S Corporations: Shareholder Tax Issues (Portfolio 732)

Tax Management Portfolio, S Corporations: Shareholder Tax Issues, No. 732, reviews the special tax status of S corporation shareholders. To view this Portfolio, visit Bloomberg Tax for a free trial.

 

Bloomberg Tax

This Portfolio is available with a subscription to Bloomberg Tax, a comprehensive research solution including over 500 Tax Management Portfolios™, practice tools, primary sources and timely news.

Description

Tax Management Portfolio, S Corporations: Shareholder Tax Issues, No. 732, reviews the special tax status of S corporation shareholders.

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 character of various items passed-through to shareholders, whether separately or non-separately stated, is discussed. Adjustments to the shareholders’ stock basis and indebtedness basis are explained in detail, and practical advice in creating basis is provided. The at-risk and passive activity loss rules are reviewed and the net investment tax impact is introduced. The impact of the alternative minimum tax at the shareholder level is summarized. Taxation of fringe benefits, qualified plans, and compensating S corporation shareholders is discussed along with practical insights. A practical discussion on S corporation shareholder buy-sell agreements is provided.

This Portfolio provides the practitioner with analysis of the taxation of S corporations and their shareholders. In addition, the Portfolio explains the relationship of the S corporation provisions with other areas of the tax laws, and illustrates the advantages and difficulties of a corporation operating in S corporation form.

For additional discussion of S Corporations, see 730 T.M., S Corporations: Formation and Termination, and 731-3rd T.M., S Corporations: Corporate Tax Issues.

This Portfolio may be cited as Sobol and Starr, 732 T.M., S Corporations: Shareholder Tax Issues.

Authors

Horacio E. Sobol, CPA

Horacio E. Sobol, partner, PricewaterhouseCoopers LLP; B.B.A., University of Michigan; M.Acc., University of Michigan; Member AICPA; former Chair, AICPA S Corporation Committee; contributor to various tax journals and lecturer at various tax seminars.

Samuel P. Starr, CPA, Esq.

Samuel P. Starr, retired partner, PricewaterhouseCoopers LLP; 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; lecturer at various tax institutes.

Table of Contents

Detailed Analysis
I. 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 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) Former Deduction for Income Attributable to Domestic Production Activities
(16) Deduction for Qualified Business Income (Pass-Through Entity Deduction)
(a) Combined Qualified Business Income Amount
(i) Deductible Qualified Business Income for Qualified Trade or Business
(A) Qualified Business Income
(B) W-2 Wage Limitation
(C) Specified Service Trade or Business Exclusion
(D) Carryover of Losses
(ii) Qualified REIT Dividends
(iii) Qualified Publicly Traded Partnership Income
(b) Special Rules for Trusts and Estates
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
e. Section 336(e) Transactions
3. Taxable Year of Inclusion
4. Net Investment Income Tax: Taxable Years Beginning After 2012
a. In General
b. The 2012 Proposed Regulations for Sales of S Corporation Stock
c. The 2013 Proposed Regulations for Sales of S Corporation Stock
d. Application of §1411 to Trusts
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
7. Overall Limitation on the Deduction of Business Interest Expense
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
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
II. 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) Treatment of Suspended Losses
(4) Erroneous Basis Adjustments
d. Investment Credit Recapture
e. Separate Basis Rule
(1) In General
(2) Spillover Rule
f. Ordering Rules
(1) Post-1996 Stock Basis Rules
(2) Pre-1997 Stock Basis Rules
g. Timing of Basis Adjustments
2. Basis in Indebtedness
a. In General — Bona Fide Indebtedness
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
c. Temporary Limitation on Excess Business Losses
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
a. Nonrelated Back-to-Back Loans
b. Related-Party 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
III. 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 (Including ESOPS)
(1) In General
(2) ESOPS
(a) ESOP Rules Inapplicable to S Corporations
(i) Section 1042
(ii) Section 404(a)(9)
(iii) Section 404(k)
(b) Section 409(p)
(3) IRAs
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
IV. 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

Working Papers

Table of Worksheets
Worksheet 1 Deferred Compensation Agreement
Worksheet 2 Shareholders Agreement
Worksheet 3 Computation of Stock Basis for Each Shareholder
Worksheet 4 Computation of Basis in Shareholder Loans to Corporation