J.K. Lasser's Small Business Taxes 2018. Barbara Weltman
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charitable contribution deduction made by a partnership passes through separately as a charitable contribution. The partner adds the amount of the pass-through charitable contribution to his or her other charitable contributions. Since an individual's cash contributions are deductible only to the extent of 50 % of adjusted gross income, the partner's allocable share of the partnership's charitable contribution is subject to his or her individual adjusted gross income limit.
Other items that pass through separately to owners include capital gains and losses, Section 179 (first-year expensing) deductions, investment interest deductions, and tax credits.
When a partnership or LLC has substantial expenses that exceed its operating income, a loss is passed through to the owner. A number of different rules operate to limit a loss deduction. The owner may not be able to claim the entire loss. The loss is limited by the owner's basis, or the amount of cash and property contributed to the partnership, in the interest in the partnership.
Example
You contributed $12,000 to the AB Partnership. In 2017, the partnership had sizable expenses and only a small amount of revenue. Your allocable share of partnership loss is $13,000. You may deduct only $12,000 in 2017, which is the amount of your basis in your partnership interest. You may deduct that additional $10,000 of loss when you have additional basis to offset it.
There may be additional limits on your write-offs from partnerships and LLCs. If you are a passive investor – a silent partner – in these businesses, your loss deduction is further limited by the passive activity loss rules. In general, these rules limit a current deduction for losses from passive activities to the extent of income from passive activities. Additionally, losses are limited by the individual's economic risk in the business. This limit is called the at-risk rule. The passive activity loss and at-risk rules are discussed in Chapter 4. For a further discussion of the passive activity loss rules, see IRS Publication 925, Passive Activity and At-Risk Rules.
S Corporations and Their Shareholder-Employees
There were more than 4.8 million S corporations in the government's 2016 fiscal year, making these entities the most prevalent type of corporation. More than 68 % of all corporations file a Form 1120S, the return for S corporations. About 78 % of S corporations have only 1, 2, or 3 shareholders.
NOTE
State laws vary on the tax treatment of S corporations for state income tax purposes. Be sure to check the laws of any state in which you do business.
S corporations are like regular corporations (called C corporations) for business law purposes. They are separate entities in the eyes of the law and exist independently from their owners. For example, if an owner dies, the S corporation's existence continues. S corporations are formed under state law in the same way as other corporations. The only difference between S corporations and other corporations is their tax treatment for federal income tax purposes.
For the most part, S corporations are treated as pass-through entities for federal income tax purposes. This means that, as with partnerships and LLCs, the income and loss pass through to owners, and their allocable share is reported by S corporation shareholders on their individual income tax returns. The tax treatment of S corporations is discussed more fully later in this chapter.
S corporation status is not automatic. A corporation must elect S status in a timely manner. This election is made on Form 2553, Election by Small Business Corporations to Tax Corporate Income Directly to Shareholders. It must be filed with the IRS no later than the fifteenth day of the third month of the corporation's tax year.
Example
A corporation (on a calendar year) that has been in existence for a number of years wants to elect S status. It had to file an election no later than March 15, 2017, to be effective for its 2017 tax year. If a corporation is formed on August 1, 2017, and wants an S election to be effective for its first tax year, the S election must be filed no later than November 15, 2017.
If an S election is filed after the deadline, it is automatically effective for the following year. A corporation can simply decide to make a prospective election by filing at any time during the year prior to that for which the election is to be effective. However, if you want the election to be effective now but missed the deadline, you may qualify for relief under Rev. Proc. 2013–30 (see the instructions to Form 2553 for making a late election).
Example
A corporation (on a calendar year) that has been in existence for a number of years wants to elect S status for its 2018 tax year. It can file an election at any time during 2017.
To be eligible for an S election, the corporation must meet certain shareholder requirements. There can be no more than 100 shareholders. Pending legislation would waive the shareholder limit for purposes of equity crowdfunding; see the Supplement for any update. For this purpose, all family members (up to 6 generations) are treated as a single shareholder. Only certain types of trusts are permitted to be shareholders. There can be no nonresident alien shareholders.
An election cannot be made before the corporation is formed. The board of directors of the corporation must agree to the election and should indicate this assent in the minutes of a board of directors meeting.
Remember, if state law also allows S status, a separate election may have to be filed with the state. Check with all state law requirements.
For the most part, S corporations, like partnerships and LLCs, are pass-through entities. They are generally not separate taxpaying entities. Instead, they pass through to their shareholders’ income, deductions, gains, losses, and tax credits. The shareholders report these amounts on their individual returns. The S corporation files a return with the IRS – Form 1120S, U.S. Income Tax Return for an S Corporation– to report the total pass-through amounts. The S corporation also completes Schedule K-1 of Form 1120S, a copy of which is given to each shareholder. The K-1 tells the shareholder his or her allocable share of S corporation amounts. The K-1 for S corporation shareholders is similar to the K-1 for partners and LLC members.
Unlike partnerships and LLCs, however, S corporations may become taxpayers if they have certain types of income. There are only 3 types of income that result in a tax on the S corporation. These 3 items cannot be reduced by any deductions:
1. Built-in gains. These are gains related to appreciation of assets held by a C corporation that converts to S status. Thus, if a corporation is formed and immediately elects S status, there will never be any built-in gains to worry about. The built-in gains tax ends once the S corporation has held the appreciated assets for more than 5 years.
2. Passive investment income. This is income of a corporation that has earnings and profits from a time when it was a C corporation. A tax on the S corporation results only when this passive investment income exceeds 25 % of gross receipts. Again, if a corporation is formed and immediately elects S status, or if a corporation that converted to S status does not have any earnings and profits at the time of conversion, then there will never be any tax from this source.
3. LIFO recapture. When a C corporation using last-in, first-out or LIFO to report inventory converts to S status, there may be recapture income that is taken into account, partly on the C corporation's final return, but also on the S corporation's return. Again, if a corporation is formed and immediately elects S status, there will not be any recapture income on which the S corporation must pay tax.
To sum up, if a corporation is formed and immediately elects S status, the corporation will always be solely a pass-through entity and there will never be any tax at the corporate level. If the S corporation was, at one time, a C corporation, there may be some tax at the corporate level.
C Corporations and Their Shareholder-Employees
A C corporation is an entity separate and apart from its owners; it has its own legal existence. Though formed under state law, it need not be formed in the state in which the business operates. Many corporations, for example,