2000 Department of the TreasuryInternal Revenue ServiceInstructions for Form 1120SU.S. Income Tax Return for an S CorporationSection references are to the Internal Revenue Code unless otherwise noted.

Paperwork Reduction Act Notice. We ask for the information on this form to carryout the Internal Revenue laws of the United States. You are required to give us theinformation. We need it to ensure that you are complying with these laws and to allowus to figure and collect the right amount of tax.

You are not required to provide the information requested on a form that is subjectto the Paperwork Reduction Act unless the form displays a valid OMB control number.Books or records relating to a form or its instructions must be retained as long as theircontents may become material in the administration of any Internal Revenue law.Generally, tax returns and return information are confidential, as required by section6103.

The time needed to complete and file this form and related schedules will varydepending on individual circumstances. The estimated average times are:

If you have comments concerning the accuracy of these time estimates orsuggestions for making these forms simpler, we would be happy to hear from you. Youcan write to the Tax Forms Committee, Western Area Distribution Center, RanchoCordova, CA 95743-0001. Do not send the tax form to this address. Instead, seeWhere To File on page 3. Changes To Note

● The FSC Repeal and ExtraterritorialIncome Exclusion Act of 2000 allows anew extraterritorial income exclusion fortransactions after September 30, 2000.The exclusion is based on a corporation'squalifying foreign trade income. For moredetails and to figure the amount of theexclusion, see new Form 8873, Extraterritorial Income Exclusion.● The corporation may need to mail itsreturn to a different service center thisyear because the IRS has changed thefiling location for several areas. If anenvelope was received with the taxpackage, please use it. Otherwise, seeWhere To File on page 3.● Generally, if a corporation's averageannual gross receipts for the 3 prior taxyears are $1 million or less, it may beeligible to adopt or change to the cashmethod of accounting. If the corporationmakes this change, it will not be requiredto account for inventories. Instead, thecorporation may treat inventory in thesame manner as costs of materials andsupplies that are not incidental. Fordetails, see Schedule A—Cost of GoodsSold , on page 16.● If the corporation, at any time during thetax year, had assets or operated abusiness in a foreign country or U.S.possession, it may be required to attachSchedule N (Form 1120) , Foreign

Contents PageAdjustments and Tax Preference

Items . . . . . . . . . . . . . . 23Foreign Taxes . . . . . . . . . . 24Other . . . . . . . . . . . . . . . 25Supplemental Information . . . . . 25

Specific Instructions . . . . . . . 26Schedule L—Balance Sheets per

Books . . . . . . . . . . . . . . 26Schedule M-1—Reconciliation of

Income (Loss) per Books WithIncome (Loss) per Return . . . . 27

Form RecordkeepingLearning about the

law or the formPreparing the

form

Copying,assembling, andsending the form

to the IRSSchedule M-2—Analysis of

Accumulated AdjustmentsAccount, Other AdjustmentsAccount, and Shareholders'Undistributed Taxable IncomePreviously Taxed . . . . . . . . 27

1120S 63 hr., 22 min. 21 hr., 21 min. 39 hr., 9 min. 4 hr., 34 min.

Sch. D (1120S) 10 hr., 31 min. 4 hr., 38 min. 9 hr., 39 min. 1 hr., 20 min.

Sch. K-1 (1120S) 15 hr., 32 min. 10 hr., 25 min. 14 hr., 50 min. 1 hr., 4 min.

Codes for Principal Business Activity 29Index . . . . . . . . . . . . . . . . 32

Contents PageContents PageGeneral Information . . . . . . . . 11Changes To Note . . . . . . . . . . 1Income . . . . . . . . . . . . . . 11Photographs of Missing Children . . 2Deductions . . . . . . . . . . . . 12Unresolved Tax Issues . . . . . . . 2Tax and Payments . . . . . . . . 15

How To Make a Contribution To Reducethe Public Debt . . . . . . . . . . 2 Schedule A—Cost of Goods Sold 16

Schedule B—Other Information . . 17How To Get Forms and Publications 2General Instructions for Schedules

K and K-1 . . . . . . . . . . . . 17General Instructions . . . . . . . . 2

Purpose of Form . . . . . . . . . 2Purpose of Schedules . . . . . . 17

Who Must File . . . . . . . . . . 2Substitute Forms . . . . . . . . . 17

Termination of Election . . . . . . 2Shareholder's Pro Rata Share Items 17

When To File . . . . . . . . . . . 3Specific Instructions (Schedule K

Only) . . . . . . . . . . . . . . . 19Period Covered . . . . . . . . . . 3Where To File . . . . . . . . . . . 3

Specific Instructions (Schedule K-1Only) . . . . . . . . . . . . . . . 19Who Must Sign . . . . . . . . . . 3

Accounting Methods . . . . . . . 3 General Information . . . . . . . . 19Accounting Periods . . . . . . . . 4 Special Reporting Requirements for

Corporations With MultipleActivities . . . . . . . . . . . . 19

Rounding Off to Whole Dollars . . 4Recordkeeping . . . . . . . . . . 4

Special Reporting Requirements forAt-Risk Activities . . . . . . . . 19

Depository Method of Tax Payment 4Estimated Tax . . . . . . . . . . 5

Specific Items . . . . . . . . . . . 19Interest and Penalties . . . . . . . 5Specific Instructions (Schedules K

and K-1, Except as Noted) . . . 19Other Forms, Returns, and

Statements That May Be Required 5Income (Loss) . . . . . . . . . . . 19Assembling the Return . . . . . . 7Deductions . . . . . . . . . . . . 20Amended Return . . . . . . . . . 7Investment Interest . . . . . . . . 21Passive Activity Limitations . . . . 7Credits . . . . . . . . . . . . . . 22Specific Instructions . . . . . . . 11

Cat. No. 11515K

Operations of U.S. Corporations, to thisreturn. See Schedule N for details.

Photographs of MissingChildrenThe Internal Revenue Service is a proudpartner with the National Center forMissing and Exploited Children.Photographs of missing children selectedby the Center may appear in instructionson pages that would otherwise be blank.You can help bring these children homeby looking at the photographs and calling1-800-THE-LOST (1-800-843-5678) if yourecognize a child.

Unresolved Tax IssuesIf the corporation has attempted to dealwith an IRS problem unsuccessfully, itshould contact the Taxpayer Advocate.The Taxpayer Advocate independentlyrepresents the corporation's interests andconcerns within the IRS by protecting itsrights and resolving problems that havenot been fixed through normal channels.

While Taxpayer Advocates cannotchange the tax law or make a technicaltax decision, they can clear up problemsthat resulted from previous contacts andensure that the corporation's case is givena complete and impartial review.

The corporation's assigned personaladvocate will listen to its point of view andwill work with the corporation to addressits concerns. The corporation can expectthe advocate to provide:● A "fresh look" at a new or on-goingproblem.● Timely acknowledgment.● The name and phone number of theindividual assigned to its case.● Updates on progress.● Timeframes for action.● Speedy resolution.● Courteous service.

When contacting the TaxpayerAdvocate, the corporation should providethe following information:● The corporation's name, address, andemployer identification number.● The name and telephone number of anauthorized contact person and the hourshe or she can be reached.● The type of tax return and year(s)involved.● A detailed description of the problem.● Previous attempts to solve the problemand the office that had been contacted.● A description of the hardship thecorporation is facing (if applicable).

The corporation may contact aTaxpayer Advocate by calling a toll-freenumber, 1-877-777-4778. Persons whohave access to TTY/TDD equipment maycall 1-800-829-4059 and ask for TaxpayerAdvocate assistance. If the corporationprefers, it may call, write, or fax theTaxpayer Advocate office in its area. See

Pub. 1546, The Taxpayer AdvocateService of the IRS, for a list of addressesand fax numbers.

How To Make a ContributionTo Reduce the Public DebtTo make a contribution to reduce thepublic debt, send a check made payableto the “Bureau of the Public Debt” toBureau of the Public Debt, DepartmentG, P.O. Box 2188, Parkersburg, WV26106-2188. Or, enclose a check withForm 1120S. Contributions to reduce thepublic debt are deductible, subject to therules and limitations for charitablecontributions.

How To Get Forms andPublicationsPersonal computer. You can access theIRS Web Site 24 hours a day, 7 days aweek at www.irs.gov to:● Download forms, instructions, andpublications.● See answers to frequently asked taxquestions.● Search publications on-line by topic orkeyword.● Send us comments or request help bye-mail.● Sign up to receive local and national taxnews by e-mail.

You can also reach us using filetransfer protocol at ftp.irs.gov .CD-ROM. Order Pub. 1796, Federal TaxProducts on CD-ROM, and get:● Current year forms, instructions, andpublications.● Prior year forms, instructions, andpublications.● Popular tax forms that may be filled inelectronically, printed out for submission,and saved for recordkeeping.● The Internal Revenue Bulletin.

Buy the CD-ROM on the Internet atwww.irs.gov/cdorders from the NationalTechnical Information Service (NTIS) for$21 (no handling fee) or call1-877-CDFORMS (1-877-233-6767) tollfree to buy the CD-ROM for $21 (plus a$5 handling fee).By phone and in person. You can orderforms and publications 24 hours a day, 7days a week, by calling1-800-TAX-FORM (1-800-829-3676). Youcan also get most forms and publicationsat your local IRS office.

General Instructions

Purpose of FormForm 1120S is used to report the income,deductions, gains, losses, etc., of adomestic corporation that has elected tobe an S corporation by filing Form 2553,Election by a Small Business Corporation,

and whose election is in effect for the taxyear.

Who Must FileA corporation must file Form 1120S if (a)it elected to be an S corporation by filingForm 2553, (b) the IRS accepted theelection, and (c) the election remains ineffect. Do not file Form 1120S for any taxyear before the year the election takeseffect.

Termination of ElectionOnce the election is made, it stays ineffect until it is terminated. If the electionis terminated in a tax year beginning after1996, the corporation (or a successorcorporation) can make another electionon Form 2553 only with IRS consent forany tax year before the 5th tax year afterthe first tax year in which the terminationtook effect. See Regulations section1.1362-5 for more details.

An election terminates automaticallyin any of the following cases:

1. The corporation is no longer a smallbusiness corporation as defined in section1361(b). The termination of an election inthis manner is effective as of the day onwhich the corporation no longer meets thedefinition of a small business corporation.If the election terminates for this reason,attach to Form 1120S for the final year ofthe S corporation a statement notifyingthe IRS of the termination and the date itoccurred.

2. The corporation, for each of threeconsecutive tax years, (a) hasaccumulated earnings and profits and (b)derives more than 25% of its grossreceipts from passive investment incomeas defined in section 1362(d)(3)(C). Theelection terminates on the first day of thefirst tax year beginning after the thirdconsecutive tax year. The corporationmust pay a tax for each year it has excessnet passive income. See the instructionsfor line 22a for details on how to figure thetax.

3. The election is revoked. An electionmay be revoked only with the consent ofshareholders who, at the time therevocation is made, hold more than 50%of the number of issued and outstandingshares of stock (including non-votingstock). The revocation may specify aneffective revocation date that is on or afterthe day the revocation is filed. If no dateis specified, the revocation is effective atthe start of a tax year if the revocation ismade on or before the 15th day of the 3rdmonth of that tax year. If no date isspecified and the revocation is made afterthe 15th day of the 3rd month of the taxyear, the revocation is effective at thestart of the next tax year.

To revoke the election, the corporationmust file a statement with the servicecenter where it filed its election to be anS corporation. In the statement, thecorporation must notify the IRS that it is

Page 2 Instructions for Form 1120S

revoking its election to be an Scorporation. The statement must besigned by each shareholder who consentsto the revocation and contain theinformation required by Regulationssection 1.1362-6(a)(3). A revocation maybe rescinded before it takes effect. SeeRegulations section 1.1362-6(a)(4) fordetails.

For rules on allocating income anddeductions between an S short year anda C short year and other special rules thatapply when an election is terminated, seesection 1362(e) and Regulations section1.1362-3.

If an election was terminated under 1or 2 above, and the corporation believesthe termination was inadvertent, thecorporation may request permission fromthe IRS to continue to be treated as an Scorporation. See Regulations section1.1362-4 for the specific requirementsthat must be met to qualify for inadvertenttermination relief.

When To FileIn general, file Form 1120S by the 15thday of the 3rd month following the datethe corporation's tax year ended asshown at the top of Form 1120S. Forcalendar year corporations, the due dateis March 15, 2001. If the due date falls ona Saturday, Sunday, or legal holiday, fileon the next business day. A business dayis any day that is not a Saturday, Sunday,or legal holiday.

If the S election was terminated duringthe tax year, file Form 1120S for the Sshort year by the due date (includingextensions) of the C short year return.

Private Delivery ServicesYou can use certain private deliveryservices designated by the IRS to meetthe “timely mailing as timely filing/paying”rule for tax returns and payments. Themost recent list of designated privatedelivery services was published by theIRS in August 1999. The list includes onlythe following:● Airborne Express (Airborne): OvernightAir Express Service, Next AfternoonService, Second Day Service.● DHL Worldwide Express (DHL): DHL"Same Day" Service, DHL USAOvernight.● Federal Express (FedEx): FedExPriority Overnight, FedEx StandardOvernight, FedEx 2Day.● United Parcel Service (UPS): UPS NextDay Air, UPS Next Day Air Saver, UPS2nd Day Air, UPS 2nd Day Air A.M.

The private delivery service can tell youhow to get written proof of the mailingdate.

ExtensionUse Form 7004, Application for AutomaticExtension of Time To File CorporationIncome Tax Return, to request an

automatic 6-month extension of time tofile Form 1120S.

Period CoveredFile the 2000 return for calendar year2000 and fiscal years beginning in 2000and ending in 2001. If the return is for afiscal year or a short tax year, fill in the taxyear space at the top of the form.Note: The 2000 Form 1120S may alsobe used if (a) the corporation has a taxyear of less than 12 months that beginsand ends in 2001 and (b) the 2001 Form1120S is not available by the time thecorporation is required to file its return.However, the corporation must show its2001 tax year on the 2000 Form 1120Sand incorporate any tax law changes thatare effective for tax years beginning afterDecember 31, 2000.

Where To FileFile your return at the applicable IRSaddress listed below.

Who Must SignThe return must be signed and dated bythe president, vice president, treasurer,assistant treasurer, chief accountingofficer, or any other corporate officer(such as tax officer) authorized to sign. Areceiver, trustee, or assignee must signand date any return he or she is requiredto file on behalf of a corporation.

If a corporate officer filled in Form1120S, the Paid Preparer's space under“Signature of officer” should remain blank.If someone prepares Form 1120S anddoes not charge the corporation, thatperson should not sign the return. Certainothers who prepare Form 1120S shouldnot sign. For example, a regular, full-timeemployee of the corporation such as aclerk, secretary, etc., should not sign.

Generally, anyone paid to prepareForm 1120S must sign the return and fillin the other blanks in the Paid Preparer'sUse Only area of the return.

The preparer required to sign the returnmust complete the required preparerinformation and:● Sign it, by hand, in the space providedfor the preparer's signature. (Signaturestamps or labels are not acceptable.)● Give a copy of Form 1120S to thetaxpayer in addition to the copy filed withthe IRS.

Accounting MethodsFigure ordinary income using the methodof accounting regularly used in keepingthe corporation's books and records.Generally, permissible methods include:● Cash,● Accrual, or● Any other method authorized by theInternal Revenue Code.

In all cases, the method used mustclearly reflect income. If inventories arerequired, the accrual method must beused for sales and purchases ofmerchandise. See Schedule A—Cost ofGoods Sold on page 16.

Generally, an S corporation may notuse the cash method of accounting if thecorporation is a tax shelter (as defined insection 448(d)(3)). See section 448 fordetails.

Under the accrual method, an amountis includible in income when:● All the events have occurred that fix theright to receive the income, which is theearliest of the date (a) the required

California(all other counties)Fresno, CA93888-0013

IllinoisKansas City, MO

64999-0013

Alabama, TennesseeMemphis, TN

37501-0013

VirginiaPhiladelphia, PA

19255-0013

If the corporation'sprincipal business,office, or agency is

located in

Use the followingInternal RevenueService Center

address

New York (New York Cityand counties of Nassau,Rockland, Suffolk, andWestchester)

Holtsville, NY00501-0013

New York (all othercounties), Connecticut,Maine, Massachusetts, NewHampshire, Rhode Island,Vermont

Andover, MA05501-0013

Florida, GeorgiaAtlanta, GA39901-0013

Delaware, District ofColumbia, Indiana, Kentucky,Maryland, Michigan, NewJersey, North Carolina, Ohio,Pennsylvania, SouthCarolina, West Virginia,Wisconsin

Cincinnati, OH45999-0013

Kansas, New Mexico,Oklahoma

Austin, TX73301-0013

Alaska, Arizona, Arkansas,California (counties of Alpine,Amador, Butte, Calaveras,Colusa, Contra Costa, DelNorte, El Dorado, Glenn,Humboldt, Lake, Lassen,Marin, Mendocino, Modoc,Napa, Nevada, Placer,Plumas, Sacramento, SanJoaquin, Shasta, Sierra,Siskiyou, Solano, Sonoma,Sutter, Tehama, Trinity, Yolo,and Yuba), Colorado, Hawaii,Idaho, Iowa, Louisiana,Minnesota, Mississippi,Missouri, Montana,Nebraska, Nevada, NorthDakota, Oregon, SouthDakota, Texas, Utah,Washington, Wyoming

Ogden, UT84201-0013

Instructions for Form 1120S Page 3

performance takes place, (b) payment isdue, or (c) payment is received, and● The amount can be determined withreasonable accuracy.

See Regulations section 1.451-1(a) fordetails.

Generally, an accrual basis taxpayercan deduct accrued expenses in the taxyear in which:● All events that determine liability haveoccurred,● The amount of the liability can befigured with reasonable accuracy, and● Economic performance takes place withrespect to the expense. There areexceptions for certain items, includingrecurring expenses. See section 461(h)and the related regulations for the rulesfor determining when economicperformance takes place.

Except for certain home constructioncontracts and other real property smallconstruction contracts, long-termcontracts must generally be accounted forusing the percentage of completionmethod described in section 460.

Mark-to-Market Accounting MethodDealers in securities must use the“mark-to-market” accounting methoddescribed in section 475. Under thismethod, any security that is inventory tothe dealer must be included in inventoryat its fair market value. Any security thatis not inventory and that is held at theclose of the tax year is treated as sold atits fair market value on the last businessday of the tax year, and any gain or lossmust be taken into account in determininggross income. The gain or loss taken intoaccount is generally treated as ordinarygain or loss. For details, includingexceptions, see section 475 and therelated regulations.

Dealers in commodities and traders insecurities and commodities may elect touse the mark-to-market accountingmethod. To make the election, thecorporation must file a statementdescribing the election, the first tax yearthe election is to be effective, and, in thecase of an election for traders in securitiesor commodities, the trade or business forwhich the election is made. Except fornew taxpayers, the statement must befiled by the due date (not includingextensions) of the income tax return forthe tax year immediately preceding theelection year and attached to that return,or, if applicable, to a request for anextension of time to file that return. Formore details, see Rev. Proc. 99-17,1999-1 C.B. 503, and sections 475(e) and(f).

Change in Accounting MethodGenerally, the corporation must get IRSconsent to change its method ofaccounting used to report taxable income(for income as a whole or for any materialitem). To do so, it must file Form 3115,

Application for Change in AccountingMethod. For more information, see Pub.538, Accounting Periods and Methods.

Accounting PeriodsGenerally, an S corporation may notchange its accounting period to a tax yearthat is not a permitted year. A “permittedyear” is a calendar year or any otheraccounting period for which thecorporation can establish to thesatisfaction of the IRS that there is abusiness purpose for the tax year.

To change an accounting period, seeRegulations section 1.442-1 and Form1128, Application To Adopt, Change, orRetain a Tax Year. Also see Pub. 538.

Election of a Tax Year Other Thana Required YearUnder the provisions of section 444, anS corporation may elect to have a tax yearother than a permitted year, but only if thedeferral period of the tax year is notlonger than the shorter of 3 months or thedeferral period of the tax year beingchanged. This election is made by filingForm 8716, Election To Have a Tax YearOther Than a Required Tax Year.

An S corporation may not make orcontinue an election under section 444 ifit is a member of a tiered structure, otherthan a tiered structure that consistsentirely of partnerships and Scorporations that have the same tax year.For the S corporation to have a section444 election in effect, it must make thepayments required by section 7519 andfile Form 8752, Required Payment orRefund Under Section 7519.

A section 444 election ends if an Scorporation changes its accounting periodto a calendar year or some otherpermitted year; it is penalized for willfullyfailing to comply with the requirements ofsection 7519; or its S election isterminated (unless it immediatelybecomes a personal service corporation).If the termination results in a short taxyear, type or legibly print at the top of thefirst page of Form 1120S for the short taxyear, “SECTION 444 ELECTIONTERMINATED.”

Rounding Off to WholeDollarsYou may round off cents to whole dollarson your return and accompanyingschedules. To do so, drop amounts under50 cents and increase amounts from 50to 99 cents to the next higher dollar.

RecordkeepingThe corporation's records must be keptas long as they may be needed for theadministration of any provision of theInternal Revenue Code. Usually, recordsthat support an item of income, deduction,or credit on the corporation's return must

be kept for 3 years from the date eachshareholder's return is due or is filed,whichever is later. Keep records thatverify the corporation's basis in propertyfor as long as they are needed to figurethe basis of the original or replacementproperty.

The corporation should also keepcopies of any returns it has filed. Theyhelp in preparing future returns and inmaking computations when filing anamended return.

Depository Method of TaxPaymentThe corporation must pay the tax due infull no later than the 15th day of the 3rdmonth after the end of the tax year. Thetwo methods of depositing corporateincome taxes are discussed below.

Electronic Deposit RequirementThe corporation must make electronicdeposits of all depository taxes (such asemployment tax, excise tax, andcorporate income tax) using the ElectronicFederal Tax Payment System (EFTPS) in2001 if:● The total deposits of such taxes in 1999were more than $200,000 or● The corporation was required to useEFTPS in 2000.

If the corporation is required to useEFTPS and fails to do so, it may besubject to a 10% penalty. If thecorporation is not required to use EFTPS,it may participate voluntarily. To enroll inor get more information about EFTPS, call1-800-555-4477 or 1-800-945-8400.Depositing on time. For deposits madeby EFTPS to be on time, the corporationmust initiate the transaction at least 1business day before the date the depositis due.

Deposits With Form 8109If the corporation does not use EFTPS,deposit corporation income tax payments(and estimated tax payments) with Form8109, Federal Tax Deposit Coupon. If youdo not have a preprinted Form 8109, useForm 8109-B to make deposits. You canget this form only by calling1-800-829-1040. Be sure to have youremployer identification number (EIN)ready when you call.

Do not send deposits directly to an IRSoffice; otherwise, the corporation mayhave to pay a penalty. Mail or deliver thecompleted Form 8109 with the paymentto an authorized depositary, i.e., acommercial bank or other financialinstitution authorized to accept Federaltax deposits.

Make checks or money orders payableto the depositary. To help ensure propercrediting, write the corporation's EIN, thetax period to which the deposit applies,and “Form 1120S” on the check or moneyorder. Be sure to darken the “1120” box

Page 4 Instructions for Form 1120S

on the coupon. Records of these depositswill be sent to the IRS.

For more information on deposits, seethe instructions in the coupon booklet(Form 8109) and Pub. 583, Starting aBusiness and Keeping Records.

Estimated TaxGenerally, the corporation must makeestimated tax payments for the followingtaxes if the total of these taxes is $500or more: (a) the tax on certain capitalgains, (b) the tax on built-in gains, (c) theexcess net passive income tax, and (d)the investment credit recapture tax.

The amount of estimated tax requiredto be paid annually is the smaller of (a)the total of the above taxes shown on thereturn for the tax year (or if no return isfiled, the total of these taxes for the year)or (b) the sum of (i) the investment creditrecapture tax and the built-in gains tax (orthe tax on certain capital gains) shown onthe return for the tax year (or if no returnis filed, the total of these taxes for theyear), and (ii) any excess net passiveincome tax shown on the corporation'sreturn for the preceding tax year. If thepreceding tax year was less than 12months, the estimated tax must bedetermined under (a).

The estimated tax is generally payablein four equal installments. However, thecorporation may be able to lower theamount of one or more installments byusing the annualized income installmentmethod or adjusted seasonal installmentmethod under section 6655(e).

For a calendar year corporation, thepayments are due for 2001 by April 16,June 15, September 17, and December17. For a fiscal year corporation, they aredue by the 15th day of the 4th, 6th, 9th,and 12th months of the fiscal year.

The corporation must make thepayments using the depository methoddescribed above.

Interest and Penalties

InterestInterest is charged on taxes not paid bythe due date, even if an extension of timeto file is granted. Interest is also chargedfrom the due date (including extensions)to the date of payment on the failure to filepenalty, the accuracy-related penalty, andthe fraud penalty. The interest charge isfigured at a rate determined under section6621.

Late Filing of ReturnA corporation that does not file its taxreturn by the due date, includingextensions, may have to pay a penalty of5% a month, or part of a month, up to amaximum of 25%, for each month the

return is not filed. The penalty is imposedon the net amount due. The minimumpenalty for filing a return more than 60days late is the smaller of the tax due or$100. The penalty will not be imposed ifthe corporation can show that the failureto file on time was due to reasonablecause. If the failure is due to reasonablecause, attach an explanation to the return.

Late Payment of TaxA corporation that does not pay the taxwhen due generally may have to pay apenalty of 1/2 of 1% a month or part of amonth, up to a maximum of 25%, for eachmonth the tax is not paid. The penalty isimposed on the net amount due.

The penalty will not be imposed if thecorporation can show that failure to payon time was due to reasonable cause.

Failure To Furnish InformationTimelySection 6037(b) requires an S corporationto furnish to each shareholder a copy ofthe information shown on Schedule K-1(Form 1120S) that is attached to Form1120S. Provide Schedule K-1 to eachshareholder on or before the day on whichthe corporation files Form 1120S.

For each failure to furnish Schedule K-1to a shareholder when due and eachfailure to include on Schedule K-1 all theinformation required to be shown (or theinclusion of incorrect information), a $50penalty may be imposed with regard toeach Schedule K-1 for which a failureoccurs. If the requirement to reportcorrect information is intentionallydisregarded, each $50 penalty isincreased to $100 or, if greater, 10% ofthe aggregate amount of items requiredto be reported. See sections 6722 and6724 for more information.

The penalty will not be imposed if thecorporation can show that not furnishinginformation timely was due to reasonablecause and not due to willful neglect.

Trust Fund Recovery PenaltyThis penalty may apply if certain excise,income, social security, and Medicaretaxes that must be collected or withheldare not collected or withheld, or thesetaxes are not paid to the IRS. These taxesare generally reported on Forms 720, 941,943, or 945. The trust fund recoverypenalty may be imposed on all personswho are determined by the IRS to havebeen responsible for collecting,accounting for, and paying over thesetaxes, and who acted willfully in not doingso. The penalty is equal to the unpaidtrust fund tax. See the instructions forForm 720, Pub. 15 (Circular E),Employer's Tax Guide, or Pub. 51(Circular A), Agricultural Employer's TaxGuide, for more details, including thedefinition of responsible persons.

Other Forms, Returns, andStatements That May BeRequired● Schedule N (Form 1120), ForeignOperations of U.S. Corporations. Thecorporation may have to file this scheduleif it had assets in or operated a businessin a foreign country or a U.S. possession.● Forms W-2 and W-3, Wage and TaxStatement; and Transmittal of Wage andTax Statements. Use these forms toreport wages, tips, other compensation,and withheld income, social security andMedicare taxes for employees.● Form 720, Quarterly Federal ExciseTax Return. Use Form 720 to reportenvironmental taxes, communications andair transportation taxes, fuel taxes, luxurytax on passenger vehicles, manufacturerstaxes, ship passenger tax, and certainother excise taxes.

CAUTION!

See Trust Fund RecoveryPenalty above.

● Form 926, Return by a U.S. Transferorof Property to a Foreign Corporation. Usethis form to report certain informationrequired under section 6038B.● Form 940 or Form 940-EZ, Employer'sAnnual Federal Unemployment (FUTA)Tax Return. The corporation may be liablefor FUTA tax and may have to file Form940 or 940-EZ if it paid wages of $1,500or more in any calendar quarter during thecalendar year (or the preceding calendaryear) or one or more employees workedfor the corporation for some part of a dayin any 20 different weeks during thecalendar year (or the preceding calendaryear). A corporate officer who performssubstantial services is considered anemployee. Except as provided in section3306(a), reasonable compensation forthese services is subject to FUTA tax, nomatter what the corporation calls thepayments.● Form 941, Employer's QuarterlyFederal Tax Return. Employers must filethis form quarterly to report income taxwithheld on wages and employer andemployee social security and Medicaretaxes. A corporate officer who performssubstantial services is considered anemployee. Except as provided in sections3121(a) and 3401(a), reasonablecompensation for these services issubject to employer and employee socialsecurity and Medicare taxes and incometax withholding, no matter what thecorporation calls the payments.Agricultural employers must file Form943, Employer's Annual Tax Return forAgricultural Employees, instead of Form941, to report income tax withheld andemployer and employee social securityand Medicare taxes on farmworkers.

Instructions for Form 1120S Page 5

CAUTION!

See Trust Fund RecoveryPenalty on page 5.

● Form 945, Annual Return of WithheldFederal Income Tax. Use this form toreport income tax withheld fromnonpayroll payments, including pensions,annuities, IRAs, gambling winnings, andbackup withholding.

CAUTION!

See Trust Fund RecoveryPenalty on page 5.

● Form 966, Corporate Dissolution orLiquidation.● Forms 1042 and 1042-S, AnnualWithholding Tax Return for U.S. SourceIncome of Foreign Persons; and ForeignPerson's U.S. Source Income Subject toWithholding. Use these forms to reportand transmit withheld tax on paymentsmade to nonresident alien individuals,foreign partnerships, or foreigncorporations to the extent such paymentsconstitute gross income from sourceswithin the United States (see sections 861through 865). For more information, seesections 1441 and 1442, and Pub. 515,Withholding of Tax on Nonresident Aliensand Foreign Corporations.● Form 1096, Annual Summary andTransmittal of U.S. Information Returns.● Form 1098, Mortgage InterestStatement. Use this form to report thereceipt from any individual of $600 ormore of mortgage interest (includingpoints) in the course of the corporation'strade or business.● Forms 1099-A, B, C, DIV, INT, LTC,MISC, MSA, OID, PATR, R, and S. Youmay have to file these information returnsto report acquisitions or abandonmentsof secured property; proceeds from brokerand barter exchange transactions;cancellation of debt; certain dividends anddistributions; interest payments; paymentsof long-term care and accelerated deathbenefits; miscellaneous incomepayments; distributions from a medicalsavings account (MSA) orMedicare+Choice MSA; original issuediscount; distributions from cooperativesto their patrons; distributions frompensions, annuities, retirement orprofit-sharing plans, IRAs, insurancecontracts, etc.; and proceeds from realestate transactions. Also use certain ofthese returns to report amounts that werereceived as a nominee on behalf ofanother person.

Use Form 1099-DIV to report actualdividends paid by the corporation. Onlydistributions from accumulated earningsand profits are classified as dividends. Donot issue Form 1099-DIV for dividendsreceived by the corporation that areallocated to shareholders on line 4b ofSchedule K-1.

For more information, see theInstructions for Forms 1099, 1098, 5498,and W-2G.

Note: Every corporation must file Forms1099-MISC if it makes payments of rents,commissions, or other fixed ordeterminable income (see section 6041)totaling $600 or more to any one personin the course of its trade or businessduring the calendar year.● Form 3520, Annual Return to ReportTransactions With Foreign Trust andReceipt of Certain Foreign Gifts. Thecorporation may have to file this form if it:

1. Directly or indirectly transferredproperty or money to a foreign trust. Forthis purpose, any U.S. person whocreated a foreign trust is considered atransferor.

2. Is treated as the owner of any partof the assets of a foreign trust under thegrantor trust rules.

3. Received a distribution from aforeign trust.

For more information, see theInstructions for Form 3520.Note: An owner of a foreign trust mustensure that the trust files an annualinformation return on Form 3520-A,Annual Information Return of ForeignTrust With a U.S. Owner.● Form 5471, Information Return of U.S.Persons With Respect to Certain ForeignCorporations. A corporation may have tofile Form 5471 if any of the followingapply:

1. It controls a foreign corporation.2. It acquires, disposes of, or owns

5% or more in value of the outstandingstock of a foreign corporation.

3. It owns stock in a corporation thatis a controlled foreign corporation for anuninterrupted period of 30 days or moreduring any tax year of the foreigncorporation, and it owned that stock onthe last day of that year.● Form 5713, International BoycottReport. Every corporation that hadoperations in, or related to, a “boycotting”country, company, or national of a countrymust file Form 5713 to report thoseoperations and figure the loss of certaintax benefits.● Form 8264, Application for Registrationof a Tax Shelter. Tax shelter organizersmust file Form 8264 to register taxshelters with the IRS for the purpose ofreceiving a tax shelter registrationnumber.● Form 8271, Investor Reporting of TaxShelter Registration Number.Corporations that have acquired aninterest in a tax shelter that is required tobe registered use Form 8271 to report thetax shelter's registration number. AttachForm 8271 to any return on which adeduction, credit, loss, or other tax benefitattributable to a tax shelter is taken or anyincome attributable to a tax shelter isreported.● Form 8275, Disclosure Statement. FileForm 8275 to disclose items or positions,

except those contrary to a regulation, thatare not otherwise adequately disclosedon a tax return. The disclosure is madeto avoid the parts of the accuracy-relatedpenalty imposed for disregard of rules orsubstantial understatement of tax. Form8275 is also used for disclosures relatingto preparer penalties for understatementsdue to unrealistic positions or disregardof rules.● Form 8275-R, Regulation DisclosureStatement, is used to disclose any itemon a tax return for which a position hasbeen taken that is contrary to Treasuryregulations.● Form 8281, Information Return forPublicly Offered Original Issue DiscountInstruments. This form is used by issuersof publicly offered debt instrumentshaving OID to provide the informationrequired by section 1275(c).● Forms 8288 and 8288-A, U.S.Withholding Tax Return for Dispositionsby Foreign Persons of U.S. Real PropertyInterests; and Statement of Withholdingon Dispositions by Foreign Persons ofU.S. Real Property Interests. Use theseforms to report and transmit withheld taxon the sale of U.S. real property by aforeign person. See section 1445 and therelated regulations for additionalinformation.● Form 8300, Report of Cash PaymentsOver $10,000 Received in a Trade orBusiness. File this form to report thereceipt of more than $10,000 in cash orforeign currency in one transaction (or aseries of related transactions).● Form 8594, Asset AcquisitionStatement. Both the seller and buyer of agroup of assets that makes up a trade orbusiness must use this form to reportsuch a sale if goodwill or going concernvalue attaches, or could attach, to suchassets an if the buyer's basis in the assetsis determined only by the amount paid forthe assets.● Form 8697, Interest ComputationUnder the Look-Back Method forCompleted Long-Term Contracts. CertainS corporations that are not closely heldmay have to file Form 8697. Form 8697is used to figure the interest due or to berefunded under the look-back method ofsection 460(b)(2) on certain long-termcontracts that are accounted for undereither the percentage ofcompletion-capitalized cost method or thepercentage of completion method. Closelyheld corporations should see theinstructions on page 26 for line 23, item10, of Schedule K-1 for details on theForm 8697 information they must provideto their shareholders.● Form 8865, Return of U.S. Person WithRespect To Certain Foreign Partnerships.A corporation may have to file Form 8865if it:

1. Controlled a foreign partnership(i.e., owned more than a 50% direct orindirect interest in the partnership).

Page 6 Instructions for Form 1120S

2. Owned at least a 10% direct orindirect interest in a foreign partnershipwhile U.S. persons controlled thatpartnership.

3. Had an acquisition, disposition, orchange in proportional interest of a foreignpartnership that:

a. Increased its direct interest to atleast 10% or reduced its direct interest ofat least 10% to less than 10%.

b. Changed its direct interest by atleast a 10% interest.

4. Contributed property to a foreignpartnership in exchange for a partnershipinterest if:

a. Immediately after the contribution,the corporation owned, directly orindirectly, at least a 10% interest in theforeign partnership; or

b. The fair market value of theproperty the corporation contributed to theforeign partnership in exchange for apartnership interest, when added to othercontributions of property made to theforeign partnership during the preceding12-month period, exceeds $100,000.

Also, the corporation may have to fileForm 8865 to report certain dispositionsby a foreign partnership of property itpreviously contributed to that foreignpartnership if it was a partner at the timeof the disposition.

For more details, including penalties forfailing to file Form 8865, see Form 8865and its separate instructions.● Form 8866, Interest ComputationUnder the Look-Back Method for PropertyDepreciated Under the Income ForecastMethod. Certain S corporations that arenot closely held may have to file Form8866. Form 8866 is used to figure theinterest due or to be refunded under thelook-back method of section 167(g)(2) forcertain property placed in service afterSeptember 13, 1995, and depreciatedunder the income forecast method.Closely held corporations should see theinstructions on page 26 for line 23, item17, of Schedule K-1 for details on theForm 8866 information they must provideto their shareholders.

StatementsStock ownership in foreigncorporations. If the corporation ownedat least 5% in value of the outstandingstock of a foreign personal holdingcompany, and the corporation wasrequired to include in its gross income anyundistributed foreign personal holdingcompany income, attach the statementrequired by section 551(c).Transfers to a corporation controlledby the transferor. If a person receivesstock of a corporation in exchange forproperty, and no gain or loss isrecognized under section 351, thetransferor and transferee must eachattach to their tax returns the informationrequired by Regulations section 1.351-3.

Assembling the ReturnAfter page 4, Form 1120S, assembleschedules and forms in the followingorder:

1. Schedule N (Form 1120).2. Form 4136, Credit for Federal Tax

Paid on Fuels.3. Additional schedules in alphabetical

order.4. Additional forms in numerical order.

To assist us in processing the return,please complete every applicable entryspace on Form 1120S and ScheduleK-1. If you attach statements, do not write“See attached” instead of completing theentry spaces on Form 1120S andSchedule K-1.

If you need more space on the formsor schedules, attach separate sheets andplace them at the end of the return. Usethe same size and format as on theprinted forms. But show the totals onthe printed forms. Be sure to put thecorporation's name and EIN on eachsheet.

Amended ReturnTo correct an error on a Form 1120Salready filed, file an amended Form1120S and check box F(4). If theamended return results in a change toincome, or a change in the distribution ofany income or other information providedany shareholder, an amended ScheduleK-1 (Form 1120S) must also be filed withthe amended Form 1120S and given tothat shareholder. Be sure to check boxD(2) on each Schedule K-1 to indicatethat it is an amended Schedule K-1.

A change to the corporation's Federalreturn may affect its state return. Thisincludes changes made as the result ofan IRS examination of Form 1120S. Formore information, contact the state taxagency for the state in which thecorporation's return was filed.

Passive Activity LimitationsIn general, section 469 limits the amountof losses, deductions, and credits thatshareholders may claim from “passiveactivities.” The passive activity limitationsdo not apply to the corporation. Instead,they apply to each shareholder's share ofany income or loss and credit attributableto a passive activity. Because thetreatment of each shareholder's share ofcorporate income or loss and creditdepends upon the nature of the activitythat generated it, the corporation mustreport income or loss and creditsseparately for each activity.

The instructions below (pages 7through 11) and the instructions forSchedules K and K-1 (pages 18 through26) explain the applicable passive activitylimitation rules and specify the type ofinformation the corporation must provideto its shareholders for each activity. If the

corporation had more than one activity, itmust report information for each activityon an attachment to Schedules K andK-1.

Generally, passive activities include (a)activities that involve the conduct of atrade or business in which theshareholder does not materiallyparticipate and (b) any rental activity(defined on page 8) even if theshareholder materially participates. Forexceptions, see Activities That Are NotPassive Activities below. The level ofeach shareholder's participation in anactivity must be determined by theshareholder.

The passive activity rules provide thatlosses and credits from passive activitiescan generally be applied only againstincome and tax from passive activities.Thus, passive losses and credits cannotbe applied against income from salaries,wages, professional fees, or a businessin which the shareholder materiallyparticipates; against “portfolio income”(defined on page 9); or against the taxrelated to any of these types of income.

Special rules require that net incomefrom certain activities that wouldotherwise be treated as passive incomemust be recharacterized as nonpassiveincome for purposes of the passiveactivity limitations.

To allow each shareholder to apply thepassive activity limitations at the individuallevel, the corporation must report incomeor loss and credits separately for each ofthe following: trade or business activities,rental real estate activities, rentalactivities other than rental real estate, andportfolio income.

Activities That Are Not PassiveActivitiesPassive activities do not include:

1. Trade or business activities inwhich the shareholder materiallyparticipated for the tax year.

2. Any rental real estate activity inwhich the shareholder materiallyparticipated if the shareholder met bothof the following conditions for the tax year:

a. More than half of the personalservices the shareholder performed intrades or businesses were performed inreal property trades or businesses inwhich he or she materially participated,and

b. The shareholder performed morethan 750 hours of services in real propertytrades or businesses in which he or shematerially participated.

For purposes of this rule, each interestin rental real estate is a separate activityunless the shareholder elects to treat allinterests in rental real estate as oneactivity.

If the shareholder is married filingjointly, either the shareholder or his or herspouse must separately meet both

Instructions for Form 1120S Page 7

conditions 2a and b above, without takinginto account services performed by theother spouse.

A real property trade or business is anyreal property development,redevelopment, construction,reconstruction, acquisition, conversion,rental, operation, management, leasing,or brokerage trade or business. Servicesthe shareholder performed as anemployee are not treated as performed ina real property trade or business unlesshe or she owned more than 5% of thestock in the employer.

3. The rental of a dwelling unit usedby a shareholder for personal purposesduring the year for more than the greaterof 14 days or 10% of the number of daysthat the residence was rented at fair rentalvalue.

4. An activity of trading personalproperty for the account of owners ofinterests in the activity. For purposes ofthis rule, personal property meansproperty that is actively traded, such asstocks, bonds, and other securities. SeeTemporary Regulations section1.469-1T(e)(6).Note: The section 469(c)(3) exception fora working interest in oil and gas propertiesdoes not apply to an S corporationbecause state law generally limits theliability of shareholders.

Trade or Business ActivitiesA trade or business activity is an activity(other than a rental activity or an activitytreated as incidental to an activity ofholding property for investment) that—

1. Involves the conduct of a trade orbusiness (within the meaning of section162),

2. Is conducted in anticipation ofstarting a trade or business, or

3. Involves research or experimentalexpenditures deductible under section174 (or that would be if you chose todeduct rather than capitalize them).

If the shareholder does not materiallyparticipate in the activity, a trade orbusiness activity of the corporation is apassive activity for the shareholder.

Each shareholder must determine if heor she materially participated in anactivity. As a result, while thecorporation's overall trade or businessincome (loss) is reported on page 1 ofForm 1120S, the specific income anddeductions from each separate trade orbusiness activity must be reported onattachments to Form 1120S. Similarly,while each shareholder's allocable shareof the corporation's overall trade orbusiness income (loss) is reported on line1 of Schedule K-1, each shareholder'sallocable share of the income anddeductions from each trade or businessactivity must be reported on attachmentsto each Schedule K-1. See PassiveActivity Reporting Requirements onpage 10 for more information.

Rental ActivitiesGenerally, except as noted below, if thegross income from an activity consists ofamounts paid principally for the use ofreal or personal tangible property held bythe corporation, the activity is a rentalactivity.

There are several exceptions to thisgeneral rule. Under these exceptions, anactivity involving the use of real orpersonal tangible property is not a rentalactivity if any of the following apply:● The average period of customer use(defined below) for such property is 7days or less.● The average period of customer use forsuch property is 30 days or less andsignificant personal services (definedbelow) are provided by or on behalf of thecorporation.● Extraordinary personal services(defined below) are provided by or onbehalf of the corporation.● Rental of the property is treated asincidental to a nonrental activity of thecorporation under Temporary Regulationssection 1.469-1T(e)(3)(vi) andRegulations section 1.469-1(e)(3)(vi).● The corporation customarily makes theproperty available during definedbusiness hours for nonexclusive use byvarious customers.● The corporation provides property foruse in a nonrental activity of a partnershipin its capacity as an owner of an interestin such partnership. Whether thecorporation provides property used in anactivity of a partnership in thecorporation's capacity as an owner of aninterest in the partnership is based on allthe facts and circumstances.

In addition, a guaranteed paymentdescribed in section 707(c) is not incomefrom a rental activity under anycircumstances.Average period of customer use.Figure the average period of customeruse of property by dividing the totalnumber of days in all rental periods by thenumber of rentals during the tax year. Ifthe activity involves renting more than oneclass of property, multiply the averageperiod of customer use of each class bythe ratio of the gross rental income fromthat class to the activity's total gross rentalincome. The activity's average period ofcustomer use equals the sum of theseclass-by-class average periods weightedby gross income. See Regulations section1.469-1(e)(3)(iii).Significant personal services. Personalservices include only services performedby individuals. To determine if personalservices are significant personal services,consider all of the relevant facts andcircumstances. Relevant facts andcircumstances include how often theservices are provided, the type andamount of labor required to perform theservices, and the value of the services in

relation to the amount charged for the useof the property.

The following services are notconsidered in determining whetherpersonal services are significant:● Services necessary to permit the lawfuluse of the rental property.● Services performed in connection withimprovements or repairs to the rentalproperty that extend the useful life of theproperty substantially beyond the averagerental period.● Services provided in connection withthe use of any improved real property thatare similar to those commonly provided inconnection with long-term rentals ofhigh-grade commercial or residentialproperty. Examples include cleaning andmaintenance of common areas, routinerepairs, trash collection, elevator service,and security at entrances.Extraordinary personal services.Services provided in connection withmaking rental property available forcustomer use are extraordinary personalservices only if the services are performedby individuals and the customers' use ofthe rental property is incidental to theirreceipt of the services. For example, apatient's use of a hospital room generallyis incidental to the care that the patientreceives from the hospital's medical staff.Similarly, a student's use of a dormitoryroom in a boarding school is incidental tothe personal services provided by theschool's teaching staff.Rental property incidental to anonrental activity. An activity is not arental activity if the rental of the propertyis incidental to a nonrental activity, suchas the activity of holding property forinvestment, a trade or business activity,or the activity of dealing in property.

Rental of property is incidental to anactivity of holding property forinvestment if both of the following apply:● The main purpose for holding theproperty is to realize a gain from theappreciation of the property.● The gross rental income from suchproperty for the tax year is less than 2%of the smaller of the property's unadjustedbasis or its fair market value.

Rental of property is incidental to atrade or business activity if all of thefollowing apply:● The corporation owns an interest in thetrade or business at all times during theyear.● The rental property was mainly used inthe trade or business activity during thetax year or during at least 2 of the 5preceding tax years.● The gross rental income from theproperty is less than 2% of the smaller ofthe property's unadjusted basis or its fairmarket value.

The sale or exchange of property thatis also rented during the tax year (wherethe gain or loss is recognized) is treated

Page 8 Instructions for Form 1120S

as incidental to the activity of dealing inproperty if, at the time of the sale orexchange, the property was held primarilyfor sale to customers in the ordinarycourse of the corporation's trade orbusiness.

See Temporary Regulations section1.469-1T(e)(3) and Regulations section1.469-1(e)(3) for more information on thedefinition of rental activities for purposesof the passive activity limitations.Reporting of rental activities. Inreporting the corporation's income orlosses and credits from rental activities,the corporation must separately report (a)rental real estate activities and (b) rentalactivities other than rental real estateactivities.

Shareholders who actively participatein a rental real estate activity may be ableto deduct part or all of their rental realestate losses (and the deductionequivalent of rental real estate credits)against income (or tax) from nonpassiveactivities. Generally, the combinedamount of rental real estate losses andthe deduction equivalent of rental realestate credits from all sources (includingrental real estate activities not heldthrough the corporation) that may beclaimed is limited to $25,000.

Report rental real estate activity income(loss) on Form 8825, Rental Real EstateIncome and Expenses of a Partnershipor an S Corporation, and on line 2 ofSchedules K and K-1, rather than on page1 of Form 1120S. Report credits relatedto rental real estate activities on lines 12cand 12d and low-income housing creditson line 12b of Schedules K and K-1.

Report income (loss) from rentalactivities other than rental real estate online 3 and credits related to rentalactivities other than rental real estate online 12e of Schedules K and K-1.

Portfolio IncomeGenerally, portfolio income includes allgross income, other than income derivedin the ordinary course of a trade orbusiness, that is attributable to interest;dividends; royalties; income from a realestate investment trust, a regulatedinvestment company, a real estatemortgage investment conduit, a commontrust fund, a controlled foreigncorporation, a qualified electing fund, ora cooperative; income from thedisposition of property that producesincome of a type defined as portfolioincome; and income from the dispositionof property held for investment.

Solely for purposes of the precedingparagraph, gross income derived in theordinary course of a trade or businessincludes (and portfolio income,therefore, does not include) only thefollowing types of income:● Interest income on loans andinvestments made in the ordinary courseof a trade or business of lending money.

● Interest on accounts receivable arisingfrom the performance of services or thesale of property in the ordinary course ofa trade or business of performing suchservices or selling such property, but onlyif credit is customarily offered tocustomers of the business.● Income from investments made in theordinary course of a trade or business offurnishing insurance or annuity contractsor reinsuring risks underwritten byinsurance companies.● Income or gain derived in the ordinarycourse of an activity of trading or dealingin any property if such activity constitutesa trade or business (unless the dealerheld the property for investment at anytime before such income or gain isrecognized).● Royalties derived by the taxpayer in theordinary course of a trade or business oflicensing intangible property.● Amounts included in the gross incomeof a patron of a cooperative by reason ofany payment or allocation to the patronbased on patronage occurring withrespect to a trade or business of thepatron.● Other income identified by the IRS asincome derived by the taxpayer in theordinary course of a trade or business.

See Temporary Regulations section1.469-2T(c)(3) for more information onportfolio income.

Report portfolio income on line 4 ofSchedules K and K-1, rather than on page1 of Form 1120S.

Report deductions related to portfolioincome on line 9 of Schedules K and K-1.

Grouping ActivitiesGenerally, one or more trade or businessactivities or rental activities may betreated as a single activity if the activitiesmake up an appropriate economic unit formeasurement of gain or loss under thepassive activity rules. Whether activitiesmake up an appropriate economic unitdepends on all the relevant facts andcircumstances. The factors given thegreatest weight in determining whetheractivities make up an appropriateeconomic unit are—

1. Similarities and differences in typesof trades or businesses,

2. The extent of common control,3. The extent of common ownership,4. Geographical location, and5. Reliance between or among the

activities.Example. The corporation has a

significant ownership interest in a bakeryand a movie theater in Baltimore and ina bakery and a movie theater inPhiladelphia. Depending on the relevantfacts and circumstances, there may bemore than one reasonable method forgrouping the corporation's activities. Forinstance, the following groupings may ormay not be permissible:

● A single activity,● A movie theater activity and a bakeryactivity,● A Baltimore activity and a Philadelphiaactivity, or● Four separate activities.

Once the corporation chooses agrouping under these rules, it mustcontinue using that grouping in later taxyears unless a material change in thefacts and circumstances makes it clearlyinappropriate.

The IRS may regroup the corporation'sactivities if the corporation's grouping failsto reflect one or more appropriateeconomic units and one of the primarypurposes for the grouping is to avoid thepassive activity limitations.Limitation on grouping certainactivities. The following activities maynot be grouped together:

1. A rental activity with a trade orbusiness activity unless the activitiesbeing grouped together make up anappropriate economic unit, and

a. The rental activity is insubstantialrelative to the trade or business activityor vice versa, or

b. Each owner of the trade orbusiness activity has the sameproportionate ownership interest in therental activity. If so, the portion of therental activity involving the rental ofproperty to be used in the trade orbusiness activity may be grouped with thetrade or business activity.

2. An activity involving the rental ofreal property with an activity involving therental of personal property (except forpersonal property provided in connectionwith real property), or vice versa.

3. Any activity with another activity ina different type of business and in whichthe corporation holds an interest as alimited partner or as a limitedentrepreneur (as defined in section464(e)(2)) if that other activity engages inholding, producing, or distributing motionpicture films or videotapes; farming;leasing section 1245 property; orexploring for or exploiting oil and gasresources or geothermal deposits.Activities conducted throughpartnerships. Once a partnershipdetermines its activities under these rules,the corporation as a partner may usethese rules to group those activities with:● Each other,● Activities conducted directly by thecorporation, or● Activities conducted through otherpartnerships.

The corporation may not treat asseparate activities those activitiesgrouped together by the partnership.

Recharacterization of PassiveIncomeUnder Temporary Regulations section1.469-2T(f) and Regulations section

Instructions for Form 1120S Page 9

1.469-2(f), net passive income fromcertain passive activities must be treatedas nonpassive income. Net passiveincome is the excess of an activity'spassive activity gross income over itspassive activity deductions (current yeardeductions and prior year unallowedlosses).

Income from the following six sourcesis subject to recharacterization. Note thatany net passive income recharacterizedas nonpassive income is treated asinvestment income for purposes offiguring investment interest expenselimitations if it is from (a) an activity ofrenting substantially nondepreciableproperty from an equity-financed lendingactivity or (b) an activity related to aninterest in a pass-through entity thatlicenses intangible property.

1. Significant participation passiveactivities. A significant participationpassive activity is any trade or businessactivity in which the shareholder bothparticipates for more than 100 hoursduring the tax year and does notmaterially participate. Because eachshareholder must determine his or herlevel of participation, the corporation willnot be able to identify significantparticipation passive activities.

2. Certain nondepreciable rentalproperty activities. Net passive incomefrom a rental activity is nonpassiveincome if less than 30% of the unadjustedbasis of the property used or held for useby customers in the activity is subject todepreciation under section 167.

3. Passive equity-financed lendingactivities. If the corporation has netincome from a passive equity-financedlending activity, the smaller of the netpassive income or equity-financed interestincome from the activity is nonpassiveincome.Note: The amount of income from theactivities in items 1 through 3 above thatany shareholder will be required torecharacterize as nonpassive income maybe limited under Temporary Regulationssection 1.469-2T(f)(8). Because thecorporation will not have informationregarding all of a shareholder's activities,it must identify all corporate activitiesmeeting the definitions in items 2 and 3as activities that may be subject torecharacterization.

4. Rental activities incidental to adevelopment activity. Net rental activityincome is the excess of passive activitygross income from renting or disposingof property over passive activitydeductions (current year deductions andprior year unallowed losses) that arereasonably allocable to the rentedproperty. Net rental activity income isnonpassive income for a shareholder ifall of the following apply:● The corporation recognizes gain fromthe sale, exchange, or other dispositionof the rental property during the tax year.

● The use of the item of property in therental activity started less than 12 monthsbefore the date of disposition. The use ofan item of rental property begins on thefirst day on which (a) the corporationowns an interest in the property, (b)substantially all of the property is eitherrented or held out for rent and ready tobe rented, and (c) no significantvalue-enhancing services remain to beperformed.● The shareholder materially participatedor significantly participated for any taxyear in an activity that involved theperforming of services to enhance thevalue of the property (or any other itemof property, if the basis of the propertydisposed of is determined in whole or inpart by reference to the basis of that itemof property).

Because the corporation cannotdetermine a shareholder's level ofparticipation, the corporation must identifynet income from property describedabove (without regard to the shareholder'slevel of participation) as income that maybe subject to recharacterization.

5. Activities involving propertyrented to a nonpassive activity. If ataxpayer rents property to a trade orbusiness activity in which the taxpayermaterially participates, the taxpayer's netrental activity income (defined in item 4)from the property is nonpassive income.

6. Acquisition of an interest in apass-through entity that licensesintangible property. Generally, netroyalty income from intangible property isnonpassive income if the taxpayeracquired an interest in the pass-throughentity after it created the intangibleproperty or performed substantial servicesor incurred substantial costs in developingor marketing the intangible property.

Net royalty income is the excess ofpassive activity gross income fromlicensing or transferring any right inintangible property over passive activitydeductions (current year deductions andprior year unallowed losses) that arereasonably allocable to the intangibleproperty.

See Temporary Regulations section1.469-2T(f)(7)(iii) for exceptions to thisrule.

Passive Activity ReportingRequirementsTo allow shareholders to correctly applythe passive activity loss and creditlimitation rules, any corporation thatcarries on more than one activity must:

1. Provide an attachment for eachactivity conducted through the corporationthat identifies the type of activityconducted (trade or business, rental realestate, rental activity other than rental realestate, or investment).

2. On the attachment for each activity,provide a schedule, using the same linenumbers as shown on Schedule K-1,

detailing the net income (loss), credits,and all items required to be separatelystated under section 1366(a)(1) from eachtrade or business activity, from eachrental real estate activity, from each rentalactivity other than a rental real estateactivity, and from investments.

3. Identify the net income (loss) andthe shareholder's share of corporationinterest expense from each activity ofrenting a dwelling unit that anyshareholder uses for personal purposesduring the year for more than the greaterof 14 days or 10% of the number of daysthat the residence is rented at fair rentalvalue.

4. Identify the net income (loss) andthe shareholder's share of interestexpense from each activity of tradingpersonal property conducted through thecorporation.

5. For any gain (loss) from thedisposition of an interest in an activity orof an interest in property used in anactivity (including dispositions before1987 from which gain is being recognizedafter 1986):

a. Identify the activity in which theproperty was used at the time ofdisposition;

b. If the property was used in morethan one activity during the 12 monthspreceding the disposition, identify theactivities in which the property was usedand the adjusted basis allocated to eachactivity; and

c. For gains only, if the property wassubstantially appreciated at the time of thedisposition and the applicable holdingperiod specified in Regulations section1.469-2(c)(2)(iii)(A) was not satisfied,identify the amount of the nonpassive gainand indicate whether or not the gain isinvestment income under Regulationssection 1.469-2(c)(2)(iii)(F).

6. Specify the amount of grossportfolio income, the interest expenseproperly allocable to portfolio income, andexpenses other than interest expense thatare clearly and directly allocable toportfolio income.

7. Identify the ratable portion of anysection 481 adjustment (whether a netpositive or a net negative adjustment)allocable to each corporate activity.

8. Identify any gross income fromsources specifically excluded frompassive activity gross income, including:

a. Income from intangible property, ifthe shareholder is an individual whosepersonal efforts significantly contributedto the creation of the property;

b. Income from state, local, or foreignincome tax refunds; and

c. Income from a covenant not tocompete, if the shareholder is anindividual who contributed the covenantto the corporation.

9. Identify any deductions that are notpassive activity deductions.

Page 10 Instructions for Form 1120S

10. If the corporation makes a full orpartial disposition of its interest in anotherentity, identify the gain (loss) allocable toeach activity conducted through the entity,and the gain allocable to a passive activitythat would have been recharacterized asnonpassive gain had the corporationdisposed of its interest in property used inthe activity (because the property wassubstantially appreciated at the time of thedisposition, and the gain representedmore than 10% of the shareholder's totalgain from the disposition).

11. Identify the following items that maybe subject to the recharacterization rulesunder Temporary Regulations section1.469-2T(f) and Regulations section1.469-2(f):

a. Net income from an activity ofrenting substantially nondepreciableproperty;

b. The smaller of equity-financedinterest income or net passive incomefrom an equity-financed lending activity;

c. Net rental activity income fromproperty developed (by the shareholderor the corporation), rented, and sold within12 months after the rental of the propertycommenced;

d. Net rental activity income from therental of property by the corporation to atrade or business activity in which theshareholder had an interest (eitherdirectly or indirectly); and

e. Net royalty income from intangibleproperty if the shareholder acquired theshareholder's interest in the corporationafter the corporation created theintangible property or performedsubstantial services or incurredsubstantial costs in developing ormarketing the intangible property.

12. Identify separately the credits fromeach activity conducted by or through thecorporation.

Specific Instructions

General Information

Name, Address, and EmployerIdentification NumberUse the label that was mailed to thecorporation. Cross out any errors andprint the correct information on the label.Name. If the corporation did not receivea label, print or type the corporation's truename (as set forth in the corporate charteror other legal document creating it).Address. Include the suite, room, orother unit number after the street address.If a preaddressed label is used, includethe information on the label. If the PostOffice does not deliver to the streetaddress and the corporation has a P.O.box, show the box number instead of thestreet address.

If the corporation changes its mailingaddress after filing its return, it can notifythe IRS by filing Form 8822, Change ofAddress.Employer identification number (EIN). Show the correct EIN in item C on page1 of Form 1120S.

Item B—Business Code No.See the Codes for Principal BusinessActivity on pages 29 through 31 of theseinstructions.

Item E—Total AssetsEnter the corporation's total assets at theend of the tax year, as determined by theaccounting method regularly used inmaintaining the corporation's books andrecords. If there were no assets at the endof the tax year, enter the total assets asof the beginning of the tax year. If the Selection terminated during the tax year,see the instructions for Schedule L onpage 27 for special rules that may applywhen figuring the corporation's year-endassets.

Item F—Initial Return, Final Return,Change in Address, and AmendedReturnIf this is the corporation's first return,check box F(1). If the corporation hasceased to exist, check box F(2). Alsocheck box D(1) on each Schedule K-1 toindicate that it is a final Schedule K-1.Indicate a change in address by checkingbox F(3). If this amends a previously filedreturn, check box F(4). If Schedules K-1are also being amended, check box D(2)on each Schedule K-1.

Income

CAUTION!

Report only trade or businessactivity income or loss on lines 1athrough 6. Do not report rental

activity income or portfolio income orloss on these lines. (See PassiveActivity Limitations beginning on page7 for definitions of rental income andportfolio income.) Rental activity incomeand portfolio income are reported onSchedules K and K-1 (rental real estateactivities are also reported on Form8825).

Do not include any tax-exempt incomeon lines 1 through 5. A corporation thatreceives any exempt income other thaninterest, or holds any property or engagesin an activity that produces exemptincome, reports this income on line 18 ofSchedules K and K-1.

Report tax-exempt interest income,including exempt-interest dividendsreceived as a shareholder in a mutualfund or other regulated investmentcompany, on line 17 of Schedules K andK-1.

See Deductions beginning on page 12for information on how to report expensesrelated to tax-exempt income.

If the S corporation has had debtdischarged resulting from a title 11bankruptcy proceeding, or while insolvent,see Form 982, Reduction of TaxAttributes Due to Discharge ofIndebtedness, and Pub. 908, BankruptcyTax Guide.

Line 1—Gross Receipts or SalesEnter gross receipts or sales from alltrade or business operations except thoseyou report on lines 4 and 5. In general,advance payments are reported in theyear of receipt. To report income fromlong-term contracts, see section 460. Forspecial rules for reporting certain advancepayments for goods and long-termcontracts, see Regulations section1.451-5. For permissible methods forreporting certain advance payments forservices by an accrual methodcorporation, see Rev. Proc. 71-21,1971-2C.B. 549.Installment sales. Generally, theinstallment method cannot be used for:● Sales of property after December 16,1999, that would otherwise be reportedunder the accrual method of accounting.● Dealer dispositions of property. A“dealer disposition” is any disposition of:

1. Personal property by a person whoregularly sells or otherwise disposes ofproperty of the same type on theinstallment plan or

2. Real property held for sale tocustomers in the ordinary course of thetaxpayer's trade or business.Exception. These restrictions on usingthe installment method do not apply todispositions of property used or producedin a farming business or sales oftimeshares and residential lots for whichthe corporation elects to pay interestunder section 453(l)(3).

Enter on line 1a the gross profit oncollections from installment sales for anyof the following:● Dealer dispositions of property beforeMarch 1, 1986.● Dispositions of property used orproduced in the trade or business offarming.● Certain dispositions of timeshares andresidential lots reported under theinstallment method.

Attach a schedule showing thefollowing information for the current andthe 3 preceding years:● Gross sales.● Cost of goods sold.● Gross profits.● Percentage of gross profits to grosssales.● Amount collected.● Gross profit on the amount collected.

Line 2—Cost of Goods SoldSee the instructions for Schedule A onpage 16.

Instructions for Form 1120S Page 11

Line 4—Net Gain (Loss) From Form4797

CAUTION!

Include only ordinary gains orlosses from the sale, exchange, orinvoluntary conversion of assets

used in a trade or business activity.Ordinary gains or losses from the sale,exchange, or involuntary conversions ofassets used in rental activities arereported separately on Schedule K as partof the net income (loss) from the rentalactivity in which the property was used.

A corporation that is a partner in apartnership must include on Form 4797,Sales of Business Property, its share ofordinary gains (losses) from sales,exchanges, or involuntary or compulsoryconversions (other than casualties orthefts) of the partnership's trade orbusiness assets.

Do not include any recapture of thesection 179 expense deduction. See theinstructions on page 25 for Schedule K-1,line 23, item 3, and the Instructions forForm 4797 for more information.

Line 5—Other Income (Loss)Enter on line 5 trade or business income(loss) that is not included on lines 1athrough 4. Examples of such incomeinclude:● Interest income derived in the ordinarycourse of the corporation's trade orbusiness, such as interest charged onreceivable balances.● Recoveries of bad debts deducted inearlier years under the specific charge-offmethod.● Taxable income from insuranceproceeds.● The amount of credit figured on Form6478, Credit for Alcohol Used as Fuel.● All section 481(a) income adjustmentsresulting from changes in accountingmethods (show the computation on anattached schedule).

The corporation must also include inother income the:● Recapture amount under section 280Fif the business use of listed property dropsto 50% or less. To figure the recaptureamount, the corporation must completePart IV of Form 4797.● Recapture of any deduction previouslytaken under section 179A. The Scorporation may have to recapture partor all of the benefit of any allowablededuction for qualified clean-fuel vehicleproperty (or clean-fuel vehicle refuelingproperty), if the property ceases to qualifyfor the deduction within 3 years after thedate it was placed in service. See Pub.535, Business Expenses, for details onhow to figure the recapture.

If “other income” consists of only oneitem, identify it by showing the accountcaption in parentheses on line 5. Aseparate schedule need not be attachedto the return in this case.

Do not net any expense item (such asinterest) with a similar income item.Report all trade or business expenses onlines 7 through 19.

Do not include items requiring separatecomputations by shareholders that mustbe reported on Schedules K and K-1.See the instructions for Schedules K andK-1 beginning on page 18.

Ordinary Income (Loss) From aPartnership, Estate, or Trust

Enter the ordinary trade or businessincome (loss) from a partnership shownon Schedule K-1 (Form 1065), from anestate or trust shown on Schedule K-1(Form 1041), or from a foreignpartnership, estate, or trust. Show thepartnership's, estate's, or trust's name,address, and EIN (if any) on a separatestatement attached to this return. If theamount entered is from more than onesource, identify the amount from eachsource

Do not include portfolio income orrental activity income (loss) from apartnership, estate, or trust on this line.Instead, report these amounts on theapplicable lines of Schedules K and K-1,or on line 20a of Form 8825 if the amountis from a rental real estate activity.

Ordinary income or loss from apartnership that is a publicly tradedpartnership is not reported on this line.Instead, report the amount separately online 6 of Schedules K and K-1.

Treat shares of other items separatelyreported on Schedule K-1 issued by theother entity as if the items were realizedor incurred by the S corporation.

If there is a loss from a partnership, theamount of the loss that may be claimedis subject to the at-risk and basislimitations as appropriate.

If the tax year of the S corporation doesnot coincide with the tax year of thepartnership, estate, or trust, include theordinary income (loss) from the otherentity in the tax year in which the otherentity's tax year ends.

Deductions

CAUTION!

Report only trade or businessactivity expenses on lines 7through 19.

Do not report rental activity expensesor deductions allocable to portfolio incomeon these lines. Rental activity expensesare separately reported on Form 8825 orline 3 of Schedules K and K-1. Deductionsallocable to portfolio income areseparately reported on line 9 of SchedulesK and K-1. See Passive ActivityLimitations beginning on page 7 for moreinformation on rental activities andportfolio income.

Do not report any nondeductibleamounts (such as expenses connectedwith the production of tax-exempt income)on lines 7 through 19. Instead, report

nondeductible expenses on line 19 ofSchedules K and K-1. If an expense isconnected with both taxable income andnontaxable income, allocate a reasonablepart of the expense to each kind ofincome.

Limitations on DeductionsSection 263A uniform capitalizationrules. The uniform capitalization rules ofsection 263A require corporations tocapitalize or include in inventory costscertain costs incurred in connection with:● The production of real and tangiblepersonal property held in inventory or heldfor sale in the ordinary course ofbusiness.● Real property or personal property(tangible and intangible) acquired forresale.● The production of real property andtangible personal property by acorporation for use in its trade or businessor in an activity engaged in for profit.

The costs required to be capitalizedunder section 263A are not deductibleuntil the property to which the costs relateis sold, used, or otherwise disposed of bythe corporation.

Exceptions. Section 263A does notapply to:● Personal property acquired for resale ifthe taxpayer's average annual grossreceipts for the 3 prior tax years are $10million or less.● Timber.● Most property produced under along-term contract.● Certain property produced in a farmingbusiness. See page 13.

The corporation must report thefollowing costs separately to theshareholders for purposes ofdeterminations under section 59(e):● Research and experimental costs undersection 174.● Intangible drilling costs for oil, gas, andgeothermal property.● Mining exploration and developmentcosts.● Inventory of a cash method corporationthat does not account for inventories. SeePub. 553 , Highlights of 2000 TaxChanges.

Tangible personal property producedby a corporation includes a film, soundrecording, video tape, book, or similarproperty.

Corporations subject to the rules arerequired to capitalize not only direct costsbut an allocable portion of most indirectcosts (including taxes) that benefit theassets produced or acquired for resale orare incurred by reason of the performanceof production or resale activities.

For inventory, some of the indirectcosts that must be capitalized are:● Administration expenses.● Taxes.

Page 12 Instructions for Form 1120S

● Depreciation.● Insurance.● Compensation paid to officersattributable to services.● Rework labor.● Contributions to pension, stock bonus,and certain profit-sharing, annuity, ordeferred compensation plans.

Regulations section 1.263A-1(e)(3)specifies other indirect costs that relate toproduction or resale activities that mustbe capitalized and those that may becurrently deducted.

Interest expense paid or incurredduring the production period ofdesignated property must be capitalizedand is governed by special rules. Formore details, see Regulations sections1.263A-8 through 1.263A-15.

For more details on the uniformcapitalization rules, see Regulationssections 1.263A-1 through 1.263A-3.Special rules for certain corporationsengaged in farming. For S corporationsnot required to use the accrual method ofaccounting, the rules of section 263A donot apply to expenses of raising any—● Animal or● Plant that has a preproductive periodof 2 years or less.

Shareholders of S corporations notrequired to use the accrual method ofaccounting may elect to currently deductthe preproductive period expenses ofcertain plants that have a preproductiveperiod of more than 2 years. Becauseeach shareholder makes the election todeduct these expenses, the corporationshould not capitalize them. Instead, thecorporation should report the expensesseparately on line 21 of Schedule K andeach shareholder's pro rata share on line23 of Schedule K-1.

See sections 263A(d) and (e) andRegulations section 1.263A-4 fordefinitions and other details.Transactions between relatedtaxpayers. Generally, an accrual basisS corporation may deduct businessexpenses and interest owed to a relatedparty (including any shareholder) only inthe tax year of the corporation thatincludes the day on which the payment isincludible in the income of the relatedparty. See section 267 for details.Section 291 limitations. If the Scorporation was a C corporation for anyof the 3 immediately preceding years, thecorporation may be required to adjustdeductions allowed to the corporation fordepletion of iron ore and coal, and theamortizable basis of pollution controlfacilities. See section 291 to determinethe amount of the adjustment.Business start-up expenses. Businessstart-up expenses must be capitalized. Anelection may be made to amortize themover a period of not less than 60 months.See section 195 and Regulations section1.195-1.

Reducing certain expenses for whichcredits are allowable. For each creditlisted below, the corporation must reducethe otherwise allowable deductions forexpenses used to figure the credit by theamount of the current year credit.

1. The work opportunity credit,2. The welfare-to-work credit,3. The credit for increasing research

activities,4. The enhanced oil recovery credit,5. The disabled access credit,6. The empowerment zone

employment credit,7. The Indian employment credit,8. The credit for employer social

security and Medicare taxes paid oncertain employee tips, and

9. The orphan drug credit.If the corporation has any of these

credits, be sure to figure each currentyear credit before figuring the deductionsfor expenses on which the credit is based.

Line 7—Compensation of Officersand Line 8—Salaries and WagesEnter on line 7 the total compensation ofall officers paid or incurred in the trade orbusiness activities of the corporation.Enter on line 8 the amount of salaries andwages paid or incurred to employees(other than officers) during the tax year inthe trade or business activities of thecorporation.

Reduce the amounts on lines 7 and 8by any applicable employment creditsfrom Form 5884, Work OpportunityCredit, Form 8861, Welfare-to-WorkCredit, Form 8844, Empowerment ZoneEmployment Credit, and Form 8845,Indian Employment Credit. See theinstructions for these forms for moreinf