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Current Developments (Part II) This two-part article on S corporation developments reviews and analyzes recent rulings and decisions. Part I, in the last issue, addressed S eligibility, elections and terminations; this part focuses on S operational issues, including use of losses, cancellation of debt income, installment sales and bad debts.
Stewart
S. Karlinsky Ph.D., CPA Hughlene
Burton Ph.D., CPA For more information about this article, contact Dr. Burton at Haburton@email.uncc.edu or Dr. Karlinsky at karlinsky_s@cob.sjsu.edu. Editor's note: Dr. Karlinsky is a member of the AICPA Tax Division's S Corporations Taxation Technical Resource Panel.
Executive Summary
Operations Installment Sales The Installment Tax Correction Act of 2000 retroactively repealed Section 536 of the Ticket to Work and Work Incentives Improvement Act of 1999, effective for sales after Dec. 16, 1999. Before the repeal, the IRS had issued Notice 2000-26,52 explaining how these rules applied 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 method or the acquiring corporation elected Sec. 338 treatment. Contrary to the notice, however, installment-sale treatment is now available for the deemed sale of an accrual-basis S corporation's assets. Tax liability on a Sec. 338 deemed sale is the acquiring corporation's responsibility; a C corporation, but not an S corporation, is deemed to have sold its assets. If a Sec. 338(h)(10) has been made, the S shareholders' stock sale is disregarded. Instead, the accrual-basis S corporation's sale of assets can be recognized on the installment basis. Secs. 453(h) and 453B(h) apply if the S corporation sold the assets to the acquirer on an installment basis in liquidation. However, Regs. Sec. 1.338(h)(10)-153 requires all the shareholders' approval, including those who did not sell their stock. The regulation leaves unclear whether shareholders who owned stock that tax year but disposed of it before the transaction are required to sign Form 8023, Corporate Qualified Stock Purchase Election. To avoid a problem, the shareholders might elect a closing of the books (Sec. 1377); the corporation might have all shareholders (both at the time of the qualified stock purchase and previous shareholders) sign the election form.
Loss Limits One of the reasons for electing S status is the ability to flow through entity-level losses to shareholders. However, a shareholder must overcome several obstacles before losses are deductible. In many cases, the issue was a shareholder's adjusted basis in stock and debt. In Gitlitz,54 the Supreme Court held that an insolvent S corporation's Sec. 108 COD income increased a shareholder's stock basis, as it was tax-exempt income. This ruling invalidated Regs. Sec. 1.1366-1(a)(2)(viii). The court also held that the basis increase occurs in the year before the year tax attributes need to be reduced under Sec. 108.
In Gitlitz, the Supreme Court ruled that the $4 million is tax-exempt income that increases A's stock basis under Sec. 1366 to $4 million. Thus, A can deduct $4 million of the $5 million loss in 2001 (subject to Secs. 469 and 465). On Jan. 1, 2002, T's tax attributes must be reduced under Sec. 108(b) by $4 million; A's remaining $1 million ($5 million 2 $4 million) suspended loss will be eliminated. The tax-exempt income increases the at-risk amount under Sec. 465. Conviser 55 involved an S corporation general partner in a real estate limited partnership. The S shareholder argued that Gitlitz applied; the Tax Court held that the COD income increased basis, permitting the deduction of suspended and current-year losses. A caveat was introduced in Toberman56—the S shareholder did not prove that the losses were from mobile home real estate partnerships or that the corporation was insolvent. Loan guarantees: Every year, taxpayers assert that a guarantee of S debt gives them basis for loss purposes under Sec. 1366(d). In Bean,57 the taxpayers owned a partnership that they converted to an S corporation. They personally guaranteed loans of up to $600,000. As a partnership, these loans gave the taxpayers basis for loss. However, as S shareholders, they were not deemed to have made an economic outlay until called on to fulfill the guarantee. Thus, their allocated S losses were suspended until the corporation generated a profit or the shareholders increased their stock or debt basis. This is one example of why "checking the box" should be carefully weighed before being elected. A similar conclusion was reach in Jeyapalan,58 in which a couple converted a real estate partnership to an S corporation, but never transferred title to the real property. The taxpayers argued the entity should be treated as a partnership, and they should be allowed to deduct losses, because title did not pass. The IRS and the Tax Court disagreed, holding that the taxpayers could not disregard the corporation for tax purposes—it was formed for a valid business reason and had sufficient business activities; because the taxpayers had insufficient basis, they could not deduct S losses. Likewise, in Jackson,59 the Tax Court ruled that bank loan guarantees did not give an S shareholder basis for loss purpose. The IRS emerged victorious in a pair of companion decisions60 in which the issue was whether the S shareholder could prove that alleged contributions and loans had really been made. The taxpayers tried to argue that a constructive contribution was made by a sister corporation, but offered no proof; thus, $100,000 of losses per shareholder was suspended. In most of these cases, there are only one or two shareholders; they should use back-to-back loans. In Nelson,61 a taxpayer in the bingo business co-borrowed with his S corporation. The Tax Court held that, because the bank looked to the entity's business profits for repayment, the shareholder was not entitled to increase his basis for loss purposes. The case is appealable to the Eleventh Circuit, which decided for the taxpayer in Selfe62 on this issue. In Grojean,63 the Tax Court held that a shareholder's participation interest in an S corporation bank loan did not increase basis for loss under Sec. 1366(d). The circular transaction was not an economic outlay; it was more like a guarantor relationship. The Seventh Circuit agreed, holding that the participation loan was merely a form of guarantee. Letter Ruling 995103564 takes the circular lending transaction one step further, holding that it does not create basis under the Sec. 465 at-risk rules. In Gregersen,65 an S shareholder was deemed to have an economic outlay for loss purposes from a guarantee on a loan to a corporation that went bankrupt. However, the accrued interest on the note did not entitle the shareholder to a net operating loss carryover. Hobby losses: FSA 20004200166 addressed the application of the hobby loss rules to an S corporation. A pilot owned two companies: an S corporation airplane charter and a C corporation that provided services to third parties. The S corporation's planes were primarily used by the related company or the shareholder and his family. The taxpayer tried to aggregate the two corporations' activities. The IRS rejected this because the entities are separate and Sec. 183 does not apply to C corporations. If the C corporation were converted to a qualified subchapter S subsidiary (QSub), the results might have been different. The shareholder also entered into a contract stating that if an expense were disallowed, the corporation would be deemed to pay compensation to him. The company paid for his clothing, entertainment and gifts, which the IRS disallowed. The company claimed a compensation deduction (and the shareholder claimed compensation income), but the IRS disallowed the deduction as not being for services rendered. In another case, O'Connor,67 a recycling and rubbish removal business acquired acreage for livestock, almonds and other farming activities. The court held that the latter activities did not constitute an activity entered into for profit. Although an increase in value of the land used in an activity normally provides a profit motive, in this case the land had declined in value. In O'Connell,68 an S corporation chartered deep-sea fishing boats. The owner failed to prove he was engaged in the activity for a profit. Further, a bad debt loss was denied, because a loan guarantee was made to secure his investment. Sec. 469: The Tenth Circuit reversed the Tax Court in St. Charles Investment Co.69 A closely held C corporation had suspended PALs that could not be used under Sec. 469(e)(2). The company later converted to S status, then sold the property that generated the PALs and passed them through to shareholders. The IRS argued, and the Tax Court agreed, that the passthrough was disallowed under Sec. 1371(b)(1). The Tax Court held that Sec. 469 implied a carryover provision, even though the literal language is that the loss is disallowed and treated as occurring the following year. The Tenth Circuit reversed, holding that this is not a carryover provision and that Sec. 469 overrides Sec. 1371; thus, when the S corporation sold the property that gave rise to the PALs in a taxable transaction, the shareholders could use the suspended PALs. In Hillman,70 the Fourth Circuit reversed a pro-taxpayer Tax Court decision. The taxpayer owned and materially participated in an S corporation that performed management services. The S corporation charged management fees to many partnerships the taxpayer owned. The corporate income that passed through to him was active income; the payment for the partnerships' management services was limited by the PAL rules. The taxpayer argued that this type of transaction should be covered by the self-charged rules, which would allow a portion of the active income to be characterized as passive and offset against PALs. However, the self-charged rules (Prop. Regs. Sec. 1.469-7) address only interest, not other types of income. The Tax Court held that the IRS unduly delayed the issuance of self-charged rules; thus, it applied the self-charged concept to management fees. However, the Fourth Circuit reversed, holding that in the absence of specific regulatory authority, the taxpayer could not offset self-charged management fees. It is unclear whether the qualified real estate professional rules (Sec. 469(c)(7)) would avoid this situation in the future. Because the self-charged interest proposed regulations were issued in 1991, perhaps Treasury should issue final regulations to cover this and other activities.
Character of Income Briggs71 dealt with several income issues between an S corporation and shareholder. The corporation was a partner in a joint venture to develop some Florida property, but the shareholder was not a developer. The shareholder had to report ordinary income on the joint venture's development income. The corporation implemented energy-saving devices on its investment real estate property, for which it was to receive gas credit rebates. The shareholder received the rebates, which the Tax Court held were ordinary income.
Deductions Charitable contributions: Rev. Rul. 2000-4372 was issued to address S charitable deductions. Sec. 170(a)(2) allows an accrual-basis corporation to deduct a charitable contribution in the year pledged, instead of the year the pledge is fulfilled, if the board of directors authorizes the gift by year-end and the corporation pays it by the 15th day of the third month of the following year. An S corporation has to compute taxable income as an individual, and can take the deduction only in the year the contribution is paid. Unanswered in the ruling is whether for Secs. 1374 and 1375 purposes, the election can be used to reduce corporate taxable income, assuming timely board approval and fulfillment. Regs. Sec. 1.1374-2(d) requires that an S corporation use its corporate accounting method in computing its taxable income limit. This means that if a cash-basis S corporation has average gross receipts above $5 million, it may use the cash method in computing its corporate taxable income limit. Because a Sec. 170(a)(2) election is not an accounting method, an accrual-basis company should be able to reduce its taxable income by a pledged charitable gift. In a series of letter rulings,73 the IRS liberalized the ban on deducting a gift of a partial interest to charity, as set forth in Sec. 170(f)(3)(A), Regs. Sec. 1.170A-7(a) and Rev. Rul. 81-282.74 A shareholder, in concert with other shareholders, had transferred her stock's voting rights to a voting trust to facilitate a sale of the company. Later, she gifted the stock (without voting rights) to a qualified charity. The IRS held that this gift was not a partial interest; thus, the shareholder could deduct the FMV of the stock, subject to the 30% adjusted-gross-income limit. The one-class-of-stock requirement is not violated if some S stock is nonvoting, as long as distribution and liquidation rights are equal. Alternatively, voting power may be placed in a voting trust. The logic is that the charitable giving of S stock without voting power should not preclude a deduction. However, the ruling does not address the appropriate FMV of the nonvoting stock. A tax adviser should also be aware that the S income allocated to the charity would be subject to Sec. 511 unrelated business income tax (UBIT). Interest expense: Is interest expense on funds borrowed to buy a business investment interest expense (deductibility limited under Sec. 163(d)) or business interest expense deductible without limit? In Rosser,75 a taxpayer bought two nursing homes, then transferred them to two S corporations. He bought the property to earn management income and to provide a salary for his spouse, who was the administrator. The IRS argued that the interest was investment interest; the taxpayer argued, and the Tax Court agreed, that the acquisition was to provide employment and business income to the taxpayer. Thus, the interest expense was business interest. In Fitzmaurice,76 interest the taxpayer paid for an S corporation's tax deficiency was held nondeductible personal interest under Sec. 163(h). Hoffman77 involved a C corporation to which the taxpayer made cash advances. The IRS argued they were interest-free loans that required imputed interest under Sec. 7872. If an S corporation were owned by several shareholders, an income-expense mismatch could result. Bad debts: A creditor is allowed a deduction for uncollectable receivables. For individuals, bad debts can be either business bad debts (ordinary deduction) or nonbusiness bad debts (capital loss). A business bad debt may be partially worthless and still create a loss, but a nonbusiness bad debt must be totally worthless before it can be deducted. To be classified as a business bad debt, the debt must have arisen in the taxpayer's trade or business. J&W Fence Supply Co., Inc.78 addressed a common issue: is an investment debt or equity? An S corporation lent $984,000 to a C corporation that supplied it with raw materials. The C corporation declared bankruptcy; the S corporation deducted a business bad debt, from which its shareholder benefited. The IRS argued, and the Seventh Circuit agreed, that the loan was really a capital contribution, because it was unwritten and unsecured. Although accrued interest was reflected on the books, no payments were actually made. Thus, the loss was capital. Many sports teams are S corporations. Rogers79 involved the Kansas City Royals baseball team, a single-shareholder S corporation. In 1983, the shareholder sold 49% of the stock for $10 million. The buyer ran into financial difficulty in the late 1980s; the S corporation lent him $34 million, secured by his S stock. The IRS argued, and a district court agreed, that the loan was really a disguised redemption; thus, the $36 million claimed business bad debt deduction for the loan plus interest was disallowed.
Fringe Benefits Section 612(a) of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) made one important change to the pension rules applicable to S shareholder- employees (and sole proprietors and partners). Currently, a C corporation's pension plan may lend up to $50,000 to shareholder-employees, but an S corporation, partnership or sole proprietorship pension plan may not. Beginning in 2002, Sec. 4975(f)(6) has been modified to allow those pension plans to lend to their owners.
Sec. 482 or Tax Benefit Rule In Catalano,80 an attorney owned boats that he rented to his S corporation. The rent expense was disallowed to the corporation under Sec. 274's entertainment-facility provisions, but the rental income was still taxable to the lessor-shareholder. The taxpayer tried to argue the tax benefit rule or Sec. 482, but the court rejected those contentions.
ESOPs Beginning in 1998, the Small Business Job Protection Act of 1996 permitted an employee stock ownership plan (ESOP) to own S stock (SESOP). Some commentators suggested that a SESOP could postpone taxation indefinitely, because it is not subject to UBIT. EGTRRA Section 656 will affect SESOPs, beginning in 2004, by prohibiting the allocation of S stock to a small group of shareholder-employees who would control the company but have the income sheltered. As discussed below, establishing a SESOP in a QSub may help provide a valid business purpose for spinning off a subsidiary to shareholders.
QSubs In January 2000, Treasury issued Sec. 1361 final regulations on QSubs.81 These rules present some interesting planning opportunities and traps, especially the potential application of the step-transaction doctrine. Several recent rulings highlight these changes. 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 new S holding company allows a shareholder to use current and suspended losses against his holding company stock basis (see Exhibit 1). This strategy is supported by Letter Rulings 200105034–5.82 Alternatively, the loss company stock could be contributed to the profitable company and the combined basis used to deduct current and suspended losses.
Letter Ruling 20010701883 allowed QSubs to be liquidated into a single-member limited liability company (SMLLC) owned by an S corporation, without gain or loss recognition. The business reason was to avoid state franchise tax. Normally, converting from a corporation to a partnership is a taxable event; however, because both the SMLLC and the QSub were still corporations, the IRS applied the step-transaction doctrine to ignore the intermediary steps of corporate formation (the result of terminating QSub status), corporate liquidation and partnership formation. The ruling also made clear that an SMLLC owned by an S corporation may own a QSub. Letter Ruling 20011802384 allowed a single-property SMLLC to be replacement property in a Sec. 1031 like-kind exchange, which helped avoid state transfer fees. It would seem equally valid for a taxpayer to use a QSub. Step-transaction doctrine: Strategies like the ones described above may be negatively or positively affected by the step-transaction doctrine. Regs. Sec. 1.1361-4 makes clear that the IRS will apply this doctrine if the 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 one, this will be a D reorganization; if liabilities exceed basis, Sec. 357(c) will cause gain recognition. Similarly, if an individual wholly owns an S corporation and wants a third party to contribute appreciated property, Sec. 351 would not be met. If the individual had previously contributed property to a corporation and subsequently merged the companies, the step-transaction doctrine would be avoided. However, if a deemed Sec. 332 liquidation took place, the IRS might assert application of the doctrine.
Other Issues Sec. 1374: In Colorado Gas Compression Inc.,85 a small C corporation converted to S status in 1988 and was covered by Tax Reform Act of 1986 Section 633(d). It terminated S status in 1990, then re-elected it in 1994. The issue was whether the transition rule still applied, due to the original conversion. According to the Tax Court, the transition rule did not apply; the company was subject to the Sec. 1374 built-in gain rules. The valuation of a company and its assets is often an important issue. When a company switches from C to S status, it may be possible to reduce unrealized built-in gain. In recent years, several court cases have addressed the valuation of gifted shares.86 The courts have held that the value of stock is based on the amount a hypothetical buyer would pay, given the built-in gain tax liability. These holdings could also help in estate planning involving an S corporation with Sec. 1374 built-in gain tax exposure. Sec. 1363(d) was enacted as a backstop to Sec. 1374; if a corporation were on the LIFO method and maintained a constant beginning and ending inventory, no gain on inventory sales would be recognized in the 10-year recognition period. The LIFO recapture tax requires income recognition in the last C year, measured by the difference between FIFO and LIFO bases. In Coggin Automotive Corp.,87 a consolidated group of corporations holding partnership interests converted to S status. The issue was whether the aggregate or entity concept applied to the partnerships owned by the S corporations. If the entity theory applied, the LIFO reserves would not be recognized under Sec. 1363(d). The Tax Court held that the aggregate theory applied (consistent with Regs. Sec. 1.1374-4(i)); thus, LIFO recapture tax applied to $4,792,372 of income. Cash method: A common reason to elect S status is that Sec. 448(c) does not apply. Thus, if inventory is not a material-producing asset, no matter the size of the entity's gross receipts, it can use the cash method. This is the preferred method of most service businesses; on the other hand, the IRS has rarely approved its use. In the past year, the Ninth Circuit88 affirmed the Tax Court's decision approving use of the cash method for an asphalt/paving service company, as the asphalt was not inventory or merchandise. Smith89 held that the IRS abused its discretion; thus, a floor-contracting S corporation could use the cash method. The Tax Court found that the business provided services, of which the flooring materials were an inseparable part. The company was not a merchandise manufacturer or a retail seller of flooring material and could use the cash method. RACMP Enterprises, Inc.90 dealt with a construction company; the Tax Court held that, because the concrete was purchased and poured for a specific project site, it was supplies, not inventory. Similarly, in Vandra Bros. Construction Co.,91 the court held that a company that prepared a site and contracted with a supplier to deliver liquid concrete to the site at a specified time could use the cash method. Corporate division: A bad Sec. 355 corporate division, instead of resulting in no recognized gain to the corporation or shareholder, can result in gain recognition at both levels. In McLaulin,92 an S corporation split-off did not meet the five-year active trade or business requirement. The transaction was thus treated as a redemption, triggering ordinary income to the distributing corporation (Sec. 311(b)) and capital gain to the redeeming shareholder (Sec. 302(b)(3)). One way to potentially minimize these dire tax consequences is to argue that the "personal goodwill" doctrine93 applies. In the S context, the primary corporate business purpose for a split-off is a shareholder dispute that affects the efficient running of the business. Letter Ruling 20012106194 involved a five-shareholder S corporation. One of the shareholder-directors continually fought with the other owners and was removed as a director. The company also created a subsidiary with a portion of the business assets (sufficient to be a separate active trade or business, with a five-year history) and spun off the controlled subsidiary's stock to the dissident shareholder in exchange for the controlling corporation's stock. According to the ruling, the transaction qualified as a divisive D reorganization, resulting in no gain to the controlling corporation or the shareholder. Similarly, Letter Ruling 20004704595 discussed an S shareholder dispute as to diversification, expansion and marketing strategies. The shareholders planned a split-off and immediately elected S status for the momentarily controlled division. It was a tax-deferred transaction; both the distributing and controlled corporations would continue to be eligible for S status. Another common corporate business purpose for a spinoff is rewarding key employees. In Letter Ruling 200047024,96 an S corporation ran one business and a QSub ran another. The QSub's key employees wanted to receive stock, but the corporation could not do that without terminating QSub status. Instead, a tax-free, pro-rata distribution of controlled stock was made; the distributed subsidiary was allowed to elect S status. The key employees would then be allowed to own its stock. In Letter Ruling 200047020,97 a consolidated group's parent elected S status; the subsidiaries became QSubs. To accommodate the desire to establish an ESOP, the parent proposed spinning off QSub stock to its shareholders. The IRS agreed this was a good business purpose. However, any Secs. 1374 and 1375 exposure existing before the liquidation would exist after the spinoff. Under Regs. Sec. 1.1366-2(c)(2), if an S corporation spins off a subsidiary under Secs. 368(a)(1)(D) and 355, any suspended losses will be allocated between the distributing and controlled corporations based on any reasonable method (including allocations based on relative FMVs, relative book basis or allocating to the business that generated the loss). Similarly, Sec. 312(h) and Regs. Secs. 1.312-10(a) and 1.1368-2(d)(3) require earnings and profits (E&P) and accumulated adjustments accounts (AAA) to be allocated between the controlled and distributing corporations. Sec. 304: For most formation, liquidation and reorganization provisions of the tax law, subchapter C provisions apply equally to an S corporation. In FSA 200041009,98 an S corporation and a C corporation were controlled by two shareholders. The shareholders sold their C stock to the S corporation, which had both AAA and accumulated E&P. Sec. 304 applied to the transaction; thus, Sec. 1368 (and not Sec. 301) also applied. The S corporation had sufficient AAA to cover the distribution; thus, the distribution was treated as a return of capital and capital gain. |
