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Current Developments (Part I)
This two-part article discusses recent
legislation, cases, rulings, regulations and other developments in the S
corporation area.
Stewart S. Karlinsky, Ph.D., CPA
Editors note: Dr. Karlinsky is a member of the AICPA Tax Divisions S Corporation Taxation Technical Resource Panel (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
During the period of this S corporation tax update (July 1, 2002June 30, 2003), the courts and Treasury continued to address important operational issues. There was a slew of recent undercompensation cases, IRS guidance on the interplay between employee stock ownership plans (ESOPs) and S corporations, and several rulings on S merger and acquisition (M&A) activity. The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) will also have a dramatic positive effect on S corporations. Part I, below, discusses these recent developments. Part II, in the November 2003 issue, will address S eligibility, elections and terminations. Interestingly, a June 2003 IRS study1 showed that 56.7% of all corporate returns filed in 2000 were from S corporations, up 4.9% from 1999. The study found that there were 292,800 new S corporations filed, of which 211,300 were newly organized companies, and 81,500 were converted C corporations. Returns filed in 2001 comprised 2,165,011 partnership returns, 2,411,981 C returns and 3,022,589 S corporation returns. The IRS announced2 that it is implementing an enhanced K1 matching compliance effort for 2001 S, partnership and trust returns. It reminded tax preparers that they should not aggregate items from Forms K-1, as it plans to better match K-1 information with Schedule E reporting.
Legislation As was mentioned above, the JGTRRA will have a significant positive effect on S status and encourage the conversion of C corporations to S status, for several reasons. First, the 35% maximum individual tax rate is now virtually the same as the normal small business corporate rate of 34%. This is in contrast to an almost 6% differential in the recent past (39.6% vs. 34%). Second, the 15% qualified dividend rate will allow newly converted S corporations to pay out their earnings and profits, thus avoiding the Sec. 1375 tax and potential S status termination under Sec. 1362(d)(3). The new 15% dividend and capital gain tax rate in JGTRRA Sections 302(a) and 301(b) will also make the passthrough nature of S corporations more attractive, as compared to C corporations. In addition, Section 105(a)s reduction in the marginal tax rates at each income bracket will reduce the advantage that C corporations had in reinvesting their earnings. Third, as the economy has declined in the past few years, many asset values are depressed, which is helpful in minimizing Sec. 1374 built-in gain (BIG) tax exposure. Fourth, the new, liberal depreciation rules make passthrough entities particularly attractive. JGTRRA Section 202 allows an increased Sec. 179 deduction of up to $100,000, assuming that there is sufficient taxable income at the entity and shareholder levels; Section 201 provides 50% bonus first-year depreciation on new tangible property and certain software (above and beyond Sec. 179 and the normal modified accelerated cost recovery allowances).3 The phaseout amount for the Sec. 179 deduction was also doubled to $400,000, which should cover most small business activities.4 Due to these changes, the number of S returns filed should significantly increase in the next few years.
Loss Limits Another motive for choosing S, rather than C, status is the ability to flow through entity-level losses to shareholders. The use of losses is more important due to the bonus depreciation provisions (including relief from the alternative minimum tax adjustment) enacted by the JGTRRA and the Job Creation and Worker Assistance Act of 2002. A shareholder still must overcome several hurdles before losses are deductible. In many cases and rulings, the shareholders adjusted bases in stock and debt were relevant. In one ruling,5 an S shareholder had deducted losses in excess of basis, but that year was closed; the IRS held that the taxpayer still had to adjust the current basis for the closed-year error.
Hobby Losses If a passthrough entity or its owners are not engaged in an activity for profit, the losses are disallowed under Sec. 183, without regard to the general limits of Secs. 1366, 465 and 469. There were several recent S cases in which the courts disallowed the losses under the Sec. 183 hobby-loss rules. One dealt with boat racing,6 another with a multiple-level marketing scheme.7 In the latter case, Sec. 6662(a) accuracy-related penalties were imposed. In Lucian T. Baldwin III,8 a bond trader bought 5,000 acres of land and created two S corporations, ostensibly for property and hotel management. The property was held to be a disguised vacation home used by the family and relatives, not held in a for-profit activity. The court also imposed negligence and accuracy-related penalties. In Timothy T. Kuberski,9 a physician had operated a horse breeding and racing operation. For 18 consecutive years, the activity showed a cumulative $880,000 loss and no substantial changes in operations. The physicians assertion that horse breeding is only profitable once in 25 years did not convince the court that his operation was run for profit.
Economic Outlay In several court cases, the substance-over-form issue determined whether an economic outlay gave the S shareholder basis for loss under Sec. 1366(d). In Jerry L. Thomas,10 the Eleventh Circuit upheld a lower courts decision that loans from related limited liabilities companies (LLCs) and C corporations would not result in a deemed economic outlay to the S shareholders and thus would not give rise to basis for loss. Similarly, in Donald G. Oren,11 Secs. 1366 and 465 basis was not increased by bookkeeping entries between related parties, as no economic outlay occurred.
Undercompensation A recent Treasury Inspector General of Tax Administration (TIGTA) audit has raised IRS field agents awareness to the S corporation undercompensation issue. The TIGTA examined 84 audited S tax returns with compensation under $10,000 and taxable income over $50,000. They found the average wage was $5,300, while the average distribution was $349,323. This behavior potentially allowed corporations and shareholders to avoid Social Security and FUTA taxes. In the last year, there was a rash of court cases in which S corporations paid zero compensation to their owner-employees. Instead, the owners withdrew funds as Social Security tax-free distributions. In Joseph M. Grey, Public Accountant, P.C.,12 a tax preparer took no salary for his labors; instead, he received distributions from his wholly owned S corporation. The court held that he was liable for Social Security and FUTA taxes, and that the Revenue Act of 1978 (RA 78) Section 53013 exception did not apply. In a series of six Tax Court memorandum cases,14 the taxpayers had four things in common: (1) the S owners were virtually the sole shareholders (sometimes, a wife or daughter owned some stock), (2) no salary was paid, but distributions usually equaled the income earned at the corporate level, (3) they did business in Pennsylvania and (4) Joseph M. Grey was their tax preparer. The court held in each case that the shareholders were key employees who provided substantial services; thus, the distributions were disguised salary. The court also opined that the RA 78 Section 530 exception was not available. Query whether the results would have been different had no distributions been made. In a consolidated Tenth Circuit case15 of two undercompensation cases reported on last year,16 the court upheld the finding that the distributions were disguised salary.
Related-Party Issues As the vast majority of S corporations are closely held, the passive activity loss and related-party transaction rules often come into play. In a recent case,17 a doctor sought to spread his income between himself (a high-bracket taxpayer) and his mother (a low-bracket taxpayer). His S corporation rented space from his mother for $52,000 annually. The court disallowed the rent deduction, finding no evidence that the S corporation used the property being rented. Treasury issued final Regs. Sec. 1.469-718 on self-charged interest between a passthrough entity and its owners. Unfortunately, the regulations do not extend self-charged treatment to rental and management fees and other potential self-charged items. However, they do address one issue of interest to small business owners: if an S shareholder has an identical interest in two passthrough entities, he or she may use the self-charged concept as it relates to loans between the entities.
BIG Tax In one ruling,19 a consolidated group had unrecognized deferred gain from intercompany transactions involving inventory prior to its conversion from C to S. The IRS held that the deferred gain would be recognized the day before the conversion to S and qualified subchapter S subsidiary (QSub) status; thus, there was no Sec. 1374 gain.
ESOPs Two recent Treasury pronouncements20 highlight the increased frequency of S corporations being owned by an ESOP. For an S corporation, the primary tax advantage of ESOP status is that income flowing through to the ESOP is not unrelated business taxable income (Sec. 512(e)(3)) and is not taxable until employees retire, which may be many years in the future. Thus, if the principal employees are in their 40s, it may be 15 to 20 years before anyone is taxable on the ESOP-allocated S income. For a C corporation, an attractive feature of ESOPs is the ability to deduct dividend payments under Sec. 404(k) to help fund the employee retirement plan. An equally important feature is Sec. 1042, which allows C corporation owners to sell their company stock to an ESOP and permanently avoid income tax on the BIG, by reinvesting in publicly traded stocks and bonds. These features are not available for an S corporation, but are important to recognize, because many of these C corporations have switched to S status. Rev. Rul. 2003-2721 discusses the basis adjustment required by Sec. 1367, and its consequences on an employees retirement. Because the ESOP is a shareholder, it must adjust its S stock basis by its share of the entitys separately and nonseparately reported income and losses. When an employee retires and receives the S stock, the net unrealized appreciation is deferred until the stock is sold, but the ESOPs basis is taxable to the retiree on the receipt of the stock. Thus, if an ESOP has a basis of $1,000 per share (an original cost of $600 per share + $400 of net income over the years) with a $1,500 per-share fair market value, and the stock is distributed to an employee on retirement, the employee will recognize $1,000 ordinary income immediately and $500 when the stock is sold. If the retiree rolls the stock over into an IRA, no taxable recognition will occur until the money or property is distributed to the employee. However, an IRA cannot be an S shareholder; thus, the consequences of the stock rollover are discussed in Rev. Proc. 2003-23.22 For a direct rollover of S stock to an IRA by a retired employee, the IRS will not terminate the corporations S status if the ESOPs terms require the corporation to repurchase the S stock immediately from the IRA, the S corporation repurchases the stock and none of the income or losses are allocated to the IRA.
Tax-Deferred Reorganizations Because of the increased use of S corporations and the flexibility engendered by a QSub disregarded entity, the volume and sophistication level of M&A activity involving S corporations increased significantly.
Corporate Divisions Shareholder disputes: In the S corporation context, the primary corporate business purpose for a split-off is shareholder disputes that affect the efficient running of a business. In one ruling,23 shareholders disputed how to allocate resources to one of the S corporations trade or business locations. After the split-off, one of the shareholder groups would own all of the controlled corporations stock, which included the disputed-location business; the other shareholders would own the original location. The fact that the disputed-location business was dropped into a single-member LLC (SMLLC) did not affect the rulings results. Another split-off ruling24 involved a shareholder dispute about the corporations two businesses. Because one business was more valuable than the other, equal valuation notes were contributed to a newly formed corporation, along with the divested business; the controlled corporation was then distributed to the dissenting shareholder in return for his stock in the controlling corporation, all tax free. Shareholder disputes also resulted in tax-free divisions structured as a split-up (rather than a split-off or a spin-off). For example,25 an S corporation with three businesses, had three shareholders with long-standing disputes over the businesses direction. They had previously formed an S corporation holding company with three QSubs. The fighting continued, so they ended the holding companys existence and split up the entity by distributing a QSub to each shareholder. In another split-off ruling,26 a family was redeemed using cash (and recognized capital gain); each of the remaining three families took shares of one of the three other corporations formed. Rewarding key employees: Another valid business purpose for a corporate division in the small business context is to reward key employees of one division or business, but not another. In one ruling involving two businesses,27 a key shareholder-employee died; key employees of one business did not want ownership in the business in which they were not involved. The S corporation contributed that business to a newly formed QSub and spun it off to the shareholders, allowing key employees to buy stock or receive stock incentives in the business in which they were involved. As part of the transaction, some of the controlled corporations business assets were dropped into a new or existing LLC in return for a managing-member interest. This was held to be a tax-free reorganization. Similarly, in another ruling,28 key employees of one location wanted some ownership interest in their location, but not in the S corporations other locations. They would buy stock on an installment basis after the spinoff. The IRS ruled that this was a valid corporate business purpose. Segregating risk: A recent ruling29 illustrates when segregating a risky business from a less risky business (both of which have the requisite five-year history) is a valid business purpose. An S corporation was conducting an activity that could not be insured for environmental liabilities and potentially jeopardized the QSubs business activity. The spin-off of the safe business to two shareholders was held to be a valid Sec. 355 corporate division.
Tax-Deferred Acquisitions Two recent rulings dealt with an interesting convergence of a disregarded entity (QSub or SMLLC), a reorganization and the step-transaction doctrine. In the first ruling,30 an S corporation wanted to break up into two entities without changing ownership; however, the IRS ruled that, taking into account the step-transaction doctrine, this was simply an F reorganization. (Normally, an F reorganization involves a name change or change in state of incorporation of one company. Although this transaction involved splitting into two legal entities, the F reorganization rules applied, because it was viewed as one company for tax purposes.) In another ruling31 five months earlier, the same results were achieved by various steps that were collapsed and disregarded; however, the IRS did not state whether this was an F reorganization. When a disregarded entity was established as the recipient of a target companys consolidated assets, the IRS ruled32 the merger was an A reorganization, not a triangular one.
Conclusion The second part of this article, in the November 2003 issue, will explore recent developments in S eligibility, elections and terminations. |
