STOCK BASIS: MECHANICS CONT ’D Timing – Adjustments are made as of the close of the corporation ’ s tax year – If a S/H disposes of stock during the year, the adjustments are effective immediately before the disposition (but note election) Ordering Rules for calculating basis post August 18, 1998 (Treas. Reg. § 1.1367-1(f)) – First, basis is increased for both separately stated and non-separately stated income items and the excess of the deductions for depletion; – Next, basis is decreased with respect to a distribution by the corporation described in § 1367(a)(2)(A) (i.e., a distribution that was not includible in the income of the S/H); – Next, basis is decreased by items that are noncapital, nondeductible expenses and the oil and gas depletion; and – Finally , any decrease attributable to separately stated loss, deduction or credit items as well as non-separately computed loss items Separate Basis Rule – Under this rule, stock basis is computed on a share-by-share basis in the same manner as that of a S/H in a C corporation – The basis of a share of stock is increased or decreased by an amount equal to the S/H ’ s pro rata portion of the items described in § 1367(a)(1) or (a)(2) that is attributable to that share 8
STOCK BASIS: MECHANICS CONT ’D Other Considerations – A distribution may be tax free to the S/H, but Sec. 31 1(b) continues to apply to a distribution of appreciated property (i.e., any gain recognized on the deemed sale under Sec. 31 1(b) will pass through to all S/Hs) – A S/H ’ s stock basis at the time of a distribution is irrelevant in determining the tax treatment of the distribution; Basis at the close of the tax year determines the tax treatment of the distribution Under the stock basis adjustment rules, distributions made during a tax year are taken into account before applying any loss limitation for the year Note that, under Sec. 1367(b)(2)(A), basis from indebtedness may only be used to deduct losses; it may not be used to receive tax-free distributions (cash received in connection with such loans must take the form of a loan repayment) – S corporation rules adopt a separate basis approach for determining the basis adjustments in S stock, computing stock basis on a share-by-share basis in the same manner as stock basis is computed for a S/H in a C corporation 9
STOCK BASIS: LOSS LIMITATIONS
LOSS LIMITATIONS Amount of losses that can be deducted by the S/H is limited to his/her adjusted basis in the stock A loss that cannot be deducted due to a lack of basis is a “ suspended loss ” A suspended loss is an attribute of the individual S/H and cannot be used by other S/Hs If a shareholder transfers some but not all of the shareholder's stock in the corporation, the amount of any disallowed loss or deduction under this section is not reduced and the transferee does not acquire any portion of the disallowed loss or deduction. If a shareholder transfers all of the shareholder's stock in the corporation, any disallowed loss or deduction is permanently disallowed. Treas. Reg. § 1.366-2(a)(6) No basis obtained in debt simply by guaranteeing a loan, etc. Payment on the loan must be made by the S/H to get basis. 11
LOSS LIMITATIONS – CONT ’D “E xample : T is the sole shareholder of X, an S corporation. During 2005, X incurred and passed through to T $6,000 in nonseparately stated loss and $4,000 in capital loss. However, T was unable to deduct any of the losses due to a lack of basis. In this situation, both losses are suspended, carry forward to 2006, and pass through again with respect to T . In 2006, X incurred and passed through $5,000 in nonseparately stated income and $2,000 in capital gain. This means that T is deemed to have $1,000 in ordinary loss ($6,000 − $5,000) and $2,000 in capital loss ($4,000 − $2,000) from X in 2006. These amounts must be compared with T ’ s basis at the end of 2006 to determine if any of these amounts may be deducted. If not deductible, those amounts again carry forward and are combined with 2007 ’ s passthrough results. ” Starr and Sobol, 731-2nd T .M., S Corporations: Operations “E xample : T is the sole shareholder of X, an S corporation. During X ’ s first three years of operations, it incurred losses totaling $100,000 that passed through to T . However, because T only had basis of $20,000 in X, $80,000 of the losses were suspended. In the fourth year of operations, T sold his stock to B. In this situation, T ’ s suspended losses are lost forever (nor are they available to offset any gain from the sale of X stock). ” Id. 12
STOCK BASIS: SALES TRANSACTION
THE SEC. 338(H)(10) ELECTION Introduction When Available – Available to any corporation that makes a Qualified Stock Purchase (QSP) of a Target Corporation – Target is an S corporation or an 80% or greater corporate subsidiary member of a consolidated group – Also, Sec. 336(e) may be a viable alternative as it does not require a “ corporate purchase r” in a qualified stock disposition ( “ QS D”) Requirements – Corporate Purchaser – QSP: at least 80% (vote and value) must be acquired – Joint election by buyer and seller: filed by the 15th day of the 9th month following the month in which the acquisition occurs 14
THE SEC. 338(H)(10) ELECTION Mechanics ● Treatment of T arget Corporation: – T arget Corporation is deemed to sell all of its assets for an amount equal to the Aggregate Deemed Sales Price – T arget Corporation reports gain or loss from deemed sale on its final tax return In the S Corporation context, gain or loss flows-through to selling shareholders (generally no federal entity-level tax is imposed on S corporations). Seller is responsible for any tax due on the deemed asset sale. 15
THE SEC. 338(H)(10) ELECTION Mechanics ● Treatment of T arget Corporation (continued): – T arget Corporation is deemed to liquidate at the end of the acquisition date If T arget S Corporation is deemed to engage in a taxable liquidation. See Sec. 331 and 336. However, the gain or loss from the deemed asset sale flows through to the selling shareholders, increasing or decreasing their tax basis in their stock, respectively . As such, there generally is no incremental taxable gain upon the deemed liquidation of T arget Corporation. – At the beginning of the day after the acquisition date, T arget Corporation is deemed to reconstitute itself as a new corporation and purchase the assets. – T arget Corporation receives a tax basis in the assets equal to the Adjusted Grossed Up Basis. T arget Corporation uses the Residual Method to allocate the Adjusted Grossed Up Basis. 16
THE SEC. 338(H)(10) ELECTION Mechanics ● Treatment of Buyer – Receives a cost basis in the stock of T arget Corporation. – T ax basis step up in target assets – Increase in after-tax cash flow – T akes the form of a stock sale for non-tax reasons – Note: historical business & tax exposures carryover 17
THE SEC. 338(H)(10) ELECTION Mechanics ● Treatment of Sellers – The stock sale is ignored for federal income tax purposes – Single level of tax (no shareholder level gain). The gain or loss from the deemed arget Corporation ’ s assets flows through to the shareholders and is sale of the T reported on their federal income tax returns. – May be additional taxes (federal + state) – for which seller may require “ gross ups ” – Complications in rolling shareholders – rollover is taxable as if stock was sold 18
THE SEC. 338(H)(10) ELECTION Summary ● Note that in the case of a Sec. 338(h)(10) election, there is only one level of tax. ● Because the deemed asset sale generally results in ordinary income, while the sale of stock results in capital gain or loss, the sellers may , in certain cases, pay more tax under a Sec. 338(h)(10) election than under a stock sale. – Individual capital gain tax rates vs. ordinary income tax rates (23.8% vs. 39.6%), although, see Sec. 1231. – State taxes (including entity-level taxes), Sec. 1374 BIG tax, etc. ● In order to make the sellers whole, the purchaser can Gross Up the sellers by increasing the purchase price to accommodate for the incremental tax that the sellers must suffer as a result of making the Sec. 338(h)(10) election. – The Gross Up Payment is included in the computations for Aggregate Deemed Sales Price and Adjusted Grossed Up Basis. – May result in additional depreciation or amortization deductions. ● A Sec. 338(h)(10) election generally makes sense if the present value of the additional depreciation and amortization deductions that result from making the election exceed the amount of the Gross Up Payment. 19
THE SEC. 338(H)(10) ELECTION Summary $300 Corporate “ACTUAL” Seller (“S”) Buyer (“B”) Stock Ste Step 2 Old T Liq uidates “DEE “DEEMED” Step 1 Assumptions Assets (basis=$200) Seller ’ s outside stock basis = $100 New T OLD T T ’ s inside asset basis = $200 “DEEMED” (C Corp) (S Corp) T ’ s liabilities = $100 $300 + $100 Buyer Pays $300 for stock Assumption of Debt Stock Sale 338(h)(10) Cost Basis in T Buyer “ B ” Cost Basis in T Stock = $300 Stock = $300 Capital / Ordinary Gain = $200 ($300 + Capital Gain = $200 $100 - $200) on deemed sales is passed Seller “ S ” through from Target; No gain on liquidation No Gain; Gain passed through to S; Basis is stepped Target “T” Carryover Basis up to $400 20
THE SEC. 338(H)(10) ELECTION The Malpractice Transaction Historical PE PE S/H Cash Historical S/H Holdco Holdco Target Stock Buyer Buyer (S Corp) Target arget from Historical S/H for cash, and both parties make a Sec. ● Buyer purchases the stock of T 338(h)(10) election. ● Historical S/H rolls part of his proceeds (7%) into Holdco, such that after the transaction is consummated he is a partner in Holdco along with PE. ● The Sec. 338(h)(10) election was invalid because Historical S/H would be viewed as a related , and you c an’t do a Sec. 338(h)(10) election with a related party party . ● A very harsh and unfair result. Had Historical S/H rolled his interest into Buyer, it would not have been a problem. The Sec. 336(e) rules partially address this issue. 21
THE SEC. 338(H)(10) ELECTION Other Considerations Rollovers where the Seller ends up with more than 20% are not good QSPs S Corp status must be valid as a 338(h)(10) can ’t be made on a stand-alone “C” corp. Gross-up for Incremental taxes Built-in gains taxes (S corporations) State taxes Character of taxable gains (ordinary versus capital) 22
BIO
A&M TAX AND PROFESSIONALS ● Darren J Mills is a Managing Director with Alvarez & Marsal Taxand in New York, with more than 20 years of international tax, M&A and ASC 740 experience. He assists multinational organizations assess Darren J Mills and improve their global tax strategies. ● His most recent leadership experiences include, assisting two large multinationals in implementing the fair market value election and analysis of overall foreign loss/overall domestic loss; successfully assisted a Fortune 500 Company with the integration of a $400 million acquisition; provided both buy side and sell side tax due diligence and structuring to both strategic and financial investors; identification of a Managing missed gain recognition agreement prior the filing of a timely tax return resulting in the preservation of a Director $500 million gain; identification of a missed tax deduction related to an investment unit and the associated tax implications of a debt restructuring resulting in a $10 million cash refund to the client; and structuring an acquisition to result in a tax-free step-up in inside basis ● Mr. Mills is frequently involved in helping companies respond to tax demands from boards of directors and shareholders, as well as in fostering cross-functional communication between tax, operations, finance and treasury teams. He has worked closely with CEOs, CFOs and private equity investors. ● Before A&M, he was the partner responsible for developing the tax advisory practice in both Metro New York and DC for a Top 20 accounting firm. Mr. Mills was also at KPMG LLP where he participated in KPMG ’ s National ASC 740 team as a local resource. He began the early part of his career with Arthur Andersen LLP. Direct: +1 212 763 1925 ● Mr. Mills earned a juris doctor from Seton Hall Law School; a Masters of Science in Taxation at Fairleigh Mobile: +1 908 612 8145 Dickinson University and a Bachelor of Science in Accounting, also from Seton Hall University. Mr. Mills dmills@alvarezan is a licensed attorney in the State of New Jersey (inactive in Pennsylvania) and a licensed CPA in the States of New Jersey & Florida as well as the Commonwealth of Virginia. ● Mr. Mills has served as an Adjunct Professor in the graduate tax programs at both Seton Hall University and the University of Baltimore. He serves as a national speaker, and has written articles and provided comments on proposed regulations and other topics related to corporate and international taxation. NOTE: Alvarez & Marsal employs CPAs but is not a licensed CPA firm. 24
31 S CORPORATIONS: Basis and Distribution Ordering Rules WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
32 General Rules A distribution of cash or property from an S corporation to a shareholder can result in one of three tax consequences: Tax-free Taxable Capital gain return of dividend, as if the capital, shareholder sold the stock (even though they did not) WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
33 Three Concepts In order to determine the consequences, we must understand three concepts: ONE TWO THREE Shareholder C Accumulated basis in S Corporation Adjustments corporation Earnings Account stock and Profits (AAA, Subchapter S) (Subchapter S) (E&P, Subchapter C) WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
34 A Quick Primer Continued The defining characteristic of S corporations is: • Distributions of previously taxed S corporation income should not be taxed a second time. • In contrast, C corporation income should be taxed twice; once when earned, once when distributed. • Distribution rules preserve this difference. WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
35 Stock Basis versus Accumulated Adjustments Account Note, stock basis and AAA may not be the same thing. AAA is a corporate attribute. Stock basis is personal to a shareholder. Stock basis is increased for tax-exempt income and decreased for expenses attributable to tax-exempt expenses, AAA is NOT. AAA can go negative, stock basis cannot. If a shareholder buys an interest in an S corporation for a premium, it has no effect on AAA. WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
36 Taxability of Distributions Must ask two questions FIRST: Was the S corporation ever a C corporation? If so, does the S corporation still have C corporation “earnings and profits?” Quick hint: If an S corporation: • Has been an S corporation since formation; • Was formed after 1982, and • Has never acquired a C corporation’s assets in a Section 381 transaction, Then the S corporation CANNOT have E&P. WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
37 Distributions From an S Corporation With No E&P Taxability of distributions if no E&P (Treas. Reg. Section 1.1368-1(c)) STEP ONE STEP TWO Distributions Distributions in are tax-free to excess of basis the extent of generate stock basis. capital gain to (and basis the s/h. must be reduced) WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
38 Distributions From an S Corporation With No E&P If an S corporation has no E&P, then all income available for distribution must have been earned while an S corporation. WHY IS If that’s the case, because S corporation income THIS should only be taxed ONCE, a distribution of THE that income should not be taxed a second time. RULE? As a result, a distribution is treated first as a tax- free return of basis to preserve the single level of taxation. WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
39 What is the Lesson? If an S corporation: Has never acquired a C Has never been a C corporation in a Section 381 corporation and transaction, then it can’t have corporate E&P. AAA is irrelevant to determining the taxability of distributions. However, you should still maintain the AAA balance on the return so you can distribute it tax-free during a post-termination transition period. WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
40 Example 1 A OWNS ALL THE STOCK OF S CO . A’S BASIS IN S CO. STOCK IS $30,000 ON 1.1.2013. S Co had $10,000 of AAA on 1.1.2013 S Co. was never a C corporation, has no E&P During 2013, S Co. had: Ordinary income $50,000 LTCL ($5,000) Made a $40,000 distribution to A on 6.1.2013 WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
41 Example 1 Continued Because S Co. has no E&P, AAA is irrelevant. Must look to stock basis: Starting basis: $30,000 Add: income: $50,000 Basis before distribution $80,000 Next: distributions: ($40,000) Remaining basis $40,000 Reduce for losses: ($5,000) End of year basis $35,000 The entire $40,000 distribution is tax free WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
42 Example 2 A OWNS ALL THE STOCK OF S CO. A’S BASIS IN S CO. STOCK IS $30,000 ON 1.1.2013 . S Co. had $10,000 of AAA on 1.1.2013 S Co. was never a C corporation, has no E&P During 2013, S Co. had: Ordinary income $20,000 LTCL ($5,000) Made a $60,000 distribution to A on 6.1.2013 WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
43 Example 2 Continued Starting basis: $30,000 Add: income: $20,000 Basis before distributions $50,000 Next: distributions, but not below zero: ($50,000) Remaining basis $0 Reduce for losses: $0 End of year basis $0 Only $50,000 of the $60,000 distribution is tax-free $10,000 results in capital gain The $5,000 loss is suspended WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
44 Example 3 BECAUSE OF THE BASIS ORDERING RULES, AN S CORPORATION WILL ALWAYS BE ABLE TO DISTRIBUTE ANY STOCK BASIS THAT EXISTS AT BEGINNING OF YEAR A owns all the stock of S Co. A’s basis in S Co. stock is $10,000 on 1.1.2013. During 2013, S Co. had: Ordinary loss ($30,000) Made a $10,000 distribution to A on 6.1.2013 WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
45 Example 3 Continued Even though S Co. has a net loss of $30,000 for the year, it can still distribute the $10,000 of beginning stock basis to A (this allows for a distribution of cash to cover tax on prior year income): Starting basis: $10,000 Add: income: $0 Next: distributions: ($10,000) Remaining basis $0 Reduce for losses: $0 End of year basis $0 The entire $10,000 distribution is tax-free The $30,000 loss is suspended WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
46 S Corporations With E&P Not all S When a C A C corporation Corporation corporation should not be distributions makes a able to avoid this should only be distribution out of result by subject to a single E&P, the converting to an S level of tax under distribution is corporation and the Subchapter S taxed a second then distributing rules. Why? time as a dividend the C corporation (Section 317/301) earnings WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
47 S Corporations With E&P If a C corporation with E&P makes an S election, the E&P survives the election and continues on. If the S corporation subsequently distributes the C corporation E&P, it will be taxed as a dividend, just as it would have if distributed while a C corporation. WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
48 S Corporations With E&P When will an S corporation have E&P? If it was a prior C corporation and had accumulated E&P on the date of S election If it had no E&P on election date, but subsequently acquired a C corporation in a Section 381 transaction. When will an S corporation never have E&P? Has been an S corporation since formation. Formed after 1982. Has never acquired a C corporation in a Section 381 transaction. WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
49 S Corporations with E&P Important: An S corporation can have accumulated E&P on the date of an S election, but cannot have current E&P while an S corporation. Effectively, the E&P of the C corporation gets “frozen” on the S election date and will get reduced when the S corporation distributes the E&P. WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
50 Concept #2: What Is E&P? Not defined anywhere in the Code or regulations. Meant to represent the measure of a corporation’s ability to make distributions to its shareholders out of earnings rather than by returning contributions to capital. As a result E&P is not concerned with tax policy or financial accounting considerations, rather, it is concerned with quantifying a corporation’s economic income . WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
51 S Corporations with E&P On S election date, accumulated E&P from prior C corporation years survive. However, the S corporation is still entitled to distribute S corporation earnings tax-free BEFORE it is deemed to distribute C corporation E&P. How do we decide whether an S corporation’s distributions are from S corporation earnings or C corporation E&P? WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
52 Concept #3: Accumulated Adjustment Account The AAA measures the Sales of stock An account of taxable income that do not impact the S was previously earned AAA, because it by the S corporation. corporation – is a corporate as opposed to attribute. This is income basis, which that was previously taxed to belongs to an shareholders and thus should be individual permitted to be shareholder. distributed without a second level of tax. WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
53 Accumulated Adjustment Account Account starts at zero on the effective date of an S election. Increase for: Non-separately stated Non-separately stated loss income Decrease for: Separately stated loss Separately stated income Do NOT decrease for Do NOT increase for tax- expenses attributable to exempt income tax-exempt income Distributions AAA, unlike basis, can be reduced below zero, but NOT by distributions. WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
54 When and in What Order Do You Adjust AAA? Depends on if you have a “net positive” or “net negative” adjustment. Net positive: Net negative: income and gain loss and exceeds loss and deduction items deduction (not exceed the distribution) income and gain items. items. WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
55 How and When Do You Adjust AAA? If you have a net positive adjustment, adjust AAA BEFORE figuring out taxability of distribution. If you have a net negative adjustment, DO NOT adjust AAA before figuring out taxability of distribution. This keeps AAA higher and allows more distribution to be a tax-free return of basis rather than a taxable dividend. WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
56 S Corp with AEP § 1368(c) Tier 1 • To the extent of Accumulated Adjustment Account (AAA), the distribution is treated as if made by a S corp WITHOUT AEP. Tier 2 • Distributions in excess of AAA are treated as a dividend up to AEP. Tier 3 • Distributions in excess of AEP are treated as if made by S corp without AEP. (i.e., same as Step 1) WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
57 Example 7 Net Positive Adj. Tom owns 100% of S Co. S Co. has AAA of $2,500 and E&P of $7,500. Tom’s stock basis on 1.1.2013 is $10,000. During the year, S Co. has the following: Loss: $2,000 Distribution: Income $9,000 $11,000 WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
58 Solution, Example 8 AAA E&P S Corp. C Corp Dist. Dist. Starting $2,500 $7,500 Increase AAA: net positive $7,000 adjustment AAA balance before distribution $9,500 Decrease: distribution ($9,500) $9,500 Ending AAA $0 Distribution from E&P ($1,500) $1,500 Ending E&P $6,000 WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
59 Solution, Example 8 Basis Starting $10,000 Increase for income $9,000 Basis before distribution $19,000 Decrease for distribution not taxed as dividend ($9,500) Decrease for losses ($2,000) Ending basis $7,500 WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
60 Example 8 What’s the Lesson? AAA is the dividing line between distributions made from S corporation income (which are tax-free to extent of shareholder basis) and those made from C corporation E&P (which must be taxed as a dividend). WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
61 Example 9 Net Negative Adj. A S corp has $500 of X is the sole s/h in S X has basis of $1,000 E&P and $200 of AAA corp. on 1/1/2013 on 1/1/2013. During 2013, S corp has $200 of capital S corp makes a $1,000 distribution. gain, has an operating loss of ($900) WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
62 Net Negative Example 9, Solution Do you have a net positive or net negative adjustment? THERE IS A NET NEGATIVE ADJUSTMENT. ($200 LTCG - $900 loss). AS A RESULT You determine the taxability of the distribution BEFORE you adjust AAA. This rule means that you can always distribute out the beginning balance in AAA under the S corporation rules, even if the current year is a huge net loss. WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
63 Solution, Example 9 AAA E&P S Corp C Corp Dist. Dist. $200 $500 Starting Decrease: distribution (not below ($200) $200 zero) AAA balance after distribution $0 ($700) Decrease AAA: net negative adjustment Ending AAA ($700) Distribution from E&P ($500) $500 $0 Ending E&P WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com Distributions in excess of AAA/E&P $300
64 Solution, Example 9 Basis Starting Basis $1,000 Increase for income $200 Decrease for distribution not taxed as dividend ($500) Basis after distributions $700 Decrease for losses ($700) Ending basis $0 Suspended losses $200 WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
65 Example 9 What’s the lesson ? Even though the AAA can go Basis CANNOT AAA is reduced S corporation negative from go negative; any by the full loss, had a net loss of losses; here it losses that even though the $700 for the ends the year at cannot be used loss may be year, the ($700). carry forward. suspended at beginning AAA the shareholder balance of $200 level. can be distributed tax free. VERY IMPORTANT: in this example, we reduced E&P to zero. It will NEVER be a problem again. From this point on, all distributions will simply be tax-free to extent of s/h basis and capital gain for any excess. WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
66 Post-Termination Transition Period If a corporation’s S election terminates and the corporation reverts to a C corporation, does that mean that all future distributions are taxed as dividends? NO. PERIOD IS LATER OF: THIS IS WHY • The corporation may • One year from date S • We must maintain AAA distribute all of its AAA election terminates, even when no E&P! in cash – and only • Due date of final S cash – under the S corporation tax return, corporation rules including extensions during the post- • Also 120 days from termination transition any later determination period. that S status ended WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
67 PTTP Example 13 S Co.’s S status ended on 1/1/2013. On 1/1/2013, S Co. had: A, the sole AAA of E&P of shareholder, $20,000 $10,000 has basis of $20,000 Even though S Co. is now a C corporation, S Co. has until 12/31/2013 to distribute $20,000 of AAA under the S corporation rules (tax-free to extent of basis, then capital gain). The distributions must be in cash. WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
68 Other Adjustments Account (OAA) Is not mentioned anywhere in the Code or regulations. Ultimately has no tax significance. Is meant to measure those items that increase or decrease shareholder basis (tax-exempt income and expenses related to tax- exempt expenses) but don’t increase or decrease AAA. Thus, you cannot make non-dividend distributions from this account. WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
69 Previously Taxed Income (PTI) Only exists for corporations that elected S status prior to 1983. Any PTI was “frozen” on 1/1/1983. Unlike AAA, PTI is a shareholder-level attribute. PTI is distributed after AAA, but before E&P. PTI must be distributed in cash, not property. Upon termination of S status, the PTI account cannot be distributed under the S corporation rules (non-dividend). Because of this, PTI should be distributed as soon as possible. Consider election to distribute PTI before AAA (see later slides) WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
70 PTI Example 14 S Co. became an S From 1983 corporation in S Co. had through 1980. On corporate 2013, S Co. In 2013, S 12/31/1982 it E&P of accumulates Co. had PTI of $20,000 on AAA of distributes $35,000 the date of $150,000, $180,000. allocated to the S but no its sole election. distributions shareholder, were made. A. WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
71 PTI Example 14 The $180,000 Then from PTI Thus, none of distribution of $35,000. the distribution comes first from is taxed as a AAA of dividend. $150,000 (tax- free to extent of A’s stock basis, capital gain for excess), WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
72 Solution, Example 14 AAA PTI E&P Starting $150,000 $35,000 $20,000 Increase AAA: net positive adjustment n/a Decrease: distribution (not below zero) ($150,000) Ending AAA $0 Distribution from PTI ($30,000) Ending PTI $5,000 Decrease E&P for dividend n/a Ending E&P $20,000 WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
73 Elections An S corporation that wants to get rid of its C corp E&P (perhaps to avoid § 1375 or use an expiring shareholder NOL) can elect to bypass AAA and distribute E&P first. Treas. Reg. § 1.1368-1(f)(2) Note, however, that if the corporation has PTI, a second distribution must be made to also bypass PTI and distribute E&P first. Also consider, if you plan to revoke your S status, may want to elect to distribute PTI first since you can’t distribute PTI during the post-termination transition period. WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
74 Elections Election to bypass AAA applies to all distributions during the year. Cannot choose specific distributions to go against E&P, the first dollars of distribution will be a dividend until all the E&P is purged. Not all E&P must be distributed. Election applies on a year-by-year basis, all shareholders who got a distribution must consent, and is attached to return. WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
75 Elections Can also elect to make a deemed dividend under Treas. Reg. § 1.1368-1(f)(3) if no cash is available. Treated as a cash distribution followed by a contribution to capital (giving a basis bump). Election is filed with return, so you have the benefit of hindsight. WithumSmith+Brown, PC | Certified Public Accountants and Consultants | withum.com
S CORPORATION OPEN ACCOUNT DEBT – 2015 By Robert S. Barnett CPA, JD, MS (TAXATION) CAPELL BARNETT MATALON & SCHOENFELD, LLP. ATTORNEYS AT LAW (516) 931-8100 rbarnett@cbmslaw.com
LOSS UTILIZATION • IRC §1366(d)(1) • LIMITS use of S Corp losses and deductions to extent of shareholder’s basis in stock • PLUS Corporate debt to shareholder. 77
LOSSES - UTILIZATION 1. First §1366(d)(1) Stock Basis 2. Then reduces Basis in debt to Corp 3. Remainder carried forward • REMEMBER – basis does not include guarantees or circular loans • Back-to-Back – must be bona fide • See §1.1366-2(a)(2)(i) & (iii),ex. 2 78
BASIS • Barnes v. Comm ., 111 AFTR 2d 2013 (DC Cir) • Affirmed Tax Court, TCM 2012-80 – reduce basis even if fail to deduct the loss • S SHs inadequate basis • Unable to deduct losses – limited to basis • Basis not increased by prior losses not claimed • Taxpayer failed to deduct suspended losses • Statute of limitations expired 79
LOSS UTILIZATION • Gleason v. Commissioner , TCM 2006-191 (9/11/06) – Taxpayer won as borrower on a $6m loan – IRS re-characterized loan properly made by taxpayer because loan payments paid by Corp and stock was pledged as collateral • Kerzener , TCM 2009-76 – CIRCULAR LOAN from p’ship to S SH to S corp did not create basis. – S Corp paid equivalent rent back to the p’ship . – Transaction lacked economic substance – MERE CONDUIT – No sufficient risk – Court distinguished Ruckriegel and Culnen • Nathel , 105 AFTR 2 ¶ 2010-927 (2nd Cir. 6/2/10) – Equity and debt are distinguishable – Contribution of equity increases basis of stock but does not restore loan basis – CONTRIBUTIONS TO CAPITAL ARE NOT INCOME! 80
NATHEL • The Corp. repaid shareholder loans (reduced basis from losses) • Recognized Ordinary Income on repayment of loan • Attempted to restore or increase loan basis • Capital contributions do not create exempt income (income increases loan basis) • Supreme court denied cert. 81
BACK TO BACK LOANS • Treas. Reg. §1.1366-2 (7/23/14) • “Bona fide indebtedness” • All facts & circumstances considered • General tax principles • MAGUIRE , TCM 2012-160 Auto dealer and finance company A/R distributed then contributed • Substitutions- State Law Formalities 82
Culnen , TCM 2000-139 • Distributions from profitable S corp (> $3mm) to loss corp added to basis: i. Amounts came out of S earnings, ii. Always shown on corp’s books as loans to/from shareholder, and iii.All bank financing statements showed the loans as personal, not corporate. • Back to Back loans & Substitutions • Treas. Reg. §1.1366-2 (7/23/14) 83
BONA FIDE DEBT • Watch Second Class of Stock Rules • Straight Debt Safe Harbor • Reg. §1.1361-1(l)(5) • Substitution- State Law Formalities 84
DEBT vs. EQUITY • Transfers to Corp generally equity, not loan • Capital contribution • Payment Personal expenses - dividends • Not repayment of loan • No debtor/creditor indicia • ACM Environmental Services , TCM 2012-335 • Proper documentation missing 85
NOT BONA FIDE DEBT • No Bad Debt Deduction – Herrera v. Comm’r , 112 AFTR2d 2013-6858 (5th Cir.) • LLC (p’ship) Loans to related steel corp. • No written promissory notes • No definite maturity • No repayment schedule • No security – no payments 86
OPEN ACCOUNT DEBT INTRODUCTION • Brooks v. Commissioner – TCM 2005-204 (August 25, 2005) • Final Regulations 87
LOANS • Assume Stock Basis $100 • If X $200 loss, shareholder deducts only $100 • §1366(d)(1) deductions limited to Basis • Excess loss carried forward • Basis can never be negative • So shareholder loans $100 to Corp on 12/31 • Stock Basis & Loan Basis is $0 • Later income first restores Loan Basis 88
OPEN ACCOUNT DEBT • Shareholder loans/advances not evidenced by written instrument • New Regulations – 10/20/08 and thereafter • Limit $25,000 per Shareholder • EXAMPLE – 10 Shareholders, each can have up to $25,000 of Open Account Debt 89
BE CAREFUL • No single Shareholder exceeds limit • Keep records per Shareholder • Not day/day – END OF S YEAR • Unless debt disposed or Shareholder terminated ownership 90
WHAT HAPPENS • When $25,000 limit exceeded • Debt at end of year treated AS IF evidenced by separate written agreement • No longer Open Account Debt • Debt existing on 10/20/2008 not subject to new rules - treated as a separate loan • Identification issues exist 91
LOSSES – ORDERING RULES • Losses first absorb Stock Basis • Then reduce Debt Basis • NOT BELOW ZERO • Multiple indebtedness – Loss Allocated • Based upon aggregate Basis • Intricate record keeping required 92
RESTORATION/ PRIORITY • Distinction between Stock & Debt Basis • “Net Income” restores Debt Basis first • First- to any Repaid Debt • Then proportionally to unrestored basis • “Net Increase” §1367(a)(1) income items • New contribution(s) - increase Stock Basis ( Nathel ) • Computations generally determined at end of the year 93
ACCELERATION • Termination of ownership • Dispose of debt 94
COMPUTATION • Advances and Repayments are netted • At close of S Corp year • Net Advance or Repayment is combined with Principal balance of Open Account Debt • Carried to next year (unless > $25,000) • IF > $25,000 – no longer Open Account Debt • Treated as if separate debt. 95
EXAMPLE ONE • A’s Stock Basis is $0 • 6/1/09 A loans S $16,000 (no note) • 12/31/09 – Open Account Debt = $16,000 96
EXAMPLE TWO – 2009 STOCK BASIS $0 • A lends $16,000 6/1/09 • 12/31/09 Loss <$8,000> • A’s BASIS in Open Account Debt is $8,000 • Principal Loan amount remains $16,000 97
EXAMPLE THREE – 2010 • A Stock Basis = $0 Loan Basis = $8,000 (principal $16,000) • 4/1/10 – S Repays to A $4,000 • 9/1/10 – A Advances $1,000 (net $3,000) • 12/31/10 – Debt Principal $13,000 • Still open Account Debt 98
EXAMPLE THREE CONTINUED • A recognizes income $1,500 (8/16 x $3,000 Net Repayment) • IF evidenced by a note gain is Capital Gain (note: Tax treatment of debt treated “as if” evidenced by a note is not yet addressed) • 12/31/10 – Open Account Debt Principal $13,000 • Carried to 2011 99
EXAMPLE FOUR (ex. 3 FACTS) • 2/1/11 – S Repays A $5,000 • 3/1/11 – A Advances $20,000 • Not evidenced by a written agreement • 2011 Net Advance $15,000 • Debt $28,000 ( > $25,000 – not Open Account Debt) • Treated as if evidenced by a separate written agreement – maintain records 100
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