Chapter 12
Digging Deeper
Contents:
| DEFINITION OF A SMALL BUSINESS CORPORATION | S CORPORATION CONSENTS |
ALLOCATION OF INCOME AND LOSS | SCHEDULE M-3: NET INCOME OR LOSS
RECONCILIATION | WORKING WITH S STOCK BASIS | TAX ON PRE-ELECTION BUILT-IN
GAIN | PASSIVE INVESTMENT INCOME TAX PENALTY |
DEFINITION OF A SMALL BUSINESS CORPORATION
1. One Class of Stock. The determination of whether stock provides identical rights to
distribution and liquidation proceeds is made based on the provisions governing the operation of
the corporation. These governing provisions include the corporate charter, articles of
incorporation, bylaws, applicable state law, and binding agreements relating to distribution and
liquidation proceeds. Employment contracts, loan agreements, and other commercial contracts
are not considered governing provisions.1 Such contracts violate the one-class-of-stock
requirement only if their principal purpose is to circumvent the requirement.
Example: Blue, a small business corporation, has two equal shareholders, Smith and Jones.
Both shareholders are employed by Blue and have binding employment contracts with the
corporation. The compensation paid by Blue to Jones under her employment contract is
reasonable in amount. The compensation paid to Smith under his employment contract, however,
is excessive, and a constructive dividend results. Smith’s employment contract was not intended
to circumvent the one-class-of-stock requirement. Because employment contracts are not
considered governing provisions, Blue has only one class of stock.
DEFINITION OF A SMALL BUSINESS CORPORATION
2. One Class of Stock. Straight debt issued in an S corporation year is not treated as a second
class of stock and will not disqualify the S election. 2 The key characteristics of straight debt are
listed below.





The debtor is subject to a written, unconditional promise to pay on demand or on a
specified date a sum certain in money.
The interest rate and payment date are not contingent on corporate profits, management
discretion, or similar factors.
The debt is not convertible into stock.
The creditor is an individual (other than a nonresident alien), an estate, or qualified trust.
Straight debt can be held by creditors actively and regularly engaged in the business of
lending money.
In addition to the straight debt safe harbor, short-term unwritten advances from a shareholder that
do not exceed $10,000 in the aggregate at any time during the corporation’s taxable year
generally are not treated as a second class of stock. Likewise, debt that is held by stockholders in
the same proportion as their stock is not treated as a second class of stock, even if it would be
reclassified as equity otherwise.3
S CORPORATION CONSENTS
3. Both husband and wife must consent if they own their stock jointly (as joint tenants, tenants in
common, tenants by the entirety, or community property). This requirement has led to
considerable taxpayer grief—particularly in community property states where the spouses may
not realize that their stock is jointly owned as a community asset.
Example: Three shareholders, Amy, Monty, and Dianne, incorporate in January and file Form
2553. Amy is married and lives in California. Monty is single and Dianne is married; both live in
South Carolina. Because Amy is married and lives in a community property state, her husband
also must consent to the S election. South Carolina is not a community property state, so
Dianne’s husband need not consent.
Finally, for current-year S elections, persons who were shareholders during any part of the
taxable year before the election date, but were not shareholders when the election was made,
must also consent to the election.4
Example: On January 15, 2011, the stock of Columbus Corporation (a calendar year C
corporation) was held equally by three individual shareholders: Jim, Sally, and LuEllen. On that
date, LuEllen sells her interest to Jim and Sally. On March 14, 2011, Columbus Corporation files
Form 2553. Jim and Sally indicate their consent by signing the form. Columbus cannot become
an S corporation until 2012 because LuEllen did not indicate consent. Had all three shareholders
consented by signing Form 2553, S status would have taken effect as of January 1, 2011.
ALLOCATION OF INCOME AND LOSS
4. The Short-Year Election. In the case of the death of a shareholder, a short-year election can
prevent the income and loss allocation to a deceased shareholder from being affected by postdeath events.
Example: Joey and Karl equally own Orchid, Inc., a calendar year S corporation. Joey dies on
June 29 (not a leap year). Orchid has income of $250,000 for January 1 through June 29 and
$750,000 for the remainder of the year. Without a short-year election, the income is allocated by
assigning an equal portion of the annual income of $1 million to each day (or $2,739.73 per day)
and allocating the daily portion between the shareholders. Joey is allocated 50% of the daily
income for the 180 days from January 1 to June 29, or $246,575.70 [($2,739.73/2)  180]. Joey’s
estate is allocated 50% of the income for the 185 days from June 30 to December 31, or
$253,425.02 [($2,739.73/2)  185].
If the short-year election is made, the income of $250,000 from January 1 to June 29 is divided
equally between Joey and Karl, so that each is taxed on $125,000. The income of $750,000 from
June 30 to December 31 is divided equally between Joey’s estate and Karl, or $375,000 to each.
SCHEDULE M-3: NET INCOME OR LOSS RECONCILIATION
5. S corporations that have total assets on Schedule L at the end of the tax year equaling or
exceeding $10 million must file Schedule M-3 in lieu of Schedule M-1. For purposes of measuring
total assets at the end of the year, assets may not be netted or offset against liabilities. Total
assets may not be reported as a negative number. Total assets are determined on an overall
accrual method of accounting unless both of the following apply: (1) the tax return of the
corporation is prepared using an overall cash method of accounting, and (2) no entity includible in
the U.S. tax return prepares or is included in financial statements prepared on an accrual basis.
Part I of the Schedule M-3 for an S corporation is similar, but not identical to, the Schedule M-3 of
a C corporation. The S corporation’s Schedule M-3 asks certain questions about the corporation’s
financial statements, and it reconciles financial statement net income or loss to the income or loss
per the income statement for the U.S. tax return. Parts II and III reconcile financial statement net
income or loss for the U.S. tax return on Schedule M-3, Part I, line 11, to total income or loss on
Form 1120S, page 3, Schedule K, line 18.
WORKING WITH S STOCK BASIS
6. The basis rules for S corporation stock are similar to the rules for determining a partner's
interest basis in a partnership. However, entity-level debt is not included in a shareholder’s stock
basis. The fact that a shareholder has guaranteed a loan made to the corporation by a third party
has no effect upon the shareholder's loan basis, unless payments actually have been made as a
result of that guarantee.5 If the corporation defaults on indebtedness and the shareholder makes
good on the guarantee, the shareholder's indebtedness basis is increased to that extent. 6
A flow-through deduction is available for a shareholder loan only where there is clear evidence
that the S corporation is liable to the shareholder. A shareholder looking for this result should
borrow the money from the bank and then loan the money to the S corporation.
If the shareholder’s basis is insufficient to allow a full flow-through and there is more than one
type of loss (e.g., in the same year the S corporation incurs both a passive loss and a net capital
loss), the flow-through amounts are determined on a pro rata basis.
Example: Ralph is a 50% owner of an S corporation for the entire year. His stock basis is
$10,000, and his shares of the various corporate losses are as follows.
Ordinary loss from operations
Capital loss
§ 1231 loss
Passive loss
$8,000
5,000
3,000
2,000
Based upon a pro rata approach, the total $10,000 allocable flow-through would be split among
the various losses as follows.
Ordinary loss =
$8,000
$18,000 × $10,000 = $ 4,444.44
Capital loss
=
$5,000
$18,000 × $10,000 = 2,777.78
§ 1231 loss
=
$3,000
$18,000 × $10,000 = 1,666.67
Passive loss =
$2,000
$18,000 × $10,000 = 1,111.11
Total allocated loss
$10,000.00
The distribution adjustments made by an S corporation during a tax year are taken into account
before applying the loss limitation for the year. Thus, distributions during a year reduce the stock
basis for determining the allowable loss for the year; the loss for the year does not reduce the
stock basis for purposes of determining the tax status of the distributions made during the year.
Example: Pylon, Inc., a calendar year S corporation, is partly owned by Doris, who has a
beginning stock basis of $10,000. During the year, Doris’s share of a long-term capital gain
(LTCG) is $2,000, and her share of an ordinary loss is $9,000. If Doris receives a $6,000
distribution, her deductible loss is calculated as follows.
Beginning stock basis
Add: LTCG
Subtotal
Less: Distribution
Basis for loss limitation purposes
Deductible loss
Unused loss
$10,000
2,000
$12,000
(6,000)
$ 6,000
($ 6,000)
($ 3,000)
Doris’s stock now has a basis of zero.
TAX ON PRE-ELECTION BUILT-IN GAIN
7. General Rules. The maximum amount of gain that is recognized over the 10- (or 5- or 7-) year
period is limited to the aggregate net built-in gain of the corporation at the time it converted to S
status. Thus, at the time of the S election, unrealized gains of the corporation are reduced by
unrealized losses. The net amount of gains and losses sets an upper limit on the tax base for the
built-in gains tax. Any appreciation after the conversion to S status is subject to the regular S
corporation pass-through rules.
Example: Waxx is a former C corporation whose first S corporation year began on January 1. At
that time, Waxx had two assets: X, with a value of $1,000 and a basis of $400, and Y, with a
value of $400 and a basis of $600. The net unrealized built-in gain as of January 1 is $400 (Asset
X $600 built-in gain  Asset Y $200 built-in loss). If asset X is sold for $1,200 during the year, and
asset Y is retained, the recognized built-in gain is limited to $400. The additional $200 of
appreciation after electing S status is not part of the built-in gain.
Loss assets on the date of conversion reduce the maximum built-in gain and any potential tax
under § 1374.7 In addition, built-in losses and built-in gains are netted each year to determine the
annual § 1374 tax base. Thus, an incentive exists to contribute loss assets to a corporation
before electing S status. However, contributions of loss property with a tax avoidance motive do
not reduce the corporation’s net unrealized built-in gain.8
Example: Connor owns all the stock of an S corporation, which in turn owns two assets on the S
conversion date: asset 1 (basis of $5,000 and fair market value of $2,500) and asset 2 (basis of
$1,000 and fair market value of $5,000). The S corporation has a potential net realized built-in
gain of $1,500 (i.e., the built-in gain of $4,000 in asset 2 reduced by the built-in loss of $2,500 in
asset 1). However, if Connor contributed the loss asset to the corporation within two years before
the S election, the built-in gain potential becomes $4,000 (i.e., the loss asset cannot be used to
reduce built-in gain).
PASSIVE INVESTMENT INCOME PENALTY TAX
8. Avoiding the Passive Investment Income Tax. Too much passive investment income (PII)
may cause an S corporation to incur a § 1375 penalty tax and/or terminate the S election. Several
planning techniques can be used to avoid both of these unfavorable events. Where a small
amount of AEP exists, an AAA bypass election may be appropriate to purge the AEP, thereby
avoiding the passive income tax altogether. Alternatively, the corporation might reduce taxable
income below the excess net passive income; similarly, PII might be accelerated into years in
which there is an offsetting NOL.
In addition, the tax can be avoided if the corporation manufactures needed gross receipts. By
increasing gross receipts without increasing PII, the amount of PII in excess of 25 percent of
gross receipts is reduced. Finally, performing significant services or incurring significant costs
with respect to rental real estate activities can elevate the rent income to nonpassive.
Example: An S corporation has paid a passive income penalty tax for two consecutive years. In
the next year, the corporation has a large amount of AAA. If the AEP account is small, an AAA
bypass election may be appropriate to purge the corporation of the AEP. Without any AEP, no
passive investment income tax applies, and the S election is not terminated. Any distribution of
AEP to the shareholders constitutes taxable dividends, however.
Another alternative is to manufacture a large amount of gross receipts without increasing PII
through an action such as a merger with a grocery store. If the gross receipts from the grocery
store are substantial, the amount of the PII in excess of 25% of gross receipts is reduced.
Notes:
1
Reg. § 1.1361–1(l)(2).
2
§ 1361(c)(5)(A).
3
Reg. § 1.1361–1(l)(4).
4
§ 1362(b)(2)(B)(ii).
5
See for example, Estate of Leavitt, 90 T.C. 206 (1988), aff'd 89-1 USTC ¶9332, 63 AFTR 2d 891437, 875 F.2d 420 (CA-4, 1989); Selfe v. U.S., 86-1 USTC ¶9115, 57 AFTR 2d 86-464, 778
F.2d 769 (CA-11, 1985); James K. Calcutt, 91 T.C. 14 (1988).
6
Rev.Rul. 70-50, 1970-1 C.B. 178.
7
§§ 1374(c)(2) and (d)(1).
8
Reg. § 1.1374-9.
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