By Joe O’Malley, CPA, MST
With the Tax Cuts and Jobs Act (TCJA) there is an increased scrutiny by the IRS of S corporations and their shareholders with regard to unrealized built-in gains from the sale of assets as well as distributions and loan repayments.
Built-In Gains Tax
The IRS has found that S corporations often don’t pay the built-in gains tax on the sale of assets acquired while a C corporation. Assets held at the time of conversion from a C corporation to an S corporation may be subject to the built-in gains tax, as well as those assets transferred later from the date the asset was acquired by the S corporation. The built-in gains tax applies to S corporations that have a net recognized built-in gains within the five-year period after conversion. To avoid this liability, some S corporations opt to delay asset sales until the five-year liability period has passed.
When the S corporation makes distributions, they are not considered income as long as the distribution does not exceed the shareholder’s stock basis. Any excess is taxed as a capital gain on the shareholder’s personal tax return in accord with the shareholder’s proportion of ownership.
The S corporation should track the stock basis for each shareholder in relation to distributions, but often this process is not followed. Three particular scenarios that trigger IRS interest occur when:
- The S corporation fails to report a gain on the distribution of appreciated property
- The S corporation fails to determine whether a distribution in cash or property should be taxable as a dividend
- A shareholder fails to report non-dividend distributions that exceed their stock basis and thus are subject to taxation
Loans made to shareholders can be a particularly thorny issue with the IRS. If there is no documentation that the amount in question is actually a loan, the IRS may re-characterize it as a shareholder distribution, which is then subject to shareholder ownership percentages. If the amount is in excess of the shareholder’s stock basis, this could trigger major tax consequences, the worst of which could lead to the IRS reclassifying an S corporation as a C corporation for failing to follow ownership percentages.
New Checkbox on Schedule E
S corporation shareholders should be aware of a new checkbox added to line 28 of the individual taxpayer return, Schedule E (Form 1040). This box should be checked if the shareholder is reporting a loss, has received a distribution, has disposed of stock or has received a loan repayment from an S corporation. The shareholder must attach documentation that details their S corporation ownership basis.
The IRS is seeking to increase compliance in all these areas through outreach to tax practitioners, issue-based examinations, soliciting responses on changes to tax forms and “soft letters.” In the meantime, it’s in the best interest of S corporations and their shareholders to stay on top of reporting requirements for their filings.
If you have any questions on your tax potential issues, please reach out to me at firstname.lastname@example.org or 617-738-5200.
About the Author
Joe O’Malley, CPA, MST has over 13 years of experience servicing the accounting and tax needs of individuals, trusts, estates, and privately held businesses. He works with clients across a broad range of industries, including law, finance, real estate, technology and professional services.
Joe began his career at ALL and later worked for international accounting firms in their respective private client service tax practices. Joe is a sought after professional for the close personal attention he gives each client and the results focused methods he brings to each engagement.
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