1 subchapter s (day 2) robert r. oliva, ph.d., ll.m., j.d., cpa university of arkansas at little...
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Subchapter S (Day 2)
Robert R. Oliva, Ph.D., LL.M., J.D., CPA
University of Arkansas at Little Rock
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Introduction
Tax effect of S election Subchapter S taxes
» BIG/PII» Recapture
Shareholder taxes: Pass Throughs: » Separately stated» Not separately stated
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Tax Effect of S Election on S
Information return No federal income taxes paid, except
» BIG» PII» Recapture: LIFO reserve; ITC
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Tax Effect of S Election on Shareholders
Introduction Separately stated items Nonseparately stated items
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Introduction
S v. partnerships S v. corporations
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S Corp v. partnerships
Similar in income computation: » Separately and non-separately stated items.
However,» S measures property distributions at FMV
– Partnerships distributions measured at AB
» S debt does not affect shareholders’ AB. – Partnership’s debt affects partners’ AB
» Disproportional distributions permitted in partnerships
– But could cause the S termination b/c creates second class of stock
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S Corp v. C Corp
Unless otherwise stated follow Sub C rules » Like C Corps, S Corps
– allowed IRC 248 org. exp. Amortization– Recognize gain on distributions of appreciated property
However, while gain is passed through but shareholder does not report it as dividend.
» But unlike C Corps, – S Corps are not allowed to an IRC 243 or IRC 291
deductions – S Corps separately report items that may have different
treatments at shareholder level.
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Separately Stated Items
charitable contributions (no 10% limit) foreign/possessions taxes
» Shareholder to elect deduction or credit tax exempt income
» Passes through as increases to AB income/loss/deduction/credit requiring separate
treatment» Capital gains & losses» IRC 1231 gains & losses» Interest and dividends received by an S, e.g., portfolio
income
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Separately Stated Deductions
IRC 179 Nonbusiness bad debt (IRC 166(d):
STCL)
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Non-separately Stated Items
Gross income less deductions Deductions: IRC 248, 291, depreciation
(not 179). Disallowed deductions: sep. stated;
personal;
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Computation of shareholders’ share
Pro rata: daily/per share Daily: Yearly income(loss) / days in
taxable year Per share: Daily income(loss) / # shares
outstanding
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Example 1: Pro rata
A and B equal owners of S » w/ O.I. of $146,000 » and LTCG of $36,500.
How much do A and B report?
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Answer to Example 1:
A and B each report 50%.
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Example 2:Pro rata
Now B sells 50% on 90th day.» B owned 50% for 89 days and 25% for 276
days » C owned 25% for 276 days
How much do B and C report?
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Answer to Example 2: Ordinary Income:
B: $146K(.5)(89/365) + $146K(.25)(276/365) = $45,400
C: $146K(.25)(276/365) = $27,600
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Answer to Example 2: LTCG
B: $36500(.5)(89/365) + $36500(.25)(276/365)=$11350
C:$36500(.25)(276/365) = $6900
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Example 3: pro rata
A owns 10% through the year; nonseparately stated = $36500
How much does he report?
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Answer to Example 3:
.10(36500) = $3650 Or:
» Daily: $36500/365= $100/day» Prorata:$100(.10)=$10/day» Yearly share: $10/day(365)=$3650
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Example 4: prorata
Same as 3 but now A buys another 10% on the 201st day:
How much does he report?
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Answer to Example 4:
10% for 200 days:$100/day(.10)(200)=$2000
20% for 165 days:$100/day(.20)(165)=$3300
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Effect of cessation of ownership:
If no election: compute as above If election: compute as if two years Why relevant?
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Relevancy of no election:
If income is NOT earned evenly throughout year, shareholders will not report their fair share
Similar election available when S terminates.
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Distributions: irc 1368
An extension of the IRC 301 water faucet analogy in Subchapter C.
But 4 buckets or tiers instead of 3 buckets» Tier 1: From AAA: Tax free
– Simultaneously reduce AAA and AB
– Recognize gain after AB.
» Tier 2: In excess of AAA: dividend up to AEP» Tier 3: Remainder of AB tax free» Tier 4: Balance in excess of AB = gain
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Therefore,
an S distribution has no impact on shareholders’ TI unless » After elimination of AAA, distribution is
sourced from EP» Distribution > Adjusted Basis
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AAA: Accumulated Adjustments Account
Rationale: Tracks the source of distributions
Two sources of distributions» Undistributed and untaxed C’s EP = AEP» Undistributed but taxed S’s operations =
post-1982 undistributed earnings
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AAA: Adjustments
Beginning balance on day 1 of S = 0» AAA = 0» AEP = $500 (leftover from C years)
Increase AAA by results of operations» If S has $100 earnings, then
– AAA= $100– AEP = $500
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AAA adjustments:
Increase AAA» Results of operations
Reduce AAA by» Pass through losses/deductions» Nondeductible expenses, not charged to
capital account
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Examples of nonded exp/not charged to cap.
expenses for tax free income illegal bribes, nondeductible fines &
penalties losses between related parties federal taxes during C years disallowed meal and entertainment
expenses
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Treatment
Redemptions, distributions and operating results» Sub S corporations with C’s EP.» Sub S corporations (never were C
corporations)
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Sub S corporations with C’s EP.
Dealing with the AAA
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AAA Adjustments: Redemption
25% stock redemption; AAA = $160 Adjust AAA by 25%: $160 - .25(160) =
$120
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AAA adjustments: Distributions
Timing Issue: » Which should be accounted for first?
– Results of operations?– Results of distributions?
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General rule:
(1) Adjust S Corp’s balances (AAA, EP, AB) by the results of operations
(2) Adjust S Corp’s balances to account for the distribution.
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Exception:
The order of adjustments is changed when there is an operating loss at EOY.» (1) Adjust for the distribution» (2) Adjust for the results of operations
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Example 5: Operating Loss
Assume one owner EOY balance before adjustments for the
results of operations and distributions » AAA=400; » AEP=1000; » AB=2000;
EOY operating results:» LTCG=400; » Operating loss=(1800)
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Order of Adjustments (the exception)
First: Distributions Then: LTCG and ordinary loss.
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Recalling treatment for distributions:
Tier 1: From AAA: Tax free» Simultaneously reduce
– AAA and AB
» Recognize gain after AB. Tier 2: In excess of AAA: dividend up to
AEP Tier 3: Remainder of AB tax free Tier 4: Balance in excess of AB = gain
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Example 6: Same facts as #5 but w/$1200 dist.
EOY balance before adjustments for the results of operations and distributions » AAA=400 (from past results of S operations); » AEP=1000 (from results when business was
conducted as a C Corp); » AB=2000;
EOY results:» LTCG=400; » Operating Loss=(1800)» Distribution during the year: $1200
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Effect on Tier 1: AAA
AAA = 400 - 400 = 0 » Note that $800 of the $1200 distribution has not
been accounted for as of this time.
Simultaneous reduction of AB » EOY AB before adjustments = 2000 - 400 AAA
reduction = 1600 AB balance
Results after dealing with 1st tier: » AB balance = $1600» ROC = $400
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The balance of the $1200, e.g., the $800:
Effect on Tier 2: In excess of AAA, div. up to AEP.» AEP=1000-800 = 200
Results after Tier 2: » AEP balance= $200» $800 dividend
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Results of the $1200 distribution:
ROC = $400; Dividend = $800 Balances
» AEP balance = $200» AAA balance = 0» AB balance = $1600
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After treatment of the $1200 distribution,
proceed to account for the results of operations,» $400 LTCG » $1800 ordinary loss
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Example 7:
AAA = Beginning balance $400 - $400 (because of distribution) + $400 LTCG - $1800 ordinary loss = - $1400 AAA negative balance
AB = Beginning balance $2000 - $400 (b/c of distribution) + $400 LTCG - $1800 loss = $200 ending balance
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Note:
Even if AB not enough to reflect loss, AAA will reflect it.
Distribution is greater than AB but the distribution is not taxable.
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Distributions under the “general rule”
(1) Adjust for results of operations (2) Adjust for distributions.
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Example 8: Facts:
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Results from operations
Non-separately stated income and deductions» $30K
Separately stated income and deductions
» LTCG: 15
» Municipal interest: 5
» Dividend income: 3
» Charitable contribution: -8
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Example 8: Balances at BOY
AB 60 AAA 40 OAA 0 AEP 25
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Example 8:
First question» What is the effect of operations on the
following accounts?– AB; AAA; OAA; AEP
Second question» What will be the effect of two $50K
distributions, one in June 1 and the other one in December 1?
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SubSExample8.xls
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Example 9: AEP and no AAA
Facts: After accounting for the results from operations Sub S Corp has the following balances: AEP=$10; AAA=0; and AB=$25. What is the effect of $50 distribution?
Effect on Tiers:» Tier 1: AAA: None» Tier 2: Div up to AEP = $10» Tier 3: Reduce AB = $25» Tier 4: Balance above AB = gain = $15
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Distributions where there is no AAA nor EP
Tier 1: AAA: None Tier 2: EP : None Tier 3: Reduce AB Tier 4: Balance above AB = gain from
s/e.
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Example 10:
Facts: Results from operations: OI=30; LTCL=(5). Sole shareholder has AB=20 at BOY and receives $35 in distributions during the year.
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First compute EOY AB and before distributions :
AB BOY 20 + 30 OI -5 LTCL = 45 AB before distributions
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Second: Compute effect of distributions:
Tier 1: AAA: None Tier 2: EP : None Tier 3: Reduce AB: 45 - 35 distribution =
10 AB balance at EOY Tier 4: Balance above AB = gain from
s/e = $0
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Example 11:
Facts: Same as 10 but now assume that OI=5, and no LTCL.
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First compute EOY AB and before distributions :
AB BOY 20 + 5 OI = 25
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Second: Compute effect of distributions:
Tier 1: AAA: None Tier 2: EP : None Tier 3: Reduce AB: 25 - 25 distribution =
0 AB balance at EOY» Additional $10 has to be accounted as gain
Tier 4: Balance above AB = gain from s/e = $10
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Example 12:
Facts: Same as 10 but now OI= (5), and no LTCL
First compute ending AB=20-5=15 Then 1st Tier: 15-15= 0 AB, 20 LTCG Is this correct?
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NOT!
Operating loss (exception of general rule). » It requires a net negative adjustment
First: reduce BOY AB by dist of 35: 20-20=0 AB
Excess of dist. over AB= 15 LTCG gain; NOT 20.
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AB Positive Adjustments: rationale
If earnings are up, stock value should be up.
If shdr sells, then substantial gain But as shdr pays for P/T, AB increases
to avoid double tax.
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AB Negative Adjustments: rationale
If earnings are down, stock value should decrease.
If shdr sells,then substantial loss But b/c P/T losses reduce other income,
losses reduce AB to avoid a double benefit.
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AB Adjustments done at EOY
NOTE: If shareholder sells during the year, gain/loss not determined until EOY.
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Pecking Order for AB Adjustments
1. Increase for income items 2. Decrease for nondeductible,
noncapital expenses 3. Decrease for losses and deductions
(could precede 2) 4. Decrease for distributions
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Example 13: AB adjustments:
Note: Previous examples involved a 100% shareholder
S reports $50 profit and distributes $20K to 50% shareholder who has $10 AB at BOY » AB BOY 10 + 25 (50% of profits) - 20
distribution = 15 AB EOY and after distributions
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Example 14: AB Adjustments
Multiple years; equity and debt: » S reports 15K loss in Yr1 and 25K profit in
Yr2.» At BOY YR 1: Stock AB=5; Debt AB = 5K
(material participation) » S distributes $8K in Yr2 to 50%
shareholder Tax effect of distribution?
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Answer to Example 15: Year 1
Yr1: $15K loss: Reduce shareholder’s AB by 50% of $15K» Decrease AB stock: BOY 5 - 5 = 0 EOY 1
(Stock AB cannot fall below 0) » Decrease AB of debt: BOY 5 - 2.5 (bal. not
used by stock AB) = 2.5 EOY Yr 1
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Answer to Example 15: Year 2
Yr.2: $25K profit; Increase shareholder’s AB by 50% of $25K» Restore debt AB: BOY Yr 2: 2.5 + 2.5
(Debt AB cannot go over original AB) = 5K at EOY 2 and before distributions
» Restore stock AB: BOY Yr 2: $0 + $10K = $10 EOY Yr 2 AB before distributions
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Answer to Example 15: Effect of $8K distribution
in Yr 2:
Stock AB EOY Yr 2 10 - 8 dist = 2 ending AB after dist.
As distribution did not exceed stock AB, it is a tax free distribution.
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Example 16:
A, B, and C equal owners. A’s AB=25 OI=36.5; muni=14.6; A sells on 1/31 for
$30K Compute A’s gain/loss.
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Answer Example 16:
AB= 25 + [36.5(1/3)(30/365)] + [14.6(1/3)(30/365)=26.4
Gain from sale of stock: 30 - 26.4 = $3.6
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Debt Basis
Use stock AB first, then debt’s AB, not below 0.
Eligible “debt”: B/E fn 115, 116. Unused loss/deduction carried forward
indefinitely Upward adjustments in reverse
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Example 17: Debt AB
1/1/00: 50% shdr, AB stock=40K, secured debt AB=20K
2000: S reports (100K). Thus ABs=0, ABd=10K
2001: S reports 10K. ABdebt=15K. S pays $20K note. Shdr reports $5K gain on
debt. Unsecured note would have resulted in $5K
OI.
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ENPI: Example 18
ENPI = NPI [ (PII-.25 GR) / PII ] Nonpassive= 35K; PII=65K; exp for
PII=10K; other exp=25» NPI = 65-10 = 55
ENPI= 65-10 [(65-.25(35+65) / 65 = $33,486
$33486 at highest rate (assume 35%) = $11,486
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Built-In Gains Tax
Recognizes any C’s BIG during 10 years after S election.
Taxes gain at highest rate, e.g., 35% If BIG imposed, it is treated as a loss for
the year. Character of loss: look at the asset
causing BIG
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Definitions
NUBIG: Excess of FMV over AB on Day 1 of S
NRBIG: Lesser of net of BIG and BIL or TI Recognized BIG: gain from sale of any asset. Exceptions:
» Asset sold not held in Day1, or» if held on Day 1, actual gain exceeded NUBIG
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Additional Limitations
NRBIG < NUBIG-NRBIG to date: top = NUBIG
C’s NOL carryforwards used v. BIG
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Example 19: BIG
1/1/96:FMV/AB: Inv(FIFO)=75/60;Mach1(1245:18/11, Mach2 (1231):15/19
Inv sold for 85: 85-60=25 OI, but 15 is BIG Mach 1 sold for 19: 19-11=8 OI, but 7 is BIG. Mach 2 (1231) sold or 16: 16-19=3 1231 loss
PT, and 3 BIG Yearly: 15+7-3=19 at 35% = $6,650 in BIG
taxes