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SUBCHAPTER S CORPS.
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Taxation on firms' distribution, passive income, accumulated positive & negative adjustment accounts.... More...
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Paper Abstract:
Taxation on firms' distribution, passive income, accumulated positive & negative adjustment accounts.
Paper Introduction:
SUBCHAPTER “S” CORPORATIONS: TAXATION ON DISTRIBUTIONS AND ACCUMULATED ADJUSTMENT ACCOUNTS
Introduction
This research examines the taxation of distributions made by Subchapter S Corporations and the use of accumulated adjustment accounts by such corporations. These two topics are closely interrelated; however, they are discussed separately in this paper.
Taxation on Distributions
The form of business organization has a direct impact on the financial structure and financial performance of a firm. This impact results from differences in income tax liabilities for different types of business forms, and differences in the abilities of the different types of business to generate capi
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J., II. This classification allows the taxpayer to deductadditional passive activity losses. Net passive income cannot be reduced bythe net operating loss deduction under or by any special corporatedeductions. [xxx]Tzinberg, 342. [vi]Ibid., 34 . M. The Subchapter S Corporation's separately computed itemsof loss and deduction. Positive adjustments: a. [xxii]Ibid., Section 1367(a). The dollar limit on earned income and self-employment income subjectto the Medicare hospital insurance tax was repealed by the RevenueReconciliation Act of 1993.[viii] Since the beginning of 1994, allcompensation and self-employment income is subject to the Medicare tax.This issue affects the question of compensation versus distributions forSubchapter S Corporations. [x]Ibid. The transaction represents a complete termination of ashareholder's interest in the Subchapter S Corporation.[xxxvi] 4. Smith, "Compensation Issues For SCorporations: Compensation Or Distributions?" CPA Journal, 65 (November1995), 62. Hood, "Accounting For S Corporation Distributions,"National Public Accountant, 38 (July 1993), 28-31. Endnotes BibliographyBrigham, E. A. Oil and gas property depletion to the extent thededuction does not exceed the shareholder's allocated portion of theproperty's adjusted basis. c. For federal income tax purposes, a passiveactivity is defined as any trade or business in which the taxpayer does notmaterially participate, or a rental activity.[xii] When a Subchapter SCorporation has no accumulated earnings and profits, a distribution thatexceeds the shareholder's adjusted stock basis is treated as a gain fromthe sale or exchange of property.[xiii] Such a gain is be treated aspassive income. The shareholders of theSubchapter S Corporation then are entitled to withdraw such income througha distribution from the corporation without additional federal income tax. c. Theelection to obtain a Subchapter S Corporation status can provide taxpayerswith substantial benefits in relation to federal income tax liability.Restrictions on Subchapter S Corporation treatment of income, losses, anddistributions must be observed closely, however, to avoid loss ofSubchapter S Corporation status, thereby risking corporate-level taxation.Observing the restrictions related to AAAs is of special importance in thisrespect. [xiv]H. Brigham, Financial Management, 7th ed. Burton, "S Corporation CurrentDevelopments: S Corporation Eligibility, Elections and Terminations;Operations; Reorganizations; and Proposed Legislative Changes," TaxAdviser, 26 (October 1995), 591. Burt, II., "Dodging the S Corporation'sSilver Bullet," Management Accounting (USA), 76 (December 1994), 34. Such electionpermits tax payers to receive the advantages of limited liability (throughthe corporate form of organization), while taking advantage of individualtax rates (in those instances where individual tax rates are lower thanthose for corporations). "Compensation Issues For S Corporations: Compensation Or Distributions?" CPA Journal, 65 (November 1995), 62- 63.Hood, W. [xxv]Tzinberg, 342. The transaction must not be essentially the equivalent of adividend.[xxxiv] 2. Any loss or deduction that is disallowed by the Internal RevenueService because it exceeds the shareholder's basis in stock and debtcarries over indefinitely in the appropriate AAA, and such loss ordeduction is treated as incurred by the Subchapter S Corporation in thesucceeding tax year with respect to that shareholder.[xxiv] In someinstances, thus, excess losses and deductions can provide federal incometax benefits to shareholders in future periods. A. Subchapter S Corporations with no accumulated earnings andprofits (AE&P) are permitted to make distributions that are free of federalincome tax liability to the extent of a shareholder's adjusted basis in thestock of the corporation. Passive investment income is defined as gross receipts derived fromroyalties, rents, dividends, interest, annuities, and the gain from thesale or exchanges of stock or securities.[xv] The gross amount ofroyalties is not reduced by any part of the cost of the fights under whichthe royalties are received; however, royalties derived in the ordinarycourse of a trade or business of franchising or licensing property are notincluded in passive investment income. [xv]Ibid., 35. This increase is doubled when the employer'sportion of the tax is added to the employee's portion."[x] Further, there are limits placed on the amount of losses from passiveactivities that a taxpayer can deduct.[xi] These limits affect SubchapterS Corporation distributions. E. d. Any remaining distributions are treated as are thosemade by a Subchapter S Corporation without AE&P. [xiii]Ibid., Section 1368(b)(2). The conceptual basis for the Subchapter S Corporation is the abilityto avoid double taxation on corporate profits.[v] Subchapter Scorporations generally are not subject to tax at the corporate level.Rather, each shareholder reports her or his share of corporate income onher or his individual income tax return. F. [xxix]Ibid., Section 1368(e)(1). The shareholder's distributive share of thecorporation's income, whether distributed or not, is not subject to thesetaxes. These two topics are closely interrelated. [viii]P. S., and Burton, H. Business operations organized as S type corporations for federalincome tax purposes have the option of electing to be taxed as partnerships(wherein corporate shareholders are taxed as individuals, and the Scorporation itself is not subject to federal income tax). [xxiv]Ibid., Section 1366(d)(2). Distributions in excess of the adjusted bases ofall of the shareholder's shares of stock are treated as gain from the saleor exchange of property, and are taxable as a capital gain. [xxxvii]Ibid., Section 3 2(b)(4). Distributions by the Subchapter S Corporation that arenot includable in the shareholder's income under the Internal Revenue Code. Hinsdale, Illinois: The Dryden Press, 1993.Gates, P. Rents derived in the active tradeor business of renting real or personal property also are not included inpassive investment income. "Small Business Tax Solutions." Journal of Accountancy, 18 (July 1995), 4 .Karlinsky, S. Karlinsky, and H. Excess net passive income for any taxable year may not exceeda corporation's taxable income for the year computed.[xvii] A corporate-level tax is imposed on a Subchapter S Corporation that atthe end of its taxable year has excess net passive income and Subchapter Cearnings and profits.[xviii] The tax is imposed on the lesser of excessnet passive income or taxable income. [xx]United States Internal Revenue Code, Section 1366(a). [xxviii]United States Internal Revenue Code, Section 1371(e). [xxxviii]R. In addition, it will have to pay a corporate-level tax."[xiv] This situation is triggered when passive investmentincome exceeds 25 percent of the gross receipts of a Subchapter SCorporation. [xxxv]Ibid., Section 3 2(b)(2). Subchapter S Corporation elections prior to 1994 alsoeliminated taxation problems associated with the issue of unreasonablecompensation-if earnings of the Subchapter S Corporation were taxed assalary to the officer shareholder, those earnings were not taxed as adistribution. Accumulated Adjustment Accounts As is true of the income of a Subchapter S Corporation, corporationlosses and credits also pass through to shareholders and are reported thefederal income tax returns of the shareholders.[xx] The pass through ofsuch losses and credits is subject to several limitations. Financial Management, 7th ed. [xvi]Ibid. [xxvi]Ibid. Subchapter S Corporations with AE&P are permitted to makedistributions that are free of federal income tax liability to the extentthat the appropriate accumulated adjustment account (AAA) of thecorporation also is free of federal income tax liability to the extent ofthe recipient shareholder's stock basis.[vii] Distributions in excess ofthe corporation's AAA are treated as taxable dividends to the extent of thecorporation's AE&P. "S Corporation Current Developments: S Corporation Eligibility, Elections and Terminations; Operations; Reorganizations; and Proposed Legislative Changes." Tax Adviser, 26 (October 1995), 59 -599.MacDonough, L. The OAA contains any post-1982 undistributed net tax-exemptincome.[xxviii] The AAA contains the balance of the Subchapter SCorporation's post-1982 net undistributed income.[xxix] The AAA of aSubchapter S corporation is always adjusted for increases beforeadjustments are made for decreases except in the case ofdistributions.[xxx] Retained earnings for a Subchapter S Corporation are considered to bedistributed in the following order: (1) AAA until totally distributed, (2)PTI until totally distributed, (3) AE&P until totally distributed, and (4)OAA until totally distributed.[xxxi] Distributions in excess of retainedearnings are considered to have come from paid-in capital.[xxxii] When a Subchapter S Corporation redeems its own stock, payments maycome out of the corporation's AAA, depending upon the treatment of thetransaction-exchange or distribution.[xxxiii] To qualify as an exchange,the transaction must meet one of the following tests: 1. Gates and D. The Subchapter S Corporation's non-separately computedloss. Tzinberg, "Proposed S Corporation Regulations Under Secs.1367 and 1368." The Tax Adviser, 24 (June 1993), 339. Taxation on Distributions The form of business organization has a direct impact on the financialstructure and financial performance of a firm. S. The Subchapter S Corporation's non-separately computedincome. Consequently, this change in the Medicare tax creates an additionalmotive for the IRS to claim that compensation is unreasonably low and toattempt to recharacterize distributions or undistributed income ascompensation. [iii]Ibid., Section 1361(b)(2)(a). The AAA is reduced by theentire amount of any loss or deduction even when a portion of the deductionis disallowed to a shareholder. Summary This research examined the taxation of distributions made bySubchapter S Corporations and the use of accumulated adjustment accounts bysuch corporations. The transaction must not represent a substantiallydisproportionate redemption.[xxxv] 3. "Dodging the S Corporation's Silver Bullet." Management Accounting (USA), 76 (December 1994), 34-38.Tzinberg, N. W. SUBCHAPTER "S" CORPORATIONS: TAXATION ON DISTRIBUTIONS AND ACCUMULATED ADJUSTMENT ACCOUNTS Introduction This research examines the taxation of distributions made bySubchapter S Corporations and the use of accumulated adjustment accounts bysuch corporations. W. b. [xxi]Ibid., Sections 1366(d)(1), 1367(a)(1), 1367(b)(2). MacDonough, "S Corporation AAAs and C Corporation AE&Ps,"Tax Adviser, 24 (January 1993), 26. E. A deduction that is attributable partly to passive investmentincome and partly to other income is allocated between the two types ofincome on any reasonable basis. The AAA is an account of the Subchapter S Corporation that is notapportioned among shareholders.[xxv] Without a specific agreement amongshareholders, no individual shareholder has a right to a share of theundistributed earnings of the corporation "unless and until the corporationdeclares a dividend distribution."[xxvi] The AAA of a Subchapter SCorporation may be reduced to a level below zero if losses and deductions,not including distributions, exceed income. (Hinsdale, Illinois:The Dryden Press, 1993), 94. Timing differences between the recognition of income for book andtaxation purposes do not affect the AAA, "except in the period in whichthey enter into the determination of taxable income. [vii]Ibid., 341. The total Medicare rate is 2.9%. 2. "Accounting For S Corporation Distributions." National Public Accountant, 38 (July 1993), 28-31.Jamison, R. The Subchapter S Corporation's separately stated itemsof income. [xii]Ibid., Section 469(c). J. [xviii]Ibid., 36. "S Corporation AAAs and C Corporation AE&Ps." Tax Adviser, 24 (January 1993), 26-27.Sprohge, H., and Burt, C. 1367 and 1368." Tax Adviser, 24 (June 1993), 339-346.United States Internal Revenue Code, Title 26, United States Code (26 USC), 1994.----------------------- [i]E. A basic feature of Subchapter S Corporation taxation is thatshareholders are able to receive tax-free distributions to the extent ofthe corporate earnings they report on their personal income taxreturns.[vi] Not all distributions are free of federal income taxliability. [xi]Internal Revenue Code, Section 469. Negative adjustments: a. Sprohge and C. [ix]Ibid. Positive and negative AAAs of merged Subchapter S Corporations may notbe offset against one another.[xxiii] The two classes of AAAs must remainsegregated an separately maintained subsequent to a merger. The number of shareholders in a Subchapter S Corporation is limited to35.[ii] To retain a Subchapter S status, a corporation cannot be a memberof an affiliated group.[iii] The purchase by a Subchapter S Corporation of8 percent or more of the stock of another corporation terminates theSubchapter S Corporation election of the acquiring Subchapter S Corporationand of the acquired corporation if the acquired corporation also is aSubchapter S Corporation.[iv] The attraction of the Subchapter S Corporation lies in the ability tobetter manage federal income tax obligations in many instances. [xxvii]Ibid. "Proposed S Corporation Regulations Under Secs. M. The taxrate imposed on the Subchapter S Corporation is the highest corporaterate.[xix] The amount of each item of passive investment income passedthrough to shareholders of a Subchapter S Corporation subject to the excessnet passive income is reduced by a pro rata amount of the tax. b. Net passive income is passive investment income reduced by anyallowable deduction connected directly with the production of income.[xvi]Deductions connected directly with the production of passive investmentincome are deductions that have a proximate and primary relationship to theincome. A. When a Subchapter S Corporation has excess passive income and"Subchapter C accumulated earnings and profits, it may face termination ofthe Subchapter S election. These two topics are closely interrelated; however,they are discussed separately in this paper. This impact results fromdifferences in income tax liabilities for different types of businessforms, and differences in the abilities of the different types of businessto generate capital.[i] An important organizational forms for many smallbusiness owners to consider is the Subchapter S Corporation. [xxxi]W. SubchapterS corporations are permitted to make an election whereby shareholders willbe taxed (for federal income tax purposes) as individuals, as opposed totaxing the business organization as a corporation and then taxingindividual shareholders on income derived from the corporation. [xxxvi]Ibid., Section 3 2(b)(3). The full amount is payableon what is considered self-employment income. [xxxii]United States Internal Revenue Code, Sections 1368(a), (b),(c), 1379(b). [xix]United States Internal Revenue Code, Sections 11(c), (d). A taxpayer receiving compensation in the amountof $25 , in 1994 or later will pay $1,667 more in Medicare hospitalinsurance than in 1993. S. The employer and theemployee are each subject to a 1.45% tax if the income is consideredcompensation for services. Any expense of the Subchapter S Corporation that is notdeductible in computing the corporation's taxable income and is notproperly chargeable to a capital account. [xxiii]L. Compensation received by stockholder/employees is subject toemployment taxes. The principal motivation for the election of Subchapter S Corporationstatus is the avoidance of the corporate-level taxation.[ix] Subchapter SCorporation elections also allow taxpayers to avoid the accumulatedearnings tax, the personal holding company tax, and some personal servicecorporation taxes. There is no provision inthe Internal Revenue Code for the carryover of non-deductible, non-capitalitems to subsequent years. [xxxiv]Ibid., Section 3 2(b)(1). The excess of the Subchapter S Corporation's deductionsfor depletion over the basis of the property subject to depletion. [xvii]Ibid. [v]N. C. [iv]S. An Subchapter S Corporation withoutany Subchapter C earnings and profits is not subject to the tax. A. Additionally, theyshould not be posted to the corporation's 'other adjustment account'because they do not represent permanent tax-exempt income or relatedexpenses."[xxvii] Thus, the sum of a Subchapter S Corporation's AAA, otheradjustment account (OAA), previously taxed income (PTI) account, and AE&Paccount will not always equal the book value of the corporation's retainedearnings account. The transaction represents a distribution in partialliquidation of a shareholder's interest in the Subchapter SCorporation.[xxxvii] The AAA is adjusted for the year's income and losses and reduced bythe same percentage as that of the outstanding shares redeemed.[xxxviii]If a Subchapter S Corporation makes other distributions during the year,the AAA is first reduced for all non-redemption distributions, and theremainder of the AAA balance is reduced by the appropriate percentage. [ii]United States Internal Revenue Code, Title 26, United States Code(26 USC), 1994, Section 1361. The change in the Medicare tax limit "increased the significance ofthe adequacy of compensation paid to stockholder/employees of Scorporations. Jamison, "Small Business Tax Solutions," Journal ofAccountancy, 18 (July 1995), 4 . F. C. [xxxiii]Ibid., Section 1368. e. S., and Smith, D. First, theaggregate amount of losses and deductions taken into account by ashareholder for any tax year cannot exceed the sum of the adjusted basis ofthe shareholder's stock in the corporation and the shareholder's adjustedbasis of any indebtedness of the corporation to the shareholder (determinedbefore any negative or positive debt.[xxi] The basis of each shareholder'sstock is increased for any period by the sum of the shareholder's positiveadjustments, while basis is decreased by the sum of the shareholder'snegative adjustments.[xxii] Positive and negative adjustments specified inthe Internal Revenue Code are as follows: 1.
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