T3: S Corporations

S corporation formation

• when a corporation is formed, it’s by default taxed as a C corp

• realized & recognized G/L to the corp & SHs upon contribution of assets in exchange for stock are computed in the same manner as for a C corp 

A contribution is nontaxable if it’s:

1. a contribution of property (not services)

2. solely in exchange for stock

3. after the transfer, the SH (or group of SHs) has control of the corp through 80% stock ownership

Transfers that don’t meet these requirements are treated as a taxable sale (gain recognized for FMV received over SH basis in assets contributed)

initial stock basis for S corp

cash contributed

+adj. basis of property contributed

+FMV of services contributed 

certain corporation-level taxes

S corps generally don’t pay tax, but there are 3 different taxes that may be imposed if the S corp was previously taxed as a C corp

1. LIFO recapture tax

2. Built-in gains tax

3. Tax on passive investment income

LIFO recapture tax

C corps that elect S status must include in taxable income for the last C corp yr the excess of inventory computed using the FIFO method over the inventory computed using the LIFO method

• resulting tax on the C corp is paid in 4 equal annual installments

• 1st payment is due w/ the final C corporation return

built-in gains tax

A distribution or sale of an S corp’s assets may result in a corporate-level tax on any built-in gain. Unrealized built-in gain results when both conditions occur:

1. C corp elects S corp status

2. FMV of assets > NBV of assets @ election date

• when these assets are later disposed of, the S corp might have to pay tax on the built-in gain

• Tax is 21% of the lesser of the:

  • recognized built-in gain for current yr

  • total net unrealized built-in gain at S election - net unrealized built-in gains recognized in previous yrs

  • taxable income of the S corp if it were a C corp (excluding DRD)

exemptions from recognition of built-in gain

S corp is exempt from a tax on built-in gains under any of the following circumstances:

1. S corp was never a C corp

2. Sale or transfer doesn’t occur within 5 yrs of the 1st day that the S election is effective

3. The S corp can demonstrate that the appreciate in the asset being sold or transferred occurred after the S election

4. S corp can demonstrate that the distributed asset was acquired after the S election

5. Total net unrealized built-in gain has been completely recognized in prior tax yrs 

tax on passive investment income

S corp is subject to an income tax imposed @ the corporate rate (21%) on the lesser of net income or excess passive investment income if the following 2 are met:

1. S corp has accumulated C corp E&P and

2. passive investment income exceeds 25% of total gross receipts 

shareholder stock basis

initial stock basis

+additional contributions

+income items

(distributions to SHs)

(non-deductible expenses)

(loss/deduction items)

=ending basis in S corp stock 

• no S corp debt included in basis b/c they have a separate debt basis 

shareholder debt basis

• S corp SHs don’t include S corp in their stock basis 

• debt basis is separate

• stock basis & debt basis can’t be reduced below zero 

limitation on pass-through of losses

For an S corp SH to deduct a loss, the SH must clear 4 hurdles in this order:

1. Tax basis limitation

2. At-risk limitation

3. Passive activity loss (PAL) limitation

4. Excess business loss limitationt

tax basis limitation (1)

• loss can only be flowed through to an S corp SH’s individual income tax return to the extent of the SH’s tax basis (tax basis = stock basis + debt basis)

• loss in excess of the SH’s tax basis is suspended until tax basis is reinstated in future yrs

• suspended loss due to insufficient tax basis can be carried forward indefinitely

• any suspended losses due to insufficient tax basis when SH disposes of their S corp stock are lost

at-risk limitation (2)

• a SH’s at-risk amount may be lower than their stock & debt basis if the taxpayer takes out a nonrecourse loan

• loss in excess of a SH’s at-risk basis is suspended until at-risk basis is reinstated in future yrs, can be carried forward indefinitely

• any suspended losses remaining when the SH disposes of their stock can be offset against any gain from selling the stock

allocation of S corp income/(loss) among SHs

• like partnerships, S corps flow through OBI or loss & separately stated items of income, gain, loss & deductions to the SHs

• allocations to SHs are made on a per-share, per-day basis

separately stated items

• rental real estate income/loss (Sch E)

• interest & dividend income (Sch B)

• royalties (Sch E)

• net short-term & long-term cap gains/loss (Sch D)

• net Sec 1231 gain/loss (Sch D)

• charitable contributions (Sch A)

• Sec 179 expense deduction 

*SHs are taxed whenever separately stated items are earned, not when $ is distributed to SHs Sec 199

Sec 199A QBI deduction

a below-the-line deduction of 20% of QBI may be available on ordinary business income flowed through from an S corp 

accumulated adjustments account (AAA)

• the accumulated E&P during the yrs the corp is an S corp

• distributions may not reduce AAA below zero

• AAA can be negative due to S corp losses & deductions 

increases to AAA:

• OBI

• separately stated income & gain items (other than tax-exempt income)

decreases to AAA:

• ordinary business losses

• separately stated losses & deductions

• nondeductible expenses (other than expenses related to tax-exempt income)

• distributions (may not reduce AAA below zero) 

other adjustments account (OAA)

an account that’s designed to keep a cumulative record of items that affect S corp SH’s stock basis but don’t affect AAA; includes:

• tax-exempt interest on municipal bonds & related expenses

• tax-exempt life insurance proceeds & related non-deductible premiums

• federal taxes paid or accrued in an S corp yr that relate to C corp yrs

*OAA doesn’t impact the taxability of S corp distributions

tax treatment of S corp distributions to SHs with no corporation E&P

	Distribution	Tax Result	Treatment
1st	to extent of S corp AAA	not subject to tax, reduces basis in stock	S corp profits (already taxed)
2nd	to extent of S corp OAA	not subject to tax, reduces basis in stock	non-taxable income/related expenses
3rd	to extent of stock basis	not subject to tax, reduces basis in stock	return of capital
4th	in excess of stock basis	taxed as LT cap gain if held for > 1 yr	cap gain distribution

tax treatment of S corp distributions to SHs with C corp E&P 

	Distribution	Tax result	Treatment
1st	to extent of S corp AAA	not subject to tax, reduced basis in stock	S corp profits (already taxed)
2nd	to extent of C corp E&P	taxed as a dividend, doesn’t reduce basis in stock	prior C corp taxable div distribution
3rd	to extent of S corp OAA	not subject to tax, reduced basis in stock	non-taxable income/related expenses
4th	to extent of stock basis	not subject to tax, reduced basis in stock	return of capital
5th	in excess of stock basis	taxed as a LT cap gain	cap gain distribution

election to bypass AAA

• an S corp can elect to treat distributions to SHs as being made 1st from prior C corp accumulated E&P rather than from AAA for a particular yr

• reasons to make this election:

  • to eliminate C corp E&P to potentially avoid terminating its S status due to excess passive investment income

  • it’s potentially a good yr for SHs to receive dividend income due to a low individual rate 

non-liquidating property distributions

amt of property distribution is the FMV of the property @ date of distribution

S corp tax treatment for a non-liquidating property distribution

• S corp recognizes a gain of distribution of appreciated property as if the property had been sold @ FMV

• gain is flowed through to the individual SHs in the same way as any other S corp gains

• an S corp doesn’t recognize a loss on the distribution of depreciated property to SHs

• S corp AAA (and/or accumulated E&P) is reduced by the FMV of the property distributed) 

SH tax treatment for a non-liquidating property distribution

• SH recognizes share of gain flowed through from S corp

• SH stock basis: increased by share of gain recognized; decreased by FMV of property distributed

• recipient SH’s basis in property distributed is FMV of property @ date of distribution

potential terminating events of S election

1. SHs > than 50% of stock (voting & non-voting) consent to a voluntary revocation

2. corporation fails to meet any qualifications for S status

3. excess passive investment income (>25% of corp’s gross receipts are from passive investment income for 3 consecutive yrs but only if the corp has prior corp E&P) 

liquidation of an S corp

*liquidation of S corp is treated the same as liquidation of an C corp

1. FMV of assets distributed - basis in assets = taxable gain/(loss) 

2. cash received + FMV of property received - liabilities assumed = amt realized - basis in stock = taxable gain/(loss)