(4) Taxation of S Corporation Income to Individual Shareholders under M.G.L. c. 62; Distributive Share Income.

(a) In general. The Massachusetts rules that attribute S corporation income to shareholders, particularly under M.G.L. c. 62, § 17A, are similar to the federal rules that require an S corporation to calculate income or loss, using the corporation’s items of income, loss and deduction, and then attribute that income or loss to its shareholders. Shareholders pay the personal income tax under M.G.L. c. 62 based on the amount of taxable income that is earned by the S corporation, attributed to the shareholder as distributive share income. The S corporation shareholder is taxed on this income whether or not any amount is actually distributed to the shareholder. Shareholders are allowed to claim certain tax credits against their personal income tax liabilities. See 830 CMR 62.17A.2(4)(g). Such allowable credits are calculated by the S corporation at the entity level, and are reported to shareholders to be used in determining the shareholders’ personal income tax liabilities. See 830 CMR 62.17A.2(3)(e)(credits may be taken at the individual shareholder level, or the S corporation entity level, but not at both levels). The taxation of an S corporation shareholder under M.G.L. c. 62 is separate and distinct from the taxation of an S corporation at the entity level under M.G.L. c. 63. An S corporation shareholder is taxable on its distributive share regardless of any S corporation entity-level tax obligation in Massachusetts. (b) Determining a shareholder's distributive share of income. An S corporation shareholder’s distributive share of income is calculated under the general rules that apply to the taxation of income under M.G.L. c. 62. The starting point for determining distributive share income is the S corporation’s federal items of ordinary income (or loss), capital gains, and other income. Massachusetts then requires state-specific adjustments as described in 830 CMR 62.17A.2(4). The shareholder's distributive share of the S corporation's items of income, loss, or deduction is passed through to the shareholder as if such items were realized directly by the shareholder. (c) Character of pass-through items . The character of any item of income, loss, deduction, or credit of an S corporation included in a shareholder's distributive share is determined under the provisions of M.G.L. c. 62 as if realized or incurred directly by the shareholder. With respect to a non-resident S corporation shareholder, the character of an item does not determine the source of the income for purposes of determining whether the item is subject to Massachusetts tax. For the sourcing rules that apply to non-resident shareholders, see 830 CMR 62.17A.2(4)(i). Example (4)(c). S corporation X provides professional services, does business only in Massachusetts, and has a taxable year that is a calendar year. During its taxable year X earns $10 million from the provision of professional services; buys a capital asset on January 30 th that it sells it at a profit on November 1 st ; and, sells a second capital asset that it has held for more than one year. Under the provisions of M.G.L. c. 62, § 2, the earnings from X’s provision of its professional services are Part B income ( see M.G.L. c. 62, § 2(b)(2)), and are reported and taxable to X’s shareholders as Part B income. The gain from the sale of the capital asset that X purchased on January 30 th and sold on November 1 st is Part A income ( see M.G.L. c. 62, § 2(b)(1)), and is reported to and taxable to X’s shareholders as Part A income. The gain from the sale of the capital asset held for more than one year is Part C income ( see M.G.L. c. 62, § 2(b)(3)), and is reported to and taxable to X’s shareholders as Part C income. (d) Treatment of capital gains. Capital gains and losses that flow through to the shareholders of an S corporation and are taxable under M.G.L. c. 62 shall be taken into account by the shareholders in proportion to each shareholder’s ownership share in the S corporation. The member’s ownership share is determined under the Code. (e) Deductions taken in determining a shareholder’s distributive share, and limitations of losses. 1. General rule. In calculating a shareholder’s distributive share, an S corporation is allowed only those expense deductions that a sole proprietor would be allowed. M.G.L. c. 62, § 2(d)(1). Deductions that are itemized by an individual for federal income tax purposes are not allowed. M.G.L. c. 62 § 2(d). Also, a deduction for a net operating loss carryover is not allowed in calculating a shareholder’s distributive share. M.G.L. c. 62, § 2(d)(1)(C). Example (4)(e)(1). S Corporation A is not engaged in a trade or business, and has an investment interest expense deduction that is allowed for federal tax purposes. The investment interest expense deduction of A as it may be allowed under federal law must be disregarded in computing the Massachusetts tax liability of A’s shareholders since investment interest does not qualify as a deductible business expense under M.G.L. c. 62. 2. Passive investment income and built-in gains. If an S corporation is taxed at the entity level on income under Code §§ 1374, 1375, such income is also taxed at the entity level under Massachusetts law. See 830 CMR 62.17A.2(8)(b)1. (Category one income). When calculating a shareholder’s distributive share, such income is reduced by the entity-level tax paid at the federal and state level that is attributable to the shareholder’s portion of the income so taxed. This rule is similar to that set forth at Code § 1366(f). 3. Limitation on losses and deductions for shareholder-level taxation under M.G.L. c. 62. a. Net Operating Losses (NOLs). Under the personal income tax provisions of M.G.L. c. 62, a net operating loss carryforward is not allowed, and therefore must be disregarded in computing distributive share income. For treatment of NOLs with respect to the entity-level tax under M.G.L. c. 63, §§ 32D, 39, see 830 CMR 62.17A.2(8)(c)3. b. Deductions limited by shareholder basis in stock. The deductions computed under M.G.L. c. 62 that can be taken into account by the shareholder of an S corporation may not exceed the sum of the adjusted Massachusetts basis of the shareholder's stock in the S corporation and the shareholder's adjusted basis in any indebtedness of the S corporation to the shareholder. 830 CMR 62.17A.2(4)(e)3.b. is similar to the rule set forth at Code § 1366(d). (f) Treatment of installment sales. 1. Effect of an installment sale by the S corporation. The determination of whether a sale or a deemed sale by an S corporation is treated as an installment sale is made at the S corporation entity level, and is binding on all shareholders. Once a transaction is determined to be treated as an installment sale, the installment transactions statute, M.G.L. c. 62, § 63 and regulation, 830 CMR 62.63.1, govern the responsibilities of the S corporation and its shareholders. In particular, 830 CMR 62.63.1(10) states the installment transaction rules that apply to flow-through entities, including S corporations and their shareholders. With respect to a non-resident shareholder, two different rules apply depending on the residence of the shareholder at the time of the sale or deemed sale by the S corporation that is treated as an installment sale. If the non-resident shareholder was a Massachusetts resident at the time of the sale or deemed sale, then the shareholder is treated as a resident with respect to income derived from such sale or deemed sale. Pursuant to the authority in M.G.L. c. 62, § 5A(b), such a shareholder is not permitted to apportion the income from the sale or deemed sale, but rather must report the full amount of such income as taxable Massachusetts source income, and is entitled to its proportionate share of the credit for taxes paid to another jurisdiction as it directly relates to such income, and under the terms that apply to credits for taxes paid to another jurisdiction, as set forth in 830 CMR 62.17A.2(4)(g)2. In the case of a non-resident shareholder who was a non-resident at the time of the sale or deemed sale, where income derived from an installment sale is subject to apportionment, the apportionment percentage that applies to such income in each year that it is taxable, irrespective of the year in which payment is actually received, is the S corporation’s apportionment percentage from the year of the sale. The S corporation’s apportionment percentage is determined under M.G.L. c. 62, § 17A(b). Example (4)(f)(1). S corporation S is a calendar-year corporation that does business in multiple taxing jurisdictions and is 100% owned by M, a Massachusetts resident. On December 15, 2010, S sells off the majority of its assets and realizes a gain of $100 million. S elects installment sale treatment. Because S has elected installment sale treatment, $40 million of its realized gain is taken into account in its taxable year ending December 31, 2010. The remaining $60 million in gain is to be taken into account ratably over the next three years. On January 1, 2011, M changes her residency to Florida. Because M was a resident at the time of the sale of S’s assets, M is treated as a resident with respect to all income that is derived from the sale. Thus, 100% of the income that is taken into account ratably over the period that M is a Florida resident is taxed in Massachusetts. M is entitled to take her proportionate share of the credit for taxes paid to another jurisdiction that directly relates to the income that derives from the installment sale income for the transaction dated December 15, 2010, under the terms that apply to credits for taxes paid to another jurisdiction, as set forth in 830 CMR 62.17A.2(4)(g)2. Example (4)(f)(2). Same facts as in Example (4)(f)(1), except that on December 15, 2010, the date of the sale that is subject to installment sale treatment, M is a non-resident residing in Florida. All of M’s income that is attributable to the installment sale is subject to the allocation and apportionment rules at 830 CMR 62.17A.2(4)(i). The determination of whether any gain should be reported to Massachusetts by M is based on the facts and circumstances in the year of the sale. If the income was Massachusetts source income in the year of the sale it will remain Massachusetts source income in subsequent years. Allocable items of income are determined based on the allocation rules that apply in the year of the sale and are reportable in their entirety to M as Massachusetts source income. Items subject to apportionment are apportioned to Massachusetts and are taxable to M using S’s apportionment percentage for the year of the sale. With respect to both Example (4)(f)(1) and Example (4)(f)(2), because the total receipts derived from the installment sale under these facts exceed the $6 million threshold for income measure taxation at the entity level for each year from 2010 through 2013, S is subject to entity-level taxation on the gain from the installment sale in each of those years, under 830 CMR 62.17A.2(8). 2. Applicability to the sale of a shareholder’s stock in an S corporation. 830 CMR 62.17A.2(4)(f) does not apply to a shareholder’s sale of S corporation stock, except where such a sale is treated as a deemed sale of assets by the S corporation, as in a transaction described at Code § 338(h)(10). (g) Credits available to S corporation shareholders. 1. General rule. A shareholder of an S corporation may be entitled to a proportionate share of the Massachusetts personal income tax credits under M.G.L. c. 62, § 6 that are calculated by the S corporation. Some Massachusetts tax credits are allowed both to corporate-level taxpayers under M.G.L. c. 63, and to personal income taxpayers under M.G.L. c. 62. However, 830 CMR 62.17A.2(3)(e), applies, namely that a credit may not be applied against both an entity-level and a shareholder-level tax, and a credit may not be divided, part being used at the corporate level, and part being passed through to the S corporation’s shareholders to be used at the individual level. Example (4)(g)(1). S corporation S is eligible for the Economic Development Incentive Program (EDIP) credit for its taxable year. The EDIP credit set forth in M.G.L. c. 62, § 6(g) and M.G.L. c. 63, § 38N, is among those credits that may be taken either by S’s shareholders and applied against a shareholder’s income tax under M.G.L. c. 62, or by S itself to apply against its entity-level tax. Therefore this credit is subject to the general rule at 830 CMR 62.17A.2(3)(e). If the EDIP credit is taken by individual shareholders, all amounts relevant to the calculation of the credit are attributed to S’s shareholders and are taken into account in determining the shareholders' credit for the taxable year during which the taxable year of S ends. If S’s shareholders take the credit with respect to property, S must maintain adequate records to specifically identify that property and to distinguish it from property with respect to which S has taken any credit. If S’s shareholders take the credit and do not use the full amount of the credit generated in a taxable year, the shareholders may carry over the unused amount of the credit to succeeding taxable years. Amounts carried over by a shareholder may be applied only to offset that shareholder's tax liability. If recapture of the credit is later required, each shareholder that took the credit must recapture. For rules related to the EDIP credit that may be taken against S’s corporation’s entity-level tax, see 830 CMR 62.17A.2(8)(a). 2. Credits for taxes paid to another jurisdiction. a. A resident shareholder may claim the credit under M.G.L. c. 62, § 6(a) for taxes paid to another jurisdiction for a taxable year if the S corporation pays a tax during the shareholder's taxable year and if the conditions set forth in 830 CMR 62.17A.2(4)(g)2.a.i. through iv. and 830 CMR 62.17A.2(4)(g)2.b, are met. For the credit to apply: i. The tax must be imposed by another state, territory, or possession of the United States, or the Dominion of Canada or its provinces; ii. The tax must be measured by income earned by the S corporation, the distributive share of which is required to be included in the shareholders' Massachusetts gross income. For the credit to be allowed, the income tax paid by the S corporation must be based on an item of Massachusetts gross income and the tax must be imposed on the apportionable net income of the entity that flows through to the Massachusetts shareholders, subject to all other requirements and limitations described in M.G.L. c. 62, § 6(a) and 830 CMR 62.17A.2(4)(g). Individuals are not allowed a credit for gross receipts-based taxes paid to another jurisdiction either by the S corporation or by the shareholder, because these taxes are not based on net income, as required under M.G.L. c. 62, § 6(a); Example (4)(g)(2)(a). S corporation M does business in Massachusetts and owns an office building in State A. State A fully allocates the rental income of $100,000 to itself, and M’s shareholders pay their proportionate share of the tax attributable to that rental income to State A. The total amount of such tax paid on this rental income to State A is $10,000. Massachusetts residents own 60% of the total value of shares of M. The rental income is included in the Massachusetts income reported to M shareholders as distributive share income. Massachusetts resident M shareholders are allowed to take the credit for taxes paid to the other jurisdiction, each member taking his or her proportionate share of the credit, in accordance with 830 CMR 62.17A.2(4)(g)2.b. The total credit taken by all Massachusetts resident shareholders may not exceed $6,000, that is 60% (representing total share ownership of Massachusetts resident shareholders) multiplied by the total amount of tax paid to State A, namely $10,000. In accordance with 830 CMR 62.17A.2(4)(g)2.d., non-resident M shareholders are not allowed the credit, but rather pay tax as determined after the application of the allocation and apportionment rules set forth at 830 CMR 62.17A.2(4)(i), and in the Non-resident Income Tax regulation, 830 CMR 62.5A.1(6). iii. The S corporation must not deduct any portion of the tax paid to another jurisdiction in computing distributive share income for Massachusetts purposes; iv. The S corporation must provide each shareholder with the names of each applicable jurisdiction to which an income tax was paid, the amount income that was subject to an income tax in the other jurisdiction, and the amount of income tax that was paid to that jurisdiction. b. A resident shareholder seeking to claim the credit under M.G.L. c. 62, § 6(a) must apply the same proportionate share percentage the S corporation uses in calculating that shareholders distributive share of income to the income tax amount that was paid to the foreign jurisdiction. Thus, the total credit amount that can be taken by the resident shareholders is limited to the residents’ total proportionate share percentage multiplied by the total tax amount paid to other jurisdictions. Example (4)(g)(2)(b). S corporation has five resident shareholders and five non-resident shareholders. Each shareholder owns a 10% interest in the S corporation. The S corporation pays taxes measured by its income in several other states, for a total tax paid to other jurisdictions of $10,000. Each resident shareholder is allowed a credit in an amount that represents a 10% share of the total eligible tax paid to the other jurisdictions. Thus each resident shareholder is allowed a credit of $1,000. c. An eligible resident shareholder must include with the shareholder's return the information from the S corporation listing the amount of the shareholder's distributive share of each tax paid by the S corporation for which a credit for taxes paid to another jurisdiction is allowable under M.G.L. c. 62, § 6(a), as well as the name of the taxing jurisdiction to which each tax was paid. d. Non-residents are not eligible for the credit for taxes paid to another jurisdiction, but rather are taxed on Massachusetts source income, as more fully set out in 830 CMR 62.17A.2(4)(i), and 830 CMR 62.5A.1. (h) State and federal differences relating to an S corporation shareholder’s distributive share income. The definition of Massachusetts gross income in M.G.L. c. 62, § 2 is based on the definition of gross income in the Code. As a general rule, M.G.L. c. 62, § 1(c) refers to the Code in effect on a specific date, but for certain other purposes, M.G.L. c. 62 refers to the Code as amended and in effect for the current tax year. In addition, Massachusetts has its own items of loss, deduction, and credit, which may not correspond to those of the Code. Thus, distributive share income may be calculated differently for state and federal purposes. The following provisions state Massachusetts rules and also provide illustrations of differences between the state and federal calculation of shareholder distributive share income. It is not a comprehensive statement of state and federal differences. 1 . Bonus depreciation decoupling. Massachusetts personal income tax provisions are decoupled from the federal bonus depreciation rules at Code § 168(k), and thus the distributive share calculation shall not take into account the federal depreciation allowance under Code § 168(k). See M.G.L. c. 62, § 2(d)(1)(N). 2. Interest on government bonds. Interest income received by an S corporation from U.S. debt obligations is included in taxable distributive share income to shareholders for federal purposes. This interest income is not taxable in Massachusetts to S corporation shareholders. M.G.L. c. 62, § 2(a)(2)(A). In contrast, non-Massachusetts state and municipal bond interest is not taxed to S corporation shareholders by the U.S. government, but is taxable in Massachusetts to S corporation shareholders. M.G.L. c. 62, § 2(a)(1)(A). See also Code § 103. An S corporation must adjust its net income figure to be reported to shareholders to reflect these differences. 3. Qualified production activities. Under federal law, an S corporation passes through to its shareholders the deduction for qualified production activities under Code § 199. Massachusetts law decouples from the qualified production activities income deduction. Thus, the deduction that is passed through to shareholders for federal purposes is not passed through in computing the distributive share for Massachusetts purposes. M.G.L. c. 62, § 2(d)(1)(O). (i) Taxation of non-resident and part-year resident shareholders of Massachusetts S corporations. 1. General rule of non-resident shareholder taxation. Except as otherwise provided, a non-resident shareholder of an S corporation is subject to tax under M.G.L. c. 62, § 5A on the shareholder's distributive share of the S corporation's income, loss, deductions, or credits from sources within Massachusetts, including all items allocated to Massachusetts, and all income apportioned to Massachusetts. M.G.L. c. 62, § 17A(b); see 830 CMR 62.5A.1. The activities of the S corporation are attributed to all its shareholders, whether or not they are residents. Thus, if a non-resident has an ownership interest in an S corporation that is engaged in the conduct of a trade or business in Massachusetts, or derives income from the ownership of real or tangible personal property in Massachusetts or otherwise receives income taxable to a non-resident under M.G.L. c. 62, § 5A, the non-resident is treated as if conducting those activities in his or her individual capacity. The S corporation must inform each non-resident shareholder at year-end of the shareholder's distributive share of income, losses, deductions, or credits apportioned to and taxable in Massachusetts, as well as each shareholder’s proportionate share of allocable income. 2. Allocable income. Other than with respect to income derived from real or tangible personal property, as stated in 830 CMR 62.17A.2(4)(i)4., where an S corporation recognizes an allocable item of income, as that term is defined in 830 CMR 63.38.1(2), that income is allocated to Massachusetts (i.e., and not apportioned to the state) if the S corporation’s commercial domicile is in Massachusetts. See 830 CMR 63.38.1(3)(c): Treatment of an Allocable Item of Income . If the corporation’s commercial domicile is not in Massachusetts, the allocable income is neither allocated nor apportioned to Massachusetts. 3. Apportionment of S corporation distributive share income of non-resident S corporation shareholders. a. In general. An S corporation with non-resident shareholders that does business both within and without Massachusetts and that realizes income from sources within Massachusetts that are derived from or effectively connected with a trade or business, must calculate its income to be apportioned according to the applicable statutory formula, such as that under M.G.L. c. 63, §§ 2A, 38, 42, or other applicable statutory apportionment formula. b. No further apportionment at the non-resident shareholder level. The allocated or apportioned income, as described in 830 CMR 62.17A.2(4)(i), that is reported to a non-resident S corporation shareholder is the Massachusetts source income amount that must be reported on the return. This amount is not subject to any other apportionment method that might otherwise apply to the non-resident under 830 CMR 62.5A.1. 4. Income derived from real or tangible personal property. Income of an S corporation that is derived from the ownership or disposition of an interest in real or tangible personal property located in Massachusetts is taxable in Massachusetts. If the real or tangible personal property is part of the trade or business of the S corporation, it is includible in the S corporation’s income that is subject to apportionment, and is passed through to shareholders as distributive share income. If the real or tangible personal property is not part of the trade or business of the S corporation, the income derived from the property is allocated, not apportioned, to Massachusetts, and is reported to the S corporation’s shareholders as such. A non-resident shareholder is taxable in Massachusetts on the full amount of such allocated income. See 830 CMR 62.5A.1(3)(d). 5. Non-resident shareholder sale of S corporation shares. A non-resident shareholder who sells shares in an S corporation may be subject to tax in Massachusetts on the income from the sale. See, e.g., 830 CMR 62.5A.1(3)(c)3.: Shares of Stock Issued by a Corporation as Compensation , and 830 CMR 62.5A.1(3)(c)8.: Sale of a Business or an Interest in a Business. 6. Filing requirements for part-year residents that are S corporation shareholders. If during the taxable year a shareholder of an S corporation that is subject to taxation in Massachusetts changes status from a non-resident to a resident, or from resident to non-resident, the shareholder is required to account separately for each period. a. Determination of income for portion of the year that the shareholder is a resident. The shareholder's items of income, loss, deduction, or credit for the portion of the taxable year that the shareholder is a resident are calculated on a daily basis. An S corporation may approximate the amount of distributive share income for the part-year period of residency by multiplying the shareholder's distributive share for the full taxable year by a ratio of the number of days of residency to the number of days in the shareholder's taxable year. b. Determination of income for portion of the year that the shareholder is a non-resident. The shareholder's items of income, loss, deduction, or credit for the portion of the taxable year that the shareholder is a non-resident are determined by multiplying the shareholder's distributive share of those items by a ratio of the number of days of non-residency to the number of days in the shareholder's taxable year, and then applying the S corporation’s apportionment ratio to the extent such income is subject to apportionment under 830 CMR 62.17A.2(4)(i). Example (4)(i). S corporation Y has income of $5,000,000 for the taxable year. Y has a Massachusetts apportionment percentage of 60% for the taxable year. Shareholder B has a 20% ownership interest in Y. B resides in Massachusetts from January 1 st through March 31 st of the taxable year, then moves out of state. B’s distributive share income from Y is $1,000,000 for the taxable year. The calculation of B’s Massachusetts tax liability for the taxable year is as follows: For the period of residency, January 1 st through March 31 st , the income taxable to Massachusetts is based on the formula at 830 CMR 62.17A.2(4)(i)6.a., namely, first determining the portion of the distributive share income that is attributable to the period of residency, in this case 90 days divided by 365 = 24.66%. Then, B’s distributive share of $1,000,000 is multiplied by 24.66% to yield $246,600, B’s distributive share income that is taxable to Massachusetts for the period of residency. For the period of non-residency, April 1 st through December 31 st , the income taxable to Massachusetts is based on the formula at 830 CMR 62.17A.2(4)(i)6.b., namely, first determining the portion of the distributive share income that is attributable to the period of non-residency, in this case 275 days divided by 365 = 75.34%. Then, B’s distributive share of $1,000,000 is multiplied by 75.34% to yield $753,400, B’s Massachusetts source income for the period of non-residency, which must then be multiplied by Y’s apportionment percentage of 60%, to yield $452,040 of Massachusetts source income taxable to B during the period of non-residency.