S Corp Taxation Basics

Chapter 16
Partnerships, Corporations,
and S Corporations
Part IV: S Corporations
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Chapter 16 Contents

1. S Corporations—Treatment of Tax and Nontax Matters
2. S Corporations—Tax Years
3. S Corporations—Accounting Methods
4. S Corporations—Tax Model
5. S Corporations—Eligibility and Election
6. S Corporations—Revoking S Status
7. S Corporation Basis Accounts—Overview
8. S Corporation Basis Accounts—Outside Basis
9. S Corporation Basis Accounts—At-Risk Basis
10. S Corporation Basis Accounts—Accumulated Adjustment Account (AAA)
11. S Corporation Basis Accounts—Other Adjustment Account (OAA)

Chapter 16, Exhibit Contents A CCH Federal Taxation Basic Principles2 of 60

Chapter 16 Contents

12. S Corporation Basis Accounts—Previously Taxed Income Account (PTI)
13. S Corporation Basis Accounts—Shareholder Loans to S Corporations
14. S Corporation Basis Accounts—Example on Effect of Operating Results
on Basis
15. S Corporation Distributions
16. S Corporation Distributions—Effect on Shareholder
17. S Corporation Distributions—Example
18. S Corporation Penalty Taxes—Code Sec. 1374 Tax on Built-in Gains
19. S Corporation Penalty Taxes—Code Sec. 1374 Tax Example
20. S Corporation Penalty Taxes—Code Sec. 1375 Tax on Excess Net
Passive Income
21. Code Sec. 1375 Tax on Excess Net Passive Income—Example

Chapter 16, Exhibit Contents B CCH Federal Taxation Basic Principles3 of 60

S Corporations—Treatment of Tax and
Nontax Matters
The Conduit Concept. For most tax matters, S
corporations are treated like partnerships. As in the
partnership conduit concept, the taxable income of an
S corporation flows through to the owners on a per-
day and per-share basis. Income and losses are
reported on Form 1120-S, allocated to each
shareholder on a supporting K-1 schedule, and then
transferred, via the K-1, to the individual owners’
1040 returns. There, at the individual level, income is
taxed and losses are deducted.

Chapter 16, Exhibit 1a CCH Federal Taxation Basic Principles4 of 60

Nontax Matters

The Entity Concept. The character of income and
losses is determined at the entity level, not at the
shareholder level. For example, a long-term capital
gain reported by the S corporation remains long-
term to the shareholder, even if his ownership in the
S corporation had been held for a short-term period.

Chapter 16, Exhibit 1b CCH Federal Taxation Basic Principles5 of 60

Nontax Matters

Distributions of Cash or Property. Actual distributions
of cash or property are generally not income to its
shareholders. Two notable differences with
partnerships are:

 Owner salaries and payroll taxes. Deductible by S
corporations, not by partnerships.
 Gain on distribution of property. S corps must
recognize gains (but not losses) on distributions of
appreciated property to shareholders; partnerships
escape this gain recognition.
Chapter 16, Exhibit 1c CCH Federal Taxation Basic Principles6 of 60

Nontax Matters

Nontax matters. For most structural matters (e.g.,
formation, redemptions and terminations), S
corporations are treated in much the same manner as
C corporations.

Chapter 16, Exhibit 1d CCH Federal Taxation Basic Principles7 of 60

S Corporations—Tax Years
An S corporation must generally use a calendar year end.
However, it may elect a fiscal tax year under any of the following
three conditions:
 Three-Month Deferral OK. A fiscal tax year would result in
income deferral of not more than three months and the
shareholder-employee’s salary earned between fiscal year
end and December 31 is both:
 Paid during that period; and,
 Proportionate to the salary paid during the preceding
fiscal year.
 Business Purpose. A business purpose can be demonstrated.
 1987 FYE. The S corporation retains the same fiscal tax
year as was used in 1987, if in existence at that time.

Chapter 16, Exhibit 2 CCH Federal Taxation Basic Principles8 of 60

S Corporations—Accounting Methods

The accrual, cash and hybrid methods are available
regardless of the size of the S corporation.


S Corporations—Tax Model

Code Sec. 702(a)(8) Income

Definition. As with partnerships, items that are always subject
to ordinary treatment are lumped together in an amount called
Code Sec. 702(a)(8) income or loss. Shareholders recognize
Code Sec. 702(a)(8) income even if no cash is actually
distributed. Accordingly, shareholders are generally not taxed
on distributions.


Code Sec. 702(a)(8) Income

Computation. Sec. 702(a)(8) is generally operating income or
loss computed as follows:
 Ordinary Income “From Whatever Source Derived”
(including Code Sec. 1245 recapture)
 Less: Exclusions
 Less: Cost of Goods Sold (resulting in gross income from
business operations)
 Less: Operating Expenses



Rationale. Each shareholder of an S corporation reports her
share of corporate net income based on her stock ownership.
Any income, loss, deduction, or credit which could uniquely
affect the tax liability of a shareholder is separately stated in the
K-1 to the shareholder.


Separately Stated Items
 Passive income and losses from rental and other non-operating activities
 Investment income and related expenses (e.g., dividends, investment
interest, ad valorem tax on stock, investment counseling fees, etc.)
 Code Sec. 1231 gain and loss
 Capital gains and losses
 Dividends eligible for a dividends-received deduction
 Charitable contributions
 Taxes paid to a foreign country or to a U.S. possession
 Code Sec. 179 deduction
 Recovery items (e.g., tax refunds, recovery of bad debts)
 Tax-exempt income and related expense
 Tax credits
 Deductions disallowed in computing S corporation income

S Corporations—Eligibility and Election
A corporation is treated as an S corporation only for those days for
which each specific eligibility requirement is met and the required
election is effective. Eligibility and election rules include:
Unanimous Consent. 100% of the shareholders must consent to the
S election.
Deadline For Filing S Election. If a calendar year C corporation
makes an S election by 3/15/x1, it is retroactive to 1/1/x1. If made
after 3/15/x1, but before 3/15/x2, it is effective 1/1/x2.
One Class of Stock. Only one class of stock is permitted.
 Rights to profits and assets on liquidation must be identical.

 Debt may be treated as a disqualifying second class of stock.



Maximum 100 Shareholders. The number of shareholders
may not exceed 100.

 A nonresident alien may not own shares.
 Each shareholder must be an individual, an estate, or a
qualified trust.
 Related taxpayers can elect to be treated as one
shareholder.



Ineligible Corporations. The corporation must be domestic
but not a bank or insurance company.

Eligible Subsidiaries.
 S corporations can own C corporations, but C

corporations cannot own S corporations.
 S corporations can own qualified subchapter S

subsidiaries (QSubs). A QSub is an electing domestic
corporation that qualifies as an S corporation and is 100%
owned by an S corporation parent.


S Corporations—Revoking S Status
The S election will be terminated upon one of the following
events:

1. Over 50% consent. Over 50% of the shareholders agree to
the revocation. The deadline for revoking S status is the
same as the deadline for electing it.

2. Prior C life AND passive investment income over 25%. If
an S corporation had a prior life as a C corporation and its
passive investment income is over 25% of its total income
for three consecutive years, it loses the S election at the start
of the fourth year.


S Corporations—Revoking S Status
3. Violation of qualifications. If any of the qualifications
mentioned above are violated (e.g., stock is sold to a C
corporation, or a second class of stock is issued), the S
election is terminated on the date of violation, and the
period before the violation is considered a “short-year.”

4. Majority shareholder revocation. If a new shareholder
owning more than 50% takes affirmative action to terminate
the election, the election dies as of the date of action.

After revocation or termination of an election, a new election
cannot be effectively made for 5 years without IRS consent.


S Corporation Basis Accounts—Overview

Outside (Stock) Basis At Risk Basis AAA Basis

Primary To determine gain or To determine how To determine
Purpose: loss when the stock is much of how much of
ultimately sold. [Also shareholder’s cash and
will limit tax-free allocations of Sec. property
distributions if stock 702(a)(8) losses and distributions are
basis is lower than separately stated tax-free.
AAA basis.] expenses are
deductible.


(“Yes” means the item to the left is used in the computation of basis):
Outside (Stock) At Risk Basis AAA Basis
Basis
+ Original basis (e.g., purchase, Yes Yes No
inheritance, gift)
± Sec. 702(a)(8) TI or Loss Yes Yes
± Separately stated items that are taxable Yes Yes Yes
or deductible to s/h
± Tax-exempt income and non- Yes Yes No
deductible exp.
+ Company debt for which s/h is No Yes No
personally liable


Basis

+ Non-recourse No No No
financing from (unlike the
qualified lenders normal at-risk
rules for
individuals)

+ Shareholder (S/H) No Yes No
loans to S Corp (unlike (unlike partnerships,
partnerships debt debt basis is held
basis is held separately from
separately from equity basis.)
equity basis.)



Basis

- Fair market value Yes Yes Yes
(FMV) of distributions (distributions (distributions (distributions reduce
reduce basis reduce at risk AAA before current
before current amount before year losses)
year losses) current year
losses)


S Corporation Basis Accounts—Outside Basis
General Rule. A shareholder’s outside basis is his/her
stock basis. Outside basis is computed in much the
same manner as a partner’s outside basis in a
partnership interest.

Exception. One notable exception is that the basis of
stock in an S corporation is not affected by the
corporation’s liabilities. This seems reasonable
because, unlike a general partner, an S corporation
shareholder is not personally liable for the debts of the
corporation.

S Corporation Basis Accounts—At-Risk Basis

General Rule. At-risk rules are applied at the shareholder level.
The amount of S corporation losses that the shareholder can
deduct may not exceed the lesser of:

 At-risk amount or
 Sum of a shareholder’s stock basis and debt basis.


S Corporation Basis Accounts—At-Risk Basis
Computation of At-Risk Basis. At-risk basis is equal to the sum of:

 Cash and basis of property contributed to the S corporation (to the
extent unencumbered)
 Outstanding shareholder loans to the S corporation
 Loans for which the shareholder has personal liability or has
pledged as security for repayment property not used in the
activity of the corporation. (However, this does not include other
debts of the corporation to third parties, even if the repayment is
guaranteed by the shareholder.)
 Allocated portion of income
 Less: Allocated portion of losses
 Less: Distributions at fair market value (not at partnership basis)


S Corporation Basis Accounts—
Accumulated Adjustment Account (AAA)
Purpose. Records and information pertaining to each
shareholder’s accumulated adjustment account (AAA) are needed
by S corporations only for purposes of helping shareholders
determine taxability of distributions when the S corporation has
earnings and profits (E&P).
 The C corporation connection. An S corporation has E&P
only if it was classified as a C corporation in the past or
acquired a C corporation.
Tax effect of distributions. The fair market value (FMV) of
distributions to shareholders are tax-free to the extent of the lesser
of (1) AAA balance and (2) stock basis.


Computation. A shareholder’s AAA balance is INCREASED
only by taxable income. It is REDUCED by all deductible
losses/expenses, by cash distributions and by the fair market
value (FMV) of property distributions.
 Same-year losses and distributions. Shareholders are allowed
to reduce the AAA basis by the amount of current year
distributions BEFORE applying current year losses against
bases. This rule enables tax-free distributions to the extent of
AAA, BEFORE AAA is reduced by the amount of losses.
While the effect is favorable for tax-free distributions, it can
also result in higher suspended losses, since distributions
reduce all bases, dollar for dollar, thus lowering the limits of
loss deductions and increasing suspended losses.
 Tax–exempt income. No adjustment to the AAA account is
made for tax-exempt income such as municipal bond interest
and life insurance proceeds (reduced by related expenses).

Negative AAA balance OK. The AAA basis (unlike the stock
basis) can have a negative balance. However only losses, (not
distributions) can make the AAA negative or increase a negative
balance.

Transferability of AAA account. If the shareholder disposes of
stock, the AAA associated with the stock passes to the new
owner.


Other Adjustment Account (OAA)

Other Adjustments Account (OAA). The OAA represents
another form of accumulated adjustments account (AAA) in that:

 The OAA is a balance sheet account in the capital section.
 The OAA is needed by S corporations only for purposes of
helping shareholders determine taxability of distributions
when the S corporation has earnings and profits (E&P).
 Any distributions from OAA are tax-free to shareholders.


Other Adjustment Account (OAA)

Timing of distributions. Tax-free distributions from OAA cannot
be made until after all accumulated E&P are paid out.

Computation. The OAA balance is increased for tax-exempt
income or decreased for nondeductible expenditures not properly
chargeable to the AAA.


Previously Taxed Income Account (PTI)
Timing of distributions. Tax-free distributions from
the PTI account are made after tax-free distributions
reduce the OAA balance to zero.

Computation. The PTI account represents a balance of
undistributed net income on which the shareholders
were already taxed prior to 1983.


Shareholder Loans to S Corporations
Using loan basis for deductions. Once stock basis is zero, any
additional basis reductions (losses or deductions, but NOT
distributions), decrease (but not below zero) the shareholder’s
basis in loans made to the S corporation.

Suspended losses/deduction. Any excess of losses or deductions
over both stock and debt bases is suspended until subsequent
items of income or contributions arise to restore basis in debt.

Restoring debt basis. Once the basis of any debt is reduced, it is
later increased (only up to the original face amount of the loan)
by the subsequent net increase resulting from all positive and
negative basis adjustments. The debt basis is adjusted before any
increase is made in the stock basis.

Distributions. A distribution in excess of stock basis does not
reduce any debt basis.

Same-year losses and distributions. If a loss and a distribution
occur in the same year, the loss reduces the debt basis before the
distribution. (This rule favors the taxpayer.)

Repayment of shareholder loan with reduced basis. If an S
corporation repays a shareholder loan when the debt basis is
below the loan amount, the difference is treated as a capital gain.
An allocation is required for partial repayments.


Example: A shareholder lends an S corporation $100,000.
Subsequent losses eliminate the shareholder’s stock basis and
reduce a portion of the debt basis. The S corporation repays
$20,000 of the $100,000 loan when the shareholder’s basis in
the loan is $75,000. The shareholder must report a capital gain
in the amount of $5,000 on the receipt of $20,000, since 25% of
the face value was not supported by debt basis [$20,000 x
($100,000 – $75,000) ÷ $100,000].


Example on Effect of Operating Results on Basis

FACTS: David, an individual, owns all of the shares of an S corporation
throughout 20x1. The corporate books show the information for 20x1 on the
following slides.

QUESTION:
(1) Compute 20x1 Code Sec. 702(a)(8) taxable income
(2) Compute David’s stock basis at 12/31/x1.
(3) Compute David’s “at risk” amount at 12/31/x1.
(4) Compute David’s AAA balance at 12/31/x1.
(5) Compute David’s debt basis at 12/31/x1.


Facts Solution
Corp. Books: (1) (2) (3) (4) (5)
Sec. 702(a) Stock At Risk AAA Debt
(8) TI Basis Basis Basis Basis

Initial bases, from 10,000 10,000 10,000 0 0
$10m stock purchase
on 1/1/x1

Net sales 200,000 200,000 200,000 200,000 200,000

Cost of goods sold (100,000) (100,000) (100,000) (100,000) (100,000)

Overhead expenses (10,000) (10,000) (10,000) (10,000) (10,000)

Sec. 1245 gain 10,000 10,000 10,000 10,000 10,000


Facts Solution

Corp. (1) (2) (3) (4) (5)
Books: Sec. 702(a)(8) TI Stock Basis At Risk AAA Debt
Basis Basis Basis

Sec. 1231 loss (10,000) (sep’ly. stated) (10,000) (10,000) (10,000)

Charitable (10,000) (sep’ly. stated) (10,000) (10,000) (10,000)
contributions

Short-term (10,000) (sep’ly. stated) (10,000) (10,000) (10,000)
capital loss

Long-term 10,000 (sep’ly. stated) 10,000 10,000 10,000
capital gain

Tax-exempt 15,000 (sep’ly. stated) 15,000 15,000
interest income


Facts Solution
Corp. (1) (2) (3) (4) (5)
Books: Sec. 702(a)(8) TI Stock Basis At Risk AAA Debt
Basis Basis Basis

Lobbying (10,000) (sep’ly. stated) (10,000) (10,000)
expense - state
officials (not
deductible)

David’s loan to 10,000 10,000 10,000
S corp.

S corp 10,000 10,000
borrowings
from banks—
recourse to
David


Facts Solution
Corp. (1) (2) (3) (4) (5)
Books: Sec. 702(a)(8) Stock Basis At Risk AAA Debt
TI Basis Basis Basis

S corp borrowings 10,000
from banks—
NONrecourse to
David.

David’s additional 10,000 10,000 10,000 10,000
stock purchases of S
corp. stock

Cash distribution to (10,000) (10,000) (10,000) (10,000)
David

Balances, 12/31/x1 125,000 100,000 95,000 115,000 80,000 10,000

Chapter 16, Exhibit 14e CCH Federal Taxation Basic Principles39 of 60

S Corporation Distributions

Does an S corporation recognize gain or loss on the
distribution of cash to shareholders?
No, never.

Does an S corporation recognize gain or loss on the
distribution of other property (other than its own
stock)?
 Gains: Yes (compute gain in the same way as if the

property were sold)
 Losses: No (except in complete liquidation).


S Corporation Distributions

What is the character of the entity’s gain on
distribution of property to owners?
 If a shareholder owns no more than 50% of the S

corporation, then the character of the entity’s gain is
the same as the character of the property distributed.
 If a shareholder owns more than 50%, then the

entity’s gain is ordinary.


S Corporation Distributions—Effect on Shareholder

S Corporation Without C Corporation E&P

Shareholder Distribution Tax Result

To extent of stock basis Tax-free; reduces stock basis

In excess of stock basis Taxed as a capital gain


S Corporation Distributions—Effect on Shareholder
S Corporation With C Corporation E&P

Shareholder Distribution Tax Result
To extent of accumulated Tax-free; reduces AAA and stock
adjustments account (AAA) basis

To extent of C corporation E&P Taxed as an ordinary dividend; does
not reduce stock basis

To extent of other adjustments Tax-free; reduces OAA, PTI, and
account (OAA) and previously taxed stock basis
income (PTI) account

To extent of any remaining stock Tax-free; reduces stock basis.
basis

In excess of stock basis Taxed as a capital gain


S Corporation Distributions—Example
FACTS:
An S corporation reports the following balances for its sole
shareholder as of 1/1/x1:
 Capital balance per corporate books: $125,000

 Stock basis: $95,000

 At-risk basis: $115,000

 AAA basis: $80,000

 Shareholder loan to S corporation: $10,000 (basis also

$10,000)

The S corporation reports a ($200,000) ordinary loss in 20x1.


QUESTIONS:
(a) What is the maximum tax-free nonstock distribution the
shareholder can receive in 20x1? (Hint: The tax-free
distribution is not affected by the 20x1 loss. Use the 1/1/x1
balance in AAA and any excess stock basis. Answer: $95,000
= $80,000 AAA + $15,000 excess stock basis)
(b) Assuming that a $95,000 cash distribution is made to the sole
shareholder in 20x1, what are the 12/31/x1 balances in stock
basis, at-risk basis, AAA and debt basis?
(c) What portion of the ($200,000) loss is deductible in 20x1
under the at-risk rules?
(d) What portion of the $200,000 loss is suspended in 20x1 under
the at-risk rules?


QUESTION:
If the S corporation repays the $10,000 shareholder debt in year
20x2, what are the tax consequences if:
 S corporation has income of $10,000 in year 20x2?

 (If the S corporation has income in year 20x2, the first

$10,000 must restore the debt basis back to $10,000. Any
income in excess of $10,000 increases the following
simultaneously: (a) the stock basis, (b) at-risk basis, and (c)
AAA balance. A subsequent repayment of the $10,000
shareholder loan does not result in capital gain.)

 S corporation has a loss in year 20x2?
 (Answer: A $10,000 capital gain passes through to the
shareholder since the debt basis is zero.)


SOLUTION: Tax Effect of a $200,000 loss and a $95,000 distribution in 20x1
Cap. Sec. 702(a) Stock Basis At Risk AAA Debt
Bal. per (8) income Basis Basis Basis
Books (loss)

Balances, 1/1/x1 125m 95m 115m 80m 10m

1st: Apply dist’n. (80m) (80m) (80m) (80m) 0
against bases: [tax-free] [tax-free] [tax-free] [Debt
Tier 1 Distribution: basis is
(i.e., Tax free: never
Lesser of, reduced
by
(1) $80m AAA
distributio
balance, or
ns]
(2) $95m stock
basis)



Cap. Bal. Sec. 702(a)(8) Stock Basis At Risk AAA Debt
per income (loss) Basis Basis Basis
Books

Balances, 1/1/x1 125m 95m 115m 80m 10m

Tier 2 Distribution: 0 0 0 0
(i.e., taxable to extent
of accumulated E &
P from prior life as a
C corp. None here.)

Chapter 16, Exhibit 17e CCH Federal Taxation Basic Principles48 of 60


Cap. Sec. 702(a) Stock At Risk AAA Basis Debt Basis
Bal. per (8) income Basis Basis
Books (loss)

Balances, 1/1/x1 125m 95m 115m 80m 10m

Tier 3 Distribution: (15m) (15m) (15m) 0 0
(i.e. tax free to extent [tax-free] [tax-free] [Dist’ns [Debt basis is
of any stock basis cannot never reduced
surviving the 1st tier create neg. by
distribution AAA bal.] distributions]
(15m = 95m - 80m)

Subtotals 30m 0 0 20m 0 10m

Chapter 16, Exhibit 17f CCH Federal Taxation Basic Principles49 of 60


Cap. Sec. 702(a)(8) Stock At Risk AAA Debt Basis
Bal. per income (loss) Basis Basis Basis
Books

Subtotals 30m 0 0 20m 0 10m
20x1 DEDUCTIBLE (200m) (10m) 0 (20m) (200m) (10m)
LOSSES UNDER [Note: Only (10m) is
AT-RISK RULES deductible, because
[Apply 200m Sec. loss deductions are
702(a)(8) loss limited to the lesser
against bases and of
determine the 1. $10m (i.e., stock
amount deductible basis of $0, + debt
under the at-risk basis of $10m); or
rules.] $20m at risk basis]

Chapter 16, Exhibit 17g CCH Federal Taxation Basic Principles50 of 60


Cap. Sec. 702(a) Stock At Risk AAA Debt Basis
Bal. per (8) income Basis Basis Basis
Books (loss)

BASES, 12/31/x2 (170m) 0 0 (40m) 0
[can’t be [can’t be [CAN be [can’t be neg.]
neg.] neg.] neg.]

20X2B (190m)     
SUSPENDED [200m- (180m) (10m)
LOSS UNDER AT- 10m] or [190m
RISK RULES [180m + nondeduct
($190m total) 10m] ible loss -
10m debt
basis]

Chapter 16, Exhibit 17h CCH Federal Taxation Basic Principles51 of 60

S Corporation Penalty Taxes—
Code Sec. 1374 Tax on Built-in Gains

All four conditions listed below must be present to subject an S
corp. to the 35% Code Sec. 1374 tax:
1. Prior life as a C corporation;
2. S-corporation election occurs after 1/1/87;
3. Asset sale with pre-election built-in gain (but not built-in
loss). [If the asset is purchased after the election, Code
Sec. 1374 would not apply.]
4. Asset sale within 10 years of election date, not effective
date of election. (e.g., if an election is made on 3/15/x1, it
is retroactively effective to 1/1/x1. The 10 year toll begins
in 3/15/x1, not 1/1/x1.)


Code Sec. 1374 Tax on Built-in Gains

Computation. At the time that an asset is sold, the corporation
will recognize (and pay tax) on the difference between the fair
market value of the asset at the time of the election. The tax
rate is the highest corporate effective rate of 35%.


Code Sec. 1374 Tax Example
FACTS: On 3/15/x0, a C corporation makes an election to become an S
corporation. At the time of the election, the corporation had the following
assets:

Asset Fair Market Value at Adjusted Basis at Built-In Gain
Election Date Election Date

Office Building $600,000 $500,000 $100,000

Land $400,000 $300,000 $100,000


QUESTION: Determine the tax effect to the corporation and to the shareholder of the
following transactions:
 One year after the election date, the corporation sells the building at a sales price of

$700,000 when the adjusted basis is $450,000.
 Twelve years after the election date, the corporation sells the land at a sales price of

$500,000.

(a) (b) (c) (d)= (b) – (c) (e) =
[Lesser of:
(a) or (d)] x
35%

Asset Built-in Gain Sales Price Basis at Realized Gain Sec. 1374
at Election Sales Date Tax

Building $100,000 $700,000 $450,000 $250,000 $35,000
Land $100,000 $500,000 $300,000 $200,000 0**

COMPUTATIONS
Tax effect of 20x1 sale of building:
 S corporation: The corporation itself pays the $35,000 tax

to the IRS. (35% x [the lesser of 100,000 or 250,000])
 Shareholders: The shareholders are allowed a deduction

for that tax. The S corporation’s K-1 would show:
Code Sec. 1231 gain/Code Sec. 1245 recapture
($700,000 - 450,000) $250,000
Code Sec. 1374 tax deduction
$ (35,000)



COMPUTATIONS
Tax effect of selling land over 10 years after the election date:
 No Code Sec. 1374 tax would be imposed since the 10-year

post-election period had lapsed. Only the $200,000 Code
Sec. 1231 gain would be reported by the S corporation on
the shareholder’s K-1.


Code Sec. 1375 Tax on Excess Net Passive Income

This tax applies to any S corporation with accumulated E&P
that has more than 25% of its gross receipts derived from
passive sources.


Computations
 Excess Net Passive Income = [(a) – {25% x (c)}] ÷ [(a) x (b)]

 Code Sec. 1375 Tax = 35% x Excess Net Passive Income, where

(a) = Gross passive investment income (e.g., royalties, rents,
dividends, interest, annuities, and gain on sales of
securities)
(b) = Net passive investment income (i.e., gross amount net of
investment expenses
(c) = Gross receipts (i.e., receipts from all sources including
active and passive sources)
 Note that Excess Net Passive Investment Income can never be

more than taxable income computed as if the S corporation had
been a C corporation.


—Example
FACTS:
1. S corporation has gross receipts of $300,000 in 20x1.
2. Included in the $300,000 is $100,000 of royalties.
3. Expenses directly connected with the production royalties are $30,000.
4. The S corporation has accumulated E & P from its prior life as a C corporation.

QUESTION:
Compute the Code Sec. 1375 tax.

SOLUTION:
Excess Net Passive Investment Income:
$17,500 =[100,000 – {25% x (300,000)}] ÷ [100,000 x 70,000]
Code Sec. 1375 tax:
$6,125 = 35% x 17,500.


S Corp Taxation Basics

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