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Your Questions Answered by Robert W. Jamison, CPA, Ph.D.

Author of CCH® Expert Treatise Library: Federal Taxation of Subchapter S Corporations

Now you can see the answers to many of the S Corporation taxation questions that professionals asked Robert W. Jamison, CPA, Ph.D., industry expert and author of CCH Expert Treatise Library: Federal Taxation of Subchapter S Corporations!*

Some technical questions have been answered by the highly experienced Wolters Kluwer Editorial Team. See how they can help you!

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1) Two-Member LLC

A two-member LLC (taxed as an S corp) — Member B is leaving. The deal is structured as though the LLC is buying out Member B. How do I account for and record payments to Member B made from the LLC?? What is the effect on Member A?

Robert W. Jamison: Since the entity has elected S corporation status, it will be treated as an S corporation in all respects, unless the entity converts to C corporation status or revokes its association election. These two actions are rarely advisable, so I assume it will retain S corporation status throughout the transaction you describe.

This deal is commonly known as a leveraged buyout. The person who winds up in control has not used personal funds to acquire the stock. For tax purposes, it is a stock redemption. In most cases where an S corporation is involved, the selling shareholder compares the redemption proceeds with the stock basis at the time of the redemption and reports capital gain or loss. If there is a gain, this transaction usually results in the best tax treatment to the seller. However, the corporation and the remaining shareholder get no tax benefit. The corporation merely purchases treasury stock, which is a nondeductible transaction. It does not create a depreciable or amortizable asset to the corporation, but is merely a reduction of shareholders’ equity.

There can be some complications if the selling shareholder and the buying shareholder are related, or if the S corporation has any accumulated earnings and profits from C corporation years.

Chapter 15 of the treatise has some material that you may find helpful.*

2) Ordering Rule on Basis

Is there an ordering rule on basis when an S Corp shareholder sells shares where the shareholder has basis from C Corp and subsequent S Corp years? Or is it lumped together before capital gains are calculated?

Robert W. Jamison: For any given share of stock, the basis is accumulated, whether it was from C corporation years, initial or additional invested capital or from earnings retained during S corporation years. However, if different shares were acquired in different transactions, the regulations prescribe a block by block approach to maintaining basis. In most cases, when the holder sells all of the shares in a single transaction, this rule does not have much impact. Even if there are long-term capital gains realized on some shares and long-term capital losses on others, they will offset each other. However, if there are sales in different years, or if there are holding periods, it may be important to track each share separately. However, basis accumulated during C corporation years and S corporation years no longer matters.

Chapter 9 of the treatise has some material that you may find helpful.*

3) Line of Credit

Many of our clients advance money to their S corporation using a line of credit with a maximum limit ($200k, for example). There is a written note and interest is paid annually using at least the applicable AFR. Money may be advanced and paid during the year. Is this arrangement subject to the open account debt rules where it would have to be broken into $25k individual notes?

Robert W. Jamison: It seems to me like you are doing the right thing by recording these advances and charging interest. As a result of some fairly recent changes to the regulations, the open account approach only works where the aggregate amount of an S corporation’s indebtedness to a particular shareholder does not exceed $25,000 at the end of a taxable year. This aggregate indebtedness includes all open account debt, as well as all written debt instruments. You can certainly write the notes in any denomination you choose, but it will not affect the treatment of the open account loans, given the magnitude of your client’s dealings.

Chapter 9 of the treatise has some material that you may find helpful.*

4) Final K-1

Shareholder in S is redeemed and gets a final K-1. Subsequently, it is determined that he is due some additional S corp income. 1. Can we issue a K-1 to her to allocate the income for the current year? 2. How to handle distribution of S corp income after 12.31.x1 year end when corp has become C corp in 20x2? 3. S corp becomes client of my firm. No one had provided basis schedules previously. Turns out, all shareholders have been claiming losses in excess of their S corp basis. Some of it beyond the statute and no one wants to amend, anyway. Any official guidance on how to handle this?

Robert W. Jamison: It sounds like you have several problems with this new client. S corporations often need to issue amended K-1’s. On occasion, one or more of the shareholders no longer owns the stock. You should consult Circular 230 and the ethics provisions of your professional licensing body regarding the errors on prior returns. I think you will find that you should advise the client to amend for the open years, but are under no obligation to go any further in this matter.

During a period after the corporation has become a C corporation, there is a limited time during which the distributions may still be treated as S corporation distributions, generally nontaxable to the extent of the recipient shareholder’s basis. See chapter 7 of the treatise and read up on the post-termination transition period.

Unfortunately you may get yourself into a bit of potential trouble if you actually prepare a return where any of it is based on prior information that you believe to be in error.

Chapter 9 of the treatise has some material that you may find helpful in preparing basis schedules.*

5) Estimated Personal Taxes

Are payments to shareholders for estimated personal taxes who are officers of the company of a Sub S considered return of equity or should they be considered taxable to the payee considering Sub S shareholders are taxed on a pass-through basis?

Robert W. Jamison: These payments will generally be treated as distributions to the shareholders. Most distributions are return of shareholder’s equity (basis), although there are some exceptions.

See Chapter 2 of the treatise to learn about tax payments made by the corporation, and see Chapter 7 for coverage of distributions.*

6) Acquisition of S Corp Stock

Acquisition of S Corporation Stock: A group of investors contact a bank requesting a loan to purchase 100% of an S Corporation’s stock. At closing, the bank looks through the investors and makes a $4 million loan agreement with the corporation. The loan is recorded on the corporation’s balance sheet. In addition, the corporation issues a distribution in the amount of $3.5 million to the new shareholders who claim the monies were paid back to the bank. 1. What Internal Revenue Code and/or regulations address this issue? 2. What is the stock basis of the investors? 3. What is the tax consequence of the distribution (the corporation does not have positive AAA or E&P)?

Robert W. Jamison: The Code and regulations are not terribly clear on the matter of bank loans, but case law is reasonably consistent. If the bank loans money to the corporation, shareholders do not usually have basis, even though they might have guaranteed the debt.

In this case, the IRS would likely contend that the original loan of $4 million did not give the shareholders any basis. Thus, if the corporation then distributed $3.5 million to the shareholders, that might constitute a taxable gain. However, if the shareholders acted on behalf of the corporation and repaid its bank loan, they would have contributed to the corporation’s capital by doing so, which would have given them basis. Without knowing the details of the transactions, it is difficult to ascertain all the tax implications, although if the shareholders used the money to repay the loan, they probably have no taxable gain.

Chapter 9 of the treatise deals with stock and debt basis.*

7) 1253 Regulations

How will the new 2011 1253 regulations on controlled groups impact S corps' abilities to take the Section 179 deduction?

Robert W. Jamison: There is some confusion surrounding this new regulation. As I read Regulation Section 1.1563-1(b)(2)(ii)(C) after last year’s amendment, an S corporation is an excluded member, but only for purposes of certain tax attributes in Code Section 1561 to which S corporations are not subject. Thus, on its face, it does not exclude S corporations from the aggregation rules applicable to Code Section 179, since that is not one of the attributes listed in Code Section 1561.

Thus, to me at least, it appears that the S corporation must aggregate its limit with other C and other S corporations under common control. The only reason I refer to any confusion is that certain treasury officials do not believe this is the case. Now neither you nor I can expect to avoid a penalty by using “I heard that some guy doesn’t think it works this way” as a defense against a position in a Final Regulation. However, you might want to be on the lookout for some kind of announcement from the IRS regarding this rule.

Chapter 6 of the treatise contains coverage of the controlled group rules and some coverage of the §179 deduction as it applies to S corporations and their shareholders.*

8) Adding to Basis

Other than the price paid for the stock of an "S" corporation, what else can be added to Basis?

Robert W. Jamison: Additions to a shareholder’s basis might include additional purchases of stock, contributions to the corporation’s capital, or loans made by the shareholder to the corporation. They also include income of the S corporation, to the extent this income exceeds losses and distributions. Surprisingly, the income consists not only of taxable items, such as ordinary income and capital gains realized by the S corporation, but also includes many types of tax-exempt income, such as municipal bond interest and life insurance proceeds.

Chapters 6 and 9 of the treatise contain a great deal of discussion on income and basis items. It can become a fairly tricky and complicated concept, so I encourage you to read it carefully. There is a fair amount of audit activity and litigation in the area of shareholder basis.*

9) Purchasing Assets of Related Corporation

I have an S Corporation client who wants to purchase the assets of a related (owners of the S corp. own the C corp.) Corporation and the manufacturing business. The C corporation is operating at a loss and they cannot benefit from the losses, so they want to bring the operations under the S Corporation to get a little step up (at FMV) in basis from the assets that were written off using bonus depreciation. What issues and pitfalls do I need to aware of, and do you have any better ideas on how to take advantage of the loss or structure the purchase? In addition, there is a four million dollar loan from the S Corporation to the C Corporation that will not get repaid. Do you have any ideas on how to convert that to an operating loss, instead of a capital loss that we cannot use except for the $3,000 per year allowance? (The S corporation is not in the business of lending money; it’s a retailer, and we have not been able to pay interest on the loan.)

Robert W. Jamison: There are some possibilities here, but it will take some very careful attention to detail, in both the transactions and the relevant tax laws. The sale of the assets from the C corporation to the S corporation would probably meet the objective of triggering gain to the C corporation, which would allow it to deduct its net operating loss carryforward. Without knowing the relative values of the assets owned by the C corporation and its net operating loss carryforward, I can’t really say much more.

The bad debt is a tricky matter. There is quite a bit of case law on what constitutes a business or nonbusiness bad debt. You may want to consider restructuring things so that the S corporation owns the C corporation, or perhaps some alternative structure.

Even though the S corporation is not in the trade or business of lending money, you mention the purchase of assets from the C corporation. If it has use for these assets, could it not accept them in payment of the loan?

If the C corporation became a subsidiary of the S corporation, might it continue until it has used up the carryforward?

Again, I see some possibilities here.

Chapters 15 and 16 of the treatise have some material that you may find helpful.*

10) S Corp in Home

S Corp business is located in 100% shareholder’s home in a dedicated 100% business-use room. The room is 20% of the total square footage of the shareholder’s home. All employees, including the 100% shareholder/employee, work in this room and all business is transacted there. How does the S Corp pay for the use of the room, or how is the cost of using the room deducted?

Robert W. Jamison: The office in home rules are very unfriendly to shareholder-employees who rent home space to their employer corporations. You will find that there is no deduction for office in home if it is rented to an employer. Thus any compensation for the property renders all of these costs nondeductible to the shareholder. On the other hand, if the shareholder-employee receives no rental income from the corporation, the office in home expense is at least potentially deductible. However, it is an employee expense subject to the 2% AGI floor and the AMT add back.

Chapter 8 of the treatise has some material that you may find helpful.*

11) Purchasing S Corp Stock

One "S" corporation shareholder buys the stock of another "S" corporation shareholder. Does the AAA account of the seller automatically go to the buyer? Does the selling price of the purchased stock get reduced by the amount of the seller’s AAA account?

Robert W. Jamison: The AAA is a corporate level account and does not belong to any shareholder, per se. The new holder will have all of the rights that the old shareholder did, merely because the stock certificates confer those rights.

The purchaser’s basis in the stock will be its cost. There is no reduction for the AAA until it is actually distributed in cash or property.

Chapter 7 of the treatise has some material that you may find helpful.*

12) Life Insurance Premiums

When Life Insurance premiums are paid by and are an expense of the S corporation, does this expense reduce the Shareholder’s tax basis? For some reason, I seem to recall that this may be an item that may not reduce shareholder basis.

Robert W. Jamison: I think your recollection concerns the corporation’s AAA, rather than the shareholder’s basis. Unfortunately such premiums are reductions of shareholder basis, although they do not reduce the AAA, if the corporation is the owner of the policy. For bookkeeping purposes, the premiums paid would go to the Other Adjustments Account (OAA).

Chapter 7 of the treatise has some material that you may find helpful.*

13) Qualified Nonrecourse Financing

My client is a real estate partnership with qualified nonrecourse financing, and one of the partners is an S Corporation. My question is whether the S Corp can add its share of the partnership's qualified nonrecourse financing to determine its amount "at risk," and whether the S Corp's amount "at risk" flows through its stockholders.

Robert W. Jamison: It appears to me that the S corporation can include its share of qualified nonrecourse financing in its amount at risk in the same manner as any other taxpayer. However, when the S corporation shareholders determine basis and amount at risk, I don't believe this qualified nonrecourse financing would help. If the shareholders have other sources of stock and debt basis, though, they might be able to claim losses. The shareholders would also be subject to the passive activity loss limits on their ability to deduct real estate losses.

Chapters 9 and 10 of the treatise have material that may be helpful to you.*

14) Transfer of Property

A house was purchased through a sub S corp and rented for two years. Stockholder wishes to close corp and transfer house to his own name. Can sale be made to stockholder at his equity value in corp, or would it have to be at fair market value of home by sub S corp?

Robert W. Jamison: The corporation would need to record the transfer of the house at its current market value, whether the distribution took the form of a dividend or as a distribution in complete liquidation of the corporation. Thus, if there were a gain, the corporation would need to recognize the gain, which would pass through to the shareholder. However, if the fair market value of the house is less than its adjusted basis to the corporation at the time of the distribution, liquidating would be the preferable alternative. There is a possibility that the corporation could recognize a loss by distributing the house in complete liquidation. This would not be possible in any other form of distribution.

Chapters 15 and 7 of the treatise contain some information you might find useful.*

15) Closing an S Corp

How do I close an S Corp?

Robert W. Jamison: Closing an S corporation is relatively easy. The corporation merely distributes its remaining assets to the shareholders. The corporation should file Form 966 to notify the IRS of its intention to liquidate. It then prepares a final Form 1120S, including all activity for the year and any gains and losses recognized on the final distribution. However, in making the decision to liquidate, you should consider other items, such as potential claims against the corporation. You should consult with competent local counsel to assess the exposure of the shareholders to any potential claims against the business. Some shareholders of defunct corporations have found themselves in the uncomfortable position of having unlimited liability for obligations that they did not even know existed.

Chapter 15 of the treatise contains some material you might find useful.*

16) Treasury Stock

The S corp has treasury stock in the amount of 300,000 from a redemption (one of the shareholders retired). The remaining shareholders want to distribute the remaining redeemed shares. What are the tax consequences, if any?

Robert W. Jamison: The distribution would likely be treated as a nontaxable stock dividend, unless it altered the proportion of any shareholders' interests in the corporation. If it were to alter the interests, the shares would be recorded at fair market value and would be taken into account by the shareholders accordingly. The corporation would recognize no gain or loss on this distribution.

Chapters 7 and 18 of the treatise have some material that you might find useful.*

17) Professional Service Corp Rules

A medical doctor is the sole owner and employee of his S corp that provides medical services. He pays himself a salary that equals about 90% of the net earnings of the S corp. The remaining 10% of the net income is shown as a K-1 passthrough income to him. (Ordinary income in box 1 of the K-1.) Question — is the box 1 ordinary income subject to self employment income? Do professional service corp rules apply in this case?

Robert W. Jamison: Under current law, there is no self-employment income on income flowing through from an S corporation to its shareholders. The IRS has been successful in reclassifying some distributions as FICA wages, when the corporation has paid either no salary or very low salary. It does not sound like you are in any danger of running into this problem, due to the salary the shareholder-employee is receiving.

Chapter 8 of the treatise has information you might find useful.*

18) Multi-Member LLC as S Corp Shareholder

Today, a member of the IRS Business Tax Law Department told me that a multi-member LLC is an eligible S corporation shareholder. Despite 1361(b)(1), he referred to the Form 2553 instructions which state that a "domestic entity eligible to be treated as a corporation" is an allowable S corp shareholder. He then referred me to Regs 301.7701-3(b) which defined "domestic eligible entity" as a partnership if it has two or more members. I challenged him on this, as he's piecing together seemingly unrelated parts, and he countered that this was an IRS position. This seems preposterous to me. What are your thoughts on this?

Robert W. Jamison: To be charitable, I will assume that either he misinterpreted your question, or that you misunderstood his answer.

In my opinion, this statement is completely incorrect, unless the LLC is a title-holding nominee, which is an unusual situation. The code specifically limits the eligible shareholders to individuals, estates, charitable and pension entities, and a few enumerated trusts. The IRS has ruled that single-member limited liability companies can be shareholders if they are disregarded entities, and the owner of the single-member limited liability company is eligible to hold shares.

I am certain that the IRS National Office would not rule favorably on this matter. If you are at all curious about the result, call the pass through entities branch at IRS National and ask if they would entertain a ruling. In my opinion, it would be a waste of your time, and theirs.

Chapter 2 of the treatise has some information that you might find useful.

19) Flexible Spending Account

Can a greater than 2% shareholder qualify for a flexible spending account, specifically on an employee/shareholder's portion of medical insurance?

Robert W. Jamison: The flexible spending account might provide some benefits, but I am afraid it would not allow you to bypass the rule regarding health insurance for the 2% shareholder. Thus, the insurance premiums would need to be included on the shareholder-employee's W-2. On the bright side, there is no FICA or Medicare tax on the premiums, and the shareholder-employee qualifies for the self-employed page 1 health insurance deduction.

Chapter 8 of the treatise has some material you might find useful.*

20) Built-In Gains

Would growing crops and prepaid expenses be considered built-in gains for a cash basis 6-30 year end corporation electing "S" status? The corporation has a share crop arrangement with the stockholder, who does the farming. The crops are corn and soybeans, which are normally planted in May and harvested in October.

Robert W. Jamison: The prepaid expenses could be considered a built-in gain, if the corporation were to distribute the seeds, supplies or whatever else the expenses represent to the shareholders, or if e corporation would resell them before use. Otherwise, these expenses would not create a recognized gain, per se, any time after the corporation becomes an S corporation. However, the value of these materials, assuming that the corporation used the cash method of accounting, might be considered part of net unrealized built-in gain. (From what I can tell, neither Congress nor the IRS has made any attempt to reconcile the built-in gain rules with farm tax rules.)

As far as the growing crops are concerned, they probably are part of net unrealized built-in gain and when the crops sell, any unrealized gain as of June 30 would be subject to the corporate level tax. I always recommend an appraisal of assets when a corporation converts from C corporation to S corporation status. A good farm appraiser should be able to give you values for the land with, and without, the growing crops. Since there is no anticipated harvest until October, the value of the corps on July 1 is not likely to be significant. However, recognized built-in gain has become an audit issue, and I would recommend that some of the sale price of the crop be treated as a built-in gain. Thus, it is important to have an appraisal that limits the value of this item.

Chapter 11 of the treatise has material you may find helpful.*

21) Real Estate S Corp

Real Estate S Corp -  The corporation keeps refinancing and the loan proceeds are deposited in the corporation. This has occurred many times over the last several years. On the balance sheet we have a loan to shareholder of 2,600,000. No Interest charged on the loan & cash of 100,000. What should we do to get rid of the receivable. The bank is owed about 5,000,000 and is being billed monthly. The capital is negative by about 100,000.

Robert W. Jamison: From the description I cannot tell if the loan to the shareholder is from funds directly loaned by the shareholder to the corporation, or is just an erroneous classification of bank loans to the corporation. Since there is no interest being charged, I am assuming it relates strictly to funds advanced by the shareholder. If there is only one shareholder, it probably does not matter too much if the advances are treated as debt or as contributed capital, in the sense that both give basis to the shareholder. There is a requirement to charge interest at the AFR for the month of the loan, though, and you could have some messy bookkeeping here. If there is only one shareholder, this rule should not have much tax impact, because the interest income and the interest deduction wind up with the same person. However, treating it all as a contribution to capital would remove this requirement, which may be a nuisance. If there are multiple shareholders, you could have some problems here.

Chapters 9 and 14 of the treatise have some information that you might find useful.*

22) Shareholder Loan

S Corp owes shareholder loan of $100,000 and there is a valid note agreement in effect. The note of $100,000 has never been used as debt basis to take S Corp losses. Payments to him of $30,000 in 2011. Shareholder filed personal bankruptcy and was discharged of debt in 2010. Due to the tax attribute reduction rules of IRC Secton 108, basis in his note from S Corp was reduced to zero as of 1/1/11 - are his loan repayments considered capital gain due to valid note agreement or ordinary income under IRC Section 1017 which has a 'Section 1245 recapture provision' on any reduced basis assets? Section 1017 talks about 'recapture' on a disposition of the asset resulting in the recapture - is a repayment considered a 'gradual disposition' of the note subject to the 1017 recapture provisions or does the valid note agreement override as capital gain treatment upon repayment?

Robert W. Jamison: I'm afraid that the Section 1017 rule treating reduced basis property as being subject to I.R.C. § 1245 has a broad brush. It treats all property which has been subject to basis reduction as recapture property. Thus, I don't see any way around treating the $30,000 repayment as ordinary income.*

23) Reduction of AAA

50/50 shareholders of S Corp that used to be a C Corp and has C Corp E&P. One shareholder dies and his shares are redeemed by the Corp. I know the AAA was to be reduced by 50% at the redemption, but what is the ordering thereafter? Do I reduce all of E&P before I go to OAA, or do I still use the 50% factor? What order?

Robert W. Jamison: If the redemption qualifies as a sale or exchange by reason of I.R.C. § 302(b), the Code requires a reduction of a proportionate amount of earnings and profits. The Code also requires a reduction to the balance of the AAA in proportion to the percent of shares redeemed. There are some tricks an measuring the E&P balance and the AAA balance, especially if there are other distributions during the taxable year of the redemption. Unfortunately there is no coordination of the reduction of AAA with the reduction of AE&P, and the regulations state that the reductions are to be determined independently. Thus we have no ordering rule, and there is apparently no cap on the reduction to either account, regardless of the redemption price. If the redemption is not treated as an exchange, the usual ordering rules would apply, and the corporation would first reduce AAA, then accumulated earnings and profits, etc.

Chapter 15 of the treatise has material you may find helpful.

24) Health Insurance and >2% Shareholders

Re: Health insurance and >2% shareholders. We do not add the health insurance paid for >2% shareholders to their W2’s. In lieu of that, we report the amount of health insurance premiums and medical expenses as a footnote to their K-1 and do not take a deduction for it on the 1120S. We then deduct the health insurance portion as an above-the-line deduction for self-employed health insurance premiums. Do you see a problem with this? If we reported it correctly, are the health insurance premiums exempt from withholding, social security, medicare, and state disability insurance? 

Robert W. Jamison: The IRS instructs the S corporation to add these payments to the W-2. However, they are not subject to VS., Medicare or FUTA. The corporation deducts the premiums. You may be missing some tax savings here, because most shareholder-employees qualify for the page 1 health insurance deduction that is available to the self-employed. (Although S corporation shareholder-employees are not self-employed, they qualify for this deduction by statute.) Thus you are depriving the corporation of a deduction for an item that washes out at the shareholder level. I would advise you to amend all open years. Your method is not in compliance with the IRS rules, but it’s difficult to see how there could be any audit adjustment, since there is no tax avoidance.

Chapter 8 of the treatise has some material you might find helpful.

25) Selling S Corp Assets

S corporation is selling all assets of corporation. Sales agreement is broken down between, customer prescriptions (a pharmacy), good will, covenant not to compete and equipment. Question on the sale of prescription lists: Is it capital gain or ordinary income? We are getting conflicting research results, some say capital, some say ordinary, some say capital on purchased and ordinary on self developed. We know it is a 197 asset and goodwill is capital gain but unsure about the customer prescription list. Thank you for your consideration of this question.

Robert W. Jamison: I don't think you will find any authority directly on point, unless the corporation has acquired the list in a taxable transaction and had claimed I.R.C. § 197 amortization. In that case, there would be ordinary income under I.R.C. § 1245 to the extent of the prior amortization deducted. Absent that situation, I would claim I.R.C. § 1231 gain on form 4797, which almost always becomes capital gain. After all, it is property used in a trade or business, and it is not a receivable or property held for sale to the customers. Nor is it a self-developed copyright.

*Legal Disclaimer

Pursuant to Regulations Governing Practice Before the Internal Revenue Service, any tax advice contained herein is not intended or written to be used and cannot be used by a taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer.

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