Prepare an S corporation passive-investment-income review

An S corporation passive-investment-income review begins with its tax history. The Form 1120-S instructions describe circumstances involving accumulated earnings and profits, including a prior C corporation period or a tax-free reorganization with a C corporation. Give the adviser the conversion and transaction records before assuming the current profit and loss statement answers the question.

Collect prior returns and earnings-and-profits workpapers. Identify distributions and earlier adjustments that affect the balance. Financial-book retained earnings and accumulated earnings and profits are different measures; if the preparer uses an estimate allowed by the instructions, document that decision and its basis. An unexplained number copied from equity is difficult to evaluate later.

Prepare a detailed receipts schedule covering operating activity, interest, dividends, rents and other relevant items. Give the adviser the underlying contracts and transaction details needed to apply the passive-investment-income definition and its exceptions. The accounting label other income can contain several categories with different treatment.

Keep gross receipts, passive investment income and associated deductions in separate columns. The excess-net-passive-income calculation uses defined measures; a ratio of investment income to accounting profit is not the requested comparison. Reconcile the schedule to all relevant return items, including amounts reported separately to shareholders.

Do not carry a shareholder's passive-activity classification into this corporation-level review without analysis. The shareholder loss-limitation rules and the corporation's passive-investment-income rules address different questions. Ask the preparer to label workpapers with the rule being tested so similarly named schedules cannot be confused.

The instructions describe an excess-net-passive-income tax when the relevant earnings-and-profits and receipts conditions apply. They also describe potential termination of the S election after three consecutive years meeting the specified conditions. Ask the adviser to assess both the current-year calculation and the sequence of prior years.

Create a year-by-year record of the reviewed earnings-and-profits balance, gross receipts, passive investment income and conclusion. Link each year's result to the filed return or final workpaper. Leave a missing historical conclusion marked unresolved rather than treating an empty cell as a year in which the condition was absent.

For an illustrative company that previously operated as a C corporation, a current-year investment sale may require historical records that the new bookkeeper never received. Request those records while the prior preparer remains available. A current-year transaction can make an old tax attribute relevant again.

Give the adviser forecasts of material receipts and planned transactions while decisions can still be reviewed. Preserve assumptions separately from completed activity. A proposed distribution, asset sale or restructuring can raise other tax and legal questions, so do not implement a transaction solely because it changes one spreadsheet ratio.

Retain the approved computation and any required return attachment, then reconcile the resulting tax and shareholder reporting to the filing package. Record the next review date and the events that should trigger earlier advice, such as another acquisition or a substantial change in investment income.