#11713 - S Corporations Pass Through - Corporate Tax (Duke Zelenak)

S corporations function as pass-through entities.

1. Under section 1366, tax credits, income, etc. of the S corporations pass through proportionately to SH according to their share proportions.

Choice of entity concerns

1. S v. C

   1. You can start out as an S corporation, and then you can revert back to C.

2. S v. K

   1. Cannot do individualized allocations for S corporations; can do individualized allocations for K, partnerships

   2. S is simpler and cheaper tax-wise if you want to go public, because you don’t have to incorporate again. If you start with K, you’ll have to incorporate again.

   3. If you start with C, and you want to become a pass-through entity, you can simple select the S. If you become a K, you’ll have to liquidate the C and then become K.

no more than 100 SH

1. husband and wife and their estates are counted as one shareholder

2. All the members of a family are treated as a single shareholder

Corporation can have only one class of stock

1. Corporation treated as having one class of stock if all of its outstanding shares confer identical rights to distributions and liquidation proceeds.

   1. Look at corporate charter, AoI, bylaws, applicable state law and binding SH’s agreement

2. Differences in voting rights among classes of common stock are disregarded.

3. Obligations treated as a second class of stock if

   1. It constitutes equity under general tax principles, and

   2. A principal purpose of issuing or entering into the instrument, obligation or arrangement is to circumvent the distribution and liquidation rights of outstanding shares or the limitation on eligible SH.

4. Safe harbor: Section 1361(c)(5): straight debt is not treated as a disqualifying second class of stock.

   1. Straight debt if the interest rate and payment dates are not contingent on profits, the borrower’s discretion or similar factors,

   2. The instrument is not convertible directly or indirectly into stock; and

   3. The creditor is an individual other than a nonresident alien, and estate, or trust that would be a qualifying shareholder in an S corporation, or a person that is actively and regularly engaged in the business of lending money

Only certain types of persons are permissible as SH

1. Individuals, estates, and certain types of trusts and tax-exempt organizations

2. no nonresident alien SH, no corporations, no partnerships, no ineligible trusts

   1. permissible trusts are:

   2. Ineligible corporations and subsidiaries:

      1. Banks and insurance companies are ineligible

      2. Subsidiaries:

Electing S corporation status: can elect under 1362 if all SH consent

1. Once made it is effective until terminated

2. Effective as of the beginning of a taxable year if made during the preceding year or on or before the fifteenth day of the third month of the current taxable year.

   1. All shareholders at any time during this 2.5 months (including past SH) must consent

Revocation of election: if SHs holding more than one-half of the corporation’s shares, including non-voting shares, consent to the revocation.

Termination of Election: may be terminated if the corporation

1. ceases to satisfy the eligibility requirement, or

2. earns an excessive amount (more than 25% of gross receipts) of passive investment income

Inadvertent terminations: if terminated, cannot reelect for 5 taxable years.

1. If termination is inadvertent, under 1362(f), the corporation can still be S if

   1. IRS determines that the termination was inadvertent

   2. The corporation takes steps within a reasonable time to rectify the problem, and

   3. The corporation and its SH agree to make adjustments required by the IRS

Taxable year of an S Corporation

1. Section 1378: S corporations must use a permitted year, which is a calendar year or an accounting period for which the taxpayer establishes a business purpose

   1. The accounting period qualifies if it coincides with a natural business year

   2. A natural business year exists if 25 percent or more of the S corporation’s gross receipts for the selected 12-month period are earned in the last two months.

   3. This 25 percent test must be met in each of the preceding three 12-month periods that correspond to the requested fiscal year.

2. Section 444 permits a newly formed S corporation to elect to use a different taxable year if the year elected results in no more than a three-month deferral of income to SH.

Problem p675

1. can elect S under 1362, if all SH consent. G would have to consent because G will be the stockholder at the time of the election.

   1. Election in the first 2.5 months of a tax year, the election will be valid retroactively if B, the previous SH, consents. If previous SH does not consent, the election will be valid next year.

   2. If B is partnership, then cannot elect to be an S corporation for the first year.

2. 2.5 months after Oct. 3 Dec. 17th (on the 15th day, so 3+15-1=17)

3. Calendar year or natural business year

4. No. has to be more than half ownership

5. Terminate the S status

6. Inadvertent terminations 1362(f)

Pass-through treatment: according to Section 1366(a), S corporation’s net income passes through to SH.

1. If there is a distribution of appreciated property, start with the S corporation, then look at pass through

Basis adjustment

1. Section 1367(a)(1) requires S corporation SH to increase the basis of their stock by their respective shares of income items and to reduce basis, but not below zero, by losses, deductions, and non-deductible expenses which do not constitute capital expenditures, and by tax-free distributions under Section 1368

2. Unlike partnerships, S corporation SH do not increase stock basis for entity-level debt, even if the debt is SH-guaranteed. (Harris)

   1. Although there is a taxpayer-favorable opinion on the issue (the 11th circuit Selfe opinion), taxpayers very seldom succeed in challenging the forms of their own transactions.

Loss limitation

1. Section 1366(d) limits the amount of losses or deductions that may pass through to a SH to the sum of the SH’s adjusted basis in the stock plus his adjusted basis in any indebtedness of the corporation to the SH.

2. Losses disallowed because of an inadequate basis may be carried forward indefinitely and treated as a loss in subsequent year in which the SH has a basis in either stock or debt.

3. If transferred to spouse or former spouse, losses can be carried forward by the transferee-spouse.

4. 1367(b)(2)(B) if you reduce basis in debt because of a pass-through loss in a previous loss, and now you have pass-through gain, before you increase basis in stock, you restore the basis in debt first.

Coordination with subchapter C

1. Section 1371(a): Except to the extent inconsistent, subchapter C shall apply to an S corporation and its SH.

Problem 3, p 689

1. 4000 loss passes through to each SH.

   1. D could deduct up to 2000+4000=6000, here he will deduct 4000. Basis in stock now 0.

   2. H could deduct up to 2000, here he will deduct 2000, and this disallowed loss can be carried forward. Basis in stock is now 0.

   3. Cannot guarantee the loan

   4. Best way is to loan some money to the corporation

2. Each gets 3000 income pass-through

   1. H, 3000 income, basis goes up to 3000. Then is reduced by the carried forward loss of 2000 1000 basis

   2. D, restores the basis of loan back to 4000, and then increase basis to 1000

3. Cross off this question

4. H can deduct the suspended loss, but cannot exceed the basis of your stock

   1. Cannot loan money to the corporation anymore

   2. Only way to do it is making capital contribution and get more basis.

13-1 (distribution of appreciated property);

1. 11-2 distribution of appreciated property, taxation of built in gain

2. 09-5 distribution of appreciated property, no E&P

The tax consequences of the distribution are determined as if the distribution were made at the end of the year.

No E&P

1. 1368(b)(1): Distribution treated as tax-free return of capital which is

   1. first applied to reduce the SH’s basis

   2. then capital gain.

Yes E&P

1. Accumulated adjustments account: to identify the source of distributions by those S corporations with accumulated EP. Net income recognized

   1. Under 1368(e)(1)(A) AAA represents the post-1982 undistributed net income of the corporation

   2. It increases and decreases annually in a manner similar to the adjustment of the basis in a SH’s stock

   3. AAA is not adjusted for tax exempt income

2. Order 1368(c)(1):

   1. Tax free recovery of AAA (also reduces basis that is represented by AAA)

   2. Dividends out of E&P

   3. Basis not represented by AAA

   4. Capital gain

Distribution of appreciated property

1. Start with the corporate level: S corporations that distribute appreciated property recognizes gain in the same manner as if the property had been sold to the shareholder at its FMV. 311(b)(1), 1371(a)

2. Gain is then taxed at corporate level:

   1. Section 1374 imposes a tax on the net recognized built-in gain of an S corporation realized during the 10-year period following the S selection.

   2. Amount taxed limited to net unrealized built-in gain (look at gainacre and lossacre together, calculate net unrealized built-in gain). 1374(c)(2).

   3. Taxed at 35%

3. The gain is then passed-through to the SH as gain, and tax amount passes through as loss.

4. AAA increases accordingly by net gain

5. Calculate net effect of gain and tax pass-through to SH’s basis

6. Distribution of FMV of property if there is E&P

   1. Order 1368(c)(1):

      1. Tax free recovery of AAA (also reduces basis that is represented by AAA)

      2. Dividends out of E&P

      3. Basis not represented...