Advanced S Corporations
The American Jobs Creation Act
of 2004
• Increase in number of shareholders
– Limit increased to 100
– Family treated as 1 shareholder
• Inadvertent Termination Relief
• IRA as a S Corporation Bank Shareholder
• ESBT Beneficiary Defined
Slide 1-1
The American Jobs Creation Act
of 2004- Losses
• Transfer of Suspended Loss to Spouse
• Passive Activity Losses and At Risk
Amounts for QSSTs
Slide 1-2
Eligible S Corporation
Shareholders
• Estates
• Certain trusts
– Grantor trusts
– Testamentary trusts
– Qualified Subchapter S Trust (QSST)
– Electing Small Business Trust (ESBT)
Slide 7-1
QSST Requirements
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Owns stock in one or more S corporations;
Beneficiary is a U.S. citizen or resident; and
Trust terms include
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Only one income beneficiary (CIB) at a time;
Corpus must be distributed to the CIB;
Interest of the CIB must terminate on the earlier of the
income beneficiary's death or the date the trust terminates;
and
All corpus and income must be distributed to the CIB when
the trust terminates.
Beneficiary must make an election to be
treated as a QSST
Slide 7-2
ESBT Characteristics
• Can have more than one CIB but each is treated
as a separate shareholder
• Trust is taxed on the S corporation income
• No interest in the ESBT can be acquired through
purchase
• Trustee must make an election to be treated as
an ESBT
Slide 7-3
Rules when a Shareholder Dies
• Estate can be an S corporation
shareholder
• In year of death will be two shareholders –
the decedent and the estate
• Must determine if:
– Stock is subject to a buy-sell agreement
– Stock is held in a trust
– Stock passes to a testamentary trust
Slide 7-4
Grantor Trust
• Can be an S corporation shareholder
• Estate will be deemed to own stock held
by a grantor trust for S corporation
purposes
• Trust can be a shareholder until the stock
is transferred or two years
• A Qualified Revocable Trust (QRT)
election can be made for a grantor trust
Slide 7-5
Testamentary Trust
• Trust that receives stock under the terms
of a will
• Is an eligible S corporation Shareholder for
two years
• At the end of the two years stock must be
transferred to an eligible shareholder
• A ORT election can be made for a
testamentary trust as well
Slide 7-6
Compensation Paid to S
Corporation Shareholders
• S corporation shareholders can be
employees
• Amount paid to shareholder / employees
are treated as wages
• Wages are subject to FUTA and FICA
Slide 2-1
Reasonable Compensation
• S corporations have a tendency to
understate compensation to shareholder /
employees
• FICA
• FUTA
• Social Security Benefits
Slide 2-2
Criteria for Reasonable
Compensation
• Size, complexity and financial condition of
business
• Employee’s position, time spent working and
nature of services performed
• Pay for comparable services and prevailing
economic conditions
• Company’s salary policy
• Employee’s responsibilities and qualifications
• Salary paid in prior years
• Distributions to shareholders
Slide 2-3
S Corporation Income Subject to
Self Employment Tax
• New proposal would increase the amount
of income subject to self-employment tax
• Issue that should be considered include
– Entity Selection Neutrality
– Choice of Entity
– No Pay – No Benefit
– Other Factors that Influence Compensation
Slide 2-4
Fringe Benefits
• Not available for “2% shareholders”
including
– Group Term Life Insurance
– Accident and Health Plans
– Meals and Lodging
– Cafeteria Plans
• Fringe Benefits paid for “2% shareholders”
treated as wages
Slide 2-5
Shareholder Expenses
• Expenses paid by accrual basis
corporations to cash basis shareholders –
corporation not allowed deduction until
shareholder reports income
• Unreimbursed shareholder expenses –
cannot be deducted by shareholder
Slide 2-6
Computation of Basis
Original basis
+ Additional capital contribution
+ Share of separately stated income items
+ Share of nonseparately stated income and gains
+ Share of tax exempt income
+ Excess of deduction for depletion over the basis of the
property subject to depletion
- Distributions
- Share of nondeductible, non-capital expenses
- Share of nonseparately stated ordinary loss
- Share of separately stated deductions/losses
- Shareholder’s deduction for depletion
Shareholder’s stock basis not below zero
Slide 3-1
Adjustments to Basis
• Basis is adjusted in the following order:
– All positive items
– Distributions
– Nondeductible, noncapital expenses
– Other deductions
• Basis is generally computed at year end
• Basis is adjusted per share
Slide 3-2
Basis of Indebtedness
• Must be direct shareholder debt
• Personal guarantees do not increase basis
• Stock Basis is decreased by losses first, then
basis in debt
• Basis in debt is restored before basis in stock
Slide 3-3
Economic Outlay
• Shareholder acquires basis in debt only if
they experience an actual economic outlay
• Issue becomes a problem with:
– Loans from Related Entities
– Back to Back Loans
Limitation of Deduction of
Losses
• Amount of losses that can be deducted
limited to the sum of the shareholders
basis in stock and direct loans
• Losses limited by Section 1336(d) are
carried over indefinitely
• Losses carried over only with respect to
that shareholder
• Losses are then limited by at-risk basis
and passive activity rules
Slide 3-5
Distributions
• Distributions are payments to
shareholders are based on stock
ownership
• No effect on corporate income
• Whether or not taxable to the shareholder
depends on if the S corporation has AE&P
Slide 4-1
Cash Distributions made by S
Corporation without E&P
• Tax Free Return of Stock Basis
• Distribution reported when received
• Gain only if amount received exceeds
basis
• Distribution reduces basis in stock
Slide 4-2
Cash Distributions by S
Corporation with AE&P
• Distributions come out of the following
accounts in the order shown
– Accumulated Adjustments Account (AAA)
– Previously Taxed Income (PTI)
– Accumulated Earnings & Profit (AE&P)
– Other Adjustments Account (OAA)
• Election allowed under Section 1368(d) to
take distribution out of AE&P first
Slide 4-3
Tax Effect of Distributions
• AAA, PTI and OAA –
– Nontaxable to the extent of basis;
– Gain in excess of basis
• AE&P –
– Taxable Dividend;
– No effect on basis
Slide 4-4
AAA
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Balance starts at zero the 1st day of the 1st
taxable year after 1982
Increased by:
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Nonseparately stated income;
Separately stated items of income and gain;
Excess depletion (other than oil and gas); and
Decreased by:
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Nonseparately stated loss;
Separately stated items of loss or deduction;
Nondeductible or noncapital expenses;
Cost Depletion
Slide 4-5
Differences Between AAA and
Basis
• The AAA increases and decreases by the same
items as basis does each year, except:
– Tax-exempt income increases basis, but does not
increase the AAA.
– Expenses relating to tax-exempt income reduce
basis, but do not decrease the AAA.
– Federal taxes relating to a C corporation year reduce
basis, but do not decrease the AAA.
– The order that increases and decreases are applied
to basis and AAA differ.
– Losses and deductions (but not distributions) can
reduce the AAA below zero. Basis can never have a
negative balance.
Slide 4-6
Property Distributions
• Amount Distributed = FMV of property
• S corporation must recognize income (but
not loss) as if the property had been sold
• Sale could be subject to BIG tax
Slide 4-7
Post Termination Transition
Period (PTTP)
• Cash distributions during PTTP applied against
basis to the extent of AAA
• PTTP begins on the day after the last day as S
corporation and ends the later of (1) one year
after termination, (2) the due date (including
extended date) of final S return or (3)120 days
after a final determination (e.g., court decision)
that S election was terminated.
Slide 4-8
Built-in Gains Tax
• BIG is gain that had accrued when a C
corporation converted to S status
• BIG recognition period is ten years after
the conversion
• BIG tax could be triggered when an S
corporation liquidates
• BIG tax determined by multiplying the
highest corporate rate by the BIG
recognized during the year.
Slide 6-4
History of QSubs
• Effective for years after 1996 S corporations can
own 100% subsidiary
• Congressional intent
– …understands that there are situations where
taxpayers may wish to separate different trades or
businesses in different corporate entities… in such
situations, shareholders should be allowed to arrange
these separate corporate entities under parentsubsidiary arrangements as well as brother-sister
arrangements.
Slide 5-1
Definition of QSub
• Section 1361(b)(3)(B) defines a QSub as
any domestic corporation that is not an
ineligible corporation if:
– An S corporation holds 100 percent of the
stock of the corporation, and
– The S corporation parent elects to treat the
subsidiary as a QSub.
Slide 5-2
Eligibility
•
A parent S corporation may elect to treat
a subsidiary as a QSub if the subsidiary
is:
1. wholly owned by the S corporation;
2. a domestic corporation; and
3. not an ineligible corporation (as that term
is defined in section 1361(b)(2)).
Slide 5-4
QSub must be Wholly-Owned
• Determination made based on general tax
principles
• Issues could arise if
– Subsidiary stock held by a disregarded entity
owned by the S corporation; or
– Another entity holds nominal title to the
shares
Slide 5-5
QSub Election
• Election must be made by filing Form 8869
• A QSub election can be made at any time
during the year and will be effective on the
date on the form. The effective date
specified cannot be more than:
– two months and fifteen days before the date the
election is filed, or
– twelve months after the date the election is filed.
• There is late election relief under Rev.
Proc. 2003-43
Slide 5-6
Termination of QSub Election
• QSub election may terminate in one of
four ways:
– By termination of the S election of the parent;
– By the subsidiary ceasing to qualify;
– By revocation; or
– By transfer of 100% of the sock by sale of
reorganization
Slide 5-8
Tax effect of Termination
• Subsidiary will be treated as a new
corporation that acquires all of its assets
and liabilities from the S parent
immediately before the termination
• New corporation must make any
necessary elections
• Formation of new corporation may or may
not be tax-free
Slide 5-9