Taxable Income and Waiver of tax with S corporation

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Waiver of Tax

The IRS may waive the tax on excess net passive income if the S corporation establishes to IRS’s satisfaction that:

(a) It determined in goodwill that it had no pre-S corporation earnings and profits at the close of the tax year, and

(b) During a reasonable period after it was determined that it did have such earnings and profits at the close of the tax year, the earnings and profits were distributed.

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Tax Preference Items

If an S corporation (or any predecessor) was a regular corporation for any of the three immediately preceding tax years, the S corporation is required to adjust tax preference items. In determining its income or loss from operations for tax purposes, these items, which are also items subject to alternative minimum tax and are considered tax preference items, must be adjusted as follows:

1. Section 1250 capital gain treatment. For §1250 property that three of during the tax year, 20% of any excess of (Quoted) the amount that would be ordinary income if the property were §1245 property,¨ over the amount treated as ordinary income under §1250, is treated as ordinary income under §1250 and will be recognized. Section 1250 property includes all real property that is subject to an allowance for depreciation, and that is not or has never been §1245 property. Section 1245 property includes any property that is or has been subject to an allowance for depreciation, and that is personal property (both tangible and intangible), and particular other property.

2. Percentage depletion. For iron ore and coal (including lignite), the amount allowable as a percentage depletion deduction is reduced by 20% of any excess of the amount of the percentage depletion deduction allowable for the tax year (determined without this adjustment), over the adjusted basis of the depletable property at the close of the tax year (figured without the depletion deduction for the tax year). Quoted from IRS

3. Pollution control facilities. The amortizable basis of pollution control facilities is reduced by 20% for purposes of determining the amortization deduction for that property.

4. Mineral exploration and development costs. The amount allowable as a deduction for mineral exploration and development costs is reduced by 30%. Special rules apply to the amount not allowed because of this adjustment. This reduction also applies to the intangible drilling costs of an integrated oil company.

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If an adjustment is made to a tax preference amount under the above rules, then an appropriate adjustment must be made to reduce the tax preference item for purposes of the alternative minimum tax.

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READ: About Publication 535, Business Expenses

LIFO Recapture Tax

If a corporation made an election to be an S corporation after December 17. 1987, and used the LIFO inventory pricing method for its last tax year before its S election became effective, the corporation may be liable for LIFO recapture. The LIFO recapture tax is figured for the pre-S corporation’s last tax year. The LIFO tax is paid in four equal installments. The first installment is due with the corporation’s Form 1120 or Form 1120A for the corporation’s last tax year, and the three remaining deferral installments are paid with the corporation’s Form 1120S for the next three tax years.

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READ: Topic Number 409 – Capital Gains and Losses

Capital Gains Tax

An S corporation that elected S corporation status before 1987 may be liable for a capital gains tax if:

(1) Its net long-term capital gain exceeds its net short-term capital loss by more than $25,000,

(2) The excess is more than 50% of the corporation’s taxable income, and

(3) The taxable income is more than $25,000. If the S corporation is also liable for the tax on excess net passive income, it should figure that tax before it figures its capital gains tax. 9-39Before an S corporation can decide whether it is liable for the capital gains tax, it must:

(1) Reduce its capital gains to the extent they are subject to the tax on excess net passive income, and

(2) Figure its taxable income.

READ: S Corporation Stock and Debt Basis

Reducing Corporate Capital Gains

If the S corporation is subject to the tax on excess net passive income, it must reduce its capital gains by the share of excess net passive income that is due to the capital gains. This reduced capital gain is the amount used to decide whether the corporation must pay a capital gains tax and how much is due.

Figuring Corporate Taxable Income

Although an S corporation’s taxable income is generally figured like a partnership’s for filing a return, taxable income for the tax on capital gains, the tax on built-in gains, discussed later, and the limit on excess net passive income is figured, with certain modifications, as though the corporation is filing a corporate tax return. Taxable income is the gross income of the corporation minus most deductions, including the amortization deduction for corporate organization costs allowed to a corporation. But it does not include the net operating loss deduction or other special deductions for corporations, such as the dividends received deductions.

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READ: Capital Gains in an S Corp

Recapture of Investment Credit

This tax may apply if the corporation claimed investment credit on a prior year’s corporate income tax return before it became an S corporation. If the S corporation makes an early disposition of the property, the S corporation, and not its shareholders, will be liable for payment of the tax.

Estimated Corporate Tax Payments

If an S corporation’s tax liability for certain capital gains, net recognized built-in

gain, excess net passive income, and recapture of investment credit totals $500 or

more, the S corporation must pay quarterly estimated tax payments.9-42

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