S Corp Vs Llc Taxation by qcz62603

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									Acct 7420
Dr. Streer
S Corporation Notes



S Corps – Pass Through Entities (True Corps)

        Avoids Double Taxation

        Allows passthrough of losses

        Pays tax in limited circumstances

                                   S Corp vs. Partnership

                    S Corporation                                     Partnerships
1. inflexible                                           1. flexible
                                                        2. basis includes share of all
2. basis does not include share of liabilities
                                                        liabilities
3. may pay tax                                          3. does not pay tax
4. liquidation is costly (regular corp. rules apply)    4. liquidation is tax free
5. no special allocations                               5. special allocations are possible
6. losses are deductible to the extent of basis in stock 6. losses are deductible to the
and loans to corp.                                       extent of basis

Qualification for S Status
Definition of small business corporation –

       Shareholders are all:
            o Individuals
            o Estates, or
            o Certain trusts and tax-exempt organizations
       Less than or equal to 100 shareholders – H & W treated as one shareholder and
        an election can be made to treat all family members as a single shareholder
       One class of stock – different voting rights o.k.
       Only eligible corps.
       No nonresident aliens
       Domestic corps only

Making the Election


       All shareholders must consent – both H & W must consent if stock jointly owned.
       2-½ month deadline to be effective for current year
            Reasonable cause exception applies
            Premature election of a new corp. is ineffective

The S election can be lost in a number of ways:

       A new majority shareholder affirmatively refuses to consent
       Shareholders owning a majority of the stock voluntarily revoke the election – 2 ½
        month rule applies as to timing to be effective for the current tax year
       The S Corp ceases to qualify as a small business corporation
       Passive income limitation is exceeded (former C Corps only)
       Reelection after termination is possible – 5 year waiting period normally applies
        (exceptions exist)

Income and Losses

       S corp.’s taxable income (No special allocations) determined in a manner that is
        similar to tax rules in sec. 703 that apply to partnerships. Income, losses,
        deductions, and credits which could affect the tax liability of any shareholder are
        separated, and each shareholder reports pro rata portion (daily allocation) of each
        item. Shareholder rendering services must be paid a reasonable salary – Sec.
        1366(e)
       Residue of nonseparately computed items is aggregated in arriving at Sec.
        1366(a)(1)(B) taxable income. Even if such income is not distributed, each
        shareholder reports pro rata portion of this amount based upon the ownership & #
        of days stock held.
       All items retain their character as they pass through to each shareholder. For
        example, tax-exempt income at the corporate level will be tax-exempt income at
        the shareholder level.
       Losses may flow through, but are only deductible to the extent of shareholder’s
        stock and loan basis (loans by shareholder to corp.). Any such unused loss may
        be carried forward, may be deducted by the same shareholder in subsequent years
        as increases in basis occur (unlimited pro rata C/F of losses)
       Following the termination of an election, any unused loss may be deducted,
        deduction is limited to the stock (not loan) basis at end of such year.
       Loss rules, At-risk rules, and passive loss rules are applied at shareholder level
        (Sec. 465 & 469)
       In the case of the transfer of stock during the year, income or loss is allocated
        among the shareholders on a per share, per day basis. Carry out this allocation
        process using the pro rata method or the per books method. (note the impact on
        basis and gain in the event of sales)
            o Use the pro-rata method unless complete termination of shareholders
                interest and election to use interim closing of the books method is made.


Operational Rules
Dividend Distributions:

      The tax treatment of a dividend distribution depends on whether an electing
       corporation has accumulated earning and profits from a C tax year.
      A constructive pass-through of net income items for the year increases a
       shareholder’s stock basis (where there is no accumulated earnings and profits).
       Distributions are tax free to the extent of stock basis – excess is taxed as capital
       gain. As for a corporation with accumulated earnings and profits, the constructive
       dividend increases the shareholder’s Accumulated adjustments account (AAA).
       Any future distribution of cash or property reduces the shareholder’s stock basis
       or the AAA, respectively.
           o AAA reflects the cumulative income and losses
           o AAA is corporate level account, distributions from an S Corp’s AAA are
                generally not affected by stock transfers.
      The selling shareholder’s share of income and loss is generally determined using
       year-end totals. The seller should include a provision in the sales contract to
       compensate the seller for any income allocated to him or her for operations after
       the sale date
      Distributions are applied to stock basis before the basis is reduced for current year
       losses and deductions. Thus, a shareholder receiving a distribution no longer
       must wait until the close of the year to determine the tax treatment of the
       distribution.
      Following the termination of an election, any cash dividends made within an
       approximately one-year, post-termination period will reduce the shareholder’s
       basis (i.e. not taxable)
      A distribution of appreciated property results in a corporate gain which is passed
       through to shareholders. Shareholder has distribution and basis equal to FMV –
       loss is not recognized (basis = FMV)
      Any C corporation that makes an S election after 1986 is subject to a corporate-
       level tax on any built-in gains recognized during the 10-year period following the
       conversion—Need appraisal. Built-in gains equal gains on the corporate assets at
       the time of conversion to S status (all regular corp. rules apply – 35% rate—can
       deduct NOL C/Fs) Built in gains recognized can’t exceed the corp.’s taxable
       income computed on a C corp. basis – C/F of gain applies.
      Passive investment income penalty tax can also apply to a former C corporation
       (but election not lost for 3 years)
      Any tax applied at the corporate level reduces the amount of the income to be
       passed through to the shareholders
      S Corp is placed on the cash method for purposes of deducting related party
       expenses (> 50% shareholders)
      Several states do not recognize an S election, so the corp. may incur state
       corporate income tax, as well


Stock Basis
       Initial Basis (cost, FMV @ DOD or DOG)
    +   Additional purchases or contributions
    +   Share of income (overall plus separately stated – includes tax-exempt income)
    -   Share of loss (overall plus separately stated)
    -   Non-deductible corporate expenses
    -   Cash or property distributions (@ FMV) – not basis

Comparison of Entity Characteristics


                  LIMITED
                                   LIMITED                 C                    S
  FACTOR         LIABILITY
                                 PARTNERSHIP          CORPORATION          CORPORATION
                 COMPANY
                Limited
                                 Limited liability    Limited liability
                liability for
                                 for limited          for shareholders
Limited         members even
                                 partners who do      even if they        Same as C corp.
Liability       if they
                                 not participate in   participate in
                participate in
                                 management           management
                management
                By all
                members,
                                                      By board of         By board of
Management      unless           By general partner
                                                      directors           directors
                managers
                appointed
                No maximum,                                               100 maximum; no
                            No maximum,
Number of       usually                                                   corporate or
                            requires at least         No maximum
members         requires at                                               nonresident-alien
                            two
                least two                                                 shareholders
                Restricted;
                requires         Restricted unless
Transferability consent of at    authorized by                            No restriction, but
                                                      No restriction
of interests    least majority   partnership                              see above
                of other         agreement
                members
Different
                                                                          Only one class of
classes of      Permitted        Permitted            Permitted
                                                                          stock permitted
interests
                                                      35% on
Federal         None at LLC None at                   corporation plus     Usually no
Income Tax      level       partnership level         tax on distributions corporate-level tax
                                                      to shareholders
State Income    Usually none None at                  Usually a           Usually no
Tax             at LLC level partnership level        corporate-level tax corporate-level tax

								
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