Leadership

May 3, 2007

Flow-Through

- Taxation at S Corp Level

- Taxation at Shareholder Level

Shareholder Basis

- Stock Basis

- Indebtedness Basis

Flow-Through

Taxation at S Corp Level

Subsection 1363(a)- S Corp is generally not subject to income tax

Subject to:

- Employment tax

- Excise tax

Exceptions to Income tax Rule 1363(a)

1. Passive Income

2. Built in Gains

Passive Income

- S Corp that has subchapter C earnings and profit

- S Corp with passive income

o Gross receipts exceed 25 percent of passive activity (pay income tax)

o Gross receipts exceeds 25 percent for 3 years (S Corp termination)

Built in Gains

- Conversion from C Corp to an S Corp

- Any appreciated assets as date of conversion are called Net Built in Gain

o Within 10 years if you sell assets you are subject to tax

Subsection 1363(b)- S Corporations taxable income is calculated in the same manner as an individual

Exceptions to 1363(b):

- Personal Exemptions under Section 152 are not deductible

- Charitable Contributions under Section 170 are not deductible

- Any additional itemized deductions (medical)

Taxation at Shareholder Level

Subsection 1366(a)- all items of income, deduction, loss, and credit recognition by S Corp are passed through to the shareholder

Knott v. Commissioner TC Memo 1991-352

- Shareholders are taxed on their allowable share of income even if not distributed

Subsection 1366(b)- Character of any item included in a shareholder pro-rata shares shall be determined as if it we realized directly from the source and incurred in the same manner as a corporation

Exceptions to 1366:

- Regulation 1.1366-1(b)(2)- if S Corp that is formed for a principle purpose of selling or exchanging contributed property that in the hands of the contributor would not be a capital gain, then the gain on the sale of the property is not capital gain (Purpose to avoid regular income tax obligations)

- Regulation 1.1366-1(b)(3)- for the contributing shareholder it is capital loss and for the S Corp it is ordinary loss to the extent that the capital loss existed at the time of contribution

Shareholders Gross Income

- Includes shareholders pro-rata share of S Corp gross income

Pro-rata- Subsection 1377(a)

- Each shareholder pro-rata share of any item for any taxable year shall be the sum of the amounts determined

o Assigning equal portion of each item to each day

o Divide pro-rata among shareholders

Example in Notebook

Separately Stated Items of Income

Subsection 1361(a)(1)(A)- all items of income (tax exempt) income, deduction, or credit that could effect the liability of the shareholder need to be separately stated

Separate items include:

- Capital gains and losses

- 1231 gains and losses

- Dividend income

- Interest income

- Investment Interest Expense

- Passive Activity items

- Tax Exempt Income and Expenses

- Foreign taxes, income and losses

Limitations on Losses

Section 1366(d)(1)- the aggregate amount of losses and deductions taken into account for any taxable year cannot exceed the sum of:

- The tax basis in the stock of the S Corp

- The tax basis in any indebt ness (Loans from the shareholder to the S Corp)

Example:

- Stock basis 10,000

- Pro-rata share of losses 12,000

- Can only deduct 10,000 of losses

- Other 2,000 of losses can be carry forward indefinitely (Section 1366(d)(2)

Section 1366-2(a)(5)- losses cannot be transferred to another person

Shareholder Stock Basis

Stock basis- why it is important

1. Section 1366(d)(1)- losses are only deductible to the extent of basis

2. Taxability of operating and liquidating distribution (Section1368)

3. Sale of Stock (Section 1001)

Beginning Stock Price

- Purchase equals cost basis Section 1012

- Contribution equals transferred basis (Section 351 basis of property)

- Increase by gain on contribution

- Decrease by boot (ASK ABOUT BOOT NEXT WEEK)

Adjustments

- Stock basis adjusted for increases before it is adjusted for decreases

o Increases

 Separately stated items of income

 Non-separately stated items of income

 Tax- Exempt Income is Included

Exception for tax-exempt income:

Regulation 1.1366-1(a)(2)(VII)- tax exempt income does not include income in Section 108 (discharge of indebtedness income)

Gitlitz Case

- Supreme Court found that the regulation was erroneous

- Subsection 108(d)(7)(A)- Congress repealed Gitlitz stating Section 108 income does not adjust your basis even if it is tax-exempt income

Decreases in Stock Basis

- Distributions by the S Corp that are not C Corp Earnings and Profit (E&P)

- Separately stated losses and deduction items

- Expenses of the S Corp that are not deductible in computing taxable income and not properly chargeable to capital accounts (kickbacks, bribes)

Section 1367(a)(2)- in no event can the shareholder’s basis be below zero

Ordering Rules basis Adjustment 1367-1(f)

1. Increases in basis attributable to income items

2. Decreases in basis attributable to a distribution that is not attributable to C Corp E&P

3. Any decrease attributable to non-capital non-deductible expenses (bribes)

4. Any decreases from items of loss and deduction

a. Can do election to adjust 4 before 3

Timing

- Adjustments in stock basis are determined at the close of the taxable year

o Exception: 1.1367-1(d)(1)

 If you dispose of your stock during the taxable year, the adjustments are effective immediately before the disposition

Example in Notebook

Separate Basis Rule- Section 1.1367-1(b)(2)

- Stock basis is computed on a share by share basis

Example:

- 12/31/05 B owns 1 Share (10 shares in S Corp)

- 7/02/06 B purchases 2 additional shares @ 25 dollars/share

During 2006

- S Corp has no income or deductions

- S Corp incurs loss of 365 dollars

Answer

- 365 dollars/ 365 days= 1 dollar of loss per day

- 10 shares in the S Corp= .10 loss per share

- Share 1 owned for 365 days= $36.50 loss

- Share 2&3 owned for 182 days= $18.20 loss

BBasis Increase Decrease Ad. Basis Excess

Share 1 30.00 0 36.50 0 6.50

Share 2 25.00 0 18.20 6.80 0

Share 3 25.00 0 18.20 6.80 0

Spill-Over Rule- Section 1.1367-1(c)(3)

- Shareholders may apply losses, deductions and distributions in excess of the basis of a share of stock, to which such item is attributable against the remaining basis of all other stock owed by the shareholder

6.50 x 6.80/ 13.60= 3.25

BBasis Increase Decrease End. Basis Excess

Share 1 0 0 0 0 0

Share 2 6.80 0 3.25 3.55 0

Share 3 6.80 0 3.25 3.55 0

Indebtedness Basis- Loan to S Corp

Initial basis- Face Amount of Loan

Decrease basis-, as principal payments are mad (Section 1366 (d) (1)(b)

Deductions and Losses- Shareholder basis in loan may be used to permit deductions and losses

- After reducing stock basis to Zero

- Basis in indebtedness may be reduced by deductions and losses (1367(b)(2)(A)

Income

- Increase basis in indebtedness

- Increase Stock basis

Basis in Indebtedness

- Items of losses and deduction

- Non-separately computed losses

- Non-deductible, non-chargeable expenses (illegal payoffs)

Reduce to the extent that it exceeds stock basis

Timing- adjustments are at the close of the taxable year

Example:

- T is a 100 percent shareholder of X (S Corp)

- T’s stock basis is $5,000

- T loans to X $10,000

During year

- No loan payments

- Operating loss of $12,000

Basis Beg. Increase Decrease End Excess

Stock 5,000 0 5,000 0 7,000

Debt 10,000 0 7,000 3,000

Multiple Loans

- The reduction in basis applies to each loan in the same proportion that the basis of each indebtedness bears to the aggregate basis of the loan

Example

- T is a 100 percent shareholder of X (S Corp)

- T’s stock basis is $5,000

- T loans to X

o $1,000

o $2,000

o $4,000

During the year

- X pays of the first loan

- Loss of $10,000

Basis Beg. Increase Decrease End Excess

Stock 5,000 0 5,000 0 5,000

Loan1 1,000 0 1,000 0 0

Loan 2 2,000 0 1,667 333

Loan 3 4,000 0 3,333 667

Loan 2 gets proportioned excess distribution= 2,000/6,000 x 5,000= 1,667

Loan 3 gets proportioned excess distribution= 4,000/6,000 x 5,000= 3,333

Indebtedness Basis Rules

- Applies first to debt basis then to stock basis

- Only applies to loans that are in existence at the beginning of the taxable year

- Basis cannot be increased above the outstanding balance of the loan at the beginning of the taxable year

Example:

- Stock basis of $5,000

- Loan of $10,000

- Loss of $12,000 Year 1

- $9,000 dollars of Income in Year 2

Basis Beg. Increase Decrease End Excess

Stock 5,000 0 5,000 0 7,000

Debt 10,000 0 7,000 3,000

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Basis Beg. Increase Decrease End Excess

Stock 0 2,000 0 2,000 0

Debt 3,000 7,000 0 10,000 2,000

Excess balance carried over because it is over the 10,000 loan amount at the beginning of the year