S Corporations

1
S Corporations
11
Chapter
2
S Corporations

• Penalty Taxes or Sting TaxesExcess Passive
  Investment Income

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Excess Net Passive Income Tax

• Applies only to S corporations that
• Are former C corporations having accumulated EP
  at the end of the year IRC 1375(a)(1) and
• That have more than 25 of gross receipts from
  passive investment income IRC 1375(a)(2)

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Excess Net Passive Income Tax

• IRC 1375(b)(3) and IRC 1362(d) Passive
  investment income gross receipts include
• Royalties received
• Rents received
• Dividends received
• Interest income received
• Annuities received
• Gains on sales of stocks or securities

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Excess Net Passive Income Tax

• IRC 1375(b)(3) and IRC 1362(d)(3) Total gross
  receipts include
• Passive investment income gross receipts
• Gains on sales of capital assets other than stock
  and securities included in the above
• All other gross receipts

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Note

• IRC 1375(b)(4) Passive investment income does
  not include any recognized built-in gain or loss
  of the corporation in the recognition period

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Excess Net Passive Income Tax

• IRC 1375(b)(2) Net passive income equals
• Passive investment income gross receipts less
• Deductions that are directly connected with the
  production of those receipts

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Excess Net Passive Income Tax

• IRC 1375(b)(1) Excess net passive income means
  the lesser of
• Net Passive Income ? Ratio, or
• The corporations taxable income for the year
  under IRC 1375(b)(1)(B)
• Where Ratio (Passive investment income gross
  receipts less 25 of total gross
  receipts) Passive investment
  income gross receipts

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Excess Net Passive Income Tax

• IRC 1375(a) A 35 tax is imposed on the excess
  net passive income for the year
• The tax imposed reduces the amounts of each item
  of total passive investment income on a pro rata
  basis IRC 1366(f)(3)

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Excess Net Passive Income Tax

• IRC 1362(d)(3) A corporations S election is
  automatically terminated if it has
• Excess passive investment income for three
  consecutive years, and
• It has accumulated earnings and profits (EP)

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Excess Net Passive Income Tax

• See Example 6

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S Corporations

• Distributions to Owners

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In General

• IRC 1371(a) Except as otherwise provided in
  this title and except to the extent inconsistent
  with this subchapter, subchapter C shall apply to
  an S corporation and its shareholders

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Treatment of S Corporation

• IRC 311(a) and (b) S corporations must
  recognize gains (but not losses) on property
  distributions to shareholders, as if the property
  were sold at its FMV
• Gains may be taxed as built-in gains
• Gains pass through to shareholders as either
  separately stated items or as part of
  nonseparately stated income (loss)

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Treatment of S Corporation

• IRC 1368(e)(1) Distributions to shareholders
  generally reduce the corporations Accumulated
  Adjustments Account (AAA)
• But not below zero Reg. 1.1368-2(a)(3)(iii)

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Treatment of S Corporation

• IRC 1368(e)(1) AAA is an account that is
  adjusted in a manner similar to the adjustments
  made in calculating a shareholders basis under
  IRC 1367 except that
• AAA is one aggregate account
• No adjustments are made for tax-exempt income or
  the related expenses
• AAA can become negative (but not due to
  distributions)
• No adjustments for FIT attributable to C
  corporation years

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Accumulated Adjustments Account (AAA)

• IRC 1368(e)(1)(C) If the net adjustments to
  AAA for the year are negative, distributions are
  deducted from AAA before the net negative
  adjustments for the year
• Distributions cannot create or add to a negative
  balance in the account Reg. 1.1368-2(a)(3)(iii)
  
• The account can have a negative balance due the
  other adjustments required IRC 1368(e)(1)(A)

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Accumulated Adjustments Account (AAA)

• IRC 1368(e)(1) Calculation of account balance
  Beginning AAA balance/- Separately
  stated items (except income that is
  exempt from tax)/- Nonseparately stated
  income (loss) - Nondeductible expenses
  (except expenses related to tax-exempt
  income and federal taxes attributable
  to a C corporation tax year) -
  Distributions out of AAA (but not below zero)
  Ending AAA balance

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Treatment of S Corporation

• Although there is no Code or Regulation section
  or official administrative pronouncements
  providing for such, Form 1120s have an Other
  Adjustments Account (OAA) which includes those
  items that are excluded from the AAA account
  under IRC 1368(e)(1)
• Distributions that exceed all other equity
  accounts come out of this account

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Other Adjustments Account (OAA)

• Calculation of account balance Beginning
  OAA balance Tax-exempt income- Expenses
  related to tax-exempt income- Federal taxes
  that are attributable to a C corporation
  tax year - Distributions out of OAA Ending
  OAA balance

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AAA and OAA

• Example 1 (Expanded)

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Treatment of Shareholders

• IRC 1368(b) rules apply to shareholders of
• S corporations that were S corporations in all
  prior taxable years and
• S corporations that were formerly C corporations
  that have already distributed all the EP that
  accumulated during their C corporation years

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Treatment of Shareholders

• IRC 1368(b) Distributions of cash and/or
  property received by shareholders with respect to
  their S corporation stock
• Are not included in taxable income to the extent
  of the shareholders stock basis (shareholders
  basis is reduced for these tax-free distributions
  received)
• Are taxed as gains from the sale or exchange of
  property to the extent the amount of the
  distribution exceeds the shareholders stock
  basis

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Treatment of Shareholders

• IRC 1368(d) To determine whether the amount of
  the distribution exceeds the basis, basis is
  calculated
• After considering the current period basis
  increases in IRC 1367(a)(1) but
• Before considering the current period basis
  decreases in IRC 1367(a)(2)

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Treatment of Shareholders

• IRC 301(d) The basis of any property received
  as a distribution is its fair market value at the
  time of the distribution

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Distributions from S Corporations

• See Examples 7, 8, 9

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S Corporations With EP

• IRC 1371(c) Accumulated EP of an S
  corporation consists solely of
• EP that accumulated during years in which the
  corporation was not an S corporation
• Less Any distributions made out of EP
• Adjusted for any stock redemptions

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S Corporations With EP

• IRC 1368(c) rules apply to shareholders of
• S corporations that were formerly C corporations
  and that still have undistributed accumulated EP
  from their C corporation years

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S Corporations With EP

• IRC 1368(c) Distributions are considered paid
  out from (and therefore reduce) the following
  accounts in order
• Accumulated Adjustments Account (AAA)
• Accumulated Earnings and Profits (EP)
• Other Adjustments Account (OAA)
• IRC 1368(e)(3) Shareholders can elect to pay a
  distribution out of accumulated EP first

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S Corporations With EP

• IRC 1368(c)(1) and (b) Distributions that are
  paid out of the AAA
• Are not taxable to the shareholder
• Reduce the basis of the shareholders stock

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S Corporations With EP

• IRC 1368(c)(2) Distributions paid out of
  accumulated EP
• Are taxable dividend income to the shareholder
• Do not reduce the stock basis

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S Corporations With EP

• IRC 1368(c)(3) and (b) Any distributions that
  exceed AAA and accumulated EP (including OAA)
• Are applied against and reduce the basis of the
  shareholders stock (but not below zero)
• Distributions that exceed the shareholders stock
  basis are treated as gains from the sale or
  exchange of property (capital gain)

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Distributions from S Corporations

• See Examples 10 11