Business Taxation: Unit 15: S Corporations
Example: Excise Taxes
Example: Bronze Beauty, Inc. is an indoor tanning salon organized as an S corporation. Bronze Beauty has two equal shareholders, Penny and Marjorie, who works full-time in the business. Although Bronze Beauty does not pay income tax on its earnings, it is required to pay payroll taxes on the wages paid to Penny and Marjorie. As an indoor tanning service provider, Bronze Beauty is also subject to the indoor tanning services excise tax. The company must file and pay quarterly excise taxes on Form 720, Quarterly Federal Excise Tax Return.
Example: Health Insurance
Example: Pulsar Consulting, Inc. an S corporation, provides health insurance coverage to its two owner-shareholders, Tucker and Cesar, as well as the health insurance premiums for their only employee, Dinah, who is a full-time secretary. Pulsar Consulting paid $9,000 of health insurance premiums for Tucker and Cesar, and $3,900 for health insurance premiums for Dinah. The corporation treats the shareholders as having received the health insurance as additional compensation and reports the insurance as W-2 wages. Dinah is not an owner/shareholder of the company, so her health insurance premiums are treated as a tax-free fringe benefit, and merely deducted as a business expense.
S Corporation Drawbacks and Benefits
> The rules governing S corporations are found in subchapter S of the Internal Revenue code. An S corporation has similarities to both a C corporation and a partnership. Like a partnership, an S corporation is a pass-through entity and is generally not taxed on its earnings. Instead, income and losses pass through to shareholders. Like a C Corporation, and S corporation enjoys a level of liability protection that a general partnership does not. >>S Corporations do have some drawbacks. They are less flexible than partnerships. For example, in a partnership, the partners can have different allocations for income and loss based on their partnership agreement. >>However, with an S Corporation, profits and losses must be passed through to the shareholders based on their percentage of stock ownership. Shareholders can't make any special agreements or arrangements for allocating profits and losses in an imbalanced manner. Unlike C corporations, an S corporation can only have one class of stock (although differences in voting right are permitted). >>S Corporations also have very strict limits on the number
Filing Requirements for S corporations
>An S corporation files its tax return on Form 1120S, and allocated amounts of income, deductions, and credits pass through to individual shareholders and are reported on Schedule K-1. This return must be signed and dated by an authorized corporate officer or, in certain instances, by a fiduciary, such as a receiver, trustee, or assignee, on behalf of the corporation. >>An S corporation is always required to file a tax return, regardless of income or loss. The filing requirement ends only when the corporation is dissolved. >>The tax return is due on the fifteenth day of the third month following the tax year end. For a calendar-year S corporation, the tax return is due March 15.
Termination or Revocation of an S election
Once the S selection is made, it stays in effect until terminated. In addition to the ways already discussed, the election will terminate automatically in any of the following cases: >The corporation no longer qualifies as a small business corporation. >For each of three consecutive tax years, the corporation -has accumulated earnings and profits, and -Derives more than 25% of its gross receipts from passive investment income. >>The corporation creates a second class of stock (such as preferred stock and common stock). >>The shareholders willingly revoke the S election.
Separately Stated Items: important for Exam
These include: >Net income or loss form rental real estate activity (rental income) >portfolio income or loss that include: ****Interest Income ****Dividend Income ****Royalty income >>capital gains or losses >>Section 1231 gain or loss >>Charitable contributions >>Section 179 expense deduction >>Foreign taxes paid or accrued >>Any business credits >>Tax preference and adjustment items need to figure a shareholders AMT >>Nonbusiness bad debts >>>>Unlike a C corporation, an S corporation is not eligible for a dividends-received deduction.
Other Taxes
> An S corporation may also be responsible for other taxes, such as: -Payroll taxes, (if it has employees). -Excise taxes, (including excise taxes on: diesel fuel and gasoline, highway usage, indoor tanning, and wagering activities), -Franchise taxes payable to state and local governments, and -Penalties, such as late filing penalties.
What is a Q-SUB?
> An S corporation must generally be owned only by individuals, trust, or estates. S corporations cannot be owned by another S corporation, a C corporation, or a partnership. Please not that an S corporation is allowed to have another S corporation as a wholly-owned subsidiary; this is called a qualified Subchapter S subsidiary, also referred to as a "Q-Sub" >>>For example, if one S corporation wholly acquires another S corporation, the acquired S corporation can be treated as a subsidiary by filing a proper election using Form 8869. The acquired S corporation is called the "subsidiary," while the purchasing corporation is called the "parent" corporation. If a proper Q-sub election is not filed, then the acquired corporation will be treated as a C corporation for tax purposes.
Inadvertent Terminations
> Sometimes a corporation will inadvertently terminate its election. For an "inadvertent termination," a corporation's S-election terminates effective on the date that the company commits the act that triggers the ineligibility. >An S corporation election can be inadvertently terminated in several ways. For example, when a couple divorces and the two ex-spouses cause the shareholder limit to exceed 100. The date of the event would be the "termination date". Another common terminating event is when a S corporation makes disproportionate distributions-for example, distributing cash to some shareholder, but not to others. This could potentially be viewed as creating a second class of stock and terminating S status.
S Corporation Requirements
>>The main requirements for S corporation status are: 1. It must be a domestic corporation 2. It cannot have more than 100 shareholders >>Shareholders generally must be U.S citizens or residents. This includes individuals, certain kinds of trusts, estates, or tax-exempt corporations. >>Corporate shareholders and partnerships are generally excluded. However, certain tax-exempt corporations, specifically 501 (c)(3) corporations, may be S corporation shareholders. In contrast, an S corporation is allowed to own a partnership interest or own stock in a C corporation. >>Nonresident aliens cannot be direct shareholders in an S corporation. (ESBT is okay) >>A business must meet the definition of a small business corporation, per IRC section 1361. >>An S corporation can only have one class of stock, but that stock can have differences in voting rights. The difference in voting rights allows one group of shareholders to retain voting control, while allowing other shareholders to benefit from corporate earnings. However, all the stock of an S corp. must possess identical rights to distribution and liquidation proceeds. >>Profits and losses must be allocated to shareholders in proportion to each one's interest in the business >>All shareholders of an S corporation must give consent for the S election.
Electing S Corporation Status
>>To become an S corporation, a business must file an election on Form 2553, Election by a Small Business Corporation. The filing must be made no later than 2.5 months after the start of its tax year for the election to be effective at the beginning of the year. >If the S election is made during the corporation's tax year for which it first takes effect, each individual shareholder who holds stock at any time during the part of that year before the election is made must also consent to the election. >>This is true even if the person may have sold or transferred his stock before the election is made.
Shareholder Restrictions
>For the 100-shareholder limit, related persons can be considered one shareholder. Spouses are automatically treated as a single shareholder. A family, defined as a group of individuals descended from a common ancestor, plus spouses and former spouses of either the common ancestor or anyone lineally descended from that person, is considered a single shareholder as long as any family member elects such treatment. >>When a shareholder dies, the deceased shareholder's spouse and the estate are still considered one shareholder for the shareholder limit. >>However, a husband and wife cannot be considered a single shareholder if they divorce, or if the marriage is dissolved for any other reason than death. Therefore, a shareholder's divorce can potentially increase the number of shareholders to a number in excess of the 100-shareholder limit. If an S corporation fails to meet this restriction, the S corporation ceases to be an S corporation and is instead taxed as a C corporation.
Form 2553
An S corporation election is made by filing Form 2553 with the Internal Revenue Service (IRS). Is generally filed by itself. You have 2.5 months to file this form from time that the corporation is formed.
Example: #1 S Corporation Election
Example: #1 (no prior tax year): Super Suds Laundry is a newly formed corporation that was incorporated on April 7, 2019. In order to elect to be an S-Corporation beginning with its first tax year, Super Suds must file Form 2553 during the period that begins April 7, 2019, and ends July 21,2019 (within 2.5 months after the start of its first tax year). Because the corporation had no prior tax year, and was not incorporated until April 7th, an election made before April 7 would not be valid.
Example: Disqualified Shareholder
Example: A husband and wife owns 90% of an S corporation, and their son owns the remaining 10% of stock. The son announces his marriage to a nonresident alien, and he gives her one-half of his stock. The S corporation's status is revoked on the date of the stock transfer, or "disqualifying event" because a nonresident alien cannot hold stock ownership in an S corporation directly.
Example #2: S Corp Election
(Prior tax year): American Copiers, Inc. is a calendar-year C corporation that has been filing Form 1120 for the past five years. American Copiers wishes to convert to an S corporation, and make an S election for its tax year beginning January 1, 2020. To be an S corporation beginning with its next tax, the corporation must file Form 2553 before March 15, 2020 (2.5 months after the start of the year it wishes to become an S corporation) to be effective as of January 1, 2020. Because the corporation was already in existence and had been filing as a C corporation in the past, it can also make the election at any time during the prior tax year (2019) to make it effective for the following year (2020).
Late Election Relief
>An election made after the first 2.5 months of the tax year becomes effective on the first day of the following tax year, unless the corporation receives IRS approval to make the election retroactive to the beginning of the tax year. Based on updated guidelines, the IRS will generally accept a late S-election if the following requirements are met: -The entity intended to be classified as an S corp. is an eligible entity, and failed to qualify as an S-corporation solely because the election was not timely, -The entity has reasonable cause for its failure to make the election timely, -The entity and all shareholders reported their income consistent with an S corporation election in effect for the year the election should have been made and all subsequent years, and... -Less than 3 years and 75 days have passed since the effective date of the election (unless certain additional conditions are met). >>Also, if a late election is made by attaching For 2553 to the corporation's Form 1120S, the corporation must enter the following verbiage in the top margin of the first page of Form 1120S: -"INCLUDES LATE ELECTION FILED PURSUANT TO REV. PROC 2013-30" >>Form 2553 can also be filed separately. If an entity does not qualify for relief under these guidelines, it may request relief through a private letter ruling.
S Corporation income and expenses
>As with a partnership, all the income of an S corporation must be allocated to the shareholders, even if it is not distributed. >>Income, gains, losses, deductions and credits are allocated to each shareholder on a pro-rata basis, according to the number of shares of stock held by the shareholder on each day of the corporation's tax year, and retain their character when they are passed through. >>The shareholder then reports the items on his tax return on Schedule E.
Health Insurance Premiums for Shareholders
>Fringe benefits to employees who are not shareholders (or who have ownership of less than 2%) are generally deductible by the S corporation as a regular business expense. These benefits are also tax-free to the employees. >>However, for shareholder-employees who have at least 2% ownership or more, health insurance premiums paid on their behalf are deductible by the S corporation as fringe benefits and are reportable as wages for income tax withholding purposes on the shareholder-employees' Form W-2. The S corporation can exclude these health benefits from the wages subject to Social Security, Medicare, FUTA taxes. >>A 2% shareholder-employee is eligible for an AGI deduction for amounts paid during the year for health insurance premiums if the health insurance coverage is established by the S corporation. If the coverage plan is in the name of the shareholder rather than the name of the S corporation, the coverage can still be considered to be established by the S corporation if: -The S corporation either paid or reimbursed the shareholder for the premiums, and -It reported the premium payment as wages on the shareholder's Form W-2. >>Neither Schedule K-1 (Form 1120S) nor Form 1099 can be used as an alternative to Form W-2 to report this additional compensation.
Termination of a shareholder's Interest
>If a shareholder sells or disposes of his stock interest in an S corp. it is treated in the same manner as the sale of stock in a C corporation. The shareholder reports the sale of the stock on Schedule D. >The gain or loss that is recognized by the shareholder is the difference between the shareholder's basis and the sale price of the stock. >>If a shareholder in an S corporation terminates his interest in a corporation during the tax year, the corporation, with the consent of all affected shareholders (including those whose interest is terminated), may elect to allocate income and expenses as if the corporation's tax year consisted of two separate short tax years, the first of which ends on the date of the shareholder's termination.
Inadvertent Terminations
>If the IRS deems that a revocation was inadvertent (that the shareholders did not mean to revoke their S election or that the revocation was accidental), the corporation may be allowed to correct the error and retain its S election status. >A terminating event will be considered inadvertent if the event was not within the control of the corporation, and the shareholders did not plan to terminate the election. Further, all of the following must occur: >>>The S election must have involuntarily terminated either because: -The corporation no longer qualified as a small business corporation, or -It had accumulated earnings and profits from past C corporation activities. >>>The IRS must agree that the termination was inadvertent. >>>The corporation must take reasonable and immediate steps to correct the issue. >>>The shareholders and the corporation must agree to any adjustments proposed by the IRS. >>>The corporation must request a private letter ruling from the IRS for any inadvertent termination relief.
Limited Taxation of S corporations
>S corporations generally are not subject to taxation since they are primarily pass-through entities. However, in certain cases, S corporations are subject to taxes. A subchapter S corporation may have to pay income tax due to: 1. Excess net passive investment income 2. Built-in gains 3. Investment credit recapture 4. LIFO recapture NOTE: Except for the reinvestment credit recapture provision, these taxes normally only apply to corporations which were once C corporations, and then converted to S corporations at a later date. If the corporation has always been an S corporation since its inception these taxes generally will not apply. >>>None of these taxes are deductible as business expenses by the S corporation (except for the portion of any built-in gains tax allocable to ordinary income).
Example: Section 1377 (A)(2) Election
Example: Sedgwick Realty, Inc. is an S corporation that operates on a calendar-year basis. Sedgwick Realty has two equal shareholders, Daniel and Kristof. In 2019, Sedgwick Realty has a $10,000 net operating loss for the first 6 months of the year (from January 1- June 30). On July 1, 2019, Daniel sells his entire stock interest in Sedgwick Realty to Wendy, an unrelated person. >There are no more items of income or loss for the rest of the year. Sedgwick Realty makes a Section 1377 (a)(2) election on its tax return. The $10,000 net operating loss would be allocated to the short taxable year ending June 30 (in other words, the first part of the year, when Daniel and Kristof were still shareholders). Daniel and Kristof would be reported on their respective Schedules K-1. Since Sedgwick had no other activity for the rest of the year, Wendy would not have any income or loss allocated to her.