Question

Barry Potter and Winnie Weasley are considering making an S election on March 1, 2019, for their C corporation, Omniocular. However, first they want to consider the implications of the following information:

• Winnie is a U.S. citizen and resident.
• Barry is a citizen of the United Kingdom, but a resident of the United States.
• Barry and Winnie each own 50 percent of the voting power in Omniocular. However, Barry's stock provides him with a claim on 60 percent of the Omniocular assets in liquidation.
• Omniocular was formed under Arizona state law, but it plans on eventually conducting some business in Mexico.

For the remainder of the problem, assume Omniocular made a valid S election effective January 1, 2019. Barry and Winnie each own 50 percent of the voting power and have equal claim on Omniocular's assets in liquidation. In addition, consider the following information:

• Omniocular reports on a calendar tax year.
• Omniocular's earnings and profits as of December 31, 2018, were $55,000.
• Omniocular's 2018 taxable income was $15,000.
• Omniocular's assets at the end of 2018 are as follows:

*$110,000 under FIFO accounting.

• On March 31, 2019, Omniocular sold the land for $42,000.
• In 2019, Omniocular sold all the inventory it had on hand at the beginning of the year. This was the only inventory it sold during the year.

• Assume that if Omniocular were a C corporation for 2019, its taxable income would have been $88,500.

For the following questions, assume that after electing S corporation status Barry and Winnie had a change of heart and filed an election to terminate Omniocular's S election, effective August 1, 2020.

In 2020, Omniocular reported the following income/expense items: F. For tax purposes, how would you recommend Barry and Winnie allocate income between the short S corporation year and the short C corporation year if they would like to minimize double taxation of Omniocular's income?

F. For tax purposes, how would you recommend Barry and Winnie allocate income between the short S corporation year and the short C corporation year if they would like to minimize double taxation of Omniocular's income?

Answer 1

Answer:

a)

All shareholders are eligible S corporation shareholders. However, it appears as though Omniocular has more than one class of stock because even though Barry and Winnie each have 50 percent of the voting power, Barry’s stock provides him with 60 percent of the assets in liquidation. Consequently, Omniocular is not eligible to make an S election.

b)

$6,300 LIFO recapture tax ($30,000 x 21%). The LIFO recapture amount is $30,000 ($110,000 FIFO inventory basis minus $80,000 LIFO inventory basis). This additional $30,000 is taxed at Omniocular’s marginal tax rate of 21%. The LIFO recapture tax is paid in four installments of $1,575 each ($6,300/4). The first installment is due on April 15, year 2019 (the unextended due date for the 2018 C corporation tax return). The remaining three installments are due on March 15 of years 2020, 2021, and 2022 (the unextended due date for the S corporation tax returns). Note that the LIFO recapture tax increases Omniocular’s tax basis in the inventory to $110,000.

c)

$3,150. Omniocular’s net unrealized built-in gain at the time it converted to an S corporation is $20,000 [$10,000 built-in gain on the land plus $15,000 built-in gain on inventory (after increasing basis to $110,000 due to LIFO recapture tax) minus $5,000 built-in loss on equipment]. Its built-in gains tax is 21% multiplied by the least of (a) $15,000 which is its recognized built-in gain on the inventory (b) $20,000 which is its net unrealized built-in gain when it converted to an S corporation (it had not recognized any of this amount previously), and (c) $88,500 which is what its taxable income would have been if it were still a C corporation.

So, its built-in gains tax is 21% x $15,000 = $3,150. This tax passes through as an ordinary loss (the tax arose from the sale of inventory so the loss is ordinary to Omniocular’s shareholders).

d)

$8,400. Omniocular’s passive and net passive investment income is $105,000 ($40,000 interest income + $65,000 qualified dividend income). Its gross receipts are $260,000 ($155,000 sales revenue + $40,000 interest income + $65,000 dividend income). Because Omniocular’s passive investment income exceeds 25% of its gross receipts it is subject to the excess net passive income tax. The amount of the tax is $8,400, computed as follows:

The excess net passive income tax is 21% multiplied by the lesser of:

(1)$40,000 [$105,000 net passive investment income x (105,000 – 25% x $260,000)/$105,000] or (2) $88,500 (Omniocular’s taxable income if it had been a C corporation). Thus its excess net passive income tax is $8,400 (21% x 40,000). Each item of passive income that flows through to the shareholders is reduced by a pro-rata portion of the excess net passive income tax. In this situation, Omniocular’s passive income is $40,000 of interest and $65,000 of qualified dividend income. Thus, the amount of interest that flows through to Omniocular’s shareholders is $34,667 [$40,000 – (40,000/105,000 x 14,000) and the amount of qualified dividend income that flows through to the shareholders is $56,333 [$65,000 – (65,000/105,000 x 14,000)]

e)

Barry is a 50 percent shareholder in Omniocular. His basis on December 31, 2019 is $48,375, computed as follows:

Description	Amount	Description
Basis on 1/1/2019	$40,000
Interest income	17,334	$34,667 (interest income reduced by portion of excess net passive income tax) x 50% (Barry is a 50 percent owner).
Qualified dividend income	28,166	$56,333 (dividend income reduced by portion of excess net passive income tax) x 50%
Business (loss) (see below)	(13,125)	($26,250) x 50%
Capital loss (on land sale)	(24,000)	($48,000) x 50%
Basis at year end	$48,375

Business income (loss):

Description	Amount
Sales revenue	$155,000
COGS (adjusted to FIFO basis due to LIFO recapture tax)	(110,000)
Loss from built-in gains tax	(5,250)
Salaries to owners	(50,000)
Employee wages	(10,000)
Depreciation expense	(5,000)
Miscellaneous expenses	(1,000)
Business income (loss)	($26,250)

f.

They should allocate the income based on the number of days in the short year compared to the entire year (i.e., the daily method). This will allow them to shift income out of the short C corporation year and into the short S corporation year and thus subject less income to double taxation.

g.

$79,171. If Omniocular allocates its income based on the number of days in the S corporation period and the C corporation period it will allocate $29,171 of income to Barry ($100,250 x 213/366 x 50% ownership). Thus, his stock basis will be $79,171 ($50,000 plus 29,171).

h.

January 1, 2025. This is the beginning of the fifth year after the year in which the S election was terminated.

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