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Current Developments (Part II)
Hughlene Burton, Ph.D., CPA Editors note: Dr. Karlinsky is a member of the AICPA Tax Divisions C Corporation Taxation Technical Resource Panel (TRP). Dr. Burton is a member of the AICPA Tax Divisions Partnership Taxation TRP. For more information about this article, contact Dr. Burton at Haburton@email.uncc.edu, or Dr. Karlinsky at karlinsky_s@cob.sjsu.edu.
This two-part article addresses recent developments in the S corporation area. Part II, below, discusses S operational issues. During the period of this update (July 1, 2004July 15, 2005), the biggest single development was the passage of the American Jobs Creation Act of 2004 (AJCA),53 on Oct. 22, 2004. Also, there was an unusually active issuance of regulatory guidance, including coverage of Sec. 1374 built-in gain (BIG) issues, LIFO recapture tax and employee stock ownership plans (ESOPs). The IRS Statistics of Income (SOI) bulletin54 shows that S corporations continue to grow as a form of doing business. For tax year 2002, 3.2 million S returns were filed, up 5.6% from tax year 2001 and comprising 60% of all corporate returns filed. SOI data also showed that an additional 333,000 new S corporations were filed for 2002, of which 90,000 converted from C to S; the rest were new businesses. The largest growth of S corporations was in the construction, professional, scientific and technical areas.
Sec. 1374 BIG Rules With many companies having converted from C to S status, one of the more complicated provisions that needs to be addressed is the Sec. 1374 BIG rules. The IRS and Treasury issued significant guidance in this area. Temporary and final regulations issued on Dec. 22, 200455 discuss two important issues: (1) the application of Sec. 1374 to an S corporation switching back and forth from C to S status56 and (2) an S corporation acquiring assets in a carryover-basis transaction (either a tax-deferred reorganization or a subsidiary converting to a qualified subchapter S subsidiary (QSub)).
Colorado Gas Compression The first issue revisits Colorado Gas Compression, Inc.,57 in which the taxpayer incorporated in 1977 and elected S status in February 1988. It revoked the election in December, 1989 and re-elected S status effective Jan. 1, 1994. The key issue for 1994 and 1995, when the company sold assets that it owned in 1988, was whether the Sec. 1374 BIG rules or the old capital gain rules applied. The Tax Court had ruled for the IRS; the most current S election is considered in determining whether a corporation is eligible for transition rules applicable to small businesses under Section 633(d) of the Tax Reform Act of 1986. The Tenth Circuit had reversed and remanded the case to the Tax Court, holding that as long as a pre-1989 S election existed, it did not have to be in effect for the company to qualify for the transition rules; thus, the old capital gain rules applied. Under Secs. 337(d) and 1374(e), Treasury has significant latitude to promulgate regulations that enforce the repeal of the General Utilities58 doctrine. Under this authority, final and temporary Regs. Sec. 1.1374-10 was issued on Dec. 24, 200459 to, in effect, overrule the Tenth Circuits decision.
Carryover-Basis Rules At the same time, Treasury also addressed the Sec. 1374(d)(8) carryover-basis rules. Basically, it is irrelevant that an S corporation has never been a C corporation or whether it converted to S status before or after 1986 or 1988. If an S corporation acquires C corporation assets under a carryover-basis provision,60 then it will be subject to Sec. 1374. Also, it will have a separate determination of its net unrealized BIG (NUBIG) and tax attribute carryovers,61 which may reduce its exposure to the tax. If it acquires several businesses this way, each pool will have its own NUBIG, 10-year recognition period and tax attributes. Also, the taxable income limit will need to be allocated among each pool by its relative recognized BIG.
A deemed Sec. 332 liquidation is triggered by this election. X will have two 10-year recognition periods that need to be trackedone from Jan. 1, 1999Dec. 31, 2008 and one from June 15, 2005June 14, 2015. Zs tax attributes can only be applied to Zs BIGs, and Xs tax attributes can only be applied to Xs BIGs. Also, the taxable income must be allocated to the two BIG pools by the relative BIGs recognized, so that the taxable income limit may be applied properly. Thus, for example, if X had $40,000 recognized BIG in 2006 and Z had $60,000, 40% of 2006 taxable income would be allocated to the X pool and 60% of taxable income to the Z pool. Note: Xs NUBIG would be reduced by the Z stocks BIG, because it is now reflected as a separate pool. Tax planning: If appropriate from a business perceptive, it may pay to liquidate a subsidiary immediately so that there is no need for a separate (1) determination of the BIG embedded in the corporate entity nor (2) recognition period.
Amount of BIG In Garwood Irrigation Co.,62 the taxpayer owned the right to divert Colorado River water. The company was worth over $22 million at the date of conversion from C to S status. One issue was, which future events may be considered to help determine the value of an asset today? This case discusses different ways to value a fairly unique asset and could be helpful when a company owns intangible assets, especially uncommon ones. In C. Van Der AA Investments, Inc.,63 the taxpayer disagreed with the IRS as to its BIG tax for 1999 (the IRS contended it was $64 million, the taxpayer maintained it was $1.5 million). The taxpayer moved for summary judgment, as it had a contemporaneous asset valuation. The court denied the taxpayers request, citing issues such as whether the appraiser was qualified, the estimates were reasonable, etc.
LIFO Recapture Tax Treasury promulgated Regs. Sec. 1.1363-2 to address a perceived problem with Coggin Automotive Corp.64 and, using Sec. 337(d), to overrule the Eleventh Circuits holding. In Coggin, the Tax Court had held that the aggregate theory applied to LIFO inventory sitting in limited liability companies (LLCs) in which Coggin was a limited partner (after a restructuring); thus, the taxpayer was subject to Sec. 1363(d) LIFO recapture tax. The Eleventh Circuit reversed the lower court and read the statute literally; because the S corporation owned no inventory directly, Sec. 1363(d) could not apply. Under new Regs. Sec. 1.1363-2, LIFO recapture rules apply to a C corporation holding a lookthrough partnership interest when the corporation elects S status or transfers the partnership interest to an S corporation in a nonrecognition transaction.
Losses and Limits A major motivation for choosing S status in a businesss early years is the ability to flow through entity-level losses to shareholders. There are several hurdles that a shareholder must overcome before losses are deductible, including Sec. 183 hobby loss, Sec. 1366 adjusted basis, Sec. 465 at-risk and Sec. 469 passive activity loss (PAL) rules.
Sec. 1366 William H. Maloof65 dealt with a sole shareholder guaranteeing a $4 million bank loan, assigning a life insurance policy as collateral and taking the position that this gave him adjusted basis for loss under Sec. 1366. The Tax Court held that there was no economic outlay and, thus, no basis increase. Why the taxpayer did not use the back-to-back loan technique is unclear. In Veronica Chu,66 the shareholder could not prove she had sufficient adjusted basis in stock and debt to absorb loss, and, thus, it was disallowed for the current year. In Blodgett,67 an S corporation paid the legal fees, Federal Trade Commission fines, etc., for deceptive advertising and fraud committed in a Ponzi scheme dealing with rare coins. The liability was held to be the shareholders and was personal in nature. Thus, the corporation was denied a deduction for legal fees it paid. In Brady,68 an IRS agent had a 10% ownership in an S corporation, which flowed through a loss that she deducted on Form 1040, Schedule E. The S corporation was audited by her employer and much of the loss was disallowed, which obviously reduced the taxpayers individual-level loss. The case dealt with whether she had to increase her individual tax for the flowthrough adjustment (she did).
Sec. 469 In Tony R. Carlos,69 a taxpayer owned two commercial properties and two S corporations (a steel company and a restaurant) that were the tenants. For Sec. 469 purposes, the taxpayer elected to group the two real estate activities as one passive activity. The restaurant property had a loss, while the steel property showed a profit. The taxpayer netted the nonpassive rental income70 and the restaurants passive loss, for a net nonpassive income. The issue was whether the single-activity netting occurred before or after nonpassive activities were segregated. The court ruled that passive/nonpassive segregation occurs before netting among the activities grouped together. The result was that the taxpayer had the worst of all worldssuspended passive losses from the restaurant property and nonpassive income from the steel property. Another interesting manifestation of the PAL rules occurred in Misko,71 which involved a C corporation (the results would have been the same using an S corporation). A successful trial lawyer did business as a corporation and rented computer and video equipment from himself. He usually broke even, but in 1998 and 1999, he lost money. The IRS raised hobby loss and passive activity issues. The Tax Court held that the Sec. 183 rules did not apply, because the activity was entered into for a profit. The taxpayer successfully maintained that the incidental-activity-exception factors under Temp. Regs. Sec. 1.469-1T(e)(3)(vi)(C) applied, because there was no rental or salary income in the two years under examination; thus, the PAL rules did not apply. The taxpayer was also deemed to be materially participating, because no one spent as much time on the activity as he did.
SE and Social Security Taxes Why set up a business as an S corporation, rather than as a partnership or an LLC? A common response (besides the loss passthrough issues discussed above) is that S shareholders are not subject to self-employment (SE) taxes or Medicare taxes on the income allocated to them; instead, Social Security and Medicare taxes are due only on reasonable compensation paid (or deemed paid). This has led to many cases in which undercompensation was the issue. Another benefit of an S corporation is that, for retirees between ages 62 and 64, there is an earned income threshold at which a taxpayer begins to lose Social Security benefits. This was the situation in Mason.72 An individual received a written promise from his familys S corporation for consulting work he did for the entity. This receipt was determined to be taxable earnings and the taxpayers Social Security benefits were reduced accordingly. Had the taxpayer been a shareholder and some of his return related to capital investments, less of the Social Security benefit would have been permanently lost.
Bankruptcy It is clear that a bankruptcy estate is an eligible S shareholder. In Mourad,73 an individual S shareholder was liable for profits generated by an S corporation in bankruptcy. A recent case74 held that when an individual declared bankruptcy near the end of his tax year, 100% of the losses from two S corporations he solely owned were allocated to his bankruptcy estate under Sec. 1398. Thus, several million dollars of NOLs were attributed to a bankruptcy estate that had owned the stock for less than a month. It would seem that if a calendar-year individual S shareholder wants to declare bankruptcy and his or her wholly owned S corporation has losses, either the shareholder should declare bankruptcy in January of the next year or the entity should declare bankruptcy.
IRS CIPs As mentioned in last years S corporation update, S corporations are being scrutinized more than ever as to potential tax shelter activities.75 The focus in last years article was on ESOPs. In the past year or so, two S corporation Coordinated Issue Papers (CIPs) were issued, of which the tax adviser needs to be aware. In May 2005, the IRS issued a CIP76 related to Notice 2002-65,77 in which a newly formed S corporation enters into foreign currency straddles, closes the profit leg first, redeems all but one gain-seeking shareholder, makes a closing-of-the-books election and then sells the loss leg. All the losses are recognized on the remaining shareholders return. This is now a listed transaction with filing requirements and potential penalties. The second CIP78 derives from Notice 2004-30,79 in which an S corporation issued nonvoting stock and warrants thereon, equal to roughly 90% of the stock. The shareholders or the corporation contribute the nonvoting stock and warrants to charities (presumably, with negative unrelated business taxable income), then take a deduction for the value of the gift, or they contribute the stock to their retirement plans. The S corporation allocates 90% of the income to tax-exempt shareholders, but defers paying any distributions until the nonvoting stock is redeemed. This is now categorized as a listed transaction.
Fringe Benefits In Chief Counsel Advice (CCA) 200344008,80 an S corporation owned a plane that it used 5% of the time for business and 95% for the personal benefit of owners and employees. Under Regs. Sec. 1.61-21, the users of the private plane picked up taxable, fringe-benefit income. However, the entitys deductible expenses were 10 times higher than the imputed income and fully deductible to the S corporation, under Sutherland Lumber-Southwest, Inc.81 This CCA and court decision have been reversed by AJCA Section 907, effective for expenses incurred after Oct. 22, 2004. Basically, the entitys tax deduction is limited to the employees taxable fringe-benefit income. This provision applies to specified individuals, which includes officers, directors and 10%-or-greater shareholders of both publicly and privately held companies.82
Disregarded Entities QSubs are commonly used by S corporations for Sec. 1031 or 1033 purposes or to acquire a new subsidiary. Final regulations83 issued on Feb. 25, 2005 discuss when a disregarded entity will be treated as separate from its owner for Federal tax liability purposes. Basically, if the QSub has a liability that existed when it was a separate entity or acquires tax liabilities along with assets in an asset acquisition, it will be liable for those taxes. These rules apply after March 31, 2004.
Sec. 179 A new final regulation84 addresses an important small business issuefirst-year expensing under Sec. 179 of new or used tangible personal property or off-the-shelf computer software. Basically, the regulation explains the procedures (1) for amending a return to elect Sec. 179, (2) to change the amount of the election or (3) to revoke the election. It allows the taxpayer to change the assets to which Sec. 179 will apply or to increase or reduce the amount expensed, as long as an amended return is filed within the statutory limits (generally, three years after the original return is filed). Interestingly, all the examples in the regulation use Form 1040, Schedule C. It would seem that flowthrough entities like S corporations and LLCs would require amended returns, too.
ESOPs Tax advisers with ESOP clients holding S corporations need to be aware of regulations85 that explain and give examples of disqualified persons, non-allocation year and synthetic equity. Note: A disqualified person is computed relative to the ESOP ownership of the various parties; a non-allocation year is computed relative to ownership in the company (including the ESOPs ownership).
Redemptions It is not uncommon for a closely held S corporations major shareholder to plan for retirement by doing a Zenz86-type bootstrap acquisition with family, employees or a competitor. In Hurst,87 an S corporation bought some of a retiring executives stock; his son and business associates bought the rest in return for installment notes, with S stock as collateral. The issue was whether the Sec. 302(b)(3) waiver-of-family-attribution requirement of no interest, other than that of a creditor, was met. The taxpayer rented the building to the S corporation, but the court held that this was in his capacity as a creditor. His wife, who had owned no stock, received a 10-year employment contact valued at $1,000 per month plus fringe benefits (e.g., a company car and medical insurance coverage). However, the wifes employment was also held not to violate the family-attribution-waiver requirements, because she was not a direct owner of the stock. The tax adviser should be careful when stock, and not assets, are used as collateral for installment notes. In the event of default, getting the stock back would recharacterize the original transaction as a Sec. 301 distribution. Given that the 15% dividend tax rate equals the capital gain rate, the importance of a redemption versus a dividend is somewhat ameliorated. However, if there is a high basis in stock, the determination could be the difference between a zero tax rate (in a redemption) and 15% (capital gain or dividend treatment).
Tax-Deferred Reorganizations Because of the increased use of S corporations and the flexibility permitted by the QSub disregarded-entity rules, there was some merger and acquisition activity involving S corporations. For example, one ruling88 dealt with the issue of a Sec. 338(h)(10) election by an acquirer and a target, after which, theoretically, a new corporation was formed that was eligible to make its own S or QSub election. The IRS held that the target remained an S corporation after acquisition by a C corporation, the Sec. 338(h)(10) election and a re-transfer of the stock back to two of the original S shareholders. Converting from a brother-sister to a parent-subsidiary under the D reorganization rules and Rev. Rul 67-27489 was the subject of Letter Ruling 200430025.90 Basically, the ruling involved three related entities, including an LLC (that made a check-the-box election), a general partner of a partnership and an owner of a third partnership. They wanted to streamline their operations and organize as an S corporation and several QSubs. The ruling allowed them to do so, tax free to all parties.
Corporate Divisions In the S corporation context, the primary business purpose for a split-off is shareholder disputes that affect the efficient running of the business. This, plus focus and segregating liabilities, were the business purposes for a corporate split-up in Letter Rulings 20051901991 and 200518034.92 In the former, six shareholders split up an S corporation into three; two individuals ended up owning one S corporation, two others owned another newly formed S corporation and the remaining two owned 100% of a third, new S corporation. In the latter ruling, 10 shareholders paired up (presumably, spouses); each ended up owning 100% of one of five new S corporations. Two other common valid business purposes that justify a company doing a tax-free corporate division are to reward key employees and to segregate risky businesses from nonrisky ones. In the past, the latter was not viewed as a good business reason, because the risky business could be dropped into a subsidiary and accomplish the purpose without spinning off the stock. In a ruling,93 the business purpose was to segregate risky assets, and to allow shareholder and management to focus on each business. Both of these were held to be valid business purposes. |
