FOR LIVE PROGRAM ONLY Determining Tax Treatment of S Corporation Distributions: Applying Section 1368 for Optimal Tax Results WEDNESDAY , JULY 20, 2016, 1:00-2:50 pm Eastern IMPORTANT INFORMATION FOR THE LIVE PROGRAM This program is approved for 2 CPE credit hours . To earn credit you must: • Participate in the program on your own computer connection (no sharing) – if you need to register additional people, please call customer service at 1-800-926-7926 x10 (or 404-881-1141 x10). Strafford accepts American Express, Visa, MasterCard, Discover . Listen on-line via your computer speakers. • • Respond to five prompts during the program plus a single verification code . You will have to write down only the final verification code on the attestation form, which will be emailed to registered attendees. To earn full credit, you must remain connected for the entire program. • WHO TO CONTACT DURING THE LIVE EVENT For Additional Registrations : -Call Strafford Customer Service 1-800-926-7926 x10 (or 404-881-1141 x10) For Assistance During the Live Program : -On the web, use the chat box at the bottom left of the screen If you get disconnected during the program, you can simply log in using your original instructions and PIN.
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Determining Tax Treatment of S Corporation Distributions July 20, 2016 Anthony J. Nitti, Tax Partner Craig Kish, CPA, Tax Supervisor WithumSmith+Brown, Aspen, Colo. WithumSmith+Brown, Orlando, Fla. anitti@withum.com ckish@withum.com
Notice ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.
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) 5
Three Concepts • In order to determine the consequences, we must understand three concepts: ONE TWO THREE Accumulated Shareholder C Adjustments basis in S Corporation Account corporation Earnings and (AAA, Subchapter S) stock Profits (Subchapter S) (E&P, Subchapter C) 6
A Quick Primer- the “Why” of Distributions Instead, the income or loss of the S corporation is S Corporations generally do computed at the entity not pay tax at the entity level, but then is allocated level. among the shareholders on Schedule K-1. The income or loss is then Upon the distribution of previously reported – and tax paid – at the earned income, the distribution is individual shareholder level. tax-free. 7
A Quick Primer Thus, 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. 8
Concept #1: Shareholder Basis FORM 1040 A S Co. uses the A invests $500 into The $100 of income is allocated $500 to generate a wholly-owned S to A on Schedule K-1; A pays $100 of taxable tax on the $100 on Form 1040. corporation. income. Thus, A would effectively Presumably, the If A did NOT adjust his initial be taxed twice on the value of S Co. is $500 basis to reflect the SAME $100 of income now $600. $100 of income earned, a earned by S Co. sale of the stock for $600 would generate $100 of gain ($600 - $500 basis) 9
Shareholder Basis and Single Level of Tax Thus, a sale of the S Co. stock for $600 A’s basis goes from: would generate no further gain or loss. STOCK INCREASE BASIS BASIS $500 $600 To avoid this result, By increasing A’s Section 1367 requires basis, the single- A to increase his stock to basis to reflect the level of taxation $100 of income $600 has been allocated to him from S Co. preserved. $600 10
Basics of S corporation Basis - § 1367 S corporation Only stock The amount of Any loss not shareholders basis is taken losses and allowed is get basis in into deductions treated as both stock of consideration taken into incurred in the corporation’s the S for determining account by a s/h can’t corporation the taxability of next tax year and amounts distributions, exceed the and loaned by the debt basis is basis of stock subsequent shareholder to not. and debt. tax years (i.e., the S unlimited (Section 1366) corporation carryover). § 1.1366-2 (debt). 11
Initial Basis in S Corp Stock Purchase of shares: basis is cost ( § 1012) Incorporation: usually basis of property transferred to corporation ( § 358) C corp electing S status: basis is basis in C stock at the time of conversion. Stock acquired by gift: donor’s basis ( § 1015) Stock acquired be inheritance: usually FMV ( § 1014) 12
Basis Adjustments: § 1367(a)(1) Basis is increased by: Non- Capital contributions separately Separately Tax-Exempt (cash and stated stated adjusted basis of income income income property contributed) (ex: Line 1 of K-1) 13
Basis Adjustments: § 1367(a)(2) After increases, basis is decreased by: Separately Non- Distributions Non- stated (cash and deductible items of separately FMV of expenses stated loss loss or property) (ex: M&E M-1) deduction 14
Order of Adjustments to Stock Basis NORMALLY MADE AT END OF THE TAX YEAR • IMPORTANT: Under § 1.1367-1(f), stock basis is adjusted in the following order: FIRST SECOND THIRD FOURTH Decrease for Decrease by Increase for Decrease for items of loss nondeductible income items distributions and deduction expenses 15
Problem 1: Ordering Rules A OWNS 100% OF S CO. 1 2 Beginning Basis $5000 $5000 Operating Inc./(loss) $2000 $2000 LTCL ($7000) ($7000) Distributions None $5000 16
Solution: 1A ONE TWO THREE FOUR Start by Next, reduce Lastly, reduce Losses are increasing for for losses: fully utilized. basis for distributions: income to highest point: No suspended $5,000 $7,000 $7,000 losses. $2,000 $0 $7,000 + - - $7,000 $7,000 $0 17
Solution: 1B ONE TWO THREE FOUR Start by Next, reduce Lastly, reduce Losses are increasing for for losses: limited. basis for distributions: income to highest point: $5,000 of $5,000 $7,000 $2,000 suspended + $2,000 - $5,000 - $2,000 losses. $7,000 $2,000 $0 18
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. 19
Election to Change Ordering Rules IMPORTANT! S/H can elect to reduce basis by loss and deduction before nondeductible expenses. ( § 1.1367-1(g)) The election is permanent and must be followed every year. Must agree to carry over unused nondeductible expenses to future years (normally don’t carry over) 20
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. 21
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 are tax-free in excess of to the extent basis of stock generate basis. (and capital gain basis must to the s/h. be reduced) 22
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. If that’s the case, because S corporation income should only be taxed ONCE, a WHY IS THIS distribution of that income should not be taxed THE RULE? a second time. As a result, a distribution is treated first as a tax-free return of basis to preserve the single level of taxation. 23
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