S corporations: pass-through

1. 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.

2. 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.

S corporation 1361(d) eligibility requirements

3. 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

4. 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

5. 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:

Election, Revocation and Termination

6. 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

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

8. 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

9. 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

10. 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.

11. 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 of the shareholders

12. 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

13. 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.

14. Loss limitation

    1. Section 1366(d) limits...

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