S corporation current developments: S corporation eligibility and elections, operations, reorganizations and proposed legislation.

From a tax perspective, the period covered in this update--August 1993 through July 1994--has held some pleasant surprises for S corporations and their shareholders. There has been an increased number of letter rulings on proposed S corporate divisions (Sec. 355), the normal plethora of inadvertent termination rulings regarding a qualified subchapter S trust (QSST} beneficiary's failure to make a timely election, and an increase in the number of rulings on the active or passive nature of rental income, following the recently released, more liberal final regulations under Sec. 1362.(1) Although letter rulings are not precedential for anyone but the requesting taxpayer, they signal the direction in which the Service is moving, and are substantial authority for taking tax return positions; the granting of inadvertent termination requests is also of interest to the S corporation tax adviser.

This update will also cover final regulations, including a Sec. 338 regulation that signifiantly' increases the value of the S corporation as a target in an acquisition, court decisions, and a revenue ruling that revokes a 17-year-old lRS postition on the use of multiple S corporations to circumvent the 35-shareholder limit. S corporation current developments will be presented in four major categories: eligibility and elections; operations; reorganizations; and proposed legislation.

Eligibility and Elections

The Code imposes many restrictions on electing and structuring an S corporation. Given that Sec. 1362(f) requires taxpayers to request a ruling if an inadvertent termination occurs, it is no surprise that the IRS issues numerous rulings annually covering eligibility and elections. This update separates the rulings into three categories: shareholder eligibility, corporate eligibility and elections.

* Shareholder eligibility

Trusts: To keep the S corporation rules simple, there are significant limitations on who can be an eligible shareholder. The area of greatest confusion concerns which type of trust qualifies as a shareholder. From past rulings, it is clear that voting trusts and revocable living trusts qualify, while individual retirement accounts (IRAs) do not. If S corporation stock is transferred to a non-qualifiying shareholder, the S election terminates. However, the corporation may request a ruling under Sec. 1362(f). If the Service rules the termination to be inadvertent, the corporation retains its S status continuously.

Two current letter rulings so held. In letter Ruling 9426036,(2) an S corporation issued stock to grantor trust. In addition, stock was issued to an IRA with assurance from counsel that it was a permitted shareholder. Subsequently, it was determined that the credit trust was not a grantor trust and thus, not a permitted shareholder. Counsel also notifed the corporation that an IRA was not a qualified shareholder. As soon as the corporation was aware of these problems, it merged with a limited partnership that took over its business while the corporation ceased to exist. The Service ruled that the transfer of stock to the credit trust was an inadvertent termination and that the corporation's S status remained intact until the merger without interruption. The credit trust and IRA were to report S corporation income and deductions for the period those entities held the S shares.

Similarly, in Letter Ruling 9416014,(3) the service ruled that the sale of S corporation stock to an IRA was an inadvertent termination. There, the corporation sold stock to an IRA without knowing that it was not a qualified shareholder. As soon as the mistake was discovered, the stock was conveyed back to the corporation and reissued to the individual. It is unclear in this ruling which entity had to pay the tax on the S corporation's income earned while the stock was held by the IRA. presumably, the Service requires the trust to report the income and pay the tax.

QSSTs: A QSST must follow certain rules. The trust beneficiary must elect to be an S shareholder, and if such election is not made, S status technically terminates. If this occurs, the S corporation can request a Sec. 1362(f) inadvertent termination ruling.

In Letter Ruling 9426035,(4) S stock was held by a living trust that qualified as an S shareholder. When one trust beneficiary died, the stock automatically transferred to a marital trust that also qualified as an S shareholder. However, the trustee of the marital trust failed to make a timely QSST election, technically terminating S status. When this error was discovered, the deceased beneficiary's surviving spouse made the election. The Service ruled that the termination was inadvertent and allowed the corporation to retain S status without interruption.(5)

The failure to make a QSST election has been the subject of countless rulings for many years. With the issuance of Rev. Proc. 94-23,(6) however, the Service reduced the number of such rulings that will be required in the future. Rev. Proc. 9423 provides automatic inadvertent termination relief to corporations whose S corporation status has been terminated because the trust beneficiary failed to file a timely QSST election. Automatic relief applies if S stock is transferred to a trust after the S corporation has already qualified, and the trust filed its tax returns as if it were an S shareholder. Note: The procedure does not apply when the QSST beneficiary fails to file an election contemporaneously with the S election. The Code also places restrictions on the type of distributions a QSST can make. Trusts may violate these requirements if they fail to make timely distributions or make distributions to someone other than the income beneficiary. The service issued several rulings regarding these issues.

In Letter Ruling 9349009,(7) three trusts wanted to make substantial distributions of voting trust certificates and nonvoting common stock for estate planning purposes. However, the beneficiaries wanted the distributions to be made from trust principal, not income. The Service ruled that the distributions of trust principal would not disqualify the trusts as S corporation shareholders.

Letter Ruling 9424014(8) addressed two issues concerning a QSST. An individual (A) set up a living trust (Trust X) that qualified as an S shareholder. On A's death, the stock in Trust X automatically transferred to a marital trust (Trust Y). However, the Trust Y trustee and the beneficiary failed to make a QSST election. In addition, another trust (Trust B) owned by A held S stock. At A's death, the assets in the Trust B were to be distributed to his three children. Under Sec. 1361(c)(2), Trust B was deemed to have terminated at A's death and the assets and to be transferred within two years of the date of death. If Trust B failed to timely distribute the assets, it became an ineligible shareholder that terminated the corporation's S status. The distribution from Trust B was delayed beyond the two-year period. Both problems (failure of Trust Y to make a QSST election and failure of Trust B to distribute assets) were corrected as soon as they were discovered. The Service ruled that the termination was inadvertent and allowed the corporation to retain S status.

The holding in Rev. Rul. 93-79(9) was less favorable. There, a trust was an S shareholder. However, the trust's terms did not satisfy the corpus distribution requirements in Sec. 1361(d)(3)(A)(ii). A court order retroactively reformed the turst to meet that section's requirements. The Service, rejecting Flitcroft,(10) ruled that the court order did not have a retroactive effect in determining the trust's eligibility to be an S shareholder. Because the trust did not qualify as an S shareholder until after the court order, the corporation did not qualify as an S corporation prior to the change. Thus, the corporation was never an S corporation, and so could newly elect S status without waiting the five-year period required by Sec. 1362(g). However, the corporation could have a potential problem under Secs. 1374 and 1375.

Nomber of shareholders: To maintain administrative simplicity, the Code limits the number of shareholders in an S corporation to 35. Past rulings have strictly applied this rule. In Rev. Rul. 77-220,(11) to avoid the shareholder limit, the taxpayers set up three separate S corporations, then joined the corporations in a partnership. The Service disallowed the S elections on the grounds that for purposes of making the S election, all the shareholders were members of one corporation and, therefore, the corporations exceeded the 35-shareholder limit. In Rev. Rul. 94-43,(12) the Service revoked Rev. Rul. 77-220, stating that administrative simplicity should not be affected by a corporation's participation in a partnership with other S corporation partners. Therefore, the 35-shareholder limit is no longer violated by the structure described in Rev. Rul. 77-220.

* Corporate eligibility

Affiliated corporations: To retain S status, a corporation cannot be a member of an affiliated group. This requirement applies to both domestic and foreign subsidiaries. The purchase by an S corporation of 80% or more of the stock of another corporation terminates the S election. In Letter Ruling 9421004,(13) an S corporation engaged in investment advisory services. The corporation set up and invested in various corporations that operated as regulated investment companies (RICs). Until the RIC's shares were sold to the public, the S corporation owned 100% of them, terminating its S election. The error arose from a breakdown of communication and lack of knowledge of the rules governing ownership of affiliated corporations. When the mistake was discovered, the S corporation diluted its interests in the stock of the RICs to less than 80%. The Service ruled that the termination was inadvertent and allowed the corporation to retain S status. '

In a similar ruling, Letter Ruling 9427004,(14) the Service allowed a corporation to retain S status even though it owned more than 80% of a foreign holding company. In this case, the corporation entered into a joint venture in a foreign country. An adviser in the foreign country suggested that the venture be incorporated. The foreign adviser was not aware of the rules prohibiting S corporation ownership of 80% or more of an affiliated corporation. When the S corporation acquired the stock, in the foreign holding company, its S status terminated. When the U.S. tax advisers discovered the problem, the corporation divested itself of the stock. The Service ruled that the termination was inadvertent and allowed the corporation to retain S status.

One class of stock: Regs. Sec. 1.1361-1(1)(1) prohibits S corporations from issuing more than one class of stock. All shares of stock in an S corporation must have identical rights to distribution and liquidation proceeds. The regulation allows S corporations to issue stock appreciation rights (SARs) and phantom stock without violating the one-class-of-stock requirement. Letter Rulings 9406017(15) and 9421024(16) reiterated these rules for SARs and units of stock in a stock plan, respectively. Both rulings hinged on the fact that the corporate instrument involved was nonvoting, part of a compensation package, unfunded and unsecured.

Letter Ruling 9425027(17) examined the limits placed on a shareholder's equity interest. An S corporation had two original shareholders. They allowed a long-time employee to purchase an interest in the company. However, the existing shareholders wanted to limit the new shareholder's equity interest to postacquisition appreciation. Otherwise, all shares of stock would have the same voting rights and the same rights to dividends and income. In addition, the corporation adopted an agreement that limited the redemption and cross-purchase price for the new share hodler's stock. Regs. Sec. 1.1361-1(1)(2)(iii)(B) provides that bona fide redemption or repurchase agreements are disregarded in determining whehter a corporation's shares of stock confer identical rights. Thus, the resriction placed on the new stockholder's shares had to be disregarded in determining if all shares conferred identical rights. Therefore, the restriction alone did not violate the one-class-of-stock requirement.

* Elections

A company must timely elect to be an S corporation. The information provided on the election form, Form 2553, Election by a Small Business Corporation (under section 1362 of the Internal Revenue Code), must be accurate. The election is required to be filed by the fifteenth day of the third month after the start of the tax year. Sometimes a corporation fails to meet some aspect of the election requirements. In Letter Ruling 9427013,(18) the S election was timely made, but the Form 2553 did not contain consents from all nine shareholders. The shareholders who did not sign the election requested an extension of time to sign it. The extension was granted to the shareholders and the corporation's election was held to be valid.

There's is a distinction between an extension to file the S election and an extension for shareholders to sign the consent form. The filing date of an S election is set by the Code and cannot be modified or extended by the Treasury. Therefore, a corporation cannot obtain an extension to file Form 2553. However, Treasury sets the requirements for what must be included in the S election, and the requirements can be modified at its discretion. Therefore, shareholders may only request an extension to sign the consent form or provide other information.

The election may be timely filed, but the information provided may be inaccurate. The rulings on this issue vary based on which information is incorrect or missing. In Letter Ruling 9424022,(19) the election was filed correctly, except for three incorrect dates: the date of incorporation, the first day of the tax year and the date the stock was issued. The errors occurred due to a delay in filing the aricles of incorporation, but did not affect the tax return or the income reported. The Service therefore ruled that the election was not invalid.

In contrast to this lenient position, the Tax Court denied S status in Garrett & Garrett, P.C.(20) The court ruled there that Form 2533 was incomplete because it did not include the number of shares issued and lacked shareholder consents. The form was eventually completed, but after the deadline for filing the election had passed, negating S status until the following tax year.

The taxpayer also lost in Smith.(21) There, the taxpayer asserted the S election was timely filed, but the IRS never received it. Because the taxpayer did not get a receipt when he mailed Form 2553, there was no proof the election was timely filed. The Tax Court ruled that no election existed, because the taxpayer could not prove that the fact that the burden of proof lies with the taxpayer and emphasizes the importance of using registered or certified mail.

Operations

* Guarantors and co-borrowers

A standard S corporation problem vis-a-vis a partnership is how the shareholder may generate stock and debt basis to use entity-level losses. Under Sec. 1366(d)(1), being a guarantor or co-borrower is not sufficient to give the shareholder basis for loss until the shareholder pays the liability. In the partnership or limited liability company (LLC) area, guaranteeing, co-borrowing or, in the case of real estate, using nonrecourse debt, is sufficient to give rise to an upward basis adjustment for loss purposes.

The long-standing judicial rule is that there must be an economic outlay before before basis in S stock is increased. Shaver(22) is the latest in a long line of cases that maintain that guaranteeing a loan does not give the S corporation shareholder basis for loss purposes until the shareholder has to make a payment on the guarantee. The court also held that for bad debt deduction purposes, the guarantee of a loan does not give rise to adjusted basis for Sec. 166 loss purposes.

Letter Ruling (TAM) 9403003(23) held that borrowing between controlled S corporations does not give the controlling S shareholder an increased basis for loss purposes. Although there was an actual cash transfer there, because the shareholder borrowed the money from his controlled company (the original creditor) and substituted shareholder debt for an intercompany debt, the IRS National Office ruled that an economic outlay did not occur under Underwood.(24) The government observed that the shareholder was not poorer in the material sense and, therefore, an economic outlay had not occurred; rather, this was similar to a journal entry or a substitution of notes among related parties. It pointed out that if the transaction involved a nonrelated party (e.g., a bank), then an increase in adjusted basis would have been allowed under Gilday(25) and Rev. Rul. 75-144.(26)

In Shaver, the shareholder owned 100% of the loss corporation and a majority of the related corporation. The taxpayer might have argued that since he owned less than 100% of the related corporation, an economic outlay did occur, because the debt was owed indirectly to other shareholders of the lending corporation. A better way to structure this would be to make back-to-back loans involving a bank or other unrelated party, to honor the form as well as the substance of the transaction.

* Passive investment income

If an S corporation either switches from C to S status or acquires trade or business assets tax free under Sec. 381, both the Sec. 1375 tax and the Sec. 1362(d)(3) termination rules can present problems.

Sec. 1362(d)(3)(A) provides that if for three consecutive years an S corporation has subchapter C earnings and profits (E&P) and passive investment income that exceeds 25% of gross receipts, then in the fourth year, S status is terminated. Under Sec. 1362(d)(3)(D)(i), "passive investment income" is defined to include gross receipts derived from royalties, rents, dividends, interest, annuities, and the sale or exchange of stock or securities. For tax years beginning after 1992, the regulations provide an exception to the type of income that is classified as rents for this purpose. According to Regs. Sec. 1.1362-2(c)(5)(ii)(B)(2), "rents" do not include rent derived in the active trade or business of renting property. Rents are considered active if, based on all the facts and circumstances, the corporation provides significant services or incurs substantial costs in the rental business.

Because of this change in the difinition of rents, the Service issued a number of rulings determining if net rental income received by an S corporation was passive income. Letter Rulings 9423023,(27) 9423012,(28) 9422049,(29) 9421023(30) and 9421007(31) are a few of the rulings in which the Service held that the net rental income was derived from a trade or business and, therefore, was not passive income. These rulings had several common factors indicating that the S corporation provided significant services or incurred substantial costs. In each case, the S corporation provided day-to-day management of the rental property, approved and negotiated leases, and supervised and paid for the maintenance and repair of common areas. In many cases, the corporation paid property taxes, insurance and utilities on the property, and provided parking for tenants. Additionally, none of the leases were net leases. Regs. Sec. 1.1362-2(c)(5)(ii)(B)(2) states that generally, significant services are not rendered and substantial costs are not incurred in a net lease.

In Letter Ruling 9345048(32) the S corporation originally had triple net leases. The leases' terms were modified so that they were no longer net leases. The corporation also provided management services similar to those in the other rulings. The Service ruled that the rental income received after the leases were changed was not passive income.

In a related situation, an S election terminated because of excess passive investment income. The Serivce ruled in Letter Ruling 9418005(33) that the corporation could re-elect to be an S corporation without waiting the mandatory five years, because the rental income was no longer passive income under newly finalized Regs. Sec. 1.1362-2(c)(5)(ii)(B)(2). Since termination would not have occurred under that regulation, there was no need for the taxpayer to wait five years before re-electing S status.

* Passthrough nature

The issue of whether activities at the S corporation level give rise to individual or corporate characteristics and treatment is the subject of several current developments. In two court cases, the S corporation and its shareholders got whipsawed by structuring the transactions incorrectly. In Rath,(34) an S corporation owned stock in another corporation that was eligible for Sec. 1244 treatment. When that company went bankrupt, the S corporation claimed ordinary loss treatment. The court held that Sec. 1244 treatment is only available to individuals and partnerships, not to an S cprporation or indirectly to its individual shareholders. The moral is to purchase Sec. 1244 stock as an individual.

In Naporano,(35) an S corporation was a shareholder in a foreign sales corporation (FSC). The dividends paid by the FSC were held to be taxable to the S corporation shareholders and not excludible under Sec. 245(c)(1)(A). In Letter Ruling (TAM) 9423003,(36) it was held that if an insolvent S corporation restructures its debt and generates Sec. 108 income, the cancellation of indebtedness income excluded at the shareholder level passes through to the shareholders as tax-deferred income, through an asset basis adjustment or offset of a tax attribute, not as tax-exempt increase their stock basis under Sec. 1366.

* Final Sec. 1367 and 1368 regulations

On Dec. 30, 1993, final regulations under Secs. 1367 and 1368 were released(37) which are very similar to the proposed regulations.(38) The effective date of both sets of regulations is tax years beginning after 1993, but if prior returns take positions consistent with the final regulations, they will be deemed reasonable. The regulations kept the proposed regulations' pecking order: nondeductible, noncapitalizable itmes are subtracted from adjusted basis before losses and distributions. However, the final regulations allow a new election(39) to deduct losses before nondeductible, noncapitalizable items. This election must be made on the S corporation's original or amended return, and must be consistently applied for all future S years.

Otherwise, the provisions of the proposed regulations have been adopted in the final form. Thus, the deemed distribution election for subchapter C E&P, ordering rules for reducing and increasing adjusted basis of debt and stock, separate-basis approach for reducing stock and related spill-over provisions, impact of closing of the books, and various elections, such as the qualifying disposition rules,(40) were all adopted in the final regulations.

Reorganization Issues

Since S status is the vehicle of choice for many small businesses, it is only natural to see more activity in the area of S corporation split-offs,(41) acquisitions, elections of asset purchase treatment(42) and other restructuring.

A fundamental issue in the restructuring area is whether an S corporation should be treated as a corporation or as an individual for purposes of various subchapter C provisions.(43) For example, only a corporation may be the parent in a Sec. 332 liquidation, the acquirer in a Sec. 338 transaction, the parent in a Sec. 338(h)(10) election, or the distributing corporation in a corporate division. In the past year, the government has continued to affirm its long-standing positions in Rev. Rul. 72320(44) and GCM 39768(45) that an S corporation is eligible to be treated as a corporation in the liquidation and reorganization areas.

In effect, as long as the momentary ownership rules are complied with, an S corporation may be the acquirer in a Sec. 332 or 338 transaction, or the distributor in an otherwise valid divisive D reorganization. Thus, Letter Ruling 9424039(46) opines than an S corporation may split its two golf course businesses into distributing and controlled corporations under Sec. 368(a)(1)(D) due to shareholder disputes, and each may qualify for S status. Letter Ruling 9424046(47) allowed a vertical division of an S corporation, followed by a split-off, to maintain S corporation eligibility. This ruling also held that the Sec. 1363(d) LIFO recapture tax did not apply to either corporation.

In Giovanini,(48) the Ninth Circuit affirmed a district court ruling that in a statutory merger of an S corporation into a C corporation, no investment tax credit recapture was required, even though the original S corporation owners had a significantly smaller percentage of the surviving C corporation. The court noted that the time to recognize recapture is when the successor corporation sells or disposes of the assets. What the court left undecided was whether the corporation or the shareholders would bear the tax.

Letter Ruling 9422055(49) extended the momentary ownership rule to a Sec. 351 scenario in which a limited partnership incorporated its assets in a newly created S corporation. Under Rev. Rul. 84111,(50) there are three ways to structure the incorporation. The partnership chose to transfer assets to the corporation and then liquidated the same day. The partnership owned the S corporation for only a moment, which the IRS ignored for purposes of Sec. 1361(b). Similarly, Letter Ruling 9421022(51) ignored a general partnership's momentary (one-day) ownership of stock.

The final Sec. 338 regulations(52) provide an appropriate but innovative twist to the issue of whether an S corporation is to be viewed as a corporation or an individual. Regs. Sec. 1.338-4 treats the collective shareholders of an S corporation as the parent corporation for purposes of Sec. 338(h)(10). This allows an S corporation to get to the correct result of one level of tax on the sale of its assets (assuming no Sec. 1374 tax).

Example: H owned all the stock of Target Corporation, an S corporation. H's basis in her stock was $100,000; Target's aggregate adjusted basis in assets was $100,000, with a fair market value of $400,000. Acquiring Corporation plans to buy the Target stock and make a Sec. 338 election. Since a Sec. 338 election would require Target to file a one-day return and the tax liability would inure to Acquiring, there would be no step-up in H's basis for the gain recognized by Target. Thus, H would recognize a $300,000 capital gain and Target would recognize $300,000 gain on the sale.

Regs. Sec. 1.338-4 allows H, an individual, to be treated as a controlling parent corporation and make a Sec. 338(h)(10) election. Therefore, Target's tax liability is with the selling group. The result is that H recognizes no gain on the stock sale. Target's deemed sale of assets is recognized by the shareholder, and H's stock basis increases by the $300,000 gain. Target will then be considered to liquidate under Sec. 331, which in this case will not give rise to more gain. The result of permitting the S corporation a Sec. 338(h)(10) election is one recognized gain and one step-up in basis of assets.

An interesting twist involves the possibility that H died and left the stock to her son, Q. Q decides he does not want to run his mother's business, so he sells to Acquiring. Since Q's basis in the stock would be $400,000 (date of death value), the flowthrough of $300,000 of Target's income would increase Q's basis to $700,000. In the deemed Sec. 331 liquidation, Q would incur a $300,000 capital loss, which would offset his $300,000 flowthrough capital gain. The net result would be no gain to the selling corporation or its shareholders, and a step-up in basis of assets for Acquiring.

If Sec. 382 applies to a loss corporation, the general rule is that the income or loss for the change year is prorated between the post- and pre-change year. Notice 87-79(53) allows the taxpayer to request to use a closing-of-the-books method. Similarly, when an S corporation terminates its S election, Sec. 1362(e)(2) and (3) prescribe the pro rata allocation method and allow an election to use the closing of the books method. However, Sec. 1362(e)(6)(D) provides that if there is a 50% or greater change in ownership, the closing-of-the-books method must be used. If a loss S corporation changes ownership during the year and also changes from S to C status, does it have a choice of methods for Sec. 382 purposes, even though it has not choice for S purposes? Letter Ruling 9424055(54) allowed the taxpayers to use the closing-of-the-books method for both alternative minimum tax and regular tax purposes.

Two recent letter rulings provide taxpayers with an easy way to restructure brother-sister S corporations into one. Letter Ruling 9350003(55) approved the merger of two S corporations. The Service held that there was no termination of S status and no termination of the year-end of the acquiring company. Similarly, Letter Ruling 9401020(56) allowed an acquisitive D reorganization in which the S corporation survivor received significantly all the assets of the target.

Proposed Legislative Changes

There were four proposed legislative changes that may affect S corporations: health care, tax simplification,(57) S corporation reform(58) and enabling LLC legislation in 45 states. Only the last one had been enacted as of Aug. 1, 1994. With health care, GATT and welfare reform on Congress's agenda, it is unlikely that the simplification and reform bills will pass this year, but some believe that they are more likely than not to pass next year.

* Health care legislation

To fund the massive proposed health care legislation, some tax changes have been proposed. One of these provisions affects 2% S corporation shareholders. Basically, the proposal will impose self-employment tax on 80% of S shareholders' earnings from services. It will impose the same tax on limited partners in service partnerships. Some inventory profits may be excluded from this provision.

* S corporation legislation

Two bills have a direct impact on S corporations--The Tax Simplification and Technical Corrections Act of 1993(59) and the S Corporations Reform Act of 1993.(60) The latter would extinguish pre-1983 E&P, increase the number of allowable S shareholders to 50, and give the IRS expanded authority to validate untimely Form 2553 elections. It would also allow affiliated groups (80% or 100% subsidiaries), nonresident alien shareholders, nonprofit shareholders and preferred stock, and create special small business trusts, which will expand the potential use of S corporations, but will not simplify their tax treatment. These bills would also treat fringe benefits under corporate, rather than partnership, rules, treat S corporations like C corporations for all purposes except the dividends-received deduction, and repeal the automatic termination provision due to excess net passive income and E&P.

* LLCs

In the past, the vehicle of choice for many small businesses concerned with limited liability was the S corporation. A relatively new, popular alternative to the S corporation is the LLC. An LLC is a hybrid entity that is a cross between a corporation and a partnership. LLCs are generally intended to provide limited liability like a corporation and, at the same time, offer the advantages of one level of tax, like a partnership. Currently, 45 states and the District of Columbia have enacted LLC statutes, and the remaining five states have LLC legislation pending. Various revenue rulings(61) have been issued that indicate the Service's position regarding the tax status of LLCs. Currently, the Service has ruled that LLCs organized under the laws of Wyoming, Virginia, Colorado, Nevada, Delaware, Illinois, West Virginia, Florida, Utah, Oklahoma, Rhode Island, Arizona, Louisiana, Alabama and Texas will be treated as partnerships for Federal tax purposes.

An LLC is more flexible in its structure, financing, etc., than is an S corporation. Specifically, the LLC has no limit on the number of members or the type of owners, allows non-pro rata distributions and special allocations of profits and losses (under Sec. 704(b)) and an increase in basis for the member's share of the LLC's debt. In the past, disadvantages of an LLC were legal tort issues and the uncertainty of how an entity with multistate income would be treated. However, with the increase in the adoption of LLC statutes, these problems may be minimized.

For many new entities, the LLC may become the optimal tax vehicle. However, for existing corporations, the cost to convert may be higher than the benefits received. For many S corporations, liquidation would trigger large gains that could be very costly to shareholders and the entity itself. A realistic alternative may be to form an LLC with individual and S corporation members, and operate the business through the LLC, without actually liquidating the S corporation. Also, an LLC may be used for new lines of business, while maintaining the S corporation for the existing business.

(1)Regs. Sec. 1.1362-2, TD 8449 (11/24/92).

(2)IRS Letter Ruling 9426036 (4/1/94).

(3)IRS Letter Ruling 9416014 (1/10/94).

(4)IRS Letter Ruling 9426035 (4/1/94).

(5)A similar result can be found in IRS Letter Ruling 9428016 (4/15/94).

(6)Rev. Proc. 94-23, 1994-10 IRB 17.

(7)IRS Letter Ruling 9349009 (9/9/93).

(8)IRS Letter Ruling 9424014 (3/14/94).

(9)Rev. Rul. 93-79, 1993-36 IRB 5.

(10)Will Flitcroft, 328 F2d 449 (9th Cir. 1964)(13 AFTR2d 825, 64-1 USTC [paragraph]9294), rev'g 39 TC 52 (1962).

(11)Rev. Rul. 77-220, 1977-1 CB 263.

(12)Rev. Rul. 94-43, 1994-27 IRB 8.

(13)IRS Letter Ruling 9421004 (2/14/94).

(14)IRS Letter Ruling 9427004 (3/31/94).

(15)IRS Letter Ruling 9406017 (11/15/93). IRS Letter Ruling 9406018 (11/15/93) is identical.

(16)IRS Letter Ruling 9421024 (2/24/94).

(17)IRS Letter Ruling 9425027 (3/25/94).

(18)IRS Letter Ruling 9427013 (4/7/94).

(19)IRS Letter Ruling 9424022 (3/15/94).

(20)Garrett & Garrett, P.C., TC Memo 1993-453.

(21)Robert L. Smith, TC Memo 1994-270.

(22)Arnold W. Shaver, Jr., TC Memo 1993-619.

(23)IRS Letter Ruling (TAM) 9403003 (9/29/93).

(24)Morris G. Underwood, 63 TC 468 (1975), aff'd, 535 F2d 309 (5th Cir. 1976)(38 AFTR2d 76-5476, 76-2 USTC [paragraph]9557).

(25)Donald S. Gilday, TC Memo 1982-242.

(26)Rev. Rul. 75-144, 1975-1 CB 277.

(27)IRS Letter Ruling 9423023 (3/14/94).

(28)IRS Letter Ruling 9423012 (3/9/94).

(29)IRS Letter Ruling 9422049 (3/9/94).

(30)IRS Letter Ruling 9421023 (2/24/94).

(31)IRS Letter Ruling 9421007 (2/17/94).

(32)IRS Letter Ruling 9345048 (8/17/93).

(33)IRS Letter Ruling 9418005 (1/27/94).

(34)Virgil D. Rath, 101 TC 196 (1993).

(35)Joseph F. Naporano, 834 F Supp 694 (DC N.J. 1993).

(36)IRS Letter Ruling (TAM) 9423003 (2/28/94).

(37)TD 8508 (12/30/93); Regs. Secs 1.1367-1 through -3 and 1.1368-1 through -4.

(38)For a discussion of the proposed regulations, see Tzinberg, "Proposed S Corporation Regulations Under Secs. 1367 and 1368," 24 The Tax Adviser 339 (June 1993).

(39)Regs. Sec. 1.1367-1(f).

(40)Regs. Sec. 1.1368-1(g).

(41)Sec. 368(a)(1)(D).

(42)Sec. 338.

(43)Sec. 1371(a)(2).

(44)Rev. Rul. 72-320, 1972-1 CB 270.

(45)GCM 39768 (12/1/88).

(46)IRS Letter Ruling 9424039 (3/21/94).

(47)IRS Letter Ruling 9424046 (3/22/94).

(48)Louis M. Giovanini, 9 F3d 783 (9th Cir. 1993)(72 AFTR2d 6512, 93-2 USTC [paragraph]50,600).

(49)IRS Letter Ruling 9422055 (3/10/94).

(50)Rev. Rul. 84-111, 1984-2 CB 88.

(51)IRS Letter Ruling 9421022 (2/24/94).

(52)TD 8515 (1/12/94).

(53)Notice 87-79, 1987-2 CB 387.

(54)IRS Letter Ruling 9424055 (3/22/94).

(55)IRS Letter Ruling 9350003 (9/1/93).

(56)IRS Letter Ruling 9401020 (10/8/93).

(57)HR 3419, 103d Cong., 1st Sess. (1993).

(58)HR 4056, 103d Cong., 1st Sess. (1993).

(59)HR 3419, note 57.

(60)HR 4056, note 58.

(61)See, e.g., Rev. Ruls. 88-76, 1988-2 CB 360; 93-5, 1993-3 IRB 6; 93-6, 1993-3 IRB 8; 93-30, 1993-16 IRB 4; 93-50, 1993-25 IRB 13; 93-38, 1993-21 IRB 4; 93-49, 1993-25 IRB 11; 93-53, 1993-26 IRB 7; 93-81, 1993-38 IRB 7; and 93-91, 1993-41 IRB 22.