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