C12-Chp-12-08A-Godfrey-S-Corporation-Update

C12-Chp-12-08A-Godfrey-S-Corporation-Update - TAX/BUSINESS...

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Unformatted text preview: _ TAX/BUSINESS AND INDUSTRY — S Corporation Up date The business entity continues to grow in popularity but requires attention to its PS and Q’s. by Howard Godfrey l r' y some accounts, the ad— ;._-__ vent of S corporations in the late 19505 was the ' most notable revolution in American tax policy since the Revolution. And it’s easy to see why: S corporation owners can protect themselves against per— sonal liability and have their in- come and gains taxed only once, as opposed to the double exposure of C corporations and their own ers at the corporate level and again on individual returns. In 1997, S corporations became the most common type of entity filing a cor— porate return with the IRS. Since then, their numbers have contin- ued to grow, reaching about 3.6 million and making the S corpo— ration the most popular corporate entity in America. “The corner- stone of America’s small business community,” the S Corporation Association of America calls it. Although the structure resting on that cornerstone has been relatively stable, CPAs must reckon with several legal and regulatory developments in recent years that affect such areas as electing and main— taining S corporation status, limits on flow~through of losses, basis issues, pay— roll taxes, built—in gains, annual returns and international issues. CPAs advising businesses must keep informed about these changes, which affect many aspects of governance and operation. Here’s an l S Corporations on the Rise The number of S corporation tax returns (form 11208) increased 3.7% in 2005 over the prior year, for a total of more than , 3.6 million returns filed. Other corporate returns (form 1120 series and form 1066) declined by 1.8% to nearly 2.5 million. Source: Internal Revenue Service, www.irs.gov. April 2007 journal of Accountancy 57 — TAX/BUSINESS AND |NDUSTRY — overview of how the S corporation landscape has evolved, with some new landmarks and a few extra bends in the road to business success. RI‘IQU IRI'éMENI'S FOR ELECTINC AND MAINTAINING STATUS Shareholder limit. In 2004, Congress increased the maximum number of share— holders in an S corporation to 100 and modified the law to allow certain family members with a common ancestor to be treated as a single shareholder As the IRS advised in notice 2005—91, any family member can make the election by notify— ing the corporation and identifying him— self or herself as well as the common ancestor and designating the tax year in which the election takes effect. The com— mon ancestor cannot be more than six generations removed from the youngest descendant shareholder. The spouses and former spouses of the common ancestor or any lineal descendant may also be count- ed as family members. Also, estates of deceased family members and family members who own stock through certain trusts will not be counted as separate shareholders. LLCs and multipurposeform 2553. A domestic LLC with two or more owners is classified as a partnership under the default rules but may choose to be treated as a corporation by filing form 8832. When corporate status is chosen, the entity may elect S status. In the past, an LLC was required to file form 8832 to elect corporate status and then file form 2553 to elect S status. New regulations simplify the paperwork I S corporations have become counted as a single shareholder. requirements. An eligible entity that makes a timely and valid election to be classified as an S corporation will be deemed to have elected to be classified as an association taxable as a corporation. When form 2553 is filed by the 15th day of the third month of a taxable year, both the deemed election to be classified as a corporation and the S elec— tion are effective as of the first day of that year. The election to be treated as a cor- under section 368(a)(l)(F). The S election would not be terminated as a result of this reorganization, and the usual basis carry- over rules would apply In addition, the new entity would keep the old employer identification number, IMPACT or DEBT ON BASIS AN D Loss FLOWTHROUGH Two cases last year show a wrong and a right way to increase shareholders’ basis for business debts so that they may deduct an S corporation loss. In 2004, Congress allowed certain family members with a common ancestor to be treated as a single shareholder. poration is effective until the entity files a different election. These regulations are effective for elections to be an S corpora- tion filed on or after July 20, 2004, but can be relied on for timely elections filed before that date. In Letter Ruling 200528021, the IRS considered whether an existing S corpo— ration may convert to an LLC and elect to be treated as a corporation without losing its S status, The new entity would be con— sidered under state law to be the same as the old entity The new entity would con— duct the same business as in the past, and there was no plan to redeem ownership interests. The IRS ruled the conversion to an LLC fol— lowed by an election to be taxed as a corporation for federal tax pur— poses would be a tax-free reorganization EXECUTIVE SUMMARY loss of 8 status. N0 pass-through. William Maloof owned several S corporations that collectively borrowed $4 million from a sank. Maloof was jointly and severally .iable on the debt and gave a security 'nterest in a $ 1 million insurance policy on ’1IS life. The Sixth Circuit Court of Appeals ound that Maloof’s role in the loan did not cause the corporation to be liable to him, which would be necessary to create basis for Maloof in debt of the corporation and permit pass—through of the losses (see “Tax VIatters,”]ofA, Mar.07, p. 73). Likewise, VIaloof’s guarantee of the debt did not esult in an additional capital contribution that would raise his basis in his stock. Basis would have increased if the bank had sought recourse on his guarantee. Pass-through allowed. In contrast, Timothy Miller successfully deducted cor— porate losses because he personally had borrowed $750,000 from a bank and tax, and larger S corporations the dominant business entity type, in part because require ments for electing the status have been relaxed and clarified. IAn S corporation may now have more shareholders because certain family members may be I When an LLC files form 2553 to elect 8 status, the form serves as an election to be taxed as a corporation as well. IThe IRS has approved a tax-free conversion of an S corporation into an LLC without I Procedures now are clearer for an S corporation making char- itable contributions of appreciat- ed property. I Regular corporations electing S status still must wrestle with the potential built-in gains (BIG) must file the new schedule M-3. Howard Godfrey, CPA, Ph.D., is a professor of accounting at the Uni- versity of North Carolina, Charlotte. His e-mall address is [email protected]/.uncc.edu. 58 journal of Accountancy April 2007 — TAX/BUSINESS AND INDUSTRY — loaned the funds to his corporation. The corporation paid the funds to the bank in fulllsatisfaction of an existing corporate debt. The Tax Court concluded that the series of transactions qualified as an economic outlay by Miller that left him economically poorer. in light of these rulings, CPAs should advise their clients that a flow—through deduction is available for a stockholder loan only if there is clear evidence that the corporation is liable to the stockholder. wages paid to employees and for other em— ployment tax obligations such as paying backup withholding under section 3406, making timely deposits ofemployment taxes, filing returns and providing wage statements to employees on form W—2. The owner of a disre— garded entity would no longer have such responsibilities. But these proposed regulations won’t be effective until 2008 at the earli— est, because they are applicable to wages CPAs should make sure business clients are aware of the”built/in gain” tax that could result. OTHER BASIS Issues Another thorny problem for S corpora— tions has been how to account for charitable contributions of appreciated property. The Pension Protection Act of 2006 brought some clarity If an S corpo— ration makes a charitable contribution of a capital asset having a basis of $100 and a fair market value of $500, the share— holders vvill be treated as having made a $500 charitable contribution (or each shareholder a pro rata share of it), unless a lesser amount is required by special rules of section 170(e). The amount of the shareholders basis reduction in the stock of an S corporation will be equal to his or her pro rata share of the adjusted basis of the contributed property if the S corpo— ration has only one shareholder, the basis of its stock will be reduced by $ 100, or the amount of the shareholders pre—contribu- tion stock basis if it is less. This provision applies to contributions made in taxable years beginning after Dec. 31, 2005, and before Jan. 1, 2008. PAYROLL TA X135 Regulations proposed in 2005 pro— vide that a qualified subchapter S subsidiary (QSub) would no longer be treated as a disregarded entity for purposes of employment taxes and certain other tax law requirements. A QSub (or other disregarded entity) would be liable for employment taxes on paid on or after the first day of the year fol— lowing their publication in final form in the Federal Register, which hadn’t hap— pened by early 2007. For that reason, Emiel Kandi, the sole owner of an LLC in Washington state, was unsuccessful in dis— trict court last year in his attempt to ex- tend the proposed regulations’ provisions retroactively to payroll taxes owed for 2001. The LLC was a disregarded entity because a check—the—box election of cor porate treatment had not been made, the court said. BUIMN GAINS CPAs should make sure business clients contemplating an election to switch from a C to an S corporation are aware of the could result. With the Tax Reform Act of 1986, Congress repealed the General Utilities Doctrine by reinstating double taxation of distributed gains by C corporations, Pre— viously, under the 12—month liquidation provision, a corporation could sell its assets without recog— nizing gain at the corporate level and distribute the pro— ceeds to its shareholders. The act also required a C corpora— tion that distributed appreci— ated property to shareholders to be treated as having sold the property to them at an amount equal to fair market so—called “built—in gain” (BIG) tax that value. Both types of distributions contin— ued to be subject to tax at the sharehold— er level. Congress acted to prevent C cor— porations from avoiding these new rules by simply electing S status. It did so, also in 1986, with a new section 1374, which imposes a tax on the ap- preciation component of assets held by a C corporation on the first day that it makes an election under subchapter S. This built~in gains tax applies if the S cor— poration disposes of the appreciated asset within 10 years after electing S status. The BIG tax does not apply to a corporation that has always been an S corporation. Under section 1374, a corporation that elected S status while owning appreciated property must hold the asset for 10 years after election to avoid the BIG tax upon sale or distribution to its shareholders. One court had held the 10-year hold- ing period started on the date of the initial election of S status for a corporation that later lost or revoked its status and then elected S status again. Final regulations D- An S corporation can make I charitable contributions of appreciated propertywith flow/through of the charitable contribution deduction and appropriate basis adjustment for the shareholder. Dr W hen an S corporation has a loss that exceeds the shareholder's stock basis, the full loss may be deducted if the. shareholder has adequate basis in a loan to the c0rp0ration.The structure of the debt can determine whether the shareholder loss deduction will be allowed. I F CPAs should advise corporations considering an S election to heed the potential for builtin gain on asset appreciation. P Large S corporations should be aware of the new requirement for filing schedule Ma 3. April 2007 Journal ofAccountancy 59 ¢ 0:. o We Have Buyers! Accounting Practice Sales has thousands of buyersjust waiting to buy a practice. We are North America’s leader in sales because we know what your practice is worth, have thousands of motivated buyers and know how to make it happen. Call today and let’s talk. Call 1.800.397.0249 www. acenuntingpraciicesulesrom - _ , ACCOUNTING ' - PRACTICE SALES NOR] H AMERICA'S LEADER IN PRACTICE SALES JOINTHE nian Toonv 340,000 GPAs like you Benefit from tool-s, information and representation onto re regulators ironies. They also receive significant discounts- on publications, conferences. oronimts and insurance programs. Visit Wwwaionaoroi niemhorsiioirtasn-or nail 888-777-7077. .Isp Logging c__ _ 60 Journal of Accountancy April 2007 _ TAX/BUSINESS AND INDUSTRY _ now provide that the 10—year period begins on the date of the most recent election. Example. A corporation using the cash method elects to become an S corporation effectivejan. 1, 2007, when it has accounts receivable of $100,000 for services ren— dered before that date. On that date, the ac— counts receivable have a fair market value of $95,000 and an adjusted basis of zero. During 2007, the company collects $100,000 on the accounts receivable and includes that amount in gross income. The company recognizes the entire $100,000 as built-n gain, which is subject to income tax of $35,000 at the corporate level (using the higlest corporate rate of 35%). The shareho ders will have a flow~ through of $65,000 of income (the tota income of $ 100,000 less the corporate tax paid). As a general rule, the amount of built-n gain recognized when an asset is sold is limited to the excess 0 " its value over its basis on the date of the 8 election. If the company above sold the receivables, the built—in gain is limited to $95,000. Other factors may re- duce the amount of recognized built—in gain for a current year, such as low taxable income for the year, or an NOL carryover from a year before the S election. A built— in gain that is realized in the current year but not recognized carries forward to fu— ture years. TAX RETURNS —SCHEDULE M— 3 CPAs providing tax services to larger S corporations should take note: Many S cor— porations must file a new tax schedule beginning this year For tax years ending on or after Dec. 31, 2006., S corporations that report assets of $10 million or more on schedule L of form 11205 must file sched— ule M—3. Part I of schedule M—3 reconciles worldwide consolidated net income or loss with net income or loss reported on the tax— payers income statement or books and records. The adjustments on part I remove income or loss from nonincludible foreign and domestic entities. They also remove certain consolidating adjustments for intercompany transactions and reconcile — AICPA RESOU RCES CPE l S, C, Partnership or LLC? Using a Business Form to Solve Your Client's Tax and Business Problems (# 735536JA). l S Corporations: The ins and Outs of Tax Reporting and Planning (# 736153JA). I Advanced Planning for S Corporations (# 733250). For more information or to make a purchase, go to www.cpa2biz.com or call the Institute at 888-777—7077. income for the statement period to the corporation’s tax year. Parts 11 and Iii of schedule M—3 reconcile the com— pany’s net income on part 1 with total income or loss shown on page three, schedule K, line 18 of form 11205. The IRS says M—3 will enable it to focus more quickly on high—risk issues and taxpayers requiring attention and reduce time spent with com— pliant taxpayers. INTERNATIONAL Tax ISSUES In lR~2005—107, the United States announced an agreement with Mexico to recognize the flow-through treatment of income earned by entities that are treated as fiscally transparent. A US. resident who is a shareholder of an S corporation will be eligible for treaty benefits on the S corporation income derived from Mexico to the extent of the resident’s share of that 'ncorne. STILL A LEADING CHOICE Even with these added nuances, S corpo- rations are likely to remain a favored entity, especially for smaller businesses. As long as business owners are poised to take advantage of pass—through treatment of income, gains and losses and need a greater level of formality than partnerships and LLCs, they will choose an S corporation structure. They’re also likely to find clear— er and simpler tax rules as its governance continues to be refined. Whatever the rea— sons businesses adopt the form, advisers must be well—furnished with knowledge of the latest developments. '3' ...
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This note was uploaded on 03/09/2012 for the course ACCT 6120 taught by Professor Godfrey,h during the Spring '08 term at UNC Charlotte.

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C12-Chp-12-08A-Godfrey-S-Corporation-Update - TAX/BUSINESS...

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