Chapter 22 "S-Corporations"

Accumulated Adjustments Account

Retained Earnings for everything - if you draw money out, you won't be taxed because the amounts in AAA have already flowed-through and paid tax, once - this account proves to the IRS that distributions should not be taxable - the AAA goes up and down almost exactly with the Basis. However, AAA does not include tax-exempt items or initial contribution & AAA can go negative (if you take money out of AAA, you usually take it out of Basis)

17. Dion, a shareholder, owned 20% of Meadowbrook's stock for 292 days and 25% for the remaining 73 days in the year. Using the per-day allocation method, compute Dion's share of the following S-corp items: - Ordinary income $60,000 - Tax-exempt interest $1,000 - Charitable contributions $3,400

20% X (292/365) = .16 PLUS: 25% X (73/365) = .05 EQUALS 0.21 - $60,000 X .21 = 12,600 - $1,000 X .21 = 210 - $3,400 X .21 = 714

22. Jonas is a 60% owner of an S corp. At the beginning of the year, his stock basis is zero. Jonas's basis in a $20,000 loan made to the S-corp and evidenced by the S-corp's ntoe has been reduced to $0 by prior losses. During the year, Jonas's net share of S-corp's taxable income is $10,000. At the end of the year, Ard makes a $15,000 cash distribution to Jonas. After these transactions, what is Jonas's basis in the stock, and what is his basis in the debt? What is Jonas's recognized capital gain?

- A shareholder's basis cannot go below zero, but the shareholder's debt basis is reduced when the loss is greater than the stock basis - Here, the stock basis is increased by $10,000 of income, which is taxable to the shareholder, but the $15,000 distribution reduces the stock basis to zero. Debt basis remains at zero, and the shareholder recognizes a $5,000 capital gain (15k-10k) - once basis in stock is zero, your loan basis will be reduced. If the company starts making money again, the basis in loan will go up.

1. Which of these taxes applies to an S corporation? a. Alternative minimum tax b. Personal holding company tax c. Property tax assessed by the county

- AMT and personal holding tax do not apply to S-corps c) ONLY property tax assessed by the count applies to S corporations

S-Corporations are NOT exposed to...

- Alternative Minimum Tax - Accumulated Earnings Tax (tax on income that is accumulated/hoarded to avoid taxation and not pay dividends) - Personal Holding Tax - excessive investment/passive income

Other Adjustments Account

- Retained Earnings account for non-taxable items (only if S-corp has E&P account)

13. Sheila Jackson is a 50% shareholder in Washington, Inc., an S corporation. This year, Jackson's share of the Washington loss is $100,000. Jackson has income from several other sources. Identify at least four tax issues related to the effects of the S corporation loss on Jackson's tax return

- Sheila should hope she has some other income on her 1040 in order to offset some of this loss - to deduct a loss, she MUST have a BASIS in STOCK or a BASIS in a LOAN to the company - she must be able to prove her basis to the IRS (keep track of it!) - she needs to know if the loss is passive or active. If the loss is active then it can be deducted. If the loss is passive, it can only be offset by passive income

11. Scott Tyrney owns 21% of an S corporation. He is confused with respect to the amounts of the corporate AAA and his stock basis. Write a brief memo to Scott, identifying the key differences between AAA and an S shareholder's stock basis

- Stock basis typically opens at a positive amount, and AAA starts out with a zero balance - AAA is a corporate account, and stock basis is calculated at the shareholder level - AAA can have a negative balance, but stock basis cannot go below zero - tax-exempt income affects stock basis, ut not AAA

10. Collette's S corporation holds a small amount of accumulated earnings and profits (AEP), requiring the use of a more complex set of distribution rules. Collette's accountant tells her that this AEP forces the maintenance of the AAA figure each year. Discuss the issues that arise with respect to distributions when an S corporation holds AEP.

- an AEP = a more complex capital structure 1. you must maintain three accounts: AAA, AEP, and OAA 2. anything from AEP will be taxed as a dividend at dividend rates 3. you can choose a bypass election and distribute out of AEP first 4. AEP does not change until distribution

19. Greiner Inc., a calendar year S-corp, holds no AEP. During the year, Chad, an individual Greiner shareholder, receives a cash distribution of $30,000 from the entity. Chad's basis in the stock is $25,000. Compute Chad's ordinary income and capital gain from the distribution. What is his stock basis after accounting for the payment?

- basis will go down to zero - $5,000 long term capital gain (30,000-25,000 basis)

AEP (Accumulated Earnings & Profit) = complex capital structure

- if an S-corp was previously a C-corp, then Earnings & Profits from previous C-corp are taxable as dividends - as a complex capital structure, you must maintain THREE accounts: AAA, AEP, OAA - anything from AEP will be taxed as a dividend - you can choose a bypass election and distribute out of the AEP first (before AAA) - AEP does not change until distribution

5. Joey lives in NC, a common law state. He is a shareholder in an S corporation. If he marries a nonresident alien, will the S election terminate? Would your answer change if he lives in Louisiana?

- if he lives in a common state, his stock is considered separate from his spouse, so the election will not terminate - if he lives in a community property, his election will terminate due to spouses non-resident alien status

S-Corporations

- more popular than LLCs! more than 4 million in USA - limited liability - flow through entity - taxed like a Partnership - separate income items flow through to shareholders - non-separate net income flows through to shareholders

Can you deduct a loss on K-1?

- only if you have basis in stock or basis in loan. You can carryover the NOL forever in an S-corp

Taxes paid on a Shareholder level

- share of income is equal to the Weighted Average of shares owned (weighted by time) - EXAMPLE: 1000X3/12 = 250 1600X2/12 = 267 400X7/12 = 233 Sum: 750 outstanding shares: 4,000 Weighted Average = 750/4000 = 18.75% * non-separate income * separate income items include: LTCG, STCG, STCL, charitable contributions, municipal interest, 1231 gain, dividends received

15. Matulis, Inc., a C corporation, owns a single asset with a basis of $325,000 and a FMV of $800,000. Matulis holds a positive E&P balance. It elects S corporation status and then sells the asset. Compute the corporate-level built-in gains tax that must be paid by Matulis

- the IRS makes you pay tax on gains for assets from when business was a C-corp (double taxation) - the difference of $475,000 (800,000-325,000) would be taxed at flat 35% rate as a S-corp when it sells the asset = a tax of $166,250. - then, there will be double taxation as the new S-corp must recognize $308,750 income (475,000-166,250) that flows through to the shareholders with NO special rate. Fully Taxable. - to avoid this double taxation, you should sell your property/assets when you are still a C-corporation before giving up C-corp status. Then your gain will be at your corporate rate which will probably be below 35%. Also, the remaining income will be taxed at dividends (capital gains) rates to the shareholders instead of being fully taxable

BASIS

- the basis is usually bigger than AAA because it will include the stockholder's initial contribution - everything that affects your S-corp should be in the basis (think of S-corp as your baby!) - individuals must account for their own basis! - your basis and AAA are non-taxable (if you keep track of them!)

Section 1231 Gain

- very similar to LTCG - almost always taxed at special gain rates - depreciable assets that must e used in business (not investment)

14. One of your clients is considering electing S status. Texas, Inc., is a six-year-old company with two equal shareholders, both of whom paid $30,000 for their stock. Going into 2015, Texas has a $110,000 NOL carryforward from prior years. Estimated income is $40,000 for 2015 and $25,000 for each of the next three years. Should Texas make an S election for 2015? Why or why not?

- you CANNOT carryforward NOL from a C-corporation to an S-corporation !!!! - No. Texas should not make an S election for 2015. If Texas stays a C-corp for 3-4 years than they can offset the $110,000 NOL against the income in the years. If they switch to an S-corp, they can not carry forward that loss.

Pecking Order for Distributions (S-Corp Accounts)

1) AAA (business income) 2) E&P (carried over from previous C-corp, has not yet been taxed as dividend - taxable to S-corp at dividend rates) 3) OAA 4) Basis 5) Capital Gain (any amount distributed over basis, will be taxable as LTCG)

Differences between AAA and Basis

1) AAA: - will start out at zero (business income) - on corporation's books - can go NEGATIVE - no tax-exempt items in it 2) Basis: (usually bigger than AAA) - will start out with amount of capital (what you pay or contribute) - stockholder maintains it - individuals must account for their own BASIS! - can NOT go negative - EVERYTHING that can affect your S-corporation is included - tax-exempt items are in the basis!

Requirements to be an S-Corporation

1. theoretical maximum of 100 shareholders (family counts as only one) 2. no non-residential aliens as shareholders 3. must be a domestic company 4. only one class of stock 5. only estates, individuals, trusts, exempt organizations

20. Holbrook, a calendar year S-corp, distributes $15,000 cash to its only shareholder, Cody, on Dec 31. Cody's basis in his stock is $20,00. Holbrook's AAA balance is $8,000, and Holbrook holds $2500 AEP before the distribution. Complete the chart below

Distribution from: AAA - (8,000) - not taxable AEP - (2500) - this is a taxable dividend, but it DOES NOT affect stock basis because it is from a previous C-corporation Stock basis - (4,500) - not taxable Effect on Stock basis: AAA - (8,000) AEP - 0 Stock basis - (4,500) Balance after Distribution AAA - 0 AEP - 0 Stock basis - 7,500

9. Classify each transaction as a + or - on Schedule M-2 of Form 1120S (AAA or OAA) a) Receipt of tax-exempt interest income b) Unreasonable compensation determined (expense) c) depreciation recapture income d) nontaxable life insurance proceeds e) expenses related to tax-exempt securities f) charitable contributions g) business gifts in excess of $25 h) nondeductible fines and penalties I) administrative expenses

a) +OAA b) -AAA c) +AAA d) +OAA e) -OAA f) -AAA g) -AAA h) -AAA I) -AAA

12. indicate whether the transaction will increase, decrease, or have no effect on the basis of the shareholder's stock in an S corporation: a. expenses related to tax-exempt income b. short-term capital gain c. nonseparately computed loss d. section 1231 gain e. depletion not in excess of basis f. separately computed income g. nontaxable return-of-capital distribution by the corp h. advertising expenses I. business gifts in excess of $25 j. depreciation recapture income k. dividend income received by the S corp l. LIFO recapture tax paid m. collection of a bad debt previously deducted n. long term capital loss o. cash distribution to shareholder out of AAA

a) - b) + c) - d) + (1231 gain is depreciable assets and other, such as land, that are used in the business) e) - (Congress allows you to continue % of revenue depletion beyond basis which you would be a +) f) + g) - h) - i) - (business gift > of $25 is considered a bribe: you can't deduct business gifts in excess) j) + (deprecation recapture: you must recapture depreciation if you sell equipment too fast after depreciating) k) + l) - (if the government thinks you abused and got too low of income through LIFO the government might make you recapture) m) + n) - o) -

23. Kaiwan, Inc. an S-corp, is partly owned by Sharrod, whose beginning stock basis is $32,000. During the year, Sharrod's share of a Kaiwan LTCG is $5,000 and his share of ordinary loss is $18,000. Sharrod then receives a $20,000 cash distribute. Compute the following: a) Sharrod's deductible loss b) Sharrod's suspended loss c) Sharrod's new basis in Kaiwan stock

a) 17,000 b) 1,000 c) 0

25. Maul, Inc. a S-corp, incurred the following items: - tax-exempt interest income - 7,000 - sales - 140,000 - depreciation recapture income - 12,000 - LTCG - 20,000 - 1231 gain - 7000 - COGS - (42,000) - Administrative expenses (15,000) - depreciation expense (17,000) - charitable contributions (7,000) a. calculate nonseparately computed income/loss b. if Carl is 40% owner, what is his share of LTCG?

a) nonseparately stated income/loss - sales - 140,000 - deprecation recapture income - 12,000 - COGS - (42,000) - administrative expenses - (15,000) - depreciation expense - (17,000) Total: $78,000 b) 20,000X.40 = $8,000

24. The profit and loss statement of Kitsch an S-corp, shows $100,000 book income. Kitsch is owned equally by four shareholders. From supplemental data, you obtain the following info about items included in book income: - revenue - 231,200 - selling expenses - 21,200 - tax-exempt interest income - 3,000 - dividends received - 9,000 - 1231 gain - 7,000 - depreciation recapture income - 11,000 - recovery of bad debts previously deducted - 5,000 - LTCL - (6,000) - Salary paid to owners (12,000 X 4) - COGS - (91,000) a. compute nonseparately stated income/loss for tax year b. what would be the share of this year's nonseparately stated income/loss items for one of the shareholders?

a) separately stated income - tax-exempt income - 3,000 - dividends received - 9,000 - 1231 gain - 7,000 - recovery of bad debts - 5,000 - LTCL - (6,000) Total: 18,000 non-separately stated income: - revenue - 231,200 - selling expenses - (21,200) - depreciation recapture income - 11,000 - salary paid to owners - (48,000) - COGS - (91,00) Total: 82,000 b) 82,000 X.25 = $20,500

21. Vogel, an S corp for five years, distributes a tract of land held as an investment to Jamari, its majority shareholder. The land was purchased for $45,000 ten years ago and is currently worth $120,000. a) As a result of distribution, what is Vogel's recognized capital gain? How much is reported as a distribution to shareholders? b) What is the net effect of the distribution on Vogel's AAA? c) Assume instead that the land had been purchased for $120,000 and was currently worth 45k. How much would Vogel recognize as a loss? What would be the net effect on Vogel's AAA? What would be Jamari's basis in the land?

a) taxable gain: 75,000 (120k-45k). $120,000 FMV is reported as a distribution to Jamari b) 45,000 decrease to AAA (gain of 75,000 - 120,000 distribution) c) would not recognize $75,000 loss at corporate level until sold. The loss does not reduce Vogel's AAA. Only when the S-corp sells the asset does it recognize the loss and reduce AAA. Therefore, the net effect on AAA is a decrease of $45,000 (FMV). Jamari would take a $45,000 basis (FMV) in the land.

2. Which of the following are requirements to be an S corporation? a. limited to a maximum of 100 shareholders b. has no resident alien shareholders c. has only one class of stock d. may have no straight debt e. cannot have an earnings and profit

c) the only requirement is that it have one class of stock (it is not limited to a maximum of 100 shareholders, but a THEORETICAL maximum because families count as one)

3. One shareholder of an S corporation takes a short-term unwritten cash advance of $9,100 during the tax year. Would this arrangement create a second class of stock? explain.

short-term unwritten debt that is held by stockholders in the same proportion as their stock is not treated as a second class of stock. - it would only create a 2nd class of stock if it looks like stock being disguised as debt