V. Federal Taxation of Entities - 5. S Corporation Taxation

Question 1

V. Federal Taxation of Entities

5. S Corporation Taxation
6. Eligibility, Elections, Terminations

I. Legal Status

B. Tax Characteristics

Answer 1

1. There is no imposition of the corporate AMT, PHC, or accumulated earnings taxes. Individual (not corporate) tax preferences are allocated to shareholders.
2. The adjusted basis of shareholders’ stock is generally adjusted at year end.
3. Partners in a partnership are not eligible to benefit from many fringe benefit exclusions because partners who work for the partnership are not considered to be employees. This same rule applies to S corporation shareholders who own 2% or more of the S corporation.
4. A 2% or greater S corporation shareholder can deduct premiums paid on health insurance policies issued in his or her own name as a deduction for AGI as long as the shareholder has earned income from the S corporation that exceeds the total of all premiums paid.

Question 2

V. Federal Taxation of Entities

5. S Corporation Taxation
6. Eligibility, Elections, Terminations

II. Eligibility Rules

A. Eligibility Entity—The corporation must be an eligible entity.

Answer 2

1. Foreign corporations are not eligible.
2. Certain members of affiliated groups, parents of subsidiaries, financial institutions, and DISCs are not eligible (certain banks are eligible).
3. S corporations may own an 80% or more equity interest in a C corporation.
4. S corporations may own a qualified Subchapter S subsidiary.

Definition

Qualified Subchapter S Subsidiary: A corporation that meets all requirements for Subchapter S status and is owned 100% by a parent S corporation.

Question 3

V. Federal Taxation of Entities

5. S Corporation Taxation
6. Eligibility, Elections, Terminations

II. Eligibility Rules

B. Shareholder Requirements—Shareholders must be eligible.

Answer 3

1. Nonresident aliens, C corporations, and partnerships are not eligible.
   * ​(Shortcut—An S corporation can be a parent corporation, but it cannot be a subsidiary of any corporation except another subchapter S corporation.)

Question 4

V. Federal Taxation of Entities

5. S Corporation Taxation
6. Eligibility, Elections, Terminations

III. Election Requirements

B. Termination Requirements

Answer 4

2. An involuntary termination can occur due to a violation of the limit on passive investment income exceeding 25% of gross receipts for three consecutive years

Note

Once terminated, S status cannot be elected without IRS permission for five years.

Question 5

V. Federal Taxation of Entities

5. S Corporation Taxation
6. Eligibility, Elections, Terminations

An S Corporation has 30,000 shares of voting common stock and 20,000 shares of non-voting common stock issued and outstanding. The S election can be revoked voluntarily with the consent of the shareholders holding, on the day of the revocation,

Shares of Shares of

voting stocknonvoting stock

1. 0 20,000
2. 7,500 5,000
3. 10,000 16,000
4. 20,000 0

Answer 5

C.

A corporation’s S election may be revoked voluntarily with the consent of the shareholders holding a majority of the corporation’s issued and outstanding stock, including nonvoting stock.

Since, in this case, the S corporation has 30,000 shares of voting common stock and 20,000 shares of nonvoting common stock issued and outstanding, shareholders holding at least 25,001 shares of stock would be needed to have a majority and, as a result, the ability to revoke the corporation’s S election.

This response correctly indicates that shareholders controlling 26,000 shares of stock (10,000 shares of voting and 16,000 shares of nonvoting) would have the ability to voluntarily revoke the corporation’s S election despite their not having a majority of the voting shares.

Question 6

V. Federal Taxation of Entities

5. S Corporation Taxation
6. Income and Basis

II. Reporting Operations

H. Expenses and interest owed to any cash-method shareholder are deductible by an accrual-method S corporation only when paid.

Answer 6

Example

An accrual-method calendar-year S corporation accrues $2,000 of salary to a cash-method employee (a 1% shareholder) during 2018 but does not make payment until February 2019. The $2,000 will be deductible by the corporation in 2019 and reported by the shareholder-employee as income in 2019.

Question 7

V. Federal Taxation of Entities

5. S Corporation Taxation
6. Income and Basis

III. Flow-Through to Shareholders

2. To calculate the daily share of income prior to (or after) the change in shares, divide annual income (and separately stated items) by the number of days in the year. Next, multiply this amount by (1) number of days prior to (after) the change and (2) the percentage ownership interest.

Answer 7

Example

As of January 1 of this year, TP1 owned all 100 shares of ABC, a calendar year S corporation. On February 9th (the 40th day of this year), TP1 sold 25 shares to TP2. This year (365 days), ABC reported $73,000 in nonseparately stated income and made no distributions to shareholders. What amount of income should TP1 report from ABC?

TP1 should report income of $56,750 calculated using the daily income ($200 per day) for the 40 days TP1 owned 100% and 75% of the daily income for the 325 days after the sale.

Note, that the seller is deemed to own the shares on the day of the sale.

Question 8

V. Federal Taxation of Entities

5. S Corporation Taxation
6. Income and Basis

IV. Adjusted Stock Basis—Each shareholder has an adjusted basis in his S stock that must be modified by contributions, income, distributions, and expenses.

Answer 8

Calculation of S Shareholder’s Basis

Initial Basis

• Plus: Additional Contributions

Shareholder’s share of: Corporate Income

Exempt Income

• Less: Distributions from AAA/OAA (in following order):

Cash

Inventory and receivables

Other property

Nondeductible Expenses

Corporate Losses

Question 9

V. Federal Taxation of Entities

5. S Corporation Taxation
6. Income and Basis

V. Loss Limitations—Loss deductions are limited in four ways.

Answer 9

1. First, the adjusted basis of the stock limits loss deductions because a shareholder’s basis cannot be reduced below zero.
2. Second, the adjusted basis of loans to the corporation by the shareholder can be used for loss deductions once the adjusted basis of the stock is exhausted. However, later increases in basis are used to restore the basis of the debt before basis of the stock.
3. Third, shareholders may only deduct losses to the extent they are “at risk” for investments in the corporation.
4. Fourth, passive loss limits may also limit loss deductions depending upon the nature of the corporate business and the shareholders’ participation in management activities.
5. Unused losses (due to inadequate basis) are carried forward indefinitely (until the adjusted basis of the stock increases or the S election is revoked).

Question 10

V. Federal Taxation of Entities

5. S Corporation Taxation
6. Income and Basis

V. Loss Limitations—Loss deductions are limited in four ways.

Answer 10

7. If an S corporation contributes appreciated property to a charitable organization, the corporation can deduct the fair market value of the property. However, S corporation shareholders can reduce their basis by only the contributed property’s basis.

Example

This year S corporation, an S electing corporation, reported the following:

Gross income $210,000

Business expenses 283,000

Charitable contributions 14,600

S has two shareholders: PW owns 10% of the stock, and M owns 90%. What amount should PW report this year from S?

S operated at a $73,000 loss, so PW should report $7,300 of loss and $1,460 of charitable contributions. Suppose that PW sold his stock 60 days after the beginning of the year. If PW sold his stock, then (absent a terminating election) the operating loss would be prorated on a daily basis. Hence, S incurred a daily loss of $200 ($73,000/365) and PW’s share would be $1,200 ($200 × 60 × 10%). Likewise, the charitable contribution would be $240 ($40 × 60 × 10%).

Example

ABC, a calendar year S corporation, had an ordinary loss of $36,500 this year. TP owned 50% of ABC for the first 40 days of the year before selling the stock to an unrelated party. TP’s basis in the stock was $10,000 and TP was a full-time employee of the corporation. What is TP’s share of the loss this year?

The share of the loss is $2,000—calculated by multiplying TP’s share (50%) of the daily loss ($100) times the number of days TP held the stock (40).

Question 11

V. Federal Taxation of Entities

5. S Corporation Taxation
6. Income and Basis

L Corporation, an S electing corporation, pays single coverage health insurance premiums of $4,000 per year and family coverage premiums of $7,000 per year (the $7,000 includes single and family coverage). SH owns 10% of L stock, and L pays SH’s family coverage under the health insurance plan. What amount of insurance premium is included in SH’s gross income?

1. $ 0
2. $ 700
3. $4,000
4. $7,000

Answer 11

D.

The entire premium payment must be included in income since SH owns 2% or more of the L’s stock. If SH owned less than 2% of the stock, the entire premium payment could be excluded from income..

Question 12

V. Federal Taxation of Entities

5. S Corporation Taxation
6. Income and Basis

Which of the following items must be separately stated on Form 1120S, U.S. Income Tax Return for a Corporation, Schedule K-1?

1. Mark-to-market income
2. Unearned revenue
3. Section 1245 gain
4. Gain or loss from the sale of collectibles

Answer 12

1. Mark-to-market income is treated as ordinary income so it does not need to be separately stated.
2. Unearned revenue is a liability account, not a revenue account. Therefore, it does not need to be separately stated.
3. Section 1245 depreciation recapture income is treated as ordinary income so it does not need to be separately stated.
4. You Answered Correctly!: Collectible gain is taxed at a maximum rate of 28% and can be offset with collectible losses, so it needs to be separately stated.

Question 13

V. Federal Taxation of Entities

5. S Corporation Taxation
6. Income and Basis

On January 1 of the first year of operation, an investor paid $10,000 for a 20% interest in Biga, an S corporation. During the same year, Biga earned $10,000 taxable income and $2,000 tax-exempt interest. Biga paid dividends totaling $1,000 to its shareholders during the same year. What is the investor’s tax basis in the shares of Biga at the end of the year?

1. $4,200
2. $10,000
3. $12,200
4. $12,400

Answer 13

C.

Question 14

V. Federal Taxation of Entities

5. S Corporation Taxation
6. Income and Basis

An S corporation has income of $72,000 after the following deductions:

IRC Section 179 election to expense

depreciable property $15,000

Charitable contributions 11,000

Salary to owner who worked as

CEO of corporation 84,000

What is the amount of nonseparately stated income shown on the S corporation’s income tax return?

1. $ 83,000
2. $ 87,000
3. $ 98,000
4. $156,000

Answer 14

C.

The Sec. 179 expense and the charitable contribution must be separately stated, so they ($15,000 + $11,000) must be added back to the $72,000 to compute nonseparately stated income ($98,000). The salary to the CEO does reduce the nonseparately stated income.

Question 15

V. Federal Taxation of Entities

5. S Corporation Taxation
6. Distributions and Special Taxes

I. Distributions

C. Shareholder Income if S Corporation Has E&P—Shareholders of S corporations with accumulated earnings and profits (E&P) from a previous status as a C corporation are subject to a complex distribution system.

Answer 15

1. Shortcut—An S corporation that has always been an S electing corporation will not need to use an accumulated adjustments account unless and until the S election is terminated. In addition, an S corporation, that was previously a C corporation, will not need to use an accumulated adjustments account unless the corporation had earnings and profits from this prior period.
2. Accumulated undistributed income generated during S status is recorded at the corporate level in the accumulated adjustments account (AAA).
3. AAA is adjusted in the same way as stock basis except (1) no adjustment is made for tax exempt income (and related expenses) and (2) AAA can be negative (only losses can reduce AAA below zero; distributions cannot create a deficit in AAA).
4. OAA is the other adjustments account that tracks tax-exempt income earned by the corporation.

Question 16

V. Federal Taxation of Entities

5. S Corporation Taxation
6. Distributions and Special Taxes

I. Distributions

C. Shareholder Income if S Corporation Has E&P

5. Order of distributions

Answer 16

1. Distributions follow this order:
   
   1. First tax-free from AAA (nontaxable; note that distributions from AAA also reduce stock basis)
   2. Then from E&P (dividend income)
   3. Next from stock basis, which is a tax-free return of capital
   4. The remaining distribution is a capital gain
2. An S corporation can make a bypass election, which allows the distribution to first come from E&P and then AAA.

Question 17

V. Federal Taxation of Entities

5. S Corporation Taxation
6. Distributions and Special Taxes

I. Distributions

C. Shareholder Income if S Corporation Has E&P

6. Distributions from AAA reduce the balance of AAA (but distributions never reduce AAA below zero—only losses can accomplish this feat).
7. Distributions from AAA and OAA reduce the adjusted basis of the shareholder’s stock.

Answer 17

Example

At the end of this year, ABC corporation (an electing S corporation) has AAA of $100 and E&P of $50. If ABC makes a distribution of $180 to its sole shareholder, the shareholder will report the first $100 as tax-free from the AAA account. Note that this $100 also reduces the basis in the stock. The next $50 is dividend income from the E&P account. The final $30 is a return of capital. If SH had a basis in his ABC stock immediately before the distribution of $120, he would report two sources of income: 1) dividend income of $50 for the distribution from the E&P account, and $10 capital gain (basis of $120 − $100 from AAA − $30 return of capital).

Question 18

V. Federal Taxation of Entities

5. S Corporation Taxation
6. Distributions and Special Taxes

II. Built-in Gains Tax—An S corporation can be subject to tax if the corporation sells property that contained a built-in gain at the time of the S election.

Definition

Built-in Gain Property: For purposes of a tax on an S corporation, appreciated property (value in excess of adjusted basis) as of the beginning of the first year of the S status.

Answer 18

1. Shortcut—A built-in gains tax is not imposed on a corporation that has always been an S electing corporation.
2. The tax is imposed at the highest corporate rate (21%) and is limited to the net amount of built-in gain at the time of election.
3. The tax can only be imposed for a period of 5 years after the S election is made.
4. In the year of the sell, if property is also sold that had built-in losses at the date of the S election, these built-in losses can offset the built-in gains.
5. The total built-in gain subject to this tax in any given year is also limited to the S corporation’s taxable income for that year.
6. The amount of built-in gains tax paid passes through on the S corporation tax return as an expense. To the extent the tax is due to built-in gains on capital assets, the tax passes through as a capital loss.

Question 19

V. Federal Taxation of Entities

5. S Corporation Taxation
6. Distributions and Special Taxes

II. Built-in Gains Tax—An S corporation can be subject to tax if the corporation sells property that contained a built-in gain at the time of the S election.

Example

Answer 19

ABC Corporation made an S election this year and, at the time of the election, it held property with a value of $100 and the basis of $80. ABC will be taxed on this $20 built-in gain (at the highest corporate rate) if the property is sold any time during the next 5 years.

For 2019, an S corporation has taxable income of $100,000, which includes a $40,000 long-term capital gain (LTCG) that is also a recognized built-in gain. Since its recognized built-in gain of $40,000 is less than its taxable income, its built-in gains tax for 2019 is $40,000 × 21% = $8,400. Since the built-in gain was a long-term capital gain, the built-in gains tax paid of $8,400 is treated as a long-term capital loss. As a result, a net long-term capital gain of $31,600 ($40,000 LTCG – $8,400 LTCL) passes through to shareholders for 2019.

Question 20

V. Federal Taxation of Entities

5. S Corporation Taxation
6. Distributions and Special Taxes

III. Passive Investment Income Tax—An S corporation can be subject to the top corporate tax rate if the corporation reports excessive passive investment income and the corporation has E&P from prior status as a C corporation.

Answer 20

1. Excessive passive income is passive income over 25% of gross receipts.
2. The IRS may waive this tax if the corporation establishes that it made distributions within a reasonable time of discovering that E&P existed from a prior year.
3. Shortcut—A corporation that has never been a regular C corporation or does not have E&P from a prior period as a C corporation cannot be subject to the corporate tax on excessive net passive income.

Question 21

V. Federal Taxation of Entities

5. S Corporation Taxation
6. Distributions and Special Taxes

IV. LIFO Recapture

Answer 21

A C corporation using LIFO that converts to S status must recapture the excess of the inventory’s value using a FIFO cost flow assumption over its LIFO tax basis as of the close of its last tax year as a C corporation.

Question 22

V. Federal Taxation of Entities

5. S Corporation Taxation
6. Distributions and Special Taxes

Prail Corporation is a C corporation that on February 1, 2019, elected to be taxed as a calendar-year S corporation. On June 15, 2019, Prail sold land with a basis of $100,000 for $200,000 cash. The fair market value of the land on February 1, 2019, was $150,000. Prail had no other income or loss for the year and no carryovers from prior years.

What is Prail’s tax?

1. $7,500
2. $10,500
3. $22,250
4. $21,000

Answer 22

B.

A C corporation that makes an S election and has unrealized built-in gains in its assets as of the election day must pay a built-in gains tax on this appreciation if it is recognized within the next 5 years.

When Prail makes the S election it has appreciation in the land of $50,000 ($150,000 – $100,000). Since the land was sold within 5 years of the election day, the first $50,000 of gain is taxed to the corporation at the rate of 21%.

Therefore, Prail must pay a tax of $10,500 ($50,000 × 21%).

Question 23

V. Federal Taxation of Entities

5. S Corporation Taxation
6. Distributions and Special Taxes

Beck Corp. has been a calendar year S corporation since its inception on January 2, 2009. On January 1, 2019, Lazur and Lyle each owned 50% of the Beck stock, in which their respective tax bases were $12,000 and $9,000. For the year ended December 31, 2019, Beck had $81,000 in ordinary business income and $10,000 in tax-exempt income. Beck made a $51,000 cash distribution to each shareholder on December 31, 2019. What was Lazur’s tax basis in Beck after the distribution?

1. $1,500
2. $6,500
3. $52,500
4. $57,500

Answer 23

B.