2013 cch basic principles ch16 piv

Chapter 16

Partnerships, Corporations, and S Corporations

Part IV: S Corporations

©2012 CCH. All Rights Reserved.4025 W. Peterson Ave.Chicago, IL 60646-60851 800 248 3248www.CCHGroup.com

CCH Federal Taxation Basic Principles 2 of 60

Chapter 16 Contents

1. S Corporations—Treatment of Tax and Nontax Matters

2. S Corporations—Tax Years

3. S Corporations—Accounting Methods

4. S Corporations—Tax Model

5. S Corporations—Eligibility and Election

6. S Corporations—Revoking S Status

7. S Corporation Basis Accounts—Overview

8. S Corporation Basis Accounts—Outside Basis

9. S Corporation Basis Accounts—At-Risk Basis

10. S Corporation Basis Accounts—Accumulated Adjustment Account (AAA)

11. S Corporation Basis Accounts—Other Adjustment Account (OAA)

Chapter 16, Exhibit Contents A


Chapter 16 Contents

12. S Corporation Basis Accounts—Previously Taxed Income Account (PTI)

13. S Corporation Basis Accounts—Shareholder Loans to S Corporations

14. S Corporation Basis Accounts—Example on Effect of Operating Results on Basis

15. S Corporation Distributions

16. S Corporation Distributions—Effect on Shareholder

17. S Corporation Distributions—Example

18. S Corporation Penalty Taxes—Code Sec. 1374 Tax on Built-in Gains

19. S Corporation Penalty Taxes—Code Sec. 1374 Tax Example

20. S Corporation Penalty Taxes—Code Sec. 1375 Tax on Excess Net Passive Income

21. Code Sec. 1375 Tax on Excess Net Passive Income—Example

Chapter 16, Exhibit Contents B


S Corporations—Treatment of Tax and Nontax Matters

The Conduit Concept. For most tax matters, S corporations are treated like partnerships. As in the partnership conduit concept, the taxable income of an S corporation flows through to the owners on a per-day and per-share basis. Income and losses are reported on Form 1120-S, allocated to each shareholder on a supporting K-1 schedule, and then transferred, via the K-1, to the individual owners’ 1040 returns. There, at the individual level, income is taxed and losses are deducted.

Chapter 16, Exhibit 1a



The Entity Concept. The character of income and losses is determined at the entity level, not at the shareholder level. For example, a long-term capital gain reported by the S corporation remains long-term to the shareholder, even if his ownership in the S corporation had been held for a short-term period.

Chapter 16, Exhibit 1b


Distributions of Cash or Property. Actual distributions of cash or property are generally not income to its shareholders. Two notable differences with partnerships are:

Owner salaries and payroll taxes. Deductible by S corporations, not by partnerships.

Gain on distribution of property. S corps must recognize gains (but not losses) on distributions of appreciated property to shareholders; partnerships escape this gain recognition.


Chapter 16, Exhibit 1c


Nontax matters. For most structural matters (e.g., formation, redemptions and terminations), S corporations are treated in much the same manner as C corporations.

Chapter 16, Exhibit 1d



S Corporations—Tax YearsAn S corporation must generally use a calendar year end. However, it may elect a fiscal tax year under any of the following three conditions:

Three-Month Deferral OK. A fiscal tax year would result in income deferral of not more than three months and the shareholder-employee’s salary earned between fiscal year end and December 31 is both:

Paid during that period; and, Proportionate to the salary paid during the preceding

fiscal year. Business Purpose. A business purpose can be demonstrated. 1987 FYE. The S corporation retains the same fiscal tax

year as was used in 1987, if in existence at that time.

Chapter 16, Exhibit 2


S Corporations—Accounting Methods

The accrual, cash and hybrid methods are available regardless of the size of the S corporation.



S Corporations—Tax Model

Code Sec. 702(a)(8) Income

Definition. As with partnerships, items that are always subject to ordinary treatment are lumped together in an amount called Code Sec. 702(a)(8) income or loss. Shareholders recognize Code Sec. 702(a)(8) income even if no cash is actually distributed. Accordingly, shareholders are generally not taxed on distributions.




Code Sec. 702(a)(8) Income

Computation. Sec. 702(a)(8) is generally operating income or loss computed as follows:

Ordinary Income “From Whatever Source Derived” (including Code Sec. 1245 recapture)

Less: Exclusions Less: Cost of Goods Sold (resulting in gross income from

business operations) Less: Operating Expenses




Rationale. Each shareholder of an S corporation reports her share of corporate net income based on her stock ownership. Any income, loss, deduction, or credit which could uniquely affect the tax liability of a shareholder is separately stated in the K-1 to the shareholder.



S Corporations—Tax ModelSeparately Stated Items

Passive income and losses from rental and other non-operating activities Investment income and related expenses (e.g., dividends, investment

interest, ad valorem tax on stock, investment counseling fees, etc.) Code Sec. 1231 gain and loss Capital gains and losses Dividends eligible for a dividends-received deduction Charitable contributions Taxes paid to a foreign country or to a U.S. possession Code Sec. 179 deduction Recovery items (e.g., tax refunds, recovery of bad debts) Tax-exempt income and related expense Tax credits Deductions disallowed in computing S corporation income



A corporation is treated as an S corporation only for those days for which each specific eligibility requirement is met and the required election is effective. Eligibility and election rules include:

Unanimous Consent. 100% of the shareholders must consent to the S election.

Deadline For Filing S Election. If a calendar year C corporation makes an S election by 3/15/x1, it is retroactive to 1/1/x1. If made after 3/15/x1, but before 3/15/x2, it is effective 1/1/x2.

One Class of Stock. Only one class of stock is permitted. Rights to profits and assets on liquidation must be identical. Debt may be treated as a disqualifying second class of stock.


S Corporations—Eligibility and Election



Maximum 100 Shareholders. The number of shareholders may not exceed 100.

A nonresident alien may not own shares. Each shareholder must be an individual, an estate, or a

qualified trust. Related taxpayers can elect to be treated as one

shareholder.




Ineligible Corporations. The corporation must be domestic but not a bank or insurance company.

Eligible Subsidiaries. S corporations can own C corporations, but C

corporations cannot own S corporations. S corporations can own qualified subchapter S

subsidiaries (QSubs). A QSub is an electing domestic corporation that qualifies as an S corporation and is 100% owned by an S corporation parent.



S Corporations—Revoking S Status

The S election will be terminated upon one of the following events:

1. Over 50% consent. Over 50% of the shareholders agree to the revocation. The deadline for revoking S status is the same as the deadline for electing it.

2. Prior C life AND passive investment income over 25%. If an S corporation had a prior life as a C corporation and its passive investment income is over 25% of its total income for three consecutive years, it loses the S election at the start of the fourth year.



S Corporations—Revoking S Status

3. Violation of qualifications. If any of the qualifications mentioned above are violated (e.g., stock is sold to a C corporation, or a second class of stock is issued), the S election is terminated on the date of violation, and the period before the violation is considered a “short-year.”

4. Majority shareholder revocation. If a new shareholder owning more than 50% takes affirmative action to terminate the election, the election dies as of the date of action.

After revocation or termination of an election, a new election cannot be effectively made for 5 years without IRS consent.



To determine how much of cash and property distributions are tax-free.

To determine how much of shareholder’s allocations of Sec. 702(a)(8) losses and separately stated expenses are deductible.

To determine gain or loss when the stock is ultimately sold. [Also will limit tax-free distributions if stock basis is lower than AAA basis.]

Primary Purpose:

AAA Basis At Risk Basis Outside (Stock) Basis


S Corporation Basis Accounts—Overview


AAA BasisAt Risk BasisOutside (Stock) Basis

NoYes No+ Company debt for which s/h is personally liable

NoYes Yes Tax-exempt income and non-deductible exp.

Yes Yes Yes Separately stated items that are taxable or deductible to s/h

Yes Yes Yes Sec. 702(a)(8) TI or Loss

NoYes Yes + Original basis (e.g., purchase, inheritance, gift)

(“Yes” means the item to the left is used in the computation of basis):




No

(unlike partnerships, debt basis is held separately from equity basis.)

Yes No

(unlike partnerships debt

basis is held separately from equity basis.)

+ Shareholder (S/H) loans to S Corp


NoNo

(unlike the normal at-risk

rules for individuals)

No+ Non-recourse financing from qualified lenders





Yes

(distributions reduce AAA before current

year losses)

Yes

(distributions reduce at risk amount before

current year losses)

Yes

(distributions reduce basis

before current year losses)

- Fair market value (FMV) of distributions






S Corporation Basis Accounts—Outside Basis

General Rule. A shareholder’s outside basis is his/her stock basis. Outside basis is computed in much the same manner as a partner’s outside basis in a partnership interest.

Exception. One notable exception is that the basis of stock in an S corporation is not affected by the corporation’s liabilities. This seems reasonable because, unlike a general partner, an S corporation shareholder is not personally liable for the debts of the corporation.



S Corporation Basis Accounts—At-Risk Basis

General Rule. At-risk rules are applied at the shareholder level. The amount of S corporation losses that the shareholder can deduct may not exceed the lesser of:

At-risk amount or Sum of a shareholder’s stock basis and debt basis.



Computation of At-Risk Basis. At-risk basis is equal to the sum of:

Cash and basis of property contributed to the S corporation (to the extent unencumbered)

Outstanding shareholder loans to the S corporation Loans for which the shareholder has personal liability or has

pledged as security for repayment property not used in the activity of the corporation. (However, this does not include other debts of the corporation to third parties, even if the repayment is guaranteed by the shareholder.)

Allocated portion of income Less: Allocated portion of losses Less: Distributions at fair market value (not at partnership basis)


S Corporation Basis Accounts—At-Risk Basis


S Corporation Basis Accounts—Accumulated Adjustment Account (AAA)Purpose. Records and information pertaining to each shareholder’s accumulated adjustment account (AAA) are needed by S corporations only for purposes of helping shareholders determine taxability of distributions when the S corporation has earnings and profits (E&P).

The C corporation connection. An S corporation has E&P only if it was classified as a C corporation in the past or acquired a C corporation.

Tax effect of distributions. The fair market value (FMV) of distributions to shareholders are tax-free to the extent of the lesser of (1) AAA balance and (2) stock basis.



Computation. A shareholder’s AAA balance is INCREASED only by taxable income. It is REDUCED by all deductible losses/expenses, by cash distributions and by the fair market value (FMV) of property distributions. Same-year losses and distributions. Shareholders are allowed

to reduce the AAA basis by the amount of current year distributions BEFORE applying current year losses against bases. This rule enables tax-free distributions to the extent of AAA, BEFORE AAA is reduced by the amount of losses. While the effect is favorable for tax-free distributions, it can also result in higher suspended losses, since distributions reduce all bases, dollar for dollar, thus lowering the limits of loss deductions and increasing suspended losses.

Tax–exempt income. No adjustment to the AAA account is made for tax-exempt income such as municipal bond interest and life insurance proceeds (reduced by related expenses).

S Corporation Basis Accounts—Accumulated Adjustment Account (AAA)



Negative AAA balance OK. The AAA basis (unlike the stock basis) can have a negative balance. However only losses, (not distributions) can make the AAA negative or increase a negative balance.

Transferability of AAA account. If the shareholder disposes of stock, the AAA associated with the stock passes to the new owner.

S Corporation Basis Accounts—Accumulated Adjustment Account (AAA)



S Corporation Basis Accounts—Other Adjustment Account (OAA)

Other Adjustments Account (OAA). The OAA represents another form of accumulated adjustments account (AAA) in that:

The OAA is a balance sheet account in the capital section. The OAA is needed by S corporations only for purposes of

helping shareholders determine taxability of distributions when the S corporation has earnings and profits (E&P).

Any distributions from OAA are tax-free to shareholders.



S Corporation Basis Accounts—Other Adjustment Account (OAA)

Timing of distributions. Tax-free distributions from OAA cannot be made until after all accumulated E&P are paid out.

Computation. The OAA balance is increased for tax-exempt income or decreased for nondeductible expenditures not properly chargeable to the AAA.



S Corporation Basis Accounts—Previously Taxed Income Account (PTI)


Timing of distributions. Tax-free distributions from the PTI account are made after tax-free distributions reduce the OAA balance to zero.

Computation. The PTI account represents a balance of undistributed net income on which the shareholders were already taxed prior to 1983.


S Corporation Basis Accounts—Shareholder Loans to S Corporations

Using loan basis for deductions. Once stock basis is zero, any additional basis reductions (losses or deductions, but NOT distributions), decrease (but not below zero) the shareholder’s basis in loans made to the S corporation. Suspended losses/deduction. Any excess of losses or deductions over both stock and debt bases is suspended until subsequent items of income or contributions arise to restore basis in debt. Restoring debt basis. Once the basis of any debt is reduced, it is later increased (only up to the original face amount of the loan) by the subsequent net increase resulting from all positive and negative basis adjustments. The debt basis is adjusted before any increase is made in the stock basis.




Distributions. A distribution in excess of stock basis does not reduce any debt basis.

Same-year losses and distributions. If a loss and a distribution occur in the same year, the loss reduces the debt basis before the distribution. (This rule favors the taxpayer.)

Repayment of shareholder loan with reduced basis. If an S corporation repays a shareholder loan when the debt basis is below the loan amount, the difference is treated as a capital gain. An allocation is required for partial repayments.




Example: A shareholder lends an S corporation $100,000. Subsequent losses eliminate the shareholder’s stock basis and reduce a portion of the debt basis. The S corporation repays $20,000 of the $100,000 loan when the shareholder’s basis in the loan is $75,000. The shareholder must report a capital gain in the amount of $5,000 on the receipt of $20,000, since 25% of the face value was not supported by debt basis [$20,000 x ($100,000 – $75,000) $100,000].



S Corporation Basis Accounts—Example on Effect of Operating Results on Basis


FACTS: David, an individual, owns all of the shares of an S corporation throughout 20x1. The corporate books show the information for 20x1 on the following slides.

QUESTION:

(1) Compute 20x1 Code Sec. 702(a)(8) taxable income

(2) Compute David’s stock basis at 12/31/x1.

(3) Compute David’s “at risk” amount at 12/31/x1.

(4) Compute David’s AAA balance at 12/31/x1.

(5) Compute David’s debt basis at 12/31/x1.

CCH Federal Taxation Basic Principles 36 of 60Chapter 16, Exhibit 14b

(5)

Debt Basis

(4)

AAA Basis

(3)

At Risk Basis

(2)

Stock Basis

(1)

Sec. 702(a)(8) TI

10,000 10,000 10,000 10,000

(10,000) (10,000) (10,000) (10,000)

(100,000) (100,000) (100,000) (100,000)

200,000200,000200,000200,000

0010,00010,000

Corp. Books:

10,000 Sec. 1245 gain

(10,000) Overhead expenses

(100,000) Cost of goods sold

200,000Net sales

10,000Initial bases, from $10m stock purchase on 1/1/x1

Facts Solution


CCH Federal Taxation Basic Principles 37 of 60Chapter 16, Exhibit 14c

15,00015,000(sep’ly. stated) 15,000Tax-exempt interest income

10,00010,00010,000(sep’ly. stated) 10,000Long-term capital gain

(10,000) (10,000) (10,000) (sep’ly. stated) (10,000) Short-term capital loss

(10,000) (10,000) (10,000) (sep’ly. stated) (10,000) Charitable contributions

(10,000) (10,000) (10,000) (sep’ly. stated) (10,000) Sec. 1231 loss

(5)

Debt Basis

(4)

AAA Basis

(3)

At Risk Basis

(2)

Stock Basis

(1)

Sec. 702(a)(8) TI

Corp. Books:

SolutionFacts





10,00010,000S corp borrowings from banks— recourse to David

10,00010,00010,000David’s loan to S corp.

(10,000) (10,000) (sep’ly. stated) (10,000) Lobbying expense - state officials (not deductible)

(5)

Debt Basis

(4)

AAA Basis

(3)

At Risk Basis

(2)

Stock Basis

(1)

Sec. 702(a)(8) TI

Corp. Books:

SolutionFacts



Chapter 16, Exhibit 14e

10,00080,000115,00095,000100,000 125,000 Balances, 12/31/x1

(10,000) (10,000) (10,000) (10,000) Cash distribution to David

10,00010,00010,000 10,000 David’s additional stock purchases of S corp. stock

10,000 S corp borrowings from banks— NONrecourse to David.

(5)

Debt Basis

(4)

AAA Basis

(3)

At Risk Basis

(2)

Stock Basis

(1)

Sec. 702(a)(8) TI

Corp. Books:

SolutionFacts


S Corporation Distributions

Does an S corporation recognize gain or loss on the distribution of cash to shareholders?

No, never.

Does an S corporation recognize gain or loss on the distribution of other property (other than its own stock)? Gains: Yes (compute gain in the same way as if the

property were sold) Losses: No (except in complete liquidation).



What is the character of the entity’s gain on distribution of property to owners? If a shareholder owns no more than 50% of the S

corporation, then the character of the entity’s gain is the same as the character of the property distributed.

If a shareholder owns more than 50%, then the entity’s gain is ordinary.


S Corporation Distributions


Taxed as a capital gainIn excess of stock basis

Tax-free; reduces stock basis To extent of stock basis

Tax Result Shareholder Distribution

S Corporation Without C Corporation E&P


S Corporation Distributions—Effect on Shareholder


S Corporation Distributions—Effect on Shareholder

Taxed as a capital gain In excess of stock basis

Tax-free; reduces stock basis. To extent of any remaining stock basis

Tax-free; reduces OAA, PTI, and stock basis

To extent of other adjustments account (OAA) and previously taxed income (PTI) account

Taxed as an ordinary dividend; does not reduce stock basis

To extent of C corporation E&P

Tax-free; reduces AAA and stock basis

To extent of accumulated adjustments account (AAA)

Tax Result Shareholder Distribution

S Corporation With C Corporation E&P



FACTS:

An S corporation reports the following balances for its sole shareholder as of 1/1/x1:

Capital balance per corporate books: $125,000 Stock basis: $95,000 At-risk basis: $115,000 AAA basis: $80,000 Shareholder loan to S corporation: $10,000 (basis also

$10,000)

The S corporation reports a ($200,000) ordinary loss in 20x1.


S Corporation Distributions—Example


QUESTIONS:

(a) What is the maximum tax-free nonstock distribution the shareholder can receive in 20x1? (Hint: The tax-free distribution is not affected by the 20x1 loss. Use the 1/1/x1 balance in AAA and any excess stock basis. Answer: $95,000 = $80,000 AAA + $15,000 excess stock basis)

(b) Assuming that a $95,000 cash distribution is made to the sole shareholder in 20x1, what are the 12/31/x1 balances in stock basis, at-risk basis, AAA and debt basis?

(c) What portion of the ($200,000) loss is deductible in 20x1 under the at-risk rules?

(d) What portion of the $200,000 loss is suspended in 20x1 under the at-risk rules?




QUESTION:

If the S corporation repays the $10,000 shareholder debt in year 20x2, what are the tax consequences if:

S corporation has income of $10,000 in year 20x2? (If the S corporation has income in year 20x2, the first

$10,000 must restore the debt basis back to $10,000. Any income in excess of $10,000 increases the following simultaneously: (a) the stock basis, (b) at-risk basis, and (c) AAA balance. A subsequent repayment of the $10,000 shareholder loan does not result in capital gain.)

S corporation has a loss in year 20x2? (Answer: A $10,000 capital gain passes through to the

shareholder since the debt basis is zero.)



CCH Federal Taxation Basic Principles 47 of 60Chapter 16, Exhibit 17d

0

[Debt basis is never

reduced by

distributions]

(80m)

[tax-free]

(80m)

[tax-free]

(80m)

[tax-free]

(80m) 1st: Apply dist’n. against bases:

Tier 1 Distribution:

(i.e., Tax free: Lesser of,

(1) $80m AAA balance, or

(2) $95m stock basis)

10m 80m 115m 95m 125m Balances, 1/1/x1

Debt Basis

AAA Basis

At Risk Basis

Stock Basis Sec. 702(a)(8) income

(loss)

Cap. Bal. per Books

SOLUTION: Tax Effect of a $200,000 loss and a $95,000 distribution in 20x1


CCH Federal Taxation Basic Principles 48 of 60Chapter 16, Exhibit 17e

0000Tier 2 Distribution:

(i.e., taxable to extent of accumulated E & P from prior life as a C corp. None here.)

10m 80m 115m 95m 125m Balances, 1/1/x1

Debt Basis

AAA Basis

At Risk Basis

Stock Basis Sec. 702(a)(8) income (loss)

Cap. Bal. per

Books



CCH Federal Taxation Basic Principles 49 of 60Chapter 16, Exhibit 17f

10m 0 20m 0 0 30m Subtotals

0

[Debt basis is never reduced

by distributions]

0

[Dist’ns cannot

create neg. AAA bal.]

(15m)

[tax-free]

(15m)

[tax-free]

(15m) Tier 3 Distribution:

(i.e. tax free to extent of any stock basis surviving the 1st tier distribution

(15m = 95m - 80m)

10m 80m 115m 95m 125m Balances, 1/1/x1

Debt Basis AAA Basis At Risk Basis

Stock Basis

Sec. 702(a)(8) income

(loss)

Cap. Bal. per Books





Chapter 16, Exhibit 17g

(10m) (200m) (20m) 0(10m)

[Note: Only (10m) is deductible, because loss deductions are limited to the lesser of

1. $10m (i.e., stock basis of $0, + debt basis of $10m); or

$20m at risk basis]

(200m) 20x1 DEDUCTIBLE LOSSES UNDER AT-RISK RULES

[Apply 200m Sec. 702(a)(8) loss against bases and determine the amount deductible under the at-risk rules.]

10m 0 20m 0 0 30m Subtotals

Debt Basis AAA Basis

At Risk Basis

Stock Basis

Sec. 702(a)(8) income (loss)

Cap. Bal. per Books




Chapter 16, Exhibit 17h

(10m)

(180m)

[190m nondeductible loss - 10m debt

basis]

(190m) [200m-10m] or [180m +

10m]

20X2B SUSPENDED LOSS UNDER AT-RISK RULES ($190m total)

0

[can’t be neg.]

(40m) [CAN be

neg.]

0

[can’t be neg.]

0

[can’t be neg.]

(170m) BASES, 12/31/x2

Debt Basis AAA Basis

At Risk Basis

Stock Basis

Sec. 702(a)(8) income

(loss)

Cap. Bal. per Books



S Corporation Penalty Taxes—Code Sec. 1374 Tax on Built-in Gains

All four conditions listed below must be present to subject an S corp. to the 35% Code Sec. 1374 tax:

1. Prior life as a C corporation;2. S-corporation election occurs after 1/1/87;3. Asset sale with pre-election built-in gain (but not built-in

loss). [If the asset is purchased after the election, Code Sec. 1374 would not apply.]

4. Asset sale within 10 years of election date, not effective date of election. (e.g., if an election is made on 3/15/x1, it is retroactively effective to 1/1/x1. The 10 year toll begins in 3/15/x1, not 1/1/x1.)



S Corporation Penalty Taxes—Code Sec. 1374 Tax on Built-in Gains

Computation. At the time that an asset is sold, the corporation will recognize (and pay tax) on the difference between the fair market value of the asset at the time of the election. The tax rate is the highest corporate effective rate of 35%.



S Corporation Penalty Taxes—Code Sec. 1374 Tax Example

$100,000$300,000$400,000Land

$100,000 $500,000$600,000 Office Building

Built-In Gain Adjusted Basis at Election Date

Fair Market Value at Election Date

Asset

FACTS: On 3/15/x0, a C corporation makes an election to become an S corporation. At the time of the election, the corporation had the following assets:



0**$200,000$300,000$500,000$100,000Land

$35,000$250,000$450,000$700,000$100,000Building

Sec. 1374 Tax

Realized Gain Basis at Sales Date

Sales Price Built-in Gain at Election

Asset

(e) =

[Lesser of: (a) or (d)] x

35%

(d)= (b) – (c) (c) (b) (a)

QUESTION: Determine the tax effect to the corporation and to the shareholder of the following transactions: One year after the election date, the corporation sells the building at a sales price of $700,000 when the adjusted basis is $450,000. Twelve years after the election date, the corporation sells the land at a sales price of $500,000.



CCH Federal Taxation Basic Principles 56 of 60Chapter 16, Exhibit 19c

COMPUTATIONS

Tax effect of 20x1 sale of building: S corporation: The corporation itself pays the $35,000 tax

to the IRS. (35% x [the lesser of 100,000 or 250,000]) Shareholders: The shareholders are allowed a deduction

for that tax. The S corporation’s K-1 would show:

Code Sec. 1231 gain/Code Sec. 1245 recapture

($700,000 - 450,000) $250,000

Code Sec. 1374 tax deduction $ (35,000)


CCH Federal Taxation Basic Principles 57 of 60Chapter 16, Exhibit 19d

COMPUTATIONS

Tax effect of selling land over 10 years after the election date: No Code Sec. 1374 tax would be imposed since the 10-year

post-election period had lapsed. Only the $200,000 Code Sec. 1231 gain would be reported by the S corporation on the shareholder’s K-1.



S Corporation Penalty Taxes—Code Sec. 1375 Tax on Excess Net Passive Income

This tax applies to any S corporation with accumulated E&P that has more than 25% of its gross receipts derived from passive sources.



Computations Excess Net Passive Income = [(a) – {25% x (c)}] [(a) x (b)] Code Sec. 1375 Tax = 35% x Excess Net Passive Income, where

(a) = Gross passive investment income (e.g., royalties, rents, dividends, interest, annuities, and gain on sales of securities)

(b) = Net passive investment income (i.e., gross amount net of investment expenses

(c) = Gross receipts (i.e., receipts from all sources including active and passive sources)

Note that Excess Net Passive Investment Income can never be more than taxable income computed as if the S corporation had been a C corporation.


S Corporation Penalty Taxes—Code Sec. 1375 Tax on Excess Net Passive Income


Code Sec. 1375 Tax on Excess Net Passive Income—Example

Excess Net Passive Investment Income:

$17,500 =[100,000 – {25% x (300,000)}] [100,000 x 70,000]

Code Sec. 1375 tax:

$6,125 = 35% x 17,500.

SOLUTION:

FACTS:

1. S corporation has gross receipts of $300,000 in 20x1.

2. Included in the $300,000 is $100,000 of royalties.

3. Expenses directly connected with the production royalties are $30,000.

4. The S corporation has accumulated E & P from its prior life as a C corporation.

QUESTION:

Compute the Code Sec. 1375 tax.


2013 cch basic principles ch16 piv

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