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Current Developments (Part I) This two-part article discusses recent cases, rulings, regulations and other developments in the S corporation area. Part I focuses on S operational aspects, such as K-1 compliance, S employee stock ownership plans, tax shelter rules, loss limits, reorganizations and acquisition rulings. Stewart S.
Karlinsky, Ph.D., CPA Hughlene
Burton, 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 the Interim Chair and 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
During the period of this update (July 1, 2003–June 30, 2004), important and sophisticated S corporation operational issues were addressed by the courts and Treasury. This year the focus is on S corporation ESOPs (SESOPs), a new temporary regulation covering synthetic equity, nonallocation year and disqualified persons; informal IRS guidance that affects accrual-basis S employers; listed transactions applying to S activities; built-in gain (BIG); Schedule K-1 matching; and the often-seen adjusted-basis issue, in its various permutations. Also, several cases and rulings involved S corporations and airplanes. Interestingly, an IRS statistical report1 showed that of the 2,986,486 Forms 1120-S, U.S. Income Tax Return for an S Corporation, filed for 2001, 56% (1,684,861) showed one shareholder, 30% (886,673) showed two shareholders and fewer than 20,000 returns (0.67%) reflected more than 10 shareholders. K-1 Compliance Six days before the 2004 busy season was over and almost a month after K-1s were due, the IRS issued IR 2004-51,2 to alert tax preparers that it will be again matching K-1s and that there are some common mistakes that preparers should avoid, such as netting; not segregating K-1 net income from unreimbursed and Sec. 179 expenses; not listing currently recognizable suspended carryforwards on a separate line; and not clearly identifying income reportable under the four-year spread of Rev. Proc. 2003-79.3 The IRS also has a K-1 project fairly along in the process, to convert the traditional K-1 into a computer-readable format, which will require tax advisers to continually refer to the formatting instructions and identification letters on various information disclosures. SESOPs Normally, S status would terminate if a retired employee rolled over stock distributed from a SESOP into an IRA, because an IRA is not an eligible shareholder. However, Rev. Procs. 2004-144 and 2003-235 held that a SESOP or S corporation could buy back the stock from the IRA, without loss of S status. Another SESOP issue that arises for accrual-basis S corporations is Sec. 267(e)’s potential override of the Sec. 404 deferred-compensation rules. If a cash-basis S employee performs services in 2004, but is not paid until January 2005, the corporation would normally take a deduction in 2004 under Sec. 404’s 21/2-month rule. However, if the employee is covered by a SESOP, the IRS has stated informally that it will apply the Sec. 267(e)(1)(B) rules to postpone the corporation’s deduction until the payment year (2005). Another recent SESOP development was the issuance of Temp. Regs. Sec. 1.409(p)-1T, the violation6 of which may subject an S corporation to a Sec. 4979A 50% excise tax. The temporary regulation defines several important terms, including “synthetic equity” (Temp. Regs. Sec. 1.409(p)-1T(f)) and how it applies in defining a “nonallocation year” (Temp. Regs. Sec. 1.409(p)-1T(c)), and a “disqualified person” (Temp. Regs. Sec. 1.409(p)-1T(d)). It is effective for all SESOPs beginning in 2005 (and in some cases, earlier).7 Tax Shelters/Listed Transactions/Disclosures Unfortunately, S corporations are hitting Treasury’s radar screen, as are investment banks and accounting and law firms. Several recent Treasury pronouncements highlight the increased frequency8 of SESOPs and some aggressive behaviors being used by promoters. Rev. Rul. 2004-49 elaborates on one type of scheme that involves SESOPs and qualified subchapter S subsidiaries (QSubs). Notice 2004-3010 and IR 2004-4411 describe another S scheme that is a reportable listed transaction—for the first time, nonprofit organizations are listed as participants and, thus, required to disclose.12 Loss Limits A major motivation for choosing S status in a business cycle’s early years is the ability to pass through entity-level losses to shareholders. With the recent changes to depreciation enacted by the Jobs and Growth Tax Relief Reconciliation Act of 2003 and the Jobs Creation and Worker Assistance Act of 2002, and the increased carryback provisions (five years back instead of two, and 100% offset for alternative minimum tax purposes for or from 2001 and 2002), the use of losses is more important than ever. There are several hurdles that a shareholder must overcome before these losses are deductible, including the Sec. 183 hobby-loss rules, Sec. 1366 adjusted basis rules, Sec. 465 at-risk rules and Sec. 469 passive activity loss (PAL) rules. In many of this year’s cases and rulings, Secs. 1366 and 465 issues were at hand. Economic Outlay This year saw several court cases in which substance over form determined whether there was an economic outlay that gave an S shareholder basis for loss under Sec. 1366(d). Donald Oren13 was appealed to the Eighth Circuit, which upheld the lower court’s decision upholding the IRS’s position. Basically, Oren owned three S corporations, two showing losses due to large depreciation deductions on trucks and trailers and one showing profits. The profitable corporation lent Oren funds. He lent the money to the loss corporation, which lent it back to the profitable corporation. Although the corporations performed all the legal niceties, the court held that there was no actual economic outlay by Oren. Thus, Secs. 1366 and 465 basis was not increased by the circular loan strategy employed among the related parties. An interesting unanswered question is whether the court’s decision would have differed had the circle not been completed (i.e., if the loss company had not re-lent the money to the original corporate lender). Clearly, if a third party had lent the money to Oren, who lent it to the loss corporations, his basis would have increased for Secs. 1366 and 465 purposes. In Luiz,14 the taxpayer argued that an S shareholder’s guarantee should increase Sec. 1366 basis for loss. The taxpayer made novel arguments to unsuccessfully rebut the well-settled case law that an S shareholder does not have an actual economic outlay when he or she guarantees a loan. He argued that (1) the Sec. 752 partnership rules should apply; (2) Selfe15 should apply; (3) California collateral rules made him economically liable; and (4) the California Supreme Court’s decision in Bender16 applied to give him basis. The court held there was no economic outlay, so no increased basis. In a recent case17 involving an S corporation and a recourse debt allocation under Sec. 752, a limited liability company (LLC) was owned by the taxpayer and his S corporation. The LLC bought a top-of-the-line airplane for $9.2 million and some smaller planes to lease out. The taxpayer and some of his other entities, but not the LLC, guaranteed the loan. The taxpayer argued that, under the Sec. 752 regulations, the LLC should be able to allocate some of the recourse debt to the S corporation and, thus, increase basis for loss. However, the court held that the related-party rules did not apply and there was no actual economic outlay under the S corporation rules. Another stumbling block (assuming sufficient Sec. 1366 adjusted stock or debt basis) is the Sec. 469 PAL rules. In Schumacher,18 the taxpayer owned 90% of an aviation business in Beaver Falls PA, which operated as an S corporation. This majority owner did not want the company to acquire a needed plane and engines, because the other 10% shareholder would benefit, so he bought the property personally and leased it to the S corporation. Both the S activity and the Schedule C leasing activity showed a loss for the years at issue. The point of law decided favorably to the taxpayer was how to interpret Regs. Sec. 1.469-(4)(d)(1), which allows an insubstantial activity (leasing of plane parts) to be grouped with a related substantial activity (running an aviation company). The court held that the leasing was insubstantial and economically linked to the other business; thus, both were nonpassive activities and the losses were deemed active. The court discussed a similar situation found in a district court case,19 in which one spouse owned a real estate management company and both spouses were principals in over 100 limited partnerships and LLCs in the low-income housing business. The two businesses were economically dependent and the management company had no income except for the fees received from the LLCs. The court held that the two businesses should be linked as one activity for Sec. 469 purposes. Following the same logic, it would seem that a doctor renting diagnostic scanning equipment to his or her own company or a trucker who rented equipment to his or her S corporation, for example, may be able to use Regs. Sec. 1.469-4(d)(1) to advantage. Fringe Benefits In October 2003, 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. Per the Standard Industry Fare Level rules (Regs. Sec. 1.61-21(g)), the plane’s users included taxable fringe benefit income. However, the entity’s deductible expense was 10 times higher than the imputed income and, thus, was fully deductible to the S corporation,20 under Sutherland Lumber.21 Undercompensation A Treasury Inspector General of Tax Administration (TIGTA) audit has raised the awareness of IRS field agents to the undercompensation of S corporation owners/officers. The TIGTA examined 84 audited S tax returns with compensation under $10,000 and taxable income over $50,000. They found that the average owner/officer wage was $5,300, while the average distribution was $349,323. This behavior allowed corporations and shareholders to avoid Social Security and FUTA taxes. This year has seen the logical consequences of last year’s rash of court cases in which S corporations paid zero compensation to their owner-employees, but the owners withdrew funds as Social Security tax-free distributions. In a series of three Third Circuit cases,22 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 amount of 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 all three instances that the shareholders were key employees who provided substantial services and, thus, the distributions were disguised salary. The courts also opined that the Revenue Act of 1978 Section 530 exception was not available.23 Accounting-Method Issues Because the vast majority of S corporations are closely held, encountering related-party transactions is not uncommon. Weaver24 involved an individual taxpayer who owned 80% of both an S corporation and a C corporation. The S was an accrual-basis calendar-year corporation; the C had a July 31 year-end and was a cash-basis taxpayer. The C performed services for the S and the S took a deduction under Sec. 461 for accrued expenses, in the belief that the Sec. 461(h) all-events test had been met. The IRS argued, and the Tax Court agreed, that because the payment was not made within 21/2 months after the payer’s year-end (March 15), that Regs. Sec. 1.461-1(a)(2)(iii)(D) would disallow the deduction until it was paid. Another accounting issue that affects S corporations is illustrated by a letter ruling25 in which a minority shareholder had taken out an insurance policy on the controlling shareholder’s life through a single-purpose LLC. Prior to the insured dying, the policy was contributed to the shareholder’s accrual-method S corporation; if the majority shareholder died, the S corporation would be able to redeem the estate’s stock. After the shareholder died and the estate was redeemed, but before the proceeds were received, the S wanted to terminate its year-end under Sec. 1377(a)(2) and allocate all of the exempt income to the remaining shareholders. The ruling held that Sec. 451 would result in the exempt income being recognized at the date of death, not on the payment of the insurance; thus, all the shareholders, not just the surviving ones, would be allocated the income under Sec. 1367. Thus, the remaining shareholders’ bases were not increased by as much as they planned. As mentioned above, Sec. 267(e) may override the normal deferred-compensation Sec. 404 21/2-month payment rules for accrual-basis taxpayers with SESOPs. Many more S corporations are using the cash method of accounting since Notice 2001-7626 was formalized by Rev. Proc. 2002-28.27 The IRS ruled28 that an S corporation could not retroactively change to the cash method because it would have been earlier than the revenue procedure’s effective date. In that ruling, the taxpayer was audited and agreed to switch from the cash to the accrual method. It signed Form 4549, Income Tax Examination Changes, reflecting the method change. After Notice 2001-76 was issued, it wanted to change back to the cash method. The ruling held that it may change prospectively, but not retroactively. BIG Tax With many companies having converted from C to S status, among the more important and complicated provisions are the Sec. 1374 BIG rules. There were four items in the past year in this area. One ruling29 dealt with a cash-basis S corporation personal-injury law firm that had previously been a C corporation. As the law firm took cases on a contingent basis, the issue was whether fees received after the C-to-S conversion were subject to the BIG tax. Essentially, the ruling held that if the case had been settled prior to the conversion, it would have been, but if the settlement was decided after the change date, it would not be subject to BIG tax. It also held that litigation costs paid after the change date (relating to undecided cases entered into before the change date) were not built-in losses (BILs). Another ruling30 dealt with a parent-subsidiary consolidated group converted to S-QSub status. The parent was a holding company and the subsidiary (QSub) was a franchisor that received royalties and license fees monthly. Income collected subsequent to conversion, related to post-change periods, was not subject to BIG tax. In June 2004, proposed regulations31 addressed a situation that might have resulted in double-counting an S corporation’s net unrealized BIG (NUBIG). Unfortunately, these rules would extend the 10-year recognition period for the situations covered. Basically, they would eliminate the inclusion of BIG on stock in the original NUBIG computation and instead include the underlying asset appreciation in a new 10-year period if the C subsidiary was liquidated under Sec. 332 (e.g., in a QSub transaction) or the rest of the company’s assets were acquired in a C reorganization. Also, if BIG is recognized on the stock and before the liquidation (e.g., stock redemption generating capital gain under Sec. 301(c)(3)), the eliminated BIG must be adjusted downward. Example: In 1998, a C corporation switched to S status and included $100,000 in its NUBIG, derived from the appreciation built into the value of a 100% subsidiary. On Dec. 31, 2004, the S elects to convert the subsidiary from a C to a QSub. Prop. Regs. Sec. 1.1374-3 reduces the NUBIG by $100,000 and creates a new $100,000 NUBIG with a 10-year period that extends from December 2004, under Sec. 1374(d)(8). The effective date of this regulation is for events occurring after Dec. 26, 1994. In September 2003, the IRS issued Notice 2003-65,32 which authorizes loss corporations that have a change in ownership to compute their BIGs and BILs using the S corporation NUBIG or NUBIL method. This will require some C corporations to study the application of the Sec. 1374 rules. Redemptions A recent ruling33 dealt specifically with a C corporation scenario, but can apply equally to an S corporation. A large family owned most of the stock. Some of the stock was placed in a voting trust. A redemption occurred; the issue was whether the voting trust stock should be viewed as controlled by the trustees and, thus, not count after the redemption. The ruling referred to Rev. Rul. 71-262,34 which has long held that the beneficiary, not the trustee, is the owner of the stock; thus, through family attribution, 100% control existed before and after the redemption. Hence, a dividend occurred. With the new 15% dividend tax rate equaling the capital gain rate, the importance of a redemption versus a dividend is somewhat ameliorated. However, if one has a high stock basis, the determination could be the difference between a zero tax rate (on redemption) and a 15% rate (capital gain or dividend treatment). Tax-Deferred Reorganizations Because of the increased use of S corporations and the flexibility engendered by the QSub disregarded entity, the volume and sophistication level of merger and acquisition (M&A) activity involving S corporations increased significantly. Corporate Divisions In the S corporation context, the primary corporate business purpose for a split-off is shareholder disputes that affect the efficient running of the business. For example, in one ruling,35 three shareholders (out of six) disputed how to run a business that had been operating for at least five years. The distributing corporation formed three Qsubs, into which it placed roughly equal amounts of business assets and property. It equalized the net fair market value by mortgaging the properties prior to contributing them to the three newly formed QSubs. The nonfighting shareholders kept the distributing corporation’s business, while each of the warring parties received one of the QSubs in exchange for the distributing corporation’s stock. The ruling held that no gain or loss would be recognized at the shareholder or distributing-corporation level. Another ruling36 also dealt with a shareholder disagreement as to the direction of a high-tech company’s exploitation of two intellectual properties, IP1 and IP2. The two properties had been owned and licensed over five years. The transaction was a bit complicated, but essentially, a QSub owned another QSub, placed IP1 and its related business into a newly formed QSub and split that off to shareholder A in return for his stock ownership in the distributing corporation. When the dust settled, B owned the distributing corporation and its QSub that owned IP2 and its related business; A owned a former QSub that was now a regular corporation, eligible to become an S corporation, and its subsidiary (which owned IP1 and its related business). Similarly, in another ruling,37 three families and their trusts controlled an S corporation. One of the families wanted to be more aggressive in the exploitation of the business assets and in-fighting was affecting the operations. They received a ruling that a split-up of the company’s trade or business (which had been operating for more than five years), in which one family would control the newly created extension and the other two families would control the remainder of the business, was a valid D reorganization. Two other valid business reasons for a tax-free corporate division are to reward key employees and to segregate risky businesses from a safer one. Letter Rulings 20040600838 and 20042202039 are examples of the former. In Letter Ruling 200406008, an existing S corporation had been losing money in two businesses. It brought in a key employee who turned around one of the business activities in a fairly short period. The corporation wanted to reward him with stock of the business that he ran, but it was combined with an unrelated business activity. The company dropped one of its businesses into a QSub and spun it off to the existing S shareholders, then sold the key employee significant stock in the affected business for a note payable. This was held to be a valid tax-free spinoff. In Letter Ruling 200422020, two existing long-time activities were doing business as an S corporation and its QSub. The two key business managers each wanted a piece of the action from their activities, but not the other manager’s business. The S owner received stock of the QSub (controlled corporation) in exchange for stock of equal value to the S stock that he already owned. This was held to be a valid corporate division and no gain was recognized by the S corporation or the shareholder. While this fact pattern is neither a spinoff nor a split-off, it still qualified. In another ruling,40 an S corporation had two lines of business, hazardous and nonhazardous, each with a five-year history. It was strongly suggested by various interested parties that they segregate the two businesses. Normally, if a risky business is dropped into a subsidiary (QSub or C corporation), the problem would be solved without the need for a tax-free reorganization. The ruling allowed the nonrisky business to be dropped into a newly formed QSub and spun off to its shareholders tax free. This is a very favorable ruling, because if the business reason can be met without a corporate division, the IRS will usually not allow a division. Tax-Deferred Acquisitions In a ruling,41 a taxpayer did not technically use the reorganization provisions, but instead used the check-the-box regulations and the fact that a single-member LLC (SMLLC) does not exist for tax purposes, but a single-member corporation does. Essentially, a sole shareholder wanted to create a SMLLC between himself and an existing S corporation. By setting up a disregarded entity and then electing corporate status, the SMLLC was recognized for tax purposes. A QSub election was then made for the existing S corporation. Another letter ruling42 had fairly unique facts. Basically, an S corporation with no accumulated earnings and profits and no Sec. 1374 exposure wanted to convert to an exempt nonprofit Sec. 501(c)(3) organization to reach needy people. The S corporation was merged into a newly created nonprofit organization in a downstream merger. The Sec. 368 rules did not apply, so Sec. 337 applied. Basically, the bargain-sale rules resulted in part gain, part charitable contribution to the S shareholders. Conclusion The second part of this article, in the November 2004 issue, will examine recent developments in S eligibility, elections and terminations. |
