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CCH Federal Taxation Comprehensive Topics Chapter 21 S Corporations
CCH Federal Taxation Comprehensive Topics Chapter 21 S Corporations
Chapter 21 Exhibits
Chapter 21 Exhibits
Chapter 21 Exhibits
Chapter 21 Exhibits
S Corporations—Tax Model
S Corporations—Tax Model
S Corporations—Tax Model
S Corporations—Tax Model
S Corporations—Tax Model
S Corporations—Tax Model
S Corporations—Tax Model
S Corporations—Tax Model
S Corporations— Treatment of Tax and Nontax Matters
S Corporations— Treatment of Tax and Nontax Matters
S Corporations— Treatment of Tax and Nontax Matters
S Corporations— Treatment of Tax and Nontax Matters
S Corporations— Treatment of Tax and Nontax Matters
S Corporations— Treatment of Tax and Nontax Matters
S Corporations— Treatment of Tax and Nontax Matters
S Corporations— Treatment of Tax and Nontax Matters
S Corporations—Eligibility and Election
S Corporations—Eligibility and Election
S Corporations—Eligibility and Election
S Corporations—Eligibility and Election
S Corporations—Eligibility and Election
S Corporations—Eligibility and Election
S Corporations—Revoking S Status
S Corporations—Revoking S Status
S Corporations—Revoking S Status
S Corporations—Revoking S Status
S Corporations— Tax Years and Accounting Methods
S Corporations— Tax Years and Accounting Methods
S Corporations— Tax Years and Accounting Methods
S Corporations— Tax Years and Accounting Methods
S Corporations— Tax Years and Accounting Methods
S Corporations— Tax Years and Accounting Methods
Basis Accounts—Overview
Basis Accounts—Overview
Basis Accounts—Overview
Basis Accounts—Overview
Basis Accounts—Overview
Basis Accounts—Overview
Basis Accounts—Outside Basis and At-Risk Basis
Basis Accounts—Outside Basis and At-Risk Basis
Basis Accounts—Outside Basis and At-Risk Basis
Basis Accounts—Outside Basis and At-Risk Basis
Basis Accounts—Outside Basis and At-Risk Basis
Basis Accounts—Outside Basis and At-Risk Basis
Basis Accounts—Accumulated Adjustment Account
Basis Accounts—Accumulated Adjustment Account
Basis Accounts—Accumulated Adjustment Account
Basis Accounts—Accumulated Adjustment Account
Basis Accounts—Accumulated Adjustment Account
Basis Accounts—Accumulated Adjustment Account
Basis Accounts—Other Adjustment Account and Previously Taxed Income
Basis Accounts—Other Adjustment Account and Previously Taxed Income
Basis Accounts—Other Adjustment Account and Previously Taxed Income
Basis Accounts—Other Adjustment Account and Previously Taxed Income
Basis Accounts—Other Adjustment Account and Previously Taxed Income
Basis Accounts—Other Adjustment Account and Previously Taxed Income
Basis Accounts—Shareholder Loans to S Corporations
Basis Accounts—Shareholder Loans to S Corporations
Basis Accounts—Shareholder Loans to S Corporations
Basis Accounts—Shareholder Loans to S Corporations
Basis Accounts—Shareholder Loans to S Corporations
Basis Accounts—Shareholder Loans to S Corporations
Basis Accounts—Shareholder Loans to S Corporations
Basis Accounts—Shareholder Loans to S Corporations
Effect of Operating Results on Basis—Example
Effect of Operating Results on Basis—Example
Effect of Operating Results on Basis—Example
Effect of Operating Results on Basis—Example
Effect of Operating Results on Basis—Example
Effect of Operating Results on Basis—Example
Effect of Operating Results on Basis—Example
Effect of Operating Results on Basis—Example
Distributions—Effect on S Corporation
Distributions—Effect on S Corporation
Distributions—Effect on S Corporation
Distributions—Effect on S Corporation
Distributions—Effect on S Corporation
Distributions—Effect on S Corporation
Distributions—Effect on Shareholder
Distributions—Effect on Shareholder
Distributions—Effect on Shareholder
Distributions—Effect on Shareholder
Distributions—Example
Distributions—Example
Distributions—Example
Distributions—Example
Distributions—Example
Distributions—Example
Distributions—Example
Distributions—Example
Distributions—Example
Distributions—Example
Distributions—Example
Distributions—Example
Distributions—Example
Distributions—Example
Penalty Taxes—Code Sec
Penalty Taxes—Code Sec
Penalty Taxes—Code Sec
Penalty Taxes—Code Sec
Code Sec
Code Sec
Code Sec
Code Sec
Code Sec
Code Sec
Code Sec
Code Sec
Code Sec
Code Sec
Penalty Taxes—Code Sec
Penalty Taxes—Code Sec
Penalty Taxes—Code Sec
Penalty Taxes—Code Sec
Penalty Taxes—Code Sec
Penalty Taxes—Code Sec
Code Sec
Code Sec
Code Sec
Code Sec

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CCH Federal Taxation Comprehensive Topics

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1 CCH Federal Taxation Comprehensive Topics Chapter 21 S Corporations

CCH Federal Taxation Comprehensive Topics Chapter 21 S Corporations

©2006, CCH, a Wolters Kluwer business 4025 W. Peterson Ave. Chicago, IL 60646-6085 800 248 3248 www.CCHGroup.com

2 Chapter 21 Exhibits

Chapter 21 Exhibits

1. S Corporations—Tax Model 2. S Corporations—Treatment of Tax and Nontax Matters 3. S Corporations--Eligibility and Election 4. S Corporations—Revoking S Status 5. S Corporations—Tax Years and Accounting Methods 6. Basis Accounts—Overview 7. Basis Accounts—Outside Basis and At-Risk Basis 8. Basis Accounts—Accumulated Adjustment Account. 9. Basis Accounts—Other Adjustment Account and Previously Taxed Income Account 10. Basis Accounts—Shareholder Loans to S Corporations

Chapter 21, Exhibit Contents A

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3 Chapter 21 Exhibits

Chapter 21 Exhibits

11. Effect of Operating Results on Basis—Example 12. Distributions—Effect on S Corporation 13. Distributions—Effect on Shareholder 14. Distributions—Example 15. Penalty Taxes—Code Sec. 1374 Tax on Built-In Gains 16. Code Sec. 1374 Tax—Example 17. Penalty Taxes—Code Sec. 1375 Tax on Excess Net Passive Income 18. Code Sec. 1375 Tax on Excess Net Passive Income—Example

Chapter 21, Exhibit Contents B

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4 S Corporations—Tax Model

S Corporations—Tax Model

Code Sec. 702(a)(8) income Definition. As with partnerships, items that are always subject to ordinary treatment are lumped together in an amount called Code Sec. 702(a)(8) income or loss. Shareholders recognize Code Sec. 702(a)(8) income even if no cash is actually distributed. Accordingly, shareholders are generally not taxed on distributions.

Chapter 21, Exhibit 1a

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5 S Corporations—Tax Model

S Corporations—Tax Model

Computation. Code Sec. 702(a)(8) is generally operating income or loss computed as follows: Ordinary Income “From Whatever Source Derived” (including Code Sec. 1245 recapture) Less: Exclusions Less: Cost of Goods Sold (resulting in gross income from business operations) Less: Operating Expenses

Chapter 21, Exhibit 1b

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6 S Corporations—Tax Model

S Corporations—Tax Model

Separately Stated Items Rationale. Each shareholder of an S corporation reports her share of corporate net income based on her stock ownership. Any income, loss, deduction, or credit which could uniquely affect the tax liability of a shareholder is separately stated in the K-1 to the shareholder.

Chapter 21, Exhibit 1c

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7 S Corporations—Tax Model

S Corporations—Tax Model

Separately stated items include: Passive income and losses from rental and other non-operating activities Investment income and related expenses (e.g., dividends, investment interest, ad valorem tax on stock, investment counseling fees, etc.) Code Sec. 1231 gain and loss Capital gains and losses Dividends eligible for a dividends-received deduction Charitable contributions Taxes paid to a foreign country or to a U.S. possession Section 179 deduction Recovery items (e.g., tax refunds, recovery of bad debts) Tax-exempt income and related expense Tax credits Deductions disallowed in computing S corporation income

Chapter 21, Exhibit 1d

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8 S Corporations— Treatment of Tax and Nontax Matters

S Corporations— Treatment of Tax and Nontax Matters

The Conduit Concept. For most tax matters, S corporations are treated like partnerships. As in the partnership conduit concept, the taxable income of an S corporation flows through to the owners on a per-day and per-share basis. Income and losses are reported on Form 1120-S, allocated to each shareholder on a supporting K-1 schedule, and then transferred, via the K-1, to the individual owners’ 1040 returns. There, at the individual level, income is taxed and losses are deducted.

Chapter 21, Exhibit 2a

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9 S Corporations— Treatment of Tax and Nontax Matters

S Corporations— Treatment of Tax and Nontax Matters

The Entity Concept. The character of income and losses is determined at the entity level, not at the shareholder level. For example, a long-term capital gain reported by the S corporation remains long-term to the shareholder, even if his ownership in the S corporation had been held for a short-term period.

Chapter 21, Exhibit 2b

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10 S Corporations— Treatment of Tax and Nontax Matters

S Corporations— Treatment of Tax and Nontax Matters

Distributions of Cash or Property. Actual distributions of cash or property are generally not income to its shareholders. Two notable differences with partnerships are: Owner salaries and payroll taxes. Deductible by S corporations, not by partnerships. Gain on distribution of property. S Corps must recognize gains (but not losses) on distributions of appreciated property to shareholders; partnerships escape this gain recognition.

Chapter 21, Exhibit 2c

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11 S Corporations— Treatment of Tax and Nontax Matters

S Corporations— Treatment of Tax and Nontax Matters

Nontax Matters. For most structural matters (e.g., formation, redemptions and terminations), S corporations are treated in much the same manner as C corporations.

Chapter 21, Exhibit 2d

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12 S Corporations—Eligibility and Election

S Corporations—Eligibility and Election

A corporation is treated as an S corporation only for those days for which each specific eligibility requirement is met and the required election is effective. Eligibility and election rules include: Unanimous Consent. 100% of the shareholders must consent to the S election. Deadline For Filing S Election. If a calendar year C corporation makes an S election by 3/15/x1, it is retroactive to 1/1/x1. If made after 3/15/x1, but before 3/15/x2, it is effective 1/1/x2.

Chapter 21, Exhibit 3a

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13 S Corporations—Eligibility and Election

S Corporations—Eligibility and Election

One Class of Stock. Only one class of stock is permitted. Rights to profits and assets on liquidation must be identical. Debt may be treated as a disqualifying second class of stock. Maximum 75 Shareholders. The number of shareholders may not exceed 75. A nonresident alien may not own shares. Each shareholder must be an individual, an estate, or a qualified trust. A husband and wife count as one shareholder; however, if they divorce, they count as two if they each own stock.

Chapter 21, Exhibit 3b

CCH Federal Taxation Comprehensive Topics

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14 S Corporations—Eligibility and Election

S Corporations—Eligibility and Election

Ineligible Corporations. The corporation must be domestic but not a bank or insurance company. Eligible Subsidiaries. S corporations can own C corporations, but C corporations cannot own S corporations. S corporations can own qualified subchapter S subsidiaries (QSub). A QSub is an electing domestic corporation that qualifies as an S corporation and is 100% owned by an S corporation parent.

Chapter 21, Exhibit 3c

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15 S Corporations—Revoking S Status

S Corporations—Revoking S Status

The S election will be terminated upon one of the following events: Over 50% consent. Over 50% of the shareholders agree to the revocation. The deadline for revoking S status is the same as the deadline for electing it. Prior C life AND passive investment income over 25%. If an S corporation had a prior life as a C corporation and its passive investment income is over 25% of its total income for three consecutive years, it loses the S election at the start of the fourth year.

Chapter 21, Exhibit 4a

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16 S Corporations—Revoking S Status

S Corporations—Revoking S Status

The S election will be terminated upon one of the following events: Violation of qualifications. If any of the qualifications mentioned above are violated (e.g., stock is sold to a C corporation, or a second class of stock is issued), the S election is terminated on the date of violation, and the period before the violation is considered a “short-year.” Majority shareholder revocation. If a new shareholder owning more than 50% takes affirmative action to terminate the election, the election dies as of the date of action. After revocation or termination of an election, a new election cannot be effectively made for 5 years without IRS consent.

Chapter 21, Exhibit 4b

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17 S Corporations— Tax Years and Accounting Methods

S Corporations— Tax Years and Accounting Methods

An S corporation must generally use a calendar year end. However, it may elect a fiscal tax year under any of the following three conditions: Three-Month Deferral OK. A fiscal tax year would result in income deferral of not more than three months and the shareholder-employee’s salary earned between fiscal year end and December 31 is both: Paid during that period; and, Proportionate to the salary paid during the preceding fiscal year.

Chapter 21, Exhibit 5a

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18 S Corporations— Tax Years and Accounting Methods

S Corporations— Tax Years and Accounting Methods

Business Purpose. A business purpose can be demonstrated. 1987 FYE. The S corporation retains the same fiscal tax year as was used in 1987, if in existence at that time.

Chapter 21, Exhibit 5b

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19 S Corporations— Tax Years and Accounting Methods

S Corporations— Tax Years and Accounting Methods

The accrual, cash and hybrid methods are available regardless of the size of the S corporation.

Chapter 21, Exhibit 5c

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20 Basis Accounts—Overview

Basis Accounts—Overview

Outside (Stock) Basis

At Risk Basis

AAA Basis

Primary Purpose:

To determine gain or loss when the stock is ultimately sold. [Also will limit tax-free distributions if stock basis is lower than AAA basis.]

To determine how much of shareholder’s allocations of Code Sec. 702(a)(8) losses and separately stated expenses are deductible

To determine how much of cash and property distributions are tax-free.

Chapter 21, Exhibit 6a

CCH Federal Taxation Comprehensive Topics

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21 Basis Accounts—Overview

Basis Accounts—Overview

Outside (Stock) Basis

At Risk Basis

AAA Basis

(“Yes” means the item to the left is used in the computation of basis):

(“Yes” means the item to the left is used in the computation of basis):

(“Yes” means the item to the left is used in the computation of basis):

(“Yes” means the item to the left is used in the computation of basis):

+ Original basis (e.g., purchase, inheritance, gift)

Yes

Yes

No

? Code Sec. 702(a)(8) TI or Loss

Yes

Yes

Yes

? Separately stated items that are taxable or deductible to s/h

Yes

Yes

Yes

? Tax-exempt income and non-deductible exp.

Yes

Yes

No

+ Company debt for which s/h is personally liable

No

Yes

No

Chapter 21, Exhibit 6b

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22 Basis Accounts—Overview

Basis Accounts—Overview

Outside (Stock) Basis

At Risk Basis

AAA Basis

+ Non-recourse financing from qualified lenders

No

No (unlike the normal at-risk rules for individuals)

No

+ Shareholder (S/H) loans to S Corp

No (unlike partnerships debt basis is held separately from equity basis.)

Yes

No (unlike partnerships, debt basis is held separately from equity basis.)

- Fair market value (FMV) of distributions

Yes (distributions reduce basis before current year losses)

Yes (distributions reduce at risk amt. before current yr. losses)

Yes (distributions reduce AAA before current year losses)

Chapter 21, Exhibit 6c

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23 Basis Accounts—Outside Basis and At-Risk Basis

Basis Accounts—Outside Basis and At-Risk Basis

Outside Basis General Rule. A shareholder’s outside basis is his/her stock basis. Outside basis is computed in much the same manner as a partner’s outside basis in a partnership interest. Exception. One notable exception is that the basis of stock in an S corporation is not affected by the corporation’s liabilities. This seems reasonable because, unlike a general partner, an S corporation shareholder is not personally liable for the debts of the corporation.

Chapter 21, Exhibit 7a

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24 Basis Accounts—Outside Basis and At-Risk Basis

Basis Accounts—Outside Basis and At-Risk Basis

At Risk Basis General Rule. At-risk rules are applied at the shareholder level. The amount of S corporation losses that the shareholder can deduct may not exceed the lesser of: At-risk amount or Sum of a shareholder’s stock basis and debt basis. Computation of At-Risk Basis. At-risk basis is equal to the sum of: Cash and basis of property contributed to the S corporation (to the extent unencumbered) Outstanding shareholder loans to the S corporation

Chapter 21, Exhibit 7b

CCH Federal Taxation Comprehensive Topics

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25 Basis Accounts—Outside Basis and At-Risk Basis

Basis Accounts—Outside Basis and At-Risk Basis

Computation of At-Risk Basis Loans for which the shareholder has personal liability or has pledged as security for repayment property not used in the activity of the corporation. However, this does not include other debts of the corporation to third parties, even if the repayment is guaranteed by the shareholder. Allocated portion of income Less: Allocated portion of losses Less: Distributions at fair market value (not at partnership basis)

Chapter 21, Exhibit 7c

CCH Federal Taxation Comprehensive Topics

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26 Basis Accounts—Accumulated Adjustment Account

Basis Accounts—Accumulated Adjustment Account

Purpose. Records and information pertaining to each shareholder’s accumulated adjustment account (AAA) are needed by S corporations only for purposes of helping shareholders determine taxability of distributions when the S corporation has earnings and profits (E&P). The C corporation connection. An S corporation has E&P only if it was classified as a C corporation in the past or acquired a C corporation. Tax effect of distributions. The fair market value (FMV) of distributions to shareholders are tax-free to the extent of the lesser of (1) AAA balance and (2) stock basis.

Chapter 21, Exhibit 8a

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27 Basis Accounts—Accumulated Adjustment Account

Basis Accounts—Accumulated Adjustment Account

Computation. A shareholder’s AAA balance is INCREASED only by taxable income. It is REDUCED by all deductible losses/expenses, by cash distributions and by the fair market value (FMV) of property distributions. Same-year losses and distributions. Shareholders are allowed to reduce the AAA basis by the amount of current year distributions BEFORE applying current year losses against bases. This rule enables tax-free distributions to the extent of AAA, BEFORE AAA is reduced by the amount of losses. While the effect is favorable for tax-free distributions, it can also result in higher suspended losses, since distributions reduce all bases, dollar for dollar, thus lowering the limits of loss deductions and increasing suspended losses. Tax–exempt income. No adjustment to the AAA account is made for tax-exempt income such as municipal bond interest and life insurance proceeds (reduced by related expenses).

Chapter 21, Exhibit 8b

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28 Basis Accounts—Accumulated Adjustment Account

Basis Accounts—Accumulated Adjustment Account

Negative AAA balance OK. The AAA basis (unlike the stock basis) can have a negative balance. However only losses, (not distributions) can make the AAA negative or increase a negative balance. Transferability of AAA account. If the shareholder disposes of stock, the AAA associated with the stock passes to the new owner.

Chapter 21, Exhibit 8c

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29 Basis Accounts—Other Adjustment Account and Previously Taxed Income

Basis Accounts—Other Adjustment Account and Previously Taxed Income

Account

Other Adjustments Account (OAA) The OAA represents another form of accumulated adjustments account (AAA) in that: The OAA is a balance sheet account in the capital section; and The OAA is needed by S corporations only for purposes of helping shareholders determine taxability of distributions when the S corporation has earnings and profits (E&P). Any distributions from OAA are tax-free to shareholders.

Chapter 21, Exhibit 9a

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30 Basis Accounts—Other Adjustment Account and Previously Taxed Income

Basis Accounts—Other Adjustment Account and Previously Taxed Income

Account

Timing of distributions. Tax-free distributions from OAA cannot be made until after all accumulated E&P are paid out. Computation. The OAA balance is increased for tax-exempt income or decreased for nondeductible expenditures not properly chargeable to the AAA.

Chapter 21, Exhibit 9b

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31 Basis Accounts—Other Adjustment Account and Previously Taxed Income

Basis Accounts—Other Adjustment Account and Previously Taxed Income

Account

Previously Taxed Income (PTI) Account Timing of distributions. Tax-free distributions from the PTI account are made after tax-free distributions reduce the OAA balance to zero. Computation. The PTI account represents a balance of undistributed net income on which the shareholders were already taxed prior to 1983.

Chapter 21, Exhibit 9c

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32 Basis Accounts—Shareholder Loans to S Corporations

Basis Accounts—Shareholder Loans to S Corporations

Using loan basis for deductions. Once stock basis is zero, any additional basis reductions (losses or deductions, but NOT distributions), decrease (but not below zero) the shareholder’s basis in loans made to the S corporation. Suspended losses/deduction. Any excess of losses or deductions over both stock and debt bases is suspended until subsequent items of income or contributions arise to restore basis in debt.

Chapter 21, Exhibit 10a

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33 Basis Accounts—Shareholder Loans to S Corporations

Basis Accounts—Shareholder Loans to S Corporations

Restoring debt basis. Once the basis of any debt is reduced, it is later increased (only up to the original face amount of the loan) by the subsequent net increase resulting from all positive and negative basis adjustments. The debt basis is adjusted before any increase is made in the stock basis Distributions. A distribution in excess of stock basis does not reduce any debt basis.

Chapter 21, Exhibit 10b

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34 Basis Accounts—Shareholder Loans to S Corporations

Basis Accounts—Shareholder Loans to S Corporations

Same-year losses and distributions. If a loss and a distribution occur in the same year, the loss reduces the debt basis before the distribution. (This rule favors the taxpayer.) Repayment of shareholder loan with reduced basis. If an S corporation repays a shareholder loan when the debt basis is below the loan amount, the difference is treated as a capital gain. An allocation is required for partial repayments.

Chapter 21, Exhibit 10c

CCH Federal Taxation Comprehensive Topics

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35 Basis Accounts—Shareholder Loans to S Corporations

Basis Accounts—Shareholder Loans to S Corporations

Example: A shareholder lends an S corporation $100,000. Subsequent losses eliminate the shareholder’s stock basis and reduce a portion of the debt basis. The S corporation repays $20,000 of the $100,000 loan when the shareholder’s basis in the loan is $75,000. The shareholder must report a capital gain in the amount of $5,000 on the receipt of $20,000, since 25% of the face value was not supported by debt basis [$20,000 x ($100,00 - $75,000) ? $100,000].

Chapter 21, Exhibit 10d

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36 Effect of Operating Results on Basis—Example

Effect of Operating Results on Basis—Example

FACTS: David, an individual, owns all of the shares of an S corporation throughout 20x1. The corporate books show the following information for 20x1:

QUESTIONS: (1) Compute 20x1 Code Sec. 702(a)(8) taxable income (2) Compute David’s stock basis at 12/31/x1. (3) Compute David’s “at risk” amount at 12/31/x1. (4) Compute David’s AAA balance at 12/31/x1. (5) Compute David’s debt basis at 12/31/x1.

Chapter 21, Exhibit 11a

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37 Effect of Operating Results on Basis—Example

Effect of Operating Results on Basis—Example

Chapter 21, Exhibit 11b

CCH Federal Taxation Comprehensive Topics

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38 Effect of Operating Results on Basis—Example

Effect of Operating Results on Basis—Example

Chapter 21, Exhibit 11c

CCH Federal Taxation Comprehensive Topics

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39 Effect of Operating Results on Basis—Example

Effect of Operating Results on Basis—Example

Chapter 21, Exhibit 11d

CCH Federal Taxation Comprehensive Topics

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40 Distributions—Effect on S Corporation

Distributions—Effect on S Corporation

Does an S corporation recognize gain or loss on the distribution of cash to shareholders? No, never.

Chapter 21, Exhibit 12a

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41 Distributions—Effect on S Corporation

Distributions—Effect on S Corporation

Does an S corporation recognize gain or loss on the distribution of other property (other than its own stock)? Gains: Yes (compute gain in the same way as if the property were sold) Losses: No (except in complete liquidation).

Chapter 21, Exhibit 12b

CCH Federal Taxation Comprehensive Topics

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42 Distributions—Effect on S Corporation

Distributions—Effect on S Corporation

What is the character of the entity’s gain on distribution of property to owners? If a shareholder owns no more than 50% of the S corporation, then the character of the entity’s gain is the same as the character of the property distributed. If a shareholder owns more than 50%, then the entity’s gain is ordinary.

Chapter 21, Exhibit 12c

CCH Federal Taxation Comprehensive Topics

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43 Distributions—Effect on Shareholder

Distributions—Effect on Shareholder

S Corporation Without C Corporation E & P

S Corporation Without C Corporation E & P

Shareholder Distribution

Tax Result

To extent of stock basis

Tax-free; reduces stock basis

In excess of stock basis

Taxed as a capital gain

Chapter 21, Exhibit 13a

CCH Federal Taxation Comprehensive Topics

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44 Distributions—Effect on Shareholder

Distributions—Effect on Shareholder

S Corporation With C Corporation E & P

S Corporation With C Corporation E & P

Shareholder Distribution

Tax Result

To extent of AAA

Tax-free; reduces AAA and stock basis

To extent of C corporation E&P

Taxed as an ordinary dividend; does not reduce stock basis

To extent of OAA

Tax-free; reduces OAA and stock basis

To extent of any remaining stock basis

Tax-free; reduces stock basis.

In excess of stock basis

Taxed as a capital gain

Chapter 21, Exhibit 13b

CCH Federal Taxation Comprehensive Topics

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45 Distributions—Example

Distributions—Example

FACTS: An S corporation reports the following balances for its sole shareholder as of 1/1/x1: Capital balance per corporate books: $125,000 Stock basis: $95,000 At-risk basis: $115,000 AAA basis: $80,000 Shareholder loan to S corporation: $10,000 (basis also $10,000) The S corporation reports a ($200,000) ordinary loss in 20x1.

Chapter 21, Exhibit 14a

CCH Federal Taxation Comprehensive Topics

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46 Distributions—Example

Distributions—Example

QUESTION: (a) What is the maximum tax-free non-stock distribution the shareholder can receive in 20x1? (Hint: The tax-free distribution is not affected by the 20x1 loss. Use the 1/1/x1 balance in AAA and any excess stock basis. ANSWER: $95,000 = $80,000 AAA + $15,000 excess stock basis)

Chapter 21, Exhibit 14b

CCH Federal Taxation Comprehensive Topics

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47 Distributions—Example

Distributions—Example

QUESTIONS: (b) Assuming that a $95,000 cash distribution is made to the sole shareholder in 20x1, what are the 12/31/x1 balances in stock basis, at-risk basis, AAA and debt basis? (c) What portion of the ($200,000) loss is deductible in 20x1 under the at-risk rules? (d) What portion of the $200,000 loss is suspended in 20x1 under the at-risk rules?

Chapter 21, Exhibit 14c

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48 Distributions—Example

Distributions—Example

If the S corporation repays the $10,000 shareholder debt in year 20x2, what are the tax consequences if: S corporation has income of $10,000 in year 20x2? (If the S corporation has income in year 20x2, the first $10,000 must restore the debt basis back to $10,000. Any income in excess of $10,000 increases the following simultaneously: (a) the stock basis, (b) at-risk basis, and (c) AAA balance. A subsequent repayment of the $10,000 shareholder loan does not result in capital gain.) S corporation has a loss in year 20x2? (Answer: A $10,000 capital gain passes through to the shareholder since the debt basis is zero.)

Chapter 21, Exhibit 14d

CCH Federal Taxation Comprehensive Topics

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49 Distributions—Example

Distributions—Example

SOLUTION: Tax Effect of a $200,000 loss and a $95,000 distribution in 20x1

SOLUTION: Tax Effect of a $200,000 loss and a $95,000 distribution in 20x1

SOLUTION: Tax Effect of a $200,000 loss and a $95,000 distribution in 20x1

SOLUTION: Tax Effect of a $200,000 loss and a $95,000 distribution in 20x1

SOLUTION: Tax Effect of a $200,000 loss and a $95,000 distribution in 20x1

SOLUTION: Tax Effect of a $200,000 loss and a $95,000 distribution in 20x1

SOLUTION: Tax Effect of a $200,000 loss and a $95,000 distribution in 20x1

Cap. Bal. Per Books

Code Sec. 702(a)(8) income (loss)

Stock Basis

At Risk Basis

AAA Basis

Debt Basis

Balances, 1/1/x1

$125,000

$95,000

$115,000

$80,000

$10,000

1st: Apply dist’n. against bases: Tier 1 Distribution: (i.e., Tax free: Lesser of, (1) $80m AAA balance, or (2) $95m stock basis)

(80m)

(80m) [tax-free]

(80m) [tax-free]

(80m) [tax-free]

0 [Debt basis is never reduced by distributions]

Tier 2 Distribution: (i.e., taxable to extent of accumulated E & P from prior life as a C corp. None here.)

0

0

0

0

Chapter 21, Exhibit 14e

CCH Federal Taxation Comprehensive Topics

49 of 63

50 Distributions—Example

Distributions—Example

Chapter 21, Exhibit 14f

CCH Federal Taxation Comprehensive Topics

50 of 63

51 Distributions—Example

Distributions—Example

SOLUTION: Tax Effect of a $200,000 loss and a $95,000 distribution in 20x1

SOLUTION: Tax Effect of a $200,000 loss and a $95,000 distribution in 20x1

SOLUTION: Tax Effect of a $200,000 loss and a $95,000 distribution in 20x1

SOLUTION: Tax Effect of a $200,000 loss and a $95,000 distribution in 20x1

SOLUTION: Tax Effect of a $200,000 loss and a $95,000 distribution in 20x1

SOLUTION: Tax Effect of a $200,000 loss and a $95,000 distribution in 20x1

SOLUTION: Tax Effect of a $200,000 loss and a $95,000 distribution in 20x1

Cap. Bal. Per Books

Code Sec. 702(a)(8) income (loss)

Stock Basis

At Risk Basis

AAA Basis

Debt Basis

BASES, 12/31/x2

(170m)

0 [can’t be neg.]

0 [can’t be neg.]

(40m) [CAN be neg.]

0 [can’t be neg.]

20X2B Suspended loss under at-risk rules ($190m total)

(190m) ? [200m-10m] or [180m + 10m]

??? ?(180m) [190m nondeductible loss - 10m debt basis]

???

???

? ?(10m)

Chapter 21, Exhibit 14g

CCH Federal Taxation Comprehensive Topics

51 of 63

52 Penalty Taxes—Code Sec

Penalty Taxes—Code Sec

1374 Tax on Built-In Gains

All four conditions listed below must be present to subject an S corp. to the 35% Code Sec. 1374 tax: 1. Prior life as a C corporation; 2. S-corporation election occurs after 1/1/87; 3. Asset sale with pre-election built-in gain (but not built-in loss). [If the asset is purchased after the election, Code Sec. 1374 would not apply.] 4. Asset sale within 10 years of election date, not effective date of election. (e.g., if an election is made on 3/15/x1, it is retroactively effective to 1/1/x1. The 10 year toll begins in 3/15/x1, not 1/1/x1.

Chapter 21, Exhibit 15a

CCH Federal Taxation Comprehensive Topics

52 of 63

53 Penalty Taxes—Code Sec

Penalty Taxes—Code Sec

1374 Tax on Built-In Gains

Computation. At the time that an asset is sold, the corporation will recognize (and pay tax) on the difference between the fair market value of the asset at the time of the election. The tax rate is the highest corporate effective rate of 35%.

Chapter 21, Exhibit 15b

CCH Federal Taxation Comprehensive Topics

53 of 63

54 Code Sec

Code Sec

1374 Tax—Example

Chapter 21, Exhibit 16a

CCH Federal Taxation Comprehensive Topics

54 of 63

55 Code Sec

Code Sec

1374 Tax —Example

QUESTION: Determine the tax effect to the corporation and to the shareholder of the following transactions: One year after the election date, the corporation sells the building at a sales price of $700,000 when the adjusted basis is $450,000. Twelve years after the election date, the corporation sells the land at a sales price of $500,000.

Chapter 21, Exhibit 16b

CCH Federal Taxation Comprehensive Topics

55 of 63

56 Code Sec

Code Sec

1374 Tax—Example

(a)

(b)

(c)

(d)= (b) – (c)

(e) = [Lesser of: (a) or (d)] x 35%

Asset

Built-in Gain at Election

Sales Price

Basis at Sales Date

Realized Gain

Code Sec. 1374 Tax

Building

$100,000

$700,000

$450,000

$250,000

$35,000

Land

$100,000

$500,000

$300,000

$200,000

0 **

Chapter 21, Exhibit 16c

CCH Federal Taxation Comprehensive Topics

56 of 63

57 Code Sec

Code Sec

1374 Tax—Example

COMPUTATIONS Tax effect of 20x1 sale of building: S corporation: The corporation itself pays the $35,000 tax to the IRS. (35% x [the lesser of 100,000 or 250,000]) Shareholders: The shareholders are allowed a deduction for that tax. The S corporation’s K-1 would show: Code Sec. 1231 gain/Code Sec. 1245 recapture ($700,000 – 450,000) $250,000 Code Sec. 1374 tax deduction $(35,000)

Chapter 21, Exhibit 16d

CCH Federal Taxation Comprehensive Topics

57 of 63

58 Code Sec

Code Sec

1374 Tax—Example

Tax Effect of Sale of Land 12 Years After S Election. No Code Sec. 1374 tax would be imposed since the 10 year post-election period had lapsed. Only the $200,000 Code Sec. 1231 gain would be reported by the S corporation on the shareholder’s K-1.

Chapter 21, Exhibit 16e

CCH Federal Taxation Comprehensive Topics

58 of 63

59 Penalty Taxes—Code Sec

Penalty Taxes—Code Sec

1375 Tax on Excess Net Passive Income

This tax applies to any S corporation with accumulated E&P that has more than 25% of its gross receipts derived from passive sources.

Chapter 21, Exhibit 17a

CCH Federal Taxation Comprehensive Topics

59 of 63

60 Penalty Taxes—Code Sec

Penalty Taxes—Code Sec

1375 Tax on Excess Net Passive Income

Computations Excess Net Passive Income = [(a) – {25% x (c)}] ? [(a) x (b)] Code Sec. 1375 Tax = 35% x Excess Net Passive Income, where (a) = Gross passive investment income (e.g., royalties, rents, dividends, interest, annuities, and gain on sales of securities) (b) = Net passive investment income (i.e., gross amount net of investment expenses (c) = Gross receipts (i.e., receipts from all sources including active & passive sources)

Chapter 21, Exhibit 17b

CCH Federal Taxation Comprehensive Topics

60 of 63

61 Penalty Taxes—Code Sec

Penalty Taxes—Code Sec

1375 Tax on Excess Net Passive Income

Note that excess net passive investment income can never be more than taxable income computed as if the S corporation had been a C corporation.

Chapter 21, Exhibit 17c

CCH Federal Taxation Comprehensive Topics

61 of 63

62 Code Sec

Code Sec

1375 Tax on Excess Net Passive Income—Example

FACTS: S corporation has gross receipts of $300,000 in 20x1. Included in the $300,000 is $100,000 of royalties. Expenses directly connected with the production royalties are $30,000. The S corporation has accumulated E & P from its prior life as a C corporation. QUESTION: Compute the Code Sec. 1375 tax.

Chapter 21, Exhibit 18a

CCH Federal Taxation Comprehensive Topics

62 of 63

63 Code Sec

Code Sec

1375 Tax on Excess Net Passive Income—Example

SOLUTION

Excess Net Passive Investment Income: $17,500 = [100,000 – {25% x (300,000)}] ? [100,000 x 70,000] Code Sec. 1375 tax: $6,125 = 35% x 17,500

Chapter 21, Exhibit 18b

CCH Federal Taxation Comprehensive Topics

63 of 63

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