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Current Developments (Part II) This two-part article on S corporation developments reviews and analyzes the recent past's rulings and decisions. Part I, in the last issue, addressed rulings on S eligibility, elections and terminations; this part focuses on S operational issues, including use of losses, cancellation of debt income and reasonable compensation. Hughlene
Burton, Ph.D., CPA
Stewart
S. Karlinsky, Ph.D., CPA
Editor's note: Dr. Karlinsky is a member of the AICPA Tax Division's Corporations & Shareholders Technical Resource Panel. For more information about this article, contact Dr. Burton at Haburton@email.uncc.edu or Dr. Karlinsky at karlinsky_s@cob.sjsu.edu.
Executive Summary
Part I of this article, in the October 2000 issue, addressed S eligibility, election and termination issues. Part II, below, discusses S operational issues, including, among others, use of losses, cancellation of debt (COD) issues and reasonable compensation. Operations Installment Sales Section 536(a) of the Ticket to Work and Work Incentives Improvement Act of 1999, effective for transactions after Dec. 16, 1999, repealed an accrual-basis taxpayer's ability to use the installment-sale method. Many tax professionals, small business trade organizations and taxpayers were surprised by this provision; at press time, there are numerous calls to repeal it. The repeal of the use of the installment method for accrual-basis taxpayers puts an additional premium on whether an S corporation is a cash- or accrual-method taxpayer. The IRS issued Notice 2000-26,67 explaining the application of the repeal to S and C corporations when a Sec. 338 or 338(h)(10) election has been made. Obviously, if a cash-method shareholder sells privately held stock for cash and a note, he can use the installment method, even if the corporation is on the accrual basis. This would also be true if the acquiring corporation elected Sec. 338 treatment. However, the deemed sale of an accrual-basis S corporation's assets would not be eligible for installment-sale treatment. Tax liability on the deemed sale is the acquiring corporation's responsibility. If a Sec. 338(h)(10) election is in effect, the sale of stock by the S shareholders is disregarded; instead, the sale of assets by an accrual-basis S corporation cannot be reported on the installment basis. In effect, this is a de facto repeal of Sec. 453B(h) for accrual-basis taxpayers. A shareholder can use the installment basis for any gain that may be recognized after reflecting the deemed-asset sale. (This will usually occur when the outside basis in the stock is lower than the inside basis of the assets.) Rev. Proc. 2000-2268 allows the IRS, in its discretion, to permit certain small businesses that would otherwise have to use the accrual method to use the cash method. This will positively affect eligible small businesses' installment-sales treatment. To qualify, the average of the business's prior three-years' gross receipts can be no more than $1 million. This use of the cash method (by eligible C and S corporations and limited liability companies) may be applied retroactively, if a financial statement conformity requirement is met. The issuance of accrual-basis financial statements on an isolated basis (e.g., to obtain a bank loan) will not violate the conformity requirement.
Loss Limits One of the reasons for choosing S status is the ability to pass through entity-level losses to shareholders. There are several hurdles confronting a shareholder seeking to deduct such losses. In 1999, final regulations addressed several stock basis-for-loss issues.69 The courts disagree on whether COD income increases S shareholders' stock basis.70 Final regs.: One of the more onerous provisions, Regs. Sec. 1.1366-2(a)(5), provides that if a shareholder of an S corporation with suspended losses sells, gifts or disposes of his entire interest, the suspended losses are forever disallowed, even if he later reacquires the S stock. However, if a shareholder kept just one share, all the suspended losses would inure to it. Additionally, if a shareholder gave his spouse all his S stock in a Sec. 1041 transaction, the suspended losses would not move with the stock; they would be permanently lost. For community property states, Regs. Sec. 1.1366-1(d) provides that each spouse is deemed to have his own shares. Whether this helps avoid the trap for residents of those nine states remains to be seen. Regs. Sec. 1.1366-2(a)(6) states that if S stock with a fair market value (FMV) below its adjusted basis is gifted, the FMV is used in computing the donee's Sec. 1366 basis. For example, if a taxpayer gifts S stock with an adjusted basis of $100,000 and an FMV of $60,000 to his grandchild, $60,000 becomes the grandchild's basis for loss purposes. The same rule applies if the property is transferred to an irrevocable qualified subchapter S trust or eligible small business trust. If a taxpayer does not have sufficient basis for loss, the allowable loss must be allocated pro rata among the various types of losses (i.e., capital, ordinary, passive). In computing the losses to be allocated, suspended losses must be included in the calculation, according to Regs. Sec. 1.1366-2(a)(4). Regs. Sec. 1.1366-1(a)(2)(viii) excludes Sec. 109 lessee improvements and Sec. 108 COD income from the definition of tax-exempt income. The Supreme Court, in Gitlitz,71 will soon decide whether this aspect of the regulation is valid. Under Regs. Sec. 1.1367-1(f), stock basis is adjusted as follows: (1) increased by taxable and tax-exempt income; (2) decreased by distributions; (3) decreased for noncapital, nondeductible expenses; and (4) decreased by losses.72 Sec. 1366(d): In Culnen,73 the Tax Court allowed a taxpayer to increase his basis for loss purposes. The taxpayer owned both profitable and unprofitable S corporations. The profitable insurance brokerage firm lent money directly to the loss company; accounting entries treated the transaction as a loan from the profitable company to the taxpayer and from the taxpayer to the loss corporation. The court was persuaded by the testimony of the taxpayer and his accountant that back-to-back loans were intended, even though purely accounting entries were made. This holding contrasts with Bergmann,74 in which the Eighth Circuit agreed with the IRS and reversed a district court, because it was not clear whether the loans were genuine. The Eighth Circuit held there was no evidence that the taxpayer made an actual economic outlay when the loans were changed. Without an economic outlay or assumption of risk, basis cannot be increased, nor additional losses allowed. The court noted that because all the parties were related, the issue of whether the shareholder or the corporation was placed at risk when the loans were restructured was unclear. A participation interest in a bank loan by the owner of a debtor S corporation did not increase basis for loss under Sec. 1366(d).75 The court held that the circular transaction was not an economic outlay; rather, it resembled a guarantor relationship. Letter Ruling (TAM) 995103576 expanded the circular lending transaction further, holding that it does not create basis under the Sec. 465 at-risk rules. The Sec. 465 issue also arose in Van Wyk.77 In that case, an S shareholder borrowed $700,000 from his brother-in-law (another S shareholder); the taxpayer then lent the funds to the S corporation. The court held that Sec. 465 precluded the loan from increasing basis for loss purposes. Sec. 469: Letter Ruling 20001401078 concerned an S corporation that engaged in two activities—running a gas station and renting out space there for a convenience store. The taxpayer unsuccessfully sought a determination that the two businesses were linked, so that losses from one sub-activity could offset the profits from the other. The IRS ruled the activities were separate and the rental income was passive.
COD Income The AICPA has endorsed the position that COD income should increase an S shareholder's basis under Sec. 1366(a)(1)(A), while the regulations and Letter Ruling (TAM) 954100679 provide otherwise. The Tax Court held, in Nelson,80 that COD income is not a flowthrough item, nor is it tax-exempt; thus, it does not increase basis under Sec. 1366. The Tenth Circuit later agreed. Gitlitz held similarly; the Supreme Court recently heard oral argument in that case. Exhibit 1 presents recent cases in this area and their holdings.
Character of Income Taxpayers obviously prefer capital gains to ordinary income, because of the preferential tax rates. Thus, a question often arises in the S corporation context as to the character of a particular item of passthrough income. Regs. Sec. 1.1366-1(b) provides that the character of an item in the S corporation's hands passes through to a shareholder, even if he would have recognized ordinary income on the transaction had he engaged in it individually. Thus, if a developer were to transfer appreciated land to an S corporation, and the entity built an apartment building or a factory on it, then later sold the property, Sec. 1231 gain would be allowed. Regs. Sec. 1.1366-1(b)(2) and (3) provide two exceptions to this general rule. If the shareholder(s) transfers noncapital gain property with the principal purpose of avoiding ordinary tax rates, the S corporation gain on that tainted property will be ordinary. Similarly, if a taxpayer transfers capital loss property with a principal purpose to convert it to ordinary loss treatment, the built-in loss (but not any postcontribution decline in value) will be treated as a capital loss. In Nahey,81 a corporate president bought out the company's stock in a management leveraged buyout. The assets and liabilities were placed in two S corporations. One of the assets that had not been allocated any of the purchase price was the rights to a pending lawsuit. When the suit was settled for $6.2 million, the S corporations reported the income as long-term capital gain. The Tax Court ruled that the income was ordinary, reasoning that the lawsuit settlement was merely a debt collection, not a sale or exchange; thus, the gain could not be capital in nature. The Seventh Circuit affirmed; it seemed to imply that, even if the acquiring S corporations had allocated part of the purchase price under Sec. 1060 to the lawsuit claim, capital gain treatment would still not be available on collection, under the origin-of-the-claim doctrine. In Ding,82 the Ninth Circuit affirmed a Tax Court decision that S losses cannot be characterized as self-employment (SE) income or loss. Thus, for Sec. 1402 purposes, S corporation losses cannot be netted against partnership or sole proprietor income.
Undercompensation A long line of cases has provided that, if a shareholder-employee performs services for an S corporation without compensation, the IRS may recharacterize distributions to that shareholder as salary income subject to SE tax. Recently, a home construction S corporation received services from its sole shareholder, but paid him no salary; thus, loans made to him were properly recharacterized as compensation income.83
Fringe Benefits Letter Ruling 20000702584 provides that payments to owners and nonowner employees for medical costs incurred during the year will not be taxable to employees and will be deductible to the employee-owners if premiums are paid into the plan, under Sec. 162(l). The IRS held that there was risk-sharing within the entity, qualifying the arrangement as an accident and health insurance plan.
Deductions Sec. 197: An S corporation bought out one of its shareholders and sought Sec. 197 amortization for a covenant not to compete, even though the sales contract was silent as to restrictive covenants.85 The Tax Court rejected the amortization argument. Related parties: In Hamdan,86 a taxpayer owned a profitable S corporation and a loss C corporation. The two companies entered into a participation agreement under which the S corporation allegedly paid $300,000 to the C corporation. However, no funds changed hands; the transaction was accomplished solely by an accounting entry. The court held that the S corporation could not deduct the payment. Bad debts: A taxpayer can take a deduction for uncollected debts. For individuals, bad debts can either be business (deductible against ordinary income) or nonbusiness (deductible against capital gains). A business bad debt can be partially worthless for deduction purposes; a nonbusiness bad debt requires total worthlessness. A business bad debt arises only in the taxpayer's trade or business. In Helwig,87 an S shareholder invested funds in a C corporation with which the S corporation conducted business; the S corporation also lent the C corporation funds. The Tax Court held the S corporation's advances were business debt, not equity. However, it was not worthless, because the shareholder continued lending to the corporation in the same years it claimed the debts worthless. In DeJoy,88 an S shareholder paid various corporate expenses, including state sales taxes and Federal employment taxes. A capital loss was claimed on the worthlessness of the stock; the taxpayer claimed his basis included the unreimbursed expenditures. The Tax Court held that the taxpayer failed to prove his stock basis and worthlessness, denying a capital loss. This case included a loan/distribution of $148,000 to the taxpayer; the court did not address the appropriate treatment of this payment, other than to note it might be a distribution that would reduce the shareholder's stock basis. Valuation is an important closely held company and S corporation issue. Many S shareholders want to transfer as much stock as possible to family members to reduce their estates. In recent years, several cases have addressed S corporations, family limited partnerships and the valuation of gifted stock.89 The latest in this line of cases is Est. of Welch,90 in which the Sixth Circuit held that the value of such stock should be based on what a hypothetical buyer would pay, taking into account the built-in gains (BIG) tax liability. These holdings could aid in estate planning involving an S corporation with Sec. 1374 BIG tax exposure and might also be useful when attempting to reduce the BIG tax when a corporation switches from C to S status.
ESOPs For tax years beginning in 1998, the Small Business Job Protection Act of 1996, Section 1316(a), permitted an employee stock ownership plan (ESOP) to own S stock (SESOP). Some commentators suggested that using an SESOP could postpone taxation indefinitely, because an S corporation is not subject to unrelated business income tax. In Letter Ruling 200003014,91 a corporation was contemplating establishing an ESOP. In 1984, a C corporation switched to S status and sought in the ruling to convert back to C status to use Sec. 1042. The ruling held that the time that the shareholder owned the S stock counts for purposes of Sec. 1042(b)(4)'s three-year holding period. This should be contrasted with Secs. 1202 and 1045, under which the corporation must have been a C corporation for "substantially all" the time that the stock is held. In Letter Ruling 9948038,92 a C corporation formed a leveraged ESOP, lent it money to buy the organizing company's stock and used the purchased stock as collateral. In a later year, the company switched to S status and planned on repaying the loan from the accumulated adjustments account (AAA) and C earnings and profits. The IRS held that Sec. 4975(d)(3) exception applied; thus, the ESOP did not lose its exempt status.
QSubs Treasury issued QSub final regulations.93 This section highlights a few of the more important general issues raised. The regulations present some interesting tax planning opportunities and traps, especially as to the potential application of the step-transaction doctrine. It also contains major transition relief that may help tax planners through the end of 2000 (and possibly through to March 14, 2001). Tax planning: If a shareholder owns two S corporations (one profitable, with high adjusted basis, and the other a loss corporation, with zero basis and suspended and/or current losses), contributing both corporations' stock to a newly formed S holding company will allow him to use current and suspended losses against his holding company adjusted basis. Alternatively, a shareholder could contribute the loss company stock to the profitable company and use the combined basis to deduct losses. This strategy is supported by two recent letter rulings.94 Similarly, if an individual owned 100% of an S corporation that owned 79% of a subsidiary, and the other 21% of the subsidiary was owned by the same individual, a contribution of the subsidiary's stock to the S corporation, followed by a QSub election (a deemed Sec. 332 liquidation), clearly would be permitted through the transition period. Six recent letter rulings allowed QSubs to be formed via a reverse merger of a parent into newly formed subsidiaries.95 Tax trap: Strategies like the one described above may trigger the step-transaction doctrine. Regs. Sec. 1.1361-4(a)(2) makes clear that, after the transition period, the IRS will apply the doctrine if a liquidation is part of a larger integrated transaction. For example, if a controlling shareholder wanted to convert a brother-sister group into a parent-subsidiary structure, this will be viewed as a Sec. 368(a)(1)(D) transaction; if liabilities exceed basis, Sec. 357(c) will apply to cause gain recognition. Fortunately, Regs. Sec. 1.1361-4(a)(5)(i) applies a transition rule to acquisitions between related companies (as defined by Sec. 267(b)), such as the example above. For QSub elections effective before 2001, the step-transaction doctrine will not apply. Given the 21/2-month look-back rule, this could mean that QSub elections made as late as March 14, 2001 could be deemed effective as of Dec. 31, 2000. Similarly, if an individual owns 100% of an S corporation and seeks a third party to contribute appreciated property to it, Sec. 351 would not be met. If the individual had previously contributed property to a corporation and subsequently merged the companies, the step-transaction rule probably could be avoided. However, if a deemed Sec. 332 liquidation occurred, the IRS would likely assert the step-transaction doctrine; no transition rule would apply.
Other Issues Sec. 1374: If an S corporation has exposure to the Sec. 1374 BIG tax or the Sec. 1375 passive income tax, one way to minimize the current tax liability is to reduce taxable income by deducting appropriate executive compensation. Exacto Spring Corp.96 held that the courts should not act as a personnel agency and decide fair compensation; rather, a hypothetical investor standard should be the sole basis for deciding whether compensation is reasonable. The Seventh Circuit affirmed the corporation's salary payments to its founder, chief executive officer and principal shareholder of $1.3 million in 1993 and $1 million in 1994. Cash method: Most service companies use the cash method of accounting; the IRS often challenges such use. This issue is more problematic after the repeal of the installment method for accrual taxpayers. Recently, three cases supported a service business's use of the cash method. Osteopathic Medical Oncology and Hematology PC97 held that when chemotherapy drugs were administered as part of the treatment provided, they were supplies, not inventory; thus, the company could use the cash method. Similarly, Mid-Del Therapeutic Center, Inc.,98 held that because the drugs could not be self-administered by patients and were provided as part of their treatment plan at the company's facility, they were supplies, not merchandise, validating use of the cash method. RACMP Enterprises, Inc.,99 dealt with construction work; the court held that, because concrete was purchased and poured for a specific project site, it functioned as supplies, not inventory. Thus, the taxpayer could use the cash method. Tax-deferred reorganizations: If a tax-deferred reorganization involves a target S corporation, Regs. Sec. 1.1366-2(c)(1) notes that suspended losses move with the target's shareholder. If the acquiring corporation is also an S corporation, when sufficient stock basis is present, the loss will be allowed under Sec. 1366(d). If the acquirer is a C corporation, the post-termination transition period rules would apply. Similar rules apply in a Sec. 332 transaction, which is very common when a QSub is created. Thus, any suspended losses of the independent target will be available to the historic target shareholders. To effect a valid tax-deferred transaction, the statutory requirements (as well as established judicial doctrines) must be met. A recent concern is that large AAA distributions will be viewed as violating the continuity-of-interest requirement. FSA 9945006100 held that a large distribution violated the "substantially all" requirement (90% of net assets and 70% of gross assets101) of a reverse triangular merger (Sec. 368(a)(2)(E)); thus, there was no valid tax-deferred transaction. This same issue would have arisen had the acquisition been structured as a C reorganization or a forward triangular merger. The ruling addressed the continuity-of-interest issue, but the IRS's position was not made clear. Corporate division: If an S corporation spins off a subsidiary under Secs. 368(a)(1)(D) and 355, suspended losses will be allocated between the distributing corporation and the controlled corporation based on any reasonable method (according to Regs. Sec. 1.1366-2(c)(2)). This includes allocations based on relative FMVs, relative book basis or to the business that generated the loss.
Consolidated Groups A compliance problem arises because of the interaction of the consolidated return regulations and the S rules; three tax returns may be required for the year an S corporation is purchased and becomes a consolidated group member. Tax returns would be due for the S short year that ends the day before the acquisition, the one-day C short year (consisting of the day of acquisition) and a short tax year (included in the consolidated return) after the acquisition date. The problem exists because the consolidated return regulations state that a subsidiary does not become a consolidated group member until the end of the day on which its status changes; under the S corporation rules, an S election terminates on the day before the terminating event. Treasury has decided that filing a separate return is no longer necessary for the day an S corporation is acquired by a consolidated group.102 Regs. Secs. 1.1362-3(a) and 1.1502-76(b) eliminate the need to file a separate return for that day. Regs. Sec. 1.1361-5(a), Example 4, illustrates this point. Under the final regulations, an S corporation would become a member of the consolidated group at the beginning of the day that includes the acquisition, instead of at the end of the day, effective for transactions occurring after Nov. 10, 1999. The new rule would result in only two short periods: an S return for the period before the S corporation became part of the group and a C return as part of the consolidated group. The closing-of-the-books method must be used in allocating income between the short S and C years, according to Regs. Sec. 1.1502-76(b)(2)(v). The due date of the short S year will be the same as that of the consolidated tax return (including extensions). If a Sec. 338 election is made, the regulations indicate that the two-return rule does not apply. |
