Presentation for CSEA IRS/Practitioner Fall Seminars S Corporation Darrell Early, IRS Date September 27, 2012
Agenda What is an S Corporation? Why would a Corporation make the S election? How does a Corporation become an S Corporation? S-corporations Taxation S Corp basis S Corporation Loss Limitations Shareholder Distributions Shareholder Compensation Issues Special Concerns for S Corporation Shareholders 2
What is an S Corporation? 3 An "S-Corporation" is a corporation that meets the requirements below and that passes-through net income, loss, deductions or credits to shareholders It is a Domestic Corporation with No more than 100 shareholders Shareholders - individuals, certain trusts, or estates, 401(a) pensions plans, 501(c)(3) - charities Shareholders - US citizens or permanent residents One class of stock - identical rights to distribution and liquidation proceeds Unanimous consent of shareholder to elect S treatment
Why make the S election? Single Level of Taxation No Self-Employment Tax on Profits No Self-Employment Tax on Distributions Avoids Personal Service Corporation (PSC) Designation & 35% flat tax Tax-Free Distributions of Profits (subject to limitations) 4
How to become an S Corporation? Make a positive election by filing Form 2553 within 2 months & 15 days of the incorporation date Each shareholder consents by signing the form 5
S-corporations Taxation S Corporation Does NOT Pay Income Tax Except: Built-in Gains Tax IRC 1374. Excessive Passive Investment Income Tax - 3 consecutive years IRC 1375. LIFO Recapture Tax IRC 1363(d). Investment Tax Credit Recapture of prior year business credits. NONE of these S-corp taxes apply unless the S- corp was once a C-corp or acquired C-corp assets with a carryover basis
S-corporations Taxation S-Corporations Items Passed-through: Ordinary income/(loss) (non-separately stated items) Separately stated items include: Income and loss from each rental activity, Portfolio income interest, dividends, royalties, Capital gains and losses, IRC 1231 gains and losses IRC 179 expense, Charitable contributions, Investment interest expense, Tax exempt income, and Non deductible expenses.
S-corporations Taxation Each S corporation shareholder reports a pro rata share of the S corporation s items of income, loss, deduction and credit. Allocations are on a per-share, per-day basis for the shareholder s taxable year in which the corporation s year ends 1377(a). Items normally retain their character when passed through to the shareholders.
S-corporations Taxation Allocation of Items If no change in ownership Based on percentage of ownership. If change in ownership Per-day allocation method, or Interim closing of the books method (if elected).
S-corporations Taxation Sh K - ($20,000) of ordinary loss, $1,000 of dividend income and a $1,500 long-term capital gain. Shares Days Owned Share Days Percentage Ordinary Loss Dividend LTCG Katie 1,000 365 365,000 50.0% ($10,000) $500 $750 Chris 500 365 182,500 25.0% ($5,000) $250 $375 Steven 500 365 182,500 25.0% ($5,000) $250 $375 Totals 730,000 ($20,000) $1,000 $1,500
Stock & Debt Basis Why Important? Computation of gain (loss) upon sale of stock. Taxability of distributions depends on basis of stock. Pass-through losses & deductions permitted only to the extent of stock and debt basis.
Stock & Debt Basis Adjustments to Stock Basis Operations of an S Corp Initial Investment (Cost) & Cannot be Negative Increases Ordinary income Separately stated income items Tax exempt income Excess depletion over basis Decreases Non-dividend (non taxable) distributions Expenses that are not deductible and are not attributable to a capital account Depletion for oil and gas property to the extent it does not exceed cost allocation Ordinary loss Separately stated loss & deduction items & business credits.
Stock & Debt Basis IRC 1367(b)(2)(A) Provides that once a shareholder's stock basis has been reduced to zero, any excess losses are applied to the shareholder's outstanding basis in loans to the corporation. Stock Basis Debt Basis Taxability of Distributions - Look to Stock Basis ONLY Taxability of Loan Repayments - Look to Debt Basis ONLY
S Shareholder s Debt Basis Beginning Debt Basis + Current Year Loans Loan Repayments Non-deductible Expenses in Excess of Stock Basis Loss Items in Excess of Stock Basis = Ending Debt Basis Distributions do not reduce debt basis 14
Stock & Debt Basis 1120S Corporation Facts at 12/31/06 Stock basis $5,000.00 Face Basis in loans to 1120S $15,000.00 During 2007, 1120S incurs an operating loss of ($12,000). Shareholder s adjusted basis as of 12-31-07: Stock basis $0.00 Basis in loans to 1120S $8,000.00 During 2008, 1120S generates operating income of $9,000. Shareholder s adjusted basis as of 12-31-08: Stock basis $2,000.00 Basis in loans to Greene Corporation $15,000.00
Stock & Debt Basis Example Ending Stock Basis $7K Beginning Loan $0K + New Loans $15K + Loan Repayments $0K Ending Debt Basis $15K Ending Total Basis $22K 16
Stock & Debt Basis Valid Shareholder Debt Direct indebtedness of shareholder to the corporation creates debt basis Shareholder guarantee or co-making/coborrowing of corporate debt does not establish shareholder debt basis. Basis is generally not increased by indirect indebtedness. Shareholder must experience an actual economic outlay such that they are poorer in the material sense. Related party transactions may be allowed as debt basis.
Stock & Debt Basis Repayment of Reduced Basis Debt in whole or in part produces income to the shareholder. Gain on Repayment ((Face A/B) Face) x Repayment = Gain Gain on loan repayment does not increase a shareholder s basis.
Stock & Debt Basis Reduced Basis Debt Restoration Only the bases of loans outstanding at the close of the year are reduced. Only loans outstanding at the beginning of the year are restored. 1.1367-2(d)
Stock & Debt Basis In 2005 SCorp repaid s/h of $8,000 of 2003 debt Year Face AB 2003 $10,000.00 $4,000.00 2004 $25,000.00 $24,000.00 Gain on Repayment (10,000-4,000)/10,000 X 8,000 = 4,800 Basis Reduction (4,000/10,000) X 8,000 = 3,200 Year Face AB 2003 $10,000.00 $4,000.00 repayment ($8,000.00) ($3,200.00) balance 12/31/xxx2 $2,000.00 $800.00
Shareholder Loss Limitations Three Loss Limitations Stock & Debt Basis Limitation - 1366(d) At-Risk Limitation - 465 Passive Activity Loss Limitation - 469 Activity Not Engaged in for Profit (IRC 183) is determined at the S corporation level.
Shareholder Loss Limitations Stock & Debt Basis Limitation- 1366(d) Losses and deductions are allocated on a pro rata basis if basis is insufficient to absorb all of the loss and deduction items 1.1366-2(a). Character of loss items is retained. Losses and deductions in excess of basis are suspended and carried forward indefinitely.
Shareholder Loss Limitations Loss Allocation Example 1120S - Form K-1 Basis 1/1/xxxx $9,000 Ordinary Loss ($20,000) income items $4,000 1231 Gain $4,000 Basis before non-deductibles $13,000 Cash contributions $5,000 non-deductible T&E $1,000 Non-deductible T&E $1,000 Allocable Basis $12,000 Ordinary Loss Loss Allocation Ordinary Loss Carry-over Loss (20,000/25,000)*12,000 ($9,600) 20,000-9,600 $10,400 Cash contributions Cash contributions (5,000/25,000)*12,000 ($2,400) 5,000-2,400 $2,600
Shareholder Loss Limitations At-Risk Amounts You are at risk in any activity for: The money and adjusted basis of property you contribute to the activity, and Amounts you borrow for use in the activity if: You are personally liable for repayment, or You pledge property (other than property used in the activity) as security for the loan. For losses to be deductible, Taxpayer needs to be At-Risk in the activity generating the loss.
Shareholder Loss Limitations Non-Recourse Borrowing A shareholder could have stock basis, but not be at risk, when the shareholder lends or contributes money obtained from non-recourse borrowing ( 465(b)(4) & 1.465-8(a)), Qualified non-recourse debt can be considered at-risk 465(b)(6). At risk if personally liable for repayment OR has pledged property, other than property used in such activity, as security for such borrowed amount.
Shareholder Loss Limitations Borrowing from Another Shareholder Under IRC 465(b)(3): A shareholder will not be considered at risk for amounts borrowed from a person having an interest in the activity, i.e. a shareholder. Also, a shareholder is not considered at risk in money borrowed from a person related to anyone (except the shareholder) who has an interest in the activity.
Shareholder Loss Limitations At-Risk Example Betsy is 100% owner of 1120S Brown, Consulting Business. Brown is 15% partner in a cable tv partnership Betsy is not involved in the operation of the partnership. 1120 S contributed $300,000 to acquire the partnership interest Partnership passed through a ($1,000,000) loss to 1120 S. Brown, Inc has two separate activities. Betsy has adequate stock or debt basis (p-ship debt allocation) for 1120S losses Betsy not at risk in the partnership activity in the amount of $700,000 ($300,000 investment - $1,000,000 partnership loss). ($700,000) of the ($1,000,000) loss to be suspended at 1040 level. Note: Betsy s stock and/or debt basis will still be reduced by the full ($1,000,000) even though she must suspend ($700,000) under the at-risk rules. IRC 1367(a)(2)(B) and 1366(a)(1)(A).
Loans From Shareholders Considerations for bona fide loan: Written promissory note Mechanism for Repayment Fair Market Value Interest (AFR) Consistent Reporting Open Account Debt Loans to Corporation w/o Written Note < $10K:de minimis, no FMV interest requirement > $25K: at year end, considered a debt with a promissory note 28
Shareholder Loss Limitations Passive Activity Losses IRC 469 Basic Rule - Passive losses can offset ONLY passive income. Passive loss rules do not apply to S Corporations!!! Passive loss rules apply to the individual investor. Deductible passive losses are computed on Form 8582
Shareholder Loss Limitations Trade or Business Shareholder Participation S Corporation cannot materially participate. Shareholders must individually meet the material participation requirements in order to deduct passive losses. Shareholder can deduct 1120S losses ONLY with MATERIAL PARTICIPATION!
Shareholder Loss Limitations Rental Activities Rentals are passive, with limited exceptions & regardless of material participation. Net income or loss from rental activities should be separately stated on Schedule K-1. Rental losses deductible against passive income. Exception: Real Estate Rentals $25,000 offset (with active shareholder participation, AGI phase-out limitations). Real estate professional (must materially participate). <10% ownership does not actively participate
Shareholder Loss Limitations Personal Property Rentals Rentals of personal property or equipment are passive, with limited exceptions. Rental losses only deductible against other passive income. No $25,000 offset allowed. Exception: Short Term Rentals - 1.469-1T.
Shareholder Loss Limitations NET OPERATING LOSS AT SHAREHOLDER LEVEL With sufficient basis in stock and debt, S corporation losses can be used to create a net operating loss (NOL) on Form 1040. The NOL can be carried back and then forward. An ordinary loss passed through will be treated as a business loss for NOL computation purposes. A capital loss will not affect the NOL computation unless there are capital gains on the 1040. Interest income will be non-business income on the 1040 in determining the amount of allowable non-business deductions such as itemized deductions.
Distributions to Shareholders S Corporation distributions with NO E&P: Nontaxable unless they exceed the shareholder s basis in the stock. Distributions in excess of stock basis taxed as a capital gain, generally long term if stock held > 1 year. All positive adjustments to basis are made before accounting for distributions. Distributions reduce shareholder s stock basis. (debt basis is not considered). 1368(b)
Distributions vs. Dividends S corporations generally do not issue dividends Distributions: return of previously taxed income not included in wages not an expense to the S corporation do not appear on the shareholders Form 1040 EXCEPT Distributions in excess of basis - capital gain. 35
Distributions to Shareholders Accumulated Adjustments Account (AAA) Corp tax account representing a cumulative total of flow-through items generated by the S corporation, taxed to the individual shareholders, and remaining undistributed. Adjusted like stock basis, except it can have negative balance created by loss and deduction items. Tracks income that can be distributed tax-free before distribution deemed to be taxable from AE&P. Everything that affects the shareholder s stock basis affects AAA except for items that are part of OAA. Everything included in the AAA will be reflected somewhere on Schedule K.
Distributions to Shareholders Distribution of Property Gain passed through to shareholders
Officer Compensation Compensation for Services
Officer Compensation Employee IRC 3121(d) provides that the term "employee" means: Corporate officers of a corporation; or any individual who, under usual common law rules applicable in determining the employer-employee relationship, has the status of an employee. Rev. Rul. 71-86, 1971-1 C.B. 285: Rev. Rul. 73-361, 1973-2 C.B. 331: Rev. Rul. 74-44, 1974-1 C.B. 287:
Officer Compensation Inadequate Compensation - three general considerations: The shareholder must be an employee, A reasonable salary paid, An actual payment: tax free distributions, loans, high rents, personal expenses, management fees, fringe benefits.
Officer Compensation Reasonable Compensation IRC 162(a)(1) requires: the amount of the payment must be reasonable in relation to services performed, and the payment is in fact intended as compensation for services rendered.
Officer Compensation Reasonable Compensation - considerations The employee s qualifications; The nature, extent and scope of the employee s work; The size and complexities of the business; A comparison of salaries paid with the gross/net income; The prevailing general economic conditions; Comparison of salaries with distributions to stockholders; The prevailing rates of compensation for comparable positions in comparable concerns; The salary policy of the taxpayer as to all employees; In the case of small corporations with a limited number of officers, the amount of compensation paid to the particular employee in previous years. Mayson Mfg. Company v. Commissioner
Officer Compensation Excessive Compensation To avoid the Built-In Gains Tax. Convert non-deductible taxable dividends to deductible wage expense. Shift income between shareholders. Establish that the shareholder materially participated for passive activity loss purposes.
Officer Compensation Excessive Compensation - considerations The three major sources of earnings are: 1. Services of shareholder 2. Services of non-shareholder employees 3. Capital and equipment gross receipts and profits from 2 and 3 should not translate into compensation to the extent of item 1.
Officer Compensation Loans to Shareholder - Considerations Wages disguised as loans? Taxable Distributions? Requirements for bona fide loan: Written promissory note Mechanism for Repayment Fair Market Value Interest (AFR) Consistent Reporting 45
Officer Compensation Inadequate Compensation or distribution? Whether security was given. Whether the shareholder is in a position to repay the loan. Whether the corporation has adequate earnings and profits. Whether a certificate of indebtedness is given to the corporation. Whether there is a repayment schedule or an attempt to repay. Whether there is there a set maturity date. Whether the corporation charges interest. Whether systematic efforts to obtain repayment. The magnitude of the advances. Whether ceiling to limit the amount the corporation can advance. What the dividend history of the corporation is.
Officer Compensation Forgiveness of Loan to Shareholder If during the year the loan to shareholder account decreased and no repayment was made, Treas. Reg. 1.301-1(m) provides that forgiveness by a corporation of debt to a shareholder is considered a distribution. As such, the S corporation is not allowed a bad debt deduction and the shareholder has a distribution.
Officer Compensation Loan to Shareholder--Imputed Interest If the S corporation is on the accrual basis, and the Loan to Shareholder has a stated interest rate in the loan documents, the S corporation should be accruing the interest income even if the shareholder has not actually paid it. This interest income would then flow-through to the shareholder(s) who would report it on their Form 1040, Sch. B. where there is no stated interest, or where the stated interest is below-market. In that situation we apply IRC 7872 and impute the interest income and expense. Under IRC 7872 there is a deemed payment of the interest income to the S corporation.
Officer Compensation Third-party resources: US Department of Labor, Bureau of Labor Statistics www.bls.gov www.salary.com www.bizstats.com/ Journal of Accountancy, Business & Industry Compensation and Benefits http://www.aicpa.org/pubs/jofa/oct2004/dennis.ht m SalaryExpert.com
Special Concern for S Shareholders 50 Distributions or Shareholder Basis Loss Limitations Loans Reasonable Compensation Fringe Benefits >2% Shareholder Taxable Non-Taxable Home Office
S Corporations Tips & Tricks Timely file your S election paper work: Form 2553. Timely file all your income tax returns. March 15 th, not April 15 th. Do not comingle personal & business funds. Pay all officers a reasonable wage & document the rationale for the particular compensation selected. Avoid making distributions in excess of shareholder salaries. Make distributions proportional to each shareholder s percentage of ownership. Make the 51 corporate resolutions for shareholder loans, and home office & accountable reimbursement plans. Report health insurance premiums through payroll. Be aware that if your spouse is eligible for subsidized coverage through another employer you will lose the Self-Employed Health Insurance deduction. Track shareholder basis at the corporate level and provide a statement to shareholders with the Schedule K-1. 51
QUESTIONS