#20 S Corporations Flashcards
(19 cards)
Who is allowed to be a shareholder in an S corporation?
1) Only the following are allowed to be S corporation shareholders:
- Individuals
- Certain estates
- Certain trusts (for the benefit of individuals)
2) All shareholders must be U.S. citizens or residents.
3) The business must be a domestic corporation and have no more than 100 shareholders.
4) S corporations are not allowed to have:
- Corporations
- Partnerships
- LLCs
- Nonresident aliens
- Big trusts or C corps
5) The purpose of these restrictions is to keep S corps limited to small, closely held U.S. businesses.
1) Shareholder basis starts with the beginning basis and is:
+ Increased by:
- Additional capital contributions
- Share of the S corporation’s income and gains
− Decreased by:
- Share of the losses and deductions
- Distributions from the S corporation (cash or property)
2) Basis can never go below zero. Losses that exceed basis are suspended until basis is restored.
3) In this example:
- Beginning basis: $13,000
- Add contribution: +$4,000
- Subtract distribution: −$3,000
- Subtract share of loss: −$6,000
- Ending basis = $8,000
4) This adjusted basis is used to determine whether losses can be deducted and how distributions are taxed.
For which entity does the owner’s basis increase with profits and decrease with losses, but is NOT affected by the entity’s debts?
1) In an S corporation, the owner’s basis is:
- Increased by their share of income and contributions
- Decreased by their share of losses and distributions
- Not increased by the corporation’s debts (no debt basis)
2) In contrast, partnerships and LLCs allow partners/members to include a share of the entity’s debts in their basis.
3) A C corporation is not a pass-through entity, so shareholder basis is not affected by profits or losses.
4) Only in an S corporation does basis equal:
Stock basis + loans the shareholder personally made to the corporation
It does NOT include third-party debt the corporation owes.
5) Therefore, the correct answer is: S corporation.
What income items from an S corporation must be separately stated on the shareholder’s tax return?
1) An S corporation passes through two types of items to shareholders:
- Ordinary business income or loss
- Separately stated items (must be reported separately on the shareholder’s return)
2) Separately stated items include things that are subject to special tax rules, such as:
- Dividends
- Capital gains/losses
- Charitable contributions
- Tax credits
- Interest income
- Section 178 expense
3) In this case, the $5,000 dividend income is separately stated. It does not go into ordinary business income.
4) All other items (gross receipts, supplies, utilities) are used to calculate ordinary business income.
5) So on the S corporation’s Schedule K, the only separately stated item is the $5,000 dividend income.
Which income and expense items are excluded from ordinary business income on an S corporation’s income tax return and must be separately stated?
1) An S corporation’s income is split into:
- Ordinary business income/loss
- Separately stated items (reported individually on the shareholder’s return)
2) Items that are separately stated because they have special tax rules include:
- Interest income (affects investment interest limitations)
- Charitable contributions (subject to AGI limits)
- Section 179 expense (subject to dollar limits)
3) Only items like sales, rent, meals (50%), and depreciation go into ordinary business income.
4) In this example:
- Start with sales: $240,000
- Subtract rent: −$25,000
- Subtract depreciation: −$1,800
- Subtract 50% of meals: −$2,500
= $210,700 ordinary business income
5) The other items ($1,000 interest, $800 charity, $5,000 Sec. 179) are separately stated and not included in the $210,700.
xHow is an S corporation shareholder’s basis calculated, and do company debts affect it?
1) Basis starts with the cash or property contributed.
2) Increased by: shareholder’s share of income, and additional contributions
3) Decreased by: shareholder’s share of losses and any distributions
4) S corporation debts do NOT increase basis — only direct loans from the shareholder do.
When does debt increase an owner’s basis in a business?
1) Partnerships: Debt increases basis based on the partner’s share of liabilities.
2) S corporations: Only direct loans from the shareholder increase basis. Third-party debt does not.
3) C corporations: Debt never affects shareholder basis. Basis only changes from stock purchases, sales, or distributions.
4) Debt never decreases basis — it increases basis only when the owner is personally at risk.
How do ordinary income, tax-exempt income, and distributions affect a shareholder’s basis in an S corporation?
1) Shareholder basis is:
- Increased by: share of ordinary income, tax-exempt income, and contributions
- Capital gains (short- and long-term)
- Decreased by: distributions and share of losses
2) Tax-exempt income increases basis, even though it’s not taxable
3) Distributions do not affect taxable income, but they reduce basis
4) Basis can never go below zero
5) In this example, basis =
$12,000 (beginning)
+ $40,500 (ordinary income)
+ $5,000 (tax-exempt income)
− $51,000 (distribution)
= $6,500 ending basis
Does a shareholder’s basis in S corporation stock increase from taxable income, tax-exempt income, or both?
1) Basis is increased by the shareholder’s pro rata share of:
- Taxable income
- Tax-exempt income
- Capital gains (short- and long-term)
2) Both types of income raise basis, even though tax-exempt income is not taxed
3) This helps avoid double-taxing tax-exempt income later when the stock is sold
4) Failing to increase basis for tax-exempt income causes a larger gain (or smaller loss) on future stock sales
5) So the correct answer is: Yes to both taxable and tax-exempt income increasing basis
What common items do NOT affect a shareholder’s basis in S corporation stock?
1) S corporation debt (unless personally loaned by the shareholder)
2) Tax credits
3) Unrealized gains/losses
4) FMV changes of stock or assets
5) Accrued but unpaid expenses
6) Depreciation deductions (directly)
7) State/local tax refunds
8) Life insurance held by the S corp (no effect unless proceeds are passed through)
9) Wages paid to a shareholder do NOT increase basis.
What items increase or decrease a shareholder’s basis in S corporation stock?
1) Increases to basis:
- Capital contributions
- Ordinary business income
- Capital gains (short- and long-term)
- Tax-exempt income (e.g., municipal interest)
- Separately stated income items
2) Decreases to basis:
- Ordinary losses
- Capital losses (short- and long-term)
- Nondeductible expenses
- Distributions (cash or property)
3) Basis can never fall below zero.
4) All adjustments are made pro rata each year, and separately stated items must be handled individually on the shareholder’s return.
What is required to voluntarily terminate an S corporation election?
1) Consent from shareholders holding over 50% of total shares (voting and nonvoting)
2) File revocation with the IRS
3) If filed by March 15, takes effect that year; otherwise, next year
4) Nonvoting shares count toward the 50% test
What must a corporation consider before electing S corporation status?
1) Must have 100 or fewer shareholders
2) Shareholders must be U.S. citizens or residents, certain trusts, or estates
3) Must be a domestic corporation
4) Can only issue one class of stock
5) Must evaluate shareholder eligibility — one ineligible owner disqualifies the election
What types of expenses can an S corporation deduct, and what must be separately stated?
1) S corporations can deduct ordinary business expenses, including:
- Salaries to employees (even if shareholders)
- Interest paid to non-shareholders
- Employee benefit programs
2) Charitable contributions are not deductible at the S corp level
– They are separately stated and passed through to shareholders
– Deductibility is handled on each shareholder’s individual tax return
3) Items with special tax rules (like donations or capital gains) are always separately stated and not included in ordinary business income.
Who is ineligible to be a shareholder of an S corporation?
S Corporation Shareholder Eligibility
1) S corporations cannot have more than 100 shareholders.
2) Shareholders must be individuals, certain estates, or qualifying trusts.
3) Individuals must be U.S. citizens or resident aliens.
4) C corporations are not permitted to be shareholders in an S corporation.
5) Estates of deceased U.S. citizens and grantor trusts created by U.S. citizens are allowed.
6) Only one class of stock is allowed.
Key Rule:
- Domestic C corporations are ineligible to own S corp stock.
Starr is a 50% shareholder in an S corporation. At the beginning of the year, her stock basis is $10,000. During the year, the S corporation distributes $8,000 to her and incurs a $1,000 ordinary loss.
How much of the distribution is included in Starr’s gross income?
Answer: $0
1) S corporation distributions are non-taxable to the extent of the shareholder’s basis.
2) Distributions reduce stock basis first, and income is only recognized if distributions exceed basis.
3) Starr had a $10,000 basis. She received an $8,000 distribution, reducing her basis to $2,000.
4) Her share of the S corp’s $1,000 loss (50%) further reduces basis by $500, ending at $1,500.
5) Since the distribution did not exceed her starting basis, no part of it is taxable or included in gross income.
IRS Basis Adjustment Order:
a) Increase for income and gains
b) Decrease for distributions
c) Decrease for nondeductible, non-capital expenses
d) Decrease for deductible losses
Key Rule:
If a distribution exceeds stock basis, the excess is taxed as a capital gain and included in gross income.
If it’s within basis, it is a return of capital, and not included in gross income.
✅ Gross income includes both ordinary income and capital gains.
✅ Distributions only trigger gross income when they exceed stock basis.
If an S corporation makes distributions in excess of a shareholder’s basis in three consecutive years, how are those excess amounts treated for tax purposes?
Answer: Taxed as capital gains in all three years
1) Distributions from an S corporation are only tax-free to the extent of stock basis.
2) Any amount that exceeds a shareholder’s basis is taxed as a capital gain.
3) It does not matter how many years this occurs — if distributions exceed basis, the excess is always capital gain.
4) In this scenario, the excess distributions occurred in all three years, so:
- All excesses are taxed as capital gains, every year.
5) This rule applies consistently, regardless of how long the S corp has existed.
Key Rule:
- Excess distributions over basis are never tax-free
- They are always taxed as capital gains, regardless of timing or frequency
- Return of capital = non-taxable (within basis)
- Excess over basis = capital gain = gross income
A sole shareholder begins the year with $5,000 basis in their S corporation. During the year, the company distributes $3,500 to them and reports a $2,000 ordinary loss.
What portion of the loss can the shareholder deduct on their individual return?
Answer: $1,500
1) A shareholder can only deduct pass-through losses from an S corporation to the extent of their remaining stock basis.
2) Basis is reduced first by distributions, then by losses.
3) In this case:
- Starting basis = $5,000
- Distribution = $3,500 → basis drops to $1,500
- Loss = $2,000
- Deductible portion = $1,500
- The remaining $500 is suspended until basis is restored
4) Suspended losses carry forward and can be used in a future year when basis increases (from income or new contributions).
Key Rule:
- Losses are deductible only after basis is reduced by distributions
- Excess loss is not deductible now, but it’s not lost — it’s carried forward
What is the minimum wait period before a corporation can re-elect S status after termination, and when does termination take effect?
Answer: 5 years; timing depends on the termination type
After S status is terminated, the corporation must wait 5 years before making a new S election, unless the IRS approves early re-election.
The 5-year period starts in the tax year after the termination takes effect.
Termination effective dates:
- Voluntary:
- Revoked within first 2½ months → effective that same tax year
- Revoked after 2½ months → effective next tax year
- Involuntary (rule violation):
- Effective on the date the rule is broken
- Excess passive income + E&P (3 years):
- Effective first day of the 4th year
The IRS may allow early re-election if over 50% of the stock is now owned by shareholders who were not owners when the S status ended.
