Taking Advantage of a Corporation’s Early Losses by Electing S Status

Editor:
Albert B. Ellentuck, Esq.
Of Counsel
King & Nordlinger, L.L.P.
Arlington, VA

This case study has been adapted from PPC’s Tax Planning Guide—S Corporations, 20th Edition, by Andrew R. Biebl, Gregory B. McKeen, George M. Carefoot, James A. Keller and Diana L. Stephens, published by Practitioners Publishing Company, Ft. Worth, TX, 2005 ((800) 323-8724; ppc.thomson.com).

A newly formed corporation often realizes operating losses during the first years of operation. Even though the shareholders may anticipate positive cashflow, tax losses may occur because of rapid depreciation deductions or other differences between book and tax reporting

Limits on Use of Passthrough Losses

An S corporation passes through corporate losses to be deducted on the shareholders’ personal returns. However, three limits could prevent immediate use of such losses.

Tax basis limit: A shareholder’s current use of S losses is limited to the shareholder’s adjusted basis in stock and direct loans to the corporation, under Sec. 1366(d)(1). Before recommending S status to allow the use of anticipated initial tax losses, the tax adviser must verify that the shareholders have sufficient basis, via either direct investment in stock or direct loans to the S corporation. It is not unusual for small, closely held corporations to secure their initial capital entirely from a bank or other third-party financing, secured by the shareholders’ personal guarantees. These guarantees alone do not provide tax basis to the shareholders; this circumstance would restrict their use of initial losses.

At-risk limit: An S shareholder may be restricted from using passthrough losses to the extent the shareholder is not “at risk.” This limit is measured at the shareholder level and is similar to basis limits.

PAL limit: An S shareholder may face restrictions on the current deductibility of a passthrough S loss if it is deemed to arise from a passive activity. Passive activity losses (PALs) may be deducted only to the extent of current income and gains from other passive activities, under Sec. 469. Unless a shareholder materially participates in the business via regular, continuous and substantial involvement, the activity is deemed to be passive.

According to Temp. Regs. Sec. 1.469-2T(d)(6), passthrough losses are limited by the various loss limit rules, in the following order:

1. Sec. 1366(d) basis limits.

2. Sec. 465 at-risk rules.

3. Sec. 469 PAL rules.

Example

Ellen and Jean form a calendar-year corporation, X Corp., in which each owns 50% of the stock. Each shareholder will materially participate in the corporation’s business activity. They expect to have annual losses of about $20,000 for the first several years. X has sufficient working capital for the first year, but Ellen and Jean project they will need additional working capital in the second year. The shareholders have substantial income from other sources and expect their current-year individual taxable income to be taxed at the highest Federal marginal rate.

They seek their tax adviser’s advice on tax planning for X. Specifically, should they make an S election for X to allow passthrough of initial losses?

If Ellen and Jean elect S status for X, corporate losses would pass through to their personal returns. The tax adviser determines that the stock and debt basis, at-risk and PAL rules do not present a barrier to S status. He then informs Ellen and Jean of the tax benefits of the S election. Based on a 35% marginal tax rate, Ellen and Jean would each have $3,500 of annual Federal tax savings (35% $10,000 share of corporate loss), assuming the $20,000 loss projection is accurate. This tax benefit could help fund X’s additional working capital needs in the second year, via loans or additional capital contributions. However, Ellen and Jean would also have to consider the negative attributes of S status (calendar-year requirement, lack of nontaxable statutory fringe benefits, etc.).

The tax adviser explains to Ellen and Jean that if X does not elect S status, its losses would produce no current tax savings but, instead, would carry forward for use against future income recognized by X in regular C status years. This is essentially the same result that occurs, for example, if either shareholder faces a loss limit due to insufficient basis or the PAL rules in S status; unused S losses or excess PALs also carry forward for use against future income. Accordingly, imposition of a basis or PAL limit may not be a significant factor in the decision to elect S status.

Revoking the S Election

While clients may be tempted to revoke the S election when the corporation becomes profitable, changing to C status carries both advantages and pitfalls. Assume that Ellen and Jean begin conducting business Sept. 1, 2006. Their projections indicate an initial loss of $20,000 for September 2006 and $30,000 of income for the last three months of that year. An S election might be made at formation, followed by a revocation when X be-comes profitable. The tax adviser would need to determine whether the use of the initial loss in the personal returns through the S election outweighs the extra corporate tax costs that might be incurred because of the tax rate annualization requirement accompanying midyear conversions to C status.

Higher taxes: Also, the conversion to C status may eventually result in detrimental long-term costs, in the form of higher taxes on liquidation or sale of the business. (The earnings retained in a C corporation will eventually bring a second level of tax to the shareholders, in the form of taxable gain on a sale or liquidation of stock.)

Waiting period: Finally, the revocation of S status also starts a five-year waiting period for re-election of S status, requiring X to operate for five tax years under C taxation rules, unless the IRS consents to an earlier election. This could lead to detrimental attributes (e.g., accumulated earnings and profits, and potential C corporation built-in gains, leading to gains on disposition) that far outweigh the savings advantage achieved in the initial year from a conversion to C status when X became profitable.