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Timing passthrough items when the S election terminates during a fiscal year.

Facts

Sky Corp. is an S corporation with a fiscal year ending July 31. Dale, the sole shareholder, reports on a calendar year. On Dec. 1, 1992, the S election is terminated. On that date the only passthrough item is ordinary income of $15,000. For the remainder of the fiscal year, the corporation recognized ordinary income of $50,000, so net income for the fun year is $65,000.

Issue

How is income allocated to each short year, and in which calendar year will Dale be taxed on the S income?

Analysis

If an S corporation termination occurs on a date other than year-end, the year is divided into two periods, an 1120S short year and 1120 short year. After the S termination year is divided into the two reporting periods, the separately stated items of income, loss, deduction or credit, and the amount of non-separately stated income or loss, must be divided between the periods.

In this case, the S termination year is split into an S corporation short year ending Nov. 30, 1992, and a C corporation short year ending July 31, 1993. The S corporation income tax return is not due until the return for the full tax year would have been due. Since the normal year-end is July 31, the return is due Oct. 15, 1993, not considering extensions.

The tax adviser determines that corporate items of income, loss, deduction or credit normally are allocated between the S corporation portion of the year and the C corporation portion of the year on a pro rata basis. However, the corporation can elect to allocate items between the S and C short years by using the specific transactions in each year, based on the company's books and records and applying normal tax accounting rules. Each person who was a shareholder during the S year and each person who was a shareholder on the first day of the C short year must consent to the election.

The best results for Dale are accomplished by making the election, so Dale will report 15,000 in taxable income from the S corporation. If the election is not made, the year's $65,000 income is allocated based on the number of days in each short year. In that case, income of $21,726 (192/365 X 65,000) would be allocated to the C corporation year.

An important exception to these rules applies ff 50% or more of the corporation's stock is sold or exchanged in the termination year. in that event, the pro rata method cannot be used, and the specific accounting method is required (rather than elective).

The election to use the specific accounting allocation method does not have to be made until the tax return for the total year is filed. In other words, the shareholders conceivably can remain undecided about whether to use the pro rata or specific accounting method right up to the filing date of the return. The due date for filing the return for the S short year is the same as for the C short year.

These facts also raise this question: Is income properly reportable by the shareholder in the year in which the S election terminates or in the year in which the S corporation's normal year ends? If the answer is the former, Dale will report the income in 1992; otherwise, he will report it in 1993.

According to Prop. Regs. Sec. 1.1362-4(e)(4), a shareholder includes the passthrough in his taxable income for the year in which the S corporation's termination year ends; 1993 in this case. The termination of the S election does not accelerate income recognition.

Conclusion

Corporate items of income, loss, deduction or credit can be allocated in one of the two ways when the S election terminates on a date other than the regular tax year-end. The general rule is that the items for the entire year are allocated between the S and C short years on a pro rata basis. However, the corporation (with shareholders' consent) can elect to allocate items based on the specific transactions in each short year, using the company's books and records and applying normal tax accounting rules. If there is a sale or exchange of 50% or more of the S corporation's stock in the termination year, the pro rata method cannot be used.

When the S election terminates, the shareholder reports passthrough items on the personal tax return for the year that includes the last day of the C short tax year. The S termination year includes both the S and C short years.

The posttermination transition period rules come into play on the termination of the corporation's S election.
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Article Details
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Author:Ellentuck, Albert B.
Publication:The Tax Adviser
Date:Feb 1, 1993
Words:784
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