Chapter 3: S Corporations
How can you be eligible for an S-Corp?
- Must be simple and small -No more than 100 shareholders -Must be composed of individuals (or estates/trusts for individuals) -Cannot be other corporations or big trusts -Shareholders must be US Residents -Must be a domestic corporation -One class of stock (no preferred stock allowed)
Can your basis limitation go below zero?
-Cannot go below zero.
How do you form an S-Corp?
-Cash or property given for 80% control -Election to form an S Corp must be 100% unanimous (like marriage), b/c they are electing to be 100% liable for income taxes -Election can be made at anytime
When can you elect to become an S Corp
-Election can be made at anytime but it must be made by the 15th day of the 3rd month. Otherwise, you are a C Corp.
What is an S-Coporation?
-It is a flow through entity -Unlike C Corps, S Corps do not directly pay income taxes -They file an 1120-S -Income reported by an S Corporation is allocated to shareholders on a Schedule K-1
"QBI" means the net amount of qualified items of income, gain, deduction, and loss, from a qualified business within the U.S. What does QBI does not include?
-Reasonable compensation paid to the taxpayer -Guaranteed payments or other payments paid to a partner for services rendered -Capital gains/losses -Dividends (or the equivalent) -Interest income (eg, investment interest income) other than business interest income
How are liquidating distributions taxed?
-Taxed in the same way as for C Corps, except passed onto the shareholders. -Recognize the gain/loss at FMV for property
How are non liquidating distributions to shareholders taxed?
-These are non taxable
Why does the Built In Gains Tax exist?
-To prevent C Corps from switching to S Corps right before liquidation in order to prevent double taxation.
What is the purpose of a schedule K?
-To summarize the ordinary income and then separately list all items that are non ordinary
What are the applicable percentages for QBI deduction but for SSTB?
1) 100% - [(TI - threshold)/$100,000] for MFJ taxpayers 2) 100% - [(TI - ½ MFJ threshold)/$50,000] for all others
What are some of the key advantages and disadvantages when a corporation switches from a C Corp to S Corp?
1) Shareholders will be taxed on all income of the S corporation, whether distributed or not. 2) Capital losses pass through to the shareholders, instead of being carried back or forward to offset against corporate capital gains. 3) NOLs are not immediately deductible if switching from C to S Corp. 4) Health insurance premiums and other fringe benefits paid by an S corporation on behalf of a more than 2% shareholder-employee are deductible by the S corporation as compensation and are includible in the shareholder-employee's gross income on Form W-2. You take your number of shares and divide it by the total number of shares issued and outstanding (20/2000=1%; therefore, you would not qualify).
When can a C corporation re-elect S corporation status?
5 years A corporation's S status can be terminated voluntarily (ie, revocation by shareholders) or involuntarily (eg, termination for violating S status requirements). The corporation may reelect S status after the fifth tax year after the effective date of termination. The waiting period is required to prevent corporations from alternating entity types based on their current tax situation. The entity may request IRS permission for earlier election if more than 50% of its shares are held by shareholders who were not owners at the time of termination or if the termination was not within the shareholders' or corporation's control.
When can a C corporation use the cash basis of accounting?
A C corporation can use the cash basis method only if the average annual gross receipts for the three prior tax years does not exceed the threshold amount ($26 million in 2020)
How do you calculate stock basis of an S Corp?
Basis is adjusted during each accounting period for the shareholder's pro rata share of the calculated ordinary income/loss, separately stated items, contributions, and distributions. The shareholder's basis may never fall below zero.
What is the rule around S Corps for built in gains?
Built-in Gains Tax (BIG) applies if a C corporation elects S corporation status and the FMV of its assets exceeds their bases. The difference is a net unrealized built-in gain. If the assets are sold within 5 years, a special built-in gains tax at the highest corporate rate applies.
What is your QBI deduction?
For the qualified business income (QBI) deduction, the wage or property limitation is fully phased in when a taxpayer's taxable income (TI) exceeds the sum of the statutory threshold plus the phase-in range.
When does a built in gains tax apply to an S Corporation?
Generally, S corporations are not subject to income taxes. However, if the S corporation was previously a C corporation, it may be subject to other corporate-level taxes (eg, built-in gains [BIG]). Such taxes do not apply to S corporations that were never C corporations. The unrealized BIG applies when a C corporation elects S corporation status and the FMV of its assets held at the time of conversion exceeds their basis (ie, net appreciated assets). The unrealized BIG represents the gain that would have been reported if the assets were sold prior to the S election. If the assets are sold within 5 years of electing S status, the S corporation pays the BIG tax, assessed at the highest corporate tax rate.
What is the qualified business income deduction?
In order to somewhat level the playing field for flow-through entities (through 2025) after reducing the corporate tax rate to 21%, Congress created a 20% Qualified Business Income (QBI) Deduction for S corporations, partnerships, sole proprietorships, trusts, estates and even some Schedule E businesses.
How do you calculate net business income/loss (Ordinary income) of an S Corp?
Income = Ordinary income/Loss + Muni-bond interest + Separately stated income items Must be computed on an average daily basis
Under Section 199A, what is a qualified business? What is the purpose of 199A?
Individuals, trusts, and estates may deduct up to 20% of qualified business income (QBI), subject to certain criteria and limitations. QBI is the net of income, deductions, gain, and loss that flows through to a taxpayer from a qualified business and that is includible in taxable income. However, it does not include investment income, capital gains and losses, or deductions allocable to investment income or capital gains and losses.
How does Municipal Bond Interest and Distribution Received by Shareholder affect your basis?
Municipal Bond Interest: -Increases your basis -Not Taxable Distribution Received by Shareholder: -First reduced by income earned -Then applied against current basis - Distributions in excess of basis are taxed like a proceeds from the sale of stock
How do you terminate an S Corp?
Must have 50% (Like marriage) -It must come from voting and nonvoting shareholders.
What are your S Corp Separately Stated items?
Note: Try to remember this list, or the difference between ordinary and nonordinary!! Separately stated items can be income, losses, deductions, or credits that are reported separately from the S corporation's ordinary income/deductions to the shareholder because they are subject to different limitations/rules when reported on the individual tax return (ie, 1040). These items are passed through according to their percentage of ownership based on a per- share/per-day method.
What is the flow of the QBI deduction?
Note: You need to subtract capital gains, b/c it already received preferential treatment.
How would calculate the QBI deduction for lower income (tier 1)?
Noticed: Not a specialized service, just a t-shirt business
How can you involuntary terminate an S Corp?
Per Sec. 1362, termination will involuntarily occur if the S corporation has passive investment income exceeding 25% of its gross receipts for each of 3 consecutive years and, if during these 3 years, the corporation was a corporation with AEP attributable to prior C corporation status.
What is a Specific Service Trade or Business (SSTB)?
Such as health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any business where the principal asset of such business is the reputation or skill of one or more of its employees/owners. This specifically does not include engineering and architecture since they are a part of building something
Who can claim a QBI deduction?
The TCJA reduced the Federal corporate income tax rate. The significant cost savings (ie, reduced tax expense) for C corporations gives them a competitive advantage over business entities (eg, partnerships, S corporations, sole proprietorships) that are taxed at the individual, trust, and estate levels. To minimize this advantage, Congress established a deduction for individuals, trusts, and estates that have qualified business income (QBI) from a qualified business and meet certain requirements. Accordingly, the deduction is claimed on the tax return of an eligible individual, trust, or estate
What is the effective date for an S Corporation?
The election must be made within the first two and a half months of the tax year (March 15 for calendar year corporations). Any election made after that is effective at the start of the following tax year.
What do accumulated earnings and profits represent?
These represent earnings and profits that were accumulated (and never taxed to shareholders) during C corporation taxable years.
What's the order the IRS requires for the annual calculation of a shareholders S corporation stock basis?
This is important because a cash distribution can be taxed before consideration of losses. Example below: Baker's basis is therefore first increased by Alpha's ordinary income of $1,000, resulting in a basis of $26,000 (from $25k). Since the distribution must be applied to basis before the loss, the $30,000 distribution reduces the basis to zero, leaving $4,000 as a taxable distribution. With the basis already at zero, the capital loss does not further reduce basis and simply passes through to Baker's individual tax return.
What are the QBI thresholds?
When enacted, the original threshold was $315,000 for MFJ. Remember that one does not need to memorize inflation-adjusted amounts but should know the ballpark amounts. The examiners are likely to provide a threshold amount to be used when a precise calculation is necessary.
What are the accounting years and methods of a C corporation?
Without restrictions in place, pass-through entities (ie, S corporations) can use a year end that differs from its owners' to defer taxable income to a later year. Because C corporations are taxpaying entities, they have more flexibility in selecting a year end than pass-through entities. A C corporation is permitted to use a calendar year end, a fiscal year ending on the last day of any month, or a 52- to 53-week year end.
Does tax exempt interest increase your basis?
Yes! Tax-exempt income increases basis, so the income remains tax-exempt. If basis is not increased, the tax-exempt income will be taxed on the eventual sale of the stock through a larger gain or smaller loss.
