Chapter 22

S Corporations

Comprehensive Volume
2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Big Picture (slide 1 of 2)

Cane, Inc., has been a C corp. for a number of years,
earning taxable income of less than $100,000 per
year.
Thus, the business has been subject to the lower C
corporation tax rates.

Due to cheap imports from China, Canes two

owners, Smith and Jones, expect operating losses for
the next two or three years.
They hope to outsource some of the manufacturing to
Vietnam and turn the company around.

How can they deduct these anticipated future losses?

The Big Picture (slide 2 of 2)

The corp. receives some tax-exempt income,
generates a small domestic production activities
deduction (DPAD), and holds some C corp. E&P.
Each owner draws a salary of $92,000.
Cane has two classes of stock, voting and non-voting
common stock.
Should Smith and Jones elect to be taxed as an S
corporation?
Do they need to liquidate or go through some type of
reorganization to do so?

Read the chapter and formulate your response.

Subchapter S Issues
(slide 1 of 6)

S corporations provide many of the benefits of

partnership taxation
Also gives the owners limited liability protection
from creditors

S corporation status is obtained through an

election by a qualifying corporation with the
consent of its shareholders

Subchapter S Issues
(slide 2 of 6)

S corporations are still corporations for legal

purposes
Owners receive the benefits of limited liability,
ability to raise capital (within limits), etc...

Subchapter S Issues
(slide 3 of 6)

Taxation resembles partnership taxation

Certain items (primarily business income and
certain expenses) are accumulated and passed
through to shareholders
Other items are separately stated and each item
is passed through to shareholders

Subchapter S Issues
(slide 4 of 6)

An S corporation is a reporting (rather than

tax-paying) entity
Tax liability may still arise at the entity level
for:
Built-in gains tax, or
Passive investment income penalty tax

Subchapter S Issues
(slide 5 of 6)

An S corporation is not subject to the

following taxes:

Corporate income tax

Accumulated earnings tax
Personal holding company tax
Corporate alternative minimum tax

Subchapter S Issues
(slide 6 of 6)

Entity is subject to Subchapter C rules for a

transaction unless Subchapter S provides
alternate rules

When to Elect S Corp Status

Following factors should be considered:
If shareholders have high marginal tax rates vs C
corp rates
If NOLs are anticipated
If currently C corp, any NOL carryovers from
prior years cant be used during S corp years
Still reduces 20 year carryover period

Character of anticipated flow-through items

S Corp Qualification
Requirements (slide 1 of 3)
To elect under Subchapter S, a corporation
must meet the following requirements:
Must be a domestic corporation
Must not otherwise be ineligible
Ineligible corporations include certain banks, insurance
companies and foreign corporations
Any domestic corp. that is not an ineligible corp. can be
a qualified Subchapter S Subsidiary (QSSS) if:
S corp owns 100% of its stock, and
Elects to treat the subsidiary as a QSSS

S Corp Qualification
Requirements (slide 2 of 3)
Corporation may have only one class of stock
Can have stock with differences in voting rights
but not in distribution or liquidation rights
It is possible for debt to be reclassified as stock
Results in unexpected loss of S corp status
Safe harbor provisions mitigate concern over
reclassification of debt

S Corp Qualification
Requirements (slide 3 of 3)
Must have 100 or less shareholders
Family members may be treated as one shareholder

Shareholders can only include individuals, estates,

certain trusts, and certain tax-exempt organizations
Partnerships, Corps, LLPs, most LLCs and most IRAs
cannot own S corp stock, but S corps can be partners in a
partnership or shareholders in a corporation

Shareholders cannot include any nonresident aliens

The Big Picture Example 3

One Class of Stock

Return to the facts of The Big Picture on p. 222.
Cane, Inc., could elect to be an S corp. as long as the 2 classes
of common stock are identical except that one class is voting
and the other class is nonvoting.
You learn that both shareholders have binding employment
contracts with Cane, Inc.
The amount paid to Jones under her employment contract is reasonable
The amount paid to Smith is excessive, resulting in a constructive
dividend.

Smiths employment contract was not prepared to circumvent

the one-class-of-stock requirement.
Because employment contracts are not considered governing
provisions, Cane still is treated as though it has only one class of stock
if an S election is made.

Making the Election

(slide 1 of 3)

To become an S corp, must make a valid

election that is:
Filed timely
All shareholders must consent to the election

Making the Election

(slide 2 of 3)

To be effective for current year

Make election by 15th day of third month of
current tax year, or
File in previous year

Making the Election

(slide 3 of 3)

Shareholder Consent
Each shareholder owning stock during election
year must sign consent for election (even if stock
is no longer owned at election date)
May be able to obtain extension of time for filing
consent from IRS
Available only if Form 2553 is filed on a timely basis,
reasonable cause is given, and the interests of the
government are not jeopardized

The Big Picture Example 6

Making The Election

Return to the facts of The Big Picture on p. 222.

Suppose that in 2011, shareholders Smith and

Jones decide to become an S corp. beginning
January 1, 2012.
Since the C corporation uses a calendar tax
year, the S election can be made at any time in
2011 or by March 15, 2012.
An election after March 15, 2012, will not be
effective until the 2013 calendar tax year.

Termination of Election
(slide 1 of 4)

The S election is lost in any of the following

ways:
1. Shareholders owning a majority of shares
voluntarily revoke the election
Revocation must be filed by 15th day of third
month to be effective for entire year
Otherwise, it is effective for first day of following
year, or any other specified future date

Termination of Election
(slide 2 of 4)

2.New shareholder owning > 50% of entity

affirmatively refuses to consent to election
3. Entity no longer qualifies as S corp
e.g., The entity has > 100 shareholders or a
nonresident alien shareholder, a second class of
stock exists, etc.
Election is terminated on date disqualification
occurs

Termination of Election
(slide 3 of 4)

4. The corporation does not meet the passive

investment income limitation
Passive investment income limitation
If passive income > 25% of gross receipts for 3
consecutive taxable years
S election is terminated as of the beginning of the fourth year

Only applies if an S corp. has C corp. E & P

Termination of Election
(slide 4 of 4)

A new election normally cannot be made

within 5 years after termination of a prior
election
Five year waiting period is waived if:
There is a > 50% change in ownership after first year
termination is applicable
Event causing termination was not reasonably within
control of the S corp or its majority shareholders

Computation of Taxable Income

(slide 1 of 2)

Determined in a manner similar to partnerships

except
S corp amortizes organizational costs under the
corporate rules
S corp must recognize gains (but not losses) on
distributions of appreciated property to
shareholders

Computation of Taxable Income

(slide 2 of 2)

S corp items are divided into:

Nonseparately stated income or loss
Essentially, constitutes Subchapter S ordinary income or
loss

Separately stated income, losses, deductions and

credits that could affect tax liability of
shareholders in a different manner
Identical to separately stated items for partnerships

Flow-Through of S Corporation Items

Separately Stated Items

Examples include:
Tax-exempt income
Gains/losses from disposal of business property
and capital assets
Charitable contributions
Income/loss from rental of real estate
Interest, dividend, or royalty income
Tax preference items

Allocation of Income and Loss

(slide 1 of 2)

Each shareholder is allocated a pro rata portion

of nonseparately stated income (loss) and all
separately stated items
If stock holdings change during year, shareholder
is allocated a pro rata share of each item for each
day stock is owned

Allocation of Income and Loss

(slide 2 of 2)

Short-year election is available if a shareholders

interest is completely terminated (through
disposition or death)
Allows tax year to be treated as two tax years
Results in interim closing of books on date of termination
Shareholders report their shares of S corp items as they
occurred during year

S Corporation Distributions
(slide 1 of 7)

Amount of distribution to shareholder = cash +

FMV of any other property distributed
Taxation of distribution depends on whether
the S corp has accumulated E&P from C corp
years

S Corporation Distributions
(slide 2 of 7)

Where no Earnings and Profits exist

1. Nontaxable to the extent of adjusted
basis in stock
2. Excess treated as gain from the sale
or exchange of property (capital gain
in most cases)

S Corporation Distributions
(slide 3 of 7)

Where Earnings and Profits exist

1. Tax-free to the extent of accumulated adjustments account*

2. Any PTI from pre-1983 tax years can be distributed tax-free
3. Remaining distribution is ordinary dividend from AEP**
4. Tax-free to extent of Other Adjustments Account
5. Tax-free reduction in basis of stock
6. Excess treated as gain from the sale or exchange of stock (capital
gain in most cases)

* Once stock basis reaches zero, any distribution from AAA is treated
as a gain from sale or exchange of stock. Basis is the maximum taxfree distribution a shareholder can receive.
** AAA bypass election is available

S Corporation Distributions
(slide 4 of 7)

Accumulated Adjustments Account (AAA)

Represents cumulative total undistributed
nonseparately and separately stated items
Mechanism to ensure that earnings of an S corp are
taxed to shareholders only once

S Corporation Distributions
(slide 5 of 7)

Accumulated Adjustments Account (AAA) is

adjusted as follows:
Increased by:
Nonseparately computed income and Schedule K items other than
tax-exempt income
Depletion in excess of basis in property

Decreased by:
Negative Schedule K adjustments other than distributions
Portion of distribution treated as tax-free from AAA (but not below
zero)

S Corporation Distributions
(slide 6 of 7)

Other issues regarding distributions:

Distributions of cash during a one-year period
following S election termination receive special
treatment
Treated as a tax-free recovery of stock basis to the
extent it does not exceed AAA account
Since only cash distributions receive this special
treatment, the corp should not distribute property during
this postelection termination period

S Corporation Distributions
(slide 7 of 7)

Other issues regarding distributions:

If E & P exists, the entity may elect to first
distribute E & P before reducing AAA
Called an AAA bypass election

Distributions of Property
If the entity distributes appreciated property
Gain must be recognized
Treated as if property sold to shareholder for FMV
Gain is allocated to shareholders and increases
shareholders basis in stock in the entity, before
considering the effect of the distribution
Basis of asset distributed = FMV

Shareholders Basis
(slide 1 of 4)

Determination of initial basis is similar to that

of basis of stock in C corp
Depends on manner stock was acquired
e.g., gift, inheritance, purchase, exchange

Basis is increased by:

Stock purchases
Capital contributions
Nonseparately computed income
Separately stated income items
Depletion in excess of basis

Shareholders Basis
(slide 2 of 4)

Basis is decreased by:

Distributions not reported as income by shareholders (e.g., from
AAA or PTI)
Nondeductible expenses (e.g., fines, penalties)
Nonseparately computed loss
Separately stated loss and deduction items

Similar to partnership basis rules

First increase basis by income items
Then decrease it by distributions and finally losses

Noncapital, nondeductible expenditures reduce stock basis

before losses or deductible items unless taxpayer elects to
have deductible items pass through before any noncapital,
nondeductible items

Shareholders Basis
(slide 3 of 4)

Shareholders basis cannot be negative

Once basis is reduced to zero, any additional
reductions (losses or deductions, but not
distributions) decrease (but not below zero) basis
in loans made to S corp
Any excess losses or deductions are suspended
Once basis of debt is reduced, it is increased by
subsequent net increases from all positive and
negative adjustments

Shareholders Basis
(slide 4 of 4)

Basis rules are similar to partnership rules

except:
Partners basis in partnership interest includes
direct investment plus a ratable share of
partnership liabilities
Except for loans from a shareholder to the S Corp,
corporate borrowing does not affect shareholders
basis

Treatment of Losses
(slide 1 of 2)

Step 1. Allocate total loss to the shareholder on a daily basis,

based upon stock ownership
Step 2. If shareholders loss exceeds stock basis, apply any
excess to adjusted basis of indebtedness to the
shareholder. Distributions do not reduce debt basis.
Step 3. Where loss > debt basis, excess is suspended and
carried over to future tax years.
If the shareholders basis is insufficient to allow a full flow
through and there is more than one type of loss, the flowthrough amounts are determined on a pro rata basis
e.g., The S corp. incurs both a passive loss and a net capital loss in the
same year

Treatment of Losses
(slide 2 of 2)

Step 4. In future tax years, any net increase in basis

adjustment restores debt basis first, up to its original
amount.
Step 5. Once debt basis is restored, remaining net increase is
used to increase stock basis.
Step 6. Suspended loss from a previous year now reduces
stock basis first and debt basis second.
Step 7. If S election terminates, any loss carryover remaining
at the end of the post-termination transition period is
lost forever.

The Big Picture Example 34

Net Operating Loss

Return to the facts of The Big Picture on p. 222.

If Smith and Jones make the S election for Cane, Inc.,

they will be able to pass through any NOLs to the
extent of the shareholders adjusted stock basis.
If the new S corporation incurs an NOL of $84,000
during 2011, both shareholders are entitled to deduct
$42,000 against other income for the tax year in
which Canes tax year ends.
Any NOL incurred before the S election is in effect
does not flow through to the two shareholders.

At-Risk Rules
Generally apply to S corp shareholders
At-risk amounts include:
Cash and adjusted basis of property contributed to corp
Any amount borrowed for use in the activity for which
the shareholder is personally liable
Net FMV of personal assets that secure nonrecourse
borrowing

Losses suspended under at-risk rules are carried

forward and are available during post-termination
transition period

Passive Losses and Credits

An S corp is not directly subject to the passive
loss rules
If the corporation is involved in rental activities or
shareholders do not materially participate
Passive losses and credits flow through to shareholders
Shareholders stock basis is reduced even if passive
losses are not currently deductible

Built-in Gains Tax

(slide 1 of 4)

Generally applies to C corporations converting

to S corp status after 1986
Corporate-level tax on built-in gain recognized in a
taxable disposition within 10 calendar years after
the effective date of the S corp election
The 10-year holding period is reduced to
7 years for tax years beginning in 2009 and 2010, and
5 years for 2011.

Built-in Gains Tax

(slide 2 of 4)

Tax base includes unrealized gain on assets

held on date of S corp election
Highest corporate tax rates apply (currently 35%)
This gain passes through to shareholders as taxable
gain

Maximum built-in gain recognized over the

required (5-,7- or 10-year) holding period is
limited to aggregate net built-in gain at time
corp. converted to S status

Built-in Gains Tax

(slide 3 of 4)

Amount of built-in gain recognized in any year

is limited to an as if taxable income,
computed as if the corp were a C corp
Any gain that escapes taxation under this limit is
carried forward and recognized in future years

S corp can offset built-in gains with unexpired

NOLs or capital losses from corp. years

Built-in Gains Tax

(slide 4 of 4)

LIFO recapture tax

Any LIFO recapture amount at time of S corp
election is subject to a corporate-level tax
Taxable LIFO recapture amount = excess of
inventorys value under FIFO over the LIFO value
Resulting tax is payable in four annual installments
First payment is due on or before due date of last C corp
tax return

Computation of Built-in
Gains Tax (slide 1 of 2)
Step 1. Select the smaller of built-in gains or
taxable income.*
Step 2. Deduct unexpired NOLs and capital
losses from C corporation tax years.
Step 3. Multiply the tax base from step 2 by the
top corporate tax rate.
*Any net recognized built-in gain > taxable income is carried
forward to the next year, as long as the next year is within the 5-,
7-, or 10-year recognition period.

Computation of Built-in
Gains Tax (slide 2 of 2)
Step 4. Deduct business credit carryforwards and AMT
credit carryovers from a C corporation tax year
from the amount obtained in step 3.
Step 5. The corporation pays any tax resulting from
step 4.

The Big Picture Example 41

Built-in Gains Tax

Return to the facts of The Big Picture on p. 222.

If Cane, Inc., becomes an S corp., a built-in

gain may be recognized.
Assume that Cane reports a $50,000 built-in
gain on conversion.
It holds a $20,000 NOL carryforward from C
corporation years before the S election.

The NOL carryforward is applied against the

built-in gain.
Canes built-in gains tax applies only to $30,000.

Passive Investment Income Penalty

Tax (slide 1 of 3)
If an S corp has accumulated E&P (AEP)
from C corp years
A tax is imposed on excess net passive income
(ENPI) calculated as follows:
Passive investment income
ENPI = > 25% of gross receipts
Passive investment income
for the year

Net passive
investment
income for
the year

Passive Investment Income Penalty

Tax (slide 2 of 3)
Passive investment income includes royalties,
rents, dividends, interest, annuities
Only net gain from disposition of capital assets is
included

Net passive income is passive income less

directly related deductions

Passive Investment Income Penalty

Tax (slide 3 of 3)
Excess net passive income cannot exceed C
corp. taxable income before considering any
NOL or other special deductions
Tax rate applied is the highest corporate tax
rate for the year

Refocus On The Big Picture (slide 1 of 3)

As long as Smith and Jones, the owners of Cane, Inc.,
maintain C corporation status, they cannot deduct any
NOLs that the business incurs on their individual tax
returns.
For the owners to deduct any future NOLs on their Forms
1040, Cane needs to be operated as a flow-through entity.
The most logical alternatives are to make an S election or
to become a limited liability company.

An S election may be appropriate for Cane.

Cane should make a timely election on Form 2553.
Both shareholders must consent to the election.

The owners should make the election on or before the

fifteenth day of the third month of the current year.

Refocus On The Big Picture (slide 2 of 3)

Normally, an S corp. does not pay any income tax.
A C corp. making an S election may be required to pay a
built-in gains tax or a LIFO recapture tax.
The base for the built-in gains tax includes any unrealized
gain on appreciated assets held by Cane on the day the
owners elect S status.
The highest corporate rate is applied to the unrealized gain
when any of the built-in gain assets are sold.
If the corporation uses the LIFO inventory method, any
LIFO recapture amount at the time of the S election is
subject to a corporate-level tax.

Refocus On The Big Picture (slide 3 of 3)

Cane does not need to liquidate or engage in a taxdeferred reorganization when converting to an S
corporation.
An S corporation can have voting and nonvoting common
stock, provided that all shares have the same economic
rights to corporate income or loss.
Data used to compute a DPAD flows through to the
shareholders.

Cane might get rid of the tax-exempt income, which

will not be reflected in AAA.
Although it is reflected in stock basis, tax-exempt income
(as part of OAA) is distributed to the shareholders only
after the S corporation has distributed all of its C
corporation E&P.

If you have any comments or suggestions concerning this

PowerPoint Presentation for South-Western Federal
Taxation, please contact:
Dr. Donald R. Trippeer, CPA
trippedr@oneonta.edu
SUNY Oneonta

2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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