Subchapter S of the Internal Revenue Code of 1986, as in effect on January 1, 1997, regarding small business corporations, has been adopted for the purpose of computing Arkansas income tax liability.

Corporations incorporated in Arkansas, or registered to conduct business within Arkansas or having income from Arkansas *sources, must file an income tax return with the State of Arkansas. Such corporations must file an S Corporation income tax return (AR1100S) with the State of Arkansas if:

The rules of Subchapter C (corporate distributions, liquidations, contributions and reorganizations) apply to S corporations, unless the Internal Revenue Code or Arkansas law otherwise provides or a Subchapter C rule is inconsistent with a Subchapter S rule.

S corporations are generally audited on a shareholder-by-shareholder basis. The general rule is that an S corporation's taxable income is computed under the rules that apply to individuals.

An S corporation shareholder should generally treat a Subchapter S item on his own individual income tax return consistently with the treatment of that item on the S corporation's return. If the shareholder treats an item or items inconsistently between his return and the corporation's return, the shareholder must notify the Department's Individual Income Tax Section (as well as the IRS) of the inconsistency. This notification should be provided on IRS Form 8082.

All resident and nonresident shareholders of corporations that have elected to be taxed by Arkansas as S Corporations and who receive a share of the corporation's income, loss, deductions or credits, must file an Arkansas individual income tax return reporting the share so received. However, a nonresident shareholder of such a corporation shall only be required to file an Arkansas individual income tax return if some or all of his share of the corporation's income, loss, credits or deductions are attributable to Arkansas sources. When an Arkansas return is required to be filed, the nonresident must report all of his gross income on his Arkansas nonresident return pursuant to ACA 26-51-435 and ACA 26-51-504. Moreover, a shareholder's share of S Corporation income attributable to Arkansas is subject to Arkansas income tax whether or not it is actually distributed to the shareholder.

An S corporation's items of income, loss, deduction and credit for its tax year are usually allocated to its shareholders on a per-share, per-day basis. An equal part of a tax year's items is assigned to each day of the tax year, and is divided pro rata among the shares outstanding on the day to which it's assigned. However, if the corporation and all *“affected” shareholders agree, an election could be made to terminate the S corporation's tax year when a shareholder terminated his interest in the corporation. The effect of the election is that the tax year of the corporation is treated as if it consists of two tax years, with the first tax year ending on the date on which the shareholder's interest was terminated. IRC Sec. 1377(a)(2)(A). The items of income, loss, deduction and credit, determined for each separate “tax year” by closing the books, are allocated on a per-share, per-day basis to shareholders who were shareholders during the separate “tax year”.

An S corporation shareholder's basis is significant because: (1) distributions in excess of his basis may result in gain to the shareholder; and (2) the shareholder can deduct his pro rata share of the corporation's losses only to the extent of his adjusted basis in the S corporation's stock and debt.

The adjusted basis of the shareholder's stock for purposes of computing the limitation on the amount of the S corporation's losses he can deduct (the loss limitation) is computed after the basis is reduced by the year's nontaxable distributions made to the shareholder. IRC Sec. 1366(d).

The adjusted basis of the shareholder's stock for determining the tax effects of the S corporation distributions to him is determined by increasing the basis for his share of the S corporation's income items for the year, but without decreasing the basis for his share of the S corporation's losses for the year. IRC Sec. 1368.