 Hello and welcome to this session in which we would look at taxes paid at a corporate level when it comes to S corporation Well, this is little little bit unusual because S corporations are flow-through entities They don't pay taxes themselves. The taxes are the responsibility of the shareholders So the corporation itself are not tax-paying entities. This is what we need to know about S corporation They should not have a tax liability on the corporate level. However Under certain circumstances the S corporation as an entity might be responsible for some taxes And usually this happens when there is a switch from a C corporation to an S corporation Now on the prior session we looked at the built-in tax gains the passive income Penalty tax in this session would look at life or recapture tax as well as the general business Credit recapture before we proceed any further I have a public announcement about my company farhatlectures.com Farhat accounting lectures is a supplemental educational tool That's gonna help you with your CPA exam preparation as well as your accounting courses My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of Lectures, multiple-choice questions, true-false questions as well as exercises. Go ahead start your free trial today No obligation, no credit card required So what is life or recapture or what's the life or recapture rule? Simply put The first thing we need to be aware of once again, you're going from a C to an S and When you were using the C corporation you were using life or last and first out So the life or recapture applies only when the FIFO when you switch and the FIFO value is greater than your life or value Well, that's a lot of terminology. That's Let's just kind of play with some number here So first when you were a C once again, you were using life. Oh and now you switched What happened is this we would look at your inventory and we will see If you're a few we assume FIFO inventory and FIFO is greater than life Oh, if FIFO is greater than life. Oh, you have that tax to pay now Why well, let's take a look at FIFO and life or rules to understand the concept. Let's use some simple numbers Let's assume you're selling widgets and the cost of the widgets is five four Five six seven. So seven is the most recent cost Now let's take a look at FIFO and life. Oh, let's assume you sold each widget for ten dollars and you sold one one widget Let's start with life. Oh, since you are using life for 4c So 10 So if you sold a widget for ten dollars and you're using life or you're going to sell this seven dollar So 10 minus seven equal to three dollars of profit And what's left is your inventory and your inventory consists of four dollars five dollars and six dollars all in all Your inventory under life. Oh is 15 Now if this company is using life Oh, if this I'm sorry if this company is using FIFO now we're assuming you're using FIFO Sales is 10 dollars minus four dollars will give us a profit of six Well, if the profit of six so you sold the four dollars What's left of your inventory? What's left in the inventory is the five the six and the seven So if we add them up our inventory is 18 dollars. So notice here we we should have a FIFO Recapture tax why because your FIFO inventory Is greater than your inventory under life. Oh now why do you have to pay this tax? So just is it like an arbitrary rule or what's the reason behind it? Here's the reason behind it Here's what the IRS or the government wants you to do you have a profit you have a profit here of A hitting profit. What do I mean by hitting profit? Basically your inventory is three dollars more under life Oh And as a result you have three dollars Of unrealized gain in your inventory. So your inventory notice It's a greater if we compare this inventory to this inventory you would say well 18 is greater than 15 So you have more inventory. So you have an unrealized gain that you are not realizing So the government says look if you want to switch from c to an s And that's the situation we want you to accelerate We want you to kind of basically accelerate means do it now and book this unrealized gain now So the difference between those is three dollars. What do you have to do? You have to book it now Book it now means pay taxes on the three dollars Now once you pay the taxes on the three dollars the three dollars is added to your Inventory. So this is the basic idea. We will work a little bit a detailed example But that's the idea behind it now taxes. How do you pay the taxes? The recapture tax is we're going to say 21 because that's the corporate tax rate How do you pay the taxes? You pay them and for equal installment with the first payment Do before the due date of a c so once you want to switch So let's assume this is year one And so what happens you're going to file your tax return in year two You have to make the first payment for this was a c corporation You have to make the first payment when it's a c corporation. There's no extension for that Then you make the remaining three payments. So you basically make four payments all in all for that tax Now to avoid any payment of additional interest the corporation should make the installment payment by the due dates There should be a due dates in addition. There are no estimated taxes on this installment So you don't have to pay any estimated taxes And the basis of the life or inventory is adjusted as I told you the inventory under life will become 18 However, the AAA account if you don't know what this is, don't worry about it We'll talk about it later is not decreased by the payment of the life or recapture tax So when you pay that tax, you don't have to lower lower your AAA. Don't worry. Just Write the rule down You will thank me when we talk about the AAA account Let's take a look at a more comprehensive example since it's formation ABC has used LIFO costing to account for its inventory That's fine. Three years later X4 the ABC shareholder decided to convert or elect the S status at the end of 2003 The basis of the inventory LIFO was 87. Well, let's see what's FIFO if we look at FIFO. It's 105 So FIFO Is greater than LIFO. Well, guess what? We're gonna have to do something about this recapture tax Well, let's see. What is the amount of LIFO recapture tax that ABC should pay? And what is the basis of the LIFO inventory for the S corporation? Well, first, let's compute the recapture Well, it's the difference the difference between 105 and 87 And we're gonna take the difference and multiply it by the 21. That's basically prompt tax rate And as long as it's in effect, it's 21. It could be something else So we're talking about an $18,000 difference Times 21 percent. The company is responsible for 3780 So they have to pay this amount immediately. Not at all. They can break it into four installment payment Which will make each payment of 945 dollars. And what is the basis? What is the basis of the inventory for LIFO now? Well, the basis is 87,000 then you add Since you already paid the taxes on the 18,000 you add the taxes on the 18,000 and the LIFO Paces and the inventory becomes 105. So basically what you did is you accelerated The gain you paid the taxes on it and you increased your inventory Let's talk about the general business credit recapture As a business operating as a C corporation, you might qualify for many business credits and this is a Various business credit investment work opportunity credit low income housing Disabled access credit so on and so forth if you convert from a C to an S and you no longer qualify because Your status has changed. Guess what? You have to recapture those credit So an S corporation that was previously taxed as a C is liable for any recapture attributed to those credit during the C Corporation taxing because basically you lost your status You qualified because you were a C you got those credit now you lost them You have to recapture them and that's all you need to know as far as this General business credit recapture for the CPA exam So the LIFO recapture tax is important Whether you are a CPA enrolled agent or an accounting student Make sure you know it. What should you do now? Go to far hat and look at mcqs through false Maybe additional exercises that's going to help you understand this concept better Understanding how S corporation works will help you understand the overall picture So the LIFO recapture tax is is an important topic It could appear on the exam easy points and you need to know this also for The FAR exam or the financial accounting and reporting or eventually the name of that The that section will be changed, but you need to know it. Good luck study hard and of course stay safe