the business entity series - clientwhys (sbeac) since 1997. ... s elections and stock transfers...

An S Corporation Mini-Intensive

The Business Entity Series

Vicki L Mulak, EA, CFP®

September 21, 2016

Vicki L Mulak, EA, CFP® Page i An S Corporation Mini-Intensive©

Vicki is an Enrolled Agent and Certified Financial Planner (CFP®). She is

insurance and securities licensed. Vicki is the owner of

American Financial and Tax, a tax preparation, planning and representation

firm, which was founded in Tustin, California in 1985, when Vicki became

both a resident and a business owner.

She frequently testifies before the Franchise Tax Board meetings in Sacramento, CA and stays

involved in California tax legislation sponsored by the California Society of Enrolled Agents

(CSEA), attending Assembly and Senate committee hearings as necessary. Vicki testified with

Senator Mimi Walters before the California Labor Committee assisting in the passage of SB1244

(CH 2010-522) and SB 1131 (CH 2014-122) which now conform California employment tax law

affecting LLCs to federal. She chairs CSEA’s annual State Tax Agency Liaison Meeting, and

the Advocacy Partnership Subcommittee, which is a committee of likeminded individuals and

professional organizations that partner with CSEA, as needed, on California legislation and tax

matters of mutual interest and concern.

In addition to her private practice, Vicki serves on two of the three California state tax agency

advisory boards: The California Franchise Tax Board (FTB) Advisory Board, since 2010 and

the Employment Development Department's (EDD) Small Business Employer’s Advisory

Committee (SBEAC) since 1997.

Vicki is a well-known presenter on federal and California tax law and update with audiences at

continuing education events hosted by the National Association of Enrolled Agents (NAEA) and

its state affiliates, CSEA’s Super Seminar, and the various CSEA chapters. She is also a

frequent presenter for Society of California Accountants (SCA). She is author of numerous

articles that have appeared in NAEA’s EA Journal, and CSEA’s California Enrolled Agent.

Vicki was honored in August 2012 with NAEA’s Bill Payne Advocacy Award in recognition of

her commitment to advocacy on behalf of Enrolled Agents. In 2011, Vicki was awarded the

“Distinguished Service Award” for enhancement of CSEA’s reputation. In 2006, she received

CSEA’s prestigious “Thomas P Hess Award” in recognition of her contributions to CSEA’s

educational goals. She appeared in December 2004 on the IRS’ web cast Tax Talk Today.

Vicki L Mulak, EA, CFP® Page ii An S Corporation Mini-Intensive©

From 1993-2012, Vicki worked to prepare students for the partnership and corporation section of

the Special Enrollment Exam Class hosted by CSEA’s Orange County Chapter. She has been

an Extended Education instructor for California State University at Fullerton for their Financial

Planning Certificate Program from 1997-1998, and has worked as an editor for Thomson

Reuters’ Practitioner Publishing Company’s Accounting Quickfinder® from 2006-2012. Vicki

was honored for her excellent support of the local business community in 1996 as the recipient of

the U.S. Small Business Administration’s “Accountant Advocate of the Year” award.

She received her Bachelor of Science in Business Administration degree from Thomas Edison

State University in Camden, New Jersey and resides with her husband, George, in Tustin, CA.

Vicki L Mulak, EA, CFP® Page iii An S Corporation Mini-Intensive©

TABLE OF CONTENTS

S Corporation Tax Law Update ...................................................................................................... 1

Due Date of Federal Tax Return Changes .................................................................................. 1

Due Date of Extensions .......................................................................................................... 2

6 Year Statute of Limitations: Basis Overstatements ................................................................. 3

Stock Basis Adjustment for Charitable Contributions [IRC § 1367(a)(2)] ................................ 4

S Corporation Built-in Gain Recognition Period ........................................................................ 4

S Corporation Newer Developments .............................................................................................. 6

Shareholder Must Reduce Stock Basis in First Year Basis is Adequate .................................... 6

Deductions in Excess of Basis in Prior Years-Closed Years .................................................. 6

Deductions in Excess of Basis in Prior Years-Open Years..................................................... 6

S Elections and Stock Transfers (Post-DOMA) ......................................................................... 7

Reduction of Tax Attributes and “Deemed S Corp NOL” ......................................................... 9

Open Account Debt..................................................................................................................... 9

Safe Harbor Threshold Increases (Notice 2015-82) ................................................................. 10

S Corporations: the Net Investment Income Tax (NIIT) .......................................................... 12

Self-Charged Rental Income and Self-Charged Interest ....................................................... 13

Shareholder Sale of S Corporation Stock ............................................................................. 13

S Election ...................................................................................................................................... 17

Eligibility .................................................................................................................................. 18

Establishing Initial Shareholder Stock and Debt Basis............................................................. 18

Check-the-Box Regulations and S Elections ............................................................................ 19

Effect of S Election on Member’s Basis in LLC ...................................................................... 20

S Election Form 2553 ................................................................................................................... 21

Form 2553-Page One ................................................................................................................ 21

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Form 2553-Page Two ............................................................................................................... 21

Spousal Ownership ............................................................................................................... 21

Form 2553-Page Three: Tax Year ............................................................................................ 22

Ownership Tax Year (Item P2) ............................................................................................. 22

Section 444 Election (Item R)............................................................................................... 23

A Business-Purpose Tax Year (Item Q) ............................................................................... 24

A Natural Business Year (Item P1) ...................................................................................... 24

Tax Year Choices for C Corporation Electing S Status ........................................................ 26

Special Rule for Personal Service Corporations ................................................................... 26

Tax Year Summary ............................................................................................................... 27

Late S Elections (Rev-Proc 2013-30) ........................................................................................... 27

General Procedures for Relief from Late S Election ................................................................ 28

Attaching Form 2553 to Current Year Return ...................................................................... 31

Attaching Form 2553 to a Prior Year Return........................................................................ 31

Form 2553-Page Four: Late Entity Classifications ................................................................... 31

Revocation/Termination of S Election.......................................................................................... 32

S Corporation Taxation: Form 1120S ........................................................................................... 33

S Corporation Failure to File Penalty ....................................................................................... 33

State Taxation ........................................................................................................................... 34

S Corporation Code Sections .................................................................................................... 34

Two Basic Categories ............................................................................................................... 35

Non-Separately Stated Income: Form 1120S-Page One ....................................................... 35

Separately Stated Items: Form 1120S Schedule K ............................................................... 36

Two Retained Earnings Accounts ................................................................................................. 37

Accumulated Adjustments Account (AAA) ............................................................................. 37

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Accumulated Earnings and Profits (AE&P) ............................................................................. 38

Tax Return Form Design Issues ............................................................................................ 39

Form 1120S: Schedule M-1 ......................................................................................................... 39

Form 1120S: Schedule M-2 .......................................................................................................... 40

Other Adjustments Account (OAA) ......................................................................................... 40

Previously-Taxed Income (PTI) ............................................................................................... 41

Shareholder Stock Basis ............................................................................................................... 42

Basis Affects Treatment of Distributions ................................................................................. 42

Basis Affects Treatment of Losses ........................................................................................... 42

Computing Stock Basis ............................................................................................................. 43

EXAMPLE—Sufficient Stock Basis .................................................................................... 44

Pro-Rata Allocation of Loss and Deduction Items ................................................................... 46

EXAMPLE--Losses/Deductions Limited by Basis .............................................................. 46

Shareholder Debt Basis ................................................................................................................. 50

Debt Basis Reductions and Restorations .................................................................................. 50

Taxation of Loan Payments ...................................................................................................... 50

Reporting Loan Repayments..................................................................................................... 51

The “Net Increase” Special Rule .................................................................................................. 51

EXAMPLE--Normal Loan Basis Restoral ................................................................................ 52

EXAMPLE--with “Net Increase Special Rule .......................................................................... 52

Miscellaneous Information on Loans ............................................................................................ 54

Multiple Loans .......................................................................................................................... 54

Gain on Loan Repayment and Investment Income ................................................................... 55

Third-Party Debt and Loan Guarantees .................................................................................... 55

Use of Personal Credit Cards .................................................................................................... 55

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Use of Credit Cards-Credit Card in Corporation’s Name ......................................................... 56

Conversion of Shareholder Debt to Equity ............................................................................... 56

EXAMPLE-Shareholder Debt Converted to Equity ............................................................. 57

Unpaid Shareholder Loans at Liquidation ................................................................................ 57

Tax Strategies to Avoid a Taxable Loan Repayment ............................................................... 58

IRS Issues Final Debt Basis Regulations .................................................................................. 58

Debt Basis Recap ...................................................................................................................... 58

AAA: Annual Adjustments and Distributions ............................................................................. 59

Stock Basis Ordering Rules ...................................................................................................... 59

AAA Ordering Rules ................................................................................................................ 59

Distributions .................................................................................................................................. 60

Distributions from S Corporations without AE&P ................................................................... 60

Distributions Reduce Stock Basis Only ................................................................................ 60

Distributions from S Corporations with AE&P ........................................................................ 61

EXAMPLE--Distribution when AE&P is Present ................................................................ 61

Shareholder Election To Reverse Ordering Rules ........................................................................ 62

Specific Accounting Election ....................................................................................................... 67

Compensation and Benefits .......................................................................................................... 71

Compensation in the C Corporation ......................................................................................... 71

Compensation in the S Corporation .......................................................................................... 71

S Corporation Distributions to President were Wages ......................................................... 72

Fringe Benefits for 2% or More Shareholders .............................................................................. 73

Nontaxable Fringe Benefits ...................................................................................................... 73

Taxable Fringe Benefits ............................................................................................................ 73

Health Savings Accounts (HSA) .......................................................................................... 74

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Medical Insurance Premiums ................................................................................................ 75

Health Insurance Purchased in Shareholder Name ............................................................... 75

ACA Impact .......................................................................................................................... 76

IRS Notice 2015-17 Transition Relief .................................................................................. 77

Comprehensive Example .............................................................................................................. 78

Year 1 History: .......................................................................................................................... 78

Year 2 ........................................................................................................................................ 79

Year 3 ........................................................................................................................................ 89

Three Levels of Loss Limitation ................................................................................................... 99

At Risk Limitation .................................................................................................................... 99

Passive Activity Limitations ................................................................................................... 101

Real Estate Activities in the S Corporation ........................................................................ 101

Loss Limitation Interaction ..................................................................................................... 101

Summary ..................................................................................................................................... 102

Vicki L Mulak, EA, CFP® Page 1 An S Corporation Mini-Intensive©

A N S C O R P O R A T I O N M I N I - I N T E N S I V E

The S corporation is a very popular entity-type today. This session will analyze various

relevant topics and concerns encountered by practitioners advising S corporation clients.

Issues related specifically to S conversion clients, including dividends, and corporate

level taxes will be considered in a subsequent session.

S CORPORATION TAX LAW UPDATE

H.R. 3236 (P.L. 114-41), The Surface Transportation and Veteran’s Health Care Choice

Improvement Act of 2015 (STVHCCIA 2015), referred to as the “Highway Act”, signed

into law on July 31, 2015:

• Changes the due dates for entity returns for years after December 31, 2015;

• Changes the due date of FinCEN Form 114 (FBAR);

• Increases the statute of limitations for basis overstatements on/after

July 31, 2015;

• Adds new basis reporting requirements for executors; and

• Augments mortgage loan reporting requirements.

DUE DATE OF FEDERAL TAX RETURN CHANGES

Effective for taxable years after December 31, 2015, returns of partnerships under

IRC § 631 and returns of S corporations under IRC §§ 6012 and 6037 made on the basis

of the calendar year are due on March 15th following the close of the calendar year.

Returns made on a fiscal year basis are due on the 15th day of the third month following

the close of the fiscal year.

Returns of C corporations are due on or before the 15th day of the fourth month following

the close of the fiscal year (April 15 for calendar year C corporations). This provision is

effective for taxable years beginning after December 31, 2015. In the case of any


C corporation with a fiscal year ending on June 30th, the change to the due date applies to

returns for taxable years beginning after December 31, 2025. As such, a C corporation

with a fiscal year-end of June 30, will continue to have a September 15th due date until

2026. Corporations with fiscal year-ends other than June 30, will be due on the 15th day

of the fourth month.

DUE DATE OF EXTENSIONS

Effective for years beginning after December 31, 2015 and before January 1, 2026, the

maximum extension for the returns of calendar-year partnerships and S corporations will

be September 15th.

The extended due date for a calendar year C corporation will continue to be

September 15th, or 5 months instead of 6 months (even though their regular due date was

moved back from March 15th to April 15th ). Effective for years beginning after

December 31, 2015 and before January 1, 2026, the extended due date of a C corporation

with a fiscal year end of June 30, will be April 15th (7 months).

Note: California AB 1775 (CH 2016-348, 9/14/16) conforms California original entity

due dates to federal due dates effective for tax years beginning on or after

January 1, 2016.

R&TC § 18604 allows FTB to set filing extension periods for corporations. According to

information the author received on September 16, 2016, FTB plans to issue a formal FTB

Notice soon which would keep the extended due date for C corporations as the 15th day

of the 10th month (October 15th for calendar year corporations, reducing their current 7-

month extension to a 6-month extension). The extended filing due date for S

corporations will be the 15th day of the 9th month reducing the current 7-month extension

to a 6-month extension. By formal Notice, FTB will bring partial conformity to the

federal extended due dates.


R&TC § 18567 limits the filing extensions for partnerships to six months after the

original due date. Since AB 1775 changes the partnership original due date from the 15th

month day of the 4th month to the 15th day of the 3rd month, FTB plans to allow the

maximum 6-month extension permitted under the statute, which will move the current

October 15th extended filing date to September 15th for calendar year partnerships.

LLCs will follow the rules that apply to partnerships, C corporations or S corporations

depending on whether they make certain entity classification changes with or without

S elections or not.

6 YEAR STATUTE OF LIMITATIONS: BASIS OVERSTATEMENTS

STVHCCIA 2015 also amends IRC § 6501(e)(1)(B) by adding, “An understatement of

gross income by reason of an overstatement of unrecovered cost or other basis is an

omission of gross income.” If a substantial omission of gross income (in excess of 25%)

is reported on the return, the 6-year statute of limitations applies. This provision is

effective for tax returns filed after July 31, 2015, and for returns filed previously that are

still open under IRC § 6501. This new law actually overturns a previous Supreme Court

ruling (5-4) in 2012 [United States v. Home Concrete & Supply, LLC, et.al., 132 S. Ct.

1836 (2012)].

The following S corporation provisions were recently made permanent by the 2015

Protecting Americans from Tax Hikes legislation [(PATH 2015) (P.L. 114-113,

12/18/15)].


STOCK BASIS ADJUSTMENT FOR CHARITABLE CONTRIBUTIONS

[IRC § 1367(A)(2)]

A temporary incentive under [IRC § 1367(a)(2)], authorized by the Pension Protection

Act [(PPA 2006), P.L. 109-280 8/17/06] allowed S corporation shareholders to reduce

their basis in their S corporation stock by their pro-rata share of the basis of the property

the S corporation contributed to a charity, rather than the FMV of the charitable

contribution that flowed through the K-1 for deduction on Form 1040. For example, if

an S corporation with one shareholder made a charitable contribution of stock with a

basis of $ 100 and a FMV of $ 500, the shareholder would be able to deduct $ 500 on

his/her tax return, but only reduce basis in his/her stock by $ 100.

This provision had expired at the end of 2011, but the 2012 American Taxpayer Relief

Act [(ATRA 2012) (P.L. 112-240)] extended this provision for two years, so that it

applied for contributions made in tax years beginning before January 1, 2014. The Tax

Increase and Prevention Act of 2014 [(TIPA 2014) (P.L. 113-295, 12/19/14)] extended

this provision for 2014.

PATH 2015 permanently extends this provision for contributions made in tax years

beginning after December 31, 2014. As such, it applies retroactively back to tax years

beginning in 2015 as well as all future years.

S CORPORATION BUILT-IN GAIN RECOGNITION PERIOD

A C corporation that converts to an S corporation generally must hold any appreciated

assets for 10 years following the conversion or, if disposed of earlier, pay tax on the

appreciation at the highest corporate rate (currently 35%). The 2009 American Recovery

and Reinvestment Act [(ARRA 2009) (P.L. 111-5, 2/17/09)] and the 2010 Small

Business Jobs Act [(SBJA 2010) (P.L. 111-240, 9/27/10)] temporarily shortened the

usual 10-year holding period as follows:


• If the 5th anniversary of the S election date occurred prior to the 2011 tax year, the

built-in gains tax did not apply in 2011; and

• If the 7th anniversary of the S election date occurred prior to either the 2009 or

2010 tax year, the built-in gains tax did not apply in 2009 or 2010.

ATRA 2012 extended the 5-year recognition period for tax years beginning in 2012 or

2013. Effectively, an S corporation was not liable for the built-in gains tax if the

S election occurred prior to 1/1/07 for gains realized in 2012 or prior to 1/1/08 for gains

realized in 2013.

TIPA 2014 extended the five-year recognition period to apply to 2014. As such, an

S corporation was not liable for the built-in gains tax if the S election occurred prior to

1/1/09 for gains realized in 2014.

PATH 2015 provides that, for S corporation tax years beginning after 12/31/2014, the

recognition period is limited to five years. As such, PATH 2015 makes the 5-year

recognition period for the S corporation built-in gains tax permanent. Specifically,

the recognition period is the five-year period beginning with the first day of the first tax

year for which the corporation was an S corporation [Code Sec. 1374(d)(7)]. The change

in the built-in gains tax recognition period applies retroactively to January 1, 2015 and

applies to all future periods.

California’s built-in gain recognition period remains at 10 years.

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S CORPORATION NEWER DEVELOPMENTS

The following are recent developments in S corporation taxation:

SHAREHOLDER MUST REDUCE STOCK BASIS IN FIRST YEAR

BASIS IS ADEQUATE

The US Court of Appeals for the District of Columbia (Barnes, CA-D.C., 2013-1 USTC

50,267 April 5, 2013) affirmed the Tax Court’s decision, which upheld the IRS’

determination that a married couple must reduce their S corporation stock basis for

suspended losses, in the first year they have adequate basis to do so. Failure to do so

does not preserve basis for a later year’s loss deduction.

Mr. and Mrs. Barnes had S corporation losses in certain pre-1997 tax years. Some of the

losses were suspended because their basis was too low to deduct all the losses. In 1997,

the taxpayers had adequate basis to deduct the suspended losses, but failed to do so. In

2003, the Barnes claimed S corporation losses of $ 279,000. The IRS determined that

their remaining basis in the S corporation was just $ 153,000, and disallowed the

deduction for the excess losses.

DEDUCTIONS IN EXCESS OF BASIS IN PRIOR YEARS-CLOSED YEARS

TAM 200619021 addressed the issue of losses claimed in excess of basis in a closed year.

It states that when a shareholder improperly claimed losses in excess of stock and debt

basis, such losses are “suspended” for basis purposes only. It states that “any basis arising

from income earned in subsequent years must first be reduced by the suspense account

(but not below zero) before giving rise to positive basis in the shareholder’s stock and in

indebtedness.”

DEDUCTIONS IN EXCESS OF BASIS IN PRIOR YEARS-OPEN YEARS

IRC §1366(d) states that a shareholder’s stock and debt basis cannot go below zero. Loss

and deduction items in excess of stock and debt basis are to be suspended and carried


forward indefinitely. When basis is computed for a new client, it is common to discover

that losses were claimed in excess of basis in error in prior years which are still open

under the statute. When this is discovered, the return claiming the loss should be

amended to correct the error.

S ELECTIONS AND STOCK TRANSFERS (POST-DOMA)

In June 2013, the U.S. Supreme Court ruled that Section 3 of the federal Defense of

Marriage Act (DOMA) is unconstitutional (Windsor). As a result, lawfully married

same-sex couples will be treated as married for federal tax purposes. However,

individuals (whether of the opposite sex or the same sex) who have entered into a

registered domestic partnership, civil union, or similar formal relationship recognized

under state law that is not denominated as a marriage under the laws of that state are not

considered to be spouses for federal tax (including Subchapter S) purposes.

All persons who actually or beneficially own stock on the date an S election is filed and

those who held stock from the beginning of the tax year through the day the S election is

filed are required to consent to the S election. This consent requirement includes a spouse

having a community interest in the stock. Therefore, lawfully married same-sex spouses

with a community interest in the stock must also consent.

Stock transfers to a spouse (or former spouse incident to a divorce) are generally tax-free

under IRC § 1041(a). When a tax-free IRC § 1041(a) transfer of S stock occurs, any

disallowed losses or deductions are carried over to the spouse or former spouse. Now,

these losses can be transferred to a lawfully married same-sex spouse or former same-sex

spouse incident to a divorce. However, individuals (whether of the opposite sex or the

same sex) who have entered into a registered domestic partnership, civil union, or other

similar formal relationship recognized under state law that is not denominated as a

marriage under the laws of that state are not considered spouses for federal tax purposes,

and such formal relationships are not considered marriages for federal tax purposes

(Rev- Rul. 2013-17).

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EXAMPLE-Share Transfers between Spouses or Ex-Spouses

Robin owns all 100 shares of RobinHood, Inc, a calendar year S corporation. His stock

basis is zero. For the 2014 tax year, the corporation has $10,000 in losses, which Robin

carries over to 2015. Halfway through the 2015 tax year, Robin transfers 50 shares to

Marian, his spouse, who also materially participates in the corporation. In 2015,

Robinhood has $8,000 in losses. Robin’s pass-through amount is $ 6,000, since his

percentage for the year is 75% (100% of the stock for half the year and 50% of the stock

for half the year). Marian's pass-through amount is $ 2,000, since her percentage is 25%

(50% of the stock for 50% of the year). Since Robin cannot deduct any losses because he

lacks basis in 2015, the losses are prorated between Robin and Marian based on their

50% stock ownership at the beginning of 2016.

The shareholders each own 50 shares of stock on January 1, 2016. Also at that date,

there is a suspended loss of $10,000 from 2014 and a suspended loss of $8,000 from

2015. The $10,000 loss from 2014 is allocated depending on the ratio of stock ownership

at the beginning of the year following the year in which the stock transfer takes place.

Thus, at the beginning of 2016, $5,000 of the $10,000 loss is attributed to Robin and

$5,000 to Marian. The 2015 loss is allocated based on the stock percentages for 2015, so

the $8,000 loss is attributed $6,000 (75%) to Robin and $2,000 (25%) to Marian.

Robin’s suspended losses to carry to 2016 are $ 11,000 ($ 5,000 from 2014 plus $ 6,000

from 2015), and Marian’s suspended losses to carry to 2016 are $ 7,000 ($ 5,000 from

2014 plus $ 2,000 from 2015).


REDUCTION OF TAX ATTRIBUTES AND “DEEMED S CORP NOL”

The Treasury Dept. issued final regulations on October 29, 2009 (TD 9469) amending

Reg § 1.108-7 for discharges of debt on or after October 30, 2009. The regulations

address situations in which shareholder’s disallowed IRC § 1366(d) losses and

deductions (carryover losses due to lack of basis) are treated as an NOL tax attribute of

the S corporation.

In years when the S corporation’s COD income has been excluded under IRC § 108(a),

any excess losses of the shareholder will be treated as a deemed NOL for the

S corporation for purposes of tax attribute reduction. The S corporation shareholder is

required to share this information with the S corporation. Once the S corporation has

reduced these tax attributes, the S corporation is required to provide the shareholders with

the amount of any excess deemed NOL that remains for future years, even if that amount

is zero.

OPEN ACCOUNT DEBT

2008 regulations affect how basis restoral in shareholder loans functions. These

regulations were in response to F.G. Brooks, Dec. 56,127(M), TC Memo. 2005-204, 90

TCM 172 in which advances of open account debt by taxpayers to their closely-held

S corporation provided the taxpayers with basis to offset repayments of open account

debt made by the company prior to each advance. The multiple advances by the

taxpayers and repayments by the corporation constituted open account debt and was

treated as a single debt rather than as separate debt. The basis in the debt was computed

by netting, at the close of the year, the advances and repayments during the year. As a

result, by restoring the basis in their debts, the advances the taxpayers made to the

S corporation shielded them from the realization of gain on debt repayments.

Under the new regulations, when open account debt exceeds $ 25,000, the debt will no

longer constitute “open account debt” and will be treated as debt evidenced by a written

note (regardless of whether there is a written instrument or not). If there is no “net

Vicki L Mulak, EA, CFP® Page 10 An S Corporation Mini-

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increase” for the year (occurs when pass-through income and gain exceed pass-through

losses, deductions and distributions), there is no restoration of debt basis. Any repayment

of debt is subject to the basis adjustment and repayment accounting rules applicable to

S corporations.

These final regulations apply to any and all shareholder advances to the S corporation

made on or after October 20, 2008 and repayments on those advances by the

S corporation.

SAFE HARBOR THRESHOLD INCREASES (NOTICE 2015-82)

In Rev-Proc. 2015-20, the Treasury Department and the IRS formally requested

comments on whether it is appropriate to increase the de minimis safe harbor limit

provided in § 1.263(a)-1(f)(1)(ii)(D) for a taxpayer without an AFS to an amount greater

than $500, and, if so, what amount should be used and the justification for considering

that amount appropriate.

The Treasury Department and the IRS received more than 150 comment letters

suggesting an increase in the amount of the de minimis safe harbor limit for taxpayers

without an AFS. The suggested increased amount ranged from $750 to $100,000.

Commenters wrote that the $500 limitation was too low to effectively reduce the

administrative burden of complying with the capitalization requirement for small

business taxpayers that frequently purchase tangible property in their trades and

businesses. Commenters noted that the cost of many commonly expensed items (for

example, tablet-style personal computers, smart phones, and machinery and equipment

parts) typically surpass the current $500 per item or invoice threshold provided in

§ 1.263(a)-1(f)(1)(ii)(D).

Commenters also stated that the $500 threshold did not correspond to the financial

accounting policies of many small businesses, which frequently permit the deduction of

amounts in excess of $500 as immaterial. Commenters noted that without an increase in


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the de minimis safe harbor limit for taxpayers without an AFS, a capitalization threshold

in excess of $500 can only be substantiated by establishing that a taxpayer’s policy

results in the clear reflection of income for federal income tax purposes, resulting in

additional burden and uncertainty for taxpayers. Many commenters expressed concern

regarding the disparate treatment of taxpayers with an AFS compared to those without an

AFS under the safe harbor requirements, stating that obtaining an AFS is cost prohibitive

for many small businesses and does not adequately justify the substantially lower de

minimis ceiling for these taxpayers.

Since Reg § 1.263(a)-1(f)(1)(ii)(D) permits the IRS to change the safe harbor limit to an

amount identified in published guidance in the Federal Register or in the Internal

Revenue Bulletin and to meet the goal of reduction in administrative burden, IRS has

increased the amount for a taxpayer without an AFS from $ 500 to $ 2,500 effective

for tax years beginning on or after January 1, 2016. Notice 2015-82 also states that

IRS will not challenge use of the higher threshold for tax years that begin after

December 31, 2011 and end before January 1, 2016.

This de minimis safe harbor election [Reg § 1.263(a)-1(f)] eliminates the burden of

determining the proper tax treatment (deduct or capitalize) of smaller amounts paid or

incurred for the acquisition or production of property.

Note: When this election is made, the taxpayer also applies the de minimis safe harbor to

all amounts paid for all materials and supplies that meet the requirements of

Reg § 1.263(a)-1(f), other than the than rotable and temporary spare parts to which the

optional method is applied or rotable, temporary, and emergency spare parts for which an

election to capitalize and depreciate is made [Reg § 1.162-3(f)].

The de minimis safe harbor election also applies to capital expenditures.


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S CORPORATIONS: THE NET INVESTMENT INCOME TAX (NIIT)

The 3.8% Net Investment Income Tax (NIIT) is effective for tax years beginning after

12/31/12. When an individual, estate or trust holds an ownership interest in an

S corporation and the entity passes through gross income, the income and related

deductions are included in calculating the shareholder’s net investment income for NIIT

purposes unless the income is derived in the ordinary course of a nonpassive IRC §

162 business activity other than the business of trading in financial instruments or

commodities [IRC § 1411(c)].

The determination of whether an S corporation is engaged in an IRC § 162 business

activity is made at the entity level. The determination of whether pass-through income,

gains, or losses from an entity’s IRC § 162 business activity is passive or nonpassive

(material participation rules) is made at the shareholder level [Reg 1.1411-4(b)(2) and

(d)(4)(i)(B)(3)].

Gross income derived in the ordinary course of a nonpassive IRC § 162 business activity

and related deductions are generally not included in net investment income. An example

of stock ownership in an S corporation considered nonpassive would include a service

provider’s interest in a personal service-type corporation. One exception is income and

related deductions related to the investment of business working capital [Reg 1.1411-6].

In other words, a shareholder’s share of passthrough gain is included in net investment

income dependent on:

1. Whether the S corporation holds the property in its IRC § 162 business activity;

and

2. Whether the shareholder materially participates.


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SELF-CHARGED RENTAL INCOME AND SELF-CHARGED INTEREST

Self-charged rents exist when a taxpayer rents property for use in a business activity

where he materially participates. This is common with small business clients that may

operate a business as an S corporation from their principal residence. This self-charged

rental income is recharacterized as non-passive, and does not release passive losses from

other activities.

The final regulations at Reg § 1.1411-4(f) provide that this rental income is considered to

be derived from an active trade or business.

The final regulations also deal with self-charged interest in a similar manner. The

amount of self-charged interest that may be excluded from net investment income will be

the taxpayer’s allocable share of the non-passive deduction in the pass-through entity.

SHAREHOLDER SALE OF S CORPORATION STOCK

Gain or loss from a disposition of S corporation stock is taken into account by the

shareholder is net investment income (NII) only to the extent of the net gain or loss that

the shareholder would take into account if the S corporation had sold all its property for

fair market value immediately before the disposition [IRC § 1411(c)(4)].

Proposed Reg § 1.1411-7 applies to transfers of stock, and is the only portion of the NIIT

regulations that were not finalized in December 2013 in an effort to provide more

opportunity for public comment. The first set of proposed regulations from 2012 used a

“deemed sale” approach which could be quite burdensome, as it requires a transferor who

materially participates in the S corporation to use a property-by-property valuation. The

2013 revised proposed regulations [Prop. Reg § 1.1411-7(c)] allow eligible transferors to

apply an optional simplified method for calculating gain or loss for NIIT purposes.


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DEEMED SALE (HYPOTHETICAL SALE) APPROACH

The amount of net gain on the sale of an interest that is treated as investment income is

the lesser of:

• The overall gain or loss on the sale of the interest; or

• The gain attributable to investment income.

EXAMPLE-Deemed Sale Approach

Jim is one of four 25% shareholders in an S corporation, ABC, Inc providing consulting

services. He sells his stock in ABC, Inc. for $ 400,000. His basis in his stock on the date

of sale is $ 100,000. His gain is $ 300,000. He has always been a material participant in

ABC, Inc. ABC, Inc. has a small portfolio of stocks at Edward Jones that has increased

in value by $ 50,000. Jim must include $ 12,500 (his 25% portion of the stock portfolio

gain) in his investment income for the year of the sale, which is the lesser of the overall

gain ($ 300,000) or the gain attributable to investment income ($ 12,500).

SIMPLIFIED METHOD

The optional simplified method uses a “look-back” period and a 5% threshold rule. It is

called “simplified” because it doesn’t involve any hypothetical asset sales. It also uses a

Section 1411 Holding Period, which is (1) the year of the disposition plus the transferor’s

preceding two tax years, or (2) the transferor’s entire ownership period if that is a shorter

time.


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Under the optional simplified method, the transferor must satisfy some eligibility

requirements:

1. The sum of the of K-1 pass-through of investment income in a look-back period

including the disposition year and the two preceding taxable years is 5% or less of

the sum of all the K-1 flow-through income in the look-back period (called the

Section 1411 Holding Period),

2. The disposition gain does not exceed $ 5 million (in instances of multiple

dispositions as part of a plan);

3. The total amount of income recognized on the disposition does not exceed

$ 250,000; and

4. The seller has directly held the ownership interest for 12 months or more.

Under the simplified method, the transferor’s regular tax gain or loss from a disposition

must be included in NIIT by multiplying it by a fraction. The numerator of the fraction is

total NIIT income, gain, loss and deductions passed through during the Section 1411

holding period divided by the total income, gain, loss and deductions passed through

during the Section 1411 holding period. In calculating the fraction, loss and deduction

items are treated as negative numbers and are netted against positive income and gain. If

the fraction is greater than one or less than zero, the fraction is deemed to be “1”. But,

the fraction is deemed to be “zero” if the numerator is negative and there is regular tax

gain on the disposition. If the numerator is positive and there is a regular tax loss on the

disposition, the fraction is deemed to be “zero”.


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EXAMPLE-Simplified Method (disposition gain)

Stella is a 25% shareholder in Star Corporation, an S corporation, for five years, and has

been a material participant. Star Corporation operations are defined as an IRC § 162

business activity, but a small fraction of assets have been invested.

In 2014, Stella sells her stock for a regular tax gain of $ 200,000. During the time Stella

was a shareholder, she was allocated $ 25,000 of interest, dividends, and capital gain

income from working capital investments. During that same period of time, she was

allocated $ 475,000 of net income. Under the simplified method, Stella must include

$ 10,000 or 5% of her gain in NIIT, calculated by multiplying her gain of $ 200,000 by a

fraction $ 25,000/$ 500,000 or .05.

EXAMPLE-Simplified Method (disposition loss)

Using the facts from the previous example, assume Stella has a ($ 100,000) loss on the

sale of her S corporation stock. Under the simplified method, Stella’s fraction remains

5%, but since the numerator of the fraction is positive, and she has a regular tax loss on

the disposition, the fraction is deemed to be zero. ($ 100,000) multiplied by zero results

in a loss of zero, and none of the regular loss is included in NIT.

EXAMPLE-Simplified Method (investment loss with disposition gain)

Using the same facts from first example, assume the corporation’s investments of

working capital produced a ($ 10,000) net loss. Under the simplified method, Stella’s

fraction is a negative number: ($ 10,000)/$ 465,000. Since the numerator of the fraction

is negative, and Stella has a regular tax gain, the fraction is deemed to be zero, which

results in none of the regular tax gain is included in NIIT.


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EXAMPLE-Simplified Method (investment loss with disposition loss)

Using the same facts from the first example, assume Stella has a ($ 100,000) loss from

the sale of her S corporation stock in conjunction with a $ 10,000 loss from the

investments. Under the simplified method, Stella’s fraction is a negative number

($ 10,000)/$ 465,000, and therefore deemed to be 1.0. Stella multiples her ($ 100,000)

regular tax loss by 1.0 which results in all $ 100,000 of her regular tax loss included in

NIIT.

EXAMPLE-Simplified Method

(Investment gain/disposition gain/1411 holding period losses)

Luna owns a 25% interest in Constellation Corporation, an S corporation. Luna is a

material participant, and almost all of Constellation’s assets are held in an IRC § 162

business activity. Luna sells her stock for a regular tax gain of $ 225,000. A small

portion of Constellation’s assets have been investments in working capital. During her

Section 1411 holding period, Luna was allocated $ 25,000 of interest, dividends and

capital gains. During that same period, she was allocated $ 300,000 of net losses from

Constellation’s business activity. Under the simplified method, Luna’s fraction is a

negative number: $ 25,000/($ 300,000). Therefore the fraction is deemed to be “1”.

Luna multiples her $ 225,000 regular tax gain by “1”. The result is that all $ 225,000

gain is subject to NIIT.

S ELECTION

In order for a corporation, or any eligible entity to be taxed as an S corporation, an

election on Form 2553 Election by a Small Business Corporation must be made. In

general, Form 2553 must be filed no more than two months and 15 days after the


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beginning of the tax year the election is to take effect or at any time during the tax year

preceding the tax year it is to take effect. Form 2553 was revised at the end of 2013.

ELIGIBILITY

A corporation desirous of making an S election must be a domestic corporation. The

corporation cannot have more than 100 shareholders and is only allowed to have one

class of stock (not judged by voting privileges). Most family members can be treated as

one shareholder, unless the individual is more than 6 generations removed from the

youngest generation of shareholders. All of the shareholders must be individuals, estates

or certain trusts, and no shareholder can be a nonresident alien. Corporations and

partnerships are not eligible S corporation shareholders. An S corporation can issue

debt only as long as it is not considered a second class of stock. Finally, the corporation

cannot be an "ineligible corporation," such as an insurance company, a possessions

corporation, a domestic international sales corporation (DISC) or former DISC, or

taxable mortgage pool. Certain corporations are not eligible for the S election including

financial institutions that are allowed a bad debt deduction under IRC § 585, certain

insurance companies, domestic international sales corporations (DISCs) or corporations

election to use the possessions tax credit under IRC § 936.

ESTABLISHING INITIAL SHAREHOLDER STOCK AND DEBT BASIS

When a C corporation elects S status, the practitioner needs to check the adequacy of the

shareholder’s basis in stock and debt. The initial basis in S corporation stock is

calculated depending on how the shareholder acquired the shares. If the shares were

purchased outright, initial basis is the cost of the shares. If the shareholder owns stock in

a C corporation at the time of its conversion to S status, the shareholder’s initial basis is

the same basis he/she shad in the C stock at the time of the conversion. Special rules

apply when the shareholder’s stock is acquired by gift, inheritance, or in exchange for

services. The shareholder’s initial basis in debt is the amount of debt the corporation


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directly owes the shareholder. The shareholder does not have debt basis unless the debt

is owed by the corporation directly to the shareholder [IRC § 1366(d)(1)(B)].

CHECK-THE-BOX REGULATIONS AND S ELECTIONS

The federal “check the box” regulations allow an entity that is not a corporation by virtue

of the statutory law of its jurisdiction to elect to be treated as a corporation (thus,

checking the box) or to be treated as a partnership (if it has more than one owner) or as a

division or disregarded entity (if it has only one owner).

Under the check-the-box system of classifying entities for tax purposes, eligible entities,

i.e., unincorporated business entities that aren't trusts and that aren't mandatorily

classified as corporations, may choose their federal tax classification. Multi-owner

eligible entities may elect to be classified as corporations or partnerships, or to retain

their default classifications in the absence of an election. Single-owner eligible entities

may elect to be classified as corporations, or may choose to have their status as entities

separate from their owners ignored. Actual elections must be filed only to choose a

classification other than the “default” classification, or to change classifications.

The check-the-box regulations have provided a new opportunity for the sole-member (or

multi-member) LLC that did not exist before. If the member or members of an LLC are

qualified to be an S shareholder, then the LLC should be eligible for an S election.

Previously there was a two-prong procedure for an LLC to be taxed as an S corporation.

It required filing Form 8832 (Entity Classification Election) and Form 2553 (Election by

a Small Business Corporation). Filing Form 8832 was the election to be taxed as a

corporation. Filing Form 2553 was necessary to obtain “S” status.

The filing of both forms is no longer necessary. The filing of Form 2553 functions as a

“deemed” entity classification request.


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Note: Once any LLC makes an S election, the LLC files its tax returns using the

S corporation schematic. The LLC is no longer liable for the California gross receipts

fee, which is a big reason eligible California LLCs find the S election attractive.

EFFECT OF S ELECTION ON MEMBER’S BASIS IN LLC

When and LLC elects to be taxed as an S corporation by filing Form 2553, the members

calculate their bases using S corporation rules, rather than partnership rules.

EXAMPLE -Basis Reduction due to 3rd Party Debt

Jason and William are 50/50 members in JW Enterprises, LLC. In their second year, they

are considering an S election, in an effort to reduce their exposure to the self-employment

tax. Their basis in their LLC member interest is $ 100,000 each, which reflects their

original contributions of $ 50,000, $ 10,000 each increase due to the flow-through from

their first-year K-1 ($ 25,000 each in ordinary income, and a distribution each of

$15,000), and $ 40,000 each for their allocation of the LLC’s recourse liabilities.

If JW Enterprises, LLC elects to be taxed as an S corporation, both Jason and William

will receive a $40,000 reduction in basis, as the recourse liabilities will not increase their

basis in their “S corporation stock”. Their basis in their LLC, taxed as an S corporation

will be $ 60,000.

Note: It is important to verify what the impact of an S election is on basis, due to the

differences in participant basis in the various entity types. The calculation should be

done as part of the planning process, in case there would be a reduction in basis since

recourse, third-party debt does not increase basis in an S corporation, like it does in LLC.


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S ELECTION FORM 2553

Form 2553 was modified at the end of 2013 to accommodate late elections under

Rev-Proc 2013-30 that are made with the first tax return. It is now a 4-page form.

FORM 2553-PAGE ONE

The first page identifies the corporation making the election. The bottom half of the first

page is for purposes of accommodating the “reasonable cause” as to why the election is

late. If the election is timely, these lines are left blank.

FORM 2553-PAGE TWO

The second page is for signed consents to the S election. All shareholders are identified

by either number of shares owned (corporation) or their percentage ownership (other

entities). To make an S election, all shareholders or participants must consent to the

election. In community property states, spousal consents are also required.

SPOUSAL OWNERSHIP

While spouses are considered as one for purposes of an S election, this is only for

purposes of the 100-shareholder limit. For shareholder consent signatures, each person

holding an interest in the stock must sign the consent, whether owning as a joint tenant,

tenant in common, or tenant by the entirety. In addition, if the S stock is community

property, or if the income from the stock is community property, each spouse is a

separate shareholder and must sign the consent [IRC §1361(c)(1); Reg. 1.1362-

6(b)(2)(i)].

Automatic relief is available if Form 2553 does not include the signature of a community

property spouse who was a shareholder solely under a state’s community property laws

(Rev-Proc 2004-35). This available relief also applies to same-sex married couples.


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FORM 2553-PAGE THREE: TAX YEAR

Page 3 consists of two parts. Part II is for selection of a fiscal year, and Part III is for an

income beneficiary (or legal representative of the income beneficiary) to make a

Qualified Subchapter S Trust (QSST) election for a trust shareholder of the corporation

making the S election on the front of Page One. In other words, a QSST election can be

made simultaneous to a corporation’s S election, but only if the stock of the corporation

has been transferred to the trust on or before the date on which the corporation makes its

election to be an S corporation. If the stock has not been transferred as of the date of the

corporation’s S election, the QSST election must be made separately.

Page 3 does not need to be completed unless:

1. The corporation is selecting a fiscal year; or

2. There is a simultaneous QSST election being made with the corporation’s

S election.

The calendar year is the required year for an S corporation, but there are also permitted

tax years. Some opportunity exists for securing a fiscal year. Due to cost, two of the

methods are not that viable to the author, and one method seems outstanding, if the

corporation can qualify:

OWNERSHIP TAX YEAR (ITEM P2)

An ownership tax year is permitted under the automatic consent provisions of

Rev-Proc 2006-46, when shareholders holding more than half of the shares of stock have

the same tax year proposed by the entity making the S election. Ownership tax years are

rarely encountered with S corporations, as most S corp shareholders are individuals, and

there is a small universe of individual taxpayers in the U.S. using a fiscal year or 52-53

week tax year. Ownership Tax Years are most frequently encountered in partnership

taxation, where fiscal year corporations are partners.


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SECTION 444 ELECTION (ITEM R)

This method only allows for a 3-month deferral of income, which generally provides 3

other alternatives to a December 31 year-end, which are September 30, October 31 or

November 30. The lack of viability to the author is due to the fact that the corporation

is required to make payments to the IRS for the tax benefit received from the income

deferral. If a Section 444 election is required, an electing corporation can check Box 1

in Item “R” on page 3 of Form 2553. Additionally, Form 8716 Election to Have a Tax

Year Other than a Required Year is filed. Then, every year, the corporation completes

Form 8752 Required Payment or Refund under Section 7519 by May 15th following the

calendar year that the original election was made. The required payment is intended to be

approximately equal to the amount of additional tax that would be paid by the

corporation's owners if it had used the required tax year instead of the one elected. Thus,

the “required payment” calculation is cumulative in nature. That is, the actual payment

for a given year is the current year's calculation of the tax deferred as a result of the

fiscal-year election, less the cumulative amount of the required payments made in prior

years.

FORM 8716

IRC § 444 elections are made by filing Form 8716 Election to Have a Tax Year Other

than a Required Tax Year. This form is only used by partnerships, S corporations,

and personal service corporations (PSC) to elect a tax year other than the required

year. It must be filed by the earlier of:

• The 15th day of the 5th month following the month that includes the 1st day of the

tax year the election will be effective; or

• The due date (not including extensions) of the income tax return for the tax year

resulting from the IRC § 444 election.


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A BUSINESS-PURPOSE TAX YEAR (ITEM Q)

To make this election simultaneous to an S election, the corporation checks Box 1 in Item

Q on page 3 of Form 2553. Since a business purpose tax year requires IRS consent, the

corporation should probably check Box 3 in Item Q, where the corporation ultimately

agrees to a December 31 year-end, with or without making a back-up Section 444

Election. It is difficult for a business to assert a bona fide business purpose reason, under

a facts and circumstances approach, that a fiscal year is needed. Section 5.02 of Rev-

Proc 2002-39, provides details on what is sufficient to establish a business purpose.

Additionally, a business purpose request can use one of the natural business year tests in

Rev-Proc 2002-39. The two tests are the Annual Business Cycle or the Seasonal

Business Test. Both tests work in a similar fashion as the 25% gross receipts rule for a

47 month history, except a shorter period of 36 months can be used.

User Fee. When Box Q1 is checked, a user fee of $ 4,200 (previously $ 2,700) applies

(for requests made after February 1, 2015). The fee is not paid when Form 2553 is filed.

IRS will notify the corporation that the fee is due.

A NATURAL BUSINESS YEAR (ITEM P1)

This is the most viable option for fiscal year, and one that should be used if the

corporation or entity making the election qualifies. Automatic approval provisions of

Rev-Proc 2006-46 apply, if the business can demonstrate on the basis of its previous 47

months (bank statements) that 25% of gross receipts are earned in two months of the

year. If so, automatic consent to end the tax year at the end of this normal two-month

“peak” is automatically granted, without a user fee. Box 1 in Item P is checked, and a

statement is attached to Form 2553 which shows the computation.


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TAX YEAR CHOICES FOR C CORPORATION ELECTING S STATUS

A fiscal-year C corporation is not automatically entitled to retain its fiscal year when it

elects S status. A C corporation electing S status generally has the same four choices as a

newly incorporated S corporation. It also has the same options for year-end with a

Section 444 election, with one other restriction. A C corporation electing S status cannot

make a Section 444 election that results in a deferral period greater than its present fiscal

year.

EXAMPLE-C Corporation with Existing Section 444 Election

ABC Corporation, a C corporation other than a PSC, whose current tax year ends

October 31, elects S status. Rather than change to the required calendar year for an

S corporation under IRC § 1378, ABC wants to make an IRC § 444 election to retain its

October 31st year-end for its tax year beginning November 1st. Since October 31 is a

deferral period of only 2 months, ABC may elect to retain its tax year ending October 31st

by filing Form 8716. ABC will also file an annual Form 8752. ABC Corporation could

also elect a November 30 year-end, as a November 30 fiscal year-end is a deferral of only

1 month. The corporation may not elect a fiscal year-end of September 30, because the

3-month deferral period would be longer than the 2 month deferral period being changed.

SPECIAL RULE FOR PERSONAL SERVICE CORPORATIONS

A special rule applies to personal service corporations (PSCs) that have an existing

Section 444 election in effect at the time of the S election. The PSC can retain the

Section 444 election, make required payments, and continue to use the PSC’s fiscal year

[Temp Reg § 1.444-1T(a)(5)]. A PSC is a C corporation whose principal activity is the

performance of personal services in the fields of health (including veterinarians), law,


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engineering, architecture, accounting, actuarial science, performing arts, and consulting.

The corporation’s services are substantially performed by employee-owners and these

employee-owners own more than 10% of the FMV of the outstanding stock

[Reg § 1.441-3]

TAX YEAR SUMMARY

To recap available tax years for S corporations:

• The required tax year is December 31, and any entity can adopt this tax year

without further effort. Box (1) is checked in Item F on the first page of Form

2553.

• There are several permitted tax years. The Natural Business Year can be

adopted under the automatic consent provisions, with no user fee, if the business

can establish the 47 month gross receipts history that is required. Both the

Business Purpose Year and the Section 444 election require IRS approval. The

Section 444 election requires an annual filing each May to determine the benefit

of deferral achieved with the election, and an ongoing deposit is kept on account

with IRS. The Business Purpose Year requires a one-time user fee. In order to

assure the S election stays valid, entities seeking permitted tax years which

require IRS approval should check either Box Q3 or R2 to accept a December 31

year-end if their fiscal-year requests are not approved by IRS.

LATE S ELECTIONS (REV-PROC 2013-30)

This revenue procedure facilitates the grant of relief to taxpayers that request relief

previously provided in numerous other revenue procedures. It also extends the period

whereby relief can be granted before a private letter ruling would be required. By

consolidating the provisions from multiple revenue procedures since 1997 into one

revenue procedure, significant simplification in late elections has been achieved.


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This procedure modifies and supersedes:

• Rev-Proc 2007-62 (Late election, including late entity classification with return);

• Rev-Proc 2003-43 (Late election filed separately from return);

• Rev-Proc 1997-48 (IRS notification failure in 6 months); and

• Rev-Proc 2004-48 (Late entity classification election).

The procedures in this Rev-Proc apply to late:

• S corporation elections;

• Electing Small Business Trust (ESBT) elections;

• Qualified Subchapter S Trust (QSST) elections;

• Qualified Subchapter S Subsidiary (QSub) elections; and

• Corporate classification elections.

Each late election must meet general requirements included in Section 4, and the specific

requirements to that election in Sections 5 through 7. The document includes a flow

chart for all late elections.

GENERAL PROCEDURES FOR RELIEF FROM LATE S ELECTION

1. The requesting entity may request relief for a late election under Subchapter S by

properly completing Form 2553, which includes reasonable cause. The top of the

form must state: “FILED PURSUANT TO REV-PROC 2013-30”;

2. The requesting entity files by:

a. Attaching Form 2553 to the corporation’s current year Form 1120S; or

b. Attaching Form 2553 to one of the S corporation’s late filed prior year

Forms 1120S.


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ATTACHING FORM 2553 TO CURRENT YEAR RETURN

The election can be attached to the current year, as long as the current year Form 1120S

is filed within 3 years and 75 days after the effective date. An extension of time to file

the current year Form 1120S will NOT extend the due date for relief under this Rev-Proc

beyond 3 years and 75 days following the effective date.

ATTACHING FORM 2553 TO A PRIOR YEAR RETURN

Form 2553 may be attached to the Form 1120S for the year including the effective date,

as long as the prior year Form 1120S for the year that includes the effective date is filed

within 3 years and 75 days after the effective date, and all other delinquent Forms 1120S

are filed simultaneously and consistently with the requested relief.

FORM 2553-PAGE FOUR: LATE ENTITY CLASSIFICATIONS

If a late entity classification election was intended to be effective on the same date that

the S corporation election was intended to be effective, relief for a late S corporation

election must include the representations that are listed on page four.


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REVOCATION/TERMINATION OF S ELECTION

An S corporation election can be terminated in 3 ways:

• By revocation of a majority of the shareholders;

• By ceasing to qualify as a small business corporation (advertent or inadvertent);

or

• If passive investment income exceeds 25% of gross receipts for 3 consecutive

years and there are C corporation earnings and profits (E&P).

A revocation or termination effective at any time other than the first day of a tax year

results in a short S corporation year and a short C corporation year. A post-termination

transition period (PTTP) is created.

An inadvertent termination (accidental) can be salvaged retroactively (prevents a C

corporation short period). This retroactive cure applies when:


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• The IRS determines that the termination was inadvertent in response to the

corporation’s written Request for a Determination of Inadvertent Termination

sent to: Internal Revenue Service, Associate Chief Counsel (Technical),

Attention: CC:PS, 1111 Constitution Ave., NW, Washington DC 20224;

• The corporation has taken steps to re-qualify within a reasonable period of time

after discovery of the event which resulted in the termination; and

• The corporation and all shareholders during the intervening period agree to any

adjustments required by the IRS.

S CORPORATION TAXATION: FORM 1120S

An S corporation is not generally subject to tax, but passes through items of income, loss, deduction and credit directly to shareholders. However, an S corporation may be taxed, if it didn’t always have an S election, but was previously a C corporation. The following are the taxes for C corporations that convert to S corporations.

1. The tax on built-in gains (IRC § 1374);

2. The tax on excess net passive income [IRC § 1375(a)];

3. The tax on recomputing a prior year’s investment credit (ITC Recapture) [IRC § 1371(d)]; and

4. LIFO recapture tax ([IRC § 1363(d)].

S CORPORATION FAILURE TO FILE PENALTY

The penalty for late S corporation returns under IRC § 6699(b)(1) increased a third time

with the passage of the Worker, Homeownership and Business Assistance Act on 11/6/09

(WHBAA 09). The penalty increased from $ 89 to $ 195 (per month per shareholder or

partner for a maximum of 12 months). The Mortgage Forgiveness Debt Relief Act of

2007 initially authorized this failure to file penalty for S corporations at $ 85 per

S shareholder per month for up to 12 months. The Worker, Retiree, and Employer

Recovery Act of 2008 (WRERA 08) increased that penalty to $ 89.


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STATE TAXATION

The state tax consequences for S corporations in most states are to follow federal law and

exempt them from entity-level taxes measured by income or net worth or capital value.

But there are exceptions.

California takes a hybrid approach, imposing a corporate-level tax on S corporations,

but at a lower rate than that imposed on C corporations. California also taxes the flow-

through income passed to shareholders.

S CORPORATION CODE SECTIONS

There are several sections of the IRC and corresponding regulations that govern taxation

and pass-through taxation from S Corporations to their shareholders:

IRC § 1363 S Corporation Taxation

IRC § 1366 Pass-Through to Shareholders

IRC § 1368 Taxation of Distributions (in general)

IRC § 1368(b) S Corporation Stock Basis Ordering Rules

IRC § 1368(b) S Corporations without Earnings and Profits

IRC § 1368(c) S Corporations with Earnings and Profits IRC § 1368(e)(3) Option to Distribute AE&P before AAA

IRC § 1371(c) S Corporation Adjustments of Earnings & Profits IRC § 1367(b)(2)(B) “Net Increase Rule” for Distributions/Reduced Loan Basis

Reg § 1.1367-1(f) Stock Basis Ordering Rules since 1996 Reg § 1.1367-1(g) Election to Change Stock Basis Ordering Rules

Reg § 1.1368-2(a)(5) AAA Ordering Rules IRC § 1368(e)(1)(C) Net Negative Adjustments Reg § 1.1361-1(1)(2) Disproportionate Distributions & 2nd Class of Stock


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TWO BASIC CATEGORIES

Because the shareholders of an S corporation, rather than the S corporation itself, are

taxed on the corporation’s income, and because some income and expense items are

subject to special rules, it is necessary to divide the income and expense of the

corporation into 2 categories:

1. Separately stated: and

2. Non-separately stated.

NON-SEPARATELY STATED INCOME: FORM 1120S-PAGE ONE

Non-separately stated income is computed on the first page of Form 1120S and is called

the ordinary income of the S corporation. Line 21 from the first page of Form 1120S is

the net of the non-separately stated income and non-separately stated expense of the S

corporation. It also transfers to Line 1 of Schedule K.

Line 22a is for the tax due on excess net passive income or the LIFO recapture tax. Line

22b receives the tax on built-in gains calculated on Schedule D. These taxes are added

together to yield a total on Line 22c.

Note: These 2 lines are only used by S corporations that used to be C corporations. An S

corporation that has always been an S corporation, will not pay a corporate tax.

Discussion of the taxes levied on S corporations that used to be C corporations will be

discussed later.

Lines 23-27 record taxes paid, owed, available for refund, or available for carryforward.


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SEPARATELY STATED ITEMS: FORM 1120S SCHEDULE K

Schedule K of Form 1120S will function as a transmittal for the shareholder K-1s. Each

numeric, lower case alpha line of Schedule K matches to Schedule K-1, numeric, upper

case lines. For instance, charitable contributions on Schedule K are reported on line 12a.

Charitable contributions on Schedule K-1 are reported on line 12A. There are still more

lines on Schedule K-1 than Schedule K to receive separately-stated items.

Categories of separately-stated items include:

• The corporation’s combined net amount of gains and losses from the sales or

exchanges of capital assets;

• The corporation’s combined net amount of gains and losses from the sales or

exchanges of property subject to the capital gain/ordinary loss rule (IRC § 1231),

grouped by holding period and applicable rate of tax;

• The corporation’s charitable contributions grouped by the percentage limitations;

• The corporation’s foreign taxes paid or accrued subject for calculation of the

foreign tax credit;

• The corporation’s items involved in determination of credits against tax, except

for the credit relating to certain uses of gasoline and special fuels;


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• The corporation’s items of gains and losses from wagering transactions, soil and

water conservation expenditures and the deduction under an election to expense

certain depreciable business expenses;

• The corporation’s items of portfolio income or loss, and related expenses;

• The corporation’s tax-exempt income and expenses (death benefits and interest on

state and local bonds); and

• The corporation’s items of adjustment and tax preference for AMT.

It is unfortunate that Schedule K is now too large for one 8 ½ x 11 page, but wraps onto

Page 4 of Form 1120S and finishes above the balance sheet.

TWO RETAINED EARNINGS ACCOUNTS

One important line on Schedule K, line 17c, does not appear on Schedule K-1 as 17C.

Line 17c on Schedule K recaps the S corporation’s dividend distributions from

undistributed accumulated C corporation earnings and profits (AE&P) from years the

S corporation was a C corporation. Dividends from AE&P are reported on

Form 1099-DIV, when the dividend is $ 600 or more to any one shareholder.

ACCUMULATED ADJUSTMENTS ACCOUNT (AAA)

Accumulated, undistributed earnings from S corporation years are retained in an account

called the Accumulated Adjustments Account (AAA). S corporations maintain an

Accumulated Adjustments Account (AAA) that tracks the amount of undistributed

income that has been taxed to the shareholders after 1982.

The AAA can be distributed to the shareholder free of tax up to the shareholder’s basis in

his stock. The AAA is a corporate level account and is not allocated to any specific

shareholder. If a shareholder sells his shares, the purchaser can receive tax-free

distributions of the AAA, even though the AAA arose before the stock purchase

occurred.


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The main purpose of the AAA is to track income that can be distributed tax-free to the

shareholders before a distribution is deemed a taxable distribution from Accumulated

Earnings and Profits (AE&P) from C corporation years. The AAA represents a

cumulative total of flow-through items generated by the S corporation which have been

taxed to the individual shareholders, and that remain undistributed by the S corporation

for taxable years after 1982.

The AAA loses most of its significance if the S corporation does not have any AE&P

from C corporation years. Unlike stock basis, the AAA can maintain a negative balance

as a result of loss and deduction flow-through [Reg § 1.1368-2(a)(3)(ii)].

The AAA is reduced by the entire amount of a loss or deduction, even though all or part

of the loss or deduction is not allowed to the shareholder due to basis, at-risk or passive

rules. An exception to this rule exists for federal income taxes attributable to a prior

C corporation period. Under IRC § 1368(e)(1)(A), the AAA is not reduced even though

the shareholder’s basis is reduced.

ACCUMULATED EARNINGS AND PROFITS (AE&P)

AE&P from C corporation years is frozen on the date the corporation converts to an

S corporation. Only a few items will cause an adjustment to the AE&P after the S

election:

The primary reason the AE&P would ever increase, is if the corporation acquires another

corporation with AE&P.

The following items would cause the AE&P of an S corporation to decrease:

1. Distributions of AE&P [IRC § 1371(c)(3)];

2. Payment of corporate-level tax due to general business credit recapture

[IRC § 1371(d)(3)];

3. Certain redemptions, reorganizations, liquidations, and corporate divisions

[IRC § 1371(c)(2)];

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4. Payment by the S corporation of tax that relates to the C corporation period

[IRC § 1371(c)(2)]; and

5. Payment by the S corporation of LIFO recapture [IRC § 1363(d)(5)].

TAX RETURN FORM DESIGN ISSUES

Unfortunately, the S corporation tax return does not have a place to reflect increases or

decreases to AE&P. The most common reasons for a decrease to AE&P during an

“S” year would be:

1. If distributions were deemed to be paid from the AE&P (more on distributions to

follow); or,

2. If the corporation were audited, and there was an increase in tax for a “C” year,

that was paid during an “S” year.

It is important that the tax preparer accurately maintain both accounts, i.e., AE&P and

AAA, if both accounts exist. Although there is only one line for Retained Earnings, Line

24 on Schedule L, and earnings from both C corporation periods and S corporation

periods (AAA) will combine into one total on Schedule L of the tax return, in reality,

these accounts are never “blended”, and separate accounts should be maintained in the

accounting records. Most professional software packages will show the detail of the

combined total in a statement that accompanies the tax return forms.

Practitioners should verify the presence of AE&P, when the date of the S election does

not coincide with the date of incorporation, as indicated on Form 1120S, Page 1.

FORM 1120S: SCHEDULE M-1

This schedule reconciles the accounting or book income with the income calculated at the

end of Schedule K, culminating in Line 18. Schedule K starts with the ordinary, non-

separately stated income from Form 1120S, Page 1, and then continues. There are 9




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other Schedule K lines of income (separately-stated), followed by certain separately-

stated expense items [line 11 through line 12d].

Schedule M-1 is divided into 2 parts to reconcile to Line 18 of Schedule K:

1. Income included on Schedule K, and not reported on books combined with

expenses recorded on books and not included on Schedule K; and

2. Income recorded on books, and not included on Schedule K, combined with

deductions included on Schedule K, but not charged against book income.

FORM 1120S: SCHEDULE M-2

This schedule analyzes the three possible accumulated earnings accounts of an

S corporation:

1. Accumulated Adjustments Account (AAA);

2. Other Adjustments Account (OAA); and

3. Previously-Taxed Income account (PTI).

Since the AAA has been previously discussed, the identity of the OAA and PTI should be

addressed.

OTHER ADJUSTMENTS ACCOUNT (OAA)

The OAA is used to track tax-exempt income and expenses related to tax-exempt income.

The OAA is increased by tax-exempt income and decreased by related expenses.

Examples of tax-exempt income include municipal bond interest and life insurance

proceeds. An example of expense related to tax-exempt income is interest borrowed on

money used to acquire municipal bonds. Items affecting OAA are included in stock basis

adjustments, but are not included in AAA adjustments.

It is unclear how the OAA came to be, but the theory is that the IRS was concerned that a

C corporation would convert to an S corporation, earn large amounts of tax-exempt


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income, and then distribute that tax-exempt income tax-free to shareholders prior to

distributing corporation AE&P. The fact that tax-exempt income and expense does not

affect AAA, functions to expedite distributions from AE&P, which is IRS’ preference.

Due to the requirement that AE&P must be distributed before tax-exempt income,

S corporations that have a lot of AE&P will probably find investments in vehicles that

distribute tax-exempt income as unattractive, as they would probably never make

distributions that are large enough to completely distribute all of the AE&P. In this

situation, the tax-exempt income increases the shareholder’s stock basis, but the

shareholders do not really benefit from it (by distribution) until they dispose of their

stock.

PREVIOUSLY-TAXED INCOME (PTI)

The previously taxed income (PTI) account of an S corporation reflects the corporation's

accumulated undistributed income for the corporation's pre-1983 years. An S corporation

can only have PTI if it was an S corporation for its last tax year before 1983.

PTI is similar in concept to the accumulated adjustments account (AAA). PTI can only

be distributed tax free to a shareholder if the corporation was an electing small business

corporation for the last year before enactment of the Subchapter S Revision Act of 1982.

The "last pre-enactment year" is defined as the last tax year of a corporation that begins

before January 1, 1983.

PTI is personal to a shareholder and cannot be transferred to another shareholder. If the S

corporation has accumulated earnings and profits, a distribution from PTI is important to

a shareholder because an S corporation shareholder who has PTI may receive a non-

taxable distribution from PTI. The distribution from PTI comes after a distribution from

AAA and before a dividend distribution from accumulated earnings and profits. The

distribution, in order to come from PTI, must be made in cash. The AAA and the


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accumulated earnings and profits of the corporation are not decreased by the portion of

the distribution treated as coming from PTI [Reg. §1.1368-1(d)(2)].

SHAREHOLDER STOCK BASIS

The amount of a shareholder’s stock and debt basis is very important for utilization of

K-1 flow-through items on Form 1040. Unlike a C corporation, each year the stock basis

of an S corporation goes up and/or down based upon the S corporation’s operations. The

S corporation Schedule K-1 provides all information needed for the increases and

decreases to a shareholder’s stock basis.

BASIS AFFECTS TREATMENT OF DISTRIBUTIONS

It is important to understand that the K-1 reflects the S corporation’s income, loss and

deductions which are allocated to the shareholder for the year. The K-1 does not state the

taxable amount of any distributions. The taxable amount of distribution is contingent on

the shareholder’s stock basis. It is not the corporation’s responsibility to track

shareholder’s stock basis or debt basis; rather it is the shareholder’s responsibility.

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.

BASIS AFFECTS TREATMENT OF LOSSES

If a shareholder is allocated an S corporation loss or deduction flow-through item, the

shareholder must first have adequate stock and/or debt basis to utilize that loss and/or

deduction. In addition, it is equally important to remember, that even when the

shareholder has adequate stock and debt basis to deduct the K-1 flow-through loss or

deduction, the shareholder must also consider at-risk limitations and passive limitations

and therefore may not be able to deduct the loss or deduction as a result of these

additional restrictions.


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COMPUTING STOCK BASIS

In computing stock basis, and unless the S corporation shares of stock were inherited or

received by gift, the shareholder starts with the initial capital contribution to the S

corporation or the initial cost of the stock purchased (same as C corporation). That

amount is then increased and/or decreased based on the flow-through amounts from the

S corporation K-1. An income item will increase stock basis, while a loss, deduction or

distribution will decrease stock basis. Basis is determined at the end of the year, except in

the year of disposition.

The order is which stock basis is increased or decreased is important. Since both the

taxability of a distribution and the deductibility of a loss are dependent on stock basis,

there is an ordering rule in computing stock basis.

In fact, basis in S corporation stock is important for 3 reasons:

1. Stock basis is the first level of shareholder loss limitation;

2. Stock basis determines the gain or loss upon disposition of the stock; and

3. Basis governs the amount of distribution that can be received from an S

corporation free of tax.

Beginning in 1997, stock basis is adjusted annually, as of the last day of the S

corporation year, in the following order:

• Increased for income items and excess depletion;

• Decreased for distributions;

• Decreased for non-deductible, non-capital expenses and depletion; and

• Decreased for items of loss and deduction.


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EXAMPLE—SUFFICIENT STOCK BASIS

Non-deductible meals and entertainment of $ 1,750 plus life insurance premiums of

$ 2,250 total to amount reported on K-1 in Box 16C of $ 3,950.

Stock Basis Loan Basis Balances 1/1/X1 $ 29,000 $ 45,000 Increases: Non-separately stated income 50,000 Tax-exempt interest income 7,000 Interest income 6,000 Balances before distribution 92,000 45,000 Distributions ( 55,000) Subtotal 37,000 45,000 Decreases other than Distributions:

Non-deductible meals ( 1,750) Life Insurance premiums ( 2,200) Investment interest expense ( 3,300) Charitable contributions ( 2,000) Section 179 deduction ( 750) Balances@ 12/31/X1 $ 27,000 $ 45,000


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PRO-RATA ALLOCATION OF LOSS AND DEDUCTION ITEMS

When stock and debt basis is insufficient and there is more than one type of K-1

flow-through item that reduces basis, the amount allowed as a flow through loss or

deduction is allocated on a pro-rata basis per Treas. Reg. §1.1366-2(a)(4). IRC

§1366(d)(2) holds that any loss suspended because of lack of stock and debt basis shall

be treated as incurred by the corporation in the succeeding taxable year with respect to

that shareholder.

EXAMPLE--LOSSES/DEDUCTIONS LIMITED BY BASIS

Test Client is the sole shareholder of an S corporation, which has always been an

S corporation. Test Client has $ 15,000 of stock basis at the beginning of the year. The

K-1 for the current year reflects a large ordinary loss of ($ 20,000), an IRC § 1231 gain of

$ 4,000, non-deductible meals of $ 1,000, charitable contributions of $ 5,000 and a

distribution of $ 12,000. The following allocation worksheets reflect what is deductible

in the current year, and what will carryforward to the following year.


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In subsequent years, suspended losses should not be combined with current income, but

listed on a separate line on Schedule E, page 2, when they again allowed due to sufficient

basis.

SHAREHOLDER DEBT BASIS

Loans between the shareholder and the corporation increase basis for purposes of

allowing loss deductions.

DEBT BASIS REDUCTIONS AND RESTORATIONS

Once a shareholder’s basis in S corporation stock has been reduced to zero, pass-through

losses and deductions are still available for deduction to the extent the shareholder has

debt basis. In the following year, debt basis is generally restored first, before stock basis

is adjusted for current year income.

TAXATION OF LOAN PAYMENTS

When the basis in a shareholder's loan has been used to support a loss deduction,

repayment of the loan is a taxable event to the extent full repayment exceeds the

shareholder's basis in the debt, or to the extent partial repayments exceed a pro-rata

portion of the basis in the debt. This income is capital gain if the debt was evidenced by

a written note or ordinary income if there is no written note, as would be the case with an

open account receivable. The equation to calculate taxable loan payments (due to lack of

basis---basis was used to facilitate the deduction of losses) is computed as follows:

Face Amt of Debt-Adjusted Basis X Loan Repayment = Gain on Repayment Face Amt of Debt


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REPORTING LOAN REPAYMENTS

The proper taxation of loan repayments to an S corporation shareholder is managed by

the Form 1040 practitioner. The S corporation practitioner reports the total of all loan

repayments to all shareholders during the year on Schedule K, Line 16e of Form 1120S.

Additionally, the amount reported on Schedule K, Line 16e as an aggregate total,

transfers to the individual Schedule K-1s for each shareholder as item 16E. The total of

all Schedule K-1, Lines 16E should match to the Schedule K, Line 16e.

It is always helpful if the S corporation practitioner includes stock basis and loan basis

calculation for the Form 1040 preparer, if possible. This assists the Form 1040 preparer

if the Form 1120S preparer is able to track basis, and believes that loan repayments may

be taxable.

Reminder: Schedule K-1 reports pro-rata amounts of all items of income, loss,

deduction, credit, distribution, and loan repayments. Schedule K-1 does not

communicate if any of the amounts reported result in a taxable distribution, a suspended

loss, or a taxable loan repayment on Form 1040.

THE “NET INCREASE” SPECIAL RULE

When debt basis has been previously reduced because of losses occurring in years after

1982, S corporation net income will increase the debt basis, up to the debt's face value,

before it increases stock basis. This is referred to as debt basis restoral.

There is a special rule under IRC § 1367(b)(2)(B), that allows current year income to be

distributed tax-free to the shareholders, assuming no C corporation E&P. Debt basis is

restored with only the “net increase” in basis. “Net increase” is defined as the amount by

which amounts that increase stock basis exceed the items that decrease stock basis. Debt

basis reductions that occurred before 1983 cannot be restored.


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In the first Example that follows, the loan basis is fully restored in the profit year that

follows the loss year. In the second Example, the loan basis is restored by the “net

increase” ($ 6,000) calculated as the net of the items increasing stock basis ($ 9,000

profit) reduced by the item decreasing stock basis ($ 3,000 distribution).

EXAMPLE--NORMAL LOAN BASIS RESTORAL

Test Client is the sole shareholder of Test Corporation, an S corporation. His stock basis

at the beginning of Year 1 was $ 5,000. His basis in loans is $ 15,000. In Year 1, the

business generates a $ 12,000 loss, and in Year 2, the business generates a $ 9,000 profit.

EXAMPLE--WITH “NET INCREASE SPECIAL RULE

If Test Client had received a $ 3,000 distribution in Year 2, his debt basis would be

increased by the amount of the “net increase” [$ 9,000 income less $ 3,000 distribution or

$ 6,000] that would allow current year earnings to be distributed tax-free. Without the

netting procedure, $ 1,000 of the $ 3,000 distribution would be taxable. The revised basis

calculations are:

Stock Basis Loan Basis Basis at 1/1/X1 $ 5,000 $ 15,000 Year 1 ordinary loss of $ 12,000 (5,000) (7,000) Basis at 12/31/X1 -0- 8,000 Year 2 ordinary income of $ 9,000 3,000 6,000 Basis after “net increase” 3,000 14,000 Year 2 Distribution (3,000) N/A Basis at 12/31/X2 -0- 14,000

Stock Basis Loan Basis Basis at 1/1/X1 $ 5,000 $ 15,000 Year 1 ordinary loss of $ 12,000 (5,000) (7,000) Basis at 12/31/X1 -0- 8,000 Year 2 ordinary income of $ 9,000 2,000 7,000 Basis at 12/31/X2 2,000 15,000


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MISCELLANEOUS INFORMATION ON LOANS

MULTIPLE LOANS

If there is more than one loan made by the shareholder to the corporation, any allocated

loss is prorated to the loans based on the ratio that each individual loan bears to the

aggregate bases of the loans [Reg. §1.1367-2(b)(3)].


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GAIN ON LOAN REPAYMENT AND INVESTMENT INCOME

The repayment of a formal note (exclusive of interest) is considered to be an amount

received in exchange for a capital asset (Rev-Rul. 64-162). Gain on loan repayment of a

formal note is considered investment income.

Gain on loan repayments of an open account loan, is not investment income, because an

open account loan is not a capital asset (Rev-Rul. 68-537).

THIRD-PARTY DEBT AND LOAN GUARANTEES

Corporate debt does not give a shareholder basis. The courts have found that the mere

guarantee itself does not create indebtedness for the shareholder. For a debt guaranteed

by a shareholder to be used as part of the shareholder's debt basis, some other action must

be taken, such as personal payment of the debt in cash or transfer of the guaranteed

collateral to the lender.

A shareholder does receive basis if the shareholder borrows money from an unrelated

party, such as a bank, which is secured by personal assets (recourse) and then makes a

separate loan to the S corporation [Gilday v. Comm., 43 TCM 1295 (1982)]. In this

instance, shareholder loan basis is generated.

USE OF PERSONAL CREDIT CARDS

Shareholders will often use a personal line of credit or a credit card to pay for corporate

expenses. In this situation, the shareholder is treated as if he personally borrowed money

from the credit card company (bank) and then loaned that money to the S corporation.

The shareholder is allowed debt basis and the S corporation is allowed a deduction for the

item purchased.

If the S corporation pays for the shareholder’s personal charges on the credit card,

payments for personal charges are treated as a distribution to the shareholder.


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Note: When shareholder personal credit cards are used, a shareholder loan balance rather

than the credit card balance is maintained on the corporation’s balance sheet.

If the shareholder is using his line of credit or personal credit card to pay corporate

expenses along with personal expenses, a month by month analysis needs to be made to

determine the business expenses incurred along with who made payments on the credit

card bill, i.e., the shareholder, the S corporation or both. If the S corporation is properly

recording the charges made on the shareholder’s personal credit card, the net amount still

owing for the payment of corporate expenses should be recorded on Line 19 of the

Balance Sheet, Loan from Shareholder.

USE OF CREDIT CARDS-CREDIT CARD IN CORPORATION’S NAME

If the S corporation actually has a line of credit or credit card in its own name,

shareholder basis is not increased when the S corporation uses that credit card. If the

shareholder personally paid the corporate line of credit or credit card, which would be

very rare, he would be allowed stock or debt basis for the amount of the payment.

In some situations the line of credit or credit card has the company name and the

shareholder/employee’s name on it. Typically, in that situation, this is a corporate debt

and the shareholder is not allowed debt basis.

CONVERSION OF SHAREHOLDER DEBT TO EQUITY

There is no requirement that a corporation issue additional stock to a shareholder in

exchange for shareholder debt forgiven. The shareholder can "contribute" the debt to the

corporation. In these instances, the corporation is treated as satisfying the debt with an

amount of money equal to the shareholder's adjusted basis in the debt.

Technically, the corporation has COD income if the shareholder has reduced basis debt.

However, a special rule for S corporations applies in this situation, to remedy the creation

of COD income. Under IRC §108(d)(7)(C), a shareholder's debt basis does not take into


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account any reduction in basis caused by loss flow-through items under IRC §1367(b)(2).

Therefore, if a shareholder "contributes" the debt to capital, the corporation is deemed to

have satisfied the debt for an amount equal to the basis without considering any loss

flow-through items from the S corporation. This results in no gain to the S corporation.

The shareholder will not have any income since there has not been a repayment of a

reduced basis loan.

The shareholder's stock basis is only increased by the amount of the debt basis

contributed to the S corporation, not by the face amount of the debt.

If the shareholder assumes corporation credit card debt at liquidation, the shareholder will

be allowed debt basis for the assumed liabilities. Unpaid basis in debt is treated as a

contribution to capital. Later payments of the credit card debt do not yield any further

deductions.

EXAMPLE-SHAREHOLDER DEBT CONVERTED TO EQUITY

The face amount of debt owed to Sole Shareholder is $100,000. Sole Shareholder’s

adjusted basis in the debt is $40,000. Sole Shareholder decides to convert the debt to

equity and contributes the loan to the corporation’s capital. Sole Shareholder is allowed a

stock basis increase of $40,000 even though the balance sheet will reflect a $100,000

decrease in Loan from Shareholder and a $100,000 increase to either Capital Stock or

Additional Paid-in Capital.

UNPAID SHAREHOLDER LOANS AT LIQUIDATION

If a debt being cancelled is a loan from shareholder to the corporation, Reg §1.61-12

states “… In general, if a shareholder in a corporation which is indebted to him

gratuitously forgives the debt, the transaction amounts to a contribution to the capital of

the corporation to the extent of the principal of the debt.”


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Therefore if the shareholder receives nothing, it is treated as a contribution to capital. If

the shareholder has reduced basis in the debt, the shareholder now has reduced basis in

the contribution to capital.

TAX STRATEGIES TO AVOID A TAXABLE LOAN REPAYMENT

• Time capital gains from taxable loan repayments to correspond to the recognition

of capital losses on the Form 1040 return; and

• If the shareholder has a potential investment interest deduction, an election is

available to treat capital gains as investment income to maximize investment

interest expense deductions.

IRS ISSUES FINAL DEBT BASIS REGULATIONS

IRS issued final regulations (T.D. 9682) on determining an S corporation shareholder’s

debt basis, which are effective July 23, 2014. The final regulations apply the same rules

that were in Prop Reg § 1.1366-2, which allow shareholders to increase their basis for

any bona fide indebtedness the S corporation owes to them. Additionally, the final

regulations retain the same rules that shareholders can increase debt basis for guarantees

only to the extent they actually perform under the guarantee.

DEBT BASIS RECAP

Unlike a member in an LLC, the shareholder in an S corporation does not receive stock

or loan basis for personal guarantee of 3rd party debt. This is one of the major differences

between the LLC and the S corporation.

If a new business is to be substantially capitalized by 3rd party debt, which will be

personally guaranteed, so as to create “at-risk” basis for the owner, and the new business

will be generating losses, sometimes an LLC is the better entity choice.


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AAA: ANNUAL ADJUSTMENTS AND DISTRIBUTIONS

The ordering rules for the AAA are not the same as the ordering rules for stock basis.

When the S corporation has always been an S corporation, this difference is of no effect.

Additionally, if the S corporation had previously been a C corporation, but all C

corporation income has been distributed, and the AE&P account is zero, this difference

will have no effect, either.

The only instance where the difference in annual adjustment order for stock basis versus

AAA will matter is when the S corporation has both undistributed C corporation

earnings. In other words, the AE&P account has a balance other than zero.

STOCK BASIS ORDERING RULES

Under the stock basis ordering rules since 1996 (Reg § 1.1367), distributions reduce basis

directly after the adjustment for current period income items and before the adjustment

for current period losses and deductions. This results in more tax-free distributions and

more deferred S corporation losses due to a lack of basis.

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 deduction.

AAA ORDERING RULES

The AAA ordering rules are governed by Reg § 1.1368-2(a)(5). The AAA will be

adjusted by the same items that adjust stock basis, but in a different order. The AAA

adjustments each year mimic the order of the line items on Schedule M-2:


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1. Increased for income items and excess depletion;

2. Decreased for non-deductible, non-capital expenses and depletion;

3. Decreased for items of loss and deduction; and

4. Decreased for distributions.

DISTRIBUTIONS

When the S corporation has only undistributed S corporation earnings, the tax

consequences of a distribution are simplified. When the corporation has combinations of

undistributed C corporation earnings and S corporation earnings, it is a little more

involved.

DISTRIBUTIONS FROM S CORPORATIONS WITHOUT AE&P

The treatment of an S corporation shareholder’s distributions, where the S corporation

does not have any AE&P, is determined under a two-tier system:

1. As a nontaxable return of capital to the extent of the adjusted basis of stock;

2. Capital gain from disposition of stock for amounts in excess of stock basis.

DISTRIBUTIONS REDUCE STOCK BASIS ONLY

A shareholder should maintain separate stock basis and debt basis; they should not be

combined. Only stock basis is reduced by distributions. Distributions do not affect debt

basis. These non-dividend distributions only look to stock basis. It is very possible for a

shareholder to have a large debt basis and still receive a taxable dividend distribution

and/or a taxable non-dividend distribution. Debt basis has specific rules depending on

whether formal notes or open account debt exists.


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DISTRIBUTIONS FROM S CORPORATIONS WITH AE&P

Under IRC § 1368(c), § 1379(c) and the Form 1120S instructions, a distribution made by

an S corporation with AE&P is made using a six-tiered system. The distribution is

determined to have been made from the following items in the following order:

1. From the AAA account (tax-free, but still limited to stock basis);

2. From Previously Tax Income (PTI) [also tax-free—IRC § 1379(c)];

3. From Accumulated Earnings and Profits (C corporation dividend);

4. From the Other Adjustments Account (OAA—also tax-free);

5. As Return of Capital (tax-free); and

6. As Deemed Sale of Stock with No Basis (capital gains).

EXAMPLE--DISTRIBUTION WHEN AE&P IS PRESENT

Cord, an S corporation, has AE&P of $ 10,000. It distributes $ 80,000 to its only shareholder, Don. Don's basis in his stock is $ 50,000. The AAA before distribution is $ 30,000. What is the order of the distributions and how are they treated by Don for tax purposes?

Distribution $ 80,000 Source Type Taxable

($ 30,000) AAA Basis Reduction No

($ 10,000) AE&P C Corp Dividend Yes

($ 20,000) Return of capital Basis Reduction No

($ 20,000) In excess of basis Capital Gain Yes

-0-


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SHAREHOLDER ELECTION TO REVERSE ORDERING RULES

Reg § 1.1367-1(g) allows the shareholder to make this election on his/her individual

return.

EXAMPLE-Normal Ordering

Test Client is the sole-shareholder of Test Corporation, and he has a $ 15,000 stock basis

at the beginning of the year. The following are the current year stock basis adjustment

items from Schedule K-1:

• IRC § 1231 gain of $ 4,000

• Distribution to Test Client of $ 17,000

• Non-deductible meals & entertainment of $ 2,500

• Ordinary loss of $ 20,000

Using the current ordering rules, Test Client’s stock basis adjustments are:

1/1 Stock Basis balance forward $ 15,000

Current Year Income 4,000

Subtotal before distributions 19,000

Current Year Distribution ( 17,000) Tax Free

Subtotal before non-deductibles 2,000

Non-deductible expense (2,500)

Stock basis at 12/31 -0-

Suspended non-deductible expense -0- $ 500 is forgotten

Suspended loss carry forward (20,000)


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Under normal ordering rules, nondeductible, non-capitalizable expenses do not carry over

to future years if basis is reduced to zero in the current year.

An election is available on the shareholder’s return to reduce basis by loss or deduction

items before nondeductible expenses as provided in Reg. 1.1367-1(g). When the

election is made excess nondeductible items carry over to succeeding years. This

election is most commonly made when an S corporation is about to liquidate and any

unused non-deductible items that would normally carryover have no effect. The election

can also be made on an amended return. The regulation does not state that the election

applies only for regular tax calculations. Therefore, the election would appear to apply

for at-risk, and AMT computation purposes also.

EXAMPLE -with Reg § 1.1367-1(g) Election

1/1 Stock Basis balance forward $ 15,000 Current Year Income 4,000

Subtotal before distributions 19,000

Current Year Distribution ( 17,000) Tax Free

Subtotal before non-deductibles 2,000

Loss limited to basis (2,000) $ 18,000 carryover

Stock basis at 12/31 -0-

Suspended non-deductible expense 2,500

Suspended loss carry forward (18,000)

Practice Tip: Take care to recognize a “check” in the K-1 “Final” box.


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Note: As can be viewed, the $ 2000 in basis is adjusted first for the deductible, ordinary

loss before the nondeductible meals and entertainment. As required with the election, the

nondeductible meals and entertainment will carry forward to the next year. If the election

is made on a return where the K-1 is marked “Final”, the carryforward will have no

effect.

SPECIFIC ACCOUNTING ELECTION

An S Corporation does not terminate because a shareholder’s entire interest in his stock is

disposed of. In these circumstances, the corporation can elect to allocate pass-through

items based on the actual transactions that occurred before and after the stock disposition

took place. This election is referred to as “the specific accounting election” or “the

election to treat the tax year as if it consisted of two tax years.”

The election affects allocation of pass-through only. The S election does not actually

terminate; only one tax return (and one Schedule K-1 per shareholder) is filed for the

entire year. The treatment on one tax return is as if the corporation had two separate tax

years.

If the election is made, the first short tax year is considered to end on the last day the

shareholder owned the shares. The corporation determines its income or loss through that

day using normal tax accounting rules, and the allocation to shareholders is based on the

actual transactions that occurred during the period.

Absent the election, the pass-through to shareholders is a per-share, per-day allocation of

the S corporation’s annual pass-through amount. IRC § 1368 also allows the corporation

to make a similar election if a “disqualifying disposition” of stock occurs.


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A “disqualifying disposition” occurs when:

• Any shareholder disposes of 20% or more of the issued stock of the corporation in

one or more transactions during any 30-day period within the corporation’s tax

year;

• 20% or more of the corporation’s outstanding stock is redeemed from a

shareholder in one or more transactions within any 30-day period during the tax

year; and

• Stock equal to or greater than 25% of the previously outstanding stock is issued to

one or more new shareholders within any 30-day period during the corporation’s

tax year.

The corporation can elect to use the specific accounting method if all the shareholders

affected by the stock disposition consent (rather than all shareholders). The shareholders

affected by the disposition include all shareholders who disposed of shares and all

shareholders acquiring shares during the tax year.

The S corporation attaches a statement to its tax return to makes the election for the year

in which the shareholder’s entire interest terminates. How the election affects each

shareholder determines whether the election makes sense or not. In the example that

follows, the departing shareholder has only a loss to report for the year. This loss would

be a decreasing adjustment to his stock basis for the year, which would cause more of his

proceeds from the sale of the stock to be eligible for long-term capital gain treatment.


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EXAMPLE -Without Election

John, Jeff, Harry and Frank form an S Corporation and each participate 25% in the

income and loss of the corporation. Frank sells his stock to Henry on July 1st. The

corporation’s ordinary income for the year is $ 80,000. Due to a recession, the period

January-June was a loss to the company of $20,000 and the period July-December was a

profit of $ 100,000. Absent any special election, the daily income allocation is $ 219.18

($ 80,000 ÷ 365= 219.18). Each 25% shareholder’s allocation is:

365 days x 219.18 x 25% = $ 20,000 of allocation.

Frank is a 25% shareholder for 181 days, and Henry is a 25% shareholder for 184 days.

Frank’s allocation is 181 days x 219.18 x 25% = $ 9,918

Henry’s allocation is 184 days x 219.18 x 25% = $ 10,082

TOTAL $ 20,000

EXAMPLE-With Election

Using the same facts as above, since the shareholders prefer that Henry not participate in

the corporation’s losses before he became a shareholder, the corporation will make the

“specific accounting election”. There is a per day amount of the loss for January to June

of $ 110.49. The per-day amount of the profit from July to December is $ 543.48. The

revised shareholder allocations are:

[(181 days x $ 110.49 x 25%) + (184 days x $ 543.48 x 25%)] = $ 20,000

Frank’s allocation would be: 181 days x $ 110.49 x 25% = ($ 5,000)

Henry’s allocation would be 184 days x $ 543.48 x 25% = $ 25,000

With the election, Frank participates in the loss period when he was a 25% shareholder,

and Henry participates in the profit period when he was a 25% shareholder. There is no

change to the amounts reported to full-year participant shareholders.


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Practice Tip: To insure against shareholders subsequent refusals to consent to the

election, shareholders should execute agreements to the election at the time of sale.

Making such an agreement ensures that the departing shareholder has no involvement in

income or deductions after the date of the stock disposition. If such an agreement is not

made, disputes between the affected shareholders can arise later because it is not possible

to know at the date the sale takes place what the year-end amounts will be if the per-

share, per-day method is used. The agreement between the affected shareholders that

specific accounting will be used, made as part of the stock sales transaction, can remove

the potential for these disputes.


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COMPENSATION AND BENEFITS

COMPENSATION IN THE C CORPORATION

In the C corporation, due to the issue with double taxation, most compensation in the

small business arena is paid in salaries, pension contributions and benefits. The biggest

issue with the C corporation is that salaries would be excessive. There have been court

cases where bonuses were challenged by the IRS, because the increase in profits was

based on the efforts of rank-and-file employees, and not through the efforts of aging

shareholders.

COMPENSATION IN THE S CORPORATION

Payment of the FICA wage base amount should avoid an audit, but sometimes this

number is not a practical amount to pay S corporation shareholders whose businesses

produce smaller net incomes. In these instances, the practitioner should be especially

diligent to insure that sufficient salary is paid in the presence of distributions.

An officer of a corporation cannot be an independent contractor to the corporation, since

IRC § 3121 provides that a corporate officer is an employee of the corporation [IRC

§3121(d)]. The common law standard is not applicable. In practical terms, this means

that a shareholder in an S corporation should never be a recipient of a Form 1099-MISC

for services provided to the S corporation.

Over the last few years, lack of appropriate compensation in the form of a reasonable

salary has been a point of audit contact by the IRS as it is viewed as a form of taxpayer

abuse. The active S corporation shareholder operates in two capacities for the

corporation. The first capacity is as a worker/employee, where the shareholder is

compensated through the reasonable salary reported on Form W-2. The second capacity

is as an investor, where realized return on capital is compensated through tax-free


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distributions of K-1 profits. Currently, K-1 profits are not subject to self-employment

tax.

The instructions to Form 1120S state: “Distributions and other payments by an S

corporation to a corporate officer must be treated as wages to the extent the amounts are

reasonable compensation for services rendered to the corporation.”

The key to establishing reasonable compensation is determined by what the shareholder

did for the S corporation. The IRS looks to the corporation’s gross receipts. There are

three major sources:

1. Services of the shareholder;

2. Services of non-shareholder employees; or

3. Capital and equipment.

If the gross receipts and profits come from the services of non-shareholder employees or

capital and equipment, then they are not associated with the shareholder-employee’s

personal services and it is reasonable that the shareholder would receive distributions

along with wage compensation.

Short answer from IRS: IRS has always responded that paying at least the social

security wage base was a reasonable salary.

S CORPORATION DISTRIBUTIONS TO PRESIDENT WERE WAGES

Glass Blocks Unlimited (GBU), an S corporation, had no other employees except its sole

owner, Mr. Blodgett. Both Mr. Blodgett and his fiancé transferred funds to GBU to cover

operating expenses during a financial downturn. GBU did not report paying any salary or

wages to Mr. Blodgett. GBU did distribute $ 30,844 in 2007 and $ 31,644 in 2008. GBU

reported these amounts as loan repayments. Although a portion of the transfers were

reported as loans on GBU’s Forms 1120S, the Tax Court found that the transfers were

capital contributions, since there were no written agreements or promissory notes. The


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Tax Court recharacterized all distributions as wages, since the amounts received were

reasonable (TC Memo 2013-180).

FRINGE BENEFITS FOR 2% OR MORE SHAREHOLDERS

Since 1983 (Subchapter Revision Act of 1982), IRC § 1372 requires 2% or more

S corporation shareholders to be treated similar to partners in a partnership with respect

to fringe benefits.

NONTAXABLE FRINGE BENEFITS

2% or more shareholders in an S corporation are eligible to receive the following

nontaxable fringe benefits:

1. Educational assistance under IRC § 127;

2. Dependent-care assistance under IRC § 129; and

3. Qualified employee discounts, no-additional-cost services, working condition

fringes, on premises athletic facilities, de minimis fringes, and retirement planning

services under iRC § 132.

The S corporation’s deduction for nontaxable fringe benefits paid on behalf of its

employees, including the 2% shareholders, is reported on Page 1, Line 18 of Form 1120S

“Employee Benefit Programs”. No additional reporting to shareholders is required on

Schedules K-1.

TAXABLE FRINGE BENEFITS

For the following fringe benefits, the S corporation does not receive a fringe benefit

deduction, but deducts the amounts paid for the 2% shareholders as compensation of

officers. The 2% shareholders can deduct the amounts on their own returns, if they are

deductible and to the extent allowable, as if they incurred the expenses themselves,

including:


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1. Cost of up to $ 50,000 of group-term life insurance (non-deductible on Form

1040);

2. Amounts paid for or to an accident and health plan under IRC § § 105 and 106

(see explanation earlier regarding transitional relief for S corporations from

market reform revisions through December 31, 2015) (currently deductible as

self-employed health insurance on Form 1040);

3. Meals and lodging furnished for the convenience of the employer under

IRC § 119 (probably not deductible on Form 1040).

Evidently, the following fringe benefits are also considered taxable fringe benefits:

1. Employee achievement awards under IRC § 74(c);

2. Cafeteria plans under IRC § 125;

3. Qualified transportation fringe benefits under IRC § 132(f)(5)(E);

4. Qualified moving expense reimbursements under IRC § 132(g); and

5. Adoption assistance programs under IRC § 137.

HEALTH SAVINGS ACCOUNTS (HSA)

S corporation contributions to an employee’s HSA, where the employee owns 2% or

more of the S corporation’s stock, are considered a taxable fringe benefit. These amounts

are reported as compensation on the shareholder’s W-2, but IRS has ruled that the

additional wages attributable to these amounts are not subject to Social Security,

Medicare or FUTA, if the payments are made pursuant to a plan providing accident and

health coverage.

The 2% shareholder can deduct the HSA contributions on Form 1040 if he or she

qualifies and would otherwise be able to deduct the HSA contributions.


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MEDICAL INSURANCE PREMIUMS

Health and accident insurance premiums paid on behalf of a greater than 2%

S corporation shareholder-employee are deductible by the S corporation and reportable as

wages on the shareholder-employee’s Form W-2, subject to income tax withholding, but

are not subject to Social Security, Medicare or Federal Unemployment Taxes (FUTA), if

the payments of premiums are made to or on behalf of an employee under a plan or

system that make4s provision for all or a class of employees (or employees and their

dependents). A such, the premiums which are treated as additional compensation are

included in the shareholder-employee’s Form W-2, Box 1 (Wages), but not in Box 3

(Social Security wages) or Box 5 (Medicare wages). The employee-shareholder is

eligible for an above-the-line deduction from AGI if the medical coverage was

established by the S corporation and the shareholder met the other self-employed medical

insurance deduction requirements. If the shareholder or the shareholder’s spouse was

eligible to participate in any subsidized health care plan, then the shareholder is not

entitled to the above-the-line deduction [IRC § 162 (l)].

HEALTH INSURANCE PURCHASED IN SHAREHOLDER NAME

The insurance laws in some states do not allow a corporation to purchase group health

insurance when the corporation only has one employee. If the shareholder is the sole

employee of the corporation, the shareholder will be required to purchase health

insurance in his/her own name.

In IRS Notice 2008-1, IRS provided guidance regarding health insurance for

S corporation shareholders. If the shareholder purchased the health insurance in his own

name and paid for the insurance with personal funds, the shareholder is NOT allowed an

above-the-line deduction for the premiums. But, if the shareholder purchased the health

insurance in his/her own name, and the S corporation either directly paid the premiums or

reimbursed the shareholder for the health insurance premiums, and also included the


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premium payment in the shareholder’s W-2, the shareholder would be allowed the

above-the-line deduction.

ACA IMPACT

The Affordable Care Act (ACA) did not change the above rules regarding the federal tax

treatment of health and accident premiums paid for 2% shareholders. But, for tax years

after 2013, the ACA imposes penalties on the S corporation if the S corporation offers a

health plan that fails to comply with certain market reform provisions, which may include

plans under which the S corporation reimburses employees for the cost of individual

health insurance premiums. The potential excise tax is $ 100 per day, per employee, per

violation (IRC § 4980D). The tax is reported and paid on Form 8928.

Among the ACA market reform provisions is a requirement that a group health plan must

not impose annual limits on essential health benefits. In IRS Notice 2013-54, the IRS

indicated that a health plan under which an employer reimburses employees for the cost

of individual health insurance premiums (referred to as an “employer payment plan”) will

general be treated as failing this requirement because the employer payment plan is

treated as imposing a limit up to the cost of the individual policy premium.

IRC § 9831(a)(2) provides for an exemption from the market reform provisions for plans

that cover fewer than two participants who are active employees (the one-employee

exemption).

The excise tax for failure to satisfy the ACA market reforms generally will not be

imposed on an S corporation in the following two situations:

1. The S corporation provides medical benefits under a health plan that satisfies the

ACA market reform requirements (for example a group health plan that does not

provide for reimbursement of individual policy premiums); or


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2. No more than one active employee participates in the employer payment plan

under which the S corporation reimburses the cost of individual policy premiums

(the one-employee exemption).

IRS NOTICE 2015-17 TRANSITION RELIEF

On February 18, 2015, IRS issued Notice 2015-17 which provides transition relief for S

corporations that sponsor employer payment plans covering 2% shareholders.

The notice provides that, unless and until additional guidance provides otherwise, S

corporations and shareholders may continue to rely on IRS Notice 2008-1 with regard to

the tax treatment of 2% shareholder-employees and their healthcare arrangements for all

federal income and employment tax purposes. The Department of Labor (DOL) and the

IRS are contemplating publication of additional guidance on the application of market

reforms to 2% shareholder-employee healthcare arrangements.

Until such guidance is issued, the excise tax under IRC § 498D will not be asserted for

any failure to satisfy the market reforms by a 2% shareholder-employee healthcare

arrangement.

Further, unless and until additional guidance provides otherwise, an S corporation with a

2% shareholder-employee healthcare arrangement will not be required to file IRS Form

8928 (regarding failures to satisfy requirements for group health plans including market

reforms) solely as a result of having a 2% shareholder-employee healthcare arrangement.


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COMPREHENSIVE EXAMPLE

YEAR 1 HISTORY:

• Corporation formed on 1/1/20X1 • Corporation makes an S election effective 1/1/20X1 • Year 1 Loss: $ 5,000 • Year 1 contribution for stock: $ 1,000 and fully depreciated equipment • Year 1 shareholder loan: $ 15,000


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THREE LEVELS OF LOSS LIMITATION

Once the S shareholder clears the basis hurdle, two additional obstacles must be

overcome before loss deductibility is assured:

1. The At-Risk Limitations of IRC § 465; and

2. Passive Activity Loss Limitations of IRC § 469.

There are actually three levels of loss limitation in an activity, and only the first limitation

of basis has been explored so far. Losses are deductible on the tax return of a participant

when the loss does not exceed the threshold of each limitation in the following order:

1. Basis Limitation;

2. At-Risk Limitation; and

3. Passive Activity Loss Limitation.

AT RISK LIMITATION

The at risk rules under IRC § 465(a)(1), apply only to individuals and closely held

corporations, meaning the limits are imposed at the shareholder level in the case of an S

corporation. In many cases, the at-risk amount equals basis, and the at-risk limitations

pose no problem. The shareholder is at risk for money and the adjusted basis of property

contributed to the S corporation.

These are the 2 most common situations where a shareholder will not be considered at

risk:

• For amounts contributed for stock or loan basis that have been borrowed from a

person having an interest in the activity, other than as a creditor; and

• For amounts contributed for stock or loan basis that have been obtained from non-

recourse financing.


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The shareholder is treated at risk for “qualified non-recourse debt” (debt secured by real

property). Unlike basis adjustments, the at-risk rules scrutinize the source of the funds

that the S corporation shareholder contributed or loaned to the corporation.

As with basis limitations, losses limited by the at-risk rules are carried over until at-risk

amounts are generated in subsequent years. Losses (and credits) limited by the passive

activity loss rules also carry over indefinitely at the shareholder level.

EXAMPLE-“At-Risk” Limitation

Jerry forms a calendar year S corporation with several of his business colleagues on

January 1, 2015. He contributes $ 40,000 of his own funds to the corporation in

exchange for stock. Jerry also borrowed $ 20,000 from his parents, and loaned the

money directly to the corporation in exchange for a written interest-bearing note. Jerry’s

mother purchased 10% of the corporation’s stock, and is a shareholder also. For 2015,

the corporation issues a K-1 to Jerry that reflects a loss of $ 70,000. Under normal

circumstances, Jerry would be able to deduct $ 60,000 of the $ 70,000 loss, as that is the

aggregate of his stock and loan basis. But, since the loan was accomplished by

borrowing funds from Jerry’s mother, these amounts do not provide “at-risk” basis for

Jerry. Since the loan does not constitute debt basis, Jerry’s loss is limited to his stock

basis of $ 40,000, with a $ 30,000 loss carried forward to 2016.

This rule restricting at-risk basis for amounts borrowed from a person with an interest in

the activity does not prevent at-risk basis for amounts borrowed from a member of the

shareholder’s family who does not hold stock in the S corporation.


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PASSIVE ACTIVITY LIMITATIONS

A passive loss is a loss from a trade or business in which the taxpayer does not materially

participate. Since the treatment of corporate income or loss depends upon the nature of

the activity that generated it, the corporation must report income and loss separately by

activity. Caution should be exercised when an S corporation, that was previously a

C corporation, reports rental income due to rental income’s inclusion in the definition of

passive investment income.

REAL ESTATE ACTIVITIES IN THE S CORPORATION

A shareholder may be able to deduct up to $ 25,000 in losses against non-passive income.

In order to qualify, the shareholder must “actively” participate in the rental activity.

“Active participation” is a less stringent standard than “material participation”. To

actively participate, the shareholder must participate in a significant way, such as making

management decisions and arranging for others to provide services. The shareholder

should own at least 10% of the stock of the S corporation to be involved in an “active

participation” basis.

A shareholder is considered a real estate professional and may treat income and losses as

non-passive, if he or she spends the majority of his time (more than half his time and 750

hours) working on real property businesses and/or rentals. The real estate professional is

held to a material participation standard.

LOSS LIMITATION INTERACTION

EXAMPLE-Loss Limitations Interaction

Carla invests $ 10,000 in exchange for 15% of the stock of the new S corporation. Her

$ 10,000 contribution for her stock consists of $ 6,000 from her savings account, and

$ 4,000 borrowed from Terry, a 25% shareholder in the company. If Carla is allocated a

loss of $ 11,000 for the first year of operation, her basis limitation restricts her deductible


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loss to $ 10,000. The at-risk rules limit her deductible loss to $ 6,000. Since Carla does

not materially participate in the company’s activities, the passive loss rules reduce her

deductible loss to -0-. Unless Carla has other passive income to offset this loss, the entire

$ 11,000 first year loss is suspended and carried over as follows:

Carla’s Carryovers

1. $ 1,000 Suspended due to lack of basis

2. $ 4,000 Suspended under at-risk rules

3. $ 6,000 Suspended under the PAL rules

$ 11,000 Total suspended losses (3 Limitation Levels)

Note: Because Carla does not materially participate in the corporation, her K-1

flow-through amounts are considered income that would be subject to the 3.8% net

investment income tax (NIIT). In years losses were deductible (other passive income

available to offset), the income base subject to 3.8% is reduced. In years where the

corporation reports a profit, the income base subject to 3.8% is increased.

SUMMARY

A myriad of issues are involved in the preparation of S corporation income tax returns

and the returns of the S corporation shareholders due to the complexities of flow-through

taxation. The foregoing discussions by explanation and example serve to unravel these

complexities resulting in greater competencies in this field of taxation.

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