Chapter
11
S Corporations
S Corporations
Penalty Taxes or “Sting Taxes”
Excess Passive Investment Income
Slide 7-3
Excess Net Passive Income Tax
Applies only to S corporations that:
 Are former C corporations having accumulated
E&P at the end of the year [IRC §1375(a)(1)] and
That have more than 25% of gross receipts from
passive investment income [IRC §1375(a)(2)]
Slide 7-4
Excess Net Passive Income Tax
[IRC §1375(b)(3) and IRC §1362(d)] Passive
investment income gross receipts include:
Royalties received
Rents received
Dividends received
Interest income received
Annuities received
Gains on sales of stocks or securities
Slide 7-5
Excess Net Passive Income Tax
[IRC §1375(b)(3) and IRC §1362(d)(3)] Total
gross receipts include:
Passive investment income gross receipts
Gains on sales of capital assets other than stock and
securities included in the above
All other gross receipts
Slide 7-6
Note
[IRC §1375(b)(4)] Passive investment income
does not include any recognized built-in gain or
loss of the corporation in the recognition period
Slide 7-7
Excess Net Passive Income Tax
[IRC §1375(b)(2)] Net passive income equals:
Passive investment income gross receipts less
Deductions that are directly connected with the
production of those receipts
Slide 7-8
Excess Net Passive Income Tax
[IRC §1375(b)(1)] Excess net passive income
means the lesser of:
Net Passive Income  Ratio, or
The corporation’s taxable income for the year under
IRC §1375(b)(1)(B)
Where Ratio = (Passive investment income gross
receipts less 25% of total gross receipts)
÷ Passive investment income gross receipts
Slide 7-9
Excess Net Passive Income Tax
[IRC §1375(a)] A 35% tax is imposed on the
excess net passive income for the year
The tax imposed reduces the amounts of each item
of total passive investment income on a pro rata basis
[IRC §1366(f)(3)]
Slide 7-10
Excess Net Passive Income Tax
[IRC §1362(d)(3)] A corporation’s S election is
automatically terminated if it has:
Excess passive investment income for three
consecutive years, and
It has accumulated earnings and profits (E&P)
Slide 7-11
Excess Net Passive Income Tax
See Example 6
S Corporations
Distributions to Owners
Slide 7-13
In General
[IRC §1371(a)] Except as otherwise provided in
this title and except to the extent inconsistent
with this subchapter, subchapter C shall apply to
an S corporation and its shareholders
Slide 7-14
Treatment of S Corporation
[IRC §311(a) and (b)] S corporations must
recognize gains (but not losses) on property
distributions to shareholders, as if the property
were sold at its FMV
Gains may be taxed as built-in gains
Gains pass through to shareholders as either
separately stated items or as part of nonseparately
stated income (loss)
Slide 7-15
Treatment of S Corporation
[IRC §1368(e)(1)] Distributions to shareholders
generally reduce the corporation’s Accumulated
Adjustments Account (AAA)
But not below zero [Reg. §1.1368-2(a)(3)(iii)]
Slide 7-16
Treatment of S Corporation
[IRC §1368(e)(1)] AAA is an account that is
adjusted in a manner similar to the adjustments
made in calculating a shareholder’s basis under
IRC §1367 except that:
AAA is one aggregate account
No adjustments are made for tax-exempt income or the
related expenses
AAA can become negative (but not due to distributions)
No adjustments for FIT attributable to C corporation years
Slide 7-17
Accumulated Adjustments Account (AAA)
[IRC §1368(e)(1)(C)] If the net adjustments to
AAA for the year are negative, distributions are
deducted from AAA before the net negative
adjustments for the year
Distributions cannot create or add to a negative
balance in the account [Reg. §1.1368-2(a)(3)(iii)]
The account can have a negative balance due the
other adjustments required [IRC §1368(e)(1)(A)]
Slide 7-18
Accumulated Adjustments Account (AAA)
[IRC §1368(e)(1)] Calculation of account balance:
Beginning AAA balance
+/- Separately stated items (except income that is
exempt from tax)
+/- Nonseparately stated income (loss)
- Nondeductible expenses (except expenses related
to tax-exempt income and federal taxes
attributable to a C corporation tax year)
- Distributions out of AAA (but not below zero)
= Ending AAA balance
Slide 7-19
Treatment of S Corporation
Although there is no Code or Regulation section
or official administrative pronouncements
providing for such, Form 1120s have an Other
Adjustments Account (OAA) which includes
those items that are excluded from the AAA
account under IRC §1368(e)(1)
Distributions that exceed all other equity accounts
come out of this account
Slide 7-20
Other Adjustments Account (OAA)
Calculation of account balance:
Beginning OAA balance
+ Tax-exempt income
- Expenses related to tax-exempt income
- Federal taxes that are attributable to a C
corporation tax year
- Distributions out of OAA
= Ending OAA balance
Slide 7-21
AAA and OAA
Example 1 (Expanded)
Slide 7-22
Treatment of Shareholders
IRC §1368(b) rules apply to shareholders of:
S corporations that were S corporations in all
prior taxable years and
S corporations that were formerly C corporations
that have already distributed all the E&P that
accumulated during their C corporation years
Slide 7-23
Treatment of Shareholders
[IRC §1368(b)] Distributions of cash and/or
property received by shareholders with respect
to their S corporation stock:
Are not included in taxable income to the extent of
the shareholder’s stock basis (shareholder’s basis is
reduced for these tax-free distributions received)
Are taxed as gains from the sale or exchange of
property to the extent the amount of the distribution
exceeds the shareholder’s stock basis
Slide 7-24
Treatment of Shareholders
[IRC §1368(d)] To determine whether the
amount of the distribution exceeds the basis,
basis is calculated:
After considering the current period basis increases
in IRC §1367(a)(1) but
Before considering the current period basis
decreases in IRC §1367(a)(2)
Slide 7-25
Treatment of Shareholders
[IRC §301(d)] The basis of any property
received as a distribution is its fair market value
at the time of the distribution
Slide 7-26
Distributions from S Corporations
See Examples 7, 8, & 9
Slide 7-27
S Corporations With E&P
[IRC §1371(c)] Accumulated E&P of an S
corporation consists solely of:
 E&P that accumulated during years in which the
corporation was not an S corporation
Less: Any distributions made out of E&P
Adjusted for any stock redemptions
Slide 7-28
S Corporations With E&P
IRC §1368(c) rules apply to shareholders of:
S corporations that were formerly C corporations
and that still have undistributed accumulated E&P
from their C corporation years
Slide 7-29
S Corporations With E&P
[IRC §1368(c)] Distributions are considered
paid out from (and therefore reduce) the
following accounts in order:
Accumulated Adjustments Account (AAA)
Accumulated Earnings and Profits (E&P)
Other Adjustments Account (OAA)
[IRC §1368(e)(3)] Shareholders can elect to pay
a distribution out of accumulated E&P first
Slide 7-30
S Corporations With E&P
[IRC §1368(c)(1) and (b)] Distributions that are
paid out of the AAA:
Are not taxable to the shareholder
Reduce the basis of the shareholder’s stock
Slide 7-31
S Corporations With E&P
[IRC §1368(c)(2)] Distributions paid out of
accumulated E&P:
Are taxable dividend income to the shareholder
Do not reduce the stock basis
Slide 7-32
S Corporations With E&P
[IRC §1368(c)(3) and (b)] Any distributions that
exceed AAA and accumulated E&P (including
OAA):
Are applied against and reduce the basis of the
shareholder’s stock (but not below zero)
Distributions that exceed the shareholder’s stock
basis are treated as gains from the sale or exchange
of property (capital gain)
Slide 7-33
Distributions from S Corporations
See Examples 10 & 11