The AJCA's domestic business provisions: the American Jobs Creation Act of 2004 (AJCA) is an expansive piece of legislation touching many types of taxpayers. This article discusses the AJCA provisions that primarily affect U.S. domestic businesses.
This article focuses on the AJCA changes that affect domestic businesses in five main categories: cost recovery, domestic production activities, sleeper provisions, alternative minimum tax (AMT) and S corporations.
Bonus Depreciation and Sec. 179
Surprisingly, the AJCA did not extend the 30% or 50% bonus cost recovery regime, thus subjecting assets placed in service after 2004 to normal modified accelerated cost recovery system depreciation and AMT adjustments.
However, AJCA Section 201 did extend the enhanced Sec. 179 first-year expense election to 2006 and 2007. Thus, if new or used tangible personal property (or certain computer software) is acquired, $100,000 ($105,000, as indexed for 2005) of these capital costs can be expensed in the year placed in service, assuming that the total of qualified property acquired that year does not exceed $400,000 ($420,000 as indexed for 2005). For example, if the amount of qualified property acquired in 2005 equals or exceeds $525,000 ($105,000 + $420,000), no Sec. 179 expense would be allowed. (2)
Sport utility vehicles: Under Sec. 280F, taxpayers are prohibited from using the flail benefit of Sec. 179 for "luxury automobiles." However, there is a fairly longstanding exception for heavy trucks (i.e., gross vehicle weight (GVW) greater than 6,000 lbs.). In an environmentally conscious world, in which certain vehicles are venerated for their gas conservation, it made little sense to reward conspicuous gas guzzlers whose weight met the heavy truck weight limit. Thus, Sec. 179(b)(6), added by AJCA Section 910(a) for purchases after Oct. 22, 2004, does not allow the full Sec. 179 deduction, but instead caps it at the old Sec. 179 limit of $25,000 (not indexed). There are exceptions for vehicles with GVW greater than 14,000 lbs. and for certain pick-up trucks, delivery vans and passenger vans (carrying more than nine passengers behind the driver), which would be eligible for the $100,000 (indexed) expensing limit.
AJCA Section 211 contains a short window of which nonresidential real estate property owners need to be aware. Basically, for qualified leasehold improvement property placed in service between Oct. 23, 2004 and Dec. 31, 2005, it authorizes a 15-year recovery period, rather than 39 years, using the straight-line method. To qualify, improvements must not be attributable to (1) a building less than three years old, (2) an enlargement of the building, (3) the building's internal structural framework, (4) a structural component benefiting common areas or (5) an elevator or escalator.
Similar rules and effective date apply to "qualified restaurant property." This term is new and denotes an improvement to a building more than three years old, for which more than half of its square footage is devoted to the restaurant business. This would seem to favor stand-alone restaurants, rather than those in a commercial building. The AJCA makes such improvements eligible for 50% bonus depreciation through the end of 2004.
AJCA Section 244 offers a significant tax incentive to movie and TV film producers. It allows them to deduct $15 million (in some cases, $20 million) in the year that the cost of a qualified film or television production is expended, provided (among other things) that at least 75% of total production compensation is for services performed in the U.S. and the film is not sexually explicit. This "super" Sec. 179 expensing rule is effective for productions starting after Oct. 22, 2004 and before 2009, but only applies to aggregate production costs that do not exceed $15 million ($20 million if filming occurs in certain designated zones).
Organization and Start-Up Costs
AJCA Section 902 allows taxpayers to elect to deduct up to $5,000 of organization costs and $5,000 of start-up costs in the year in which business begins, rather than amortizing them over 60 months, as under pre-AJCA Secs. 248, 709 and 195. However, $1 of the $5,000 expensing limit is lost for every such dollar spent above $50,000. Any nonexpensed start-up or organization costs have to be amortized over 15 years. This rule is effective for expenditures paid or incurred after Oct. 22, 2004. Total cumulative expenditures include expenditures that occur before and after the enactment date for purposes of the $50,000 test.
Domestic Production Activities Deduction
The World Trade Organization had imposed substantial tariffs on certain U.S.-produced goods, because it deemed that the U.S. was violating international tariffs and trade agreements, by enacting rules on domestic international sales corporations, foreign services corporations and, most recently, extraterritorial income (ETI). To avoid these tariffs, AJCA Section 102 phased out the ETI provisions and added Sec. 199, which allows a phased-in 9% U.S. production activities deduction for all domestic producers. For tax years beginning in 2005 and 2006, the deduction percentage is 3%; for tax years beginning in 2007-2009, it is 6%; and for 2010 and thereafter, it is 9% of the smaller of the taxpayer's qualified production activities income or taxable income.
Although Sec. 199 applies to all taxpayers (as is discussed below), the usefulness for partnerships, limited liability companies (LLCs) and sole proprietors may be reduced by the requirement that the business have W-2 wages and positive qualified production activities income.
The deduction is a percentage of the taxpayer's "qualified production activities income" for the tax year (or taxable income, if smaller). Qualified activities are broadly defined to include gross receipts derived from any sale, exchange, disposition, lease, rental or license of qualifying production property manufactured, produced, grown or extracted by the taxpayer, in whole or in significant part, within the U.S.; certain films produced by the taxpayer; and electricity/natural gas/potable water produced by the taxpayer in the U.S. Domestic production gross receipts also include gross receipts derived from U.S. construction and engineering and architectural services related to domestic real estate. The only explicitly excluded categories are retail sales of food or beverages prepared by the taxpayer; transmission of electricity/natural gas/potable water; or a lease, license or rental of property to a related party.
"Qualified Production Activities Income"
This term is defined as domestic production gross receipts, less the cost of goods sold properly allocable to those receipts, less directly and indirectly related expenses, deductions and losses allocable to such receipts. The allocation of indirectly related expenses requires significant guidance from Treasury. (3)
Two main limits apply to Sec. 199. First, a taxpayer's qualified production activities income and taxable income (without regard to the Sec. 199 deduction) must both be positive. If either reflects a loss, no Sec. 199 deduction or carryover is permitted. Second, the deduction may not exceed one-half of the W-2 wages (not necessarily from the production activity) reported in the calendar year that ends in the tax year of the deduction.
Example 1: X Corp. has (1) a Sept. 30, 2006 year-end that reflects $400,000 in net profit from a manufacturing activity, (2) W-2 wages of $10,000 from production salaries in 2005 and (3) $100,000 from nonproduction salaries in 2005. X's Sec. 199 deduction is $12,000 ($400,000 x 0.03), which does not exceed $55,000 ($110,000W-2 wages in 2005 x 0.50).
This limit may be problematic for partnerships, LLCs and sole proprietors, because guaranteed payments are not deemed W-2 wages, partners/ members are not deemed employees and sole proprietors cannot pay salaries to themselves. However, it favors S corporations, because an owner may also be an employee. As a result, the employment of spouses or adult children in the business may become more common, although the effect of Social Security taxes is also a consideration.
An interesting issue is whether the Sec. 199 deduction for individuals is above or below the line. There seems to be a disconnect between the Conference Report language and the statute; hopefully, proposed technical corrections will clarify that the deduction is above the line for individuals.
Sec. 351 Double Loss
The IRS is not overly concerned with the double taxation of built-in gains (BIGs) on property contributed tax free to a corporation under Sec. 351, possibly because the taxpayer can withhold the property and let the corporation use it via a lease. However, after several tax shelter deals, double losses are the subject of a sleeper provision in the AJCA.
Example 2: W, an individual, contributed land with a $100,000 adjusted basis and a $60,000 fair market value (FMV) to a controlled corporation, H. Under Sec. 362, H would take a $100,000 carryover basis and W would take a $100,000 substituted basis. Thus, one built-in loss (BIL) may potentially generate two BIGs (one at the entity level, one at the shareholder level).
AJCA Section 836 adds Sec. 362(e)(2) to provide carryover basis limitation rules that apply on a transferor-by-transferor basis. If the aggregate of the contributed properties' adjusted basis to the corporation exceeds the aggregate FMV, the corporation must reduce its aggregate basis in the assets to FMV in proportion to the contributed properties' BILs. Thus, in Example 2 above, the aggregate properties' transferred FMV is less than its adjusted basis; H would reduce its basis in the land to $60,000.
AJCA Section 836 includes an irrevocable election under Sec. 362(e)(2)(C) that allows a transferor to reduce its stock basis, instead of the transferee (corporation) reducing asset basis. This might be advantageous to individuals who already have sufficient potential or actual capital losses, or if the corporate-level loss would be ordinary, while the shareholder's would be capital. Also, the election may be appropriate if the corporation is likely to sell the asset before the transferor sells the stock. This provision is effective for transfers after Oct. 22, 2004.
Planning opportunity: What if, in Example 2 above, the transferor and transferee agree to reduce W's adjusted basis in the stock and H also distributed $25,000 cash to W? The property distribution (including cash) would normally trigger gain to the shareholder under Sec. 351(b), but because a loss is involved, no gain would be recognized. While the cash would reduce W's stock basis to $75,000 ($100,000--$25,000), this would be meaningless, because the parties agreed to reduce W's basis to the property's $60,000 FMV, anyway. This may be a way to move cash out of the corporation without tax consequences.
For purposes of allocating a tax benefit among a controlled group of brother-sister corporations, AJCA Section 900 reduces the requirements. Previously, there was an 80% and a 50% test. Under pre-AJCA Sec. 1563(a)(2), a brother-sister controlled group existed if (1) five or fewer persons (individuals, estates or trusts) owned at least 80% of the total combined voting power of all classes of voting stock (or at least 80% of the value of all stock) in each corporation and (2) more than 50% of the total combined voting power of all classes of voting stock (or more than 50% of the value of all stock), taking into account stock ownership only to the extent identical in each corporation.
After the AJCA, a brother-sister controlled group is simply two or more corporations owned by five or fewer persons (individuals, estates or trusts) who possess more than 50% of the total combined voting power of all classes of voting stock or more than 50% of the value of all stock, taking a person's stock ownership into account only to the extent it is identical in each corporation.
Example 3: If individual S had 20% ownership in A Corp. and 60% ownership in B Corp., his identical ownership would be 20%. If individual K had 70% ownership in A and 25% in B, K's identical ownership would be 25%. The two together control 80% or more of both corporations (90% of A and 85% of B), but have identical ownership of less than 50% (20% for A and 25% for B).
Because A and B are not brother-sister corporations, they do not have to share the graduated tax brackets, Sec. 179 limits, AMT statutory exemption, accumulated earnings tax (AET) statutory credit/deduction, etc. Generally, the AJCA does not change this scenario. However, under new Sec. 1563(a)(2), only the 50% rule has to be met for A and B to be subject to Sec. 1561 and required to allocate the Sec. 1561 tax benefits (graduated Sec. 11 tax rates, AET statutory deduction of $250,000 and $40,000 corporate AMt exemption). In other words, the 80% brother-sister requirement has been removed only for purposes of these three Sec. 1561 tax benefits.
Example 4: Individual S owns 100% of A Corp. and 75% of B Corp. Individual K owns 25% of B.
Under pre-AJCA law, A and B would not be brother-sister corporations because, although they meet the 50% identical-ownership test (S's 75%), they do not meet the 80% test, as mutual owners control only 75% of B (K is not counted, because he does not own stock in both corporations.) Under AJCA Section 900, effective for tax years beginning after Oct. 22, 2004, they would be a brother-sister controlled group. (4)
In a bizarre twist, these AJCA rules only affect tax benefit allocations specifically mentioned in Sec. 1561; other references to controlled groups keep both the 80% and 50% tests (unless specifically stated otherwise in the referring provision).
Reporting Taxable M&As
AJCA Section 805 expands the Form 1099 reporting system. It requires an acquiring corporation, in a transaction in which any of the acquired corporation's shareholders recognize gain, to report to the IRS and the selling shareholders by January 31 of the following year, a description of the acquisition and the name and address of each such shareholder who must recognize gain in the acquisition. In addition, the acquiring corporation must report the boot (cash and property) transferred to each such shareholder. Thus, the new reporting provision would apply if the acquired and acquiring corporations engage in an A reorganization or a reverse triangular merger, and at least one of the acquired corporation's shareholders recognizes gain because the shareholder receives cash as well as stock. This change is effective for acquisitions after Oct. 22, 2004. The information can be filed by the stock transfer agent who records the stock transfers, instead of the acquiring corporation.
Estimated Taxes on Deemed Asset Sales
AJCA Section 839(a) affects sellers of stock sales deemed asset sales under Sec. 338(h)(10). Under amended Sec. 338(h)(13), estimated taxes will be due by the seller, effective for qualified stock purchase transactions after Oct. 22, 2004. Thus, if a parent sells the stock of an 80% subsidiary in a taxable purchase, estimated tax on the sale will be required. If the transaction is recast as a deemed asset sale before it closes, estimated taxes will be due on the basis of an asset sale. If the determination is made after the transaction closes, estimated taxes must be recomputed based on an asset sale, rather than on a stock sale, by the selling corporation.
Reporting Charitable Contributions of Appreciated Property
All C corporations that donate noncash property (other than inventory and publicly traded securities) must obtain qualified appraisals if the donation exceeds $5,000. This requirement already existed for individuals, closely held corporations, personal service corporations, partnerships and S corporations; it is now expanded to C corporations, under AJCA Section 883. If the donated property exceeds $500,000, then the donor must attach an appraisal to its return. If an appraisal is not available, the deduction will be fully disallowed (even for basis), unless the failure is due to reasonable cause. (5) This rule is effective for contributions made after June 3, 2004.
Personal Use of Company Airplanes
Effective for expenses incurred after Oct. 22, 2004, Sutherland Lumber-Southwest, Inc. (6) has been overruled by AJCA Section 907, amending Sec. 274(e)(2) and (9). Basically, prior to this legislation, corporate executives and other employees could use a corporate jet for personal use and include income as prescribed by the Standard Industry Fare Level formula in Regs. Sec. 1.61-21(g), while the corporation could deduct the entire cost of the employee fringe benefit, which often was eight or 10 times the employee inclusion amount. AJCA Section 907 limits the corporate deduction to the employee's income for public company individuals subject to Section 16(a) of the Securities Exchange Act of 1934. (7) Private companies are also subject to these rules if these same individuals would be included had the company issued equity securities.
Moratorium on ISO and ESPP Withholding
AJCA Section 251 adds Secs. 3121(a)(22) and 3306(b)(19), effective for exercises after Oct. 22, 2004, to make permanent the current moratorium on withholding payroll taxes (including FICA, FUTA and Federal tax withholding) on a disqualifying disposition of incentive stock options (ISOs) and employee stock purchase plans (ESPPs). Also, FICA and FUTA do not apply when such a statutory stock option is exercised.
85% Repatriation DRD
The AJCA Conference Report (8) makes it clear that the repatriation 85% dividends-received-deduction (DRD) is not an AMT adjustment or preference, nor is it an adjusted current earnings (ACE) adjustment, even though it is not a deduction for earnings and profits (E&P) purposes.
Production Activities Deduction Not Subject to AMT or ACE Adjustment
As discussed above, the 3%/6%/9% domestic production activities deduction is computed based on the lesser of qualified production activities income or taxable income. For AMT purposes, a limit based on the lesser of qualified production activities income or alternative minimum taxable income (AMTI) is required to be computed, under AJCA Section 102(a) and Sec. 199(d)(6).
FTC 100% AMT Offset
For tax years beginning after 2004, AJCA Section 421 removes the 90% limit on foreign tax credits (FTCs) available to offset AMT liability. Previously, the AMT FTC could not result in more than a 90% reduction of AMT (computed before any AMT net operating loss (NOL) and FTC). This is favorable for taxpayers with overseas activity.
Example 5: A Corp. has $10 million of current AMTI before NOLs, an $8 million AMTNOL carryover and a $300,000 FTC carryover.
The $8 million NOL is deductible against AMTI, giving rise to $2 million AMTI. The tax before the FTC would be $400,000. In the past, only $200,000 of the FTC could be used against the minimumm tax; the taxpayer would owe $200,000 in minimum tax, have a $100,000 FTC carryover and a $200,000 minimum tax credit (MTC). Beginning in 2005, the AMT would be $100,000; there would be a $100,000 MTC carryover and no FTC carryover.
The AJCA makes significant positive changes to international taxation. Prior to the AJCA, the FTC rules allowed only a two-year carryback and a five-year carryforward. This created ill-advised tax planning to soak up expiring FTCs. AJCA Section 417 rectifies some of the problems, by allowing a 10-year carryforward period, applicable to FTCs that can be carried to any tax year ending after Oct. 22 2004. Thus, if a corporate or individual taxpayer had an FTC in calendar-year 1999, it would be allowed in calendar-year 2004 and could be carried over for an additional five years, until 2009. Similarly, if a taxpayer had an FTC arise in an Oct. 31, 2001 fiscal year, the carryover would be allowed in the tax year ending Oct. 31, 2004 and for seven additional years (10 years less the three taken already).
For FTCs arising in tax years beginning after Oct. 22, 2004, the carryback period is one year, rather than two. The elimination of one year of the carryback period is scored as a revenue raiser. Because only a one-year carryback will be available, taxpayers should monitor their FTCs. This also affects planning for dividend payments and deemed-paid foreign taxes.
Business Energy Credits
Under AJCA Section 711(a), certain business energy credits can offset AMT, as well as regular taxes, for tax years ending after Oct. 22, 2004.
S Corporations and Shareholders
The AJCA contains several taxpayer-friendly S corporation provisions. Unfortunately, there is a trade-off; the rules are a bit more complicated and, in some cases, may help only a handful of families.
Increase in the Number of S Shareholders
Prior to the AJCA, an S corporation could have no more than 75 shareholders. For this purpose, a husband and wife (and their estates) were treated as one shareholder. This limit is increased to 100 under AJCA Section 232(a). According to AJCA Section 231(a), all family members are counted as one shareholder, if a family member so elects. (9)
A family, for this purpose, consists of a common ancestor, and his or her lineal descendants and their spouses (and former spouses). The common ancestor can be no more than six generations removed from the youngest generation of family shareholders. Importantly, the "oneness" of husband and wife and of family members applies only to the 100-shareholder limit. Thus, each shareholder (including each family member), as well as husband and wife, who owns stock on the S election date, must consent to the election. These provisions apply to tax years beginning after 2004.
IRA as a Bank S Shareholder
Congress was concerned about hurdles that prevented small and community banks from qualifying as S corporations. One of these obstacles prohibited an IRA from being an S shareholder. (10) AJCA Section 233 (11) now allows certain IRAs (including a Roth IRA) to be shareholders of a bank S corporation. Under these rules, for most purposes, an IRA beneficiary is deemed a shareholder of the bank S corporation. Thus, the beneficiary, and not the IRA, is the consenting authority for purposes of (1) an S election, (2) revocation of an S election, (3) rescission of a revocation and (4) the election not to allocate income on the pro-rata method during an S termination year. Presumably, the beneficiary is the consenting authority for other subchapter S elections made by the bank that require shareholder consent. (12)
Unfortunately, the IRA's interest in the bank S is treated as an interest in an unrelated trade or business; thus, all items of income, loss or deduction that flow through to the IRA from the bank S and the gains and losses on the IRA's disposition of the bank's stock, are taken into account in computing the IRA's unrelated business taxable income.
Under new Sec. 4975(d)(16), as added by AJCA Section 233(c), the IRA's sale of the bank's S stock to the IRA beneficiary is not a prohibited transaction, assuming the:
1. Stock is held by the IRA on Oct. 22, 2004;
2. Sale is pursuant to an S election by the bank;
3. Sale is for FMV (as established by an independent appraiser), the terms of which are at least as favorable to the IRA as they would be on a sale to an unrelated party;
4. IRA incurs no commissions, costs or expenses in connection with the sale; and
5. Stock is sold in a single transaction for cash, not more than 120 days after the S election is made. Note: The effective date of the S election is not relevant.
This provision was effective Oct. 22, 2004.
PII Exclusions for Bank S Corporations
An S corporation with positive E&P and excessive passive investment income (PII) may encounter negative consequences--the Sec. 1375 tax and Sec. 1362(d)(3) termination of S status. Effective for tax years beginning after 2004, for certain banks, bank holding companies and financial holding companies, PII does not include (1) interest income and (2) dividends on assets required to be held by such bank or company.
Under Sec. 1361(c)(2)(A)(v), an electing small business trust (ESBT) is an eligible S shareholder. According to Sec. 1361(e)(2), an ESBT's potential current beneficiary (PCB) for any period is any person who at any time during that period is entitled to receive, or at the discretion of any person may receive, a distribution from the trust's principal or interest. In determining whether a corporation is a small business corporation, each PCB is treated as a shareholder. Thus, a PCB who is a nonresident alien will terminate the S election. In addition, each PCB counts toward the shareholder limit.
Under Regs. Sec. 1.1361-1(m)(4)(vi), any person to whom a distribution is or may be made during a period, pursuant to a power of appointment, is a PCB. Even if the power were unexercised, a person who may have been designated to receive a current distribution was a PCB. Thus, if A, a trust beneficiary, has a current power to appoint income or principal of the trust to anyone except A, A's creditors, A's estate and creditors of A's estate, everyone in the world would be a PCB except for A and the aforementioned estate and creditors. As a result, the 100-person S shareholder limit would be exceeded and the S election would terminate. (13) However, for tax years beginning after 2004, unexercised powers of appointment are ignored for PCB purposes under Sec. 1361(e)(2), as amended by AJCA Section 234. The new law also extends the period during which an ESBT can dispose of S stock after an ineligible person becomes a PCB (and, thus, avoid S termination) from 60 days to one year.
Transfers of Suspended Losses to Spouse or Former Spouse
Sec. 1366(d) generally provides that if an S shareholder is allocated losses that exceed the sum of his or her S stock and debt basis, the excess is suspended and carried forward. Under prior law, the suspended loss was personal to the shareholder and could not be transferred to another. (14) This resulted in a fairly common problem when stock was transferred to a spouse in a divorce. Sec. 1366 (d)(2)(B), as amended by AJCA Section 235(a), makes an exception to the nontransferability rule for certain stock transfers to a shareholder's spouse (or former spouse) incident to a divorce, for tax years beginning after 2004. Basically, any suspended loss on stock transferred under Sec. 1041(a) "carries over" to the transferee or former spouse.
Use of PALs and At-Risk Amounts by a QSST Beneficiary
Under Sec. 1361(d)(1), a qualified subchapter S trust (QSST) is a permitted S shareholder, and its current income beneficiary is treated as the Sec. 678 owner of the portion of the trust consisting of S stock. Thus, the trust's share of the S corporation's income, loss and deduction items flows directly to the current income beneficiary.
However, under Regs. Sec. 1.1361-l(j)(8), the QSST, not the current income beneficiary, is treated as the S stock owner in determining and attributing the tax consequences of a stock disposition. This interpretation created problems when S losses flowed through to the current income beneficiary, only to be suspended by the passive activity, loss (PAL) or at-risk rules. A taxpayer's suspended PAL associated with an activity is generally freed up under Sec. 469(g) on the taxpayer's sale of the entire activity in a fully taxable transaction to an unrelated party. However, because the QSST's sale of the S stock was attributed to the trust, prior law was, at best, unclear on whether the current income beneficiary's PAL would be freed up on such sale.
Effective for transfers after 2004, a QSST's disposition of S stock is treated as a disposition by the current income beneficiary when applying the at-risk and PAL rules, under Sec. 1361(d)(1)(C), as added by AJCA Section 236. Thus, any PAL (with respect to the S activity) of the current income beneficiary would be freed up under Sec. 469(g), if the QSST were to sell all its S stock. Presumably, any gain recognized by the trust on such sale would increase the current income beneficiary's at-risk amount, thereby allowing increased at-risk flowthrough. (15)
The AJCA made two changes for qualified subchapter S subsidiaries (QSubs). First, under AJCA Section 238, the IRS can waive inadvertently invalid QSub elections and terminations that occur after 2004, if the conditions of Sec. 1362(f) (e.g., inadvertence, corrective steps and agreement to IRS conditions) are met. Second, under Sec. 1361(b)(3)(A), as amended by AJCA Section 239, Treasury can provide guidance on QSub information returns for tax years beginning after 2004.
AJCA Section 898(b) makes a taxpayer-friendly amendment to Sec. 357(c) which, among other things, eliminates a trap for certain common QSub transactions.
Example 6: Individual F owns all of the stock of two corporations, X and Y. X is an S corporation. For sound business reasons, F decides to conduct the businesses in parent-subsidiary form, rather than as brother-sister. Thus, pursuant to a plan, F contributes all the Y stock to X; X then makes a QSub election for Y.
Under the step-transaction doctrine, this transaction would be deemed a nondivisive D reorganization, assuming the other conditions for a reorganization (e.g., continuity of business enterprise) are met. (16) Under prior law, this could have been a trap; if the Y liabilities deemed assumed by X exceeded Y's total basis in its assets, such excess would have been a recognized gain under Sec. 357(c). Effective for transactions after Oct. 21, 2004, however, Sec. 357(c) (which applies to corporations in general, not just to QSubs) no longer applies to nondivisive D reorganizations. Sec. 357(c) gain is now limited to property transferors in Sec. 351 transactions and divisive D reorganizations, thus deactivitating the aforementioned QSub trap.
Repayment of Loans for Qualifying Employee Securities
AJCA Section 240(a) adds new Sec. 4975(f)(7), under which an ESOP maintained by an S corporation does not violate any Code qualification requirement or engage in a prohibited transaction merely because, in accordance with plan provisions, a Sec. 1368(a) distribution on S stock is used to make principal and interest payments on a loan used to acquire the employer securities. This new relief provision, retroactively effective for distributions on S stock made after 1997, is analogous to one for C corporations with ESOPs. (17)
After an S election terminates, any suspended Sec. 1366 losses can be claimed only during a post-termination transition period (PTTP), up to the amount of stock basis as of the last day of the PTTP. Also, under Sec. 1371(e), cash distributions by the former S corporation to shareholders during a PTTP generally are deemed made first out of the corporation's accumulated adjustments account (AAA).
The PTTP rules were amended, not by the AJCA, but by the Working Families Tax Relief Act of 2004 (WFTRA), effective retroactively to tax years beginning after 1996. WFTRA Section 407(a) focuses solely on the 120-day audit-related PTTP. Under new Sec. 1377(b)(3), suspended losses do not carry over to the 120-day, audit-related PTTP. Essentially, they can be used in this regard only in prior shareholder tax years, to the extent supported by the audit adjustments to S taxable income for S tax years. In addition, cash distributions during the 120-day, audit-related PTTP are deemed to come from AAA only to the extent of any increase in AAA due to the audit adjustments.
The AJCA will clearly create opportunities for CPAs, attorneys and their clients, due to its scope, complexity and the uncertainty introduced by many of the new provisions. The Sec. 199 qualified domestic production activities deduction rules, the international provisions and the tax shelter and executive compensation changes are of major proportions and apply to both large and small businesses.
The AJCA also requires more reporting for corporate charitable giving and M&As. The potentially crucial change in the controlled group rules may require an immediate change in stock ownership. However, several S corporation traps have been eliminated. Further, the AJCA eroded the corporate AMT through the 100% FTC offset, but the larger potential problem--individual AMT--was left untouched.
(1) P.L. 108-357.
(2) However, the Sec. 179(a)(3) limit, based on taxable income from all of a taxpayer's trades or businesses, must also be taken into account.
(3) At press time, the IRS issued Notice 2005-14, 2005 IRB-7, providing broad interim guidance on most aspects of the domestic production activities deduction, which may be relied on until regulations are issued. The Service expects that regulations will incorporate the rules set forth in the notice and will be effective for tax years beginning after 2004. The notice requests comments on the interim guidance and any additional guidance that should be provided in regulations.
(4) In effect, the new law obsoletes the decision in Vogel Fertilizer Co., 455 US 16 (1982), as to Sec. 1561 benefits.
(5) See Regs. Sec. 1.170A-13 and John T. Hewitt, 109 TC 258 (1997), aff'd, 166 F3d 332 (4th Cir. 1998), for examples of this rule's potential application.
(6) Sutherland Lumber-Southwest, Inc., 114 TC 197 (2000), aff'd, 255 F3d 495 (8th Cir. 2001), acq., AOD 2002-02; for a discussion, see McGuire, Tax Clinic, "Company Planes: the AJCA Extends Bonus Depreciation, but Grounds Sutherland Lumber," 36 The Tax Adviser 68 (February 2005).
(7) Generally, officers, directors and 10%-or-greater shareholders of public or private companies would be included in this category.
(8) See Conf. Rep't No. 108-755, 108th Cong., 2d Sess. (2004).
(9) Also, AJCA Section 231(b) amends Sec. 1362(f) to provide that an inadvertently invalid election or termination under this rule may be waived by the IRS. The conditions of Sec. 1362(f) (e.g., inadvertence, corrective steps and agreement to IRS conditions) must be met.
(10) See Rev. Rul. 92-73, 1992-2 CB 224. But see Rev. Proc 2004-14, IRB 2004-7, 489, which provides that if certain requirements are met (including immediate repurchase of the stock by the S corporation or employee stock ownership plan (ESOP)), a corporation's S status will not terminate on a direct rollover of the corporation's stock from the ESOP to a participant's IRA.
(11) This provision applies only to the extent of bank stock held by an IR_A on Oct. 22, 2004.
(12) For more details on S elections, see MacDonough and Orbach, "S Corporation Elections Guide," 34 The Tax Adviser 540 (September 2003).
(13) See Regs. Sec. 1.1361-1(m)(8), Example (7).
(14) See pre-AJCA Sec. 1366(d)(2) and Regs. Sec. 1.1366-2(a)(5).
(15) See Prop. Regs. Sec. 1.465-66.
(16) See Regs. Sec. 1.1361-4(a)(2)(ii), Example (3).
(17) See Secs. 404(k)(5)(B), (2)(A)(iv) and (2)(B).
* In general, the AJCA contains many depreciation and cost recovery provisions affecting business property and expenditures; a 9% domestic production activities deduction is available for businesses with W-2 wages and positive income.
* Corporate provisions address BILs on Sec. 351 property contributions, allocation of tax benefits among a controlled group, reporting of taxable M&As and estimated taxes on stock sales that are deemed asset sales.
* The AJCA makes numerous S corporation changes, including increasing the number of shareholders, allowing IRA shareholders of bank S corporations, and permitting the transfer of suspended losses incident to divorce and the use of PALs and at-risk amounts by a QSST beneficiary.
For more information about this article, contact Dr. Karlinsky at firstname.lastname@example.org or Dr. Orbach at email@example.com.
Editor's note: Dr. Karlinsky is a member of the AICPA Tax Division's Corporations & Shareholders Tax Technical Resource Panel (TRP). Dr. Orbach is the immediate past chair of the S Corporation Taxation TRP.
Stewart S. Karlinsky, Ph.D., CPA
Graduate Tax Director
San Jose State University
San Jose, CA
Kenneth N. Orbach, Ph.D., CPA
Professor of Accounting
Florida Atlantic University
Boca Raton, FL
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|Author:||Orbach, Kenneth N.|
|Publication:||The Tax Adviser|
|Date:||Mar 1, 2005|
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