Shareholders of existing S corporations should consider the following year-end planning tips:
- Shareholders must have basis in their stock or in loans to the corporation in order to take advantage of anticipated losses. Basis may be increased by additional capital contributions or direct shareholder loans to the corporation. Shareholder loans should always be well-documented.
- After a shareholder’s basis in stock of an S corporation has been reduced to zero, the shareholder’s basis in a loan to the corporation is reduced by pass-through losses and increased by the pass-through of subsequent years’ income. Because loan repayments may produce taxable income for the shareholder, they should be timed, if possible, to result in the least amount of tax. Advances should be evidenced by a written document in order to obtain favorable capital gain treatment if gain will result when the loan is repaid. Delaying loan repayments beyond 12 months (for long-term capital gain treatment) will allow any gain to be taxed at the lower (20%) capital gains tax rate.
- Distributions to shareholders which exceed the corporation’s accumulated adjustments account (AAA) may result in inadvertent dividends if the corporation has E&P accumulated from the time it was a C corporation. Therefore, distributions should be delayed if the amount of the AAA balance at year-end is uncertain.
- Dividends received by non-corporate shareholders from domestic and qualified foreign corporations are taxed at a maximum 20% rate. Accordingly, S corporations with C corporation E&P should avoid making an actual or a deemed dividend distribution of this E&P, unless there are other compelling reasons for generating taxable dividend income.
- Consider making gifts of S corporation stock to shift income between family members. Gifts of nonvoting stock may be made to keep voting control, if desired.
- Under certain conditions, an S corporation that sells appreciated property will be subject to tax on “built-in gains” (generally the property’s appreciation prior to the corporation becoming an S corporation). A built-in gain is determined as follows:
Total gain on asset’s sale $1,000,000
Less appreciation accruing while an
S corporation 300,000
Built-in gain $ 700,000
If an S corporation has sold property and recognized built-in gains, it should consider offsetting these gains by recognizing built-in losses. Alternatively, the built-in gains tax may be deferred or, in some circumstances, eliminated if the corporation’s taxable income can be eliminated.
Caution: Estimated taxes must be paid on net recognized built-in gains. (These estimates cannot be based on the preceding year’s tax, if any.)
The built-in gains tax generally applies only to gains recognized during a specified recognition period. Changes enacted by Congress over several recent years have resulted in the permanent reduction of the recognition period to five years, however, the recognition period for Iowa currently is ten years. Thus, for federal income tax purposes the tax will not be imposed if the S corporation had completed a five-year recognition period at the time the built-in gain is recognized. The tax applies when an S corporation has converted from C corporation status, but it also applies to assets that an S corporation has acquired from a C corporation in a tax-free transaction.
Other less recent changes have made more corporations eligible to become S corporations. For instance, financial institutions not using the reserve method of accounting can become S corporations; S corporations can have up to 100 shareholders and in determining the number of shareholders, extended family groups can be treated as a single shareholder; certain tax-exempt organizations can be shareholders; S corporations can hold controlling interests in other corporations; and wholly-owned domestic subsidiaries of S corporations can be disregarded as entities separate from their parent S corporations if an election is made by the S corporation.
In addition, income allocable to an employee stock ownership plan (ESOP) as a shareholder of an S corporation is not currently taxed, but rather is taxed to the ESOP beneficiary at the time of distribution.
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