EA PART II - CORPORATIONS: 11. S Corp (Form 1120S)

THE "S" ELECTION

* ALL SHAREHOLDERS MUST AGREE * The corporation must file Form 2553 NO MORE than TWO MONTHS and 15 DAYS AFTER the beginning of the tax year the election is to take effect, or in the year prior. 1. It must be a small business corporation: * It has no more than 100 shareholders. * All shareholders are individuals, estates, exempt organizations, or certain trusts (NOT PARTNERSHIPS or CORPORATIONS). * It has no nonresident alien shareholders. * It has only one class of stock. 2. It is not one of the following ineligible corporations: 1. A bank or thrift institution that uses the reserve method of accounting 2. An insurance company subject to tax 3. A corporation that has elected to be treated as a possessions corporation 4. A domestic international sales corporation (DISC) or former DISC

INCOME & EXPENSES

An S corporation allocates income (or loss) and separately stated items in proportion to the shareholder's percentage of ownership. This is in contrast to a partnership, which is not required to allocate items based on the partner's percentage of ownership. Ownership is determined for each day of the year. A shareholder CANNOT DEDUCT A LOSS THAT EXCEED THE BASIS of his STOCK INCREASED by any loans the shareholder MADE to the S corp. SHAREHOLDER LOSSES ARE SUBJECT to the FOLLOWING LIMITATIONS, in the order in which they apply, the basis rules, the at-risk limitations, the passive activity limitations, and the excess business loss limitations. Additional details on these limitations appear in the section on Loss Limitations. The amount of a shareholder's stock and debt basis is very important. UNLIKE a C corporation, the stock and/or debt basis of an S corporation goes up and/or down each year based on the S corporation's operations.

S CORPORATION FILING PENALTIES

Failure to FURNISH K-1 to shareholder (§6722) - A $280 penalty may be imposed for each failure If the TAXPAYER INTENTIONALLY DISREGARDS the requirement to furnish or report correct information the penalty INCREASES to $570 OR, if greater, 10% of the AMOUNT REQUIRED TO BE REPORTED.

Schedules K-2 and K-3 (are new for the 2021 tax year).

For tax years beginning in 2021, flow-through entities WITH ITEMS OF INTERNATIONAL TAX RELEVANCE MUST complete the new schedules. The new Schedules K-2 and K-3 IMPROVE reporting by standardizing international tax information to shareholders and flow-through investors, making it easier for them to report these items on their tax returns. In addition, the changes ease flow-through return preparation compliance by clarifying obligations and standardizing the format for reporting.

DISTRIBUTION FOR S CORP

GENERALLY, the S corporation HAS ACCUMULATED E&P only if it has not distributed E&P accumulated in prior years when the S corporation was a C corporation. Treat the portion of a distribution attributed to accumulated E&P as a DIVIDEND.

S corporation

Generally, an S corp is exempt from federal income tax other than tax on certain capital gains and passive income.

If a shareholder receives a non-dividend distribution from an S corporation...

If a shareholder receives a non-dividend distribution from an S corporation, the distribution IS TAX-FREE to THE EXTENT it DOES NOT EXCEED the shareholder's stock basis. A shareholder TREATS a NON-DIVIDENDS DISTRIBUTION IN EXCEES of stock basis AS A CAPITAL GAIN (usually LTCG) on the shareholder's personal return.

IF S CORP HAS AE&P MUST MAINTAIN THE FOLLOWING ACCOUNTS TO DETERMINE TAXABLE DIVIDENDS:...

If the S corporation has AE&P it must maintain the following accounts to determine taxable dividends: * ACCUMULATED ADJUSTMENT ACCOUNT (AAA) - generally reflects the accumulated undistributed net income after 1982. * SHAREHOLDERS' UNDISTRIBUTED TAXABLE INCOME PREVIOUSLY TAXED - ALSO CALLED, Previously Taxed Earnings and Profits (PTEP), This account is for income before 1983. It is maintained only if the corporation had a balance in this account at the start of its current tax year. ). A distribution from PTEP is tax-free to the extent of a shareholder's basis in their stock in the corporation. * ACCUMULATED EARNINGS & PROFITS (AE&P) - If the S corporation was a C corporation in a prior year OR if it engaged in a tax-free reorganization with a C corporation. TREAT DISTRIBUTIONS AS TAXABLE DIVIDENDS * OTHER ADJUSTMENT ACCOUNTS (OAA) - The other adjustments account (OAA) TRACKS TAX-EXEMPT INCOME (and RELATED EXPENSES) and federal taxes attributable to a C corporation tax year if the S corporation has AE&P. TAX-EXEMPT INCOME INCREASES shareholder BASIS and EXPENSES RELATED to tax-exempt income DECREASES shareholder BASIS. TREAT OAA DISTRIBUTIONS as NON-TAXABLE DISTRIBUTIONS to the shareholder, REDUCING the SHAREHOLDER'S BASIS.

TERMINATION OF S ELECTION

If the corporation terminates the election, the corporation (or a successor corporation) CAN MAKE ANOTHER ELECTION on Form 2553 ONLY WITH IRS CONSENT FOR ANY TAX YEAR BEFORE THE FIFTH TAX YEAR AFTER TERMINATION. An election terminates automatically in any of the following cases: 1. The corporation is no longer a small business corporation. 2. The corporation, for each of three consecutive tax years, has accumulated earnings and profits and derives more than 25% of its gross receipts from passive investment income. 3. The election is revoked with the consent of shareholders who hold more than 50% of the number of issued and outstanding shares of stock (including non-voting stock).

S corporation

In most cases, all items pass through to S corp shareholders; HOWEVER, there are circumstances where the S corp MAY HAVE A INCOME TAX LIABILITY if the S corp WAS PREVIOUSLY a C corp AND has: 1. BUILT-IN GAINS 2. EXCESS NET PASSIVE INCOME - An S corp with accumulated E&P that has passive investment income exceeding 25% of gross receipts must pay tax on excess net passive income 3. LIFO RECAPTURE TAX 4. INVESTMENT CREDIT RECAPTURE

S CORPORATION FILING PENALTIES

Late or incomplete filing (§6699) (a) fails to file the return by the due date, including extensions, OR (b) files a return that fails to show all the required information. A penalty of $210 for each MONTH OR PART of a month (for a maximum of 12 months) the failure continues, MULTIPLIED by the TOTAL NUMBER of SHAREHOLDERS in the S corporation during any part of the S corporation's tax year for which the return is due.

S CORP (When taxable and not taxable)

ORDERING RULES DETERMINE THE TAXATION OF DISTRIBUTIONS: 1 Accumulated Adjustments Account (AAA) Not Taxable (These are Return of Capital, tax-free to the extent of the shareholders' basis, not below) 2 Previously Taxed Earnings and Profits (PTEP) Not Taxable (Not below zero, tax-free to the extent of the shareholders' basis). 3 Accumulated Earnings and Profits (AE&P) Taxable Dividend (Not below zero, 4 Other Adjustments Account (OAA) Not Taxable (tax-exempt income & related expenses, tax-free to the extent of the shareholders' basis) 5 Stock Basis/Return of Capital Not Taxable 6 In Excess of Stock Basis Capital gain DISTRIBUTIONS of APPRECIATED PROPERTY ARE VALUED at FMV. The S corp will recognize a gain (BUT NOT A LOSS) on the property to the extent that the FMV of the property exceeds its basis. The gain will pass through to the shareholders on the K-1.

ACCUMULATED ADJUSTMENTS ACCOUNT

On the first day of the corporation's first tax year as an S corporation, the balance of the AAA is $0. AT THE END OF THE TAX YEAR, ADJUST the AAA for the items as explained below: 1. INCREASE the AAA by INCOME(other than tax-exempt income) 2. DECREASE the AAA by DEDUCTIBLE LOSSES AND EXPENSES, and NONDEDUCTIBLE EXPENSES (other than expenses related to tax-exempt income). 3. DECREASE THE AAA (BUT NOT BELOW ZERO) BY DISTRIBUTION (OTHER THAN DIVIDENDS DISTRIBUTIONS FROM AE&P). TIP: AAA is INCREASE for THE SAME ITEMS that INCREASE BASIS EXCEPT for CAPITAL CONTRIBUTIONS and TAX-EXEMPT INCOME. AAA is DECREASED for THE SAME ITEMS that DECREASE BASIS EXCEPT for NONDEDUCTIBLE EXPENSES RELATED to TAX-EXEMPT INCOME. UNLIKE STOCK BASIS, the AAA MAY BE REDUCED BELOW ZERO, BUT ONLY BY LOSSES AND NOT BY DISTRIBUTIONS.

S Corporation Ordering of Distributions (Continue...)

Reduce any remaining shareholders' equity accounts. The REMAINING DISTRIBUTIONS A RETURN OF CAPITAL AND ARE TAX-FREE UP TO THE SHAREHOLDERS' BASIS. IF the shareholders' BASIS is REDUCED to $0, the REMAINING DISTRIBUTION IS A CAPITAL GAIN.

S CORPORATIONS (FORM 1120S)

SCHEDULE K SHAREHOLDERS' Pro RATA SHARE ITEMS is part of Form 1120S and is a SUMMARY of how the S corporation reports its taxable items of income, loss, deduction, credit, etc. SCHEDULE K IS THEN DIVIDED into "BABY" SCHEDULES known as K-1s. Each shareholder receives a Schedule K-1, with the various items of income and loss allocated according to the number of shares. All the K-1s add up to Schedule K.

Shareholder BASIS IS INCREASED AND DECREASED by...

SHAREHOLDER BASIS is INCREASED by: 1. Separately stated items of income (including tax-exempt) 2. Non-separately computed income 3. The excess of the deductions for depletion over the basis of the property SHAREHOLDER BASIS is DECREASED by: 1. Distributions by the corporation not includible in the income of the shareholder 2. Separately stated loss items 3. Non-separately computed loss 4. Any expense of the corporation not deductible in computing its taxable income and not properly chargeable to capital account 5. The shareholder's deduction for depletion for any oil and gas property held by the S corp

SEPARATELY STATED ITEMS

Schedule K-1 states each shareholder's pro-rata share of the NON-SEPARATELY STATED and SEPARATELY STATED ITEMS for shareholders to include on their own tax returns. Some of the items STATED SEPARATELY on Schedule K-1 (Form 1120S) include the following: * Net rental real estate income (loss) * Other net rental income (loss) * Interest income (loss) * Ordinary and qualified dividends * Royalties * Capital gains and losses (LTCG, STCG, 1250, and 1231) * Collectibles (28%) gains (loss) * Section 179 deduction * Foreign transactions * AMT items * Items affecting shareholder basis (including drilling costs) * Charitable contributions * Credits * Qualified business income, W-2 wages, and other information so the shareholders may determine their deduction for 20% of qualified business income (Section 199A qualified business income deduction)

Schedule K-2 (Form 1120S)

Schedule K-2 (Form 1120S) is an EXTENSION of SCHEDULE K of Form 1120S and is used to report items of international tax relevance from the operation of an S corporation

Schedule K-3 (Form 1120S)

Schedule K-3 (Form 1120S) is an EXTENSION of SCHEDULE K-1 (Form 1120S) and is generally USED to REPORT TO SHAREHOLDER THEIR SHARE of the international tax items reported on Schedule K-2. Shareholders must include the information reported on Schedule K-3 on their tax or information returns.

S ELECTION

The TCJA expands qualifying beneficiaries of an electing small business trust (ESBT), effective January 1, 2018. An ESBT may be a shareholder of an S corporation. A nonresident alien individual may not be a shareholder of an S corporation, BUT the TCJA, allows a nonresident alien individual to be a potential current beneficiary of an ESBT. TIP: Members of a family are treated as 1 shareholder. This includes a husband and wife, all members of a family that share a common ancestor, and their respective estates. TIP: An entity intending to be classified as an S corporation that fails to make a timely "S" election may qualify for late election relief UNDER REVENUE PROCEDURE 2013-30. There must be reasonable cause, and GENERALLY, LESS THAN 3 YEARS and 75 DAYS HAVE PASSED since the effective date of the election.

DISTRIBUTIONS FOR S CORP

The earnings and profits of an S corp are taxable to its shareholders, whether distributed or not. The taxable amount of distribution is contingent on the shareholder's stock basis (Shareholder is responsible to track its basis) TREAT a DISTRIBUTION to shareholders from an S corp that DOES NOT have accumulated E&P AS A RETURN OF CAPITAL to the shareholders' basis AND AS A GAIN from the SALE OR EXCHANGE of property on the excess

SHAREHOLDER STOCK BASIS IN S CORPORATION

The order in which stock basis is increased or decreased is important... there is an ordering rule in computing stock basis. Stock basis ADJUST ANNUALLY, as of the last day of the S corporation year, IN THE FOLLOWING ORDER: 1. INCREASED for INCOME items and EXCESS depletion; 2. DECREASED for DISTRIBUTIONS; 3. DECREASED for NON-DEDUCTIBLE, NON-CAPITAL EXPENSES and DEPLETION; and 4. DECREASED for items of LOSS AND DEDUCTIONS.

Elections relating to source of distributions

These elections are IRREVOCABLE and APPLY ONLY FOR THE TAX YEAR for which it is made. The corporation may modify the above ordering rules by making one or more of the following elections: 1. Election to distribute AE&P first 2. Election to make a deemed dividend 3. Election to forego PTEP TIP: To make any of these elections, the corporation MUST ATTACHED A STATEMENT to a TIMLEY FILED AN ORIGINAL or AMENDED Form 1120S for the tax year for which the election is made.