4. If the liquidation results in a capital gain or loss being recognized, then the additional payment is deductible as a capital loss by a shareholder, who uses the cash method of accounting in the year of payment (i.e., an amended tax return is not filed for the year in which the gain or loss from the liquidation was originally reported). EXAMPLE: X Corporation is liquidated in 2014 with Don reporting a $30,000 long-term capital gain on the exchange of stock. In 2015 Don is required to pay $5,000 as part of the settlement of a lawsuit against X Corporation. An additional amount must be paid by all shareholders, because the settlement exceeds the amount of funds that X Corporation placed into an escrow account as a result of the litigation. The $5,000 additional payment is reported in 2015 by Don as a long-term capital loss.L. Open Versus Closed Transactions 1. In some cases the value of a property received in a corporate liquidation cannot be determined by the usual valuation techniques. Property that can only be valued on the basis of uncertain future payments falls into this category. 2. In such a case, the shareholders may attempt to rely upon the open transaction doctrine of Burnet v. Logan and treat the liquidation as an open transaction. 3. Under the open transaction doctrine, the shareholder's gain or loss from the liquidation is not determined until those assets that cannot be valued are subsequently sold, collected, or able to be valued. 4. Any assets that cannot be valued are assigned a zero value. 5. The shareholder's receipt of those properties that have an ascertainable FMV is reported using the general liquidation rules. Therefore, a shareholder must report a gain on the liquidation if the FMV of those properties that have an ascertainable FMV exceeds the shareholder's basis for the stock. 6. If the assets that are not able to be valued are subsequently sold, collected, or able to be valued, and the shareholder still has unrecovered stock basis then the subsequent payments or amounts received are initially treated as a return of capital on the liquidation transaction. If gain was previously recognized then any additional receipt would also be gain in the year received. 7. The character of any additional gain that is reported is the same as was originally reported when the other properties were received.
EXAMPLE #1: Mesa Corporation is owned by Don. Mesa’s properties include $10,000 of cash, $30,000 of land, and a royalty agreement with a coal company that will pay Mesa a royalty only as the coal is produced. No coal has ever been produced on the property, and there is no minimum royalty amount mentioned in the agreement. According to a qualified appraisal company, no FMV can be assigned to the royalty agreement. Don's basis in his Mesa stock is $50,000. Mesa Corporation liquidates in 2004 with Don receiving the cash, land, and royalty agreement. Relying on the open transaction doctrine, the $40,000 that is received would be reported as a recovery of his investment in the Mesa stock. Don would have $10,000 of unrecovered basis against which subsequent royalty payments could be offset before reporting any capital gain on the receipt of such payments. If Don's basis for the Mesa stock were instead $25,000, then Don would report a $15,000 ($40,000 - $25,000) long-term capital gain on the liquidation and any additional amounts that were received under the royalty agreement would also be long-term capital gain.8. The IRS's position is that a taxpayer may use the open transaction method to report a corporate liquidation only in unusual circumstances.9. Generally the IRS opts for a closed transaction. All of the assets in a closed transaction have a basis equal to their FMV on the distribution date. If a transaction is closed, any gain or loss is determined on the liquidation date based upon the FMV of all of the assets.10. When the liquidated property with the uncertain value is ultimately sold or collected by the former shareholder, gain or loss is determined by comparing the sale price or amount collected with respect to the property to its basis in the former shareholder's hands. This is typically the value established on the liquidation date.11. The character of the gain or loss depends upon whether the asset is a capital asset or not in the hands of the former shareholder.12. The closing of the transaction typically accelerates the reporting of the shareholder's gain from the transaction. KEY POINT: The position of the IRS is that the FMV of almost any asset should be able to be determined. Thus, the IRS assumes that the open transaction method should be used only in rare and extraordinary circumstances.
EXAMPLE #2: Assume the same facts as in Example #1 above, except that the FMV of the royalty agreement is determined to be $12,000 and the royalty payments received under the agreement are: 2005, $9,000; and 2006, $8,000. Don reports a $2,000 ([$10,000 + $30,000 + $12,000] - $50,000) long-term capital gain on the liquidation. The basis of the royalty agreement is $12,000 to Don. The $9,000 royalty payment in 2005 is a tax-free return of capital and reduces Don's basis in the royalty agreement to $3,000 ($12,000 - $9,000). The $8,000 royalty payment in 2006 would recover the remaining basis and result in Don recognizing $5,000 ($8,000 - $3,000) of ordinary income. The closed transaction requirement has accelerated the recognition of the capital gain on the liquidation, as well as converted $5,000 of long-term capital gain into ordinary income.M. Installment Obligations Received by a Shareholder 1. Shareholders who receive an installment obligation as part of their liquidating distribution ordinarily report the FMV of their obligation as part of the consideration received in order to calculate the amount of the recognized gain or loss. 2. §453(h)(1)(A) provides a general rule that shareholders who receive an installment obligation that was acquired by the liquidating corporation in connection with a sale or exchange of property are eligible for special treatment in reporting their gain on the liquidating transaction if: The sale or exchange takes place during the 12-month period beginning on the date a plan of complete liquidation is adopted AND The liquidation is completed during such 12-month period. 3. §453(h) (1) (A) provides that these shareholders may report their gain as the installment payments are received. §453(h) (1) (B) provides an exception to the general rule above. The special tax deferral does not apply to the portion of the gain attributable to the sale of the inventory or property held for sale to customers in the ordinary course of its trade or business, unless such sale is to one person in one transaction and involves substantially all of the inventory-type properties attributable to a trade or business of the corporation.
§453(h)(1)(c) provides that an installment obligation arising from the sale of depreciable property by the corporation to the shareholder's spouse or a person related to the shareholder are also ineligible for the special tax deferral. A related party is defined by §1239(b).EXAMPLE: Don owns all of the stock of Cleveland Corporation. The stock hasa $300,000 basis. Cleveland Corporation adopts a plan of liquidation, sells itsnoncash assets having a basis of $600,000 for which it receives $300,000 in cashand $700,000 in installment obligations. It liquidates within a 12-month period.None of the obligations are attributable to inventory.Cleveland Corporation realizes a $400,000 gain on the sale. However, $120,000must be recognized when the sale takes place (($300,000/$1,000,000) x$400,000). The remaining $280,000 of deferred gain is recognized by Clevelandwhen the obligations are distributed to Don.After paying its corporate liabilities, $100,000 in cash and $700,000 ofinstallment obligations are distributed to Don in complete liquidation of his stockinvestment. Don must recognize $62,500 of gain in the year of liquidation as aresult of receiving the cash. The remaining gain is recognized as the installmentobligations are collected by Don. §331(a) Shareholder Calculation:Amount Received $800,000Less: Adjusted Basis in Stock (300,000)Recognized Gain $500,000§453 Installment Calculation:Cash Received $100,000 x $500,000 Realized GainTotal Received 800,000=Current Year Income $62,500VI. Effects of Liquidating on the Liquidating Corporation A. Liquidating Issues 1. The corporation must address two issues:The recognition of gain or loss by the liquidating corporation when itdistributes property,The deductibility of the expense of liquidating.
2. In the recognition of Gain or Loss When Property is Distributed in Redemption of Stock, §336(a) provides that gain or loss must be recognized by the liquidating corporation when property is distributed in a complete liquidation. 3. The amount and character of the gain or loss are determined as if the property is sold at its FMV. EXAMPLE #1: Under West Corporation's plan of liquidation, land is distributed to one of the shareholders, Don. The land, which is used in West's trade or business, has a $40,000 adjusted basis to West and a $120,000 FMV on the distribution date. West must recognize an $80,000 §1231 gain ($120,000 - $40,000) when it makes the liquidating distribution. Don must recognize a gain to the extent that the land's FMV exceeds his basis for the West stock. Don's basis for the land is its $120,000 FMV. The distribution of the land to Don produces the same tax burden as if West Corporation had sold the land and distributed the cash proceeds. KEY POINT: The general rule is that the liquidating corporation recognizes gain or loss on a distribution in a complete liquidation. The gain or loss is computed as if the liquidating corporation had sold all of its assets to the distributee shareholder at the property's FMV. 4. With limited exceptions, the liquidating corporation can recognize a loss when property that has decreased in value is distributed to its shareholders. EXAMPLE #2: Assume the same facts as in Example #1 above except that the FMV of the land is $10,000. West Corporation is permitted to recognize a $30,000 §1231 loss ($10,000 - $40,000 adjusted basis) when the land is distributed to Don. Don's basis for the land is $10,000.B. General vs. Specific Expenses of the Liquidation 1. The corporation is permitted to deduct the general liquidation expenses incurred in connection with the liquidation transaction. 2. These costs include attorneys and accountant’s fees, costs incurred in drafting the plan of liquidation and obtaining shareholder approval, etc. 3. The specific liquidation expenses associated with selling the corporation's properties are treated as an offset against the sales proceeds. When a corporation sells an asset pursuant to its liquidation, the selling expenses reduce the amount of gain or increase the amount of loss reported by the corporation.
EXAMPLE: NSTP Corporation adopts a plan of liquidation on July 15, 2015, and shortly thereafter sells a parcel of land on which it realizes a $60,000 gain before the deduction of a $6,000 sales commission. NSTP pays its legal counsel $1,500 to draft the plan of liquidation. All of the remaining properties are distributed to its shareholders in December 2015. The $1,500 paid to legal counsel is deductible as a general liquidation expense on the 2015 income tax return. The specific sales commission reduces the $60,000 gain realized on the land sale, so that the corporation recognized gain is reduced to $54,000 ($60,000 - $6,000). 4. Any amounts of capitalized expenditures that are unamortized at the time of liquidation should be deducted if they have no further value to the corporation (e.g., unamortized organizational costs). 5. Capitalized expenditures that have value must be allocated to the shareholders receiving the benefit of such an outlay (e.g., prepaid insurance, prepaid rent, etc.). 6. Expenses related to the issuing of the corporation's stock are not deductible by the corporation, even at the time of liquidation. They are treated as a reduction in paid-in capital on the corporate books.C. Corporate Filing Requirements for Corporate Dissolution or Liquidation 1. §6043(a) of the Internal Revenue Code requires that every corporation shall: Within 30 days after the adoption by the corporation of a resolution or plan for: The dissolution of the corporation OR The liquidation of the capital stock make a return setting forth the terms of such resolution or plan and such other information as the Secretary shall prescribe by forms or regulations, AND When required by the Secretary, make a return regarding its distributions in liquidation, stating the: Name and address of each shareholder, Number and class of shares owned by each shareholder, And The amount paid to each shareholder.
If the distribution is in property other than money, then the fair market value of the property must be reported as of the date the distribution is made to each shareholder. D. TOPIC REVIEW: Tax Consequences of a Corporate Liquidation General Corporate Liquidation Rules 1. The shareholder's recognized gain or loss equals the amount of cash plus the FMV of the other property received minus the adjusted basis of the stock redeemed. 2. Corporate liabilities assumed or acquired by the shareholder reduce the amount realized. 3. The gain or loss is capital in nature if the stock investment is a capital asset. 4. If a loss is recognized on the liquidation, then §1244 permits ordinary loss treatment for qualifying individual shareholders. 5. The adjusted basis of the property received by the shareholder is its FMV on the date of distribution. 6. The shareholder's holding period for the property commences on the day after the distribution date. 7. The distributing corporation recognizes gain or loss when making the distribution. 8. The amount and character of the gain or loss is determined as if the property had been sold for its FMV immediately before the distribution. 9. Special rules apply when corporate liabilities are assumed or acquired by the shareholders and the amount of such liabilities exceed the property's FMV.VII. Introduction to the Preparation Issues of the Corporate Income Tax Return A. Imposition of the Corporate Income Tax 1. §11(a) of the Internal Revenue Code provides that a tax will be imposed for each taxable year on the taxable income of every corporation.
2. §11(b) (1) provides a general rule that the amount of the tax imposed will be the sum of: 15% on the first $50,000 of taxable income, 25% on the next $25,000 of taxable income, 34% on the amount of taxable income which exceeds $75,000 up to $10,000,000 and 5% on the amount in excess of $10,000,000.3. In the case of a corporation which has taxable income in excess of $100,000 for any taxable year, the amount of the tax on the excess over $100,000 shall be increased by an amount which is the lesser of: 5% of the excess or $11,750 The result of this provision is that the lower marginal tax brackets of 15% and 25% are phase-out between $100,000 - $335,000 of taxable income. Corporate Tax Rate ScheduleIf taxable income is: Of the Over But Not Over Tax Is: Amount Over $0 0 $ 50,000 50,000 15% $ 75,000 50,000 $ 100,000 75,000 7,500 + 25% 75,000 $ 335,000 100,000 $10,000,000 100,000 13,750 + 34% 335,000 $15,000,000 10,000,000 $18,333,333 335,000 22,250 + 39% 15,000,000 10,000,000 113,900 + 34% -0- 15,000,000 3,400,000 + 35% 18,333,333 5,150,000 + 38% - 35%EXAMPLE #1: NSTP Corp. has taxable income of $90,000 for 2005. The tax iscalculated as follows:1. 15% on first $50,000 = $7,5002. 25% on next $25,000 = 6,2503. 34% on next $15,000 = 5,100 $18,850 Total tax liabilityEXAMPLE #2: Same as above except the taxable income is now $335,000.1. 15% on first $50,000 = $7,5002. 25% on next $25,000 = 6,2503. 34% on next $25,000 = 8,5004. 39% up to $335,000: $235,000 = 91,650 $113,900 Total tax liability
4. §11(b) (2) provides an exception to the graduated rate structure for “certain” personal service corporations (PSC) as defined in §448(d)(2). Tax Professional Alert: These PSC’s have a flat tax rate imposed at 35% beginning with the first dollar of taxable income.5. A corporation generally must make estimated tax payments as it earns or receives income during the year.6. Generally a corporation must make installment payments if it expects that its estimated tax for the year will be $500 or more.7. If the corporation does not pay the installments when due then it could be subjected to an underpayment penalty.8. §6655(c) states that installment payments are due by the 15th day of the 4th, 6th, 9th and 12th month of the corporation’s taxable year. Therefore:Calendar Year December 31 Fiscal Year June 301st Quarter April 15th 1st Quarter October 15th2nd Quarter June 15th 2nd Quarter3rd Quarter September 15th 3rd Quarter December 15th4th Quarter December 15th 4th Quarter March 15th June 15thIf the due date of the estimated tax payment is a Saturday, Sunday or legal holidaythen the installment is due on the next business day.9. §6655(d)(1)(A) provides for the amount of required installments and states that in general the amount shall be 25% of the required annual payment.10. §6655(d) (1)(B) provides a general rule that the term “required annual payment” means the lesser of:100% of the tax shown on the return for the current taxable year (or, if noreturn is filed, 100% of the tax for such year), or100% of the tax shown on the return of the corporation for the precedingtaxable year.NOTE: For purposes of the preceding taxable year in b. above; the test for thepreceding year will not apply if:That taxable year was not a full 12 month period orThe corporation did not file a return for such preceding taxable yearshowing a liability for tax.
Tax Professional Alert: In IRS Publication 542 the allowance for the lesser of 100% of the prior year tax test states that the prior year tax must have shown a positive tax liability (not zero). The IRS takes this position in Reg. §1.6655- 2(a)(1). This is not the language in the statute and as a practical matter penalties generally are not assessed. Tax Professional Reference: If a corporation’s income is expected to vary during the year then it may be able to lower the amount of one or more of the required installments by using either an annualized installment method or adjusted seasonal installment method. Underpayment Penalty: If the corporation does not pay a required installment of estimated tax by the due date then a penalty could be imposed. The penalty is calculated for each installment due date. The corporation may owe a penalty for an earlier due date even if it paid enough later to make up the underpayment. IRS FORM 2220 IRS Form 2220 is used to determine and calculate any penalty. The amount of the penalty depends on three factors. 1. Amount of the underpayment. 2. The period during which it was due and unpaid, and 3. The interest rate for underpayment provided in the published quarterly Internal Revenue Bulletin (IRB).B. Filing Requirements of a Corporate Return 1. All domestic corporations in existence for any part of a taxable year must file an income tax return whether or not the entity has any taxable income. (NOTE: This includes corporations in bankruptcy.) 2. A corporation must generally file IRS Form 1120 to report its income, gains, deductions, losses, credits and to calculate its income tax liability. 3. Generally, a corporation must file its income tax return by the 15th day of the 3rd month after the end of its taxable year. This is March 15th if the corporation has a calendar year end and September 15th if the corporation has a fiscal year end of June 30th. 4. A new corporation filing a short period return must generally file by the 15th day of the 3rd month after its short period ends. 5. A corporation that has liquidated must generally file by the 15th day of the 3rd month after the date it has liquidated.
6. If the due date of the corporate return is a Saturday, Sunday, or legal holiday then the due date is extended to the next business day. 7. IRS Form 7004 provides an automatic 6 month extension of time to file a corporate income tax return if filed and the tax is paid by the due date of the return. 8. Form 7004 does not extend the time for paying the tax. Interest and penalty are charged from the original due date of the return to the date of payment. (Refer to the filing instructions of Form 7004.)C. Penalty for Late Filing of Return 1. If a corporation does not file its tax return by the due date (including extensions) then it may be penalized 5% of the unpaid tax for each month or part of a month the return is not filed, up to a maximum of 25% of the unpaid tax. 2. If the corporation is charged a penalty for late payment of tax for the same period of time that it isn’t filed, then the penalty for late filing is reduced by the amount of the penalty for late payment. 3. The minimum penalty for a return that is over 60 days late is the smaller of the tax due or $100. 4. The penalty will not be imposed if the corporation can show the failure to file on time was due to a reasonable cause. A corporation that has a reasonable cause to file late must attach a statement to its tax return explaining the reasonable cause.D. Penalty for Late Payment of Tax 1. A corporation that does not pay the tax when due may be penalized ½ of 1% of the unpaid tax for each month or part of a month the tax is not paid, up to a maximum of 25% of the unpaid tax. The penalty will not be imposed if the corporation can show that the failure to pay on time was due to a reasonable cause.E. Capital Losses 1. A corporation can deduct capital losses only up to the amount of its capital gains. Therefore, if a corporation has an excess capital loss, it cannot deduct the loss in the current tax year against other income. 2. The corporation carries the loss to other tax years and deducts it from any net capital gains that occur in those years.
3. A capital loss is carried to other years in the following order: Back 3 years prior to the loss year, then Back 2 years prior to the loss year, then Back 1 year prior to the loss year, then Any loss remaining is carried forward for a maximum period of 5 years. *Any loss remaining after the 5 year carryforward period is lost forever.4. When the corporation carries a net capital loss to another tax year, it is treated as a short-term loss. It does not retain its original identity as long term or short term.EXAMPLE: In 2014 a calendar year corporation had a net short-term capital gainof $3,000 and a net long-term capital loss of $9,000. The short-term gain offsetssome of the long-term loss, leaving a net capital loss of $6,000. The corporationtreats this $6,000 as a short-term loss when carried back or forward.The corporation carries the $6,000 short-term loss back 3 years to 2011. In 2011,the corporation had a net short-term capital gain of $8,000 and a net long-termcapital gain of $5,000. It subtracts the $6,000 short-term loss first from the netshort-term gain. This results in a net capital gain for 2011 of $7,000. This consistsof a net short-term capital gain of $2,000 ($8,000 - $6,000) and a net long-termcapital gain of $5,000.YEAR 2014 $3,000Short-Term Capital Gain (9,000)Long-Term Capital (Loss) $(6,000)Net Long-Term Capital LossYear 2011 Prior Carryback Adjustment PostShort-Term Capital Gain $8,000 $(6,000) $2,000Long-Term Capital Gain 5,000 (-0-) 5,000Net Capital Gains $13,000 $(6,000) $7,000F. Rules for Carryovers and Carrybacks 1. When carrying a capital loss from one year to another, the following rules apply: The current year’s net capital loss cannot be combined with a capital loss carried from another year. Therefore, carry capital losses back only to years that would otherwise have had a total net capital gain in that prior carry back year. If the corporation carries capital losses from 2 or more years to the same year, then deduct the loss from the earliest year first.
NOTE: A corporation cannot use a capital loss carried from another year to create or increase a net operating loss (NOL) in the year to which it is carried back.G. Refunds 1. When there is a carryback of a capital loss to an earlier tax year the corporation must calculate the tax for that year. If the recalculated tax is less than the original tax owed, then the corporation uses either Form 1139 or Form 1120X to apply for a refund.H. Form 1139 1. A corporation can get a refund faster by using Form 1139. 2. However, the corporation cannot file Form 1139 before filing the return for the corporation’s capital loss year. 3. The corporation must file Form 1139 no later than one year after the year it sustains the capital loss.I. Form 1120X 1. If the corporation does not file Form 1139, then it must file Form 1120X to apply for a refund. 2. The corporation must file Form 1120X within 3 years of the due date of the return, (including extensions) for the year in which it sustains the capital loss.J. Charitable Contributions 1. A corporation can claim a limited deduction for any charitable contributions made. 2. Cash Method Corporation. A corporation using the cash method of accounting deducts contributions in the tax year actually paid. 3. Accrual Method Corporation. A corporation using an accrual method of accounting can elect to deduct unpaid contributions for the tax year the board of directors authorizes them if it actually pays them within 2 ½ months after the close of that tax year. 4. The corporation makes the election by reporting the contribution on the corporation’s return for the tax year. A statement declaring that the board of directors adopted the resolution during the tax year must be attached to the return. The declaration must include the date the resolution was adopted.
5. Amount of the Limited Contribution. A corporation cannot deduct charitable contributions that exceed 10% of its taxable income for the tax year. For purposes of this provision the corporation must calculate the taxable income without the following items. The deduction for the charitable contributions themselves. The deduction for dividends received. Any net operating loss carryback to the tax year. Any capital loss carryback to the tax year. 6. Carryover of excess contributions. A corporation can carryover to each of the subsequent five years any charitable contributions made during the current year that exceed the 10% limit. 7. The corporation will lose any excess not used within that 5 year period. Example: If a corporation has a carryover of excess contributions paid in 2003 and it does not use all the excess on its return for 2004, then it can carry the rest over to 2005, 2006, 2007 and 2008. The corporation cannot deduct a carryover of excess contributions in the carryover year until after it deducts the contributions made in that year (subject to the 10% limit). 8. A corporation cannot deduct a carryover of excess contributions to the extent it increases a net operating loss carryover.K. Schedule M-1 Reconciliation of Taxable Income and Financial Net Income 1. The purpose of Schedule M-1 on Page 4 of Form 1120 is to reconcile net income for financial purposes with taxable income on the tax return. 2. The starting point on Schedule M-1 is “net income per books.” 3. The following items are reported on lines 2-5 as additions: FIT Expense Excess capital losses Income includible for tax (but not for books: prepaid income) Various nondeductible tax items e.g. (Penalties, food & entertainment, excess charitable contributions.)
4. The following items are reported on lines 7-8 as subtractions: Tax exempt income Prior years carryovers of charitable contributions. The adjustments will result in the taxable income on page 1 of Form 1120 (before the NOL deduction and DRD). L. Schedule M-2 Analysis of Unappropriated Retained Earnings Per Books (line 25, Schedule L) 1. Schedule M-2 reconciles the unappropriated retained earnings at the beginning of the year with the unappropriate retained earnings at the end of the year. 2. The ending balance from the prior year’s tax return is the starting point for the current year’s balance. Retained earnings is then increased or decreased on line 2 by the current year’s net income or net loss per the taxpayer’s books. 3. Distributions on line 5 will decrease retained earnings and the ending balance on line 8 will reconcile to the amount in Schedule L, line 25.VIII. Subchapter C-Corporations “Professional Service Corporations” (PSC) A. Definition of a PSC 1. The Internal Revenue Code defines a Professional Service Corporation under §§441 and 448 as those corporations rendering personal services in the fields of: Health Law Engineering (including surveying & mapping) Architecture Accounting Actuarial Science Performing Arts Consulting 2. §441 involves the issue of a calendar year vs. a fiscal year. 3. §448 involves the issues of: Graduated tax rates vs. a flat rate and Cash basis vs. accrual basis accounting.
B. Advantages Available to PSC 1. Fringe benefits are an important issue for a PSC. Tax-free fringe benefits are available to the owner-employees of a PSC. The normal benefits are available such as: §79 provides group life insurance §101 provides employee death benefits §105-106 provide accident and health insurance plans §119 provides meals and lodging for benefit of employer §120 provides group legal services §125 provides cafeteria plans §127 provides educational assistance programs §129 provides dependent care assistance program §132 provides de minimis fringe benefits, no additional cost services, working condition fringes and allows employee discounts.C. Distribution of Profits Via Bonus 1. A PSC can avoid double taxation by distributing potential profits to the owners by declaring bonuses at quarterly intervals. This will bring taxable income to a minimum level if not zero. 2. However the issue of “reasonable compensation” is always potentially challenged by the Service. Having defenses available before the audit takes place is advisable.D. Tax Issues of a PSC 1. When distribution of profits via bonus are paid the IRS may attempt to reclassify these payments as dividends and therefore disallow a deduction. 2. The Service is still challenging the issue of “unreasonable compensation.” The Service will contend that the amounts paid were actually corporate earnings, disguised as salary which should have been non-deductible dividends, since there was no specific or actual services provided for the payment. Periodic victories for the IRS on this issue alerts tax professionals that this issue is alive and dangerous.E. Distribution of Profits Via Bonus–Unchallenged 1. If the Service does not challenge the bonus paid as “unreasonable compensation” then the owner-employees have a severe current year tax burden.
2. In order to avoid the 35% corporate flat tax imposed on a Qualified PSC an individual in the 35% or 39.6% tax bracket will really have a higher marginal tax rate because of additional taxable income resulting from provisions pertaining to: Phase-out of itemized deductions Phase-out of personal and dependency exemptions Phase-out of Roth IRA contribution Phase-out of education credits Phase-out of passive losses Imposition of net investment income tax on Form 8960 Imposition of .009% on additional Medicare tax on Form 8959 This results in an effective marginal rate which is much greater than 35% and 39.6%. NOTE: Also, the additional Medicare tax of 2.9% on the whole amount will provide a 1.45% deduction to the corporation which requires added calculations to determine the proper amount available for the bonus.F. Calendar Year Requirements 1. Subchapter C-Corporations are generally allowed to have a fiscal tax year. 2. §441(i), however, requires a calendar year for a PSC. The PSC is required to use the calendar if it passes two tests. These two tests are the: Principal Activity Test And Substantial Performance Test 3. The principal activity test is met if: More than 50% of the corporation's total compensation, during the testing period, is the result of rendering services in the specified professional fields by all employees of the corporation whether directly or indirectly. 4. The substantial performance test is met if: (a) More than 20% of total compensation is the result of personal services paid to employee-owners. (b) An “employee owner” is an employee who owns more than 10% of the stock on any day of the “testing period.”
NOTE: The “testing period” is the taxable year preceding the tax year for which a determination is being made.G. Flat Tax and Cash Basis 1. §448 provides that a qualified PSC will have a flat 35% tax rate and a cash method of accounting if the corporation passes two tests. These two tests are the: • Function Test And • Ownership Test The function test is met if 95% or more (substantially all) of the time spent by all employees is for the performance of personal services (direct and indirect). The ownership test is met if 95% or more of the stock value is owned at all times during the tax year by the: • Employees performing services in the specified fields, • Retired employees who performed those services, • Estate of a person who performed those services • Or • Any person who acquired the stock by reason of death of a person who performed those services, but only for the two-year period following the death of the performance person. 2. The professional corporation should seek to fail these mechanical tests by having the entity involved in a business activity which will not be considered to be a personal service as defined in the specific fields mentioned in the law. 3. The PSC can also be avoided by the election of a Subchapter S-Corporation.
Case Study Issues1. Angel Pagan and his brother Diabalo are 50/50 owners of a business that began January 1, 2013.2. The company’s gross receipts from sales was $1,000,000 and they received qualified dividends from investments of $10,000.3. Per the employment contracts Angel received $200,000 for his service to the company and Diabalo received $175,000. In addition they each received a distribution of $20,000 from the profits for the year.4. Other non-owner employees received $200,000 of compensation in the form of W-2 salary. $25,000 of payroll taxes were paid by the company for these employees and $25,000 was paid in payroll taxes for Angel and Diabalo.5. The company paid $10,000 of interest expense on loans and there was a $10,000 charitable contribution. In addition there is a pension plan which contributes 25% of compensation for all employees.6. Medical benefits include health insurance premiums totaling $25,000 for Angel and Diabalo and $25,000 for the employees.7. If estimated entity income taxes were needed a $50,000 estimate was timely paid.8. The company had outstanding loans receivable from the owners of $4,500 and the company paid $6,000 in escrow into another asset account.9. There is a loan due to the owners of $10,000 on December 31, 2014 and the equity on January 1, 2014 was $35,000.10. The company invested $100,000 in equipment and elected a §179 expense deduction.
National Society of Tax Professionals presents The 2015 Special Topics Seminar and WorkshopWilliamsburg XV - June 25-26, 2015 Napa III - July 21-22, 2015 Introduction to and Overview of the Subchapter S-Corporation: From Start-Up to Operation to Liquidation Nina Tross, EA, MBA NSTP Executive Director Paul La Monaca, CPA, MST NSTP Director of Education
Seminar materials and seminar presentations are intended to stimulate thought and discussionand to provide attendees with useful ideas and guidance in the areas of federal taxation andadministration. These materials as well as the comments of the instructors do not constitute and shouldnot be treated as tax advice regarding the use of any particular tax procedure, tax planning technique ordevice or suggestion or any of the tax consequences associated with them. Although the author has made every effort to ensure the accuracy of the materials and theseminar presentation, neither the author, the presenter nor the National Society of Tax Professionalsassumes any responsibility for any individual’s reliance on the written or oral information presentedduring the presentation. Each attendee should verify independently all statements made in the materialsand during the seminar presentation before applying them to a particular fact pattern and shoulddetermine independently the tax and other consequences of using any particular device, technique orsuggestion before recommending the same to a client or implementing the same on a client’s or on his orher own behalf. Copyright © Paul La Monaca 2015
TABLE OF CONTENTS Page I. Subchapter S-Corporation.........................................................................................................1 A. Pass-Through Entity..........................................................................................................1 B. Formation..........................................................................................................................2 C. Form of Consent ...............................................................................................................3 D. Relief Provisions Available for Failing to Make a Timely Election ................................3 E. Qualifying as a Small Business Corporation ...................................................................5 F. No Double Taxation..........................................................................................................6 G. Property Distributions By an S-Corporation ...................................................................8 H. Liquidation of an S-Corporation.......................................................................................9 I. Shareholder’s Basis in the S-Corporation: Determining Initial Basis ............................10 J. Annual Adjustments that Increase Stockholder Basis ....................................................11 K. Annual Adjustments that (Decrease) Stockholder Basis ................................................11 L. Entity Debt Does Not Create Basis.................................................................................12 M. §1367 Pre-1/1/97 Ordering Rules to Shareholder Basis in the S-Corporation Stock....................................................................................13 N. Post 12/31/96 Ordering Rules to Shareholder Basis ......................................................13 O. Disadvantages of an S-Corporation: Restrictions on Stock Ownership .........................15 P. Built-in Gains Tax (BIG) ................................................................................................16 Q. One Class of Stock Restrictions......................................................................................17 R. Allowance of Differing Powers ......................................................................................18 S. Safe Harbor for Debt.......................................................................................................19 T. Service Can Waive Invalid Subchapter S-Election ........................................................20 U. S-Corporation Termination and the 5-Year Waiting Period...........................................21 V. Termination of S-Election ...............................................................................................22 W. Employment Issues of an S-Corporation Shareholder....................................................23 X. Establishing Reasonable Compensation .........................................................................24 Y. Health Insurance Premiums for Subchapter S Shareholders ..........................................26II. Corporate Life Cycle Includes Termination: Liquidation....................................................30 A. General Review...............................................................................................................30
Page B. Income Tax Effects of Corporate Liquidations: Gain or Loss to Shareholders and Entity .............................................................................................31 C. Basis of Property Received by the Shareholder in Liquidation of the Corporation ..........................................................................................................31 D. Gain or Loss Recognized by the S-Corporation on Property Distributed in Complete Liquidation ..............................................................................32 E. Definition of a Complete Liquidation: Not Defined in the Code ...................................33 F. Tax Effects of the General Liquidation Rules ................................................................34 G. Amount of Recognized Gain or Loss..............................................................................34 H. Stock Acquired at Various Times ...................................................................................35 I. Basis of Property Received in the Liquidation ...............................................................35 J. Subsequent Assessments Against the Shareholders .......................................................35 K. Effects of Liquidation on the Liquidating Corporation ..................................................36 L. General vs. Specific Expenses of Liquidation ................................................................37 M. Corporate Filing Requirements.......................................................................................38III. Exhibits ......................................................................................................................................39 • Summary of Shareholder’s Basis....................................................................................40 • Statement of Revocation of S-Election...........................................................................41 • Statement of Consent of Revocation of the S-Election ..................................................42 • Statement of Consent to Rescind the Revocation of the S-Election...............................43 • Election Not to Apply Pro Rata Allocation ....................................................................44 • Per-Share, Per-Day Allocation Method ..........................................................................46 • Subchapter S-Corporation Checklist...............................................................................47 • Tax Advocate’s Report Highlights Subchapter S-Corporation Issues IR 2008-4, 01/08/2008 ........................................................................................48Supplemental Materials: • Form 1120S Case Study Issues......................................................................................52 • IRS Form 2553 Election by a Small Business Corporation and Instructions ................63 • IRS Form 8832 Entity Classification Election and Instructions ....................................73
I. Subchapter S-Corporation A. Pass Through Entity 1. In 1958 Congress passed the Small Business Corporation Act which created an entity for tax purposes which would help safeguard the family owned business allowing legal protection and the pass-through of profits and losses to the individual owners without incurring taxes at the corporate level and again through the distribution of dividends to the owners of the family-owned business. 2. It also allowed the use of the business loss to be passed down to the owners instead of being locked in at the entity level. It was truly for small family businesses and the number of shareholders was limited to 5 individuals. The latest Statistics of Income Bulletin (SOI) reports the data on Tax Year 2012 and reports that there were 4,205,452 Subchapter S-Corporations in 2012 and the number of shareholders were 9,236,384. The total receipts generated in 2012 was over $6 trillion at $6,572,866,128,000. The business receipts generated was $6,427,057,090,000 with the balance coming from investment vehicles. 3. Total deductions were $6,192,398,601,000 and of that amount $247,064,024,000 was compensation of Officers. Rent on business property generated $166,243,987,000 of deductions. Net income generated $475,998,050,000. 4. The number of returns with net profits were 2,873,437 with 6,229,191 shareholders. It is obvious that the Subchapter S-Corporation is an entity that has evolved into an entity of choice for many small businesses. 5. In terms of the manner in which it functions for non-tax issues a Subchapter S- Corporation is just like a Subchapter C-Corporation. An S-Corporation combines the business and legal characteristics of a C-Corporation. 6. S-Corporations have the features of: a. Limited liability for the owners, b. Operates with a management group, and c. Has a board of directors and officers. 7. S-Corporations differ from C-Corporations in regard to income tax matters. An S-Corporation is a “pass through” entity. It has many of the federal income tax characteristics of a partnership. The corporation acts as a conduit through which the tax attributes flow through to shareholders on a pro-rata method. Large and public companies generally cannot elect S-Corporation status. Many small businesses have made it the entity of choice. 8. Double taxation of corporate earnings is avoided because there is generally no corporate-level income tax. Earnings are taxed only once at the shareholder level in the year when earned (regardless of when they are distributed). 1
9. §6072(b) provides that an S-Corporation must file an annual return on IRS Form 1120S, U.S. Income Tax Return for a Corporation by the 15th day of the third month following the close of the corporation’s tax year. The law provides that the return must be filed until liquidated. Therefore, even if there is no activity in the current tax year the return is required to be filed. Tax Professional Red Alert: There is a monthly penalty for the failure to file a Form 1120S. §6699 provides an S-Corporate level penalty of $195 per shareholder per month or fraction of a month up to 12 months for the failure to file an S- Corporation return. 10. An automatic 6-month extension is granted for filing the Form 1120 by filing IRS Form 7004 by the 15th day of the 3rd month after the end of the tax year. The Form Code is 25. 11. §6722 provides for a $100 corporate level penalty per shareholder for failure to provide Schedule K-1 to shareholders or failure to include all the required information. This penalty is increased from $50 beginning January 1, 2011.B. Formation 1. Since a Subchapter S-Corporation is only a filing status for Federal Income Tax purposes the formation of the corporation is dictated by state statute the same way as is a regular C-Corporation. Therefore, the same formalities are required such as: a. Written Corporate Charter b. Articles of Incorporation c. Adoption of Written By-Laws d. Election of a Board of Directors e. Holding of Organizational Meetings f. Written Minutes of Organizational Meetings g. Stock Certificates h. Franchise Fees i. Registered Agent 2. The significant difference between a Subchapter S-Corporation and a regular C-Corporation is that a formal election must be made by the corporation to be treated as a Subchapter S-Corporation for Federal Income Tax purposes. Note: The election is valid only if all shareholders consent to the “election.” 2
C. Form of Consent 1. §1362(a) (2) provides that all shareholders must consent to the election by signing IRS Form 2553, Election by a Small Business Corporation. The required consent may be provided on the Form 2553 or on a separate statement attached to the election. Once made, an election continues until a disqualifying act or shareholders affirmatively revoke the election. 2. §1362(b) (2) requires that the election must be filed with the Service by the 15th day of the third month of the taxable year in which the election is to take effect. The election must be signed by a person authorized to sign the corporation’s tax return. 3. The corporation must meet all of the eligibility requirements for the pre-election period of the tax year, and all persons who were shareholders during the pre- election period also must consent to the election. 4. §1362(b)(3) provides that if the election is filed after the 15th day of the third month then the S-Corporation status does not take effect until the beginning of the following tax year.D. Relief Provisions Available For Failing to Make a Timely Election 1. The Service provides a procedure for granting relief for failing to timely file a Subchapter S-election. Under this procedure there is a simplified method for shareholders to request relief. Eligible entities may be granted relief if the request for relief is within 24 months of the due date of the election. This simplified procedure is to be followed instead of having to request a letter ruling therefore user fees are not required (Rev. Proc. 2003-43). 2. If an entity has failed to timely file both its S-Corporation election and its election to be treated as a corporation, then a separate relief procedure applies (Rev. Proc. 2004-48). 3. An entity seeking to obtain this relief must file Form 2553 within six months after the due date of the tax return for the first year of the intended S-Corporation election, excluding extensions. 3
4. The form must state at the top that it is “FILED PURSUANT TO REV. PRC. 2004-48” and include a statement explaining the entity’s failure to timely file the S corporation and entity classification elections; among the eligibility requirements is reasonable cause for that failure. An entity that obtains relief under the revenue procedure is treated as having made both an election to be classified as an association taxable as a corporation under Reg. §301.7701-3(c) and an S-Corporation election as of the same date.5. Shareholders in community property states are eligible for automatic relief for late S elections if their spouses did not file timely shareholder consents. In order to qualify for this relief the S-Corporation election must be invalid solely because the spouse’s signature is missing from the election form. Note: Shareholders must alert the IRS that they are seeking relief under Rev. Proc. 2004-35 and identify the number of shares they own as of the date of the election. Each spouse must sign a separate statement indicating his or her consent to the election.6. For taxable years that end on or after December 31, 2007, the IRS has issued Revenue Procedure 2007-62 which allows small businesses that missed filing Form 2553 before filing their first Form 1120S to file both forms simultaneously.7. The Service states that this new process will save time and effort for those taxpayers who establish reasonable cause for making a late election. The Service has updated the Form 2553 and instructions to reflect the new rule.8. The new guidance provides a simplified method to request relief by permitting taxpayers to file their first Form 1120S along with Form 2553 and include a statement on the form declaring reasonable cause.9. The new procedure will reduce taxpayer burden by allowing the Service to process a properly completed tax return and its corresponding election without delays or additional contracts with taxpayers to resolve the issue of a missing election. NOTE: The forms must be filed together no later than 6 months after the due date of the tax return (excluding extensions) for the first taxable year in which the S-Corporation election was intended.10. The procedure also requires that no shareholder whose tax liability or tax return would be affected by the S-Corporation election has reported inconsistently with the S-Corporation election. 4
11. Upon receipt of a completed application requesting relief, the Service will determine whether the requirements for granting relief have been satisfied. Therefore, if the entity receives relief then it will be classified as an S-Corporation as of the effective date of the election.E. Qualifying as a Small Business Corporation 1. Unlike a C-Corporation, an S-Corporation faces significant restrictions regarding the number and type of shareholders permitted to have ownership. A corporation is eligible to elect and be taxed as an S-Corporation only if it qualifies as a “small business corporation.” 2. §1361(b)(2) specifies that in order to qualify as a “small business corporation” the enterprise must meet the following tests: a. An S-Corporation can have only one class of stock (the stock may, however, carry different voting rights); b. The shareholders may only be individuals, estates and certain trusts (corporations, partnerships, most trusts, and nonresident aliens may not be shareholders); c. An S-Corporation must not be an “ineligible corporation” (defined as financial institutions, insurance companies, DISCs, and members of affiliated groups) and d. An S-Corporation must have no more than 100 shareholders. 3. For purposes of applying the 100 shareholder limitation there are situations where two or more shareholders can be deemed to be only one shareholder based on relationship of the shareholders to each other: • §1361(c) (1) provides that spouses and their estates are counted as one shareholder. • Qualifying members of a family who hold stock are deemed to be one shareholder. 4. A family is defined as a common ancestor, the lineal descendants of the common ancestor and the spouses (or former spouses) of the common ancestor and the descendants. 5
5. §1361(c)(1)(B) provides that the common ancestor can be no more than six generations removed from the youngest shareholder who is treated as a member of the family on the latest of: a. The date the S-Corporation election is made. b. The earliest date that a family member first holds stock in the corporation, or c. October 22, 2004. 6. §1361(c)(1)(C) further provides that any legally adopted child, any child lawfully placed with the individual for legal adoption and any eligible foster child are deemed to be a child by blood. 7. §1361(c) (1) (A) provides that the estate of a family member is also treated as a member of the family for purpose of determining the number of shareholders. 8. §1361(c)(2)(A) provides that the term “eligible shareholder” includes: a. A grantor trust (where the grantor is regarded as a shareholder). b. A Voting Trust (where each beneficiary is treated as a shareholder). And c. Any testamentary trust that receives S-Corporation stock. Note: The testamentary trust is treated as an eligible shareholder only for two years after the deemed owners death. (Reg. §1.1361-1(h)). Note: A single member LLC which is disregarded for federal income tax purposes can be a shareholder of an S-Corporation if the member is eligible to own S Corporation stock. The stock is considered held directly by the member. (IRS Letter Ruling 200107025).F. No Double Taxation 1. The most significant advantage in electing the S-status is the single level of federal income taxation. There is no corporate level tax. 2. The taxation of corporate profits is assessed only once at the individual shareholder's level. 6
EXAMPLE #1: Two corporations both have net taxable income of $100,000.Net Income C-Corporation S-Corporation $100,000 $100,000Less: Corporate Tax (22,250) (-0-)Balance Available to $77,750 $100,000Shareholders NOTE: The income tax result of the balance available to shareholders will depend on each shareholder’s tax rate vs. the 15% qualified dividend rate available during tax years 2010-2012.3. An S-corporation is a “pass-through” entity. It is a conduit through which all profits, losses, deductions, credits, etc. flow through to the shareholders on a pro- rata method (per share, per day allocation).EXAMPLE #2: Based on the results in Example #1 above, Don is a 20%shareholder of the S-Corporation and he owed his stock for only 120 days duringthe current tax year. As a result his per-share per day allocation reported on hisSchedule K-1 is calculated as follows:$100,000 x 20% x 120/365= $6,575If he owned 20% for 120 days and then acquired another 5% for 20 days thenthe allocation would be as follows:$100,000 x 20% x 120/365= $6,575$100,000 x 25% x 20/365= $1,370Total reported on Schedule K-1 $7,9454. If new corporations are expected to generate losses in the early years then the use of the S-Corporation is often preferable to a C- Corporation because losses from an S-Corporation flow through to shareholders and can be used to offset other income of the shareholders and their spouses if a joint income tax return is filed.EXAMPLE: Two corporations both have net taxable losses of $50,000.Net Loss C-Corporation S-CorporationOther Sources of income $(50,000) $(50,000)NOL Carryforward -0- $50,000Deduction Current Year $(50,000) -0- -0- $50,000 7
5. A shareholder may not be able to claim a loss in a current year if the loss is prohibited by another provision in the Code such as §469 passive activity loss rules. Also a taxpayer cannot claim a deductible loss if there is insufficient basis in stock. EXAMPLE: Don owns stock in an S-Corporation which reports a loss of $20,000. Don owns 25% of the stock. His pro-rata share is $5,000. However, he can deduct only $3,500 because his basis in his stock is $3,500. The excess $1,500 is deferred.G. Property Distributions By an S-Corporation 1. When dealing with property distributions by an S-Corporation the distribution is a deemed sale.Gain is measured at the corporate level using the following formula:FMV of Asset on Distribution DateLess: Adjusted Basis of AssetEquals: Corporate Level Gain2. An advantage of an S-Corporation over a C-Corporation is that the gain is not taxed at the corporate level.3. The gain is passed through to the individual shareholders based on their pro-rata allocation on Schedule K-1. Therefore, the tax is imposed only once.4. The gain recognized by the shareholder increases their individual stock basis.5. The character of the gain is dependent on the character of the property in the hands of the S-Corporation.Tax Professional Note: Losses on distributions of property are not recognized.EXAMPLE: A Subchapter S-Corporation has an asset with an FMV of $14,000and an adjusted basis of $8,000 which is distributed to Don a 50% shareholder.Don's stock basis prior to the distribution is $10,000. Corporate Level:FMV of property $14,000Less: Adjusted Basis $(8,000)Corporate Gain $6,000 8
Shareholder Level: $10,000 Stock Basis Prior to Distribution $3,000 Add: 50% of Corporate Gain - Schedule K-1 $13,000 Adjusted Basis Prior to Distribution $14,000 FMV of Property Received (13,000) Less: Adjusted Basis of Stock $1,000 Capital GainH. Liquidation of an S-Corporation1. When an S-Corporation liquidates it ceases to exist and the shareholders transfer their stock back to the corporation in exchange for the corporate assets: The corporation can liquidate the assets by either: a. Selling the assets and distributing the proceeds directly to the shareholders or b. Distributing the assets directly to the shareholders (“deemed sale”).2. In either situation the corporation has a recognized gain or (recognized loss) under §336 by measuring the difference between: FMV of Assets at Date of Liquidation Less: Adjusted Basis of Assets Equals: Corporate Level Gain (Loss)3. However, there is no tax effect of the liquidation at the corporate level. The gain is passed-through to the individual shareholder on their Schedule K-1 based on their individual pro-rata allocation. The gain is recognized by shareholders on their current year tax returns. Also, the individual's stock basis is increased by the amount of the gain in the year of liquidation.4. Therefore, the shareholder's gain or loss on the liquidation of their stock is calculated as follows:Shareholder's Stock Basis Calculation: $Beginning Balance @ 1/1/XXAdd: Current Year Income (Schedule K-1) $Current Year Capital Contributions $Less: Current Year Distributions to Shareholder $( )Current Year Losses & Deductions (Schedule K-1) $( ) $Equals: Stock Basis Prior to Liquidation of Stock 9
Shareholder's §331 Gain (Loss) Calculation Reported on Schedule D: $FMV of Assets Received From CorporationLess: Basis of Stock Prior to Liquidation $Equals: Gain (Loss) on Liquidation of Stock $I. Shareholder's Basis in the S-Corporation Stock: Determining Initial Basis1. The starting point for calculating basis in a conduit entity is to determine initial basis depending on whether the owner acquired the interest by purchase, capitalization of a newly-formed entity, gift or inheritance.• Acquisition by purchase: §1012 states that the shareholder's basis will be the purchase price of the stock on the date of acquisition: Cost.• Acquisition in exchange for contributed property: §351 provides that the initial basis will be the adjusted basis of the assets given up in exchange for the stock: Carryover Basis.• Acquisition by gift: §1015 provides that the donor's basis will be transferred to the donee: Carryover Basis.• Acquisition by inheritance: §1014 provides that the shareholder's stock basis will be stepped up at date of the decedent’s death: Fair Market Value.2. Once the taxpayer determines the initial basis, it is adjusted each year. Generally basis adjustments are calculated at the close of the S-Corporation's taxable year.3. There are two exceptions to this year-end calculation rule:a. If the S-election is terminated or revoked then the S-Corporation is required to treat the tax year as consisting of two separate years for purposes of allocating items to the shareholders;ORb. When a shareholder disposes the stock during the year, the basis for gain or loss is determined as of the day before the ownership interest is sold.As a result, the basis adjustments are made as if the year consisted of severalseparate tax years. 10
J. Annual Adjustments that Increase Stockholder Basis 1. §1367(a)(1) provides that a shareholder’s S-Corporation stock basis is increased by: a. Non-separately stated ordinary income passed through by the S-Corporation as a result of its operations; b. Separately stated items of income passed through by the entity whether taxable or not; and c. Any subsequent contributions of capital by the shareholders to the corporation. Tax Professional Reminder: It is important to note that if an item of taxable income that should have been included as income on the return was not included in the gross income, then that item does not increase the shareholder's stock basis.K. Annual Adjustments that (Decrease) Stockholder Basis 1. §1367(a)(2) provides that a shareholder’s S-Corporation stock basis is decreased by: a. Non-separately stated ordinary loss passed through by the S-Corporation as a result of its operations; b. Separately stated items of loss and expenses; c. Nontaxable distributions to the shareholder; and d. Nondeductible expenses not properly chargeable to a capital account, (such as meals, political contributions, penalties, etc.). Tax Professional Reminder: The basis of the shareholder's stock is decreased by the amount of any loss or deduction that is allowed for the taxable year, regardless of whether the loss or deduction is disallowed or deferred under another provision of the Internal Revenue Code, such as the passive loss rules under §469. Tax Professional Reminder: The annual adjustments to the stockholder's basis are generally made at end of the entity's tax year and have specific ordering rules. 2. §1367(b)(2) provides that if a shareholder’s stock basis is reduced to zero, then the remaining net decrease attributable to losses and deductions is applied to reducing the basis in any debt owed to the shareholder by the S-Corporation. 11
Tax Professional Reminder: Distributions may not be applied against basis in debt. 3. Any net increase in basis in a subsequent year is first applied to restore debt basis before stock basis. Tax Professional Reference: There are detailed rules stated in IRS Reg. §1.1367-2 pertaining to adjustments in the basis of a shareholder’s corporate debt basis.L. Entity Debt Does Not Create Basis 1. A shareholder's basis is not increased by the shareholder's pro-rata share of the S- Corporation debt. 2. This is true even if the shareholder has guaranteed the debt. 3. The reason is that there is no increase in basis unless the shareholder has an actual economic outlay. 4. If a shareholder wants to create basis then the shareholder should make an actual loan to the corporation. 5. If the shareholder does not have the money then shareholder should borrow the money directly from a bank and lend it to the corporation. Tax Professional Note: Letter Ruling 8747013 provides that money loaned by the bank to the shareholder, and subsequently lent by the shareholder to the corporation, will constitute debt basis assuming all of the following are met: a. The stockholder is personally liable for the bank loan, b. The corporation is not a guarantor or co-maker on the loan, and c. The interest rate on the bank's loan to the stockholder is at the bank's current rate. 12
Debt Substitution: Another technique is to restructure the debt of the corporation. Revenue Ruling 75-144 provides shareholders with additional basis when the shareholders guarantee obligations of the corporation and substitute their own notes for those of the corporation. This is true provided the creditor relieves the corporation from its liability on the old note and substitutes the shareholders as the primary obligors. This lack of basis creation at the entity level is a great disadvantage of an S- corporation as opposed to the favorable treatment of entity debt available for creating basis for partners of a partnership.M. §1367 Pre 1/1/97 Ordering Rules to Shareholder Basis in the S-Corporation Stock 1. A shareholder's stock basis is first increased for all positive basis adjustments, including current year cash and property contributions, income from operations, nontaxable income, etc. 2. A shareholder's stock basis is then decreased for nondeductible, non-capital expenses and certain oil and gas depletion deductions. 3. A shareholder' stock basis is then decreased for items of loss or deduction (not below zero) for the year including any carryovers from prior year, and 4. Finally, a shareholder's stock basis is then decreased (not below zero) for distributions of both cash and or property.N. Post 12/31/96 Ordering Rules to Shareholder Basis 1. Effective for taxable years beginning after 1996, the Small Business Act of 1996 provides that the adjustments for distributions made during the year are taken into account before applying the loss limitation for the year. 2. Therefore, distributions during a year reduce the adjusted basis for purposes of determining the allowable loss for the year, but the loss for a year does not reduce the adjusted basis for purposes of determining the tax status of the year's distributions. 13
3. Consequently, these ordering rules for S stock basis will more closely resemble the partnership ordering rules as follows: a. A shareholder's stock basis is first increased for all positive basis adjustments, including current year cash and property contributions, income from operations, nontaxable income, etc; b. A shareholder's stock basis is then decreased (not below zero) for distributions of both cash and or property. c. A shareholder's stock basis is then decreased for nondeductible, non-capital expenses and certain oil and gas depletion deductions.d. Finally, a shareholder's stock basis is then decreased for separately stated and non-separately stated items of loss or deduction (not below zero) for the year including any carryovers from prior year.EXAMPLE: Don owns 25% of an S-Corporation and his stock basis at thebeginning of the year is $15,000 before the corporation distributes $8,000 andreports Schedule K-1 losses of $10,000. Don determines his allowable currentyear loss under the ordering rules follows:Balance 1/1/XX Basis CarryoverLess: Distributions $ 15,000 $3,000Balance Available $ (8,000)Less: Current year loss $ 7,000Balance 12/31/XX $(10,000)Unallowed loss carryforward ZeroIf Don had the same transactions occur in the subsequent tax year then thedistribution would be greater than basis and he would have to recognize a capitalgain and increase his unallowed loss to $13,000.If Don sold his stock in the next tax year for $1,000 then he would recognize acapital gain on the sale of his stock and the $13,000 loss would be lost.4. §1366(d)(2) provides that for tax years beginning after 2004 any unused losses are transferred with the transfer of S-Corporation stock to a spouse or former spouse incident to a divorce and the losses are deemed to be incurred by the Corporation in the year after the transfer of the stock. Therefore, the losses cannot be used in the year of the transfer by the spouse or former spouse.14
O. Disadvantages of an S-Corporation: Restrictions on Stock Ownership 1. The Code imposes several restrictions as to who can be a shareholder of an S-corporation. 2. §1361(b) provides that the income taxation of the S-status can be lost if the corporation runs afoul to the rules pertaining to: a. Type of shareholders b. Number of shareholders c. Type of business operation d. Type of stock 3. If these strict rules are not adhered to then the S-election will be “terminated” as of the date of the “terminating event.” 4. As a result, the corporation will then be reclassified as a Subchapter C-Corporation for income tax purposes. 5. This will cause the corporation to have two short tax years; a “Short-S” tax year and a “Short-C” tax year. 6. The “Short-S” year would run from January 1 through the date prior to the “terminating event.” 7. The “Short-C” year would run from the date of the “terminating event” to the last day of the tax year. 8. The main issue is that in most cases the “terminating event” is not discovered until: a. The end of a tax year, b. After the filing of the tax return and the Schedule K-1's or c. Probably not until the audit of the return itself. 9. Therefore, the termination of the S-Corporation status could cause the imposition of a C-Corporate level tax and dividend income at the individual shareholder level and/or denial of losses, deductions and credits which had passed through to the shareholders individual income tax returns. 15
P. Built-In Gains Tax (B-I-G)1. An S-Corporation that has always been an S-Corporation pays no entity-level tax.2. Generally, the same treatment applies to C-Corporations that convert to “S” status. However, there is an exception.3. §1374(a) provides a general rule that if a former C-Corporation had appreciated assets when it converted to “S” status and disposes of those assets within 10 years (recognition period) after its first day as an S-Corporation, then the S-Corporation could be liable for a tax at the highest corporate rate on the net built-in gains.4. The tax is imposed on a Subchapter S-Corporation that has been converted from a Subchapter C-Corporation that disposes of the net appreciated assets before the “recognition period” has passed.5. §1374(d)(7) provides a general rule that the “recognition period” means the 10 year period beginning with the first day of the first taxable year for which the corporation was an S-Corporation.Tax Professional Note: Corporations which made the election prior to January 1,2015 had a temporary provision which required a recognition period of only 5years.EXAMPLE: Don Corp. made an S-election, to be effective as of 1/1/XX. Thecorporation's sole assets are appreciated accounts receivable which on 1/1/XX had afair market value of $60,000 and an adjusted basis of $-0-. In addition, theC-Corporation had a net operating loss carryover of $10,000. When the corporationcollects the accounts receivable on 1/02/XX it would have a corporate tax of$17, 5000 computed as follows:$60,000 (built-in gain) reduced by $10,000 (Net operating loss carryover)= $50,000 x 35% = $17,500. Corporation $60,000FMV @ S-election date 1/1/XX -0-Less: Adjusted BasisBuilt-In Gain $60,000NOL Carryover §1374(b)(2) deduction $(10,000)Gain subject to tax $50,000x Highest Corporate RateBuilt-in Gains Tax Reported on Form 1120-S 35% $17,000 16
Don, the sole shareholder, will be taxed on the gain that flows through from thecorporation, reduced by the built-in gains tax. Therefore, Don will be taxed on$32,500. The flow through is net of built in gains tax. Shareholder Level $ 60,000Amount Realized (-0-)Less: Adjusted BasisGain $ 60,000Less: NOL Carryover $(10,000)Net Realized Gain $ 50,000Less: Built-in Gains Tax $(17,000)Taxable Income Pass Through to Shareholder $ 32,500via Schedule K-1Q. One Class of Stock Restrictions1. §1361(b) (1) (D) provides that an S-Corporation may only have one class of stock.2. Reg. §1.1361-1(1) (i) states that a corporation will be considered to have one class of stock if all of its outstanding shares confer identical rights with regard to distribution and liquidation proceeds.3. Therefore, S-Corporation stock cannot give some shareholders preferences regarding current or liquidating distributions.4. Reg. §1.1361-1(1)(2) also states that differences with regard to timing or the amount of distributions will not cause a finding of a second class of stock as long as the governing instruments provide for identical distributions.5. For this purpose, Reg. §1.1361-1(1)(2)(i) states that governing provisions include:a. The corporate charter, articles of incorporation and by-laws,b. Applicable state law, and binding agreements relating to distribution and liquidation proceeds.Tax Professional Note: Taxpayers should be aware that shareholders andcorporations can generally enter into employment contracts and lease or loanagreements without the agreements being treated as creating a second class ofstock, which would result in a loss of the corporation's SubchapterS- Corporation status. Reg. §1.1361-1(1) (2) (i). 17
EXAMPLE: An S-Corporation has two equal shareholders, Don and Nanette. In accordance with the shareholder agreement and corporate by-laws (the governing provisions), Don and Nanette are entitled to equal distributions. In the current year, the S Corporation distributes $50,000 to Don, but does not distribute $50,000 to Nanette until the following year. If the difference in timing did not occur by reason of a binding agreement, then it will not cause the S-Corporation to be treated as having more than one class of stock since the governing provisions state that Don and Nanette are entitled to equal distributions. Reg. §1.1361-1(1) (2) (ii) Example 2.R. Allowance of Differing Powers 1. §1361(c) (4) provides that differences in voting power among classes of stock, do not violate the one class of stock requirement. As a result, an S-Corporation may have both voting and nonvoting common stock. 2. Also, note that Reg. §1.1361-1(1)(2)(iii) states that buy-sell agreements, agreements restricting the transferability of stock, and redemption agreements generally do not cause a corporation to violate the one class of stock requirement. 3. However, Reg. §1.1361-1(1)(2)(iii) further states that such agreements may result in a finding of a second class of stock if two conditions are met: a. A principal purpose of the agreement is to circumvent the one class of stock requirement; and b. The agreement established a purchase price that was significantly different from the FMV of the stock. 4. In determining whether a purchase price differs significantly from the FMV of the stock, neither the book value nor a price between FMV and book value is considered significantly different from the fair market value. 5. A good faith effort to determine the value will be respected unless the determination of value was not performed with reasonable diligence. 6. Bona fide agreements to redeem or purchase stock at the time of death, divorce, disability, or termination of employment are disregarded in determining whether there is a second class of stock. 18
Tax Professional Recommendation: In order to satisfy the requirement that there has been a good faith effort to determine the value of an S-Corporation's stock the shareholders should obtain an appraisal of the stock's value before entering into a buy-sell agreement, an agreement restricting the transferability of stock, or a redemption agreement.S. Safe Harbor for Debt 1. When a corporation issues what in form is a debt instrument, the Service may claim that the debt should be reclassified as equity for tax purposes. 2. If the Service prevails then the debt will be reclassified as a second class of stock, and therefore the corporation will no longer qualify as an S-Corporation. 3. Reg. §1.1361-1(1)(4)(ii) states that purported debt will only be considered a second class of stock for purposes of the S-election if its principal purpose is to circumvent the rights to distribution or liquidation proceeds of outstanding shares. 4. In order to prevent the Service from reclassifying debt to equity, S-Corporations should be aware of three safe harbors: a. Unwritten Advances: 1) Reg. §1.1361-1(1) (4) (ii) (B) (1) states that unwritten advances from a shareholder that are $10,000 or less at any time in a year are treated as debt. 2) Also, it is expected that the debt will be repaid in a reasonable time. 3) If the debt is greater than $10,000 on any day then it must be in writing. b. Proportionately Held Debt: 1) Reg. §1.1361-1(1)(4)(ii)(B)(2) states that identical debt instruments owned only by shareholders of the corporation in the same proportion as their stock will not be considered a second class of stock. 19
c. Straight Debt: 1) §1361(c)(5) defines straight debt as a written unconditional promise to pay on demand or on a specified date a sum of money when: • The interest rate is not contingent on profits or the borrower's discretion, • There is no convertibility into stock, and • The creditor is an individual, an estate, or a trust that qualifies an S Corporation shareholder as defined under §1361(c) (2). NOTE: Reg. §1.1361-1(1) (5) allows that the debt obligations to be subordinated to other debt of the corporation.T. Service Can Waive Invalid Subchapter S-Election 1. For years the Service had the authority to waive the effect of an inadvertent termination of an S-election. The Service would grant the reinstatement of the Subchapter S status. As long as the corporation followed: a. The IRS procedures within a reasonable period of time from the discovery of the disqualifying event, and b. The shareholders agreed to make the required adjustments on their personal income tax returns. 2. It is important to note however that the Service could not waive the effect of an invalid S-“election.” In the Small Business Job Protection Act of 1996 (H.R. 3636) Congress finally gave the Service the authority to grant relief for inadvertent failures to make a qualified S-election. 3. §1362(f) provides that where an S-Corporation election is ineffective because it failed to: a. Qualify as a small business corporation or b. Obtain shareholder consent, the corporation will be treated as an S-Corporation during the period specified by the Service if the following conditions are met: (1) The Service determines that the facts and circumstances resulting in the invalidity of the election were inadvertent; 20
(2) Within a reasonable period after discovering these circumstances which caused the invalidity steps are taken to qualify the corporation as a small business corporation or obtain the requisite shareholder consents; and (3) The corporation and each person who was a shareholder during the relevant period agree to the Service's prescribed adjustments consistent with the treatment of the corporation as an S-Corporation during the relevant period. 4. This authority includes retroactive inadvertent invalid elections. The effective dates of this provision is for retroactive for elections made for tax years beginning after December 31, 1982. 5. The Committee Report states that the reason for the change is that the Secretary of the Treasury should have the same authority to validate inadvertent defective Subchapter S-elections as it had for inadvertent Subchapter S terminations. 6. The Committee Report also states that the Service may consider relevant information provided by any affected shareholder, including a person who became a shareholder in a period after the S-election was made, before determining the validity of the S-election for the tax year. EXAMPLE: If a person who acquired shares of the corporation with the understanding that the corporation was not an S-Corporation does not want to be taxed on the income of that corporation, then the taxpayer may be able to prevent the IRS from granting relief to treat the corporation as an S-Corporation. Because of the adjustments required when retroactive relief is requested, conflicts among shareholders may often arise. In order to prevent a shareholder from holding up the retroactive relief, the corporation should resolve these conflicts before making its request for relief.U. S-Corporation Termination and The Five Year Waiting Period 1. §1362 provides a general rule that if the S-Corporation election is terminated or revoked then the corporation cannot make another S-Corporation election without the consent of the IRS before the fifth tax year after the first tax year for which the termination or revocation was effective. 21
V. Termination of S-Election 1. Taxpayers who elect an S-Corporation must be aware of the termination rules. Taxpayers incur the risk of inadvertent termination of the organization's “S” corporation status. 2. §1362(d) provides that there are three events which can terminate a valid S-election: • Voluntary revocation of the S-Election by those owning a majority of the corporation's stock; • The corporation's ceasing to qualify as an S-Corporation; or • An S-Corporation with old “Subchapter C-Corporation earnings and profits” having passive investment income that exceeds 25% of gross receipts for three consecutive taxable years. 3. §1362(e) provides that if an S-election is terminated during the corporation's taxable year, then the tax year is divided into two short years. 4. For the period ending before the first day on which the termination is effective, the corporation will be taxed as an S- Corporation. 5. For the remaining portion, beginning on the first day of the termination, the corporation will be taxed as a C-Corporation. Items of income and deduction are then allocated between the two periods. Reg. §1.1362-3. a. Termination by Revocation: §1362(d) (1) provides that a Subchapter S-election will be considered revoked if the majority of shareholders file a notice of revocation with the Service. Reg. §1.1362-6(a) (3). (1) The revocation generally becomes effective in the following year. (2) However, the corporation may specify a prospective date on which it wishes the revocation to become effective. If the revocation is made on or before the 15th day of the third month of a taxable year, then it will be retroactive and effective as of the first day of the year. Reg. §1.1362-2(a). 22
b. Termination Through A Terminating Event: (1) An S-election may also be terminated if the corporation fails to meet any of the qualification requirements. For example, a transfer of shares to a nonqualifying shareholder, such as a corporation, will result in immediate loss of S status. (2) §1362(g) provides that if an election is terminated, or revoked then the corporation cannot make another Subchapter S-election for five years unless consent is obtained from the IRS. c. Inadvertent Termination: (1) §1362(f) provides that if there is an inadvertent termination of a Subchapter S-election, then the corporation may continue to be taxed as an S corporation, if it gets permission from the Service and if the appropriate remedial action is taken. Reg. §1.1362-4.W. Employment Issues of an S-Corporation Shareholder: 1. Subchapter S-Corporation shareholders who are activity involved in the daily operations of the business are subjected to the employment provisions of the Code. The employer should pay a reasonable salary and withhold income taxes, social security and medicare and pay the required employer matching. The shareholder employee salaries are also included for purpose of FUTA and SUTA. 2. Unreasonably low wages relative to services provided can be challenged by the Service, causing the excess profits to be recharacterized as wages and subjected to additional social security and medicare taxes. In addition there will be interest assessed as well as penalties for failure to pay and failure to file employment tax returns. 3. §3121 provides that wages are defined as all renumeration for employment. 4. §3121(d) provides a definition of employee to include any officer of a corporation. Tax Professional Note: Reg. §31.3121(d)-1(b) allows an exception to the employee status for an officer who performs no services or only minor services to the corporation. 23
X. Establishing Reasonable Compensation 1. In order for compensation to be deductible, it must be reasonable for the services actually rendered. The Code specifically empowers the IRS to reallocate an S-Corporation’s income in family income-splitting situations. 2. 1366(e) provides that a member of an S-Corporation shareholder’s family must receive reasonable compensation for services rendered or capital furnished to the corporation. This provision applies to family members whether or not they own shares in the corporation. Tax Professional Note: The instructions to the Form 1120S, state: “Distributions and other payments by an S-Corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services render to the corporation.” 3. Under these rules, the Service can adjust income to reflect reasonable compensation for services rendered or capital furnished to the corporation. In addition, rent and interest payments to shareholders or family members could be reallocated by the IRS if ruled unreasonably high. 4. There is no definition for reasonable compensation. Each situation must be resolved based on its unique facts and circumstances. Several Tax Court decisions have focused on these factors: • The character and financial condition of the corporation, • The role the shareholder-employee plays in the corporation, including position, hours worked and duties and responsibilities; • Training and experience; • The corporation’s compensation policy for all employees and the shareholder’s salary history, including the internal consistency in establishing the shareholder’s salary; • How the compensation compares with similarly situated employees of other companies; • Timing and manner of paying bonuses to key employees; 24
• Whether a hypothetical, independent investor would conclude that there is an adequate return on investment after considering the shareholder’s compensation; • Compensation agreements; • The employee’s qualifications and education; • The size and complexity of the business; • The use of a formula to determine compensation; • A comparison of salaries paid in relation to sales and net income; • General and specific economic conditions of the country, geographic area and the industry; • Salaries versus distributions and retained earnings; • Compensation paid in prior years; • The corporation’s earning and distribution history; • Whether employee and employer dealt at arm’s length and • Whether employee guaranteed employer’s debt. No single factor controls, but rather a combination of the factors must be considered. Furthermore, these factors are not all-inclusive (and may not be given equal weight).5. The Service’s position as to the key for establishing reasonable compensation is determining what the shareholder-employee did for the S-Corporation. The Service instructs its auditors to look to the source of the S-Corporation’s gross receipts and they specify 3 major sources as follows: a. Services of shareholder, b. Services of non-shareholder employees, or c. Capital and equipment. If the gross receipts and profits come from items 2 and 3, then that should not be associated with the shareholder-employee’s personal services and it is reasonable that the shareholder would receive distributions along with compensations. On the other hand, if most of the gross receipts and profits are associated with the shareholder’s personal services, then most of the profit distribution should be allocated as compensation. 25
In addition to the shareholder-employee direct generation of gross receipts, the shareholder-employee should also be compensated for administrative work performed for the other income producing employees or assets. For example, a manager may not directly produce gross receipts, but he assists the other employees or assets which are producing the day-to-day gross receipts.Y. Health Insurance Premiums for Subchapter S-Corporate Shareholders: IRS Position Eased 1. In 2005 the IRS stated in Chief Counsel Advice (CCA) 200524001, that a self- employed individual who is a sole proprietor and who purchases health insurance in his or her own name may treat that as health insurance purchased in the name of the sole proprietor’s business. 2. Therefore, the insurance would qualify under the provisions of §162(l). Assuming the self-employed individual meets the other provisions of §162(l), the individual may claim a deduction for the health insurance premiums in arriving at adjusted gross income on Form 1040, Page 1. 3. However, if the business is operating as a Subchapter S-Corporation, then there is a different tax consequence if the individual who is the sole shareholder and sole employee, purchases the health insurance in the shareholder’s own name. 4. §1372(a) provides that for certain fringe benefits paid by the S-Corporation, including health insurance premiums, the S-Corporation will be treated as a partnership and any shareholder who owns more than 2% of the S-Corporation stock will be treated as a partner of such partnership. 5. Revenue Ruling 91-26 holds that accident and health insurance premiums paid by a partnership on behalf of a partner are guaranteed payments under §707(c) if the premiums are paid for services rendered in the capacity of a partner and to the extent the premiums are determined without regard to partnership income. As guaranteed payments, the premiums are deductible by the partnership under §162 and includible in the recipient-partner’s gross income under §61. 6. Therefore, the health insurance premiums paid by the S-Corporation would not be deductible by the S-Corporation as a fringe benefit but would be recharacterized and deductible by the S-Corporation as compensation to the 2% shareholder. The health insurance premiums paid by the S-Corporation for the 2% shareholder should be included in the 2% shareholder’s W-2 in Box 1 but not Boxes 3 and 5. 26
7. §162(l) (5) provides that a 2% shareholder that is treated as a partner under §1372 will be treated as a self-employed person and, assuming all of the other provisions of §162(l) are met, may deduct the health insurance premiums paid by the S-Corporation as an above-the-line deduction in determining AGI. Tax Professional Note: There are some limitations under §162(1) (2). The limitation that often affects a 2% shareholder is the issue of other coverage. An above-the-line deduction is not allowed for any calendar month for which the shareholder is eligible to participate in any subsidized health plan maintained by any other employer of the shareholder or of the spouse of the shareholder. 8. If there are no other subsidized health plans, then the issue arises if a sole shareholder/employee purchases the health insurance in their own name instead of the S-Corporation. In this situation, if the S-Corporation has not established a plan to provide medical care coverage, then there is no fringe benefit paid to the 2% shareholder and the provisions of §1372 are not applicable. 9. If the provisions of §1372 are not applicable, then the S-Corporation is not treated as a partnership and therefore the shareholder is not treated as a partner. 10. If the shareholder is not treated as a partner, then the shareholder is not treated as self-employed and therefore is not eligible for the above-the-line deduction treatment under §162(l). NOTE: The shareholder is still able to deduct the health insurance as an itemized deduction which is subject to the 7.5% AGI limitation. Tax Professional Alert: Some states do not allow a corporation to purchase a group health plan with only one participant. This prevents the S-Corporation from acquiring a health plan and therefore requires the shareholder to purchase the plan in their own name. This state law limitation does not override the requirements that the S-Corporation must provide fringe benefits to its employees in order to have the 2% shareholder qualify for the §162(l) benefits.Changes to the Rules Notice 2008-1, 2008-2IRB In January 2008 the IRS released a new notice which explains when a 2% shareholder- employee in an S-Corporation is entitled to the §162(1) above-the-line deduction for health insurance premiums that are paid or reimbursed by the S-Corporation and included in gross income of the 2% Shareholder. 27
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