Form 1120S Challenges
Amanda Wilson
Orlando, Florida
www.lowndes-law.com
(407) 418-6220
Amanda.Wilson@lowndes-law.com
June 27, 2013
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I.
Adjustments to Accumulated Adjustment
Accounts
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Accumulated Adjustment Accounts
An accumulated adjustment account (AAA) generally reflects the
accumulated undistributed net income of the corporation for the S
corporation's post-1982 years.
More simply, it tracks the S corporation’s ability to make tax-free
distributions to shareholders.
The AAA reflects the earnings of the S corporation that have been
previously taxed to the shareholders, reduced by any amounts that
have already been distributed to the shareholders. To the extent there
is a positive AAA balance, distributions can be made tax-free to the
shareholders.
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Accumulated Adjustment Accounts
AAA is zero as of the start of the S corporation’s first taxable year for
which the S election is in effect.
Adjustments to an AAA are similar to the adjustments to the
shareholder’s basis provided for under Section 1367, except that an
AAA can go negative.
AAA balance disappears following the end of the post termination
transition period after termination of S election, even if corporation later
re-elects S status.
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Accumulated Adjustment Accounts
All S corporations should maintain an AAA in case the S corporation
ever engages in a Section 381 transaction with another corporation.
The AAA is an account of the S corporation and is not apportioned to
the shareholders in any way.
Adjustments to AAA depend on the taxable year.
º Current rules
º Rules for taxable years beginning before 1/1/1997
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Current AAA rules
AAA is:
1. Increased for separately and nonseparately stated income
(excluding tax-exempt income) and certain depletion
deductions;
2. Decreased by separately and nonseparately stated loss,
nondeductible expenses (other than federal taxes attributable
to any C corporation taxable years or tax-exempt income
related expenses), and depletion deductions (capped by the
amount of the increase in (1));
3. Decreased (but not below zero) for tax-free distributions under
Section 1368(b) or (c)(1) (i.e., distributions that reduce basis);
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Current AAA rules
4. Decreased by the amount of separately and nonseparately
stated loss, nondeductible expenses (other than federal taxes
attributable to any C corporation taxable years or tax-exempt
income related expenses), and depletion deductions to the
extent that they exceed the amount of the increase in (1) (i.e.,
the amount that was not allowed under (2) because of the cap);
and
5. Decreased or increased (as appropriate) for any redemption
distributions qualifying under Section 302(a) or 303(a).
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Example
XYZ Inc. is a new S corporation formed as of January 1. In Year 1,
XYZ has $20,000 in losses and no distributions.
º
XYZ’s AAA as of December 31, Year 1 is negative $20,000.
In Year 2, XYZ has $60,000 of income and makes a $15,000
distribution.
º
XYZ’s AAA as of December 31, Year 2 is $25,000 [-$20,000 + $60,000 $15,000]
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Example
In Year 3, XYZ has $30,000 of separately stated income, $40,000 of
nonseparetely stated loss, and makes a $5,000 distribution.
º
XYZ’s AAA as of December 31, Year 3 is $10,000
• First, increase $25,000 starting AAA balance by $30,000 of income
• Second, decrease by $30,000 loss ($10,000 is not taken under this step
because loss is capped by amount of income)
• Third, decrease (but not below zero) by $5,000 distribution
• Fourth, decrease by $10,000 remaining loss
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Pre-1997 AAA rules
AAA is:
1. Increased for separately and nonseparately stated income
(excluding tax-exempt income) and certain depletion
deductions;
2. Decreased by separately and nonseparately stated loss,
nondeductible expenses (other than federal taxes attributable
to any C corporation taxable years or tax-exempt income
related expenses), and depletion deductions;
3. Decreased (but not below zero) for tax-free distributions under
Section 1368(b) or (c)(1); and
4. Decreased or increased (as appropriate) for any redemption
distributions qualifying under Section 302(a) or 303(a).
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Difference between the Rules
The difference between the current and prior AAA adjustment rules
relates to when an AAA is measured to determine whether a
distribution is tax-free.
Under the old rules, income and losses were taken into account when
making the AAA adjustments before distributions were tested.
The current rules provide that distributions be taken into account before
any net negative adjustment (i.e., losses in excess of income) are taken
into account.
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AAA Adjustments
AAA can become negative as a result of loss and deductions items.
If this occurs, S corporation must generate future income to overcome
this negative balance before the S corporation can once again
distribute cash tax-free.
Negative adjustments to AAA are made by deduction items, even if the
shareholders allocated the deduction items are unable to deduct such
items currently (i.e., because they lack sufficient basis). When the
shareholders are later able to utilize the deduction, there is no
adjustment to AAA.
AAA is generally determined as of the close of the S corporation’s tax
year.
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III. Character and Treatment of Distributions and
Dividends
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Distributions
Tax treatment of distributions from S corporation is governed by
Section 1368.
If S corporation has no E&P, Section 1368(b) applies.
º
Distribution is tax-free to extent of shareholder’s basis, and
º
Remaining distribution treated as gain from the sale or exchange of property (i.e.,
capital gain).
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Distributions
If S corporation has E&P, Section 1368(c) applies:
º
Distribution is treated as provided for under Section 1368(b) to the extent of E&P
(Treas. Reg. sec. 1.1368-1(d)(2) expands this to include previously taxed
income) [i.e., tax-free to extent of shareholder’s basis, capital gain for amount in
excess of basis].
º
Treated as a dividend to extent of accumulated E&P [note that dividend income
is subject to net investment income tax under Section 1411], then
º
Any remainder is treated as provided for under Section 1368(b) [i.e., tax-free to
extent of shareholder’s basis, capital gain for amount in excess of basis].
Dividend income will be reported by the S corporation on 1099-Div, not
Schedule K-1.
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Example
ABC Inc. has $25,000 AAA balance and $2,000 accumulated E&P.
Shareholder has basis in stock of $30,000. ABC Inc. distributes
$30,000 to Shareholder.
ABC Inc. has E&P so Section 1368(c) applies.
º
$25,000 (AAA balance) treated under Section 1368(b). Shareholder has
$30,000 basis so distribution is tax-free.
º
$2,000 treated as dividend because of $2,000 accumulated E&P.
º
Remaining $3,000 treated under Section 1368(b). Shareholder has $5,000
remaining basis so distribution is tax-free.
º
Shareholder’s basis is reduced to $2,000 after distribution.
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Fringe Benefits
One of the tax benefits of a C corporation is that an owner/shareholder
can be treated/respected as an employee of the corporation. This
contrasts to the partnership area which does not allow an
owner/partner to be treated as an employee.
As a result, an owner/shareholder can participate in certain fringe
benefits offered to employees. The C corporation can generally deduct
the cost of fringe benefits provided to employee owners without the
employee owner having to include the value of the fringe benefits in
taxable income.
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Special Rule for S Corporations
While the rules applicable to C corporations generally apply to S
corporations as well, Section 1372 provides that, in applying the rules
applicable to employee fringe benefits
º An S corporation is treated as a partnership, and
º any 2% or more shareholder is treated as a partner of the
partnership.
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Special Rule for S Corporations
A 2% shareholder is any person who on any day of the corporate year
owns more than 2% of the outstanding stock or more than 2% of the
voting power of all of the stock.
The constructive ownership rules of Section 318 apply. As a result, a
person can be a 2% shareholder even if he does not own any stock
directly.
º
For example, Father owns 5% of stock in Y. Son works for Y but holds no stock.
Under Section 318, stock ownership is attributed between members of a family
(spouses, children, grandchildren and parents). Son is treated as a 2%
shareholder because the stock of Father is attributed to Son.
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What Does This Mean?
2% shareholders generally do not get the benefit of excluding fringe
benefits from income, since the fringe benefit exclusion provisions
generally only apply to “employees”.
Note that this rule is for 2% shareholders only. Less than 2%
shareholders are caught by Section 1372.
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What Fringe Benefits Are Covered?
Section 1372 does not specifically define what fringe benefits are
covered. What does appear to be covered based on legislative history:
º
Exclusion from income amounts received under accident and health plans
(Section 105) (See Part V).
º
Exclusion from an employee’s income employer-provided coverage under an
accident and health plan (Section 106) (See Part V).
º
Exclusion from employee’s taxable income of the cost (up to $50,000) of group
term life insurance provided by an employer on employee’s life. (Section 79).
º
Exclusion from employee’s taxable income of meals or lodging provided by an
employer to an employee for the convenience of the employer (Section 119).
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What Fringe Benefits Are Not
Covered/Impacted
The following benefits are generally not covered/impacted, as these
provisions specifically define employees to include self-employed
individuals (including partners).
º
Defined contribution plans and defined benefit plans, including employee stock
ownership plans (Sections 401-417).
º
Qualified group legal services plans (Section 120).
º
Dependent care assistance programs (Section 129).
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Cafeteria Plans
A cafeteria plan allows employees to pay certain qualified expenses on
a pre-tax basis (i.e., flexible spending accounts).
Section 125 provides that employee benefits provided under a cafeteria
plan are not included in an employee’s income merely because the
employee had the chance, before the cash became available, to chose
to receive the cash or nontaxable benefits under the cafeteria plan.
Section 125 requires that all participants in the cafeteria plan be
employees. Based on Section 1372, the IRS has issued proposed
regulations under Section 125 stating that 2% shareholders are not
employees and thus cannot participate in cafeteria plans.
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Health Related Fringe benefits
The IRS addressed how to apply Section 1372 to payments of health
insurance premiums by an S corporation in Revenue Ruling 91-29.
In that ruling, the S corporation paid accident and health insurance
premiums for both 2% shareholder employees and a less than 2%
shareholder employee. The IRS held:
º
The employee fringe benefits paid or furnished for the benefit of 2% shareholder
employees were to be treated like a guaranteed payment under Section 707(c).
º
The 2% shareholders had to include cost of the premiums in their gross income.
º
The less than 2% shareholder employee could exclude the cost from income
under Section 106.
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Revenue Ruling 91-29
In addition, the IRS held that the S corporation could deduct the cost of
providing the employee fringe benefits if the requirements under
Section 162(a) were satisfied (i.e., if the cost was an ordinary and
necessary expense paid or incurred in carrying on trade or business).
The IRS also stated that the 2% shareholders could deduct the cost of
the insurance premiums if they satisfied the requirements of Section
162(l).
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Announcement 92-16
In Announcement 92-16, the IRS reiterated its holding in Revenue
Ruling 91-29.
It then stated that while the premium payments by the S corporation are
included in the 2% shareholder’s wages for income tax withholding
purposes (i.e., listed on the W-2), they are not wages subject to the
Social Security and Medicare taxes.
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Notice 2008-1
The IRS provided rules regarding when a 2% shareholder is entitled to
deduct accident and health insurance premiums under Section 162(l) in
Notice 2008-1.
Section 162(l) provides that an employee (including a self-employed
individual such as a partner) may deduct amounts paid for medical care
insurance subject to the following limitations:
º
Deduction shall not be allowed to the extent the deduction exceeds the
individual’s earned income from the trade or business with respect to which the
plan providing the medical care coverage is established.
º
Deduction is not allowed for amounts during a month in which the individual is
eligible to participate in any subsidized health plan maintained by an employer of
the individual or their spouse.
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Notice 2008-1 Requirements
In addition to the Section 162(l) requirements, Notice 2008-1 requires:
º
Plan providing medical coverage must be established by the S corporation. Either
• S corporation makes the premium payments for the accident and health
insurance policy in the current taxable year, or
• 2% shareholder makes the premium payments and furnishes proof of
payment to the S corporation and S corporation then reimburses the 2%
shareholder in the current taxable year.
If premiums are not paid or reimbursed by S corporation and included in 2%
shareholder’s gross income, requirement is not satisfied and no deduction.
º
S corporation must report the accident and health insurance premiums paid or
reimbursed as wages on the 2% shareholder’s Form W-2.
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Earned Income
Section 162(l) provides that the deduction is limited to the amount of the
individual’s earned income from the trade or business with respect to
which the plan providing the medical care coverage is established.
Wages paid to a 2% shareholder are deemed to be earned income for
purposes of this Section 162(l) limitation.
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Health Savings Account
An individual can generally, under Section 223, deduct contributions
made to a health savings account (HSA) established to pay for qualified
medical expenses. If the employer makes the contribution, the
contribution is generally excluded from income and wages under
Section 106(d).
In Notice 2005-8, the IRS stated that an S corporation’s contribution to
HSA of 2% shareholder is treated as a guaranteed payment under
Section 707(c). The S corporation can deduct the contribution under
Section 162 and the 2% shareholder must include it in gross income.
The deduction must be included in wages on W-2, but not subject to
Social Security or Medicare tax.
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In Short
2% shareholders often do not get the benefit of excluding fringe
benefits from income, since the fringe benefit exclusion provisions
generally only apply to “employees”.
The 2% shareholders must generally include the fringe benefit in gross
income. A deduction may be available in some cases (e.g., Section
162(l)).
The S corporation should issue the 2% shareholder a W-2 with respect
to the fringe benefits, although Social Security and Medicare generally
do not apply.
The S corporation may be able to deduct the cost of the fringe benefits
as a business expense under Section 162.
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IV. Recent Legislative and Administrative
Developments
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Section 179 Expensing
Section 179 allows taxpayers to elect to deduct as an expense certain
types of property and computer software.
Expense limitation on the amount deductible was set to be reduced
from $139,000 (with phaseout threshold of $560,000) in 2010 and
2011 to $25,000 (with phaseout threshold is $200,000) in 2012.
American Taxpayer Relief Act of 2012 increased dollar expensing
limitation for 2012 and 2013 to $500,000 (with phaseout threshold of
$2 million) and extended 50% first-year additional bonus depreciation
to 2013.
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Section 179 Expensing
Expensing deduction is limited to the aggregate amount of taxable
income that the taxpayer has from an active trade or business.
Expense deductions above this amount can be carried forward.
For an S corporation, the limitations on taking an expensing deduction
(phase-out threshold and taxable income limitation) are applied at the
S corporation and the shareholder level.
º
An S corporation cannot allocate an expense deduction to its shareholders in
excess of the S corporation’s taxable income for that year.
º
Shareholder cannot take an expense deduction for any tax year more than the
shareholder’s taxable income limitation for that year.
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Section 179 Expensing
For purposes of the expensing deduction limitation, all component
members of a controlled group shall be treated as one taxpayer.
Definition of members of a controlled as provided under Section
1563(a) except that the test is more than 50% instead of at least 80%.
However, an S corporation is generally not a component member of a
controlled group by virtue of Treasury Regulation section 1.15631(b)(2).
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Limitations on Losses and
Deductions
Under section 1366(d)(1), a shareholder is limited in the amount of
losses and deductions that it can take in any taxable year to the sum
of the shareholder’s adjusted basis in stock and adjusted basis of any
indebtedness of the S corporation to that shareholder.
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Stock Basis
Generally, initial basis equals the cost paid for the stock. If property
was contributed for stock, then basis equals basis of property
contributed, adjusted for gain recognized and boot distributed.
Basis increased by
º
º
º
Additional capital contributions
Share of S corporation income (including exempt income)
Excess of depletion deductions over basis
Basis decreased by
º
º
º
Share of S corporation losses, deductions, and depletion
Share of noncapital, nondeductible expenses (e.g. penalties or bribes).
Certain distributions
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Debt Basis
Debt basis – General rule
º
º
º
Initial basis equals the cost of the debt.
Decreased by the repayment of principal.
Reduced to zero if the debt becomes worthless.
Adjustments are first made to reduce stock basis (down to zero), and
then debt basis.
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Proposed Regulations on
Basis
Proposed Regulation section 1.1366-2(a)(2) was issued October
2012.
It provides that:
The term basis of any indebtedness of the S corporation to the
shareholder means the shareholder's adjusted basis (as defined in
§1.1011-1 and as specifically provided in section 1367(b)(2)) in
any bona fide indebtedness of the S corporation that runs
directly to the shareholder. Whether indebtedness is bona fide
indebtedness to a shareholder is determined under general
Federal tax principles and depends upon all of the facts and
circumstances.
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Proposed Regulations on
Basis
In addition, the proposed regulation provides that a shareholder does
not obtain basis in indebtedness of an S corporation merely by
guaranteeing a loan or acting as a surety. A shareholder that makes a
payment on bona fide indebtedness for which the shareholder has
acted as a guarantor, the shareholder may increase its basis in the
indebtedness by the amount of the payment. Treas. Reg. sec.
1.1366-2(a)(2)(ii).
Contrasts from treatment of partners in a partnership.
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Inadvertent Termination Relief
Section 1362(f) provides relief where an S election was not effective
(because the S corporation was not a small business corporation or all
shareholders did not consent) or where such election was terminated
(because the S corporation ceased to be a small business corporation
or had too much passive investment income).
º
The Secretary must determine that the circumstances were inadvertent.
º
Corrective steps must be taken within a reasonable period of time after
discovery.
º
S corporation and all people who were shareholders during relevant period
must agree to make adjustments required by the Secretary.
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Inadvertent Termination Relief
The corporation has the burden of establishing that under the relevant
facts and circumstances the Commissioner should determine that the
termination or invalid election was inadvertent.
“The fact that the terminating event or invalidity of the election was not
reasonably within the control of the corporation and, in the case of a
termination, was not part of a plan to terminate the election, or the fact
that the terminating event or circumstance took place without the
knowledge of the corporation, notwithstanding its due diligence to
safeguard itself against such an event or circumstance, tends to
establish that the termination or invalidity of the election was
inadvertent.” Treasury Regulation section 1.1362-4(b).
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Inadvertent Termination Relief
The corporation seeks relief by requesting a private letter ruling from
the IRS.
The IRS grants a substantial number of ruling requests. For example,
for the period between January 1, 2012 and the date of this webinar,
approximately 113 requests have been released.
Situations where relief was granted include:
º
person signing S election was not authorized to sign on behalf of shareholder,
º
ineligible shareholders (including failure to file QSST or QSBT election),
º
excessive passive income
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Circular 230
To comply with Treasury Department regulations, we inform you that,
unless otherwise expressly indicated, any tax advice contained in this
communication (including any attachments) is not intended or written to
be used, and cannot be used, for the purpose of (i) avoiding penalties
that may be imposed under the Internal Revenue Code or any other
applicable tax law, or (ii) promoting, marketing or recommending to
another party any transaction, arrangement, or other matter.