Class Exercises S Corporations

Illustrations of Situations
A) Profit Sharing:
Sam, Sylvia, and Sharona form an S Corporation. Each contributes $10,000 in exchange for 100 shares
of stock. The shareholders decide that Sam will be allocated 40% of the profits since he has the most
expertise and that Sylvia will only be allocated 20% of the profits because she is only willing to assume
20% of the losses. Comment on these shareholder allocations.
Cant do that because the differential profit sharing would be evidence of more than one class of
stock
B) Self-Employment Income:
2) Suppose Sam, Sylvia, and Sharona under the same facts as above agree to share profits equally. Each
will take a salary of $10,000. After deducting the salaries and other expenses, the ordinary income of the
S Corporation for the first year is $300,000. What is each of the shareholders share of profit? What is
each shareholders share of employment income? What issue is presented by these facts?
Each share of profit would be 100,000; each share of employment income is 10,000; these salaries may be
unreasonably low to avoid payroll taxes.
C) S Corporation Formation:
3) Dabney, Drew and Donna form an S Corporation. Dabney contributes cash of $30,000, Drew
contributes property with a $50,000 value, a $40,000 basis, and encumbered by a liability of $20,000.
Donna contributes cash of $30,000 and also loans the corporation $10,000. What are Dabney, Drew, and
Donnas basis in the S Corporation stock? What are their bases for purpose of deducting losses?
Follows the same logic as section 351; transfer of property in exchange for stock; and in control
afterward. Those conditions are satisfied here so the transfer is non-taxable.
Dabney: Stock basis is the same as basis in contributed property - 30,000
Drew: Stock basis = property basis less liability contributed (40,000 20,000) 20,000
Donna Stock Basis is the same as basis in contributed property 30,000
Also has a 10,000 basis in loan.
For purposes of deducting pass through losses the basis limitation includes basis in stock plus any
basis in loan made by the shareholder to the S corporation.
D) Special Taxes Levied on S Corporations:
4) Are there any taxes that may be imposed on an S Corporation? If so, what are they and when do they
apply?
There are three: Built-in Gains tax, Excess Passive Income Tax, LIFO Recapture Tax
These taxes only apply to S corporations that were formerly C Corporations who have
undistributed Earnings and Profits from the C Corporation years.

E) Distributions by S Corporations:
5) An S Corporation that was formerly a C Corporation has a $20,000 balance in its accumulated
adjustments account (AAA) and $10,000 of undistributed retained earnings from its C Corporation years.
If the S Corporation makes a distribution of $15,000 to its shareholders, are the shareholders, assuming
they have sufficient basis, taxed on the distribution? How would the answer change if the distribution
was $25,000?
The first one would be tax free at a 15,000 distribution because this distribution is less than AAA.
At 25,000 distibutio: This distribution exceeds AAA so the first 20,000 is tax free and 5,000 is from
AEP and is taxable dividend.
F) Order of Basis Items:
6) An S Corporation that has always been an S Corporation distributes $10,000 to a shareholder. The
shareholders share of loss for the year is $3,000. The shareholders basis in the S Corp. prior to these
events is $12,000. How much of the loss is deductible by the shareholder?
Order of Basis adjustments (Same as partnership: income increases basis before distributions, but
distributions reduce basis before losses)
Basis after distribution = 12,000 10,000 = 2,000
Only 2,000 of the 3,000 loss is deductible, the other 1,000 is suspended until basis is restored.
7) An S Corporation that has always been an S Corporation distributes $10,000 to its sole shareholder.
The shareholders share of income for the year is $3,000. The shareholders basis in the S Corp. prior to
these events is $9,000. Is this distribution taxable to the shareholder?
Income increases basis to 12,000 before the distribution reduces it so the distribution is not in excess
of basis, so it is not taxable.
8) Continuing the facts of #6, assume the shareholder has also loaned the corporation $5,000. Would that
change the deductibility of the pass through loss? What would be the effects if, after absorbing any pass
through loss, the company repaid the debt to the shareholder?
Basis after distribution = 12,000 10,000 = 2,000
Now, the shareholder has an additional 5000 of basis due to the personal loan made to the S
corporation. The shareholder can add this basis for purposes of the limitation on loss deduction.
The entire 3,000 of loss is deductible because the shareholder has a total basis (after the
distribution) of 7,000 for deducting pass through losses.
Stock basis is reduced to 0, Loan basis is reduced to 4000 by the 3000 pass through loss, assuming
tax payer materially participates the whole 3000 loss is deductible.
G) Distributions of Appreciated Property:
9) An S Corporation distributes $20,000 of securities equally ($10,000 each) to its two shareholders. The

corporation purchased the securities three years ago for $12,000. Each shareholder has a $40,000 basis in
the S Corporation. What are the tax effects of the distribution on the corporation and the shareholders?
8000 gain split between shareholders, so increases shareholders basis to 44,000 then reduces down to
34,000
10) An S Corporation liquidates by distributing $50,000 of assets with a $40,000 basis to its shareholders.
Prior to the distribution, the shareholders have a $35,000 basis (total) in the S Corporation. What are the
tax effects of the liquidation?
10000 gain split between shareholders increases basis to 45,000. When liquidates
shareholders recognize a 5000 capital gain.