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S Corporation
At-Risk Rules – §465
At-risk rules may limit an S corporation shareholder’s deductible loss from an activity conducted an S corporation. These limitations apply at the shareholder level. An S corporation shareholder’s amount at risk equals:
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(1) The shareholder’s cash contributions and the adjusted basis of other property that the shareholder contributed to the S corporation, plus
(2) Funds borrowed for use in the activity that the shareholder is personally liable for the repayment of, or has pledged property not used in the activity as security for the borrowed amount. To determine if the at-risk rules apply to an activity, the S corporation must identify each activity engaged in. Therefore, when the S corporation is involved in more than one activity, and one or more of the activities incur a loss for the year, the profit and loss of each activity is figured separately. The S corporation should provide each shareholder with a schedule that reflects that shareholder’s part of gross income and deductions for each activity. Separate activities must be combined and treated as one activity if:
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(1) The shareholder actively participates in the management of the trade or business, or
(2) 65% or more of the losses from the operations are allocated to people who actively take part in the management of the trade or business.Also, all activities involving tangible personal property leased or held for lease must be treated as one activity. The at-risk rules do not apply to an activity of holding real property (other than mineral property) if the asset was used in service before 1987, and the shareholder acquired the interest in the S corporation before 1987. However, the at-risk rules do apply to losses from an interest in an S corporation acquired after 1986, regardless of when the property used in the activity of holding real property was placed in service.
Reasonable Compensation
If a family member renders services to an S corporation, there must be reasonable compensation to that individual before allocation of the remaining income to stock held by other family members (§1366(e)). This provision prevents the use of an S corporation to split personal service income.
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What is a Reasonable Salary for an S Corporation Officer?
Related Party Rules
Sales or exchanges of property between related parties generally may not be deducted (§267). If the related party who acquired the property on which the loss was disallowed later resells the property at a gain, the gain is recognized only up to the amount that is more than the disallowed loss.
Definition of Related Party
Related parties include the following:
(a) When corporations that are part of the same controlled group of corporations determined by applying a 50% ownership test,
(b) An individual and a corporation if the individual owns more than 50% of the value of the outstanding stock,
(c) A trust fiduciary and a corp. if the grantor or trust of the trust owns “more than 50% in value of the outstanding stock of the corporation,” (Quoted from IRS)
(d) The grantor and a fiduciary of any trust,
(e) A fiduciary of a trust and a beneficiary of the trust,
(f) Any two S corporations if the same persons own more than 50% in value of the outstanding stock of each corporation,
(g) An S corporation and a corporation that is not an S corporation if the same persons own more than 50% in value of the outstanding stock of each corporation, and
(h) A corporation and a partnership if the same persons own more than
50% in value of the outstanding stock of the corporation and more than
50% of the capital interest, or profits interest, in the partnership. Quoted from IRS Ordinary or Capital Gain or Loss
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Stock Attribution Rules
In deciding whether a person owns any of the outstanding stock of a corporation, the following rules apply:
(a) “Stock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust is treated as being owned proportionately by or for its shareholders, partners, or beneficiaries,” Quote origin IRS; Sales and Exchanges Between Related Persons
(b) An individual is treated as owning the stock owned, directly or indirectly, by or for his or her family, (Quotes IRS)
(c) Any individual owning, other than applying paragraph (a), any stock in a corporation is treated as owning the stock owned, directly or indirectly, by or for his or her partner, (Quotes IRS)
(d) The family of an individual includes only his or her brothers and sisters (half-brothers or half-sisters), spouse, ancestors, and lineal descendants, and
(e) Stock constructively owned by a person under paragraph (a), for applying paragraphs (a), (b), or (c), is treated as owned by that person. But stock constructively owned by an individual under (Quotes IRS) paragraphs.
(b) (c) Or is not treated as owned by him or her, for again applying either paragraph (b) or (c), to make another person the constructive owner of that stock.
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Business Expenses And The S Corporation – What You Need To Know!
Business Expenses & Interest
An accrual method S corporation must use the cash method to deduct business expenses and interest owed to cash method related parties. Therefore, an S corporation may not deduct business expenses or interest owed to a cash basis related party until the day payment is made and the amount is includible in the related party’s gross income. This rule will apply even if the S corporation and the related person cease to be related to the expenses or interest are includible in that person’s gross income.
Related parties include those just above and also include, in the case of any amount paid or incurred by, to, or in favor of an S corporation:
(a) A person that is an S corporation and a shareholder of the S corporation, that owns any of the stock of the S corporation, no meter if it is directly or indirectly.
(b) An S corporation and anyone who owns, directly or indirectly, any capital or profits interest of a partnership in which this S corporation owns, directly or indirectly, any capital or profits interest, and
(c) Any person related to the related party rules to a person described in (a) or (b). The rule in (b) applies to a transaction only if the deal is related either to the operations of the partnership or an interest in this partnership. 9-49
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Next publication will be on S corporate.