Question

"Explaining the Basics of S-Corporations"

You are the lead S-Corporations tax specialist in your area. Your client, Cathyrn, has purchased an S Corporation and needs to be versed on how this type of corporation works. Identify three operating issues (e.g. accounting period, income/loss allocation, operating/liquidating distributions, stock basis calculations, fringe benefit rules) that Cathyrn should be aware of in managing this form of business.

Answer 1

ANS:

S corporation is most the popular business type in world, It's kind of like the lite version of a c corporation (c corp). An s corp offers investment opportunities, perpetual existence, and that coveted protection of limited liability. But, unlike a c corp, s corps only have to file taxes yearly and they are not subject to double taxation. Read on if this sounds enticing for your business.

S Corp Advantages

Read 'em and weep.

• Limited liability. Company directors, officers, shareholders, and employees enjoy limited liability protection.
• Pass-through taxation. Owners report their share of profit and loss on their individual tax returns.
• Elimination of double taxation of income. Income is not taxed twice – once as corporate income and again as dividend income.
• Investment opportunities. The company can attract investors through the sale of shares of stock.
• Perpetual existence. The business continues to exist even if the owner leaves or dies.
• Once-a-year tax filing requirement. Versus c corps, which must file quarterly.

apart from its advantages there are some disadvantages of S corp.

S Corp Disadvantages

There's a lot to love, but here's a few things to consider before adding the 's' to your corp.

• U.S. citizens and permanent residents only. Unlike the c corp and LLC (Limited Liability Company), you have to be a legal resident of the U.S.
• Limited ownership. An s corp may not have more than 100 shareholders.
• Formation and ongoing expenses. It is necessary to first incorporate the business by filing Articles of Incorporation with your desired state of incorporation, obtain a registered agent for your company, and pay the appropriate fees. Many states also impose ongoing fees, such as annual report and/or franchise tax fees.
• Tax qualification obligations. Mistakes regarding the various filing requirements can accidentally result in the termination of s corp status.
• Closer IRS scrutiny. Payments to employees and shareholders could be distributed as either salaries or dividends. Each are taxed differently, which is what leads the IRS to scrutinize that distribution more closely.

That's why Cathyrn should be aware of following operations issues in managing this form of business.

1) Accounting period:

The use of a fiscal year defers reporting of the S corporation’s passthrough income to the shareholders and facilitates year-end tax planning. The shareholders can determine their income from the S corporation before their individual calendar tax year ends. This allows them to prepare for the effects of passthrough from the S corporation and implement any appropriate tax planning strategies before the end of their tax years. Further, a fiscal year may result in the deferral of income.

Using a Permitted Year

The S corporation tax-year rules, similar to those governing partnerships, state that an S corporation must use a permitted year. Under Sec. 1378(b), a permitted year is a tax year that (1) ends on December 31 or (2) is any other accounting period for which the corporation establishes a business purpose to the satisfaction of the IRS.

A business-purpose fiscal year may be automatically established if it is:

1. A natural business year because it meets a 25% mechanical test;
2. An ownership tax year because it coincides with the tax year used by shareholders holding more than 50% of the corporation’s stock on the first day of the requested tax year; or
3. A certain 52-53-week year.

If the requested business-purpose tax year cannot be established under the automatic approval provisions, it must be established based on facts and circumstances. As an alternative to using a calendar year or a business-purpose fiscal year, the corporation may elect a fiscal year if it meets the requirements of Sec. 444.

Choosing a Fiscal Year When the Corporation Elects S Status

When a corporation elects S status by filing a properly completed Form 2553, Election by a Small Business Corporation (Under Section 1362 of the Internal Revenue Code), it simultaneously applies for a tax year. The entry of a month and day in the “selected tax year” space provided on Form 2553 is a formal request for a specific year that ends on the last day of that month.

A company electing to be an S corporation can:

1. Use a calendar year;
2. Make the Sec. 444 election and use an acceptable fiscal year;
3. Apply for a fiscal year that will be approved automatically; or
4. Apply for a business-purpose fiscal year established by facts and circumstances.

When a C corporation elects S status, the S corporation’s first tax year begins on the first day following the calendar or fiscal tax year of the electing C corporation.

Changing the Year of an Existing S Corporation

An existing S corporation may change its tax year to (1) a calendar year; (2) an allowable Sec. 444 fiscal year; (3) a year that coincides with the tax year used by shareholders holding more than 50% of the corporation’s stock, a certain 52-53- week year, or a business-purpose year that will be automatically approved; or (4) a business-purpose year that requires IRS approval.

An existing S corporation generally uses Form 1128, Application to Adopt, Change, or Retain a Tax Year, to apply for a change in a permitted fiscal year. However, Form 8716, Election to Have a Tax Year Other Than a Required Tax Year, is used to apply for a change under Sec. 444.

Using a Fiscal Year by Making the Sec. 444 Election

An alternative to using a permitted year is provided by two Code sections dealing with fiscal years—Secs. 444 and 7519. Sec. 444 allows an S corporation to elect to use a fiscal year if it meets certain criteria. Sec. 7519 states that the entity must make required payments if it elects a fiscal year under Sec. 444. The required payments are intended to approximate the amount of tax that would be paid by the shareholder if the corporation changed to a calendar year. Thus, in most cases, the payments offset the income tax deferral provided by the fiscal year.

If an S corporation makes the Sec. 444 election, there are restrictions on the fiscal years that it can choose. S corporations making the Sec. 444 election are limited to year ends of September 30, October 31, or November 30. Furthermore, an S corporation generally must make a required payment in each year for which the Sec. 444 election is effective (Sec. 7519). Required payments are cumulative, however, and no payments are due until the cumulative required payments exceed $500.

The Sec. 444 election remains in effect until terminated—for example, when the corporation changes to a calendar year. If the S corporation terminates its Sec. 444 election, it cannot make the election again.

Using a Fiscal Year Under the Grandfather Rules

An S corporation that used a fiscal year for the year that began in 1986 can continue using that fiscal year if it made the Sec. 444 election by July 26, 1988. Also, an S corporation that received IRS permission to use a fiscal year on or after July 1, 1974, can retain that fiscal year if the fiscal year did not end on September 30, October 31, or November 30. The S corporation does not have to make a Sec. 444 election.

Obtaining Automatic Approval of Fiscal Year

The automatic approval provisions allow an S corporation to elect a fiscal year using simplified procedures. Automatically approved fiscal years are considered to have a business purpose. Thus, they are not subject to Sec. 444, and the S corporation does not have to make required payments. The IRS will automatically approve a tax year when the S corporation is (Rev. Proc. 2006-46):

1. Adopting, changing to, or retaining a calendar year;
2. Adopting, retaining, or changing to a fiscal year that is considered a natural business year because it meets an objective 25% test;
3. Adopting, retaining, or changing to an ownership tax year because it is the same as the fiscal year used by shareholders who own more than half its shares; or
4. Changing to a certain 52-53-week year.

Using a Business-Purpose Tax Year Established by Facts and Circumstances

Rev. Proc. 2002-39 and Rev. Rul. 87-57 contain the IRS position on granting business- purpose fiscal years established by facts and circumstances. Apparently, obtaining a year that requires IRS approval will be very difficult. Rev. Proc. 2002-39 states that the IRS will grant a taxpayer permission to adopt, change, or retain a fiscal year under the facts-and-circumstances test only in “rare and unusual circumstances.” Nevertheless, the practitioner may encounter an existing or newly electing S corporation operating under extraordinary circumstances that warrant applying for a business-purpose fiscal year.

The IRS assesses a user fee when an S corporation applies for a business-purpose fiscal year established by facts and circumstances, but not when an S corporation applies for an automatically approved year or a fiscal year under Sec. 444.

Changing Fiscal Year End Following Termination of S Status

S corporations generally must use a calendar year under Sec. 1378 or a September, October, or November fiscal year under Sec. 444. C corporations are not restricted to such required years. C corporations (except personal service corporations) can generally use any fiscal year end. Thus, a corporation may want to change its tax year following a voluntary or involuntary termination of S status.

2) income/loss allocation:

When a shareholder joins or leaves an S corporation during the year it can cause many problems. Among these problems is the question of how to allocate income for tax purposes. The IRS has issued Treasury Regulations to clarify how to deal with some of these situations.

The S corporation’s structure is simple. There is generally no tax at the entity level. By making an S election, the shareholders have elected to report and pay tax on all of the corporation’s income on their personal income tax returns. But while this seems easy enough, it can be somewhat complex. What happens when a shareholder is bought out during a year?   What happens if new shareholders buy-in? What happens if a shareholder dies? What happens if the S election terminates during a year? What happens if a shareholder goes bankrupt?

Under the general rule, income of an the S corporation must be allocated among the shareholders pro-rata on a per-share, per-day basis.   For example, if you owned 50% of the stock of an S corporation, and the corporation’s year end is December 31^st, and you sold your stock to another shareholder as of June 30^th, your share of the corporation’s income for the entire year would be 25% (50% ownership interest for half a year). Under the general rule, it makes no difference if corporation had a great first half of the year and a terrible second half of the year. Under the general rule, the shareholder is allocated a share of the entire year’s income or loss.

However, the S corporation allocation rules also permit the shareholders to elect a “closing of the books” allocation methodology. Under this special rule, if a shareholder disposes of his or her entire interest during a year, or disposes of more than 20% of his or her ownership interest, the shareholders may elect to actually close the books as of the date of that disposition. To do this, however, every person who was a shareholder on any day during that year must consent. In this case, if you owned 50% of the stock, and you sold your stock to another shareholder as of June 30^th, you would be allocated 50% of the corporation’s income only for that portion of the year during which you owned stock (January 1^st to June 30^th). If the corporation had a great first half and a terrible second half, you would be allocated a lot of income based on the first half results.

Whether this would be a better or worse result for you would depend on your personal tax situation and whether the corporation distributed cash in accordance with income allocations. The point is, if you are contemplating the sale of your S corporation stock, you need to consult with your tax advisor and consider whether doing a special “closing of the books” election is in your best interests. If so, you need to make such an election a condition to closing on the stock sale.

And remember, you will need to get everyone who was a shareholder at any time during the year to sign a consent to make the “closing of the books” election. This consent should include language whereby the corporation and all of the shareholders agree to attach the election to the corporation’s tax return for that year and compute the tax allocation accordingly.stock

Although you are closing the book as of the date of disposition, the corporation will not file two (2) tax returns for the year. Rather, the corporation will file one return for the year, and such return will be due at the same time as the return is normally due. Yet the corporation will need to be able to allocate the amount of income and loss between the pre and post stock disposition periods so as to issue accurate Schedule K-1s to the shareholders.

Further, some complications may arise in allocating income and expense between the pre and post disposition periods. For example, an amount that is accrued but unpaid by the corporation to a shareholder may not be deducted by the corporation until the year actually paid (even if the corporation is an accrual-basis taxpayer).   Under the Treasury Regulations, the date of disposition is treated as if it were the corporation’s year end for this purpose. Therefore, if there are any amounts owed to shareholders which accrued but unpaid on the date of disposition, those expenses are treated as falling in the part of the year in which they are actually paid. This would also be true of accruals to family and affiliates of the shareholders (unless the affiliates were also accrual-basis taxpayers).

3) operating/liquidating distributions:

The liquidation provisions governing C corporations also govern the liquidation of an S corporation. The principal difference between liquidating and nonliquidating distributions is that the recognition of loss with respect to nonliquidating distributions is not permitted, while loss may generally be recognized on liquidating distributions. IRC § 311, 336, 336(d)(1).

Tax Consequences of Distributions from S Corporations

An S corporation’s income, losses, deductions and credit are passed through to the shareholders for Federal tax purposes and taxed directly to them. Because the income of S corporations is taxed to the owners when the income is earned, a mechanism is needed to ensure that the shareholder is not taxed again when the earnings are distributed. This is done through a system of rules that track and adjust the shareholder’s stock basis. While there are differences, the S corporation basis system is similar to the rules that apply to partnerships.

Shareholder Tax Consequences

The tax consequences of distributions by an S corporation to a shareholder depend on the shareholder’s basis in the S corporation stock. Distributions to the shareholder are not included in the shareholder’s gross income if the distribution does not exceed the shareholder’s basis in the stock. If the amount of the distribution exceeds the shareholder’s basis, the excess is taxed to the shareholder as capital gain.

Because the tax consequences of distributions depend on the shareholder’s basis, it is important to keep up with changes in the shareholder’s basis over time. A shareholder’s basis in his S corporation stock is increased by the share of the S corporation income that is passed through to the shareholder. This effectively gives the shareholder a credit to apply against the earned income when it is ultimately distributed to the shareholder, ensuring that the income is only taxed once.

The shareholder’s basis is decreased (but not below zero) by the shareholder’s share of the S corporation’s items of loss and deduction, nondeductible expenses (except expenses that are not chargeable to the capital account), depletion deduction for oil and gas property, and distributions to the shareholder that are not made from accumulated earnings and profits. This helps ensure that the shareholder only benefits once from reductions in income earned by the S corporation.

Corporate Tax Consequences

Like C corporations, S corporations recognize no gain or loss on a distribution of cash to its shareholders. If the S corporation distributes appreciated property to a shareholder, the corporation must recognize gain as if the property were sold to the shareholder at fair market value.

Note: Special rules apply if the S corporation has accumulated earnings and profits.

Tax Consequences of Liquidation

Liquidating distributions are not governed by the normal S corporation distribution rules. Instead, liquidation of an S corporation is governed by the same rules that apply to liquidation of a C corporation.

If the corporation distributes the assets in kind to a shareholder under a plan of liquidation, it is treated as having sold the assets to the shareholder for fair market value. This is essentially the same treatment that would apply if the corporation sold its assets to a third party and distributed the resulting cash to the shareholder. The corporation will recognize gain or loss if the amount realized (or the property’s value) differs from the corporation’s basis in the distributed asset.

The shareholder will also have two tax consequences from the liquidation.

• Pass-Through of Corporate Gain. If the corporation distributes appreciated or depreciated assets as part of the liquidation, the S corporation’s gain or loss from the deemed sale of assets is passed through to the shareholder. The shareholder’s basis in her stock is increased to reflect the gain or loss. The shareholder will take a basis in the distributed property equal to the property’s fair market value.
• Taxation on Surrender of Stock. The shareholder will also be taxed on the liquidation itself. The amount that a shareholder receives in a liquidating distribution is treated as full payment in exchange for the shareholder’s S corporation stock. In other words, if the S corporation is making a liquidating distribution, the shareholder is treated as having sold her stock for the amount of the distribution. The shareholder will recognize gain or loss equal to the difference between the amount of the distribution and the shareholder’s basis in the S corporation stock.

4)stock basis calculations:

An S corporation is a corporation with a valid "S" election in effect. The impact of the election is that the S corporation's items of income, loss, deductions and credits flow to the shareholder and are taxed on the shareholder's personal return.

The two main reasons for electing S corporation status are:

1. Avoid double taxation on distributions.
2. Allow corporate losses to pass through to its owners.

There are three shareholder loss limitations:

1. Stock and Debt Basis Limitations
2. At Risk Limitations
3. Passive Activity Loss Limitations

Each limitation is addressed in the order shown above and must be met before a shareholder is allowed to claim a pass-through loss.

The fact that a shareholder receives a K-1 reflecting a loss does not mean that the shareholder is automatically entitled to claim the loss.

S Corporation Shareholders are Required to Compute Both Stock and Debt Basis

The amount of a shareholder's stock and debt basis in the S corporation is very important. Unlike a C corporation, each year a shareholder's stock and/or debt basis of an S corporation increases or decreases based upon the S corporation's operations. The S corporation will issue a shareholder a Schedule K-1.

It is important to understand that the K-1 reflects the S corporation's items of income, loss and deduction that are allocated to the shareholder for the year. The K-1 shows the amount of non-dividend distribution the shareholder receives; it does not state the taxable amount of a distribution. The taxable amount of a distribution is contingent on the shareholder's stock basis. It is not the corporation's responsibility to track a shareholder's stock and debt basis but rather it is the shareholder's responsibility.

If a shareholder receives a non-dividend distribution from an S corporation, the distribution is tax-free to the extent it does not exceed the shareholder's stock basis. Debt basis is not considered when determining the taxability of a distribution.

Loss or Deduction Pass-Through Items

If a shareholder is allocated an item of S corporation loss or deduction, the shareholder must first have adequate stock and/or debt basis to claim that loss and/or deduction item. In addition, it is important to remember that, even when the shareholder has adequate stock and/or debt basis to claim the S corporation loss or deduction item, the shareholder must also consider the at-risk and passive activity loss limitations and therefore may not be able to claim the loss and/or deduction item.

S Corporation Stock and Debt Basis

Importance of Stock Basis

It is important that a shareholder know his/her stock basis when:

• The S corporation allocates a loss and/or deduction item to the shareholder.
  In order for the shareholder to claim a loss, they need to demonstrate they have adequate stock and/or debt basis.
• The S corporation makes a non-dividend distribution to the shareholder.
  In order for the shareholder to determine whether the distribution is non-taxable they need to demonstrate they have adequate stock basis.
• The shareholder disposes of their stock.
  As with any asset, including C corporation stock, when the asset is sold or disposed of, basis needs to be established in order to reflect the proper gain or loss on the disposition.

Since shareholder stock basis in an S corporation changes every year, it must be computed every year.

Computing Stock Basis

In computing stock basis, the shareholder starts with their initial capital contribution to the S corporation or the initial cost of the stock they purchased (the same as a C corporation). That amount is then increased and/or decreased based on the pass-through amounts from the S corporation. An income item will increase stock basis while a loss, deduction, or distribution will decrease stock basis.

5)Fringe benefit rules:

Fringe Benefits. An S corporation is treated as a partnership and any "two percent shareholder" is treated as a partner of such partnership. IRC § 1372(a). The impact of the treatment of a two percent shareholder as a partner of a partnership is that the payment of fringe benefits to such a person is to be treated like partnership guaranteed payments under Section 707(c). Treatment of Guaranteed Payments Generally. The cost or value of a fringe benefit paid to or on behalf of a partner that are treated as guaranteed payments is includable in the income of the partner under Section 61. Because the recipient partner is treated as self-employed and not as an "employee" with respect to his distributive share of partnership income, the recipient-partner cannot exclude from income the cost or value of the fringe benefits pursuant to those provisions of the Code which provide exclusions from income in the case of "employees," such as Sections 79 (group-term life), 104 (compensation for injuries or sickness), 105 (accident and health insurance), 106 (employer cohtributions to accident and health plans), and 119 (meals or lodging). However, the recipient-partner can exclude from income the cost or value of fringe benefits pursuant to those provisions of the Code that provide exclusions to self-employed persons, such as Sections 101(b)(3)(B) (death benefits), 120 (group legal services), 127 (educational assistance program), and 129 (dependent care assistance).