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Calculating S Corp Stock and Debt Basis: Avoiding Loss Limitations and Excess Distributions

WEDNESDAY , AUGUST 16, 2017, 1:00-2:50 pm Eastern

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• Aug. 16, 2017

Calculating S Corp Stock and Debt Basis

Robert S. Barnett, Partner Capell Barnett Matalon & Schoenfeld, Jericho, N.Y . rbarnett@cbmslaw.com Darren J. Mills, Esq., CPA Mills Estate & Tax Law, Red Bank, N.J. djmills1267@gmail.com

Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

DARREN J MILLS, ESQ., CPA Mills Estate & Tax Law LLC Stock Basis: Mechanics; Loss Limitations; & Sale Transactions

DISCLAIMER

The views/content, typos, errors, etc. expressed herein are solely those of the

• presenter. The content herein is based on the Internal Revenue Code of 1986

(as amended) and the regulations thereunder. This material will not be updated for any changes in law and does not address and foreign or state and local tax

• issues. Please consult your individual advisor regarding any tax, legal or

accounting advice with respect to your personal situation.

6

CONTENTS

• Stock Basis: Mechanics
• Stock Basis: Loss Limitations
• Stock Basis: Sales Transactions
• Bio

7

STOCK BASIS: MECHANICS

8

STOCK BASIS: MECHANICS

• It is important that a shareholder know his/her stock basis when:
• The S corporation allocates a loss and/or deduction item to the shareholder.
• In order for the shareholder to claim a loss, they need to demonstrate they have adequate stock

and or debt basis.

• The S corporation makes a non-dividend distribution to the shareholder.
• In order for the shareholder to determine whether or not the distribution is a non-taxable they need

to have adequate stock basis.

• The shareholder disposes of their stock.
• As with any asset, including C corporation stock, when the assets is sold or disposed of, basis

needs to be established in order to reflect the proper gain or loss on the disposition.

• Since shareholder stock basis is an S corporation changes every year, it must be computed every year.
• Increase Basis.
• Ordinary Income
• Separately Stated Income Items.
• Tax Exempt Income
• Excess Depletion – the excess of the deductions for depletion over the basis of the property subject to

depletion

• Decreases Basis
• Ordinary Loss
• Separately State Loss Items
• Nondeductible Expenses
• Non-Dividend Distributions
• In no event may a shareholder’s stock basis be reduced below zero

9

STOCK BASIS: MECHANICS CONT’D

• Staring point:
• Substituted basis – Sec. 358
• Cost basis – Sec. 1012
• Gift/inheritance – Sec. 1014/1015
• Substituted basis
• Incorporation of either a sole proprietorship or partnership (including an LLC taxed

as a partnership) – The basis of the stock received (or deemed received in a meaningless gesture transaction) is the same as the adjusted basis of the property transferred.

• If money (including as assumed liability) or other property is received by the

transferor then special basis adjustment rules apply.

• Such basis is first decreased by the amount of money received, the fair market

value of any other property received, and any loss recognized on the exchange. The basis is then increased by any amount that is treated as a dividend and by the amount of any gain recognized as a result of the exchange (excluding that portion of the gain that is treated as a dividend).

10

STOCK BASIS: MECHANICS CONT’D

• Holding Period
• In a “sec. 351” transaction, the holding period generally “tacks”
• Loss Duplication Issues
• Policy – A single economic loss should not give rise to two tax deductions. This

result can occur as a result the mechanical application of the substituted basis rules. Generally, under Sec. 362, the transferee (e.g., an S Corporation) would take a “carryover basis” in the assets transferred to it. As such, if a shareholder transferred built-in loss assets in a Sec. 351 transaction, the S/H would take a substituted basis in the stock received under Sec. 358 and the Corporation would take a carryover basis under Sec. 362; therefore, as a result of the mechanical application of the basis rules two built-in losses arose from the same economic loss. According, with the AJCA Congress rectified this result with the enactment of Sec. 362(e)(2). If aggregate AB > aggregate FMV then basis is limited to aggregated FMV.

• Election available to reduce stock basis in lieu of the transferee’s basis in the built-in

loss asset. See Sec. 362(e)(2)9C) and the regulations thereunder.

11

STOCK BASIS: MECHANICS CONT’D

• Loss Duplication Issues – cont’d
• A, an individual, owns Asset 1 (basis $90, value $60) and Asset 2 (basis $110, value

$120). In a transaction to which Code Sec. 351 applies, A transfers Asset 1 and Asset 2 to X, a domestic corporation, in exchange for a single outstanding share of X stock representing all the outstanding X stock immediately after the transaction. A’s transfer of Asset 1 and Asset 2 is a Code Sec. 362(a) transaction. For purposes of Code Sec. 362(e)(2), X’s aggregate basis in those assets would be $200 ($90 + $110), which would exceed the aggregate value of the assets $180 ($60 + $120) immediately after the transaction. Accordingly, the transfer is a loss duplication transaction and A has a net built-in loss of $20 ($200 - $180). Asset 1 is loss duplication property since X’s basis in Asset 1 would be $90, which would exceed Asset 1’s $60 value immediately after the transaction. X’s basis in Asset 2 would be $110, which would not exceed Asset 2’s $120 value immediately after the transaction, so Asset 2 is not loss duplication property. X’s basis in Asset 1 is $70, computed as its $90 basis under Code Sec. 362(a), reduced by A’s $20 net built-in loss. X has transferred basis of $110 in Asset 2. Under Code Sec. 358(a). A has exchanged basis of $200 in the X stock it received in the transaction. Treas. Reg. § 1.362-4(h). Example 1(i).

12

STOCK BASIS: MECHANICS CONT’D

• Timing
• Adjustments are made as of the close of the corporation’s tax year
• If a S/H disposes of stock during the year, the adjustments are effective immediately

before the disposition (but note election)

• Ordering Rules for calculating basis post August 18, 1998 (Treas. Reg. § 1.1367-1(f))
• First, basis is increased for both separately stated and non-separately stated income

items an the excess of the deductions for depletion;

• Next, basis is decreased by items that are noncapital, nondeductible expenses and the
• il and gas depletion; and
• Finally, any decrease attributable to separately stated loss, deduction or credit items

as well as non-separately computed loss items

• Separate Basis Rule
• Under this rule, stock basis is computed on a share-by-share basis in the same manner

as that of a S/H in a C corporation

• The basis of a share of stock is decreased by an amount equal to the S/H’s pro rata

portion of the items described in § 1367(a)(1) or (a)(2) that is attributable to that share

13

STOCK BASIS: MECHANICS CONT’D

• Other Considerations
• A distribution ay be tax free to the S/H, but Sec. 311(b) continues to apply to a

distribution of appreciated property (i.e., any gain recognized in the deemed sale under Sec. 311(b) will pass through to all S/Hs)

• A S/H’s stock basis at the time of a distribution is irrelevant in determining the tax

treatment of the distribution:

• Basis at the close of the tax year determines the tax treatment of the distribution
• Under the stock basis adjustment rules, distributions made during a tax year are

taken into account before applying any loss limitation for the year

• Note that, under Sec. 1367(b)(2)(A), basis from indebtedness may ply be used

to deduct losses; it may not be used to receive tax-free distributions (cash received in connection with such loans must take the form of a loan repayment)

• S corporation rules adopt a separate basis approach for determining the basis

adjustments in S stock, computing stock basis on a share-by-share basis in the same manner as stock basis is computed doe a S/H in a C corporation

14

STOCK BASIS: LOSS LIMITATIONS

15

STOCK BASIS: LOSS LIMITATIONS

• Amount of losses that can be deducted by the S/H is limited to his/her adjusted basis in the

stock

• A loss that cannot be deducted due to a lack of basis is a “suspended loss”
• A suspended loss is an attribute of the individual S/H and cannot be used by other S/Hs
• If a shareholder transfers some but not all of the shareholder’s stock in the

corporation, the amount of any disallowed loss of deduction under this section is not reduced and the transferee does not acquire any portion of the disallowed loss or

• deduction. If a shareholder transfers all of the shareholder’s stock in the corporation,

any disallowed loss or deduction § 1.366-2(a)(6)

• No basis obtained in debt simply by guaranteeing a loan, etc. Payment on the loan must be

made by the S/H to get basis.

16

STOCK BASIS: LOSS LIMITATIONS CONT’D

• “Example: T is the sole shareholder of X, an S corporation. During 2005, X incurred

and passed through to T $6,000 in nonseparately stated loss and $4,000 in capital loss. However, T was unable to deduct any of the losses due to a lack of basis. In this situation, both losses are suspended, carry forward to 2006, and pass through again with respect to T. In 2006, X incurred and passed through $5,000 in nonseparately stated income and $2,000 in capital gain. This means that T is deemed to have $1,000 in

• rdinary loss ($6,000 − $5,000) and $2,000 in capital loss ($4,000 − $2,000) from X in
• 2006. These amounts must be compared with T’s basis at the end of 2006 to determine if

any of these amounts may be deducted. If not deductible, those amounts again carry forward and are combined with 2007’s passthrough results.” Starr and Sobol, 731-2nd T.M., S Corporations: Operations

• “Example: T is the sole shareholder of X, an S corporation. During X’s first three years
• f operations, it incurred losses totaling $100,000 that passed through to T. However,

because T only had basis of $20,000 in X, $80,000 of the losses were suspended. In the fourth year of operations, T sold his stock to B. In this situation, T’s suspended losses are lost forever (nor are they available to offset any gain from the sale of X stock).” Id.

17

STOCK BASIS: SALES TRANSACTION

18

THE SEC. 338(H)(10) ELECTION

Introduction

• When Available
• Available to any corporation that makes a Qualified Stock Purchase (QSP) of a Target

Corporation

• Target is an S Corporation or an 80% or greater corporate subsidiary member of a

consolidated group

• Also, Sec. 336(e) may be a viable alternative as it does not require a “corporate

purchaser” in a qualified stock disposition (“QSD”)

• Requirements
• Corporate Purchaser
• QSP: at least 80% (vote and value) must be acquired
• Joint election by buyer and seller: filed by the 15th day of the 9th month following

the month in which the acquisition occurs

19

THE SEC. 338(H)(10) ELECTION

Mechanics

• Treatment of Target Corporation:
• Target Corporation is deemed to sell all of its assets for an amount equal to the

Aggregated Deemed Sales Price

• Target Corporation reports gain or loss from deemed sale on its final tax return
• In the S Corporation context, gain or loss flows-through to selling shareholders

(generally no federal entity-;level tax is imposed on S corporations).

• Seller is responsible for any tax due on the deemed asset sale.

20

THE SEC. 338(H)(10) ELECTION

Mechanics

• Treatment of Target Corporation (continued):
• Target Corporation is deemed to liquidate at the end of the acquisition date
• If Target S Corporation is deemed to engage in a taxable liquidation. See Sec.

331 and 336. However, the gain or loss from the deemed asset sale flows through to the selling shareholders, increasing or decreasing their tax basis in their stock, respectively. As such, there generally is no incremental taxable gain upon the deemed liquidation of Target Corporation.

• At the beginning of the day after the acquisition date, Target Corporation is deemed

to reconstitute itself as a new corporation and purchase the assets.

• Target Corporation receives a tax basis in the assets equal to the Adjusted Grossed Up

Basis.

• Target Corporation uses the Residual Method to allocate the Adjusted

Grossed Up Basis.

21

THE SEC. 338(H)(10) ELECTION

Mechanics

• Treatment of Buyer
• Receives a cost basis in the stock of Target Corporation.
• Tax basis step up in target assets
• Increase in after-tax cash flow
• Takes the form of a stock sale for non-tax reasons
• Note: historical business & tax exposures carryover

22

THE SEC. 338(H)(10) ELECTION

Mechanics

• Treatment of Sellers
• The stock sale is ignored for federal income tax purposes
• Single level of tax (no shareholder level gain). The gain or loss from the deemed sale
• f the Target Corporation’s assets flows through to the shareholders and is reported
• n their federal income tax returns.
• May be additional taxes (federal + state) – for which seller may require “gross ups”
• Complications in rolling shareholders – rollover is taxable as if stock was sold

23

THE SEC. 338(H)(10) ELECTION

Summary

• Note that in the case of a Sec. 338(h)(10) election, there is only one level of tax.
• Because the deemed asset sale generally results in ordinary income, while the sale of stock

results in capital gain or loss, the sellers may, in certain cases, pay more tax under a Sec. 338(h)(10) election than under a stock sale.

• Individual capital gain tax rates vs. ordinary income tax rates (23.8% vs. 39.6%),

although, see Sec. 1231.

• State taxes (including entity-level taxes), Sec. 1374 BIG tax, etc.
• In order to make the sellers whole, the purchaser can Gross Up the sellers by increasing the

purchase price to accommodate for the incremental tax that the sellers must suffer as a result of making the Sec. 338(h)(10) election.

• The Gross Up Payment is included in the computations for Aggregate Deemed Sales

Price and Adjusted Grossed Up Basis.

• May result in additional depreciation or amortization deductions.
• A Sec. 338(h)(10) election generally makes sense if the present value of the additional

depreciation and amortization deductions that result from making the election exceed the amount of the Gross Up Payment.

24

THE SEC. 338(H)(10) ELECTION

Summary

$300 Seller (“S”) $300 + $100 Assumption of Debt Step 2 Old T Liquidaes “DEEMED” OLD T (S Corp) Corporate Buyer (“B”) “ACTUAL” Stock Step 1 Assets New T (C Corp) (basis=$200) “DEEMED”

Assumptions  Seller’s outside stock basis = $100  T’s inside asset basis = $200  T’s liabilities = $100  Buyer Pays $300 for stock

Cost Basis in T Stock = $300 Stock = $300 Carryover Basis up to $400 Stock Sale 338(h)(10) Buyer “B” Seller “S” Target “T” Cost Basis in T Capital / Ordinary Gain = $200 ($300 + Capital Gain = $200 $100 - $200) on deemed sales is passed through from Target; No gain on liquidation No Gain; Gain passed through to S; Basis is stepped

25

THE SEC. 338(H)(10) ELECTION

The Malpractice Transaction

Historical S/H PE PE

Cash

Historical S/H

Holdco Holdco

Stock

Buyer Target Buyer Target (S Corp)

• Buyer purchases the stock of Target from Historical S/H for cash, and both parties make a Sec.338(h)(10)

election.

• Historical S/H rolls part of his proceeds (7%) into Holdco, such that after the transaction is

consummated he is a partner in Holdco along with PE.

• The Sec. 338(h)(10) election was invalid because Historical S/H would be viewed as a related party

, and you can’t do a Sec. 338(h)(10) election with a related party .

• A very harsh and unfair result. Had Historical S/H rolled his interest into Buyer, it would not have been a
• problem. The Sec. 336(e) rules partially address this issue.

26

THE SEC. 338(H)(10) ELECTION

Other Considerations

• Rollovers where the Seller ends up with more than 20% are not good QSPs
• S Corp status must be valid as a 338(h)(10) can’t be made on a stand-alone “C” corp.
• Gross-up for Incremental taxes
• Built-in gains taxes (S corporations
• State Taxes
• Character of taxable gains (ordinary versus capital)

27

BIO: DARREN J MILLS

28

DARREN J MILLS, ESQ., CPA

Darren is an attorney licensed in the State of New Jersey and the Commonwealth of Pennsylvania. He is also a licensed CPA in the States of New Jersey and Florida. He has taught numerous graduated level tax classes as well as professional continuing education. Darren earned his undergraduate and law degree from Seton Hall University. He also has a Masters in Taxation from Fairleigh Dickinson University where he was inducted into the tax honor society. Finally, Darren has authored articles on various tax and elder law

• issues. He can be reached at djmills@millstaxlaw.com

29

S CORPORATION – LOSS UTILIZATION

By Robert S. Barnett

CPA, JD, MS (TAXATION) CAPELL BARNETT MATALON & SCHOENFELD, LLP. ATTORNEYS AT LAW (516) 931-8100 rbarnett@cbmslaw.com

LOSS UTILIZATION

• IRC §1366(d)(1): S Corp losses and

deductions limited to extent of SH’s basis in stock PLUS corporate debt to SH. Basis determines: –Deductibility of losses and deductions –Taxability of distributions –Gain/Loss on sale of stock

• Contribution to Capital raises Stock Basis
• WATCH AT RISK REQUIREMENTS

32

LOSS ORDERING

• First apply At-Risk Rules & Basis
• If Limited by § 465 – not a PAL
• If Insufficient Basis – not a PAL for

year

• When Limitations Removed – PAL

applies

• Therefore, must pass Basis & At-

Risk Tests

33

RATABLE SHARE

• If part of S loss is disallowed § 1366(d)
• Ratable portion of each S loss item is

disallowed

• Permitted to compute limitations on net

loss

• Unless individual item taxed differently
• Ex. Part of Passive Rental Activity

34

HOW IS BASIS CREATED?

• Purchase / Gift / Inheritance
• Contribute cash or property (less

liability assumed) KEEP RECORDS & RETURNS

• Accumulated and undistributed income
• Tax-exempt income
• Reduced by distributions losses and

nondeductible expenses

35

INHERITANCE

• §1367(b)(4)(B)
• Reduction of FMV Basis
• By portion of value of stock

attributable to IRD

36

EXAMPLE

• Inherit 20% S Corp.
• S Corp. fmv $1 million
• Including $500k cash A/R
• Basis = $100k

37

• REG. 1.1367-1 BASIS
• Stock Basis purchase/ gift / inheritance
• Increase by K-1 income items & tax free
• Pro rata – per share per day
• Decrease (not below 0) k-1 losses &

distributions

• Compute at end of year (or before

disposition)

38

BASIS CONTINUED

• Contribute property – basis less liability

assumed, WATCH §357(c)

• EXAMPLE: Property Basis $40,000, Value

$100,000 and mortgage of $30,000 is contributed: STOCK – BASIS $10,000

• Special Estate Considerations – reduction

for IRD type items

• Ordering Rules – will be discussed

39

BASIS DETERMINES

• Deductibility of losses and deductions
• Taxability of distributions
• Gain/Loss on sale of stock

40

LOSS UTILIZATION

• IRC §1366(d)(1)
• LIMITS use of S Corp losses and

deductions to extent of shareholder’s basis in stock

• PLUS Corporate debt to shareholder.

41

LOSSES - UTILIZATION

• 1. First §1366(d)(1) Stock Basis
• 2. Then reduces Basis in debt to Corp
• 3. Remainder carried forward
• REMEMBER – basis does not

include guarantees or circular loans

• Back-to-Back – must be bona fide
• See §1.1366-2(a)(2)(i) & (iii),ex. 2

42

BASIS

• Barnes v. Comm., 111 AFTR 2d 2013 (DC

Cir)

• Affirmed Tax Court, TCM 2012-80 – reduce

basis even if fail to deduct the loss

• S SHs inadequate basis
• Unable to deduct losses – limited to basis
• Basis not increased by prior losses not

claimed

• Taxpayer failed to deduct suspended losses
• Statute of limitations expired

43

LOSS UTILIZATION

• Gleason v. Commissioner, TCM 2006-191 (9/11/06)

– Taxpayer won as borrower on a $6m loan – IRS re-characterized loan properly made by taxpayer because loan payments paid by Corp and stock was pledged as collateral

• Kerzener, TCM 2009-76

– CIRCULAR LOAN from p’ship to S SH to S corp did not create basis. – S Corp paid equivalent rent back to the p’ship. – Transaction lacked economic substance – MERE CONDUIT – No sufficient risk – Court distinguished Ruckriegel and Culnen

• Nathel, 105 AFTR 2 ¶ 2010-927 (2nd Cir. 6/2/10)

– Equity and debt are distinguishable – Contribution of equity increases basis of stock but does not restore loan basis – CONTRIBUTIONS TO CAPITAL ARE NOT INCOME!

44

NATHEL

• Attempted to restore or increase loan basis
• Corp. repaid shareholder loans with

reduced basis (from losses)

• Recognized Ordinary Income on

repayment of loan

• Capital contributions do not create exempt

income (income increases loan basis)

• Supreme court denied cert.

45

Culnen, TCM 2000-139

• Distributions from profitable S to loss S

added to basis > $3 Mil:

• i. amounts came out of S earnings,
• ii. always shown on books as loans

to/from shareholder, and iii.all bank financing statements showed the loans as personal, not corporate.

• IRS permits Back to Back loans (bona fide)

46

BACK TO BACK LOANS

• Prop. Reg. §1.1366-2
• “Bona fide indebtedness”
• All facts & circumstances considered
• General tax principles
• MAGUIRE, TCM 2012-160
• Auto dealer and finance company
• Finance A/R distributed then

contributed

47

BONA FIDE DEBT

• Watch Second Class of Stock

Rules

• Straight Debt Safe Harbor
• Reg. §1.1361-1(l)(5)

48

DEBT v. EQUITY

• Transfers to Corp generally equity, not loan
• Capital contribution
• Corp’s payment of personal expenses =

dividends

• Not repayment of loan
• No debtor/creditor indicia
• ACM Environmental Services, TCM 2012-335
• Proper documentation missing

49

NOT BONA FIDE DEBT

• No Bad Debt Deduction –Herrera v.

Comm’r, 112 AFTR2d 2013-6858 (5th Cir.)

• LLC (partnership) Loans to related steel

corp.

• No written promissory notes
• No definite maturity
• No repayment schedule
• No security – no payments

50

OPEN ACCOUNT DEBT INTRODUCTION

• Brooks v. Commissioner –

TCM 2005-204 (August 25, 2005)

• Final Regulations

51

LOANS

• Assume Stock Basis $100
• If X $200 loss, shareholder deducts only

$100

• §1366(d)(1) deductions limited to Basis
• Basis can never be negative
• So shareholder loans $100 to Corp on

12/31

• Stock Basis & Loan Basis is $0
• Later income first restores Loan Basis

52

OPEN ACCOUNT DEBT

• Shareholder loans/advances not

evidenced by written instrument

• New Regulations – advances

10/20/08 and thereafter

• Limit $25,000 per Shareholder
• EXAMPLE – Each Sh. can have up

to $25,000 of Open Account Debt

53

BE CAREFUL

• No Shareholder exceeds limit
• Keep records per Shareholder
• Not day/day – END OF S YEAR
• Unless debt disposed or

Shareholder terminated

54

WHAT HAPPENS

• When $25,000 limit exceeded
• Debt at end of year treated AS IF

evidenced by separate written agreement

• No longer Open Account Debt
• Debt existing on 10/20/2008 is not

subject to new rules and is treated as a separate loan

• Identification issues exist

55

LOSSES – ORDERING RULES

• Losses first absorb Stock Basis
• Then reduce Debt Basis
• NOT BELOW ZERO
• Multiple indebtedness – Loss

Allocated

• Based upon aggregate Basis
• Intricate record keeping required

56

RESTORATION

• Distinction between Stock & Debt Basis
• “Net Income” restores Debt Basis first
• “Net Increase” is §1367(a)(1) income

items

• New contribution(s) - increase Stock

Basis (Nathel)

• Computations generally determined at

end of the year

57

COMPUTATION

• Advances and Repayments are netted
• At close of S Corp year
• Net Advance or Repayment is combined with

Principal balance of Open Account Debt

• Carried to next year (unless > $25,000)
• IF > $25,000 – no longer Open Account Debt
• Treated as if separate debt.

58

EXAMPLE ONE

• A’s Stock Basis is $0
• 6/1/09 A loans S $16,000 (no note)
• 12/31/09 – Open Account Debt =

$16,000

59

EXAMPLE TWO – 2009 STOCK BASIS $0

• A lends $16,000 6/1/09
• 12/31/09 Loss <$8,000>
• A’s BASIS in Open Account Debt

is $8,000

• Principal Loan amount remains

$16,000

60

EXAMPLE THREE – 2010

• A Stock Basis = $0 Loan Basis =

$8,000 (principal $16,000)

• 4/1/10 – S Repays to A $4,000
• 9/1/10 – A Advances $1,000 (net

$3,000)

• 12/31/10 – Debt Principal $13,000
• Still open Account Debt

61

EXAMPLE THREE CONTINUED

• A Ordinary Income $1,500

(8/16 x $3,000 Net Repayment)

• IF evidenced by note Capital Gain
• Debt treated “as if” evidenced by note,

tax effect not addressed

• 12/31/10 – Open Account Debt Principal

$13,000

• Carried to 2011

62

EXAMPLE FOUR (ex. 3 FACTS)

• 2/1/11 – S Repays A $5,000
• 3/1/11 – A Advances $20,000
• Not evidenced by a written agreement
• 2011 Net Advance $15,000
• Debt $28,000 (> $25,000 – not Open

Account Debt)

• Treated as if evidenced by a separate

written agreement – maintain records

63

REPORTING REQUIREMENTS

• Must keep records per shareholder
• IF hold more than one indebtedness at close
• f year –
• Basis is reduced proportionately to

aggregate Basis

• Net increase is applied to first restore debt

basis before stock basis

• First restore Basis of any debt which is

repaid during year

64

WHO CARES?

• The IRS & the Treasury
• $25,000 limitation eliminates Year End

Repayments

• Mixed blessing
• Gain on Repayment of Debt evidenced

by notes is CAPITAL GAIN

• Repayment of Open Account Debt with

reduced basis = ORDINARY INCOME

66

NATHEL

• Attempted to restore or increase loan basis
• Corp. repaid shareholder loans with

reduced basis (from losses)

• Recognized Ordinary Income
• Capital contributions do not create exempt

income (income increases loan basis)

• Supreme court denied cert.

67

PLANNING

• Reduce YE Balance < $25,000
• Use Note – Capital Gain
• Do Not Repay
• Identify Debt Repaid
• Contribute to Capital

68

SCOTT SINGER INSTALLATIONS

• INC. – TCM 2016-161
• IRS – payment of personal expenses

WAGES

• TP Advanced $ to Corp.
• Corp. paid TP’s expenses
• TP – Loan repayment not wages
• No Notes or Debt Acknowledgement

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SHAREHOLDER LOAN SUFFICENT?

• Court Said Yes
• In years Co. was profitable
• In other years No!
• Look at all factors
• Need Debtor/Creditor Relationship

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S CORP DISTRIBUTIONS

• Goals:
• 1. Avoid/Defer taxation
• 2. Avoid C corp taxation
• 3. Preserve S election
• 4. Maximize tax-free $

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BASIS DETERMINES

• Deductibility of losses and

deductions

• Taxability of distributions
• Gain/Loss on sale of stock

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S CORP DISTRIBUTIONS

• Initial question:
• Does S corp have AEP?
• Accumulated Earnings & Profits
• Next compute Basis

73

EARNINGS AND PROFITS (E & P)

• Measures ability to pay

Dividends

• Net profits after SH Dividends
• Special adjustments
• Cumulative computations

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Example

• Accumulated deficit of

$20,000

• Current E & P of $10,000
• Distribution of $10,000
• Taxable Dividend
• Wait until next year

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C Corp w/ AEP  S Election

• C corp has $100 AEP
• C corp makes S election
• C corp becomes S corp
• S corp has $100 AEP

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STOCK BASIS DECREASE

• Deductions and Losses
• NOT below zero
• Distributions
• Nondeductible expenses

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BASIS ADJUSTMENTS

• Per share, per day
• At year end, generally
• First increases, then decreases
• Special election – to close books

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S Corp Distribution – No AEP

• No tax to extent of Basis
• Distribution  Decrease Basis
• Yearly adjustment
• Distributions > Basis  capital gain
• AAA Irrelevant

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NO AEP – EXAMPLE

• Bob owns all S corp stock
• Basis = $10K on 1/1/2015
• During 2015:
• $30K ordinary loss
• $10K distribution

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NO AEP – EXAMPLE

• Distribution = Basis
• Bob not taxed on distribution
• Decrease Basis to $0
• No Basis  $30K loss

suspended

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DISTRIBUTIONS IF AEP

• 4 Tiers:
• 1. Tax free to AAA (Accumulated

Adjustments Account, Up to Basis)

• 2. Dividend to AEP
• 3. Return of capital – Basis
• 4. Excess: Gain sale or exchange

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AAA (1982)

• Previously Taxed Income
• §1368(e)(1)(A) – corp. attribute
• Computed similar to Basis, except:
• No adjustment for exempt income
• No adjustment for C level taxes
• CAN BE LESS THAN ZERO
• But not by distributions

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AAA Adjustments

• INCREASE
• Non-separately stated income
• Separately stated income
• DECREASE
• Non-separately stated loss
• Separately stated loss
• Distributions

84

AAA Stock Sale/Redemption

• Stock sale to 3rd party:
• AAA unaffected
• AAA affects transferee’s distributions
• Redemption:
• Reduces AAA
• Based on ratio of shares redeemed

85

1ST: Net Positive or Net Negative?

• Net Positive:
• (income + gain) > (loss + deduction)
• NOT including distribution(s)
• Net Negative:
• (loss + deduction) > (income + gain)
• NOT including distribution(s)

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2ND: Timing

• Net Positive AAA Adjustment:
• Adjust AAA BEFORE taxing

distribution

• Net Negative AAA Adjustment :
• Adjust AAA AFTER taxing distribution
• Allows more tax-free basis return

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3RD: Default Order

• 1. To extent AAA, Capital Return
• 2. Then Dividend to AEP
• 3. Then Capital Return to Basis
• 4. Excess is Capital Gain

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S Corp w/ AEP – Example 1

• Joan owns 100% S Corp:
• Basis = $10K on 1/1/2015
• AAA = $2.5K
• AEP = $8.5K
• In 2015:
• $10K income
• $3K loss
• $12K distribution

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Example 1 (Net Positive)

AAA AEP S Corp Dist. C Corp Dist. Starting $2,500 $8,500 Increase AAA: net positive $7,000 AAA balance before Dist. $9,500 Decease: distribution $9,500 $9,500 Ending AAA $0 Distribution from AEP $2,500 $2,500 Ending AEP $6,000

• Dividend $2500

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Example 1 Basis

Basis

Starting

$10,000

Increase for income

$10,000

Basis before distribution

$20,000

Decease for dist. not taxed as dividend

($9,500)

Decrease for losses

($3,000)

Ending Basis

$7,500

• Return of capital $9500

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Example 1

• $10K Pos. Adj. > $3K Neg. Adj.
• $10K - $3K = $7K Net Positive Adjustment
• Adjust AAA BEFORE taxing distribution
• AAA increased by $7K  $9.5K
• First: Capital return to extent of AAA
• AAA = $9.5K; Capital Return of $9.5K
• AAA decreased by $9.5K  $0

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Example 1

• Distribution $12K – $9.5K AAA = $2.5K
• Second: Dividend to extent of AEP
• Remaining $2.5K < 8.5K AEP
• Dividend of $2.5K
• AEP Adjustment
• $8.5K - $2.5K dividend = $6K

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Example 1

• Basis Adjustment
• $10K at start
• Increase $10K income  $20K
• Decrease $9.5K capital return  $10.5K
• Decrease $3K loss  $7.5K
• (AAA = 0)

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Example 2 (Net Negative)

• Sally owns 100% S Corp:
• Basis = $2,000 on 1/1/2015
• AAA = $300
• AEP = $500
• In 2015:
• $200 capital gain
• $1,000 loss
• $2,000 distribution

95

Example 2

AAA AEP S Corp Dist. C Corp Dist. Starting $300 $500 Decrease: distribution (not below zero) ($300) $300 AAA Balance after dist. $0 Decease AAA: net negative adjustment ($800) Ending AAA ($800) Distribution from AEP ($500) $500 Ending AEP $0

• Dist. in excess of AAA/AEP

$1200

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Example 2

Basis

Starting

$2,000

Increase for Income

$200

Decease for Dist. not taxed as dividend

($1,500)

Basis after distributions

$700

Decrease for losses

($700)

Ending Basis

$0

Suspended losses

$300

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Example 2

• $1,000 Neg. Adj. > $200 Pos. Adj.
• $1,000 - $200 = $800 Net Negative

Adjustment

• Adjust AAA AFTER distribution

1. Beginning AAA $300 distributed TAX FREE! 2. AAA negative (not Basis) 3. AAA reduced by full net negative adj.

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Example 2

• First: Capital Return to extent of AAA
• AAA = $300 capital return
• AAA decreases by $300  $0
• THEN apply Net Negative Adjustment
• $800 Net Negative Adjustment
• Decreases AAA by $800
• AAA = -800

99

Example 2

• Second: Dividend to extent of AEP
• $500 of remaining distribution
• Dividend of $500
• AEP  0
• Third: Adjust Basis  Capital Return
• Remaining $1,200 of $2,000

distribution

• Capital Return of $1,200 + $300

100

Example 2

• Basis Adjustment & Suspended Loss
• Basis = $2,000 at start
• Increase for $200 income  $2,200
• Decrease for $1,500 Capital Return 

$700 ($300 AAA + $1,200 remaining distribution)

• Decrease for $700 loss  $0
• Basis cannot be < zero
• Remaining $300  suspended loss

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Property Distribution

• Similar rules apply
• Distribution = FMV
• Gain as if sold § 311(b)
• Gain to extent FMV exceeds basis
• Gain passes to SH, increases stock

basis

• Property Basis = FMV
• SH Basis decreased by property FMV

102

Depreciated Property Distribution

• Generally no loss allowed, § 311(a)
• Value of dist. is FMV of property
• SH Basis in property is FMV
• Treated as non-deductible, non-capital
• expense. CCA 201421015.
• AAA & SH Basis reduced by loss
• Sell Property!

103