us internal revenue service: i1120s--1998

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1998 Department of the TreasuryInternal Revenue ServiceInstructions for Form 1120SU.S. Income Tax Return for an S CorporationSection references are to the Internal Revenue Code unless otherwise noted.

Paperwork Reduction Act Notice. We ask for the information on this form to carryout the Internal Revenue laws of the United States. You are required to give us theinformation. We need it to ensure that you are complying with these laws and to allowus to figure and collect the right amount of tax.

You are not required to provide the information requested on a form that is subjectto the Paperwork Reduction Act unless the form displays a valid OMB control number.Books or records relating to a form or its instructions must be retained as long as theircontents may become material in the administration of any Internal Revenue law.Generally, tax returns and return information are confidential, as required by section6103.

The time needed to complete and file this form and related schedules will varydepending on individual circumstances. The estimated average times are:

If you have comments concerning the accuracy of these time estimates orsuggestions for making these forms simpler, we would be happy to hear from you. Youcan write to the Tax Forms Committee, Western Area Distribution Center, RanchoCordova, CA 95743-0001. DO NOT send the tax form to this address. Instead, seeWhere To File on page 3.

Changes To Noteq The new Codes for PrincipalBusiness Activity beginning on page 26are based on the North American IndustryClassification System (NAICS), which wasdeveloped by the statistical agencies ofCanada, Mexico, and the United States incooperation with the Office ofManagement and Budget. TheNAICS-based codes replace the industrycodes previously based on the StandardIndustrial Classification (SIC) system.q For tax years beginning after 1997,exempt organizations described in section401(a) or 501(c)(3) are permitted to beshareholders.

Unresolved Tax ProblemsMost problems can be resolved with onecontact either by calling, writing, or visitingan IRS office. But if the corporation hastried unsuccessfully to resolve a problemwith the IRS, it should contact theTaxpayer Advocate's Problem ResolutionProgram (PRP). Someone at PRP willassign the corporation a personaladvocate who is in the best position to tryto resolve the problem. The TaxpayerAdvocate can also offer special help if thecorporation has a significant hardship asa result of a tax problem.

Contact the Taxpayer Advocate if:q The corporation has triedunsuccessfully to resolve a problem withthe IRS and has not been contacted bythe date promised, orq The corporation is on its secondattempt to resolve a problem.

You may contact a Taxpayer Advocateby calling a new toll-free assistancenumber, 1-877-777-4778. Persons whohave access to TTY/TDD equipment maycall 1-800-828-4059 and ask for theTaxpayer Advocate. If the corporationprefers, it may write to the Taxpayer

Contents PageSpecific Instructions . . . . . . . 24

Schedule LBalance Sheets perBooks . . . . . . . . . . . . . . 24

Schedule M-1Reconciliation ofIncome (Loss) per Books WithIncome (Loss) per Return . . . . 24

Schedule M-2Analysis ofAccumulated AdjustmentsAccount, Other AdjustmentsAccount, and Shareholders'Undistributed Taxable IncomePreviously Taxed . . . . . . . . 24

Form RecordkeepingLearning about the

law or the formPreparing the

form

Copying,assembling, andsending the form

to the IRSCodes for Principal Business Activity 26

1120S 63 hr., 22 min. 21 hr., 21 min. 39 hr., 9 min. 4 hr., 34 min.

Sch. D (1120S) 10 hr., 31 min. 4 hr., 38 min. 9 hr., 39 min. 1 hr., 20 min.

Sch. K-1 (1120S) 15 hr., 32 min. 10 hr., 25 min. 14 hr., 50 min. 1 hr., 4 min.

Contents PageContents PageTax and Payments . . . . . . . . 14Changes To Note . . . . . . . . . . 1Schedule ACost of Goods Sold 15Unresolved Tax Problems . . . . . 1Schedule BOther Information . . 15

How To Make a Contribution To Reducethe Public Debt . . . . . . . . . . 1 General Instructions for Schedules

K and K-1 . . . . . . . . . . . . 16How To Get Forms and Publications 2Purpose of Schedules . . . . . . 16

General Instructions . . . . . . . . 2Substitute Forms . . . . . . . . . 16

Purpose of Form . . . . . . . . . 2Shareholder's Pro Rata Share Items 16

Who Must File . . . . . . . . . . 2Specific Instructions (Schedule K

Only) . . . . . . . . . . . . . . . 17Termination of Election . . . . . . 2

When To File . . . . . . . . . . . 2Specific Instructions (Schedule K-1

Only) . . . . . . . . . . . . . . . 17Period Covered . . . . . . . . . . 3

Where To File . . . . . . . . . . . 3 General Information . . . . . . . . 17Who Must Sign . . . . . . . . . . 3 Special Reporting Requirements for

Corporations With MultipleActivities . . . . . . . . . . . . 17

Accounting Methods . . . . . . . 3

Accounting Periods . . . . . . . . 3Special Reporting Requirements for

At-Risk Activities . . . . . . . . 17Rounding Off to Whole Dollars . . 4

Recordkeeping . . . . . . . . . . 4

Specific Items . . . . . . . . . . . 17Depository Method of Tax Payment 4Specific Instructions (Schedules K

and K-1, Except as Noted) . . . 17Estimated Tax . . . . . . . . . . 4

Interest and Penalties . . . . . . . 4Income (Loss) . . . . . . . . . . . 17Other Forms and Statements That

May Be Required . . . . . . . . 5 Deductions . . . . . . . . . . . . 19

Investment Interest . . . . . . . . 19Attachments . . . . . . . . . . . . 6Credits . . . . . . . . . . . . . . 20Amended Return . . . . . . . . . 6Adjustments and Tax Preference

Items . . . . . . . . . . . . . . 21Passive Activity Limitations . . . . 6

Specific Instructions . . . . . . . 10Foreign Taxes . . . . . . . . . . 22General Information . . . . . . . . 10Other . . . . . . . . . . . . . . . 22Income . . . . . . . . . . . . . . 10Supplemental Information . . . . . 23Deductions . . . . . . . . . . . . 11

Cat. No. 11515K


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Advocate at the IRS office that lastcontacted the corporation.

While Taxpayer Advocates cannotchange the tax law or make a technicaltax decision, they can clear up problemsthat resulted from previous contacts andensure that the corporation's case is givena complete and impartial review.Taxpayer Advocates are working to putservice first. For more details, see Pub.1546, The Problem Resolution Programof the Internal Revenue Service.

How To Make a ContributionTo Reduce the Public DebtTo make a contribution to reduce thepublic debt, send a check made payableto "Bureau of the Public Debt" to Bureauof the Public Debt, Department G,Washington, DC 20239-0601. Or,enclose a check with Form 1120S.Contributions to reduce the public debtare deductible, subject to the rules andlimitations for charitable contributions.

How To Get Forms andPublications

Personal Computer

Access the IRS's internet web site atwww.irs.ustreas.gov to do the following:q Download forms, instructions, andpublications.q See answers to frequently asked taxquestions.q Search publications on-line by topic orkeyword.q Send us comments or request help viae-mail.q Sign up to receive hot tax issues andnews by e-mail from the IRS DigitalDispatch.

You can also reach us using:q Telnet at iris.irs.ustreas.govq File transfer protocol at

ftp.irs.ustreas.govq Direct dial (by modem) at

703-321-8020.

CD-ROM

Order Pub. 1796, Federal Tax Productson CD-ROM, and get:q Current year forms, instructions, andpublications.q Prior year forms and instructions.q Popular forms that may be filled inelectronically, printed out for submission,

and saved for recordkeeping.Buy the CD-ROM on the Internet atwww.irs.ustreas.gov/cdorders from theNational Technical Information Service(NTIS) for $13 (plus a $5 handling fee),and save 35%, or call 1-877-CDFORMS(1-877-233-6767) toll-free to buy theCD-ROM for $20 (plus a $5 handling fee).

By Phone and in Person

You can order forms and publications 24hours a day, 7 days a week, by calling1-800-TAX-FORM (1-800-829-3676). You

can also get most forms and publicationsat your local IRS office.

General Instructions

Purpose of FormForm 1120S is used to report the income,deductions, gains, losses, etc., of adomestic corporation that has elected tobe an S corporation by filing Form 2553,Election by a Small Business Corporation,

and whose election is in effect for the taxyear.

Who Must FileA corporation must file Form 1120S if (a)it elected to be an S corporation by filingForm 2553, (b) the IRS accepted theelection, and (c) the election remains ineffect. Do not file Form 1120S for any taxyear before the year the election takeseffect.

Termination of ElectionOnce the election is made, it stays ineffect until it is terminated. If the election

is terminated in a tax year beginning after1996, the corporation (or a successorcorporation) can make another electionon Form 2553 only with IRS consent forany tax year before the 5th tax year afterthe first tax year in which the terminationtook effect. See Regulations section1.1362-5 for more details.

An election terminates automaticallyin any of the following cases:

1. The corporation is no longer a smallbusiness corporation as defined in section1361(b). The termination of an election inthis manner is effective as of the day onwhich the corporation no longer meets thedefinition of a small business corporation.

If the election terminates for this reason,attach to Form 1120S for the final year ofthe S corporation a statement notifyingthe IRS of the termination and the date itoccurred.

2. The corporation, for each of threeconsecutive tax years, (a) hasaccumulated earnings and profits and (b)derives more than 25% of its grossreceipts from passive investment incomeas defined in section 1362(d)(3)(C). Theelection terminates on the first day of thefirst tax year beginning after the thirdconsecutive tax year. The corporationmust pay a tax for each year it has excessnet passive income. See the instructions

for line 22a for details on how to figure thetax.3. The election is revoked. An election

may be revoked only with the consent ofshareholders who, at the time therevocation is made, hold more than 50%of the number of issued and outstandingshares of stock (including non-votingstock). The revocation may specify aneffective revocation date that is on or afterthe day the revocation is filed. If no dateis specified, the revocation is effective atthe start of a tax year if the revocation is

made on or before the 15th day of the 3rdmonth of that tax year. If no date isspecified and the revocation is made afterthe 15th day of the 3rd month of the taxyear, the revocation is effective at thestart of the next tax year.

To revoke the election, the corporationmust file a statement with the servicecenter where it filed its election to be anS corporation. In the statement, thecorporation must notify the IRS that it isrevoking its election to be an S

corporation. The statement must besigned by each shareholder who consentsto the revocation and contain theinformation required by Regulationssection 1.1362-6(a)(3). A revocation maybe rescinded before it takes effect. SeeRegulations section 1.1362-6(a)(4) fordetails.

For rules on allocating income anddeductions between an S short year anda C short year and other special rules thatapply when an election is terminated, seesection 1362(e) and Regulations section1.1362-3.

If an election was terminated under 1or 2 above, and the corporation believes

the termination was inadvertent, thecorporation may request permission fromthe IRS to continue to be treated as an Scorporation. See Regulations section1.1362-4 for the specific requirementsthat must be met to qualify for inadvertenttermination relief.

When To FileIn general, file Form 1120S by the 15thday of the 3rd month following the datethe corporation's tax year ended asshown at the top of Form 1120S. Forcalendar year corporations, the due dateis March 15, 1999. If the due date falls ona Saturday, Sunday, or legal holiday, file

on the next business day. A business dayis any day that is not a Saturday, Sunday,or legal holiday.

If the S election was terminated duringthe tax year, file Form 1120S for the Sshort year by the due date (includingextensions) of the C short year return.

Private Delivery Services

You can use certain private deliveryservices designated by the IRS to meetthe timely filing as timely filing/payingrule for tax returns and payments. TheIRS publishes a list of designated privatedelivery services in September of eachyear. The list published in September

1998 includes only the following:q Airborne Express (Airborne): OvernightAir Express Service, Next AfternoonService, Second Day Service.q DHL Worldwide Express (DHL): DHL"Same Day" Service, DHL USAOvernight.q Federal Express (FedEx): FedExPriority Overnight, FedEx StandardOvernight, FedEx 2Day.q United Parcel Service (UPS): UPS NextDay Air, UPS Next Day Air Saver, UPS2nd Day Air, UPS 2nd Day Air A.M.

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The private delivery service can tell youhow to get written proof of the mailingdate.

Extension

Use Form 7004, Application for AutomaticExtension of Time To File CorporationIncome Tax Return, to request anautomatic 6-month extension of time tofile Form 1120S.

Period CoveredFile the 1998 return for calendar year1998 and fiscal years beginning in 1998and ending in 1999. If the return is for afiscal year or a short tax year, fill in the taxyear space at the top of the form.Note: The 1998 Form 1120S may alsobe used if(a)the corporation has a taxyear of less than 12 months that beginsand ends in 1999 and(b)the 1999 Form1120S is not available by the time thecorporation is required to file its return.However, the corporation must show its1999 tax year on the 1998 Form 1120Sand incorporate any tax law changes thatare effective for tax years beginning afterDecember 31, 1998.

Where To FileFile your return at the applicable IRSaddress listed below.

Who Must SignThe return must be signed and dated bythe president, vice president, treasurer,assistant treasurer, chief accountingofficer, or any other corporate officer(such as tax officer) authorized to sign. Areceiver, trustee, or assignee must signand date any return he or she is requiredto file on behalf of a corporation.

If a corporate officer filled in Form1120S, the Paid Preparer's space under

Signature of officer should remain blank.If someone prepares Form 1120S anddoes not charge the corporation, thatperson should not sign the return. Certainothers who prepare Form 1120S shouldnot sign. For example, a regular, full-timeemployee of the corporation such as aclerk, secretary, etc., should not sign.

Generally, anyone paid to prepareForm 1120S must sign the return and fillin the other blanks in the Paid Preparer'sUse Only area of the return.

The preparer required to sign the returnMUST complete the required preparerinformation and:q Sign it, by hand, in the space provided

for the preparer's signature. (Signaturestamps or labels are not acceptable.)q Give a copy of Form 1120S to thetaxpayer in addition to the copy filed withthe IRS.

Accounting MethodsFigure ordinary income using the methodof accounting regularly used in keepingthe corporation's books and records.Generally, permissible methods include:q Cash,q Accrual, orq Any other method permitted by theInternal Revenue Code.

In all cases, the method adopted mustclearly reflect income.Generally, an S corporation may not

use the cash method of accounting if thecorporation is a tax shelter (as defined insection 448(d)(3)). See section 448 fordetails.

Under the accrual method, an amountis includible in income when:q All the events have occurred that fix theright to receive the income, andq The amount can be determined withreasonable accuracy.

See Regulations section 1.451-1(a) fordetails.

Generally, an accrual basis taxpayercan deduct accrued expenses in the taxyear in which:q All events that determine liability haveoccurred,q The amount of the liability can befigured with reasonable accuracy, andq Economic performance takes place withrespect to the expense. There areexceptions for certain items, includingrecurring expenses. See section 461(h)and the related regulations for the rulesfor determining when economicperformance takes place.

Except for certain home constructioncontracts and other real property smallconstruction contracts, long-termcontracts must generally be accounted forusing the percentage of completionmethod described in section 460.

Mark-to-Market Accounting Methodfor Dealers in Securities

Dealers in securities must use themark-to-market accounting methoddescribed in section 475. Under this

method, any security that is inventory tothe dealer must be included in inventoryat its fair market value. Any security thatis not inventory and that is held at theclose of the tax year is treated as sold atits fair market value on the last businessday of the tax year, and any gain or lossmust be taken into account in determininggross income. The gain or loss taken intoaccount is generally treated as ordinarygain or loss. For details, includingexceptions, see section 475 and therelated regulations.Note: Dealers in commodities, andtraders in securities and commodities,may make an election to use the

mark-to-market accounting method. Seesections 475(e) and (f) for details.

Change in Accounting Method

Generally, the corporation may change itsmethod of accounting used to reporttaxable income (for income as a whole orfor any material item) only by gettingconsent on Form 3115, Application forChange in Accounting Method. For moreinformation, see Pub. 538, AccountingPeriods and Methods.

Accounting PeriodsGenerally, an S corporation may notchange its accounting period to a tax year

that is not a permitted year. A permittedyear is a calendar year or any otheraccounting period for which thecorporation can establish to thesatisfaction of the IRS that there is abusiness purpose for the tax year.

To change an accounting period, seeRegulations section 1.442-1 and Form1128, Application To Adopt, Change, orRetain a Tax Year. Also see Pub. 538.

Election of a Tax Year Other Thana Required Year

Under the provisions of section 444, anS corporation may elect to have a tax yearother than a permitted year, but only if the

deferral period of the tax year is notlonger than the shorter of 3 months or thedeferral period of the tax year beingchanged. This election is made by filingForm 8716, Election To Have a Tax YearOther Than a Required Tax Year.

An S corporation may not make orcontinue an election under section 444 ifit is a member of a tiered structure, otherthan a tiered structure that consistsentirely of partnerships and Scorporations that have the same tax year.For the S corporation to have a section444 election in effect, it must make the

If the corporation'sprincipal business,office, or agency is

located in

Use the followingInternal RevenueService Center

address

New Jersey, New York (New YorkCity and counties of Nassau,Rockland, Suffolk, and Westchester)

Holtsville, NY00501-0013

New York (all other counties),Connecticut, Maine, Massachusetts,New Hampshire, Rhode Island,Vermont

Andover, MA05501-0013

Florida, Georgia, South CarolinaAtlanta, GA39901-0013

Indiana, Kentucky, Michigan, Ohio,West Virginia

Cincinnati, OH45999-0013

Kansas, New Mexico, Oklahoma,Texas

Austin, TX73301-0013

Illinois, Iowa, Minnesota, Missouri,Wisconsin

Kansas City, MO64999-0013

Alabama, Arkansas, Louisiana,Mississippi, North Carolina,Tennessee

Memphis, TN37501-0013

Alaska, Arizona, California (countiesof Alpine, Amador, Butte, Calaveras,Colusa, Contra Costa, Del Norte, ElDorado, Glenn, Humboldt, Lake,Lassen, Marin, Mendocino, Modoc,

Napa, Nevada, Placer, Plumas,Sacramento, San Joaquin, Shasta,Sierra, Siskiyou, Solano, Sonoma,Sutter, Tehama, Trinity, Yolo, andYuba), Colorado, Idaho, Montana,Nebraska, Nevada, North Dakota,Oregon, South Dakota, Utah,Washington, Wyoming

Ogden, UT84201-0013

California (all other counties),Hawaii

Fresno, CA93888-0013

Delaware, District of Columbia,Maryland, Pennsylvania, Virginia

Philadelphia, PA19255-0013

Instructions for Form 1120S Page 3


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payments required by section 7519 andfile Form 8752, Required Payment orRefund Under Section 7519.

A section 444 election ends if an Scorporation changes its accounting periodto a calendar year or some otherpermitted year; it is penalized for willfullyfailing to comply with the requirements ofsection 7519; or its S election isterminated (unless it immediatelybecomes a personal service corporation).If the termination results in a short tax

year, type or legibly print at the top of thefirst page of Form 1120S for the short taxyear, SECTION 444 ELECTIONTERMINATED.

Rounding Off to WholeDollarsYou may round off cents to whole dollarson your return and accompanyingschedules. To do so, drop amounts under50 cents and increase amounts from 50to 99 cents to the next higher dollar.

RecordkeepingThe corporation's records must be kept

as long as they may be needed for theadministration of any provision of theInternal Revenue Code. Usually, recordsthat support an item of income, deduction,or credit on the corporation's return mustbe kept for 3 years from the date eachshareholder's return is due or is filed,whichever is later. Keep records thatverify the corporation's basis in propertyfor as long as they are needed to figurethe basis of the original or replacementproperty.

The corporation should also keepcopies of any returns it has filed. Theyhelp in preparing future returns and inmaking computations when filing an

amended return.

Depository Method of TaxPaymentThe corporation must pay the tax due infull no later than the 15th day of the 3rdmonth after the end of the tax year. Somecorporations (described below) arerequired to electronically deposit alldepository taxes, including corporationincome tax payments.

Electronic Deposit Requirement

The corporation must make electronicdeposits for all depository tax liabilities

that occur after 1998 if:q It was required to electronically deposittaxes in prior years,q It deposited more than $50,000 in socialsecurity, Medicare, and withheld incometaxes in 1997, orq It did not deposit social security,Medicare, or withheld income taxes in1997, but deposited more than $50,000 inother taxes under section 6302 (such ascorporate income taxes) in 1997.

For details, see Regulations section31.6302-1(h).

The Electronic Federal Tax PaymentSystem (EFTPS) must be used to makeelectronic deposits. If the corporation isrequired to make electronic deposits andfails to do so, it may be subject to a 10%penalty.Note: A penalty will not be imposed fortax liabilities that occur prior to July 1,1999, if the corporation was first requiredto use EFTPS on or after July 1, 1997.

Corporations that are not required tomake electronic deposits may voluntarily

participate in EFTPS. To enroll in EFTPS,call 1-800-945-8400 or 1-800-555-4477.For general information on EFTPS, call1-800-829-1040.

Deposits With Form 8109

If the corporation does not use EFTPS,deposit corporation income tax payments(and estimated tax payments) with Form8109, Federal Tax Deposit Coupon. Donot send deposits directly to an IRS office;otherwise, the corporation may have topay a penalty. Mail or deliver thecompleted Form 8109 with the paymentto a qualified depositary for Federal taxesor to the Federal Reserve bank (FRB)

servicing the corporation's geographicarea. Make checks or money orderspayable to that depositary or FRB.

To help ensure proper crediting, writethe corporation's employer identificationnumber, the tax period to which thedeposit applies, and Form 1120S on thecheck or money order. Be sure to darkenthe 1120 box on the coupon. Recordsof these deposits will be sent to the IRS.

For more information on deposits, seethe instructions in the coupon booklet(Form 8109) and Pub. 583, Starting aBusiness and Keeping Records.

Estimated Tax

Generally, the corporation must makeestimated tax payments for the followingtaxes if the total of these taxes is $500or more: (a) the tax on certain capitalgains, (b) the tax on built-in gains, (c) theexcess net passive income tax, and (d)the investment credit recapture tax.

The amount of estimated tax requiredto be paid annually is the smaller of (a)the total of the above taxes shown on thereturn for the tax year (or if no return isfiled, the total of these taxes for the year)or (b) the sum of (i) the investment creditrecapture tax and the built-in gains tax (orthe tax on certain capital gains) shown onthe return for the tax year (or if no return

is filed, the total of these taxes for theyear), and (ii) any excess net passiveincome tax shown on the corporation'sreturn for the preceding tax year. If thepreceding tax year was less than 12months, the estimated tax must bedetermined under (a).

The estimated tax is generally payablein four equal installments. However, thecorporation may be able to lower theamount of one or more installments byusing the annualized income installmentmethod or adjusted seasonal installmentmethod under section 6655(e).

For a calendar year corporation, thepayments are due for 1999 by April 15,June 15, September 15, and December15. For a fiscal year corporation, they aredue by the 15th day of the 4th, 6th, 9th,and 12th months of the fiscal year.

The corporation must make thepayments using the depository methoddescribed above.

Interest and Penalties

InterestInterest is charged on taxes not paid bythe due date, even if an extension of timeto file is granted. Interest is also chargedfrom the due date (including extensions)to the date of payment on the failure to filepenalty, the accuracy-related penalty, andthe fraud penalty. The interest charge isfigured at a rate determined under section6621.

Late Filing of Return

A corporation that does not file its taxreturn by the due date, includingextensions, may have to pay a penalty of5% a month, or part of a month, up to a

maximum of 25%, for each month thereturn is not filed. The penalty is imposedon the net amount due. The minimumpenalty for filing a return more than 60days late is the smaller of the tax due or$100. The penalty will not be imposed ifthe corporation can show that the failureto file on time was due to reasonablecause. If the failure is due to reasonablecause, attach an explanation to the return.

Late Payment of Tax

A corporation that does not pay the taxwhen due generally may have to pay apenalty of 1/2 of 1% a month or part of amonth, up to a maximum of 25%, for each

month the tax is not paid. The penalty isimposed on the net amount due.

The penalty will not be imposed if thecorporation can show that failure to payon time was due to reasonable cause.

Failure To Furnish InformationTimely

Section 6037(b) requires an S corporationto furnish to each shareholder a copy ofthe information shown on Schedule K-1(Form 1120S) that is attached to Form1120S. Provide Schedule K-1 to eachshareholder on or before the day on whichthe corporation files Form 1120S.

For each failure to furnish Schedule K-1

to a shareholder when due and eachfailure to include on Schedule K-1 all theinformation required to be shown (or theinclusion of incorrect information), a $50penalty may be imposed with regard toeach Schedule K-1 for which a failureoccurs. If the requirement to reportcorrect information is intentionallydisregarded, each $50 penalty isincreased to $100 or, if greater, 10% ofthe aggregate amount of items requiredto be reported. See sections 6722 and6724 for more information.



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The penalty will not be imposed if thecorporation can show that not furnishinginformation timely was due to reasonablecause and not due to willful neglect.

Trust Fund Recovery Penalty

This penalty may apply if certain excise,income, social security, and Medicaretaxes that must be collected or withheldare not collected or withheld, or thesetaxes are not paid to the IRS. These taxesare generally reported on Forms 720, 941,

943, or 945. The trust fund recoverypenalty may be imposed on all personswho are determined by the IRS to havebeen responsible for collecting,accounting for, and paying over thesetaxes, and who acted willfully in not doingso. The penalty is equal to the unpaidtrust fund tax. See the instructions forForm 720, Pub. 15 (Circular E),Employer's Tax Guide, or Pub. 51(Circular A), Agricultural Employer's TaxGuide, for more details, including thedefinition of responsible persons.

Other Forms and StatementsThat May Be Requiredq Forms W-2 and W-3, Wage and TaxStatement; and Transmittal of Wage andTax Statements.q Form 720, Quarterly Federal ExciseTax Return. Use Form 720 to reportenvironmental excise taxes,communications and air transportationtaxes, fuel taxes, luxury tax on passengervehicles, manufacturers' taxes, shippassenger tax, and certain other excisetaxes.Caution: SeeTrust Fund RecoveryPenaltyabove.q Form 926, Return by a U.S. Transferorof Property to a Foreign Corporation. Use

this form to report certain informationrequired under section 6038B.q Form 940 or Form 940-EZ, Employer'sAnnual Federal Unemployment (FUTA)Tax Return. The corporation may be liablefor FUTA tax and may have to file Form940 or 940-EZ if it paid wages of $1,500or more in any calendar quarter during thecalendar year (or the preceding calendaryear) or one or more employees workedfor the corporation for some part of a dayin any 20 different weeks during thecalendar year (or the preceding calendaryear). A corporate officer who performssubstantial services is considered anemployee. Except as provided in section3306(a), reasonable compensation forthese services is subject to FUTA tax, nomatter what the corporation calls thepayments.q Form 941, Employer's QuarterlyFederal Tax Return. Employers must filethis form quarterly to report income taxwithheld on wages and employer andemployee social security and Medicaretaxes. A corporate officer who performssubstantial services is considered anemployee. Except as provided in sections3121(a) and 3401(a), reasonablecompensation for these services is

subject to employer and employee socialsecurity and Medicare taxes and incometax withholding, no matter what thecorporation calls the payments.Agricultural employers must file Form943, Employer's Annual Tax Return forAgricultural Employees, instead of Form941, to report income tax withheld andemployer and employee social securityand Medicare taxes on farmworkers.Caution: SeeTrust Fund RecoveryPenaltyabove.

q Form 945, Annual Return of WithheldFederal Income Tax. Use this form toreport income tax withheld fromnonpayroll payments, including pensions,annuities, IRAs, gambling winnings, andbackup withholding.Caution: SeeTrust Fund RecoveryPenaltyabove.q Form 966, Corporate Dissolution orLiquidation.q Forms 1042 and 1042-S, AnnualWithholding Tax Return for U.S. SourceIncome of Foreign Persons; and ForeignPerson's U.S. Source Income Subject toWithholding. Use these forms to reportand transmit withheld tax on payments

made to nonresident alien individuals,foreign partnerships, or foreigncorporations to the extent such paymentsconstitute gross income from sourceswithin the United States (see sections 861through 865). For more information, seesections 1441 and 1442, and Pub. 515,Withholding of Tax on Nonresident Aliensand Foreign Corporations.q Form 1096, Annual Summary andTransmittal of U.S. Information Returns.q Form 1098, Mortgage InterestStatement. Use this form to report thereceipt from any individual of $600 ormore of mortgage interest and points inthe course of the corporation's trade or

business.q Forms 1099-A, B, C, DIV, INT, LTC,MISC, MSA, OID, PATR, R, and S. Youmay have to file these information returnsto report acquisitions or abandonmentsof secured property; proceeds from brokerand barter exchange transactions;cancellation of debt; certain dividends anddistributions; interest payments; paymentsof long-term care and accelerated deathbenefits; miscellaneous incomepayments; distributions from a medicalsavings account; original issue discount;distributions from cooperatives to theirpatrons; distributions from pensions,annuities, retirement or profit-sharing

plans, IRAs, insurance contracts, etc.;and proceeds from real estatetransactions. Also use certain of thesereturns to report amounts that werereceived as a nominee on behalf ofanother person.

Use Form 1099-DIV to report actualdividends paid by the corporation. Onlydistributions from accumulated earningsand profits are classified as dividends. Donot issue Form 1099-DIV for dividendsreceived by the corporation that areallocated to shareholders on line 4b ofSchedule K-1.

For more information, see theInstructions for Forms 1099, 1098, 5498,and W-2G.Note: Every corporation must file Forms1099-MISC if it makes payments of rents,commissions, or other fixed ordeterminable income (see section 6041)totaling $600 or more to any one personin the course of its trade or businessduring the calendar year.q Form 5471, Information Return of U.S.Persons With Respect to Certain Foreign

Corporations. A corporation may have tofile Form 5471 if any of the followingapply:

1. It controls a foreign corporation.2. It acquires, disposes of, or owns

5% or more in value of the outstandingstock of a foreign corporation.

3. It owns stock in a corporation thatis a controlled foreign corporation for anuninterrupted period of 30 days or moreduring any tax year of the foreigncorporation, and it owned that stock onthe last day of that year.q Form 5713, International BoycottReport. Every corporation that hadoperations in, or related to, a boycotting

country, company, or national of a countrymust file Form 5713 to report thoseoperations and figure the loss of certaintax benefits.q Form 8264, Application for Registrationof a Tax Shelter. Tax shelter organizersmust file Form 8264 to register taxshelters with the IRS for the purpose ofreceiving a tax shelter registrationnumber.q Form 8271, Investor Reporting of TaxShelter Registration Number.Corporations that have acquired aninterest in a tax shelter that is required tobe registered use Form 8271 to report thetax shelter's registration number. Attach

Form 8271 to any return on which adeduction, credit, loss, or other tax benefitattributable to a tax shelter is taken or anyincome attributable to a tax shelter isreported.q Form 8275, Disclosure Statement. FileForm 8275 to disclose items or positions,except those contrary to a regulation, thatare not otherwise adequately disclosedon a tax return. The disclosure is madeto avoid the parts of the accuracy-relatedpenalty imposed for disregard of rules orsubstantial understatement of tax. Form8275 is also used for disclosures relatingto preparer penalties for understatementsdue to unrealistic positions or disregard

of rules.q Form 8275-R, Regulation DisclosureStatement, is used to disclose any itemon a tax return for which a position hasbeen taken that is contrary to Treasuryregulations.q Form 8281, Information Return forPublicly Offered Original Issue DiscountInstruments. This form is used by issuersof publicly offered debt instrumentshaving OID to provide the informationrequired by section 1275(c).q Forms 8288 and 8288-A, U.S.Withholding Tax Return for Dispositions



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by Foreign Persons of U.S. Real PropertyInterests; and Statement of Withholdingon Dispositions by Foreign Persons ofU.S. Real Property Interests. Use theseforms to report and transmit withheld taxon the sale of U.S. real property by aforeign person. See section 1445 and therelated regulations for additionalinformation.q Form 8300, Report of Cash PaymentsOver $10,000 Received in a Trade orBusiness. File this form to report the

receipt of more than $10,000 in cash orforeign currency in one transaction (or aseries of related transactions).q Form 8594, Asset AcquisitionStatement. Both the purchaser and sellerof a group of assets constituting a tradeor business must file this form if section197 intangibles attach, or could attach, tosuch assets and if the purchaser's basisin the assets is determined only by theamount paid for the assets.q Form 8697, Interest ComputationUnder the Look-Back Method forCompleted Long-Term Contracts. CertainS corporations that are not closely heldmay have to file Form 8697. Form 8697

is used to figure the interest due or to berefunded under the look-back method ofsection 460(b)(2) on certain long-termcontracts that are accounted for undereither the percentage ofcompletion-capitalized cost method or thepercentage of completion method. Closelyheld corporations should see theinstructions on page 23 for line 23, item10, of Schedule K-1 for details on theForm 8697 information they must provideto their shareholders.q Form 8866, Interest ComputationUnder the Look-Back Method for PropertyDepreciated Under the Income ForecastMethod. Certain S corporations that are

not closely held may have to file Form8866. Form 8866 is used to figure theinterest due or to be refunded under thelook-back method of section 167(g)(2) forcertain property placed in service afterSeptember 13, 1995, and depreciatedunder the income forecast method.Closely held corporations should see theinstructions on page 24 for line 23, item17, of Schedule K-1 for details on theForm 8666 information they must provideto their shareholders.

Statements

Stock ownership in foreigncorporations. If the corporation ownedat least 5% in value of the outstandingstock of a foreign personal holdingcompany, and the corporation wasrequired to include in its gross income anyundistributed foreign personal holdingcompany income, attach the statementrequired by section 551(c).Transfers to a corporation controlledby the transferor. If a person receivesstock of a corporation in exchange forproperty, and no gain or loss isrecognized under section 351, thetransferor and transferee must eachattach to their tax returns the informationrequired by Regulations section 1.351-3.

AttachmentsAttach Form 4136, Credit for Federal TaxPaid on Fuels, after page 4, Form 1120S.Attach schedules in alphabetical orderand other forms in numerical order afterForm 4136.

To assist us in processing the return,please complete every applicable entryspace on Form 1120S and ScheduleK-1. If you attach statements, do not writeSee attached instead of completing the

entry spaces on Form 1120S andSchedule K-1.If you need more space on the forms

or schedules, attach separate sheets. Usethe same size and format as on theprinted forms. But show the totals onthe printed forms. Attach these separatesheets after all the schedules and forms.Be sure to put the corporation's name andemployer identification number (EIN) oneach sheet.

Amended ReturnTo correct an error on a Form 1120Salready filed, file an amended Form1120S and check box F(4). If the

amended return results in a change toincome, or a change in the distribution ofany income or other information providedany shareholder, an amended ScheduleK-1 (Form 1120S) must also be filed withthe amended Form 1120S and given tothat shareholder. Be sure to check boxD(2) on each Schedule K-1 to indicatethat it is an amended Schedule K-1.

A change to the corporation's Federalreturn may affect its state return. Thisincludes changes made as the result ofan IRS examination of Form 1120S. Formore information, contact the state taxagency for the state in which thecorporation's return was filed.

Passive Activity LimitationsIn general, section 469 limits the amountof losses, deductions, and credits thatshareholders may claim from passiveactivities. The passive activity limitationsdo not apply to the corporation. Instead,they apply to each shareholder's share ofany income or loss and credit attributableto a passive activity. Because thetreatment of each shareholder's share ofcorporate income or loss and creditdepends upon the nature of the activitythat generated it, the corporation mustreport income or loss and creditsseparately for each activity.

The instructions below (pages 6through 10) and the instructions forSchedules K and K-1 (pages 16 through24) explain the applicable passive activitylimitation rules and specify the type ofinformation the corporation must provideto its shareholders for each activity. If thecorporation had more than one activity, itmust report information for each activityon an attachment to Schedules K andK-1.

Generally, passive activities include (a)activities that involve the conduct of atrade or business in which the

shareholder does not materiallyparticipate and (b) any rental activity(defined on page 7) even if theshareholder materially participates. Forexceptions, see Activities That Are NotPassive Activities below. The level ofeach shareholder's participation in anactivity must be determined by theshareholder.

The passive activity rules provide thatlosses and credits from passive activitiescan generally be applied only against

income and tax from passive activities.Thus, passive losses and credits cannotbe applied against income from salaries,wages, professional fees, or a businessin which the shareholder materiallyparticipates; against portfolio income(defined on page 8); or against the taxrelated to any of these types of income.

Special rules require that net incomefrom certain activities that wouldotherwise be treated as passive incomemust be recharacterized as nonpassiveincome for purposes of the passiveactivity limitations.

To allow each shareholder to apply thepassive activity limitations at the individual

level, the corporation must report incomeor loss and credits separately for each ofthe following: trade or business activities,rental real estate activities, rentalactivities other than rental real estate, andportfolio income.

Activities That Are Not PassiveActivities

Passive activities do not include:1. Trade or business activities in

which the shareholder materiallyparticipated for the tax year.

2. Any rental real estate activity inwhich the shareholder materiallyparticipated and met both of the following

conditions for the tax year:a. More than half of the personal

services the shareholder performed intrades or businesses were performed inreal property trades or businesses inwhich he or she materially participated,and

b. The shareholder performed morethan 750 hours of services in real propertytrades or businesses in which he or shematerially participated.

For purposes of this rule, each interestin rental real estate is a separate activityunless the shareholder elects to treat allinterests in rental real estate as oneactivity.

If the shareholder is married filingjointly, either the shareholder or his or herspouse must separately meet both of theabove conditions, without taking intoaccount services performed by the otherspouse.

A real property trade or business is anyreal property development,redevelopment, construction,reconstruction, acquisition, conversion,rental, operation, management, leasing,



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or brokerage trade or business. Servicesthe shareholder performed as anemployee are not treated as performed ina real property trade or business unlesshe or she owned more than 5% of thestock in the employer.

3. The rental of a dwelling unit usedby a shareholder for personal purposesduring the year for more than the greaterof 14 days or 10% of the number of daysthat the residence was rented at fair rentalvalue.

4. An activity of trading personalproperty for the account of owners ofinterests in the activity. See TemporaryRegulations section 1.469-1T(e)(6).Note: The section 469(c)(3) exception fora working interest in oil and gas propertiesdoes not apply to an S corporationbecause state law generally limits theliability of corporate shareholders.

Trade or Business Activities

A trade or business activity is an activity(other than a rental activity or an activitytreated as incidental to an activity ofholding property for investment) that

1. Involves the conduct of a trade or

business (within the meaning of section162),

2. Is conducted in anticipation ofstarting a trade or business, or

3. Involves research or experimentalexpenditures deductible under section174 (or that would be if you chose todeduct rather than capitalize them).

If the shareholder does not materiallyparticipate in the activity, a trade orbusiness activity of the corporation is apassive activity for the shareholder.

Each shareholder must determine if heor she materially participated in anactivity. As a result, while thecorporation's overall trade or businessincome (loss) is reported on page 1 ofForm 1120S, the specific income anddeductions from each separate trade orbusiness activity must be reported onattachments to Form 1120S. Similarly,while each shareholder's allocable shareof the corporation's overall trade orbusiness income (loss) is reported on line1 of Schedule K-1, each shareholder'sallocable share of the income anddeductions from each trade or businessactivity must be reported on attachmentsto each Schedule K-1. See PassiveActivity Reporting Requirements onpage 9 for more information.

Rental ActivitiesGenerally, except as noted below, if thegross income from an activity consists ofamounts paid principally for the use ofreal or personal tangible property held bythe corporation, the activity is a rentalactivity.

There are several exceptions to thisgeneral rule. Under these exceptions, anactivity involving the use of real orpersonal tangible property is not a rentalactivity if any of the following apply:

q The average period of customer use(defined below) for such property is 7days or less.q The average period of customer use forsuch property is 30 days or less andsignificant personal services (definedbelow) are provided by or on behalf of thecorporation.q Extraordinary personal services(defined below) are provided by or onbehalf of the corporation.q Rental of the property is treated as

incidental to a nonrental activity of thecorporation under Temporary Regulationssection 1.469-1T(e)(3)(vi) andRegulations section 1.469-1(e)(3)(vi).q The corporation customarily makes theproperty available during definedbusiness hours for nonexclusive use byvarious customers.q The corporation provides property foruse in a nonrental activity of a partnershipin its capacity as an owner of an interestin such partnership. Whether thecorporation provides property used in anactivity of a partnership in thecorporation's capacity as an owner of aninterest in the partnership is based on all

the facts and circumstances.In addition, a guaranteed payment

described in section 707(c) is not incomefrom a rental activity under anycircumstances.Average period of customer use.Figure the average period of customeruse of property by dividing the totalnumber of days in all rental periods by thenumber of rentals during the tax year. Ifthe activity involves renting more than oneclass of property, multiply the averageperiod of customer use of each class bythe ratio of the gross rental income fromthat class to the activity's total gross rentalincome. The activity's average period of

customer use equals the sum of theseclass-by-class average periods weightedby gross income. See Regulations section1.469-1(e)(3)(iii).Significant personal services. Personalservices include only services performedby individuals. In determining whetherpersonal services are significant personalservices, consider all of the relevant factsand circumstances. Relevant facts andcircumstances include how often theservices are provided, the type andamount of labor required to perform theservices, and the value of the services inrelation to the amount charged for the useof the property.

The following services are notconsidered in determining whetherpersonal services are significant:q Services necessary to permit the lawfuluse of the rental property.q Services performed in connection withimprovements or repairs to the rentalproperty that extend the useful life of theproperty substantially beyond the averagerental period.q Services provided in connection withthe use of any improved real property thatare similar to those commonly provided in

connection with long-term rentals ofhigh-grade commercial or residentialproperty. Examples include cleaning andmaintenance of common areas, routinerepairs, trash collection, elevator service,and security at entrances.Extraordinary personal services.Services provided in connection withmaking rental property available forcustomer use are extraordinary personalservices only if the services are performedby individuals and the customers' use of

the rental property is incidental to theirreceipt of the services. For example, apatient's use of a hospital room generallyis incidental to the care that the patientreceives from the hospital's medical staff.Similarly, a student's use of a dormitoryroom in a boarding school is incidental tothe personal services provided by theschool's teaching staff.Rental property incidental to anonrental activity. An activity is not arental activity if the rental of the propertyis incidental to a nonrental activity, suchas the activity of holding property forinvestment, a trade or business activity,or the activity of dealing in property.

Rental of property is incidental to anactivity of holding property for investmentif both of the following apply:q The main purpose for holding theproperty is to realize a gain from theappreciation of the property.q The gross rental income from suchproperty for the tax year is less than 2%of the smaller of the property's unadjustedbasis or its fair market value.

Rental of property is incidental to atrade or business activity if all of thefollowing apply:q The corporation owns an interest in thetrade or business at all times during theyear.q The rental property was mainly used inthe trade or business activity during thetax year or during at least 2 of the 5preceding tax years.q The gross rental income from theproperty is less than 2% of the smaller ofthe property's unadjusted basis or its fairmarket value.

The sale or exchange of property thatis also rented during the tax year (wherethe gain or loss is recognized) is treatedas incidental to the activity of dealing inproperty if, at the time of the sale orexchange, the property was held primarilyfor sale to customers in the ordinarycourse of the corporation's trade or

business.See Temporary Regulations section

1.469-1T(e)(3) and Regulations section1.469-1(e)(3) for more information on thedefinition of rental activities for purposesof the passive activity limitations.Reporting of rental activities. Inreporting the corporation's income orlosses and credits from rental activities,the corporation must separately report (a)rental real estate activities and (b) rentalactivities other than rental real estateactivities.



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Shareholders who actively participatein a rental real estate activity may be ableto deduct part or all of their rental realestate losses (and the deductionequivalent of rental real estate credits)against income (or tax) from nonpassiveactivities. Generally, the combinedamount of rental real estate losses andthe deduction equivalent of rental realestate credits from all sources (includingrental real estate activities not heldthrough the corporation) that may be

claimed is limited to $25,000.Report rental real estate activity income(loss) on Form 8825, Rental Real EstateIncome and Expenses of a Partnershipor an S Corporation, and on line 2 ofSchedules K and K-1 rather than on page1 of Form 1120S. Report credits relatedto rental real estate activities on lines 12cand 12d and low-income housing creditson line 12b of Schedules K and K-1.

Report income (loss) from rentalactivities other than rental real estate online 3 and credits related to rentalactivities other than rental real estate online 12e of Schedules K and K-1.

Portfolio Income

Generally, portfolio income includes allgross income, other than income derivedin the ordinary course of a trade orbusiness, that is attributable to interest;dividends; royalties; income from a realestate investment trust, a regulatedinvestment company, a real estatemortgage investment conduit, a commontrust fund, a controlled foreigncorporation, a qualified electing fund, ora cooperative; income from thedisposition of property that producesincome of a type defined as portfolioincome; and income from the dispositionof property held for investment.

Solely for purposes of the precedingparagraph, gross income derived in theordinary course of a trade or businessincludes (and portfolio income,therefore, does not include) only thefollowing types of income:q Interest income on loans andinvestments made in the ordinary courseof a trade or business of lending money.q Interest on accounts receivable arisingfrom the performance of services or thesale of property in the ordinary course ofa trade or business of performing suchservices or selling such property, but onlyif credit is customarily offered tocustomers of the business.q

Income from investments made in theordinary course of a trade or business offurnishing insurance or annuity contractsor reinsuring risks underwritten byinsurance companies.q Income or gain derived in the ordinarycourse of an activity of trading or dealingin any property if such activity constitutesa trade or business (unless the dealerheld the property for investment at anytime before such income or gain isrecognized).

q Royalties derived by the taxpayer in theordinary course of a trade or business oflicensing intangible property.q Amounts included in the gross incomeof a patron of a cooperative by reason ofany payment or allocation to the patronbased on patronage occurring withrespect to a trade or business of thepatron.q Other income identified by the IRS asincome derived by the taxpayer in theordinary course of a trade or business.

See Temporary Regulations section1.469-2T(c)(3) for more information onportfolio income.

Report portfolio income on line 4 ofSchedules K and K-1, rather than on page1 of Form 1120S.

Report deductions related to portfolioincome on line 9 of Schedules K and K-1.

Grouping Activities

Generally, one or more trade or businessactivities or rental activities may betreated as a single activity if the activitiesmake up an appropriate economic unit formeasurement of gain or loss under thepassive activity rules. Whether activities

make up an appropriate economic unitdepends on all the relevant facts andcircumstances. The factors given thegreatest weight in determining whetheractivities make up an appropriateeconomic unit are

1. Similarities and differences in typesof trades or businesses,

2. The extent of common control,3. The extent of common ownership,4. Geographical location, and5. Reliance between or among the

activities.Example: The corporation has a

significant ownership interest in a bakery

and a movie theater in Baltimore and ina bakery and a movie theater inPhiladelphia. Depending on the relevantfacts and circumstances, there may bemore than one reasonable method forgrouping the corporation's activities. Forinstance, the following groupings may ormay not be permissible: a single activity,a movie theater activity and a bakeryactivity, a Baltimore activity and aPhiladelphia activity, or four separateactivities.

Once the corporation chooses agrouping under these rules, it mustcontinue using that grouping in later taxyears unless a material change in the

facts and circumstances makes it clearlyinappropriate.The IRS may regroup the corporation's

activities if the corporation's grouping failsto reflect one or more appropriateeconomic units and one of the primarypurposes for the grouping is to avoid thepassive activity limitations.Limitation on grouping certainactivities. The following activities maynot be grouped together:

1. A rental activity with a trade orbusiness activity unless the activities

being grouped together make up anappropriate economic unit, and

a. The rental activity is insubstantialrelative to the trade or business activityor vice versa, or

b. Each owner of the trade orbusiness activity has the sameproportionate ownership interest in therental activity. If so, the portion of therental activity involving the rental ofproperty to be used in the trade orbusiness activity may be grouped with the

trade or business activity.2. An activity involving the rental of

real property with an activity involving therental of personal property (except forpersonal property provided in connectionwith real property), or vice versa.

3. Any activity with another activity ina different type of business and in whichthe corporation holds an interest as alimited partner or as a limitedentrepreneur (as defined in section464(e)(2)) if that other activity engages inholding, producing, or distributing motionpicture films or videotapes; farming;leasing section 1245 property; orexploring for (or exploiting) oil and gas

resources or geothermal deposits.Activities conducted throughpartnerships. Once a partnershipdetermines its activities under these rules,the corporation as a partner may usethese rules to group those activities witheach other, with activities conducteddirectly by the corporation, and withactivities conducted through otherpartnerships. The corporation may nottreat as separate activities those activitiesgrouped together by the partnership.

Recharacterization of PassiveIncome

Under Temporary Regulations section

1.469-2T(f) and Regulations section1.469-2(f), net passive income fromcertain passive activities must be treatedas nonpassive income. Net passiveincome is the excess of an activity'spassive activity gross income over itspassive activity deductions (current yeardeductions and prior year unallowedlosses).

Income from the following six sourcesis subject to recharacterization. Note thatany net passive income recharacterizedas nonpassive income is treated asinvestment income for purposes offiguring investment interest expenselimitations if it is from (a) an activity of

renting substantially nondepreciableproperty from an equity-financed lendingactivity or (b) an activity related to aninterest in a pass-through entity thatlicenses intangible property.

1.Significant participation passiveactivities. A significant participationpassive activity is any trade or businessactivity in which the shareholder bothparticipates for more than 100 hoursduring the tax year and does notmaterially participate. Because eachshareholder must determine his or herlevel of participation, the corporation will



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not be able to identify significantparticipation passive activities.

2.Certain nondepreciable rentalproperty activities. Net passive incomefrom a rental activity is nonpassiveincome if less than 30% of the unadjustedbasis of the property used or held for useby customers in the activity is subject todepreciation under section 167.

3.Passive equity-financed lendingactivities. If the corporation has netincome from a passive equity-financed

lending activity, the smaller of the netpassive income or equity-financed interestincome from the activity is nonpassiveincome.Note: The amount of income from theactivities in items1 through3above thatany shareholder will be required torecharacterize as nonpassive income maybe limited under Temporary Regulationssection 1.469-2T(f)(8). Because thecorporation will not have informationregarding all of a shareholder's activities,it must identify all corporate activitiesmeeting the definitions in items2and3as activities that may be subject torecharacterization.

4.Rental activities incidental to adevelopment activity. Net rental activityincome (defined below) is nonpassiveincome for a shareholder if all of thefollowing apply: (a) the corporationrecognizes gain from the sale, exchange,or other disposition of the rental propertyduring the tax year; (b) the use of the itemof property in the rental activity startedless than 12 months before the date ofdisposition (the use of an item of rentalproperty begins on the first day on which(i) the corporation owns an interest in theproperty, (ii) substantially all of theproperty is either rented or held out forrent and ready to be rented, and (iii) no

significant value-enhancing servicesremain to be performed); and (c) theshareholder materially participated orsignificantly participated for any tax yearin an activity that involved theperformance of services for the purposeof enhancing the value of the property (orany other item of property, if the basis ofthe property disposed of is determined inwhole or in part by reference to the basisof that item of property).

Net rental activity income is theexcess of passive activity gross incomefrom renting or disposing of property overpassive activity deductions (current yeardeductions and prior year unallowedlosses) that are reasonably allocable tothe rented property.

Because the corporation cannotdetermine a shareholder's level ofparticipation, the corporation must identifynet income from property described initems 4(a) and 4(b) as income that maybe subject to recharacterization.

5.Activities involving propertyrented to a nonpassive activity. If ataxpayer rents property to a trade orbusiness activity in which the taxpayermaterially participates, the taxpayer's net

rental activity income (defined in item 4)from the property is nonpassive income.

6.Acquisition of an interest in apass-through entity that licensesintangible property. Generally, netroyalty income from intangible property isnonpassive income if the taxpayeracquired an interest in the pass-throughentity after it created the intangibleproperty or performed substantial servicesor incurred substantial costs in developingor marketing the intangible property.

Net royalty income is the excess ofpassive activity gross income fromlicensing or transferring any right inintangible property over passive activitydeductions (current year deductions andprior year unallowed losses) that arereasonably allocable to the intangibleproperty.

See Temporary Regulations section1.469-2T(f)(7)(iii) for exceptions to thisrule.

Passive Activity ReportingRequirements

To allow shareholders to correctly applythe passive activity loss and credit

limitation rules, any corporation thatcarries on more than one activity must:

1. Provide an attachment for eachactivity conducted through the corporationthat identifies the type of activityconducted (trade or business, rental realestate, rental activity other than rental realestate, or investment).

2. On the attachment for each activity,provide a schedule, using the same linenumbers as shown on Schedule K-1,detailing the net income (loss), credits,and all items required to be separatelystated under section 1366(a)(1) from eachtrade or business activity, from eachrental real estate activity, from each rental

activity other than a rental real estateactivity, and from investments.

3. Identify the net income (loss) andthe shareholder's share of corporationinterest expense from each activity ofrenting a dwelling unit that anyshareholder uses for personal purposesduring the year for more than the greaterof 14 days or 10% of the number of daysthat the residence is rented at fair rentalvalue.

4. Identify the net income (loss) andthe shareholder's share of interestexpense from each activity of tradingpersonal property conducted through thecorporation.

5. For any gain (loss) from thedisposition of an interest in an activity orof an interest in property used in anactivity (including dispositions before1987 from which gain is being recognizedafter 1986):

a. Identify the activity in which theproperty was used at the time ofdisposition;

b. If the property was used in morethan one activity during the 12 monthspreceding the disposition, identify theactivities in which the property was used

and the adjusted basis allocated to eachactivity; and

c. For gains only, if the property wassubstantially appreciated at the time of thedisposition and the applicable holdingperiod specified in Regulations section1.469-2(c)(2)(iii)(A) was not satisfied,identify the amount of the nonpassive gainand indicate whether or not the gain isinvestment income under Regulationssection 1.469-2(c)(2)(iii)(F).

6. Specify the amount of gross

portfolio income, the interest expenseproperly allocable to portfolio income, andexpenses other than interest expense thatare clearly and directly allocable toportfolio income.

7. Identify the ratable portion of anysection 481 adjustment (whether a netpositive or a net negative adjustment)allocable to each corporate activity.

8. Identify any gross income fromsources specifically excluded frompassive activity gross income, including:

a. Income from intangible property, ifthe shareholder is an individual whosepersonal efforts significantly contributedto the creation of the property;

b. Income from state, local, or foreignincome tax refunds; and

c. Income from a covenant not tocompete, if the shareholder is anindividual who contributed the covenantto the corporation.

9. Identify any deductions that are notpassive activity deductions.

10. If the corporation makes a full orpartial disposition of its interest in anotherentity, identify the gain (loss) allocable toeach activity conducted through the entity,and the gain allocable to a passive activitythat would have been recharacterized asnonpassive gain had the corporationdisposed of its interest in property used inthe activity (because the property wassubstantially appreciated at the time of thedisposition, and the gain representedmore than 10% of the shareholder's totalgain from the disposition).

11. Identify the following items that maybe subject to the recharacterization rulesunder Temporary Regulations section1.469-2T(f) and Regulations section1.469-2(f):

a. Net income from an activity ofrenting substantially nondepreciableproperty;

b. The smaller of equity-financedinterest income or net passive incomefrom an equity-financed lending activity;

c. Net rental activity income fromproperty developed (by the shareholderor the corporation), rented, and sold within12 months after the rental of the propertycommenced;

d. Net rental activity income from therental of property by the corporation to atrade or business activity in which theshareholder had an interest (eitherdirectly or indirectly); and

e. Net royalty income from intangibleproperty if the shareholder acquired theshareholder's interest in the corporation



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after the corporation created theintangible property or performedsubstantial services or incurredsubstantial costs in developing ormarketing the intangible property.

12. Identify separately the credits fromeach activity conducted by or through thecorporation.

Specific Instructions

General Information

Name, Address, and EmployerIdentification Number

Use the label that was mailed to thecorporation. Cross out any errors andprint the correct information on the label.Name. If the corporation did not receivea label, print or type the corporation's truename (as set forth in the corporate charteror other legal document creating it).Address. Include the suite, room, orother unit number after the street address.If a preaddressed label is used, pleaseinclude the information on the label. If thePost Office does not deliver to the streetaddress and the corporation has a P.O.box, show the box number instead of thestreet address.

If the corporation changes its mailingaddress after filing its return, it can notifythe IRS by filing Form 8822, Change ofAddress.Employer identification number (EIN).Show the correct EIN in item C on page1 of Form 1120S.

Item BBusiness Code No.

See the new Codes for PrincipalBusiness Activity on pages 26 through28 of these instructions.

Item ETotal Assets

Enter the corporation's total assets at theend of the tax year, as determined by theaccounting method regularly used inmaintaining the corporation's books andrecords. If there were no assets at the endof the tax year, enter the total assets asof the beginning of the tax year. If the Selection terminated during the tax year,see the instructions for Schedule L onpage 24 for special rules that may applywhen figuring the corporation's year-endassets.

Item FInitial Return, Final Return,

Change in Address, and AmendedReturn

If this is the corporation's first return,check box F(1). If the corporation hasceased to exist, check box F(2). Alsocheck box D(1) on each Schedule K-1 toindicate that it is a final Schedule K-1.Indicate a change in address by checkingbox F(3). If this amends a previously filedreturn, check box F(4). If Schedules K-1are also being amended, check box D(2)on each Schedule K-1.

IncomeCaution: Report only trade or businessactivity income or loss on lines 1a through6. Do not report rental activity incomeor portfolio income or loss on theselines. (SeePassive Activity Limitationsbeginning on page 6 for definitions ofrental income and portfolio income.)Rental activity income and portfolioincome are reported on Schedules K andK-1 (rental real estate activities are alsoreported on Form 8825).

Do not include any tax-exempt incomeon lines 1 through 5. A corporation thatreceives any exempt income other thaninterest, or holds any property or engagesin an activity that produces exemptincome, reports this income on line 18 ofSchedules K and K-1.

Report tax-exempt interest income,including exempt-interest dividendsreceived as a shareholder in a mutualfund or other regulated investmentcompany, on line 17 of Schedules K andK-1.

See Deductions beginning on page 11for information on how to report expenses

related to tax-exempt income.If the S corporation has had debtdischarged resulting from a title 11bankruptcy proceeding, or while insolvent,see Form 982, Reduction of TaxAttributes Due to Discharge ofIndebtedness, and Pub. 908, BankruptcyTax Guide.

Line 1Gross Receipts or Sales

Enter gross receipts or sales from alltrade or business operations except thoseyou report on lines 4 and 5. For reportingadvance payments, see Regulationssection 1.451-5. To report income fromlong-term contracts, see section 460.

Installment sales. Generally, theinstallment method cannot be used fordealer dispositions of property. A dealerdisposition is any disposition of personalproperty by a person who regularly sellsor otherwise disposes of property of thesame type on the installment plan or anydisposition of real property held for saleto customers in the ordinary course of thetaxpayer's trade or business. Thedisposition of property used or producedin the farming business is not included asa dealer disposition. See section 453(l)for details and exceptions.

Enter on line 1a the gross profit oncollections from installment sales for anyof the following:q Dealer dispositions of property beforeMarch 1, 1986.q Dispositions of property used orproduced in the trade or business offarming.q Certain dispositions of timeshares andresidential lots reported under theinstallment method.

Attach a schedule showing thefollowing information for the current andthe 3 preceding years:q Gross sales.

q Cost of goods sold.q Gross profits.q Percentage of gross profits to grosssales.q Amount collected.q Gross profit on the amount collected.

Line 2Cost of Goods Sold

See the instructions for Schedule A onpage 15.

Line 4Net Gain (Loss) From Form

4797Caution: Include only ordinary gains orlosses from the sale, exchange, orinvoluntary conversion of assets used ina trade or business activity. Ordinarygains or losses from the sale, exchange,or involuntary conversions of assets usedin rental activities are reported separatelyon Schedule K as part of the net income(loss) from the rental activity in which theproperty was used.

A corporation that is a partner in apartnership must include on Form 4797,Sales of Business Property, its share ofordinary gains (losses) from sales,exchanges, or involuntary or compulsoryconversions (other than casualties orthefts) of the partnership's trade orbusiness assets.

Do not include any recapture of thesection 179 expense deduction. See theinstructions on page 23 for Schedule K-1,line 23, item 3, and the Instructions forForm 4797 for more information.

Line 5Other Income (Loss)

Enter on line 5 trade or business income(loss) that is not included on lines 1athrough 4. Examples of such incomeinclude:

1. Interest income derived in theordinary course of the corporation's tradeor business, such as interest charged onreceivable balances;

2. Recoveries of bad debts deductedin earlier years under the specificcharge-off method;

3. Taxable income from insuranceproceeds;

4. The amount of credit figured onForm 6478, Credit for Alcohol Used asFuel;

5. All section 481 income adjustmentsresulting from changes in accountingmethods (show the computation on anattached schedule); and

6. Ordinary income (loss) from trade

or business activities of a partnership(from Schedule K-1 (Form 1065), line 1).The corporation must include as other

income the recapture amount for section280F if the business use of listed propertydrops to 50% or less. To figure therecapture amount, the corporation mustcomplete Part IV of Form 4797.

The corporation must also include inother income the amount of any deductionpreviously taken under section 179A thatis subject to recapture. The S corporationmay have to recapture the benefit of anyallowable deduction for qualified



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clean-fuel vehicle property (or clean-fuelvehicle refueling property), if the propertylater ceases to qualify for the deduction.See Pub. 535, Business Expenses, fordetails on how to figure the recapture.

Do not include items requiring separatecomputations by shareholders that mustbe reported on Schedules K and K-1.See the instructions for Schedules K andK-1 beginning on page 16.

If other income consists of only oneitem, identify it by showing the account

caption in parentheses on line 5. Aseparate schedule need not be attachedto the return in this case.

Do not net any expense item (such asinterest) with a similar income item.Report all trade or business expenses onlines 7 through 19.

DeductionsCaution: Reportonlytrade or businessactivity expenses on lines 7 through 19.

Do not report rental activity expensesor deductions allocable to portfolio incomeon these lines. Rental activity expensesare separately reported on Form 8825 or

line 3 of Schedules K and K-1. Deductionsallocable to portfolio income areseparately reported on line 9 of SchedulesK and K-1. See Passive ActivityLimitations beginning on page 6 for moreinformation on rental activities andportfolio income.

Do not report any nondeductibleamounts (such as expenses connectedwith the production of tax-exempt income)on lines 7 through 19. Instead, reportnondeductible expenses on line 19 ofSchedules K and K-1. If an expense isconnected with both taxable income andnontaxable income, allocate a reasonablepart of the expense to each kind ofincome.

Limitations on Deductions

Section 263A uniform capitalizationrules. The uniform capitalization rules ofsection 263A require corporations tocapitalize or include in inventory certaincosts incurred in connection with:q The production of real and tangiblepersonal property held in inventory or heldfor sale in the ordinary course ofbusiness.q Personal property (tangible andintangible) acquired for resale.q The production of property constructedor improved by a corporation for use in its

trade or business or in an activityengaged in for profit.The costs required to be capitalized

under section 263A are not deductibleuntil the property to which the costs relateis sold, used, or otherwise disposed of bythe corporation.

Exceptions. Section 263A does notapply to:q Personal property acquired for resale ifthe taxpayer's average annual grossreceipts for the 3 prior tax years are $10million or less.

q Timber.q Most property produced under along-term contract.q Certain property produced in a farmingbusiness. See below.

The corporation must report thefollowing costs separately to theshareholders for purposes ofdeterminations under section 59(e):q Research and experimental costs undersection 174.q Intangible drilling costs for oil, gas, andgeothermal property.q Mining exploration and developmentcosts.

Tangible personal propertyproducedby a corporation includes a film, soundrecording, video tape, book, or similarproperty.

Corporations subject to the rules arerequired to capitalize not only direct costsbut an allocable portion of most indirectcosts (including taxes) that benefit theassets produced or acquired for resale.

For inventory, some of the indirectcoststhat must be capitalized are:q Administration expenses.

q Taxes.q Depreciation.q Insurance.q Compensation paid to officersattributable to services.q Rework labor.q Contributions to pension, stock bonus,and certain profit-sharing, annuity, ordeferred compensation plans.

Regulations section 1.263A-1(e)(3)specifies other indirect costs that relate toproduction or resale activities that mustbe capitalized and those that may becurrently deducted.

Interest expense paid or incurred

during the production period of certainproperty must be capitalized and isgoverned by special rules. For moredetails, see Regulations sections1.263A-8 through 1.263A-15.

For more details on the uniformcapitalization rules, see Regulationssections 1.263A-1 through 1.263A-3.Special rules for certain corporationsengaged in farming. For S corporationsnot required to use the accrual method ofaccounting, the rules of section 263A donot apply to expenses of raising anyq Animal orq Plant that has a preproductive periodof 2 years or less.

Shareholders of S corporations notrequired to use the accrual method ofaccounting may elect to currently deductthe preproductive period expenses ofcertain plants that have a preproductiveperiod of more than 2 years. Becauseeach shareholder makes the election todeduct these expenses, the corporationshould not capitalize them. Instead, thecorporation should report the expensesseparately on line 21 of Schedule K andeach shareholder's pro rata share on line23 of Schedule K-1.

See sections 263A(d) and (e) andTemporary Regulations section1.263A-4T for definitions and otherdetails.Transactions between relatedtaxpayers. Generally, an accrual basisS corporation may deduct businessexpenses and interest owed to a relatedparty (including any shareholder) only inthe tax year of the corporation thatincludes the day on which the payment isincludible in the income of the related

party. See section 267 for details.Section 291 limitations. If the Scorporation was a C corporation for anyof the 3 immediately preceding years, thecorporation may be required to adjustdeductions allowed to the corporation fordepletion of iron ore and coal, and theamortizable basis of pollution controlfacilities. See section 291 to determinethe amount of the adjustment.Business start-up expenses. Businessstart-up expenses must be capitalized. Anelection may be made to amortize themover a period of not less than 60 months.See section 195.Reducing certain expenses for which

credits are allowable. For each creditlisted below, the corporation must reducethe otherwise allowable deductions forexpenses used to figure the credit by theamount of the current year credit.

1. The work opportunity credit,2. The welfare-to-work credit,3. The credit for increasing research

activities,4. The enhanced oil recovery credit,5. The disabled access credit,6. The empowerment zone

employment credit,7. The Indian employment credit,8. The credit for employer social

security and Medicare taxes paid oncertain employee tips, and9. The orphan drug credit.

If the corporation has any of thesecredits, be sure to figure each currentyear credit before figuring the deductionsfor expenses on which the credit is based.

Line 7Compensation of Officers

Enter on line 7 the total compensation ofall officers paid or incurred in the trade orbusiness activities of the corporation,including fringe benefit expendituresmade on behalf of officers owning morethan 2% of the corporation's stock. Alsoreport these fringe benefits as wages in

box 1 of Form W-2. Do not include on line7 amounts paid or incurred for fringebenefits of officers owning 2% or less ofthe corporation's stock. These amountsare reported on line 18, page 1, of Form1120S. See the instructions for that linefor information on the types ofexpenditures that are treated as fringebenefits and for the stock ownership rules.

Report amounts paid for healthinsurance coverage for a more than 2%shareholder (including that shareholder'sspouse and dependents) as aninformation item in box 14 of that



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shareholder's Form W-2. For 1998, amore than 2% shareholder may beallowed to deduct up to 45% of suchamounts on Form 1040, line 28.

Do not include on line 7 compensationreported elsewhere on the return, suchas amounts included in cost of goodssold, elective contributions to a section401(k) cash or deferred arrangement, oramounts contributed under a salaryreduction SEP agreement.

Line 8Salaries and WagesEnter on line 8 the amount of salaries andwages paid or incurred for the tax year,reduced by any applicable employmentcredits from Form 5884, WorkOpportunity Credit, Form 8861,Welfare-to-Work Credit, Form 8844,Empowerment Zone Employment Credit,and Form 8845, Indian EmploymentCredit. See the instructions for theseforms for more information. Include fringebenefit expenditures made on behalf ofemployees (other than officers) owningmore than 2% of the corporation's stock.Also report these fringe benefits as wagesin box 1 of Form W-2. Do not include on

line 8 amounts paid or incurred for fringebenefits of employees owning 2% or lessof the corporation's stock. These amountsare reported on line 18, page 1, of Form1120S. See the instructions for that linefor information on the types ofexpenditures that are treated as fringebenefits and for the stock ownership rules.

Report amounts paid for healthinsurance coverage for a more than 2%shareholder (including that shareholder'sspouse and dependents) as aninformation item in box 14 of thatshareholder's Form W-2. For 1998, amore than 2% shareholder may beallowed to deduct up to 45% of suchamounts on Form 1040, line 28.

Do not include on line 8 salaries andwages reported elsewhere on the return,such as amounts included in cost ofgoods sold, elective contributions to asection 401(k) cash or deferredarrangement, or amounts contributedunder a salary reduction SEP agreement.

If a shareholder or a member of thefamily of one or more shareholders of thecorporation renders services or furnishescapital to the corporation for whichreasonable compensation is not paid, theIRS may make adjustments in the itemstaken into account by such individuals andthe value of such services or capital. Seesection 1366(e).

Line 9Repairs and Maintenance

Enter the costs of incidental repairs andmaintenance, such as labor and supplies,that do not add to the value of theproperty or appreciably prolong its life, butonly to the extent that such costs relateto a trade or business activity and are notclaimed elsewhere on the return. Newbuildings, machinery, or permanentimprovements that increase the value ofthe property are not deductible. They are

chargeable to capital accounts and maybe depreciated or amortized.

Line 10Bad Debts

Enter the total debts that becameworthless in whole or in part during theyear, but only to the extent such debtsrelate to a trade or business activity.Report deductible nonbusiness bad debtsas a short-term capital loss on ScheduleD (Form 1120S).Caution: Cash method taxpayers cannot

take a bad debt deduction unless theamount was previously included inincome.

Line 11Rents

If the corporation rented or leased avehicle, enter the total annual rent orlease expense paid or incurred in thetrade or business activities of thecorporation. Also complete Part V ofForm 4562, Depreciation andAmortization. If the corporation leased avehicle for a term of 30 days or more, thededuction for vehicle lease expense mayhave to be reduced by an amount calledthe inclusion amount. The corporation

may have an inclusion amount if

See Pub. 463 for instructions onfiguring the inclusion amount.

Line 12Taxes and LicensesEnter taxes and licenses paid or incurredin the trade or business activities of thecorporation, if not reflected in cost ofgoods sold. Federal import duties andFederal excise and stamp taxes aredeductible only if paid or incurred incarrying on the trade or business of thecorporation.

Do not deduct the following taxes online 12:q State and local sales taxes paid orincurred in connection with the acquisitionor disposition of business property.These taxes must be added to the costof the property, or in the case of a

disposition, subtracted from the amountrealized.q Taxes assessed against local benefitsthat increase the value of the propertyassessed, such as for paving, etc.q Federal income taxes, or taxes reportedelsewhere on the return.q Section 901 foreign taxes. Report thesetaxes separately on line 15e, ScheduleK.q Taxes allocable to a rental activity.Taxes allocable to a rental real estate

activity are reported on Form 8825.Taxes allocable to a rental activity otherthan a rental real estate activity arereported on line 3b of Schedule K.q Taxes allocable to portfolio income.Report these taxes separately on line 9of Schedules K and K-1.q Taxes paid or incurred for theproduction or collection of income, or forthe management, conservation, ormaintenance of property held to produceincome. Report these taxes separately on

line 10 of Schedules K and K-1.See section 263A(a) for information on

capitalization of allocable costs (includingtaxes) for any property.

Line 13Interest

Include on line 13 only interest incurred inthe trade or business activities of thecorporation that is not claimed elsewhereon the return.

Do not include interest expense on debtused to purchase rental property or debtused in a rental activity. Interest allocableto a rental real estate activity is reportedon Form 8825 and is used in arriving atnet income (loss) from rental real estate

activities on line 2 of Schedules K andK-1. Interest allocable to a rental activityother than a rental real estate activity isincluded on line 3b of Schedule K and isused in arriving at net income (loss) froma rental activity (other than a rental realestate activity). This net amount isreported on line 3c of Schedule K and line3 of Schedule K-1.

Do not include interest expense clearlyand directly alloc

us internal revenue service: i1120s--1998

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