Chapter 14: S Corporations.
An "S" corporation is a corporation that has elected to have its income, deductions, capital gains and losses, charitable contributions, and credits passed through to its shareholders. For federal income tax purposes, an S corporation is treated much like a partnership (see Chapter 12). For almost all other purposes, an S corporation is treated as a "regular" corporation (see Chapter 13).
WHEN IS IT INDICATED?
1. When the owners of the business entity would like the limited liability that is available with a corporation, but also desire pass-though treatment for federal (and in most but not all cases, state) income tax purposes. The pass-through treatment is advantageous both because the income of the corporation will be taxed only once, and because it allows the owners to deduct any losses that the corporation may incur. This is in contrast to the income of a C corporation which is taxed both when it is earned at the corporate level and then when it is paid out to shareholders in the form of dividends. Also, any capital gains earned by a C corporation are generally taxed at the C corporation's regular tax rate.
The ability to deduct losses may be especially important in the early years of a corporation. Some corporations are formed as S corporations to take advantage of the owners' ability to deduct losses in the early years, and then when the company becomes profitable, the S election is terminated.
2. When the owners of the corporation want to spread the corporation's income among members of the owner's family. Having stock owned by family members who are in a lower tax bracket can lower the overall tax liability of the family. However, certain income of taxpayers who are younger than age 19 (age 24 for students) will be taxed to them but at their parent's income tax rate.
3. When avoidance of the alternative minimum tax is desired. S corporations are not subject to the corporate alternative minimum tax.
4. When avoidance of the corporate accumulated earnings tax is desired. S corporations are not subject to the accumulated earnings tax.
1. As in a regular corporation, an S corporation allows its owners to be subject to limited liability for the debts and obligation of the S corporation. However, business owners who are also employees of the S corporation cannot limit their liability for actions that they themselves commit. For example, if a doctor incorporates his medical practice as an S corporation, he will be personally liable for any medical malpractice he might commit (and his S corporation will probably also be liable as his employer). Also, for a small S corporation, limited liability may not be realized, because creditors may require personal guarantees from the shareholders of the S corporation.
2. The profits of an S corporation are taxed only once. In a C corporation, the profits of the corporation are taxed at the corporate level under the corporate tax rates. Then when income is distributed to shareholders in the form of dividends, it is taxed again to the shareholders. However, in an S corporation, the income of the corporation is taxed in much the same way as a partnership (see Chapter 12 for the treatment of partnerships). Income of an S corporation is pro-ratably "passed-through" to the shareholders based on their ownership interests. For example, assume an S corporation has two shareholders, one who owns 30% of the shares, and the other owns the other 70%. If the corporation has a profit of $1,000 in a particular tax year, the 30% owner will have $300 of gross income and the 70% shareholder will have $700 of gross income.
1. There are requirements on the number and type of shareholders an S corporation may have. There are also other potential "traps" that an S corporation must be aware of so that it does not unexpectedly lose its S status. For example, if an S corporation has retained earnings from when it was a C corporation, its S election may be terminated if it has too much passive income. Also, if stock is sold or given to someone who is an ineligible shareholder, such as a nonresident alien or a C corporation, the election will be terminated, with possible adverse tax consequences for the other shareholders.
2. Owners who own more than two percent of the S corporation are treated as partners for fringe benefit purposes. This severely limits the ability of owners to take advantage of tax-favored fringe benefits. However, S corporation shareholders have almost all of the qualified retirement opportunities that non-shareholder employees can use.
3. If the shareholders are in the highest marginal income tax bracket, the income from an S corporation may be taxed at a higher rate than if it was a C corporation and could have had its income taxed at the lower corporate tax bracket. For example, if an S corporation with one shareholder earns $50,000 and the shareholder is in the 35% marginal tax bracket, the shareholder will pay $17,500 in federal income tax on the S corporation's income. If the corporation is a C corporation, the corporation will pay a corporate income tax of $7,500, leaving $42,500 to distribute to the shareholder as a dividend. If the $42,500 dividend is taxed at 15%, the tax liability will be $6,375, for a total tax liability of $13,875, which would be a savings of $3,625 versus an S corporation.
WHAT ARE THE REQUIREMENTS?
1. An S corporation may have no more than 100 shareholders. (1) Members of a family, as well as a husband and wife, are considered one shareholder for purposes of the 100 shareholder rule. (2)
2. An S corporation must be a domestic corporation. It must have been organized under the laws of the United States or one of the individual states. (3)
3. S corporation shareholders must generally be individuals, estates, or certain trusts. Nonresident aliens may not be shareholders of an S corporation. (4) Certain trusts can be shareholders of an S corporation: (1) a grantor trust whose owner is a U.S. citizen or resident, (2) a trust that was a grantor trust before the owner's death may be a shareholder for two years after the death of the owner, (3) a trust that has S corporation stock transferred to it may be a shareholder for two years after the transfer, (4) a voting trust, and (5) an electing small business trust (ESBT). (5)
4. An S corporation must have a single class of stock. (6) Each share must have equal distribution and liquidation rights. However, different shares may have different voting rights. (7) For example, shares could be issued that have no voting rights, or some shares may have twice (or three times) the number of votes as other shares. Generally, bona fide buy sell agreements, agreements to restrict the transferability of shares, and redemption agreements will not be considered as creating a second class of stock. (8) Generally, providing a shareholder with reasonable employee benefits such as split-dollar life insurance or nonqualified deferred compensation will not be considered as creating a second class of stock.
5. Certain types of entities are not eligible to elect S corporation treatment: (1) a financial institution that uses the reserve method of accounting, (2) an insurance company, (3) corporations that elect to have credits for certain income from non-U.S. sources, and (4) a current or former domestic international sales corporation. (9)
6. An election must be made in which all shareholders of the corporation consent to have the corporation become an S corporation. (10) The election can be effective for the next taxable year, or if the election is made before the 15th day of the 3rd month of the taxable year, the election can be effective for that tax year. (11) For example, an election made on February 28, 2009, could be effective for 2009 or 2010, but an election made on March 30, 2009, could be effective for only 2010.
HOW IS IT DONE--AN EXAMPLE
Assume there are four equal shareholders of The Widget Corporation, which earns corporate taxable income of $100,000 per year. If Widget is a C corporation, the federal corporate income tax on this $100,000 is $22,250, which leaves $77,750 to be distributed to the four shareholders. If the corporation distributes all the profits to the shareholders, they will each receive $19,437.50. Assuming the shareholders are taxed on dividends at the 15% rate, they will each pay $2,915.63 in taxes on the dividends. Thus, in total, the C corporation and its shareholders will pay $33,912.52 in federal corporate and individual income taxes, nearly 34% of the taxable income of the corporation.
If Widget is an S corporation, the entire $100,000 in taxable income will be "passed-through" to the shareholders and taxed on their individual tax returns. Each shareholder will include $25,000 of the S corporation's earnings in income. Assuming the shareholders are in the 28% marginal tax bracket, the shareholders will each pay $7,000 in federal income taxes. Together the shareholders will pay a total of $28,000 in federal income taxes. Therefore, in this example, an S election will save $5,912.52 ($33,912.52--$28,000) annually.
1. Much like a partnership, an S corporation is generally not subject to tax at the entity (corporate) level. (12) Whether the S corporation's profits are distributed to them or not, S corporation shareholders are taxed on the S corporation's taxable income. Shareholders take into account their shares of income, loss, deductions, and credit on a per-share, per-day basis. (13)
S corporation income that could directly affect the tax liability of the shareholder is passed directly through the corporation to the shareholder. Also, any loss or deduction that the S corporation takes that could directly affect the liability of the shareholder is also passed directly through to the shareholder. An example of this "separately stated" income is the treatment of capital gain income, which is taxed at a different rate than ordinary income. Another example is the treatment of charitable deductions of an S corporation, which are passed directly through to the shareholder. (14)
2. The basis of each shareholder's stock is increased by his share of income (including tax-exempt income) and by any excess of deductions for depletion over the basis of property subject to depletion.
The basis of each shareholder's stock is decreased (but not below zero) by (a) his share of any loss the corporation suffers; (b) any expense of the corporation that is not deductible and is not a capital expense; and (c) depletion deductions to the extent the deduction does not exceed the shareholder's share of the basis in the property subject to depletion.
If the shareholder's basis would be reduced to less than zero, any excess reductions are used to reduce his basis in any debt of the S corporation. A shareholder may not take deductions that exceed his basis in the stock and debt of the S corporation that he holds. These disallowed deductions and losses may be carried forward to future tax years indefinitely. Therefore, a shareholder may not deduct any more than he has "at risk" with the S corporation. Basis in a shareholder's stock is also reduced by distributions from the S corporation that are not included in the shareholder's income. (15)
Example: A shareholder of an S corporation has a basis of $100 in the stock he owns. He also holds debt of the corporation that has a basis of $50. The S corporation has income in year one and the shareholder's share of the income is $20. In that same year, the S corporation distributes $10 to the shareholder. His basis in the stock is now $110 ($100 + $20-10). The next year, the corporation has a loss and the shareholder's share of the loss is $65. The shareholder's basis in his stock is now $45 ($110-$65). The following year, the S corporation has another loss and the shareholder's share of the loss is $55. The basis in his stock goes to $0, and the basis in the debt he holds is reduced to $40.
3. Distributions from an S corporation that do not exceed a shareholder's basis will not result in income to the shareholder. They are recovered income tax free. Any distributions from an S corporation that are not from the corporation's earnings and profits and that are in excess of a shareholder's basis in his stock will be treated as a capital gain.
If an S corporation has earnings and profits, distributions to shareholders are treated as a distribution by an S corporation without earnings and profits, to the extent of an account called the accumulated adjustment account (AAA). If an S corporation has earnings and profits, it will likely be because it had earnings and profits from when it was a C corporation, or as the result of a corporate acquisition. The AAA is an account of the S corporation that generally tracks how much of the S corporation's income was taxed to the shareholders minus any amounts that have been distributed to the shareholders. The AAA is designed to ensure that shareholders of an S corporation are not taxed twice on S corporation income.
Distributions from S corporations that have earnings and profits that are in excess of the AAA will be treated as a distribution under the normal corporate tax rules. This will generally result in a dividend up to the amount of earnings and profits, then a reduction of basis in the S corporation stock, and then finally a capital gain. If all shareholders who receive distributions agree, an S corporation with an AAA may elect to have distributions treated as if there was no AAA, which has the effect of reducing earnings and profits. An S corporation may do this because there can be negative tax consequences to an S corporation with earnings and profits and too much passive income. (16)
4. An S corporation is generally not subject to tax at the corporate level. However, a tax is imposed at the corporate level on certain gains. For S elections made after 1986 where the corporation had previously been a C corporation, when an S corporation disposes of property within 10 years after an election has been made, it may be required to pay tax on part of the gain. The gain attributable to pre-election appreciation of the property (built in gain) is taxed at the corporate level to the extent the gain does not exceed the amount of taxable income imposed on the corporation if it were not an S corporation. (17) In 2009 and 2010, no tax is imposed on built-in gain if the 7th year of the 10-year period preceded such year.
5. A tax is imposed at the corporate level on excess "net passive income" of an S corporation but only if the corporation, at the end of the tax year, has accumulated earnings and profits and if passive investment income exceeds 25% of gross receipts. The rate is the highest corporate rate (currently 35%). Passive investment income for this purpose is rents, royalties, dividends, interest, annuities, and proceeds from sales or exchanges of stock or securities.
However, passive investment income does not include rents for the use of corporate property if the corporation also provides substantial services in connection with the property (such as maid service in a hotel); interest derived in the ordinary course of any trade or business; or interest on obligations acquired in the ordinary course of business, such as interest earned on accounts receivable. Passive investment income also does not include gross receipts derived in the ordinary course of a trade or business of lending or financing; dealing in property; purchasing or discounting accounts receivable, notes, or installment obligations; or servicing mortgages. Passive investment income does not include certain dividends from C corporations where the S corporation owns 80% or more of the C corporation. (18)
WHERE CAN I FIND OUT MORE ABOUT IT?
Bittker, Boris, and James Eustice, Federal Income Taxation of Corporations and Shareholders, 7th ed., (Warren, Gorham & Lamont, 2002).
QUESTIONS AND ANSWERS
Question--What are the rules regarding qualified subchapter S trusts (QSSTs) and electing small business trusts (ESBTs)?
Answer--A QSST must have only one current income beneficiary (who must be a citizen or resident of the United States). It must distribute all income in the year it is earned and its assets may not be distributed to anyone else during the life of the beneficiary. The income interest must terminate upon the earlier of the beneficiary's death or the termination of the trust, and if the trust terminates during the lifetime of the income beneficiary, all the trust's assets must be distributed to that beneficiary. The beneficiary must make an election for the trust to be treated as a QSST. (19)
The QSST is a rather inflexible planning tool, so Congress created the ESBT in 1996. An ESBT is a trust in which all of the beneficiaries are individuals, estates, or certain charitable organizations. Each potential current beneficiary of an ESBT is treated as a shareholder for purposes of the 100- shareholder limitation. A potential current beneficiary is generally someone who is entitled to, or in the discretion of any person, may receive a distribution of principal or interest of the trust. Trusts that are exempt from income tax, QSSTs, charitable remainder annuity trusts, and charitable remainder unitrusts may not be ESBTs. An interest in an ESBT may not be obtained by purchase. An ESBT is taxed at the highest income tax rate under IRC Section 1(e) (35% in 2009).20
Question--Can an S corporation own stock in another corporation?
Answer--Yes, and there are special rules that an S corporation can take advantage of if it owns 100% of the shares of another corporation. The S corporation can make an election to treat the wholly-owned corporation as a qualified subchapter S subsidiary (QSSS). A QSSS is a corporation that could generally elect S corporation status except for the fact that its stock is owned by the parent S corporation, if 100% of its stock is owned by the parent S corporation, and the parent S corporation elects to treat the subsidiary as a QSSS. A QSSS is generally not treated as a separate corporation for tax purposes and its assets, liabilities, and items of income, deductions, and credit are treated as those of the parent S corporation. (21)
Question--What will cause the termination of an S election?
Answer--An S corporation election may terminate in a number of ways. (22) First, shareholders holding more than 50% of the S corporation may elect to terminate the S election. A "consent" termination will be effective for the following tax year unless it is made before the 15th day of the 3rd month of the year, in which case the termination is effective for that tax year. For example, a termination election made on March 1, 2009, will be effective for 2009, but a termination election effective on March 30, 2009, will not be effective until 2010.
Another way an S corporation can have its S election terminate is if it no longer meets the requirements to be an S corporation, such as having more than 100 shareholders, or having an ineligible shareholder. A termination because of failure to meet the S corporation requirements will be effective the date the requirements are not met.
Finally, a corporation can have its S election terminate if it has "excessive" passive income for three years and it has earnings and profits from when it was a C corporation or due to a corporate acquisition. Excessive passive income is passive income that exceeds 25% of the gross receipts of the S corporation for three consecutive years. The termination will be effective the first day of the year following the three consecutive years of excessive passive income.
If an S election is terminated, the corporation generally cannot elect S status again for five years without the consent of the IRS. (23) The IRS may waive an inadvertent termination if the corporation corrects the event that caused the termination and agrees to treat the corporation as an S corporation during the period of time the election was terminated. (24)
Question--How are S corporation shareholders treated for fringe benefit purposes?
Answer--All S corporation shareholders who own more than 2% of the stock of an S corporation are treated as partners for fringe benefit purposes. (25) What this generally means is that these shareholders will not be able to take advantage of some of the tax-favored rules for insurance plans offered by the S corporation. Generally, the cost or benefit of coverage provided to these shareholders will be taxed to the shareholders in much the same way it is taxed to partners in a partnership. (See The Tools & Techniques of Employee Benefit and Retirement Planning for more on this topic).
(1.) IRC Sec. 1361(b)(1)(A).
(2.) IRC Sec. 1361(c)(1).
(3.) IRC Sec. 1361(b)(1).
(4.) IRC Sec. 1361(b)(1).
(5.) IRC Sec. 1361(c)(2).
(6.) IRC Sec. 1361(b)(1)(D).
(7.) IRC Sec. 1361(c)(4).
(8.) Treas. Reg. [section] 1.1361-1(l)(2).
(9.) IRC Sec. 1361(b)(2).
(10.) IRC Sec. 1362(a)(2).
(11.) IRC Sec. 1362(b).
(12.) IRC Sec. 1363(a).
(13.) IRC Sec. 1366(a).
(14.) IRC Sec. 1366(a)(1).
(15.) IRC Sec. 1367.
(16.) IRC Sec. 1368.
(17.) IRC Sec. 1374.
(18.) IRC Sec. 1375.
(19.) IRC Sec. 1361(d).
(20.) IRC Sec. 1361(e).
(21.) IRC Sec. 1361(b)(3).
(22.) IRC Sec. 1362(d).
(23.) IRC Sec. 1362(g).
(24.) IRC Sec. 1362(f).
(25.) IRC Sec. 1372.
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|Publication:||Tools & Techniques of Income Tax Planning, 3rd ed.|
|Date:||Jan 1, 2009|
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