These lectures cover taxation of S corporation, nonseparately stated income or loss, separately stated income, accumulated earnings and profit.
Basic of S Corporation
Separately and Non-Separately Stated Items on Schedule K 1
Accumulated Adjustment Account AAA
Example: Accumulated Adjustment Account AAA
Example: Property distribution for S corporation
Example: Property Dividend Distribution for C Corporation
CHOICE OF BUSINESS ENTITY
S corporations (like C corporations) are organized under state law. Other than for income tax purposes, they are recognized as separate legal entities and generally pro- vide shareholders with the same liability protection available to C corporations. For Federal income tax purposes, however, taxation of S corporations resembles that of partnerships. As with partnerships, the income, deductions, and tax credits of an S corporation flow through to shareholders annually, regardless of whether distributions of wealth (like cash) are made to the shareholders. Thus, income is taxed at the share- holder level and not at the corporate level. Payments to S shareholders by the corporation are distributed tax-free to the extent the distributed earnings were previously taxed. Further, C corporation taxes such as the alternative minimum tax do not apply directly to an S corporation. Although the Federal tax treatment of S corporations and partnerships is similar, the two sets of computations are not identical. For instance, liabilities affect an owner’s basis differently, and S corporations may incur a tax liability at the corporate level. Further- more, an S corporation may not make a special allocation of tax items like a partnership can, and distributions of appreciated property are taxable in an S corporation situation.
Definition of a Small Business Corporation
To achieve S corporation status, a corporation first must qualify as a . If each of the following requirements is met, then the entity can elect
S corporation status.
• Isadomesticcorporation(incorporatedandorganizedintheUnitedStates). • Isaneligiblecorporation(seethefollowingsectionforineligibletypes). • Issuesonlyoneclassofstock. • Islimitedtoatheoreticalmaximumof100shareholders.
• Has only individuals, estates, and certain trusts and exempt organizations as shareholders.
• Hasnononresidentalienshareholders. No maximum or minimum dollar sales or capitalization restrictions apply to small
S corporations are treated much like partnerships for tax purposes. With a few excep- tions,22 S corporations generally make tax accounting and other elections at the corporate level. Each year, the S corporation determines nonseparately stated income or loss and separately stated income, deductions, and credits. These items are taxed only once, at the shareholder level. All items are allocated to each shareholder based on average owner- ship of stock throughout the year.
Computation of Taxable Income An S corporation’s taxable income or loss is determined in a manner similar to the tax rules that apply to partnerships, except that S corporations amortize organizational expenditures under the C corporation rules and must recognize gains, but not losses, on distributions of appreciated property to shareholders. Other special provisions affecting only the computation of C corporation income, such as the dividends received deduction, do not extend to S corporations.25 Finally, as with partnerships, certain deductions of individuals are not permitted, including alimony payments, personal moving expenses, certain dependent care expenses, the personal exemption, and the standard deduction. In general, S corporation items are divided into (1) nonseparately stated income or loss and (2) separately stated income, losses, deductions, and credits that could affect the tax liability of any shareholder in a different manner, depending on other factors in the shareholder’s tax situation. Nonseparate items are aggregated into an undifferentiated amount that constitutes Subchapter S ordinary income or loss. An S corporation’s separately stated items are identical to those separately stated by partnerships. These items retain their tax attributes on the shareholder’s return. Separately stated items are listed on Schedule K of the 1120S.
They include the following. • Tax-exempt income. • Long-term and short-term capital gains and losses. • Section 1231 gains and losses. • Charitable contributions(no grace period). • Passive activity gains,losses, and credits. • Certain portfolio income. • Section 179 deduction. Domestic production gross receipts and deductions. • Tax preferences and adjustments for the alternative minimum tax. • Depletion. • Foreign in come or loss. • Recoveries of tax benefit items. • Intangible drilling costs. • Investment interest,income, and expenses.
Allocation of Income and Loss
Each shareholder is allocated a pro rata portion of nonseparately stated income or loss and all separately stated items. The pro rata allocation method assigns an equal amount of each of the S items to each day of the year. If a shareholder’s stock holding changes during the year, this allocation assigns the shareholder a pro rata share of each item for each day the stock is owned. On the date of transfer, the transferor (and not the transferee) is considered to own the stock.
Tax Treatment of Distributions to Shareholders The amount of any actual distribution of wealth (like cash) to an S corporation share- holder is equal to the cash plus the fair market value of any other property distributed. How the distribution is taxed depends upon whether the S corporation has C corporation accumulated earnings and profit.
Shareholder’s Basis in S Stock LO.8 Calculate a shareholder’s basis in S corporation stock. The calculation of the initial tax basis of stock in an S corporation is similar to that for the basis of stock in a C corporation and depends upon the manner in which the shares are acquired (e.g., gift, inheritance, purchase, or exchange under § 351). Once the initial tax basis is determined, various transactions during the life of the corporation affect the shareholder’s basis in the stock. Although each shareholder is required to compute his or her own basis in the S shares, neither Form 1120S nor Schedule K–1 provides a place for deriving this amount. A shareholder’s basis is increased by stock purchases and capital contributions. Operations during the year cause the following upward adjustments to basis.• Nonseparately computed income. • Separately stated income items(e.g.,nontaxable income). • Depletion in excess of basis in the property. Basis then is reduced by distributions not reported as income by the shareholder (e.g., an AAA distribution). Next, the following items reduce basis (but not below zero). • Nondeductible expenses of the corporation (e.g., fines, penalties, and illegal kickbacks). • Nonseparately computed loss. • Separately stated loss and deduction items. As under the partnership rule, basis first is increased by income items; then it is decreased by distributions and finally by losses. In most cases, this losses last rule is advantageous to the S shareholder.
Treatment of Losses Net Operating Loss
One major advantage of an S election is the ability to pass through any net operating loss of the corporation directly to the shareholders. A shareholder can deduct an NOL for the year in which the S corporation’s tax year ends. The corporation does not deduct the NOL. A shareholder’s basis in the stock is reduced to the extent of any pass-through of the NOL, and the entity’s AAA is reduced by the same deductible amount.
Deductions for an S corporation’s loss pass-throughs (e.g., NOL, capital loss, and charitable contributions) cannot exceed a shareholder’s adjusted basis in the stock plus the basis of any loans made by the shareholder to the corporation. If a taxpayer is unable to prove the tax basis, the loss pass-through can be denied.
Distributions made by an S corporation are taken into account before applying the loss limitations for the year.