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Current Developments (Part I) This two-part article on S corporation developments reviews and analyzes recent cases, rulings and decisions. Part I, below, focuses on S operational issues, including accounting methods, loss limits, economic outlay, alternative minimum tax, built-in gain tax and reorganization issues.
Stewart S. Karlinsky,
Ph.D., CPA
Editor’s note: Dr. Karlinsky is a member of the AICPA Tax Division’s S Corporation Taxation Technical Resource Panel (TRP). Dr. Burton is a member of the AICPA Tax Division’s 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.
Executive Summary
This two-part article addresses recent developments in the S corporation area. Part I, below, discusses S operational issues. Part II, in the next issue, will examine S eligibility, elections and terminations. Operations During the time frame of this S tax update (July 1, 2001–June 30, 2002), the courts and Treasury continued to address S operational issues. The Job Creation and Worker Assistance Act of 2002 (JCWAA) will have three significant effects on the computation of S taxable income (in many cases, retroactive to already filed 2001 entity- and shareholder-level returns). The changes involve S cancellation-of-debt (COD) income, additional first-year depreciation and a five-year net operating loss (NOL) carryback.1 Further, many S corporations will now be able to switch automatically from the accrual to the cash method of accounting. A LIFO recapture tax case yielded a taxpayer-favorable result. Other issues involved undercompensation, mergers and acquisitions (M&A) of S corporations and qualified subchapter S subsidiaries (QSubs), and use of S losses. Cash Method A common reason to elect S status is that Sec. 448(c) does not apply, allowing use of cash accounting. Most service companies prefer that accounting method. Historically, the IRS had argued vigorously that the accrual method better reflects income and that supplies related to the delivery of services were really merchandise or inventory; thus, use of the cash method was not permissible. After losing many court cases, Treasury has now allowed certain businesses to switch automatically from the accrual to the cash method. The IRS issued a series of pronouncements2 that essentially allow S corporations with less than $10 million in average annual gross receipts for the three prior years to use the cash method; if they were using the accrual method, they can automatically switch to the cash method. Although there are some limits, the rules cover service businesses, contractors (e.g., roofers, electricians, floor-tilers, plumbers) and custom manufacturers and fabricators (e.g., asphalt, concrete, custom jewelers, custom home builders, granite and marble fabricators, infusion therapy pharmacies, etc.). Rev. Proc. 2002-193 requires a one-year catch-up for negative Sec. 481 adjustments and a four-year spread for most positive ones. Loss Limits S status offers the ability to flow through entity-level losses to shareholders. As discussed below, the loss attribute is more important after the JCWAA changes to first-year depreciation and NOL carrybacks. A shareholder must overcome several hurdles before such losses are deductible. In numerous cases and rulings, the shareholder’s adjusted basis in stock and debt was the relevant issue. In Gitlitz,4 the Supreme Court held that an insolvent S corporation’s Sec. 108 COD income increased the shareholders’ stock basis, because it was tax-exempt income. JCWAA Section 402(a) and (b) overturned the Supreme Court’s decision, effective for debt discharges occurring after Oct. 11, 2001. Discharges occurring before Oct. 12, 2001 increase stock basis, perhaps requiring amended returns.
Economic Outlay Several court cases addressed whether an economic outlay occurred to give an S shareholder basis for loss under Sec. 1366(d). In Yates,5 a profitable S corporation lent money directly to a loss S corporation owned by the same shareholder. The taxpayer’s accountant recorded the transaction as a distribution to the shareholder and a contribution/loan to the loss company. The court allowed the losses at the shareholder level. In Est. of Bean,6 the Eighth Circuit upheld a Tax Court decision that S shareholders had made no economic outlay. The taxpayers owned a partnership that they converted to an S corporation. They personally guaranteed loans of up to $600,000, using their homes as collateral. Had the entity been a partnership, the taxpayers would have had basis for loss. However, in an S corporation, no economic outlay occurs until shareholders are required to fulfill their guarantee; thus, the shareholders’ allocated S losses were suspended until the company generated a profit or the shareholders increased their basis in stock or debt. This difference in basis rules is one reason why the S election decision should be made carefully. In Cox,7 three shareholders of a farming S corporation secured a loan with jointly owned property. According to the Tax Court, this was an insufficient economic outlay, suspending use of losses. In Griffin,8 an S shareholder paid real estate taxes on behalf of his S corporation and its partnerships. The court held that the shareholder could not deduct the taxes paid, because he had no direct liability for them. Instead, the payment was a capital contribution by the 60% owner (which increased his basis) and a deductible payment by the entity that flowed through to all shareholders. The Tax Court held in Thomas9 that advances made by related third parties were not shareholder economic outlay and did not increase basis. The IRS held in FSA 20020701510 that when an S shareholder has suspended losses and the corporation terminates S status, the sale of some of the company’s stock (with a zero basis) does not reduce the losses; the shareholder’s use of the sales proceeds to buy additional stock generates basis for loss at the end of the post-termination transition period (PTTP). Similarly, FSA 20022305211 held that the merger of an S corporation (in which there was zero stock basis) into a C corporation (in which there was stock basis) gave a shareholder basis in the PTTP for Sec. 1366(d) purposes.
Undercompensation Two recent cases, Veterinary Surgical Consultants P.C.12 and Yeagle Drywall Co., Inc.,13 dealt with S corporations that intentionally undercompensated their owner-employees. The owners withdrew funds as distributions free from income and Social Security taxes. The court held in each instance that the shareholders were key employees who provided substantial services for disguised salary. Olde Raleigh Realty Corp.14 addressed a taxpayer trying to avoid FICA and FUTA taxes. The company paid the shareholder’s personal expenses, which the Tax Court held was disguised salary.
Fringe Benefits The Economic Growth and Tax Relief Reconciliation Act of 2001, Section 612(a), made a small but important change to the Sec. 4975(f)(6) pension plan rules applicable to S shareholder-employees (and sole proprietors and partners). Effective in 2002, these entities’ pension plans may lend up to $50,000 to their owner-employees.
LIFO Recapture Tax In a stunning reversal, the Eleventh Circuit held15 that Sec. 1363(d) must be read literally; because the taxpayer was a holding company with no inventory, it was not subject to LIFO recapture tax, even though the partnership aggregate theory would have attributed the inventory activity to the partnerships’ owner. How far the courts will extend the aggregate vs. entity dichotomy remains to be seen.
Entertainment Expenses Letter Ruling (TAM) 20021400716 examined a planning idea involving a shareholder who owned two S corporations. One corporation owned an entertainment facility and rented it out at fair market rent to the other S corporation, employees and charitable organizations. The IRS ruled that, while the facility’s owner could deduct all costs related to the facility under Sec. 274(e)(8) and Regs. Sec. 1.274-2(f)(2)(ix), the lessee had to reduce its deduction by 50%.
AMT Allen17 involved an S corporation and its alternative minimum tax (AMT) treatment of the targeted jobs credit (TJC) Sec. 280C adjustment. Both the IRS and the taxpayer argued that the AMT is a separate, independent system from the regular tax system, but disagreed on its application. The Tax Court held that, unless specifically stated as such, systems are not independent. The S shareholder could not deduct the Sec. 280C adjustment for AMT purposes, even though the TJC yields no AMT benefit. Whether the same result would be found in the corporate arena remains to be seen. An interesting question is whether Sec. 196 would apply (after the 15- or 20-year carryover period expires) to allow the deduction for AMT purposes; this could be a big benefit to S shareholders and C corporations.
BIG Tax An unusual amount of activity occurred in the built-in gain (BIG) tax area. Rev. Rul. 2001-5018 clarified the IRS’s letter ruling position that income from timber, coal and iron ore and working interests in oil and gas property are not subject to BIG tax. The ruling also modified Rev. Proc. 2001-51,19 removing the issue from the no-ruling list. Consistent with this position, the IRS issued Letter Ruling 200205028,20 providing that a sale of minerals mined in a company’s quarries owned at the conversion date is not subject to BIG tax. Letter Ruling 20013402221 held that when a C corporation switched to S status and was subjected to the 10-year BIG recognition period, in a subsequent switch back to C status as a real estate investment trust, the 10-year BIG recognition period under Temp. Regs. Sec. 1.337(d)-5T(b)(2) included the time the corporation was an S corporation.
Reorganizations Because of the increased use of S corporations and QSubs, the number and sophistication level of S M&A activity surged significantly.22
Corporate Divisions In the S context, the primary business purpose for a split-off is shareholder disputes that affect the efficient running of the business. In Letter Ruling 200123006,23 two families owned an S corporation; the board chairman and the president, each from a different family, fought continuously over corporate governance. The company created a QSub from one of its two 15-year-old businesses and spun off the controlled subsidiary’s stock to one of the families for their controlling corporation stock. Neither the controlling corporation nor its shareholders recognized gain on this divisive D reorganization; further, both corporations were eligible for S status. In Letter Ruling 200141045,24 four siblings and a trust owned S stock. The siblings fought to the point it affected corporate governance. The S corporation created four QSubs, with roughly equal parts of the same business (a vertical division). The S corporation liquidated after each sibling received one of the companies and the trust received ownership in all four entities. The IRS held that neither the corporation nor the shareholders realized gain, and all four corporations could elect S status. In Letter Ruling 200205001,25 an S corporation was owned by four shareholders, two of whom constantly battled over the company’s fundamental management and operations. The S corporation dropped half of the business into a new subsidiary and spun it off to one of the fighting shareholders, plus the two neutral shareholders. After the transaction, the neutral shareholders owned stock in both companies, while each disputing shareholder owned one of the S companies. Both corporations were allowed S status immediately thereafter. Unfortunately, the result in McLaulin26 was not as favorable. The Eleventh Circuit agreed with the Tax Court that the distribution of a subsidiary’s stock by its parent and sole shareholder (an S corporation) to the parent’s individual shareholders did not qualify for nonrecognition treatment. The distribution occurred on the same day (but after) the subsidiary’s redemption of a 50% shareholder’s stock, a transaction that resulted in the parent becoming the sole shareholder of the outstanding shares. The contemporaneous redemption and distribution failed the active trade or business requirement, because the parent acquired control of the subsidiary within five years of a transaction in which gain was recognized by the 50% shareholder, violating Sec. 355(b)(2)(D)(ii).
Tax-Deferred Acquisitions Treasury reissued Prop. Regs. Sec. 1.368-2(b)(1),27 which directly affects acquiring S corporations. Often, an acquiring company will use a new or existing subsidiary to acquire a target to protect its assets from the target’s undisclosed or contingent liabilities. The original proposed regulations28 did not recognize a disregarded entity (such as a QSub or single-member limited liability company) as either an acquirer or a target. The new proposed regulation allows a QSub to be an acquirer. In Letter Ruling 200150009,29 the taxpayer was in a consolidated group that included four subsidiaries and a foreign sales corporation (FSC); the parent was owned equally by an individual and a corporation. Using Secs. 351 and 332, they rearranged the corporate structure so that a newly formed corporation elected S status and owned five QSubs and the FSC. The group is subject to Sec. 1374 BIG tax, but neither the corporations nor the shareholders immediately recognize gain.
Conclusion The first part of this two-part article has examined current developments in S operational issues. The second part, in the November 2002 issue, will explore S eligibility, elections and terminations. |
