S Corporations and Exempt Organizations

Question 1

An S corporation does not file a tax return?

Answer 1

The tax treatment of S corporation items of income, loss, deduction, and credit is determined at the corporate level. The S corporation files a tax return (Form 1120S).

Question 2

An S corporation must have only one class of stock.

Answer 2

An S corporation must have only one class of stock. Variation in voting rights of that one class of stock is permitted. Rights to profits and assets on liquidation must be identical

Question 3

The number of shareholders in an S corporation may not exceed 75.

Answer 3

The number of shareholders in an S corporation may not exceed 100. A husband and wife are considered a single shareholder for this purpose. A nonresident alien (NRA) may not own any shares. Each shareholder must be either an individual, an estate, a single member LLC, or a qualified trust.

Question 4

A majority of shareholders at the time the S corporation election is made must file a consent.

Answer 4

An eligible corporation must make the election for S corporation status. All shareholders at the time the election is made must file a consent. In addition, each person who was a shareholder at any time during the part of the tax year before the election is made must also consent. If any former shareholders do not consent, the election is considered made for the following year.

Question 5

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

Answer 5

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

Question 6

Upon the occurrence of a terminating event, an S corporation becomes a partnership.

Answer 6

Upon the occurrence of a terminating event, an S corporation becomes a C corporation. The IRS may waive termination that is a result of the corporation’s ceasing to be a small business corporation or failing the passive income test for 3 consecutive years when it has Subchapter C earnings and profits (E&P) if the terminating event is found to be inadvertent and is corrected within a reasonable time.

Question 7

A majority of shareholders must consent to a revocation of an S corporation.

Answer 7

An S corporation election is terminated when a majority of the shareholders (voting and nonvoting) consent.

Question 8

Passive investment income (PII) termination occurs when, for 3 consecutive tax years, the corporation has both Subchapter C E&P on the last day, and PII that is greater than 10% of gross receipts.

Answer 8

Passive investment income (PII) termination occurs when, for 3 consecutive tax years, the corporation has both Subchapter C E&P on the last day, and PII that is greater than 25% of gross receipts.

Question 9

An S corporation is not required to use the accrual method.

Answer 9

An S corporation is not required to use the accrual method. Accounting method election is generally made by the S corporation.

Question 10

Generally, an S corporation must adopt a calendar tax year.

Answer 10

Generally, an S corporation must adopt a calendar tax year. With IRS consent, it may adopt a fiscal year, if it establishes a valid business purpose for doing so, that does not result in deferral of income to shareholders but coincides with a natural business year. A natural business year may end with or after the end of the peak period of a cyclical business. An S corporation that deposits the equivalent amount of the deferred tax may elect a fiscal year.

Question 11

A person who directly or by attribution owns more than 2% of the stock of an S corporation (voting power or amount) on any day during its tax year is treated as not being an employee entitled to employee benefits.

Answer 11

A person who directly or by attribution owns more than 2% of the stock of an S corporation (voting power or amount) on any day during its tax year is treated as not being an employee entitled to employee benefits. The S corporation must treat an amount paid for fringe benefits as deductible compensation, and the shareholder must include the amount in gross income. This rule does not apply to pension and profit-sharing plans.

Question 12

S corporation items of income, deduction, and credit, which could alter the tax liability of shareholders if taken into account by them on their personal returns, are required to be stated (and are passed through) separately.

Answer 12

S corporation items of income, deduction, and credit, which could alter the tax liability of shareholders if taken into account by them on their personal returns, are required to be stated (and are passed through) separately. Items not required to be separately stated are combined at the corporate level, and a net amount or ordinary income or loss is passed through to shareholders.

Question 13

The amount of each item that each S corporation shareholder takes into account is computed on a per-month and then a per-share basis.

Answer 13

The amount of each item that each S corporation shareholder takes into account is computed on a per-day and then a per-share basis. A stock transferor takes into account the per-day and per-share portions of the items through the day preceding the transfer. The transferee takes into account the remaining daily allocations for each share for the remainder of the tax year. Upon a termination of a shareholder’s interest during the tax year, an election is available to allocate items according to the books and records of the corporation (its accounting methods), instead of by daily proration.

Question 14

Pro rata shares of S corporation items passed through may be reallocated by the IRS among shareholders who are members of the same family.

Answer 14

Pro rata shares of S corporation items passed through may be reallocated among shareholders who are members of the same family. Distributive shares must reflect reasonable compensation for services or capital furnished to the corporation by family members. The IRS may disregard a stock transfer (by gift or sale) motivated primarily by tax avoidance.

Question 15

Any shareholder owning more than 2% of the stock in an S corporation is treated as an employee-owner rather than an employee.

Answer 15

Any shareholder owning more than 2% of the stock in the corporation is treated as an employee-owner rather than an employee. Thus, payments to accident and health plans, group-term life insurance coverage up to $50,000, medical reimbursement plans and disability plans, meals and lodging furnished for the convenience of the employer, cafeteria plans, qualified transportation benefits, and personal use of employer-provided property or services would all be treated as additional compensation to the shareholder.

Question 16

Accident and health insurance premiums paid by an S corporation for employee-owners are considered for services rendered.

Answer 16

Accident and health insurance premiums paid by an S corporation are considered for services rendered. The premiums are deductible by the S corporation and includible in the shareholder’s W-2. The premiums are excludable for Social Security and Medicare if the payments are made under a “qualified plan.” Qualified plans are those that treat all employees uniformly and do not give preferential treatment to key employees.

Question 17

A 2% or greater shareholder is not eligible for an above-the-line deduction on his or her personal return for medical insurance premiums paid for by the S corporation.

Answer 17

A medical insurance deduction is available for 2% or greater shareholders of S corporations for amounts paid by their corporation for health insurance on their behalf. The premiums must be included in wages of the 2% or greater shareholder. The deduction is allowed as an above-the-line adjustment on Form 1040 if the S corporation paid the premiums and the amount paid was included on the shareholder’s W-2.

Question 18

If an S corporation shareholder purchases stock, the shareholder’s original basis in the stock is its FMV.

Answer 18

Generally, if a shareholder purchases stock, the shareholder’s original basis in the stock is its cost.

Question 19

The shareholder’s portion of S corporations liabilities always increases the shareholder’s basis on the S corporation.

Answer 19

Generally, corporate level debt does not add to a shareholder’s basis. Two exceptions apply:

1) The shareholder makes payments on the loan
2) The shareholder is the primary signer on the note, and the S corporation is the guarantor.

Question 20

Any excess of each S corporation shareholder’s pro rata share of passed-through losses for the tax year over his or her amount at risk at the close of his or her tax year is not deductible in the current tax year.

Answer 20

At-risk rules are applied at the shareholder level. Any excess of each S corporation shareholder’s pro rata share of passed-through losses for the tax year over his or her amount at risk at the close of his or her tax year is not deductible in the current tax year. It is suspended and carried forward indefinitely until the shareholder’s amount at risk with regard to the particular activity has increased.

Question 21

Each S corporation shareholder’s at-risk amount equals cash and the adjusted basis of property contributed to the corporation minus amounts borrowed and lent to the corporation.

Answer 21

Each shareholder’s at-risk amount equals, basically, the sum of the following:

1) Money and the adjusted basis of property contributed to the corporation, and
2) Amounts borrowed and lent to the corporation to the extent the shareholder has personal liability for repayment or (s)he has pledged as security for repayment property not used in the activity (of the corporation). However, it does not include other debts of the corporation to third parties, even if the repayment is guaranteed by the shareholder.

Question 22

If the S corporation engages in rental activity or if a shareholder does not materially participate (even if the S corporation materially participates) in the trade or business conducted by the corporation, current deductibility of any losses passed through is limited at the shareholder level to passive activity income.

Answer 22

If the S corporation engages in rental activity or if a shareholder does not materially participate (even if the S corporation materially participates) in the trade or business conducted by the corporation, current deductibility of any losses passed through is limited at the shareholder level to passive activity income. A shareholder’s amount at risk must be reduced by the full amount allowable as a current deduction after application of the at-risk rules, even if part of it must be suspended by the passive loss rules.

Question 23

The accumulated adjustments account (AAA) represents the current cumulative balance of the S corporation.

Answer 23

The accumulated adjustments account (AAA) represents the current cumulative balance of all the separately stated items and nonseparately stated items (ordinary) of the S corporation. It is calculated without regard to any net negative adjustments (excess of losses and deductions over income and gains).

Question 24

An S corporation does not recognize a gain on the distribution of appreciated property.

Answer 24

An S corporation recognizes gain realized on the distribution of appreciated property (FMV > basis). The amount and character of the gain and its treatment are determined as if the distributed property were sold to the shareholder at its FMV. Ordinary income results if the property is depreciable in the hands of a more-than-50% shareholder.

Question 25

When loss property is distributed, a loss may be recognized by the S corporation.

Answer 25

When loss property (basis > FMV) is distributed, no loss may be recognized by the S corporation. The loss is passed through to the shareholders but is not deductible. Nevertheless, each shareholder must reduce the basis in his or her stock in the S corporation and take a FMV basis in the property distributed. Finally, the distributee shareholder must determine the proper treatment of the distribution. Sale instead of distribution results in pass-through of loss.

Question 26

Shareholder treatment of distributions from the S corporation is determined at the end of the S corporation’s tax year.

Answer 26

The AAA, OAA, bases in shareholders’ stock, and basis in corporate-shareholder debt must be adjusted for the S corporation’s items of income, deduction, etc., for the entire tax year before determining the proper treatment by the shareholders for the distributions.

Question 27

If an S corporation has Subchapter C E&P, the distribution is first treated as return of capital to the extent of the shareholder’s AAA balance and then to PTI (up to any basis in the shareholder’s stock).

Answer 27

If an S corporation has Subchapter C E&P, the distribution is first treated as return of capital (tax free) to the extent of the shareholder’s AAA balance and then to PTI (up to any basis in the shareholder’s stock). Any excess distribution over remaining basis distributed is treated as gain from the sale of the stock.

Question 28

An S corporation, with Subchapter C E&P at the close of its tax year and more passive investment income (PII) than 35% of its gross receipts, is subject to tax of 25% of excess net passive income.

Answer 28

An S corporation, with Subchapter C E&P at the close of its tax year and more passive investment income (PII) than 25% of its gross receipts, is subject to tax of 35% of excess net passive income. Net passive income is PII reduced by expenses directly attributable to its production.

Question 29

An S corporation that, upon conversion from C to S status after 1986, had net appreciation inherent in its assets is subject to tax of 35% on net gain recognized (up to the amount of built-in gain on conversion) during the recognition period.

Answer 29

An S corporation that, upon conversion from C to S status after 1986, had net appreciation inherent in its assets is subject to tax of 35% on net gain recognized (up to the amount of built-in gain on conversion) during the recognition period. For conversions made after the 2010 tax year, the recognition period is the 5-year period beginning on the date the S election became effective. The tax liability is passed through, as a loss, pro rata to its shareholders. It reduces basis in each shareholder’s stock and any AAA balance. Subchapter C E&P are not reduced by built-in gains tax liability.

Question 30

Any excess of the FIFO inventory value over LIFO inventory value at the close of the last tax year of C corporation status (before the S corporation election becomes effective) is gross income to a corporation that used the LIFO method to inventory goods.

Answer 30

Any excess of the FIFO inventory value over LIFO inventory value at the close of the last tax year of C corporation status (before the S corporation election becomes effective) is gross income to a corporation that used the LIFO method to inventory goods. Basis of the inventory is increased by the amount on which the recapture tax is imposed. The income is spread over 4 years: the last C corporation year and the first 3 years of the S corporation.

Question 31

An organization may qualify for exemption from federal income tax if it is organized and operated exclusively for one or more of the following purposes: charitable, religious, educational, scientific, literary, or testing for public safety.

Answer 31

An organization is tax-exempt only if it is of a class specifically described by the IRC as one on which exemption is conferred. Organizations formed and operated exclusively for religious, charitable, scientific, educational, literary, or similar purposes are a broad class of exempt organizations.

Question 32

Lending without adequate security is not a prohibited transaction for an exempt employee trust.

Answer 32

Certain employee trusts lose exempt status if they engage in prohibited transactions, e.g., lending without adequate security or reasonable interest or paying unreasonable compensation for personal services.

Question 33

An organization may qualify for exemption from federal income tax under Internal Revenue Code section 501 if it is organized and operated exclusively as a Political Action Committee.

Answer 33

Exempt status depends generally on the nature and purpose of an organization. An organization is tax-exempt only if it is of a class specifically described by the IRC as one on which exemption is conferred. Political Action Committees are specifically precluded from tax-exempt status.

Question 34

An organization that pays all of its profits to exempt organizations is conferred exempt status.

Answer 34

A feeder organization must independently qualify for exempt status. It is not enough that all of its profits are paid to exempt organizations.

Question 35

A tax-exempt organization that is required to file Form 990 must file the form by the 15th day of the fifth month following the end of its tax year.

Answer 35

Exempt organizations are generally required to file annual information returns (e.g., Form 990, Return of Organizations Exempt from Income Tax) on or before the 15th day of the fifth month following the close of the taxable year.

Question 36

An organization, other than a church or an employees’ qualified pension or profit-sharing trust, must apply in writing to its IRS district director for a ruling or a determination that it is tax-exempt.

Answer 36

An organization, other than a church or an employees’ qualified pension or profit-sharing trust, must apply in writing to its IRS district director for a ruling or a determination that it is tax-exempt.