Due to changes brought about by the Tax Cuts and Jobs Act (TCJA), the IRS has determined that S corporations and their shareholders must closely monitor certain factors affecting their tax liability, including unrealized built-in gains (BIG) following the sale of assets, distributions and loan repayments. The following information defines each of these liabilities and explains why the IRS is on heightened alert.
Assets held at the time of the conversion from a C corporation to an S corporation may be subject to the BIG tax, along with those assets transferred after the date the asset was acquired by the S corporation. According to the IRS, some S corporations simply don’t pay the BIG tax on the sale of assets acquired when they were a C corporation. The BIG tax applies to S corporations that have a net recognized BIG within the five-year period following conversion from a C corporation. To avoid BIG tax liability, some S corporations choose to delay asset sales until the five-year liability period has ended.
When an S corporation makes distributions, they are not considered income as long as the distribution does not exceed the shareholder’s stock basis. However, any surplus is taxed as a capital gain on the shareholder’s personal tax return in accord with the shareholder’s proportion of ownership.
While the S corporation should carefully track the stock basis for each shareholder in relation to distributions, often this process is not followed. The following scenarios can trigger the attention of the IRS:
- 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 particularly problematic for the IRS. When there is no documentation that the amount in question is really a loan, the IRS may re-characterize it as a shareholder distribution, which is 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.
S corporation shareholders should be aware of a new checkbox added to line 28 of the individual taxpayer return, Schedule E (Form 1040). The taxpayers should check this box 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.
To improve compliance, the IRS is conducting outreach in these areas by communications with tax practitioners, soliciting responses on changes to tax forms, issue-based examinations, and “soft letters.” S corporations and their shareholders can avoid IRS scrutiny by being aware of reporting requirements for their filings.
Do you have questions about this blog or other tax services topics? Please contact Kevin Harris at 214-635-2473.
Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.