Chapter 22

S Corporations

Comprehensive Volume
2014 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.
Cane is located in Texarkana, Texas.
Smith lives in Texas, and Jones lives in Arkansas.
Both are married to nonresident aliens.

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

State and local tax laws
A variety of other factors

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

The Big Picture Example 3

One Class of Stock

Return to the facts of The Big Picture on p. 221.
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.

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

Shareholders may include resident individuals,

estates, certain trusts, and certain tax-exempt
organizations
Charitable organizations, employee benefit trusts exempt
from taxation, and a one-person LLC classified as a
disregarded entity also can qualify as shareholders of an S
corporation
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 6

Nonresident Aliens

Return to the facts of The Big Picture on p. 221.

Jones lives in Arkansas, a common law property state.

Being married to a nonresident alien spouse would not
affect an S election.

However, Smith lives in Texas, a community property

state.
His nonresident alien spouse would be treated as owning
half of his community property stock.

Consequently, an S election would not be allowed.

To qualify for S status, Smith could move to Arkansas
or his spouse could move to Texas (becoming a
resident alien).

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 7

Making The Election

Return to the facts of The Big Picture on p. 221.

Suppose that in 2013, shareholders Smith and

Jones decide to become an S corp. beginning
January 1, 2014.
Since the C corp. uses a calendar tax year, the
S election can be made at any time in 2013 or
by March 15, 2014.
An election after March 15, 2014, will not be
effective until the 2015 calendar tax year.

Termination of Election
(slide 1 of 4)

An S election remains in force until revoked or lost,

however, an S election can terminate if:
1. Shareholders owning a majority of shares voluntarily
revoke the election
Revocation must be filed by 15th day of third month of tax
year to be effective for entire year
Otherwise, it is effective for first day of following year, or
any other specified future date
A revocation that designates a future effective date splits the corps
tax year into a short S corp. year and a short C corp. year

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

If an S corp. fails to qualify as a small business corp. at

any time after the election has become effective, its status
as an S corp. ends

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 corp. does not meet the passive

investment income limitation
If an S corp. has C corp. E & P and passive income
> 25% of its gross receipts for three consecutive
taxable years
The S election is terminated as of the beginning of the
fourth year

Applies to S corps. that were previously C corps.

or for S corps. that have merged with C corps.

Termination of Election
(slide 4 of 4)

A new S 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 C
corp. rules
S corp. must recognize gains (but not losses) on
distributions of appreciated property to
shareholders
Certain other special C corp. provisions do not
extend to S corps.
e.g., Dividends received deduction

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
On the date of transfer, the transferor (and not the
transferee) is considered to own the stock

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 stock
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. Distributions from AEP constitute dividend income. **
3. Tax-free to extent of Other Adjustments Account
4. Tax-free reduction in basis of stock*
5. 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)

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 their
basis in stock before considering the distribution
Basis of asset distributed = FMV

Loss is not recognized

Basis of asset distributed = FMV
Essentially, loss property receives a stepdown in basis
without any loss recognition by the S corp.
Thus. distributions of loss property should be avoided

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)
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

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 35

Net Operating Loss

Return to the facts of The Big Picture on p. 221.

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 corp. incurs an NOL of $84,000 during
2013, 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
S corp. shareholders are limited in the amount of loss
they may deduct by their at-risk amounts
Rules for determining at-risk amounts are similar, but not
identical, to the partner at-risk rules
At-risk rules apply to the shareholders, but not to the corp.

Amount at risk is determined separately for each

shareholder

The amount of the corporate losses that are passed

through and deductible by the shareholders is not
affected by the amount the corp. has at risk

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 corps. 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 through 2013

Built-in Gains Tax

(slide 2 of 4)

Tax base includes unrealized gain on appreciated

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 C 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. 221.

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 corp.
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

The Big Picture Example 46

Salary Vs. Distribution

Return to the facts of The Big Picture on p. 221.

The two shareholders should consider reducing their

$92,000 salary and instead receiving a larger
undistributed share of the S corp. income.
A shareholders share of pass-through S corp. income is not
treated as self-employment income, whereas compensation
is subject to a 12.4% Social Security tax and 2.9%
Medicare tax.
By receiving the $92,000 as a distribution rather than
salary, each shareholder saves $14,076 ($92,000 15.3%).

Refocus On The Big Picture (slide 1 of 3)

As long as Smith and Jones, the owners of Cane, Inc.,
maintain C corp. 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.

Cane does not need to liquidate or engage in a taxdeferred reorganization when converting to an S corp.
An S corp. 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

Refocus On The Big Picture (slide 3 of 3)

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

2014 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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