Essentials of taxation 2016 cengage chapter 15

Chapter 15 S Corporations Essentials of Taxation © 2016 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 of 2) • Fowle, Inc., has been a C corp for a number of years, earning taxable income of less than $100,000 per year – The company has accumulated its earnings for a variety of business needs and has not paid dividends to date • Thus, the corporation has been able to – Take advantage of lower C corp tax rates, and – Avoid double taxation problems so far • The corp receives some tax-exempt income, generates a small domestic production activities deduction (DPAD), and holds about $200,000 of C corp E&P The Big Picture (slide of 2) • David, the company’s sole owner, draws a salary of $92,000 • Fowle has two classes of stock, voting and nonvoting common stock • Due to cheap imports from China, David expects operating losses for the next few years • David would like to know if he can deduct these anticipated future losses? • Read the chapter and formulate your response Subchapter S Issues (slide 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 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 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 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 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 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 can’t 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 Built-in Gains Tax (slide 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 – years for tax years beginning in 2009 and 2010, and – years for 2011 through 2013 Built-in Gains Tax (slide 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 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 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 inventory’s 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 of 2) Step Select the smaller of built-in gains or taxable income.* Step Deduct unexpired NOLs and capital losses from C corporation tax years Step Multiply the tax base from step 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 of 2) Step Deduct business credit carryforwards and AMT credit carryovers from a C corporation tax year from the amount obtained in step Step The corporation pays any tax resulting from step Passive Investment Income Penalty Tax (slide 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 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 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 of 5) • As long as Fowle, Inc., maintains C corp status, David cannot deduct any NOLs that the business incurs on his individual tax returns – However, the corp can carry any NOLs back and claim refunds for prior taxes paid and carry any remaining NOLs forward to reduce taxes paid if the company becomes profitable again • If David wants to deduct any future NOLs on his individual return, Fowle needs to be operated as a flow-through entity • Assuming that Fowle meets the one class of stock requirement, an S election may be appropriate – Fowle should make a timely election on Form 2553 – David must consent to the election in writing • David should make the election on or before the fifteenth day of the third month of the current year to be effective this year Refocus On The Big Picture (slide of 5) What if? • What if David expects the loss years to be followed by years of increased profitability? – In this case, David expects that the corporation will make significant distributions to him • How might this affect David’s decision about whether the corporation should make an S election? • David should be aware of several rules that may result in income tax being paid by the S corporation or by him as the shareholder Refocus On The Big Picture (slide of 5) What if? • First, distributions from an S corp may be treated as taxable dividends to a shareholder to the extent of E&P dating to its years as a C corp – While distributions are deemed to be made first from accumulated net S corp earnings, distributions in excess of that amount may be treated as a taxable dividend, being paid from AEP Refocus On The Big Picture (slide of 5) What if? • The S corporation’s DPAD computations flow through to David, as does Fowle’s tax-exempt interest income – The entity may want to reconsider its salary and fringe benefits levels for David, so as to minimize the creation of a payroll tax burden, and to manage the restrictions on deductions for fringe benefits provided to an S shareholder • Fowle’s tax-exempt interest can be distributed to David tax-free only after all of the entity’s AEP has been accounted for Refocus On The Big Picture (slide of 5) • In addition, David should be aware that an S corp that has been a C corp in the past may be required to pay a built-in gains tax or LIFO recapture tax – The base for the built-in gains tax includes any unrealized gain on appreciated assets held by Fowle, Inc., on the day the company becomes an S corp – The highest Federal corporate income tax rate is applied to the unrealized gains when any of the assets are sold within a specified number of years – If Fowle uses the LIFO inventory method, any LIFO recapture amount at the time of the S election also is subject to a corporate-level tax 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 © 2016 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 64 ... anticipated future losses? • Read the chapter and formulate your response Subchapter S Issues (slide of 6) • S corporations provide many of the benefits of partnership taxation – Also gives the owners... reclassification of debt The Big Picture – Example One Class of Stock • Return to the facts of The Big Picture on p 15 1 • Fowle, Inc., could elect to be an S corporation, except that one class of stock... or by March 15, 2017 • An election after March 15, 2017, will not be effective until the 2018 calendar tax year Termination of Election (slide of 4) • The S election is lost in any of the following