S Corporations: Corporate Tax Issues (Portfolio 731)

Tax Management Portfolio, S Corporations: Corporate Tax Issues, No. 731-3rd, reviews the special tax status of S corporations. While S corporations generally avoid federal income tax at the corporate level, S corporation shareholders are taxed pro rata on the corporation's income, which is passed through to them, whether or not distributed. The Portfolio also discusses S corporation operations.

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Tax Management Portfolio, S Corporations: Corporate Tax Issues, No. 731-3rd, reviews the special tax status of S corporations. While S corporations generally avoid federal income tax at the corporate level, S corporation shareholders are taxed pro rata on the corporation's income, which is passed through to them, whether or not distributed. The Portfolio also discusses S corporation operations.

The Portfolio examines the limited circumstances in which the S corporation is taxed, discusses the mechanics of the flow-through of income and loss items, analyzes the taxation of shareholders and distributions, and explains the calculation of shareholder basis in stock and indebtedness. Special rules are also examined, including the passive loss limitations and at-risk rules, the built-in gain rules, and allocation of interest expense. Among other areas, the use of S corporations in an international context is explored.

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Samuel P. Starr, B.S., Pennsylvania State University; J.D., University of Virginia; LL.M. in Taxation, Georgetown University Law Center; former Chair, AICPA S Corporation Committee; former Co-chair, ABA Tax Section Task Force on Taxable and Tax-Free Acquisitions Involving S Corporations; Adjunct Professor, Georgetown University Law Center; Departmental Editor, Journal of Taxation; lecturer at various tax institutes.

Horacio E. Sobol, B.B.A. University of Michigan, M.Acc. University of Michigan; Member AICPA; contributor to various tax journals and lecturer at various tax seminars.


Detailed Analysis

I. Taxation of the S Corporation

A. General

1. S Corporation Exempt from Income Tax

2. Application of Subchapters C and K

3. Computation of Taxable Income

4. Earnings and Profits

5. Carrybacks and Carryforwards

a. Net Operating Losses

b. Other Carryover Items

6. Controlled Group Membership

7. Elections at the Corporate Level

8. Foreign Tax Credit

B. Passive Income

1. General

2. Definitions

a. Accumulated Earnings and Profits

b. Gross Receipts

c. Passive Investment Income

(1) Rental Income

(a) Favorable Rulings Not Constituting Rents

(b) Unfavorable Rulings Constituting Rents

(c) Favorable Cases Not Constituting Rents

(d) Unfavorable Cases Constituting Rents

(2) Royalties

(3) Interest

(4) Dividends

(5) Annuities

(6) Sale of Stock or Securities

3. Passive Income Tax

a. Computing the Tax

b. Waivers

4. Passive Income Terminations

5. Planning for the Passive Investment Tax

a. Distributing E& P

b. Monitoring Passive and Taxable Income

C. Built-in Gains Tax

1. General

2. Who Is Subject to the Built-in Gains Tax?

a. Elections Made Before January 1, 1987

b. Transitional Relief for Elections Made After December 31, 1986 but Before January 1, 1989

c. Elections After 1988

3. Assets Subject to the Built-in Gains Tax

4. Computing Built-in Gain

a. Net Unrealized Built-in Gain

(1) Anti-Stuffing Rule

(2) Effect of Liabilities

(3) Accounting Method Changes

(4) Valuing Inventory When Computing NUBIG

b. Dispositions

(1) Partnership Interests

(2) Inventory

5. Recognizing Built-in Gains and Losses

a. Net Recognized Built-in Gain

b. Recognition

(1) Installment Sales

(2) Nonrecognition Transactions

6. Calculating the Built-in Gains Tax

a. Pre-limitation Amount

b. Taxable Income

c. Net Unrealized Built-in Gain Limitation

d. Carryover Utilization

e. Gain Passthrough

7. Planning for the Built-in Gains Tax

D. Former Capital Gains Tax

1. General

2. Taxation at Corporate Level

a. Exceptions

b. Capital Gains of Options and Commodities Dealers

c. Comparison and Interaction with Built-in Gains Tax

E. Transition Corporations - Partial Relief from the Built-in Gains Tax (1987 and 1988 Elections)

1. Transition Relief

2. Qualified Corporations

3. Qualifying for Transition Relief

4. Taxable Income Limitation

F. LIFO Recapture Tax

1. General

2. Successor Corporations

3. C Corporations with Inventory

4. Calculating the LIFO Tax

G. Estimated Tax Payments

H. Consistent or Inconsistent Subchapter C Provisions

1. Subchapter C Provisions Consistent with Subchapter S

2. Subchapter C Provisions Inconsistent with Subchapter S

II. Tax Treatment of Income and Losses to Shareholders

A. Flow-Through Entity

1. Separately and Nonseparately Stated Items

a. Character Retention

b. Specific Items

(1) State and Local Income Taxes

(2) Charitable Contributions

(a) Accrued Charitable Contribution Deduction

(b) Appreciated Property

(3) Section 165 Losses

(a) Casualty Losses

(b) Worthless Stock

(4) Installment Sales

(5) Section 179 Expensing

(6) Bad Debt Expense

(7) Miscellaneous Itemized Deductions

(8) Meal and Entertainment Expenses

(9) Interest on Subchapter C and Subchapter S Tax Deficiencies

(10) Interest on S Corporation Debt

(a) Applicable High Yield Debt Obligations (AHYDO)

(b) Interest on Disqualified Debt Instruments

(11) Tax Benefit Items

(12) Exclusion and Rollover of Gain on Sale of Qualified Small Business Stock

(a) Exclusion of Gain Under § 1202

(b) Deferral of Gain Under § 1045

(13) Real Property Subdivided for Sale

(14) Discharge of Indebtedness

(a) General Application of Discharge of Indebtedness Rules to S Corporations

(b) Section 1366 and Regulations

(c) Contributions of Corporate Indebtedness to Capital

(15) Income Attributable to Domestic Production Activities

2. Pro Rata Share Defined

a. Termination of S Status

b. Termination of a Shareholder's Interest

c. Qualifying Dispositions

d. Section 338 Transactions

(1) Section 338(g) Elections

(2) Section 338(h)(10) Elections

3. Taxable Year of Inclusion

B. Interest Allocation

1. Interest Expense Tracing

2. Debt Repayments

3. Debt-Financed S Corporation Distributions

a. General Rule

b. Optional Method

c. Non-Pro-Rata Debt Financed Distributions

d. Repayment of Debt Allocated to Distributions

4. Debt-Financed Stock Acquisitions and Capital Contributions

a. Acquisitions from Existing Shareholders

b. Direct Investment in S Corporation

5. Leveraged Stock Redemptions

6. Loans Between S Corporations and Shareholders - Self-Charged Interest

a. Passthrough Entity Defined

b. Effective Date

c. Recharacterized Self-Charged Interest

C. Estimated Taxes for Subchapter S Items

D. Employment Taxes

1. Self-Employment

2. Employee Wages

a. Unreasonable Compensation

b. Effect on Net Operating Losses

E. Treatment of Expenses Owed to Shareholders

F. Alternative Minimum Tax (AMT) on Shareholders

1. Basis Limitations for AMT Purposes

2. Distributions for AMT Purposes

3. Suspended Losses

4. Research and Experimentation Expenditures

G. Passive Loss Limitations Under § 469

1. In General

a. Passive Activities

(1) General

(2) Tests for Material Participation

(3) Activities Qualifying as Participation

(4) Character of Items as Active or Passive

(5) Recharacterization Rules

(6) Special Rules for Rental Activities

b. Definition of Activity

c. Treatment of Losses and Credits from Passive Activities

d. Portfolio Income

e. Dispositions

(1) Suspended Losses

(2) Gain or Loss on Disposition

(3) Effect of Conversion to C or S Status

2. Effective Date and Transition Rules

H. Former Subchapter S Corporation Shareholders

1. Overview

2. Computation of Former Subchapter S Corporation Taxable Income

3. Computation of Undistributed Taxable Income

4. Constructive Distributions Received as Dividends

5. Passthrough of Long Term Capital Gain

a. General

b. Allocation of Capital Gain Among Distributions

6. Persons with Beneficial Ownership Taxed on Undistributed Taxable Income

III. Shareholder Basis in Stock and Indebtedness

A. Adjustments to Basis in Stock and Indebtedness

1. Stock Basis

a. In General

b. Increases in Stock Basis

c. Decreases in Stock Basis

(1) In General

(2) Nondeductible, Noncapital Expenses

(3) Erroneous Basis Adjustments

d. Investment Credit Recapture

e. Separate Basis Rule

(1) In General

(2) Spillover Rule

f. Ordering Rules

(1) Post-1996 Rules

(2) Pre-1997 Rules

g. Timing of Basis Adjustments

2. Basis in Indebtedness

a. In General

b. Method of Basis Adjustment

c. Multiple Indebtedness

d. Open Account Debt

e. Coordination with § § 165 and 166

B. Loss and Deduction Items

1. Basis Limitation and Carryover

a. Suspended Losses

b. Net Operating Loss Carryover

2. Charitable Contributions of Property

3. Treatment on Shareholder's Return

4. Case Law

C. Restoration of Basis in Indebtedness

1. Priority for Indebtedness

a. In General

b. Net Increase Applied Against Basis

2. Gain Recognized on Repayment

D. At-Risk Limitation

1. General

2. Amount At-Risk

3. At-Risk vs. Basis Limitation

4. Suspended Losses and Carryover Rule

5. Loss Recapture

6. Aggregation Rules

7. At-Risk, S Corporations and Partnerships

E. Creating Basis in an S Corporation

1. General

2. Shareholder Guarantees

a. Basis in Indebtedness of Corporation to Shareholder

b. Basis in Equity of the Corporation

3. Back-to-Back Loans

4. Substitutions of Corporate Debt

5. Shareholder Payments on Corporate Debt

6. Indirect Indebtedness

7. Lack of Investment

8. Shareholder Guarantees for Business Purposes

F. Alternative Minimum Tax - Basis Limitations

IV. Treatment of S Corporation Distributions

Introductory Material

A. Corporations Without Earnings and Profits

1. General

2. Form 1120S and the Accumulated Adjustments Account

B. Corporations with Earnings and Profits

1. General

2. Tax-Free Distributions Out of the AAA

3. Dividends, Return of Capital, Capital Gain

4. Distributions of Previously Taxed Income

5. Elections to Distribute Accumulated E& P Before the AAA

a. General

b. Planning for E& P Distributions

c. Election to Make a Deemed Dividend

d. Filing the Election

6. Distributions by Former DISC Subsidiaries

7. AAA Adjustments for Redemptions and Reorganizations

a. Redemptions

b. Reorganizations

8. Elections to Terminate Year

9. Post-Termination Transition Period Distributions

10. Summary of Operating Distribution Rules for S Corporations with Accumulated E& P

C. Accumulated Adjustments Account

1. Definition and Adjustment Ordering

a. Pre-1997 Rules

b. Post-1998 Rules

2. Tax-Exempt Income

3. Nondeductible Expenses

4. Negative AAA

5. Distributions Contingent in Amount

6. Distributions in Excess of AAA

7. Effect of Stock Transfers on the AAA

8. Form 1120S Reconciliation

D. Distributions to Shareholders of Fiscal Year S Corporations

E. Property Distributions

F. Disproportionate Distributions

G. Former Subchapter S Corporation Tax-Free Distributions

1. Distributions Attributable to Prior Year

a. Qualifying Distributions - General Requirements

b. Effects of Qualifying Distribution

c. Nontransferability of Right to Receive Qualifying Distributions

d. Survival of Right to Receive Qualifying Distributions

2. Distributions of Previously Taxed Income (PTI)

a. General

b. Requirements for a PTI Distribution

(1) Basic Rules

(2) Order of Distributions

(3) Property Distributions

(4) Right to Distribute PTI Did Not Survive Termination of Election

(5) PTI Not Distributed by a Distribution in Exchange for Stock

(6) Right to Receive PTI Distributions Is Nontransferable

c. Computation of PTI Account

3. Distributions of “Money”

V. Fringe Benefits, Reasonable Compensation and Family Allocations

A. Fringe Benefits

1. General

2. Two Percent Shareholder Defined

3. Fringe Benefit Defined

4. Effect of Partnership Treatment

a. Effect on Employee

b. Reporting and Withholding Requirements

c. Application to Other Benefits

B. Qualified Pension Plans

1. 1982 TEFRA Changes to Qualified Plans

2. Qualified Plans Under Current Law

a. Qualified Plan Trusts

b. Plan Loans

c. Effect of § 1372 on Qualified Plans

d. Shareholder-Level Plans

C. Compensation in an S Corporation

1. Cash Compensation

a. General

b. Impact of § 267 on Compensation

c. Unreasonable Compensation

(1) Excessive Compensation

(2) Inadequate Compensation

(3) Family Allocations

d. S Corporation and Self-Employment Income

e. Social Security Issues

2. Incentive Compensation

a. Stock Options

(1) Nonqualified Stock Options

(2) Incentive Stock Options

b. Phantom Stock, Stock Appreciation Rights and Other Equity-Flavored Compensation

(1) Phantom Stock

(2) Stock Appreciation Rights

(3) Performance Bonuses

c. Restricted Stock

d. Deferred Compensation Devices Using Trusts

(1) Rabbi Trusts

(2) Secular Trusts

e. Split-Dollar Life Insurance

VI. Redemptions, Liquidations, Taxable and Nontaxable Mergers and Acquisitions

A. General

B. Redemptions

1. General

2. Capital Gain Redemptions

3. Noncapital Gain Redemptions

4. Tax Treatment Compared

5. Basis Adjustments

6. Other Considerations

C. Liquidations

1. General

2. Section 337 Liquidations

3. Distribution of Installment Obligations

D. Acquisitions by an S Corporation

1. Direct Taxable Asset Acquisitions

a. Tax Consequences to an Acquiring S Corporation

(1) Effect on S Election

(2) Income Allocation in Year of Purchase

(3) Corporate Level Tax

(4) Distributions

b. Tax Consequences to the Acquired Corporation

c. Section 1374 Built-In Gain Rulings

d. Employment Taxes and Employer Identification Numbers

2. Deemed Asset Acquisitions Under § 338

a. Tax Consequences to an Acquiring S Corporation

(1) Section 338 Election

(2) Section 338(h)(10) Election

(3) Income Allocation in Year of Acquisition

(4) Pre-1996 SBJPA Law

b. Tax Consequences to the Acquired Corporation and Its Shareholders

E. Tax-Free Asset Acquisitions by an S Corporation

1. General

2. “A” Reorganizations

a. Effect on S Status

b. Nontaxable Transaction (Post-SSRA ‘82)

c. Corporate Level Taxes

d. Accumulated Adjustments Account (AAA)

e. S Election After Termination

f. Income Allocation in Year of Reorganization

g. Tax Attribute Consequences to Target and Its Shareholders

h. Tax Attribute Consequences if Target Was a C Corporation

i. Distributions

j. Taxable Year

k. Effect on Shareholder Debt

(1) Deferral Approach

(2) Capital Contribution Approach

3. Tax-Free Acquisitions as Alternatives to Liquidation of a Subsidiary

a. Downstream Merger

b. Effect on S Status

4. Other Tax-Free Acquisitive Transactions

a. “C” Reorganizations

b. “D” Reorganizations

(1) Acquisitive “D” Reorganization

(2) Divisive “D” Reorganization

(a) Business Purpose

(b) Corporate Level Tax

(c) Accumulated Adjustments Account/ITC

c. “F” Reorganizations

d. Section 351 Transactions

(1) S Corporation as Transferee Corporation

(2) S Corporation as Transferor Corporation

F. Taxable and Nontaxable Stock Acquisitions by an S Corporation

1. Taxable Stock Acquisitions

a. Tax Consequences to the Acquiring S Corporation

b. Tax Consequences to the Acquired Corporation and its Shareholders

(1) C Corporation as Target

(a) Deferred Intercompany Transactions

(b) Excess Loss Accounts

(2) S Corporation as Target

2. Nontaxable Stock Acquisitions

a. General

b. “B” Reorganization

G. Recapitalizations and Changes in Form

1. Recapitalizations

2. Changes in Form

H. Other Acquisition Issues

1. Utilization of Shareholder Suspended Losses

2. Loss Limitation Rules

3. S Corporation Capital Purchase Program

VII. Buy-Sell Agreements for S Corporations and Their Shareholders

A. Need for a Buy-Sell Agreement

1. Preserving S Status

2. Business Continuity

3. Liquidity

4. Estate Planning

5. Non-Tax Issues

B. Issues to Consider in a Buy-Sell Agreement

1. Prohibited Transfers

2. Corporate Level Restrictions

3. Income Allocations

4. Accumulated Adjustments Account (AAA)

5. Operating Distributions

6. One-Class-of-Stock Restriction

7. Capital Contributions

8. Revocation and Termination of S Status

9. IRS Examinations

C. Structuring Buy-Sell Agreements

1. Cross-Purchase Approach

2. Stock Redemption

D. Funding

1. General

2. Key-Man Insurance and Effect on Shareholder Basis

a. Term Life Insurance

(1) Payment of Premiums

(2) Receipt of Death Benefits

(3) Other Issues

b. Cash-Value Life Insurance

(1) Payment of Premiums

(2) Increase in CSV Exceeds Premium Amount

(3) Receipt of Death Benefits

(4) Termination of Contract

(5) Sale or Exchange of Contract

c. Split-Dollar Life Insurance

E. Establishing a Buy-Sell Price

VIII. Foreign Operations

A. General

B. Structuring Foreign Operations

1. Operating Abroad Through a Foreign Branch or Partnership

a. Foreign Taxation

b. U.S. Taxation

c. Special-Purpose S Corporations

d. Foreign Partnerships

2. Operating Abroad Through a Foreign Entity That Is Treated as a Partnership or Disregarded for U.S. Tax Purposes

3. Operating Through a Foreign Subsidiary

a. Taxation of Foreign Subsidiary Earnings

b. Ownership Interest in a Foreign Subsidiary

4. Foreign Sales Corporations, Domestic International Sales Corporations, Extraterritorial Income Exclusion, and Repeal of Extraterritorial Income Exclusion

C. Other Issues Affecting Foreign Operations of S Corporations

1. The Look-Through Rule of § 1373

2. Effect of Electing or Terminating S Corporation Status on Foreign Losses (§ 1373(b))

3. Corporate Indebtedness to Shareholders

4. Arm's-Length Pricing Requirement of § 482

5. Electing S Status for C Corporations with Existing Foreign Operations

D. Foreign Investment in S Corporation Business

1. Restrictions on Foreign Shareholders

2. Foreign Investment in S Corporation Operations Through a Partnership

3. Foreign Investment Through Convertible Debt or Debt with Warrants

IX. Other Issues

A. S Corporations and Partnerships

1. S Corporations as Partners

2. Partnership Incorporations

B. Below-Market Loans

1. Loans from an S Corporation to Its Shareholders

a. Corporation-Shareholder Loans

b. Compensation-Related Loans

2. Shareholder Loans to S Corporations

3. Administrative Matters

C. Oil and Gas Considerations

1. Depletion Allowance

2. Grandfather Rules for Subchapter S Corporations

3. Intangible Drilling Costs

4. Transfers of Proven Oil and Gas Properties

a. Conversions from C Corporations to S Corporations

b. Conversions from S Corporations to C Corporations

5. Passive Loss Limitations

6. Recapture Potential

a. Disposition of Natural Resource Recapture Property

b. Sale or Exchange of S Corporation Stock

(1) In General

(2) Exceptions

c. Section 1254 Costs

(1) In General

(2) Acquiring Shareholder After Certain Acquisitions

(3) Former C Corporation

(4) Former S Corporation

(5) Certain Stock Transactions Require § 1254 Cost Reallocation

7. Alternative Minimum Tax Consequences

D. Accounting Method Changes

1. Adoption and Changes

2. Section 481 Adjustments

3. Cash vs. Accrual Method of Accounting

E. Accounting Periods

1. Automatic Change Procedures

2. Nonautomatic Change Procedures


Working Papers

Table of Worksheets

Worksheet 1 Committee Reports on P.L. 100–647 (Tax on Built-In Gains on the Conversion of a C Corporation to an S Corporation)

Worksheet 2 Committee Reports on P.L. 101–239 (Method of Computing Net Unrealized Built-In Gain or Loss)

Worksheet 3 Committee Report on the S Corporation Provisions in H.R. 3448, The Small Business Act of 1996

Worksheet 4 Conference Report on the S Corporation Provisions in H.R. 4520, the American Jobs Creation Act of 2004

Worksheet 5 Preamble to Final Regulations on S Corporation Stock Basis and Distributions

Worksheet 6 T.D. 8567, Final Regulations Relating to the Recapture of LIFO Benefits Under § 1363(d)

Worksheet 7 T.D. 8579, Preamble to Final Regulations on Built-In Gain Tax

Worksheet 8 Election to Distribute Accumulated Earnings and Profits Before Accumulated Adjustments Account

Worksheet 9 Election to Distribute Accumulated Earnings and Profits Before Previously Taxed Income

Worksheet 10 Election to Treat Distributions of Money During Post-Termination Transition Period as Coming Out of Earnings and Profits

Worksheet 11 Election to Make a Deemed Dividend Election

Worksheet 12 Election to Terminate Year Upon Termination of Shareholder's Interest

Worksheet 13 Election to Terminate Year Upon Qualifying Disposition

Worksheet 14 Rev. Proc. 94-61, 1994-2 C.B. 775 and Announcement 88-60, 1988-15 I.R.B. 47, Relating to LIFO Recapture Amount

Worksheet 15 Case Study: § 338(h)(10) Election




Treasury Regulations:

Committee Reports:

Treasury Rulings: