S Corporations, CGES and Sec. 179.

Many CPAs believe that controlled group election statements (CGES) should be filed for every S corporation that has more than 50% common ownership with another corporation, to allocate the benefits of Sec. 179. The Sec. 179 regulations provide limits for component members of controlled groups and different limits for S corporations and their shareholders.

When do the various limits apply? This item analyzes these issues and draws some conclusions as to when S corporations should file CGES.

Controlled Group vs. Component Member

A "controlled group" of corporations generally includes those connected through at least 80% common ownership. For Sec. 179 purposes, however, the threshold is only "more than 50 percent." However, a "component member" of a controlled group, as defined in Sec. 1563(b), excludes certain corporations that would otherwise qualify. While S corporations are not listed in Sec. 1563(b)(2) as all excluded member, they are listed in the regulations thereunder as being excluded.

Specifically, Regs. Sec. 1.1563-1(b)(2)(ii) provides that, "[a] corporation which is a member of a controlled group ... shall be treated as an excluded member of such group ... if ... such corporation is ... an electing small business corporation ... not subject to the tax imposed by section 1378." (Emphasis added.) Although Sec. 1378 has been super-seded, the regulation has not been amended to account for the change, which eliminated the tax at the S level on certain capital gains.

Drawing an Analogy 

Treasury wrote Regs. Sec. 1.1563-1(b)(2)(ii) so as to include as a component member of a controlled group any S corporation subject to tax under now-superseded Sec. 1378, because that section allowed the benefit of the lower corporate tax brackets and required an allocation of same among the group members. The regulation meshes well with the Code's general theory and construction, so it would seem plausible to draw an analogy between superseded Sec. 1378 and current Sec. 1374, which imposes an S level tax on certain built-in gains (BIGs). Under this analogy, S corporations taxed on BIGs under Sec. 1374 during the current tax year would be treated as component members; hence they should file CGES.

This theory does not hold if one considers that Sec. 1374 does not permit S corporations to use the lower corporate tax brackets to calculate the tax on BIGs. Because the lower brackets were permitted under superseded Sec. 1378, but are not permitted under current Sec. 1374, an analogy between these sections would seem illogical in the CGES context.

Sec. 179

Sec. 179(d)(8) provides that the Sec. 179(b) limits should apply at both the corporate and shareholder levels.

Example 1: Individual Towns 100% of S1 Corp. and 51% of S2 Corp., two S corporations. S1 had taxable income of $140,000 in 2004 and placed in service $350,000 of assets qualifying for Sec. 179. S2 had taxable income of $50,000 in 2004 and placed in service $200,000 of Sec. 179 assets.

S2's Schedule K-1 (prepared by the other shareholder's CPA) reported to T a Sec. 179 expense of $25,500 (or 51% of $50,000), by applying the Sec. 179 limit to S2's taxable income. The Sec. 179(b)(3) taxable income limit applies at the S level.

Before receiving the S2 Schedule K-1, T's CPA prepared S1's return. That return reported a $100,000 Sec. 179 expense, the maximum allowed under Sec. 179(b)(1), because neither Sec. 179(b)(2) ($400,000 property cap) nor (3) (taxable income cap) applies at the corporate level. One month later. T's CPA prepared his Form 1040, calculating the Sec. 179(b)(1) limit as $100,000 The other $25,500 was lost, as there is no carryover provision.

T's outside basis in S2 is not reduced by the $25,500 not used. This creates a difference between inside and outside basis, because S2 reduced its inside basis by the reported Sec. 179 expense. Communication, coordination and planning might have prevented this unfavorable result.

Regs. Sec. 1.179-2(b)(3) and (4) do not require T to include the assets placed in service at the S level in his calculation of the Sec. 179(b)(2) limit. In other words, S1 placed in service $350,000 of Sec. 179 assets; T's allocable portion of such S2 assets placed in service was $102,000, making the total Sec. 179 assets $452,000. Even though this amount is much greater them the $400,000 limit, T may still deduct the $100,000.

Sec. 179(d)(6) provides that the Sec. 179(b) limit should be applied so as to treat all component members of a controlled group as one taxpayer. Does this mean that Sec. 179(d)(6) should prevail over See. 179(d)(8) in the case of an S corporation? This question becomes moot under the conclusions drawn below.

Example 2: The facts are the same as in Example 1, but T also owns 100% of C1 Corp., a C corporation. C1 would also like to claim the maximum Sec 179 deduction of $100,000. so it can reduce its taxable income.

Should entities in this position file CGES to allocate the Sec. 179 deduction? No. As long as neither S1 nor S2 is recognizing BIGs under Sec. 1374, it is excluded from the definition of a component member; thus, Sec. 179(d)(6) does not apply. C1 may claim its $100,000 Sec. 179 deduction on Form 1120, even though T is also claiming a $100,000 Sec. 179 deduction on Form 1040.

If, instead, S1 was recognizing a BIG during the current year, S1 would he treated as a component member of the group comprised of' C1 and S1 under the Sec. 1378/Sec. 1374 analogy theory. However, this highlights another argument: because a Sec. 179 deduction cannot offset Sec. 1374 gain, should the Sec. 179 benefit be allocated at all on CGES?

Using the Code's theory and construction, one could argue that because a Sec. 179 deduction cannot offset a Sec. 1374 gain, there should be no allocation of the Sec. 179 benefit on the CGES, and both C1 and T should be allowed to claim a Sec. 179 benefit. Although controversial, this reasoning is correct: S corporations should never have to file CGES, because Sec. 179(d)(8) always controls, and Sec. 179(d) (6) never applies to S corporations.

Conclusion

Sec. 1374 does not permit the use of the lower tax brackets to calculate the tax on BIGs for S corporations. Thus, there is a strong, logical argument that S corporations can never be treated as a "component member" of a controlled group, as Regs. Sec. 1.1563-1(b)(2)(ii), which used to apply to superseded Sec. 1378, does not make sense being applied to Sec. 1374.This conclusion is further supported by the notion that a Sec. 179 deduction cannot offset a Sec. 1374 BIG. For these reasons, S corporations should not have to file CGES.

RANDALL L. ZAMARRA, CPA, DAORO ZYDEL & HOLLAND, SAN FRANCISCO, CA