Any corporation, including a professional corporation or association, is considered a C corporation, taxable under the following rules, unless an election is made to be treated as an S corporation
(see Q 839).
Graduated Tax Rates
A corporation pays tax according to a graduated rate schedule.The rates range from 15% to 35%, with higher effective rates of 38% and 39% applicable to income at certain levels. (1) See Appendix B for the rates. A "personal service corporation" is subject to a different income tax rate. See Q 840.
Taxable income is computed for a corporation in much the same way as for an individual. Generally, a corporation may take the same deductions as an individual, except those of a personal nature (e.g., deductions for medical expenses and the personal exemptions). A corporation also does not receive a standard deduction. There are a few special deductions for corporations, however, including a deduction equal to 70% of dividends received from other domestic corporations, 80% of dividends received from a 20% owned company, and 100% for dividends received from affiliated corporations. (2) A corporation may deduct contributions to charitable organizations to the extent of 10% of taxable income (with certain adjustments). (3) Generally, charitable contributions in excess of the 10% limit may be carried over for five years. (4)
A corporation is also allowed a deduction for production activities. When this deduction is fully phased in (in 2010) it will be equal to nine percent of a taxpayer's qualified production activities income (or, if less, the taxpayer's taxable income). The deduction is limited to 50 percent of the W-2 wages paid by the taxpayer for the year. The definition of "production activities" is broad and includes construction activities, energy production, and the creation of computer software. (5)
Capital gains and losses are netted in the same manner as for an individual and net short-term capital gain, to the extent it exceeds net long-term capital loss, if any, is taxed at the corporation's regular tax rates (see Q 815). A corporation reporting a "net capital gain" (i.e., where net long-term capital gain exceeds net short-term capital loss; see Q 815) is taxed under one of two methods, depending upon which produces the lower tax:
1. Regular method. Net capital gain is included in gross income and taxed at the corporation's regular tax rates.
2. Alternative method. First, a tax on the corporation's taxable income, exclusive of "net capital gain," is calculated at the corporation's regular tax rates. Then a second tax on the "net capital gain" (or, if less, taxable income) for the year is calculated at the rate of 35%. The tax on income exclusive of net capital gain and the tax on net capital gain are added to arrive at the corporation's total tax. For certain gains from timber, the maximum rate is 15%. (6)
Alternative Minimum Tax
A corporate taxpayer must calculate its liability under the regular tax and a tentative minimum tax, then add to its regular tax so much of the tentative minimum tax as exceeds its regular tax. The amount added is the alternative minimum tax. (1) See Q 829.
To calculate its alternative minimum tax (AMT), a corporation first calculates its "alternative minimum taxable income" (AMTI). (2) Also, the corporation calculates its "adjusted current earnings" (ACE), increasing its AMTI by 75% of the amount by which ACE exceeds AMTI (or possibly reducing its AMTI by 75% of the amount by which AMTI exceeds ACE). (3) The tax itself is a flat 20% of AMTI. (4) Each corporation receives a $40,000 exemption; however, the exemption amount is reduced by 25% of the amount by which AMTI exceeds $150,000 (thus phasing out completely at $310,000). (5)
AMTI is regular taxable income determined with certain adjustments and increased by tax preferences. (6) Tax preferences for corporate taxpayers are the same as for other taxpayers (see Q 829). Adjustments to income include the following: (1) property is generally depreciated under a less accelerated or a straight line method over a longer period, except that a longer period is not required for property placed in service after 1998; (2) mining exploration and development costs are amortized over 10 years; (3) a percentage of completion method is required for long-term contracts; (4) net operating loss deductions are generally limited to 90% of AMTI (although some relief was available in 2001 and 2002); (5) certified pollution control facilities are depreciated under the alternative depreciation system except those that are placed in service after 1998, which will use the straight line method; and (6) the adjustment based on the corporation's adjusted current earnings (ACE). (7)
To calculate ACE, a corporation begins with AMTI (determined without regard to ACE or the AMT net operating loss) and makes additional adjustments. These adjustments include adding certain amounts of income that are includable in earnings and profits but not in AMTI (including income on life insurance policies and receipt of key person insurance death proceeds). The amount of any such income added to AMTI is reduced by any deductions that would have been allowed in calculating AMTI had the item been included in gross income. The corporation is generally not allowed a deduction for ACE purposes which is not allowed for earnings and profits purposes. However, certain dividends received by a corporation are allowed to be deducted. Generally, for property placed into service after 1989 but before 1994, the corporation must recalculate depreciation according to specified methods for ACE purposes. For ACE purposes, earnings and profits are adjusted further for certain purposes such as the treatment of intangible drilling costs, amortization of certain expenses, installment sales, and depletion. (8)
Application of the adjustments for adjusted current earnings with respect to life insurance is explained in Q 96.
A corporation subject to theAMT in one year may be allowed a minimum tax credit against regular tax liability in subsequent years. The credit is equal to the excess of the adjusted net minimum taxes imposed in prior years over the amount of minimum tax credits allowable in prior years. (9) However, the amount of the credit cannot be greater than the excess of the corporation's regular tax liability (reduced by certain credits such as certain business related credits and certain investment credits) over its tentative minimum tax. (1)
Certain small corporations are deemed to have a tentative minimum tax of zero and thus are exempt from the AMT. To qualify for the exemption, the corporation must meet a gross receipts test for the three previous taxable years. To meet the test, a corporation's average annual gross receipts for the three years must not exceed $7.5 million. For purposes of the gross receipts test, only tax years beginning after 1993 are taken into account. For a corporation not in existence for three full years, those years the corporation was in existence are substituted for the three years (with annualization of any short taxable year). To initially qualify for the exemption, the corporation must meet the three-year gross receipts test but with $5 million substituted for $7.5 million. Generally, a corporation will be exempt from the AMT in its first year of existence. (2)
If a corporation fails to maintain its small corporation status, it loses the exemption from the AMT. If that happens, certain adjustments used to determine the corporation's AMTI will be applied for only those transactions entered into or property placed in service in tax years beginning with the tax year in which the corporation ceases to be a small corporation and tax years thereafter. (3) A corporation exempt from the AMT because of the small corporation exemption may be limited in the amount of credit it may take for AMT paid in previous years. In computing the AMT credit, the corporation's regular tax liability (reduced by applicable credits) used to calculate the credit is reduced by 25% of the amount that such liability exceeds $25,000. (4)
Accumulated Earnings Tax
A corporation is subject to a penalty tax, in addition to the graduated tax, if, for the purpose of preventing the imposition of income tax upon its shareholders, it accumulates earnings instead of distributing them. (5) The tax is 15% of the corporation's accumulated taxable income. (6) Accumulated taxable income is taxable income for the year (after certain adjustments) less the federal income tax, dividends paid to stockholders (during the taxable year or within 2V2 months after the close of the taxable year), and the "accumulated earnings credit." (7)
The tax can be imposed only upon amounts accumulated beyond those required to meet the reasonable needs of the business since an accumulated earnings credit, generally equal to this amount, is allowed. A corporation must demonstrate a specific, definite and feasible plan for the use of the accumulated funds in order to avoid the tax. (8) The use of accumulated funds for the personal use of a shareholder and his family is evidence that the accumulation was to prevent the imposition of income tax upon its shareholders. (9) In deciding whether a family owned bank was subject to the accumulated earnings tax, the IRS took into account the regulatory scheme the bank was operating under to determine its reasonable needs. (10) Most corporations are allowed a minimum accumulated earnings credit equal to the amount by which $250,000 ($150,000 in the case of service corporations in health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting) exceeds the accumulated earnings and profits of the corporation at the close of the preceding taxable year. (11) Consequently, an aggregate of $250,000 ($150,000 in the case of the above listed service corporations) may be accumulated for any purpose without danger of incurring the penalty tax.
Tax-exempt income is not included in the accumulated taxable income of the corporation but will be included in earnings and profits in determining whether there has been an accumulation beyond the reasonable needs of the business. (1) But, a distribution in redemption of stock to pay death taxes which is treated as a dividend does not qualify for the "dividends paid" deduction in computing accumulated taxable income (see Q 83, Q 86). (2)
The accumulated earnings tax applies to all C corporations, without regard to the number of shareholders in taxable years beginning after July 18, 1984. (3)
Personal Holding Company Tax
The personal holding company (PHC) tax is a second penalty tax designed to keep shareholders from avoiding personal income taxes on securities and other income-producing property placed in a corporation to avoid higher personal income tax rates. The PHC tax is 15% of the corporation's undistributed PHC income (taxable income adjusted to reflect its net economic income for the year, minus dividends distributed to shareholders), if it meets both the "stock ownership" and "PHC income" tests. (4)
A corporation meets the "stock ownership" test if more than 50% of the value of its stock is owned, directly or indirectly, by or for not more than 5 shareholders.5 Certain stock owned by families, trusts, estates, partners, partnerships, and corporations may be attributed to individuals for purposes of this rule. (6)
A corporation meets the "PHC income" requirement if 60% or more of its adjusted ordinary gross income is PHC income, generally defined to include the following: (1) dividends, interest, royalties, and annuities; (2) rents; (3) mineral, oil, and gas royalties; (4) copyright royalties; (5) produced film rents (amounts derived from film properties acquired before substantial completion of the production); (6) compensation from use of corporate property by shareholders ; (7) personal service contracts; and (8) income from estates and trusts. (7)
Professional Corporations and Associations
Organizations of physicians, lawyers, and other professional people organized under state professional corporation or association acts are generally treated as corporations for tax purposes. (8) However, to be treated as a corporation, a professional service organization must be both organized and operated as a corporation. (9) Although professional corporations are generally treated as corporations for tax purposes, they are not generally taxed the same as regular C corporations. See Q 840. Note that if a professional corporation has elected S corporation status, the shareholders will be treated as S corporation shareholders. See Q 839.
Although a professional corporation is recognized as a taxable entity separate and apart from the professional individual or individuals who form it, the IRS may under some circumstances reallocate income, deductions, credits, exclusions, or other allowances between the corporation and its owners in order to prevent evasion or avoidance of tax or to properly reflect the income of the parties. Under IRC Section 482, such reallocation may be made only where the individual owner operates a second business distinct from the business of the professional corporation; reallocation may not be made where the individual works exclusively for the professional corporation. (1) However, note that the IRS has stated that it will not follow the Foglesong decision to the extent that it held that the two business requirement of IRC Section 482 is not satisfied where a controlling shareholder works exclusively for the controlled corporation. (2) A professional corporation may also be subject to the special rules applicable to "personal service corporations," see Q 840.
839. How is an S corporation taxed?
An S corporation is one that elects to be treated, in general, as a passthrough entity, thus avoiding most tax at the corporate level. (3) To be eligible to make the election, a corporation must meet certain requirements as to the kind and number of shareholders, classes of stock, and sources of income. An S corporation must be a domestic corporation with only a single class of stock and may have up to 100 shareholders (none of whom are nonresident aliens) who are individuals, estates and certain trusts. An S corporation may not be an ineligible corporation. An ineligible corporation is one of the following: (1) a financial institution that uses the reserve method of accounting for bad debts; (2) an insurance company; (3) a corporation electing (under IRC Section 936) credits for certain tax attributable to income from Puerto Rico and other U.S. possessions; and (4) a current or former domestic international sales corporation (DISC). Qualified plans (see Q 424) and certain charitable organizations may be S corporation shareholders. (4)
Members of a family are treated as one shareholder. "Members of the family" are defined as "the common ancestor, lineal descendants of the common ancestor, and the spouses (or former spouses) of such lineal descendants or common ancestor." Generally, the common ancestor may not be more than six generations removed from the youngest generation of shareholders who would be considered members of the family. (5)
Trusts which may be S corporation shareholders include: (1) a trust all of which is treated as owned by an individual who is a citizen or resident of the United States under the grantor trust rules (see Q 844); (2) a trust which was described in (1) above immediately prior to the deemed owner's death and continues in existence after such death may continue to be an S corporation shareholder for up to two years after the owner's death; (3) a trust to which stock is transferred pursuant to a will may be an S corporation shareholder for up to two years after the date of the stock transfer; (4) a trust created primarily to exercise the voting power of stock transferred to it; (5) a qualified subchapter S trust (QSST); (6) an electing small business trust (ESBT); and (7) in the case of an S corporation that is a bank, an IRA or Roth IRA. (6)
A QSST is a trust that has only one current income beneficiary (who must be a citizen or resident of the U.S.), requires that all income be distributed currently, and requires that corpus not be distributed to anyone else during the life of such beneficiary. The income interest must terminate upon the earlier of the beneficiary's death or termination of the trust, and if the trust terminates during the lifetime of the income beneficiary, all trust assets must be distributed to that beneficiary. (7) The beneficiary must make an election for the trust to be treated as a QSST. (8)
An ESBT is a trust in which all of the beneficiaries are individuals, estates, or certain charitable organizations. (1) Each potential current beneficiary of an ESBT is treated as a shareholder for purposes of the shareholder limitation. (2) A potential current beneficiary is generally someone who is entitled to, or in the discretion of any person may receive a distribution of principal or interest of the trust. (3) Trusts exempt from income tax, QSSTs, charitable remainder annuity trusts, and charitable remainder unitrusts may not be ESBTs. An interest in an ESBT may not be obtained by purchase. (4) If any portion of a beneficiary's basis in the beneficiary's interest is determined under the cost basis rules, the interest was acquired by purchase. (5) An ESBT is taxed at the highest income tax rate under IRC Section 1(e). (6)
An S corporation may own a qualified subchapter S subsidiary (QSSS). A QSSS is a domestic corporation that is not an ineligible corporation, if 100% of its stock is owned by the parent S corporation and the parent S corporation elects to treat the subsidiary as a QSSS. Except as may be provided in regulations, a QSSS is not treated as a separate corporation and its assets and liabilities and items of income, deduction, and credit are treated as those of the parent S corporation. (7) A QSSS may be required to file a separate information return. (8) Regulations provide special rules regarding the recognition of a QSSS as a separate entity for tax purposes in certain circumstances. (9)
If a QSSS ceases to meet the above requirements, it will be treated as a new corporation acquiring all its assets and liabilities from the parent S corporation in exchange for its stock. If the corporation's status as a QSSS terminates, the corporation is generally prohibited from being a QSSS or an S corporation for five years. (10) Regulations provide that in certain cases following a termination of a corporation's QSSS election, the corporation may be allowed to elect QSSS or S corporation status without waiting five years if, immediately following the disposition, the corporation is otherwise eligible to make an S corporation election or QSSS election, and the election is effective immediately following the termination of the QSSS election. Examples where this rule would apply include an S corporation selling all of its QSSS stock to another S corporation, or an S corporation distributing all of its QSSS stock to its shareholders. (11)
A corporation will be treated as having one class of stock if all of its outstanding shares confer identical rights to distribution and liquidation proceeds. (12) However, a bona fide buy-sell agreement will be disregarded for purposes of the one-class rule unless a principal purpose of the arrangement is to circumvent the one-class rule and it establishes a purchase price that is not substantially above or below the fair market value of the stock. Agreements that provide for a purchase price or redemption of stock at book value or a price between book value and fair market value will not be considered to establish a price that is substantially above or below fair market value. (13) Agreements triggered by divorce and forfeiture provisions that cause a share of stock to be substantially nonvested will be disregarded in determining whether a corporation's shares confer identical rights to distribution and liquidation proceeds. (14) Also, the typical unfunded deferred compensation plan should not be considered to create a second class of stock. (1) The Service has ruled privately that a split dollar arrangement offered as a fringe benefit to employees of an S corporation does not violate the one class of stock restriction. (2) Likewise, a split dollar arrangement entered into between an S corporation and a trust holding a second-todie policy on the life of the majority shareholder/employee does not alter rights to distribution and liquidation proceeds and does not create a second class of stock. (3) See Q 467, Q 468. An employment agreement between an S corporation and its sole shareholder does not violate the provision. (4) The fact that an S corporation continues to be registered as a corporation in a foreign country does not violate the one class of stock rule. (5) Further, where distributions to shareholders were based on cumulative earnings instead of percentage of ownership, the S corporation avoided a violation of the one class of stock rule by correcting the distributions the following year. (6)
An S corporation is generally not subject to tax at the corporate level. However, a tax is imposed at the corporate level on certain gains. For S elections made after 1986 where the corporation had previously been a C corporation, when an S corporation disposes of property within 10 years after an election has been made, gain attributable to pre-election appreciation of the property (built in gain) is taxed at the corporate level to the extent such gain does not exceed the amount of taxable income imposed on the corporation if it were not an S corporation. (7) This includes the fair market value of work-in-process inventory of the corporation. (8) ARRA 2009 provides that, in the case of a taxable year beginning in 2009 or 2010, no tax is imposed on the built in gain if the 7th taxable year of the 10-year recognition period precede such taxable year. For S elections made before 1987, unless the corporation was an electing corporation for the three immediately preceding tax years (or had been in existence less than four taxable years and had been an electing corporation each of its taxable years), a tax is imposed at the corporate level on its net capital gain which exceeds $25,000 if the net capital gain exceeds 50% of the corporation's taxable income for the year and the taxable income is more than $25,000. (9)
A corporation switching from a C corporation to an S corporation may be required to recapture certain amounts in connection with goods previously inventoried under a LIFO method. (10) In addition, a tax is imposed at the corporate level on excess "net passive income" of an S corporation but only if the corporation, at the end of the tax year, has accumulated earnings and profits and if passive investment income exceeds 25% of gross receipts. The rate is the highest corporate rate. (11) Passive investment income for this purpose is rents, royalties, dividends, interest, and annuities. (12) However, passive investment income does not include rents for the use of corporate property if the corporation also provides substantial services in connection with the property (such as maid service in a hotel); interest derived in the ordinary course of any trade or business; or interest on obligations acquired in the ordinary course of business, such as interest earned on accounts receivable. (13) Passive investment income specifically does not include gross receipts derived in the ordinary course of a trade or business of lending or financing; dealing in property; purchasing or discounting accounts receivable, notes, or installment obligations; or servicing mortgages. (1) Passive investment income does not include certain dividends from C corporations where the S corporation owns 80% or more of the C corporation. (2) If amounts are subject to tax both as built in gain and as excess net passive income, an adjustment will be made in the amount taxed as passive income. (3) Tax is also imposed at the corporate level on the recapture of investment credit which was allowed prior to the effective date of the S election. (4)
Like a partnership, an S corporation computes its taxable income in generally the same way as an individual, except that certain personal deductions are not allowed and the corporation may elect to amortize organizational expenses. The deduction for production activities is also allowed (see Q 838). Each shareholder then reports on his individual return his proportionate share of the corporation's items of income, loss, deductions and credits; these items retain their character on passthrough. Certain items of income, loss, deduction or credit must be passed through as separate items because they may have an individual effect on each shareholder's tax liability. For example, net capital gains and losses pass through as such to be included with the shareholder's own net capital gain or loss. Any gains and losses on certain property used in a trade or business are passed through separately to be aggregated with the shareholder's other section 1231 gains and losses. (5) If any tax is imposed on built in gains (described above), the amount of the tax imposed will be treated as a loss by the corporation. (6) Charitable contributions pass through to shareholders separately subject to the individual shareholder's percentage limitations on deductibility. tax-exempt income passes through as such. Items involving determination of credits pass through separately. Items that do not need to be passed through separately are aggregated on the corporation's tax return and each shareholder reports his share of such nonseparately computed net income or loss on his individual return. (7) Before passthrough, each item of passive investment income is reduced by its proportionate share of the tax at the corporate level on excess net passive investment income. (8)
Thus, whether amounts are distributed to them or not, shareholders are taxed on the corporation's taxable income. Shareholders take into account their shares of income, loss, deduction and credit on a per-share, per-day basis. (9) Treasury Regulation Section 1.1377 1(a)(2) contains provisions for determining a shareholder's pro rata share. The S corporation income must also be included on a current basis by shareholders for purposes of the estimated tax provisions (see Q 801). (10)
The Tax Court determined that when an S corporation shareholder files for bankruptcy, all the gains and losses for that year flowed through to the bankruptcy estate. The gains and losses should not be divided based on the time before the bankruptcy was filed. (11)
The basis of each shareholder's stock is increased by his share of items of separately stated income (including tax-exempt income) and by his share of any nonseparately computed income, and by any excess of deductions for depletion over the basis of the property subject to depletion. (12) An S corporation shareholder may not increase his basis due to excluded discharge of indebtedness income. (13) The basis of each shareholder's stock is decreased (not below zero) by items of separately stated loss and deductions and nonseparately computed loss, any expense of the corporation not deductible in computing taxable income and not properly chargeable to capital account and any depletion deduction with respect to oil and gas property to the extent that the deduction does not exceed the shareholder's proportionate share of the property's adjusted basis. For tax years beginning after 2005 and before 2010, if an S corporation makes a charitable contribution of property, each shareholder's basis is reduced by the pro-rata share of their basis in the property. (1) If the aggregate of these amounts exceeds his basis in his stock, the excess reduces the shareholder's basis in any indebtedness of the corporation to him. (2)
A shareholder may not take deductions and losses of the S corporation which, aggregated, exceed his basis in his S corporation stock plus his basis in any indebtedness of the corporation to him. (3) Such disallowed deductions and losses may be carried over indefinitely, but these losses may not be carried over by transferees of stock unless the transferees are certain divorced spouses. (4) In other words, he may not deduct in any tax year more than he has "at risk" in the corporation. Basis is also reduced by distributions from the corporation that are not includable in income. (5) Loans from shareholders' partnership to the shareholder, followed by a loan from the shareholders to the S corporation, did not increase the basis of the shareholders' debt in the S corporation. (6)
Post-1982 earnings of an S corporation are not treated as earnings and profits. An S corporation may have accumulated earnings and profits for any year in which a valid election was not in effect or as the result of a corporate acquisition in which there is a carryover of earnings and profits under IRC Section 381. (7) Corporations that were S corporations before 1983 but were not S corporations in the first tax year after 1996 are able to eliminate earnings and profits that were accumulated before 1983 in their first tax year beginning after May 25, 2007. (8)
A distribution from an S corporation which does not have accumulated earnings and profits lowers the shareholder's basis in the corporation's stock.9 Any excess is generally treated as gain.10
If the S corporation does have earnings and profits, distributions are treated as distributions by a corporation without earnings and profits, to the extent of the shareholder's share of an accumulated adjustment account (generally, post-1982 gross receipts less deductible expenses, which have not been distributed). Any excess distribution is treated under the usual corporate rules. That is, it is a dividend up to the amount of the accumulated earnings and profits. Any excess is applied to reduce the shareholder's basis. Finally, any remainder is treated as a gain.11 However, in any tax year, shareholders receiving the distribution may, if all agree, elect to have all distributions in the year treated first as dividends to the extent of earnings and profits and then as return of investment to the extent of adjusted basis and any excess as capital gain.12 If the IRC Section 1368(e)(3) election is made, it will apply to all distributions made in the tax year.13 A stock redemption may be treated as a distribution that reduces the S corporation's accumulated adjustments account.14
An LLC may be treated as either a corporation (see Q 838), partnership (see Q 842), or sole proprietorship for federal income tax purposes. A sole proprietor and his business are one and the same for tax purposes. An eligible entity (a business entity not subject to automatic classification as a corporation) may elect corporate taxation by filing an entity classification form; otherwise it will be taxed as either a partnership or sole proprietorship depending upon how many owners are involved.
A separate entity must exist for tax purposes, in that its participants must engage in a business for profit. Trusts are not considered business entities. (1) Certain entities, such as corporations organized under a federal or state statute, insurance companies, joint stock companies, and organizations engaged in banking activities, are automatically classified as corporations for federal tax purposes. A business entity with only one owner will be considered a corporation or a sole proprietorship. In order to be classified as a partnership, the entity must have at least two owners. (2) If a newly-formed domestic eligible entity with more than one owner does not elect to be taxed as a corporation, it will be classified as a partnership. Likewise, if a newly-formed single-member eligible entity does not elect to be taxed as a corporation, it will be taxed as a sole proprietorship. Under most circumstances, a corporation in existence on January 1, 1997 does not need to file an election in order to retain its corporate status. (3)
If a business entity elects to change its classification, rules are provided for how the change is treated for tax purposes. (4)
Revenue Ruling 95-37 (5) provides that a partnership converting to a domestic LLC will be treated as a partnership-to-partnership conversion (and therefore be "tax free") provided that the LLC is classified as a partnership for federal tax purposes. The partnership will not be considered terminated under IRC Section 708(b) upon its conversion to an LLC so long as the business of the partnership is continued after the conversion. Further, there will be no gain or loss recognized on the transfer of assets and liabilities so long as each partner's percentage of profits, losses and capital remains the same after the conversion. The same is true for a limited partnership converting to an LLC. (6)
An LLC formed by two S corporations was classified as a partnership for federal tax purposes. (7) An S corporation may merge into an LLC without adverse tax consequences provided the LLC would not be treated as an investment company under IRC Section 351 and the S corporation would not realize a net decrease in liabilities exceeding its basis in the transferred assets pursuant to Treasury Regulation Section 1.752 1(f). Neither the S corporation nor the LLC would incur gain or loss upon the contribution of assets by the S corporation to the LLC in exchange for interests therein pursuant to IRC Section 721. (8) A corporation will retain its S election when it transfers all assets to an LLC, which is classified as a corporation for federal tax purposes due to a preponderance of corporate characteristics (see below), provided the transfer qualifies as a reorganization under IRC Section 368(a)(1)(F) and the LLC meets the requirements of an S corporation under IRC Section 1361. (9)
If the S corporation distributes appreciated property to a shareholder, gain will be recognized to the corporation as if the property were sold at fair market value; the gain will pass through to shareholders like any other gain. (1)
The rules discussed above generally apply in tax years beginning after December 31, 1982. Nonetheless, certain casualty insurance companies and certain corporations with oil and gas production will continue to be taxed under the rules applicable to Subchapter S corporations prior to these rules. (2)
840. How is a "personal service corporation" taxed?
Certain personal service corporations are taxed at a flat rate of 35%. (3) In effect, this means that the benefit of the graduated corporate income tax rates is not available. (See Appendix B). A personal service corporation for this purpose is a corporation substantially all of the activities of which involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting. In addition, substantially all of the stock must be owned directly by employees, retired employees, or their estates or indirectly through partnerships, S corporations, or qualified personal service corporations. (4)
IRC Section 269A permits the IRS to reallocate income, deductions, credits, exclusions, and other allowances (to the extent necessary to prevent avoidance or evasion of federal income tax) between a personal service corporation (PSC) and its employee-owners if the corporation is formed for the principal purpose of securing tax benefits for its employee-owners (i.e., more than 10% shareholderemployees after application of attribution rules) and substantially all of its services are performed for a single other entity. For purposes of IRC Section 269A, a personal service corporation is a corporation the principal activity of which is the performance of personal services and such services are substantially performed by the employee-owners. (5) A professional basketball player was considered to be an employee of an NBA team, not his personal service corporation, and all compensation from the team was taxable to him individually, even though his PSC had entered into a contract with the team for his personal services. (6)
In addition, special rules apply to the tax year that may be used by a personal service corporation (as defined for purposes of IRC Section 269A, except that all owner-employees are included and broader attribution rules apply). (7)
(1.) IRC Sec. 11(b).
(2.) IRC Sec. 243.
(3.) IRC Sec. 170(b)(2).
(4.) IRC Sec. 170(d)(2).
(5.) IRC Sec. 199.
(6.) IRC Secs. 1201, 1222.
(1.) IRC Secs. 55-59.
(2.) IRC Sec. 55(b)(2).
(3.) IRC Sec. 56(g).
(4.) IRC Sec. 55(b)(1)(B).
(5.) IRC Secs. 55(d)(2), 55(d)(3).
(6.) IRC Sec. 55(b)(2).
(7.) IRC Secs. 56(a), 56(c), 56(d).
(8.) IRC. Sec. 56(g).
(9.) IRC Sec. 53(b).
(1.) IRC Sec. 53(c).
(2.) IRC Secs. 55(e), 448(c)(3).
(3.) IRC Sec. 55(e)(2).
(4.) IRC Sec. 55(e)(5).
(5.) IRC Secs. 531-537; GPD, Inc. v. Comm., 75-1 USTC [paragraph] 9142 (6th Cir. 1974).
(6.) IRC Sec. 531.
(7.) IRC Sec. 535.
(8.) EyefullInc. v. Comm.,TC Memo 1996-238.
(9.) Northwestern Ind. Tel. Co. v. Comm., 97-2 USTC [paragraph] 50,859 (7th Cir. 1997).
(10.) TAM 9822009.
(11.) IRC Sec. 535(c)(2).
(1.) Rev. Rul. 70-497, 1970-2 CB 128.
(2.) Rev. Rul. 70-642, 1970-2 CB 131.
(3.) IRC Sec. 532(c).
(4.) IRC Secs. 541, 542, 545.
(5.) IRC Sec. 542(a)(2).
(6.) IRC Sec. 544.
(7.) IRC Secs. 542(a)(1), 543(a).
(8.) Rev. Rul. 77-31, 1977-1 CB 409.
(9.) Roubik v. Comm., 53 TC 365 (1969).
(1.) Foglesong v. Comm., 82-2 USTC [paragraph] 9650 (7th Cir. 1982).
(2.) Rev. Rul. 88-38, 1988-1 CB 246.
(3.) See IRC Secs. 1361, 1362, 1363.
(4.) IRC Sec. 1361.
(5.) IRC Sec. 1361(c)(1).
(6.) IRC Secs. 1361(c)(2), 1361(d).
(7.) IRC Sec. 1361(d)(3).
(8.) IRC Sec. 1361(d)(2).
(1.) IRC Sec. 1361(e).
(2.) IRC Sec. 1361(c)(2)(B)(v).
(3.) Treas. Reg. [section] 1.1361-1(m)(4).
(4.) IRC Sec. 1361(e).
(5.) Treas. Reg. [section] 1.1361-1(m)(1)(iii).
(6.) IRC Sec. 641(c).
(7.) IRC Sec. 1361(b)(3).
(8.) IRC Sec. 1361(b)(3)(E).
(9.) Treas. Reg. [section] 1.1361-4(a).
(10.) IRC Sec. 1361(b)(3).
(11.) Treas. Reg. [section] 1.1361-5(c).
(12.) Treas. Reg. [section] 1.1361-1(l)(1).
(13.) Treas. Reg. [section] 1.1361-1(l)(2)(iii). See IRC Secs. 1361, 1362.
(14.) Treas. Reg. [section] 1.1361-1(l)(2)(iii)(B).
(1.) See Treas. Reg. [section] 1.1361-1(b)(4). See also Let. Rul. 9421011 (plan providing for payment at termination of employment of a fraction of corporation's book value and providing for payment of dividend equivalents taxed currently does not create second class of stock); Let. Rul. 9317021 (stock equivalency plan does not create a second class of stock); Let. Ruls. 9501032 and 9233005 (phantom stock plans do not create a second class of stock); Let. Rul. 9626033 (bonus deferral plan does not create a second class of stock).
(2.) Let. Rul. 9248019.
(3.) Let. Rul. 9651017.
(4.) Let. Rul. 9442007.
(5.) Let. Rul. 9512001.
(6.) Let. Rul. 9519048.
(7.) IRC Sec. 1374.
(8.) Reliable Steel Fabricators, Inc. v. Comm., TC Memo 1995-293.
(9.) IRC Sec. 1374, prior to amendment by TRA '86.
(10.) IRC Sec. 1363(d).
(11.) IRC Sec. 1375(a).
(12.) IRC Secs. 1362(d)(3), 1375(b)(3).
(13.) Treas. Reg. [section] 1.1362-2(c)(5)(ii)(B), (D).
(1.) Treas. Reg. [section] 1.1362-2(c)(5)(iii)(B).
(2.) Treas. Reg. [section] 1.1362-8.
(3.) IRC Sec. 1375(b)(4).
(4.) IRC Sec. 1371(d).
(5.) IRC Secs. 1366(a), 1366(b).
(6.) IRC Sec. 1366(f)(2).
(7.) IRC Sec. 1366(a)(1).
(8.) IRC Sec. 1366(f)(3).
(9.) IRC Sec. 1377.
(10.) Let. Rul. 8542034.
(11.) Williams v. Comm., 123 TC 144 (2004).
(12.) IRC Sec. 1367(a)(1).
(13.) IRC Sec. 108(d)(7)(A).
(1.) IRC Sec. 1367(a)(2).
(2.) IRC Sec. 1367(b)(2).
(3.) IRC Sec. 1366(d)(1).
(4.) IRC Sec. 1366(d)(2).
(5.) IRC Sec. 1367(a)(2)(A).
(6.) TAM 200619021.
(7.) IRC Sec. 1371(c).
(8.) SBWOTA 2007 Sec. 8235.
(9.) IRC Sec. 1367(a)(2)(A).
(10.) IRC Sec. 1368(b)(2).
(11.) IRC Sec. 1368(c).
(12.) IRC Sec. 1368(e)(3).
(13.) Let. Rul. 8935013.
(14.) Rev. Rul. 95-14, 1995-1 CB 169.
(1.) IRC Sec. 311(b), 1366(a)(1).
(2.) Subchapter S Revision Act of 1982, Sec. 6.
(3.) IRC Sec. 11(b)(2).
(4.) IRC Sec. 448(d)(2).
(5.) IRC Sec. 269A(b)(1).
(6.) Leavell v. Comm., 104 TC 140 (1995).
(7.) IRC Secs. 441(i), 444.