REG 3 - S Corporations

Question 1

S Corporations

Answer 1

A closely held corporation in which the S corporation do not pay income taxes (pass-through entity), but are required to file annual information returns (Form 1120-S) reporting income & the allocation of that income to various shareholders (on K-1).

• Flow through entity - Form 1120S / K1
• Information Return ONLY
• Due 3/15, can file 6 mos extention
• Formal Creation - Limited Liability

Question 2

Qualifications for S Corporation Status (5)

Answer 2

In order for a corporation to elect S corporation status it must have (Simple & Small):

1. Only one class of stock
   
   • ​With Profits/Losses allocated proportionately according to ownership
2. No more than 100 shareholders
   
   • Husband & Wife counts as ONE shareholder
3. Shareholders are generally Individuals
   
   • No Corporations, Partnerships or Big Trusts
   • Grantor & Testamentary trusts are OKAY
   • Bankruptcy Estates & Trust are OKAY
4. All shareholders must be a resident or citizen of the US
5. S Corp MUST be a Domestic corporation

Question 3

Formation of S Corps

Basis

Answer 3

Formation - Similar to a C corporation - Formal

• Cash or Property > 80% or more (control)
  
  • Tax Free
  • Carryover basis (of asset)
  • Carryover holding period
• Services or < 80%
  
  • Taxable at FMV of stock
• **Cash or Property
  
  • All Taxable at FMV of stock
    
    • Property is taxed at the amt of FMV less Basis**

Question 4

S corporation - Election/Effective

Answer 4

The election to become an S corporation must be made unanimously (100%) by the shareholders (including those with no voting rights).

• Election may be made at any time. Calendar or Fiscal.
• Must be made by the 15th day of the 3rd month of the tax year in order to be effective for that year.
• Any election made after the 15th day of the 3rd month cannot become effective until the start of the following tax year.

Question 5

Operation of S Corp

How to compute Net Basis?

Answer 5

Initial Basis

+/- Income Loss (computed on an ADB)

+ Muni Bond Interest (increases basis only)

+/- Separately Stated Items (not calculated in ord income)

• Distributions Received

= Net Basis

Question 6

Allocation of Income/Loss

“Average Daily Basis”

Answer 6

ADB = (Income/365) x (# of Days owned) x (% of Shares)

Applies to when a parter sells their share.

Question 7

Types of Income (4)

Answer 7

Net Business Income (Ordinary Business Income)

• Income
  
  • Ordinary Income/Loss
  • Muni Bond Interest
  • Separately Stated Items
  • NOTE: Income is computed on Average Daily Basis
• Losses
  
  • Limited to amount invested + amount loaned to company
  • Cannot go below zero (basis cannot go negative)
• Muni Bond Interest
  
  • Increases basis, but NOT taxable
• Distribution Received
  
  • Reduces Basis
  • Not Taxed

NOTE: Separately Stated Items are NOT deductible in the calculation of ordinary business income.

Question 8

Separately Stated Items (7)

(Must Memorize-Tested)

Answer 8

Items that are reported separately on the tax return of an S corporation (1120S) because of their tax treatments, enabling shareholders to each recognize their proportionate share of each item & handle it properly on their tax returns. An S corporation is not allowed to take these deductions when calculating its ordinary business income. (HOW Q’S IS ASKED)

Any amount that can hit a limit on your individual tax return:

1. Capital Gains/Losses
   
   • Limit on deductibility of net capital losses, $3K limit
2. Section 1231 Gains/Losses
   
   • Section 1231 is the section of the Internal Revenue Code that governs the tax treatment of gains and losses on the sale or exchange of real or depreciableproperty used in a trade or business and held over one year.
   • Classification of net gain as Capital Gain
     
     • Losses may only offset Capital Gains
3. Secton 179 Depreciation Deduction
   
   • Dollar limit on use of election per year
4. Passive Activities (Rent & Royalty)
   
   • Passive acivity loss limitations, $25K threshold
5. Charitable Contributions
   
   • Must itemize to deduct/ up to 50% of AGI
6. Dividends & Interest
   
   • Investment interest expenses may only be deducted against investment income
7. Tax Credits
   
   • Limited to tax liability

Question 9

Schedule K

&

Schedule K-1

Answer 9

The S corporation prepares a Schedule K that summarizes the ordinary income & then separately lists all items that are not ordinary.

Additionally, a Schedule K-1 is prepared for each shareholder showing that owner’s allocated share of all the items on the Schedule K.

Question 10

S Corporation Distribution Order

Answer 10

1. AAA - Accumulated Adjustment Account (NOT Taxable)
   
   • AAA represents the cumulative total of undistributed net income items for S corporations.
   • NOT Taxable (is taxed on the individual side thru K1)
2. AEP - Accumulated Earnings & Profits (Taxable)
   
   • AEP represents the earnings & profits that were accumulated during the C Corp taxable years that were undistributed
   • Taxable as Dividend Income
3. Basis - Not Taxable (return of basis)
   
   • Distributions of in excess of AAA & AEP (return of capital)
   • NOT Taxable
4. Gain - Taxable (stock sold in excess of basis = capital gain)
   
   • Distributions in excess of stock basis are treated as a Capital Gain from the sale of stock.
   • Taxable as capital gain

NOTE: Distributions goes in the following order. Deplete each type of income beginning with AAA.

Question 11

S Corporation - Status Termination

Answer 11

An election to terminate a corporation’s status as an S Corp only requires shareholders holding majority (50% - voluntary) the shares to agree (including voting & non-voting).

S Corp status will be revoked (Involuntary) if it violates requirements such as:

• >25% of gross receipts comes from PASSIVE Investments
• Over 100 shareholders
• More than one type of stock
• Shares are sold to non-resident or not an Individual
• Once an S Corp’s status is revoked, it cannot re-elect such status for 5 years.

Question 12

Built-in Gains Tax

(BIG)

Answer 12

BIG - Applies if a C-Corp elects S-Corp status & the FMV of its assets exceeds their basis. If assets are sold within 5yrs, a special built-in gains tax of 35% applies. Only the gain is taxed at the 35% rate (FMV-Basis * 35%)

NOTE:Reason for this tax is that C-Corp gets taxed at 35% while S-Corp flows through the Individual & gets taxed at a capital gains rate of 20%.

Question 13

After an S corporation elects to revoke its status as an S corporation, it must?

Answer 13

When S corporation status is revoked (either voluntarily or through failing to meet the requirements), a corporation can apply to the IRS National Office for an early reelection. The IRS will usually grant the early reelection if ownership has changed by more than 50% or when the termination was not within their control, such as death of a shareholder and inheritance of the stock by someone who is not a U.S. citizen or resident.