Saturday April 20, 2024
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4.14.1 Sub S Taxation
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The most common type of corporation is a traditional "C corporation." All companies whose stock is publicly traded are C corporations. C corporations pay tax on their net income at the corporate level and then when that income is distributed to shareholders in the form of dividends, the shareholders also pay tax. The result is that C corporation income is taxed twice - once at the corporate level and once at the shareholder level.
"S" Election
"S corporations" resemble C corporations except that they elect to be taxed differently. Not all corporations are eligible to make this election. To make the election, a corporation must have only one class of stock and no more than 100 shareholders who are all individuals, estates, and certain types of trusts and charities. Sec. 1361.
"Pass Through" Taxation
An S corporation does not pay tax at the corporate level. Instead, the shareholders of an S corporation must include their share of the S corporation's income, deductions and credits on the shareholder's personal tax return – even if that income isn't actually distributed. This is called "pass through" taxation because the S corporation "passes" its income, deductions and credits "through" to its shareholders.
Inside and Outside Basis
The concept of tax basis appears regularly in the context of charitable giving. A person's initial tax basis in an asset is generally equal to his or her investment in that asset; often, tax basis is the amount a person paid for an asset (i.e., the asset's "cost" to them). When the fair market value of an asset is more than its tax basis, the asset is appreciated and, if sold, will result in taxable gain to the owner. Charitable giving often allows the owner of an asset to bypass or defer some of the gain.
With S corporations, this basis concept is more complex because there are two types of basis at issue. The first is the S corporation's basis in its assets - this is often referred to as "inside basis." The second is the shareholder's basis in his or her S corporation stock - this is often referred to as "outside basis." The shareholder's outside basis can be impacted (reduced) as a result of charitable giving by the S corporation itself.
The sale of an asset with a basis that differs from its fair market value will generally produce either gain or loss to its owner. For an S corporation disposing of an asset, the gain or loss on the sale to the corporation is determined by the difference between the sale price and the inside basis in the asset. In the same way, for a shareholder disposing of S corporation stock, the gain or loss is determined by the difference between the sale price and the S corporation's outside basis in the stock.
Charitable Gifts Involving Subchapter S Corporations
There are two possible charitable gifts involving subchapter S corporations. The first are gifts of corporate assets by the S corporation itself. Because S corporations are "flow through" entities that do not pay tax at the corporate level, any deductions flow through to the shareholders in proportion to their ownership interest or other partnership arrangement. The deduction amount is generally based on the fair market value of the assets gifted. Additionally, the deduction flowing through will force an adjustment of the shareholder's outside basis in the S corporation stock. The outside basis will be reduced by the basis of the corporation in the appreciated asset gift (but not below zero). Sec. 1367(a)(2). See GiftLaw 4.14.10.
The other type of charitable gifts involving subchapter S corporations are gifts of subchapter S corporation stock by shareholders. These are a bit simpler. The charitable deduction will be based on the fair market value of the stock and will be reduced if there is any ordinary income element attributable to the S corporation itself. Sec. 170(e)(1). See GiftLaw 4.14.10.
For example, an S Corporation made a gift of appreciated stock to charity with a cost basis of $200 and fair market value of $500. A pro rata amount of the $500 appreciated deduction flows through to each shareholder, who in turn reduces their stock cost basis by the basis allocated to this pro rata amount. The reduction is limited to the amount of the shareholder's outside basis - any unused deduction will be carried forward for use in a future year once the shareholder has acquired more outside basis.
Passive Income Limitations
Another unique aspect of S corporations is that they are subject to passive income limitations. Specifically, the passive investment income of an S corporation that has earnings and profits from previous years as a C corporation may not exceed 25% of that corporation's gross receipts for 3 consecutive years. For a discussion of how this impacts gifts of S corporation stock and assets, see GiftLaw Pro 4.14.7.
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Case Studies on Sub S Taxation
George's "Green" Sub S Gift On Hold:
George Green was a man of humble beginnings. He was born in Bulgaria and lived with his parents on their farm. But George was a diligent student and was determined to become a successful business owner. After high school he obtained permission to come to America to go to college.
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Private Letter Rulings
PLR
200644013 Built-in Gain for C Corp to S Corp Conversion:
Company reported taxable income as a C corporation until Date 1. Company elected to be taxed as an S Corporation beginning on Date 2. Company deals in residential and commercial real estate.
PLR
200830011 No Passive Rental Income for S Corporation:
Company (X), an S corporation, owns several commercial and rental real estate properties that are leased to tenants. Through its agent, X provides certain services in connection with leasing the properties which include maintaining and repairing the buildings, common areas and grounds, cleaning, painting, electrical, plumbing, roof and structural maintenance, garbage and recycling, landscaping and extermination services.
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