20,000 E&P of $10,000 A, the sole shareholder, has basis of $20,000 Even though S Co. is now a C corporation, S Co. has until 12/31/2013 to distribute $20,000 of AAA under the S corporation rules (tax-free to extent WithumSmith+Brown, of basis, then PC capital Certified gain). Public The Accountants distributions and Consultants must withum.com be in cash.

68 68 Other Adjustments Account (OAA) Is not mentioned anywhere in the Code or regulations. Ultimately has no tax significance. Is meant to measure those items that increase or decrease shareholder basis (tax-exempt income and expenses related to tax-exempt expenses) but don t increase or decrease AAA. Thus, you cannot make non-dividend distributions from this account. WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

69 69 Previously Taxed Income (PTI) Only exists for corporations that elected S status prior to Any PTI was frozen on 1/1/1983. Unlike AAA, PTI is a shareholder-level attribute. PTI is distributed after AAA, but before E&P. PTI must be distributed in cash, not property. Upon termination of S status, the PTI account cannot be distributed under the S corporation rules (non-dividend). Because of this, PTI should be distributed as soon as possible. Consider election to distribute PTI before AAA (see later slides) WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

70 70 PTI Example 14 S Co. became an S corporation in On 12/31/1982 it had PTI of $35,000 allocated to its sole shareholder, A. S Co. had corporate E&P of $20,000 on the date of the S election. From 1983 through 2013, S Co. accumulates AAA of $150,000, but no distributions were made. In 2013, S Co. distributes $180,000. WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

71 71 PTI Example 14 The $180,000 distribution comes first from AAA of $150,000 (taxfree to extent of A s stock basis, capital gain for excess), Then from PTI of $35,000. Thus, none of the distribution is taxed as a dividend. WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

72 72 Solution, Example 14 AAA PTI E&P Starting $150,000 $35,000 $20,000 Increase AAA: net positive adjustment Decrease: distribution (not below zero) ($150,000) Ending AAA $0 Distribution from PTI ($30,000) n/a Ending PTI $5,000 Decrease E&P for dividend n/a Ending E&P $20,000 WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

73 73 Elections An S corporation that wants to get rid of its C corp E&P (perhaps to avoid 1375 or use an expiring shareholder NOL) can elect to bypass AAA and distribute E&P first. Treas. Reg (f)(2) Note, however, that if the corporation has PTI, a second distribution must be made to also bypass PTI and distribute E&P first. Also consider, if you plan to revoke your S status, may want to elect to distribute PTI first since you can t distribute PTI during the post-termination transition period. WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

74 74 Elections Election to bypass AAA applies to all distributions during the year. Cannot choose specific distributions to go against E&P, the first dollars of distribution will be a dividend until all the E&P is purged. Not all E&P must be distributed. Election applies on a year-by-year basis, all shareholders who got a distribution must consent, and is attached to return. WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

75 75 Elections Can also elect to make a deemed dividend under Treas. Reg (f)(3) if no cash is available. Treated as a cash distribution followed by a contribution to capital (giving a basis bump). Election is filed with return, so you have the benefit of hindsight. WithumSmith+Brown, PC Certified Public Accountants and Consultants withum.com

76 S CORPORATION OPEN ACCOUNT DEBT 2015 By Robert S. Barnett CPA, JD, MS (TAXATION) CAPELL BARNETT MATALON & SCHOENFELD, LLP. ATTORNEYS AT LAW (516)

77 LOSS UTILIZATION IRC 1366(d)(1) LIMITS use of S Corp losses and deductions to extent of shareholder s basis in stock PLUS Corporate debt to shareholder. 77

78 LOSSES - UTILIZATION 1. First 1366(d)(1) Stock Basis 2. Then reduces Basis in debt to Corp 3. Remainder carried forward REMEMBER basis does not include guarantees or circular loans Back-to-Back must be bona fide See (a)(2)(i) & (iii),ex. 2 78

79 BASIS Barnes v. Comm., 111 AFTR 2d 2013 (DC Cir) Affirmed Tax Court, TCM reduce basis even if fail to deduct the loss S SHs inadequate basis Unable to deduct losses limited to basis Basis not increased by prior losses not claimed Taxpayer failed to deduct suspended losses Statute of limitations expired 79

80 LOSS UTILIZATION Gleason v. Commissioner, TCM (9/11/06) Taxpayer won as borrower on a $6m loan IRS re-characterized loan properly made by taxpayer because loan payments paid by Corp and stock was pledged as collateral Kerzener, TCM CIRCULAR LOAN from p ship to S SH to S corp did not create basis. S Corp paid equivalent rent back to the p ship. Transaction lacked economic substance MERE CONDUIT No sufficient risk Court distinguished Ruckriegel and Culnen Nathel, 105 AFTR (2nd Cir. 6/2/10) Equity and debt are distinguishable Contribution of equity increases basis of stock but does not restore loan basis CONTRIBUTIONS TO CAPITAL ARE NOT INCOME! 80

81 NATHEL The Corp. repaid shareholder loans (reduced basis from losses) Recognized Ordinary Income on repayment of loan Attempted to restore or increase loan basis Capital contributions do not create exempt income (income increases loan basis) Supreme court denied cert. 81

82 BACK TO BACK LOANS Treas. Reg (7/23/14) Bona fide indebtedness All facts & circumstances considered General tax principles MAGUIRE, TCM Auto dealer and finance company A/R distributed then contributed Substitutions- State Law Formalities 82

83 Culnen, TCM Distributions from profitable S corp (> $3mm) to loss corp added to basis: i. Amounts came out of S earnings, ii. Always shown on corp s books as loans to/from shareholder, and iii.all bank financing statements showed the loans as personal, not corporate. Back to Back loans & Substitutions Treas. Reg (7/23/14) 83

84 BONA FIDE DEBT Watch Second Class of Stock Rules Straight Debt Safe Harbor Reg (l)(5) Substitution- State Law Formalities 84

85 DEBT vs. EQUITY Transfers to Corp generally equity, not loan Capital contribution Payment Personal expenses - dividends Not repayment of loan No debtor/creditor indicia ACM Environmental Services, TCM Proper documentation missing 85

86 NOT BONA FIDE DEBT No Bad Debt Deduction Herrera v. Comm r, 112 AFTR2d (5th Cir.) LLC (p ship) Loans to related steel corp. No written promissory notes No definite maturity No repayment schedule No security no payments 86

87 OPEN ACCOUNT DEBT INTRODUCTION Brooks v. Commissioner TCM (August 25, 2005) Final Regulations 87

88 LOANS Assume Stock Basis $100 If X $200 loss, shareholder deducts only $ (d)(1) deductions limited to Basis Excess loss carried forward Basis can never be negative So shareholder loans $100 to Corp on 12/31 Stock Basis & Loan Basis is $0 Later income first restores Loan Basis 88

89 OPEN ACCOUNT DEBT Shareholder loans/advances not evidenced by written instrument New Regulations 10/20/08 and thereafter Limit $25,000 per Shareholder EXAMPLE 10 Shareholders, each can have up to $25,000 of Open Account Debt 89

90 BE CAREFUL No single Shareholder exceeds limit Keep records per Shareholder Not day/day END OF S YEAR Unless debt disposed or Shareholder terminated ownership 90

91 WHAT HAPPENS When $25,000 limit exceeded Debt at end of year treated AS IF evidenced by separate written agreement No longer Open Account Debt Debt existing on 10/20/2008 not subject to new rules - treated as a separate loan Identification issues exist 91

92 LOSSES ORDERING RULES Losses first absorb Stock Basis Then reduce Debt Basis NOT BELOW ZERO Multiple indebtedness Loss Allocated Based upon aggregate Basis Intricate record keeping required 92

93 RESTORATION/ PRIORITY Distinction between Stock & Debt Basis Net Income restores Debt Basis first First- to any Repaid Debt Then proportionally to unrestored basis Net Increase 1367(a)(1) income items New contribution(s) - increase Stock Basis (Nathel) Computations generally determined at end of the year 93

94 ACCELERATION Termination of ownership Dispose of debt 94

95 COMPUTATION Advances and Repayments are netted At close of S Corp year Net Advance or Repayment is combined with Principal balance of Open Account Debt Carried to next year (unless > $25,000) IF > $25,000 no longer Open Account Debt Treated as if separate debt. 95

96 EXAMPLE ONE A s Stock Basis is $0 6/1/09 A loans S $16,000 (no note) 12/31/09 Open Account Debt = $16,000 96

97 EXAMPLE TWO 2009 STOCK BASIS $0 A lends $16,000 6/1/09 12/31/09 Loss <$8,000> A s BASIS in Open Account Debt is $8,000 Principal Loan amount remains $16,000 97

98 EXAMPLE THREE 2010 A Stock Basis = $0 Loan Basis = $8,000 (principal $16,000) 4/1/10 S Repays to A $4,000 9/1/10 A Advances $1,000 (net $3,000) 12/31/10 Debt Principal $13,000 Still open Account Debt 98

99 EXAMPLE THREE CONTINUED A recognizes income $1,500 (8/16 x $3,000 Net Repayment) IF evidenced by a note gain is Capital Gain (note: Tax treatment of debt treated as if evidenced by a note is not yet addressed) 12/31/10 Open Account Debt Principal $13,000 Carried to

100 EXAMPLE FOUR (ex. 3 FACTS) 2/1/11 S Repays A $5,000 3/1/11 A Advances $20,000 Not evidenced by a written agreement 2011 Net Advance $15,000 Debt $28,000 (> $25,000 not Open Account Debt) Treated as if evidenced by a separate written agreement maintain records 100

101 WHO CARES? The IRS & the Treasury $25,000 limitation eliminates Year End Repayments Mixed blessing Gain on Repayment of Debt evidenced by notes is CAPITAL GAIN Repayment of Open Account Debt with reduced basis = ORDINARY INCOME 101