Exhibit 22-4 compares tax consequences for C corporations, S corporations, and partner- ships discussed in this chapter.
Tax Characteristic Forming or contributing property to an entity
Type of owner restrictions
Number of owner restrictions
Election
Income and loss allocations
Entity debt included in stock (or partnership interest) basis
Loss limitations
Self-employment income status of ordinary income allocations
EXHIBIT 22-4 Comparison of Tax Consequences for C and S Corporations and Partnerships
C Corporation No gain or loss on contribution of appreciated or depreciated property if transferors of property have control (as defined in §351) after transfer.
No restrictions
No restrictions
Default status if corporation under state law.
Not allocated to shareholders.
No
Losses remain at corporate level.
Not applicable
S Corporation Same as C corporation.
Only individuals who are U.S. citizens or residents, certain trusts, and tax-exempt organizations.
Limited to 100 shareholders. (Family members and their estates count as one shareholder.) Must formally elect to have corporation taxed as S corporation.
Income and loss flow through to owners based on ownership percentages.
Generally no.
However, loans made from shareholder to corporation create debt basis. Losses may be deducted to extent of stock basis and then debt basis.
Losses flow through but subject to basis limitation, at-risk limitation, passive activity limitations, and excess business loss limitation.
Not self-employment income.
Partnership/LLC Same as C and S corporations except no control requirement (§721 applies to partnerships).
No restrictions
Must have more than one owner.
Default status if un - incorporated and have more than one owner.
Income and loss flow through to owners but may be allocated based on something other than ownership percentages (special allocations).
Yes. All entity liabilities are allocated to basis of partners.
Same as S corporations.
May be self- employment income depending on partner’s status.
CONCLUSION
This chapter highlighted the rules specific to S corporations and compared S corpora- tions to C corporations and partnerships. S corporations are a true hybrid entity: They share characteristics with C corporations (the legal protection of a corporation and the tax rules that apply in organizing and liquidating a corporation). They also share charac- teristics with partnerships (the flow through of the entity’s income and loss to its own- ers, ability to make tax-free distributions to the extent of the owner’s basis, and basis calculations for owners).
Although many S corporation attributes follow from the C corporation or partner- ship rules, several specific attributes unique to S corporations may be particularly im- portant in choosing an entity form or operating an S corporation in a tax-efficient manner. These attributes include unique S corporation taxes, the rules for how debt enters into the basis calculations and loss limitation rules for S corporations, and the rules for how distributions are taxed for S corporations previously operating as C corporations.
EXHIBIT 22-4 (concluded)
Salary to owners permitted
Fringe benefits
Operating distributions:
Owner tax consequences Operating distributions:
Entity tax consequences
Liquidating distributions
Entity-level taxes
Tax year
Tax Characteristic C Corporation S Corporation Partnership/LLC Yes
Can pay nontaxable fringe benefits to owners who own 2 percent or less of stock.
Generally not taxable to extent of owner’s basis.
Same as C corporations.
Same as C corporations.
Generally no, but may be required to pay built-in gains tax, excess passive investment income tax, or LIFO recapture tax if converting from C to S corporation.
Generally calendar year.
Yes
Can pay nontaxable fringe benefits to owners.
Taxable as dividends to extent of earnings and profits.
Gain on distribution of appreciated property;
no loss on distribution of depreciated property.
Corporation and shareholders generally recognize gain or loss on distributions.
Yes, based on corporate tax rate schedule.
Last day of any month or 52/53- week year.
Generally no. Salary- type payments are guaranteed payments subject to self- employment tax.
May not pay nontaxable fringe benefits to owners.
Same as S corporations.
Generally no gain or loss on distribution of property.
Partnership and partners generally do not recognize gain or loss on liquidating distributions.
No
Based on tax year of owners.
Summary
Describe the requirements and process to elect S corporation status.
• Shareholders of S corporations are able to defer realized gains when they contribute property to the corporation if they have control of the corporation after the contribution.
• S corporations are limited in the type of owners they may have. Only individuals who are U.S. citizens or residents, certain trusts, and certain tax-exempt organizations may be shareholders of S corporations.
• S corporations may have no more than 100 shareholders. For this purpose, family mem- bers and their estates count as one shareholder. Family members include a common ancestor and her lineal descendants and their spouses (or former spouses).
• S corporations may have only one class of stock. The stock may have differences in voting rights between shares, but all stock must have identical rights with respect to corporate distribution and liquidation proceeds.
• The S corporation election is made on Form 2553. All shareholders on the date of the election must consent to the election.
• To be effective for the current year, the election must be filed in the prior tax year or on or before the 15th day of the third month of the year. Even then, the election may not be effective in certain circumstances.
Explain the events that terminate the S corporation election.
• The S corporation election may be voluntarily revoked by shareholders owning more than 50 percent of the S corporation stock. In general, revocations made on or before the 15th day of the third month of the year are effective as of the beginning of the year and revocations after that date are effective on the first day of the next year. Alterna- tively, the shareholders may choose an alternate date that is not before the revocation election is filed.
• An S corporation’s election is automatically terminated on the date it fails to meet the S corporation requirements.
• If an S corporation has earnings and profits from a previous C corporation year, its S election is terminated if it has passive investment income in excess of 25 percent of gross receipts for three consecutive years.
• When an S corporation election is terminated mid-year, the corporation files a short-year tax return for the period it was an S corporation and a short-year tax return for the portion of the year it was a C corporation. It can allocate the income on a per-day basis or it may specifically identify the income to each period.
• When an S corporation’s S election is terminated, it may not reelect S status until the beginning of the fifth tax year after the tax year in which the election was terminated.
Describe operating issues relating to S corporation accounting periods and methods, and explain income and loss allocations and separately stated items.
• When C corporations elect to become S corporations, all prior accounting methods carry over to the S corporation.
• S corporations are generally required to use a calendar tax year.
• Income and losses are allocated to S corporation shareholders pro rata based on the number of outstanding shares each shareholder owns on each day of the tax year or, with shareholder consent, it may use its normal accounting rules to allocate income and loss to the shareholders.
• S corporations determine their ordinary business income and separately stated items for the year and allocate these to the shareholders during the year.
• Separately stated items are tax items treated differently at the shareholder level than a shareholder’s share of ordinary business income.
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Explain stock-basis calculations, loss limitations, determination of self-employment income, and fringe benefit rules that apply to S corporation shareholders.
• An S corporation’s shareholder’s initial basis in her stock is generally the basis of the property contributed to the corporation minus liabilities assumed by the corporation on the contribution.
• S corporation shareholders adjust their stock basis annually. They increase it for (in this or- der) contributions to the S corporation during the year, the shareholder’s share of ordinary business income, and separately stated income/gain items. They decrease it for distribu- tions during the year, the shareholder’s share of nondeductible expenses, and the share- holder’s share of ordinary business loss and separately stated expense/loss items. The basis may not be reduced below zero.
• S corporation shareholders are not allowed to include the S corporation’s debt in their stock basis. However, they are allowed to create debt basis for the amount of loans they make directly to the S corporation. Debt basis can absorb S corporation losses (see below).
• For an S corporation shareholder to deduct them, S corporation losses must clear three sep- arate hurdles: (1) tax-basis limitation in stock (and debt), (2) at-risk amount limitation, and (3) passive activity loss limitation. In addition, for losses that clear each of the three separate hurdles, S corporation shareholders are not allowed to deduct excess business losses.
• Losses suspended at a particular level remain suspended until the shareholder creates additional tax-basis or at-risk amounts, clears the passive loss hurdle, or sells her stock in the S corporation.
• If a shareholder’s stock and debt basis is reduced by loss allocations and then increased by subsequent income allocations, the income allocation first increases the debt basis to the debt’s outstanding amount before increasing the stock basis.
• When an S corporation’s S election is terminated, S corporation shareholders can deduct their share of S corporation losses on the last day of the post-termination transition period as long as the losses are able to clear the three loss limitation hurdles.
• Allocation of ordinary business income is not self-employment income to S corporation shareholders.
• If S corporation shareholders are employees of the corporation, their wages are subject to employment taxes.
• S corporation shareholders are subject to the net investment income tax on their share of an S corporation’s gross income from interest, dividends, annuities, royalties, rents, a trade or business that is a passive activity or a trade or business of trading financial instruments or commodities, and generally any net gain from disposing of property, less any allowable deductions from these items.
• Many fringe benefits that are nontaxable to other S corporation employees are taxable to employees who own more than 2 percent of the S corporation.
Apply the tax rules for S corporation operating distributions and liquidating distributions.
• Operating distributions from S corporations without accumulated earnings and profits from C corporation years are nontaxable to the extent of the shareholder’s basis and then taxable as capital gain to the extent they exceed the shareholder’s stock basis.
• Operating distributions from S corporations with accumulated earnings and profits from C corporation years are a nontaxable reduction in stock basis to the extent of the S corpo- ration’s accumulated adjustments account, a dividend to the extent of the corporation’s earnings and profits, and then a nontaxable return of capital to the extent of the stock basis. Amounts in excess of the stock basis are capital gain.
• The accumulated adjustments account represents the cumulative income or losses for the period the corporation has been an S corporation.
• When S corporations distribute appreciated property to shareholders they must recog- nize gain on the distribution (the gain is allocated to the shareholders). When they distrib- ute loss property, they are not allowed to deduct the losses. In either case, the fair market value of the property (reduced by liabilities) is the amount of the distribution to the shareholders.
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• When an S election is terminated, cash distributions during the post-termination transition period are tax-free to the shareholder to the extent of the S corporation’s accumulated adjustments account and the shareholder’s stock basis.
• S corporations making liquidating distributions recognize gain or loss on the distributions.
The gains or losses are allocated to the shareholders. The shareholders compare the amount received in the liquidating distribution to their stock basis to determine if they recognize gain or loss on the distributions.
Describe the taxes that apply to S corporations, estimated tax requirements, and tax return filing requirements.
• S corporations that were formerly C corporations may be required to pay the built-in gains tax. The tax applies if the S corporation had a net unrealized built-in gain at the time it con- verted to an S corporation. It must pay the tax when it recognizes these net built-in gains during its first five years operating as an S corporation.
• The base for the tax is limited to the least of (1) the net of the recognized built-in gains and losses for the year, (2) the net unrealized built-in gains as of the date of the S election date less the net recognized built-in gains in previous years, and (3) the corporation’s taxable income for the year using the C corporation tax rules (excluding the dividends received deduction and NOL deduction). The base is then reduced by any net operating loss (NOL) or capital loss carryovers from prior C corporation years.
• S corporations that were formerly C corporations and have C corporation earnings and profits must pay the excess net passive income tax when their passive investment income exceeds 25 percent of their gross receipts.
• The formula for the tax is 21 percent (the highest corporate tax rate) × {net passive invest- ment income × [passive investment income − (25% × gross receipts)]/passive investment income}.
• C corporations that elect to be taxed as S corporations and that use the LIFO method of accounting for inventories must pay the LIFO recapture tax. The tax is the C corporation’s marginal tax rate times the excess of the inventory valued under the LIFO method over the inventory valued under the FIFO method at the time the S election became effective. The corporation pays one-quarter of the tax on its final C corporation tax return and the final three installments on its S corporation tax return for the first three years it is an S corporation.
• S corporations that must pay the built-in gains tax or the excess passive income tax gener- ally must pay estimated taxes in four quarterly installments. They are not required to make estimated tax payments for the LIFO recapture tax.
• S corporations file Form 1120S by the 15th day of the third month after the tax year-end (generally March 15).
• S corporations may receive a six-month extension by filing Form 7004.
• On Form 1120S, S corporations report ordinary business income and separately stated items on Schedule K. Each shareholder’s portion of items on the Schedule K is reported to the shareholder on her Schedule K-1.
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accumulated adjustments account (AAA) (22-18)
at-risk amount (22-14) built-in gains tax (22-22) built-in gains tax recognition
period (22-22) debt basis (22-13)
earnings and profits (E&P) (22-2) excess business loss (22-15)
excess net passive income (22-24) excess net passive income
tax (22-22) Form 1120S (22-28) Form 2553 (22-4) Form 7004 (22-28) gross receipts (22-6)
LIFO recapture amount (22-26) LIFO recapture tax (22-22)
net passive investment income (22-24) net unrealized built-in gain (22-22) ordinary business income (loss) (22-9) passive activity loss rules (22-15) passive investment income (PII) (22-6) post-termination transition period
(PTTP) (22-14) S corporation (22-2)
separately stated items (22-9)
KEY TERMS
DISCUSSION QUESTIONS
Discussion Questions are available in Connect®.
1. In general terms, how are C corporations different from and similar to S corporations?
2. What are the limitations on the number and type of shareholders an S corporation may have? How are these limitations different from restrictions on the number and type of shareholders C corporations or partnerships may have?
3. Why can’t large, publicly traded corporations be treated as S corporations?
4. How do the tax laws treat family members for purposes of limiting the number of owners an S corporation may have?
5. Super Corp. was organized under the laws of the state of Montana. It issued com- mon voting stock and common nonvoting stock to its two shareholders. Is Super Corp. eligible to elect S corporation status? Why or why not?
6. Karen is the sole shareholder of a calendar-year-end C corporation she formed last year. If she elects S corporation status this year on February 20, when will the elec- tion become effective and why? What if she had made the election on March 20?
7. JB Corporation is a C corporation owned 80 percent by Jacob and 20 percent by Bauer. Jacob would like JB to make an S election but Bauer is opposed to the idea.
Can JB elect to be taxed as an S corporation without Bauer’s consent? Explain.
8. In what circumstances could a calendar-year C corporation make an election on February 1, year 1, to be taxed as an S corporation in year 1 but not have the election effective until year 2?
9. Theodore, Alvin, and Simon are equal shareholders of Timeless Corp. (an S corpo- ration). Simon wants to terminate the S election, but Theodore and Alvin disagree.
Can Simon unilaterally elect to have the S election terminated? If not, what would Simon need to do to have the S election terminated?
10. Juanita is the sole shareholder of Belize Corporation (a calendar-year S corporation).
She is considering revoking the S election. It is February 1, year 1. What options does Juanita have for timing the effective date of the S election revocation?
11. Describe the circumstances in which an S election may be involuntarily terminated.
12. Describe a situation in which a former C corporation that elected to be taxed as an S corporation may have its S election automatically terminated, but a similarly situ- ated corporation that has always been taxed as an S corporation would not.
13. When a corporation’s S election is terminated mid-year, what options does the cor- poration have for allocating the annual income between the S corporation short year and the C corporation short year?
14. On June 1, year 1, Jasper Corporation’s S election was involuntarily terminated.
What is the earliest Jasper may be taxed as an S corporation again? Are there any exceptions to the general rule? Explain.
15. Apple Union (AU), a C corporation with a March 31 year-end, uses the accrual method of accounting. If AU elects to be taxed as an S corporation, what will its year-end and method of accounting be (assuming no special elections)?
16. Compare and contrast the method of allocating income or loss to owners for part- nerships and for S corporations.
17. Why must an S corporation report separately stated items to its shareholders? How is the character of a separately stated item determined? How does the S corporation report this information to each shareholder?
18. How do S corporations report dividends they receive? Are they entitled to a dividends received deduction? Why or why not?
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19. Shawn receives stock in an S corporation when it is formed in a tax-deferred trans- action by contributing land with a tax basis of $50,000 and encumbered by a
$20,000 mortgage. What is Shawn’s initial basis in his S corporation stock?
20. Why is a shareholder’s basis in an S corporate stock adjusted annually?
21. What adjustments are made annually to a shareholder’s basis in S corporation stock and in what order? What impact do these adjustments have on a subsequent sale of stock?
22. Can a shareholder’s basis in S corporation stock ever be adjusted to a negative num- ber? Why or why not?
23. Describe the three hurdles a taxpayer must pass if he wants to deduct a loss from his share in an S corporation. What other loss limitation rule may impact the deductibility of losses from an S corporation?
24. Is a shareholder allowed to increase her basis in her S corporation stock by her share of the corporation’s liabilities, as partners are able to increase the basis of their ownership interest by their share of partnership liabilities? Explain.
25. How does a shareholder create debt basis in an S corporation? How is debt basis similar and dissimilar to stock basis?
26. When an S corporation shareholder has suspended losses due to the tax-basis or at-risk amount limitation, is he allowed to deduct the losses if the S corporation status is terminated? Why or why not?
27. When considering C corporations, the IRS checks to see whether salaries paid are too large. In S corporations, however, it usually must verify that salaries are large enough. Account for this difference.
28. How does the tax treatment of employee fringe benefits reflect the hybrid nature of the S corporation?
29. If a corporation has been an S corporation since inception, describe how its operat- ing distributions to its shareholders are taxed to the shareholders.
30. How are the tax consequences of a cash distribution different from those of a noncash property distribution to both the corporation and the shareholders?
31. What role does debt basis play in determining the taxability of operating distribu- tions to shareholders?
32. What does the accumulated adjustments account represent? How is it adjusted year by year? Can it have a negative balance?
33. If an S corporation with accumulated E&P makes a distribution, from what accounts (and in what order) is the distribution deemed to be paid from?
34. Under what circumstances could a corporation with earnings and profits make a tax-free distribution to its shareholders after the S election termination?
35. How do the tax consequences of S corporation liquidating distributions differ from the tax consequences of S corporation operating distributions at both the corporate and shareholder levels?
36. When is an S corporation required to pay a built-in gains tax?
37. When is an S corporation required to pay the excess net passive income tax?
38. Is the LIFO recapture tax a C corporation tax or an S corporation tax? Explain.
39. When must an S corporation make estimated tax payments?
40. On what form does an S corporation report its income to the IRS? When is the tax return due? What information does the S corporation provide to shareholders to allow them to complete their tax returns?
41. Compare and contrast S corporations, C corporations, and partnerships in terms of tax consequences at formation, shareholder restrictions, income allocation, basis cal- culations, compensation to owners, taxation of distributions, and accounting periods.
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