Current developments - eligibility, elections and terminations; operations; reorganizations; and legislation.
From a tax perspective, the period covered in this update--August 1995 through August 1996--has been an eventful one for S corporations and shareholders. The enactment of the Small Business Job Protection Act of 1996 (SBJPA) expanded the maximum number of eligible S shareholders to 75, added new categories of eligible shareholders, allows the IRS to waive inadvertent errors related to the making of an S election, relaxed the 2 1/2-month rule to file Form 2553, Election by a Small Business Corporation (under Section 1362 of the Internal Revenue Code), and allows sprinkling trusts, charities and pension plans to be S shareholders; also, S corporations can now be members of affiliated groups. The Health Insurance Portability and Accountability Act of 1996 (HIPAA) also made beneficial changes for S shareholders.
Recent IRS statistics(1) presented a historical perspective on S corporation return filings. In 1993, over 1.9 million S returns were filed, representing 48% of all corporate tax returns. (Compare this with 1986, in which S returns represented only 24.1% of filed corporate returns.) Over 81% of all 1993 filed S returns reported one or two shareholders.
Last year's update article(2) discussed the IRS's proposed plan to conduct Taxpayer Compliance Measurement Program (TCMP) audits on 12,500 1994 S returns nationwide. The TCMP program was scuttled due to political pressure, lack of funds and other congressional criticisms; instead, there will be more financial status audits at the individual level.(3)
With all these new or converted S corporations filing returns, it is not surprising there were a number of court cases dealing with invalid Form 2553 filings. A number of letter rulings opined on proposed corporate divisions (Sec. 355) of S corporations, but fewer letter rulings involved the failure of qualified subchapter S trust (QSST) beneficiaries to timely elect S status (due to Rev. Proc. 94-23(4)), and fewer negative rulings were issued on the passive nature of rental income (due to the liberalized Sec. 1362 regulations). Some odd S corporation issues (e.g., regarding election mailing, debt forgiveness, passive activity loss (PAL) use and relatively liberal inadvertent terminations) arose in the past year. Another major development was the "check-the-box" proposed regulations,(5) which allow a new noncorporate entity to elect partnership, limited liability company (LLC) or C or S corporation status for tax purposes, without applying the four-factor corporate attribute test of Regs. Sec. 301.7701-2.
This update is presented in four major categories: eligibility, elections and terminations; operations; reorganizations; and new legislation. Many of the issues discussed below will be eliminated by the SBJPA when fully in effect; most of its provisions apply to tax years beginning after 1996. However, the new law will trigger a different set of S corporation issues.
Eligibility, Elections and Terminations
The Sec. 1361 definition of "S corporation" includes restrictions on the type and number of shareholders and the type of corporation that can qualify for the election. If an S corporation violates one of the restrictions, S status automatically terminates; the taxpayer can then request a ruling under Sec. 1362(f). If the IRS rules the termination is inadvertent, the corporation retains its S status continuously. With the urging of Congress,(6) the IRS has been reasonable in granting such rulings.
Filing the S Election
To elect S status, the taxpayer and all shareholders on the date of the election (as well as other affected shareholders) must timely file a valid Form 2553. To ensure receipt, the taxpayer should send the election by certified mail, return receipt requested, or by registered mail. Newly enacted Section 1210 of the Taxpayer Bill of Rights 2 allows the use of certain designated private delivery services (e.g., Federal Express, Airborne Express, DHL, United Parcel Service, etc.) to be treated as the use of regular mail for Sec. 7502 purposes.
Sec. 7502(c) and Regs. Sec. 301.7502-1 provide that a document (e.g., Form 2553) sent by U.S. registered or certified mail is deemed filed on the date of the U.S. postal service postmark stamped on the cover in which the document was mailed ("timely mailing as timely filing" rule). Under the case law "mail box rule," there is a rebuttable presumption that a document deposited in a U.S. mailbox, properly addressed, placed in a sealed envelope and bearing sufficient postage, is received by the IRS. The Sixth Circuit in Miller(7) and the Second Circuit in Deutsch(8) have held that only Sec. 7502(c) applies, while the Tax Court and the Eighth Circuit in Est. of Wood(9) and the Ninth Circuit in Anderson(10) allow either the statutory or case law doctrine to apply. Most recently, the Supreme Court denied certiorari in Carroll,(11) in which the Sixth Circuit agreed with the Second Circuit's decision in Deutsch, and disagreed with Est. of Wood and Anderson, holding that use of regular mail without additional proof of mailing is insufficient to prove timely filing of an S election.
Sec. 1361(b)(1)(D) bars an S corporation from issuing more than one class of stock; according to Regs. Sec. 1.1361-1 (1) (1), classes of stock differ if they have different rights to distribution and liquidation proceeds. In Letter Ruling 960SO12,(12) an S corporation issued preferred stock to its shareholders. After the shareholders were informed that this was an impermissible second class of stock, it was eliminated, and inadvertent termination relief was requested and granted under Sec. 1362(f). The ruling does not specify how the preferred stock was eliminated; an "E" reorganization generally results in more benign tax effects than does a Sec. 302 redemption.
Sec. 1361(b)(2)(A) prohibits an S corporation from being a member of an affiliated group (i.e., owning 80% or more of the stock of another corporation). In Letter Ruling 9601049,(13) S corporation X created a wholly owned subsidiary, Y, to protect itself from a lawsuit; X transferred assets to Y, which then conducted business. Three years passed before it was discovered that X's S status had technically terminated. The IRS granted inadvertent termination relief and ruled that any distributions from Y to X during the inadvertent termination period constituted income to X's sole shareholder.
In Letter Ruling 9609022,(14) S corporation X bought 100% of the stock of Y, a foreign corporation. (Presumably, X thought it could hold foreign stock because the consolidated return rules do not apply to foreign corporations, under Sec. 1504(b).) When it was discovered that S status had terminated, because X was a member of an affiliated group, it sold 50% of its Y stock and requested inadvertent termination relief, which was granted. The result was the same in Letter Rulings 9626025(15) and 9625041,(16) addressing timely corrected affiliated group stock ownership.
In Letter Ruling 9626031,(17) S corporation X owned 92.5% of an LLC that owned 79% of C corporation Y. The LLC proposed to buy the remaining 21% of Y The IRS ruled that, assuming the nominal owners are the real owners, there is no affiliated group, because X did not directly own 80% or more of Y.
The IRS had ruled in Letter Ruling 9211027(18) that a certain bank could elect S status. Letter Ruling 9602029(19) revoked it prospectively, ruling that Secs. 1361 (b)(2)(B) and 585 apply, whether or not the bad debt reserve method is allowed or used.
One of the basic eligibility requirements for S status is that there cannot be more than 35 shareholders, according to Sec. 1361(b)(1)(A). In Letter Ruling 9611020,(20) an S corporation had 36 shareholders, because one shareholder sold some stock to a new shareholder. Sec. 1362(f) relief was granted, because shortly after the election terminated, the number of shareholders was reduced to 35.
If an S corporation has accumulated subchapter C earnings and profits (C E&P), it must carefully monitor the composition of its gross receipts, for two reasons. First, if it does not purge its C E&P, and it has excess passive investment income (PII) (i.e., PII exceeding 25% of gross receipts) for three consecutive years, S status will terminate in the fourth year, under Sec. 1362(d)(3). Second, Sec. 1375 imposes a tax on excess net passive income (ENPI) (as defined in Sec. 1375(b)(1)).
Letter Ruling 9602008(21) addressed the first issue; a cash-basis commodity broker was an S corporation with C E&P. Its sources of income shifted from brokerage fees and trading activity to (passive) exchange seat rental income, leading to termination of its S status. In granting inadvertent termination relief, the IRS allowed a deemed distribution of C E&P to the shareholders.
How much C E&P an S corporation has is not always apparent. The amount of E&P can be crucial both for determining the taxability of distributions and for the Sec. 1375 ENPI tax and Sec. 1362 termination rules. In Cameron,(22) the Tax Court held that a highway construction company that underestimated its Sec. 312(n)(6) percentage-of-completion contract costs for its C years could not revise its C E&P after electing S status. The court ruled that because the election is voluntary, a "freezing" of such E&P is required even if based on an erroneous estimate of costs. This seems a harsh and unfair result, because E&P is not frozen as to distributions, redemptions, consent dividends, etc.
In Letter Ruling 9616022,(23) a minority S shareholder threatened to sell one share of stock to an ineligible shareholder (a corporation) unless a dividend was paid. Although the corporation declared a dividend, the shareholder made the sale. Because this was not an inadvertent termination, Sec. 1362(f) did not apply; normally, under Sec. 1362(g), the corporation would have to wait five years before being able to re-elect S status. Regs. Sec. 1.1362-5(a) suggests that an earlier re-election may be permitted if more than 50% of the stock is owned by persons who did not own stock on the termination date; if this threshold is not met, early re-election will be denied. Here, less than 50% of the stock changed hands, but the corporate shareholder sold its stock to the other S shareholders. The IRS found the greenmail element to be so compelling that leniency was warranted; however, the S corporation is exposed to taxes under Secs. 1374 and 1375. This is a good example of why an S corporation should issue stock with a right of first refusal, a shareholder transfer agreement or a call option.
Letter Ruling 9603014(24) dealt with a transfer of S stock to an ineligible shareholder. Within two months of the discovery of the inadvertent termination, the corporation redeemed that shareholder's stock. The IRS granted Sec. 1362(f) relief, but required the ineligible shareholder to include the corporation's separately and nonseparately stated items in its tax return and to adjust its stock basis accordingly.
In Letter Ruling 9621027,(25) one of the shareholders of an S corporation was a nonresident alien (NRA). The problem was immediately rectified after discovery by having the NRA transfer the stock to his wife, a U.S. citizen. Sec. 1362(f) relief was granted. Caution is warranted in such a situation--in a community property state, the NRA spouse of a shareholder could cause a deemed termination.
It is generally recognized that an individual retirement account (IRA) trust is not an eligible S shareholder.(26) However, in Letter Ruling 9627006,(27) an accountant was unaware of this. In the ruling, three employees of an S corporation bought the stock through their IRAs. When the error was discovered, short-period S and C returns were filed. When counsel recognized the problem, the IRA-held shares were redeemed and the corporation requested and received an inadvertent termination ruling. The prior years' corporate and shareholder returns had to be amended and the IRAs had to include their share of S losses. Had the company been profitable, would the IRAs have faced unrelated business income tax on the income?
An S corporation and its tax adviser must be careful if the entity has trust shareholders. In the past year, a variety of inadvertent termination letter rulings dealt with a multitude of trust issues. For example, in Letter Ruling 9603007,28 a QSST owned stock in an S corporation, as well as non-S investments. The trustee distributed only the S corporation income to the beneficiary in violation of Sec. 1361(d)(3)(B), which requires all QSST income to be distributed. The IRS granted Sec. 1362(f) relief.
In Letter Ruling 9603028,(29) a C corporation elected S status in December 1986, effective on Jan. 1, 1987, to avoid the Sec. 1374 built-in gains (BIG) tax. In December 1990, four QSSTs were formed and given the S stock. The beneficiaries of those trusts inadvertently omitted signing the QSST election. Four years later, the mistake was discovered; new QSST elections were then filed with the appropriate signatures. The IRS held the S election was undisturbed from December 1990 to December 1994.
In Letter Ruling 9613017,(30) the shareholder of an S corporation that developed real estate died; his shares had been held in a grantor trust. The value of that stock was included in the estate and placed in a testamentary trust. The executor did not know that the stock had to be released from the trust within two years of death, under Sec. 1361(c)(2)(A). The IRS granted inadvertent termination relief. In Letter Ruling 9625008,(31) a sole shareholder died and the stock was to be transferred to two QSSTs; instead, the stock went to ineligible trusts, but later was transferred to two QSSTs. The IRS granted relief.
In Letter Ruling 9621014,(32) a shareholder of an S corporation that published compact disks transferred stock to a trust that was ineligible due to drafting errors. Soon after this was discovered, the corporation sold some stock to a limited partnership to terminate S status. The trust was later amended to qualify as a QSST. Inadvertent termination relief was granted for the drafting errors, but not for the sale to the limited partnership.
A relatively new issue is the conforming of grantor retained annuity trust and QSST terms to achieve both favorable income and estate tax results. Letter Ruling 962502133 examines a trust's indenture provisions in detail to test their compliance with the QSST rules, and holds that the trust complied with Sec. 1361(c). This ruling may be useful for the tax adviser as a road map of permissible provisions.
The S corporation has often been described as mirroring the partnership with regard to operations, and the C corporation as to formation, liquidation, reorganization and liability issues. The tax adviser must be careful not to oversimplify this rule. For example, Letter Ruling (TAM) 9627004(34) addresses whether there is a penalty under Sec. 6698 for an S corporation that did not file a return for its first two years of operations, but filed in the fourth year of operations for those open years. Sec. 6698 refers to filings under Sec. 6031(a), which addresses the filing of partnership returns; Sec. 6037 deals with S corporation filings. The IRS ruled that Sec. 6698 was inapplicable. However, Secs. 6723 and 7203 could apply to imnose penalties of up to $100.000 each for failure to file an information return. Also, if any corporate-level tax was due, Sec. 6651 failure-to-file penalties could be imposed. Further, the statute of limitations does not start to run until a return is filed.
Aggregate vs. Entity Theory
The past year has seen a judicial split as to the appropriate treatment of interest expense paid on a business-related tax deficiency. Miller,(35) an Eighth Circuit case, and True,(36) a Tenth Circuit case, held that such interest is nondeductible personal interest. A recent Tax Court decision, Redlark,(37) held that Temp. Regs. Sec. 1.163-9T(b)(2)(i)(A), which disallows deduction of such personal interest, is invalid, because it conflicts with the Conference Report on the Tax Reform Act of 1986,(38) which states only that personal interest generally includes interest on tax deficiencies, not that all interest on tax deficiencies is personal interest. The dissension among the courts may allow for some tax reporting positions contrary to the temporary regulation.(39)
One of the common motivations for electing S status is the ability to flow through entity-level losses to shareholders. There are several hurdles that the shareholders must face before a loss may be used: hobby loss rules (Sec. 183), basis for loss purposes (Sec. 1366), PAL rules (Sec. 469) and business versus nonbusiness bad debt rules.
Hobby loss: In Ballard,(40) the Tax Court held that an investment banker generated only hobby losses from his S corporation's yacht-chartering activity. Similarly, in Hilliard,(41) a doctor was limited to a hobby loss deduction for his S corporation's losses from sailboat and fishing boat charter activities.
Sec. 1366 limitation: If a taxpayer does not have sufficient adjusted basis in S stock or debt, passthrough losses are suspended until the shareholder's basis increases. Letter Ruling 9552001(42) held that such suspended losses do not transfer to a spouse who receives the S stock pursuant to divorce. In the ruling, the stock was given to a spouse tax free under Sec. 1041 as part of a divorce settlement. The IRS held that the suspended losses were not transferable. Although the ruling is not clear on this point, if the taxpayers were in a community property state, it could have been argued that half of the losses belonged to the transferee spouse in any case.
Suspended PALs: Letter Ruling (TAM) 9628002(43) holds that when a closely held C corporation (CHC) converts to S status, its suspended PALs do not carry over, and are lost. The IRS position is that Sec. 1371(b)(1) bars tax carryforwards from a C to an S year. How ever, Sec. 469 treats excess PALs and credits as disallowed and allocable to the next year without describing the allocation as a carryover or carryforward; thus, the excess PAL or credit should not be disallowed when the corporation converts from C to S status. This position is supported by the fact that Sec. 469 (1986) was enacted after Sec. 1371 (1982), and Sec. 469 does not characterize the excess PAL as a carryover or bar the carryover on conversion. The reason for thus omission may be that the PAL rules are significantly more stringent for individuals than are the CHC provisions; thus, the losses will be more difficult to recognize through the use of an S corporation, so there is no perceived abuse. Also, Sec. 469(f)(2) addresses a change in status of a CHC, under which PALs are treated more favorably than under the individual rules (and under TAM 9628002).
Business vs. nonbusiness bad debt: A common area of complexity is the distinction between capital and ordinary gain or loss treatment. In Gubbini,(44) a doctor loaned and advanced funds to an S corporation for its printing business. The Tax Court held that the doctor was an investor, not a professional money lender; thus, the losses were nonbusiness bad debts and short-term capital losses. If the basis of a loan was reduced by allowed losses and the loans were repaid, payment of a note receivable would yield capital gain treatment, while the existence of an open account would result in ordinary income.
Cash Method of Accounting
One of the advantages of S status is that if the cash method of accounting is otherwise appropriate, an S corporation can use it no matter the size of its gross receipts. The IRS has been attacking contractors' use of the cash method in the last few years. The C corporation taxpayer prevailed in Ansley-Sheppard-Burgess CO.,(45) but lost in Thompson Electric, Inc.(46) In Ansley, the Tax Court found that there was consistent use of the cash method, no maintenance of inventory, and no attempt to unreasonably prepay expenses or defer income recognition. In Thompson Elearic, the Tax Court found that the taxpayer could not separate service activity from supplies, and that inventory and supplies equaled 37%-44% of cash receipts.
In Durando,(47) a taxpayer argued that allocated S corporation income was self-employment (SE) income for Keogh plan purposes. The Ninth Circuit held that S corporation income is not "earnings" from SE and so is not includible income in calculating a Keogh contribution. This result is consistent with the employment rules that many tax practitioners have been using to reduce their clients' exposure to SE tax. Query the proper treatment of partnership or LLC SE income for an S corporation partner or member.
Covering a similar issue, Letter Ruling 9530005(48) addressed a sole S shareholder's receipt of management fees and his claim that they were SE income. The Service ruled that management fees paid to a corporate officer who performs significant services are wages subject to FICA, FUTA and income tax withholding.
Cancellation of Debt Income
An area of current controversy is whether an insolvent S corporation's cancellation of debt (COD) income excluded under Sec. 108(a)(1) is passed through to shareholders as tax-exempt income under Secs. 1366(a)(1)(A) and 1367 and increases their stock bases, or is some other type of tax-deferred income that does not increase basis. In Letter Ruling (TAM) 9541006,(49) the IRS ruled that such income does not increase basis. This position is consistent with Letter Ruling (TAM) 9423003,(50) the holding of which has been opposed by the AICPA Tax Division S Corporation Taxation Committee.(51)
For C corporations that elect S status after 1986, Sec. 1374 imposes a tax on the net recognized BIG. There have been few rulings and cases on this issue; in Argo Sales Co.,(52) the Tax Court held that a Sec. 481(a) adjustment arising from the taxpayer's required change from the cash to the accrual method was BIG. The taxpayer elected S status in the fourth year (of six) of reporting the Sec. 481(a) adjustment.
If a C corporation converts to S status or an S corporation acquires trade or business assets tax free under Sec. 381, both the Sec. 1375 ENPI tax and the Sec. 1362(d)(3) termination rules may apply.
As was discussed, Sec. 1362(d)(3) provides that, if for three consecutive years an S corporation has C E&P, and has PII exceeding 25% of gross receipts, S status terminates in the fourth year. Regs. Sec. 1.1362-2(c)(5)(B) provides that PII for this purpose does not include rents of real or personal property, if substantial services are provided or substantial costs incurred. The IRS has issued a myriad of letter rulings in this area, opining on the active nature of the rental activity. Several of these rulings(53) dealt with activities by an LLC or partnership in which an S corporation was a member or partner, and held that the income was not PII.
An interesting feature of twin Letter Rulings 9536007(54) and 9536008(55) is that the leases involved were net leases. The tenant paid a fixed rent plus a percentage of gross receipts and paid for maintenance, repairs, taxes and insurance. The IRS ruled that the rent was not PII, perhaps because the leases provided that the S corporation lessor would render a certain number of consulting and advisory hours per year.
[ILLEGIBLE WORD] S corporations the vehicle of choice for many existing small businesses, it is only natural to see more split-off, acquisition and restructuring activity. A fundamental issue in the restructuring area is whether an S corporation should be treated as a corporation or an individual under Sec. 1371(a)(2) for various subchapter C provisions. 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 IRS has continued to affirm its longstanding position in Rev. Rul. 72-30(56) and GCM 39768(57) that an S corporation can 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 or controlled corporation in an otherwise valid divisive D reorganization. Thus, Letter Rulings 9625038(58) and 9602019,(59) among others, hold that an S corporation may spin off or split off, and remain or create a new S corporation, assuming the business purpose test and the other Sec. 355 requirements are met.
In Letter Ruling 9625036,(60) an S corporation was allowed to spin off a division to raise capital in an initial public offering. In Rev. Proc. 96-30,(61) the IRS has reiterated that a valid corporate business purpose does not include the desire to be eligible for S status. If an S corporation is involved in a Sec. 355 transaction, Appendix C of the procedure lists certain representations that may be provided to lessen the IRS's concerns about the potential avoidance of Federal taxes.
In the normal C corporation situation, an individual shareholder wants redemption (i.e., capital gain) treatment for a treasury stock transaction, rather than dividend status. In the S corporate arena, the reverse is often true. Letter Ruling 9607003(62) held that because the redemption did not qualify for exchange treatment under Sec. 302(b), the distribution was a tax-free dividend to the extent of the accumulated adjustments account.
The SBJPA includes a more modest expansion of the S corporation rules than had been proposed in the past few years. Many of these changes will simplify the S corporation rules or eliminate procedural traps; a few will complicate the rules to benefit a small subset of taxpayers. A welcome addition to the rules would have been the tax-free treatment of employee fringe benefits; but the revenue cost of such a provision prevented its inclusion in the enacted legislation.
Effective date: Unless otherwise noted, the effective date of these provisions is tax years beginning after 1996. Because the SBJPA changes are major and favorable, C corporations that converted from S status in a tax year beginning before 1997 can automatically re-elect S status without waiting the five-year period required by Sec. 1362(g); Secs. 1374, 1363(d) and 1375 apply to the re-election.
Number and type of shareholders: SBJPA Section 1301 expands the allowable number of S shareholders from 35 to 75. Given that only 800 of 1.9 million 1993 S returns had more than 30 shareholders,(63) query whether many S corporations will be affected.
SBJPA Section 1302 creates a new type of qualified S shareholder, the electing small business trust (ESBT). An ESBT may only receive S stock by gift, bequest, etc., not by purchase. An ESBT is similar to a QSST, but allows the spraying or sprinkling of income to various beneficiaries; the beneficiaries must be eligible shareholders, and charitable organizations may hold contingent remainder interests. Given the experience with QSSTs, this provision will keep busy for years to come the IRS personnel who issue inadvertent termination rulings.
An ESBT is taxed on its share of S income at 39.6% (capital gains at 28%); no deduction is allowed for distributions to beneficiaries. The trustee makes the ESBT election.
As with QSSTs and estates, if the ESBT terminates before the end of the S corporation's tax year, it takes into account its pro rata share of S corporation items for its final year.
SBJPA Section 1316 permits Sec. 501(c)(3) charitable organizations and Sec. 401(a) pension trusts to be S shareholders, but not IRAs, and restricts the tax benefits of employee stock option plan ownership of S stock. This will probably help some start-up ventures to obtain pension financing, but will not allow venture capital partnerships to invest in S corporations. Because neither the S corporation nor a tax-exempt shareholder pays tax on its income, the latter must treat its share of S income as UBTI. This rule applies to active and portfolio income and gain or loss on the sale of S stock. In the case of pension funds, this leads to double taxation: first, on the trust and second, on the participants when they retire and receive benefits. This provision is effective for tax years beginning after 1997.
Streamlined administrative procedures: SBJPA Section 1305 gives the IRS discretion to grant inadvertent error relief under Sec. 1362(f) for failure to obtain required shareholder consents or to qualify as a small business corporation. This will alleviate many of the QSST failure to sign problems, as well as the Form 2553 issues previously discussed. Similarly, for reasonable cause, the IRS may treat a late S election as timely. These provisions apply to tax years beginning after 1982. It remains to be seen whether these provisions will be used to "play" with S status (i.e., an S corporation with losses could elect S status retroactively or maintain C status if it has a profit).
Under SBJPA Section 1303, a grantor trust, Sec. 678 trust or testamentary trust that is a permissible S shareholder under Sec. 1361(c)(2)(A) may be an S shareholder for up to two years after the death of the deemed owner. The previous holding period under Sec. 1361(c)(2)(A)(ii) and (iii) was 60 days.
When a shareholder sells all (or substantially all) of his S stock during the year, a pro rata allocation of the corporation's income is made. An election to close the books as of the date of the disposition, if made, must be made by all shareholders. SBJPA Section 1306 provides that the election need only be made by the corporation and "affected" shareholders (i.e., the seller and the buyer of the shares); however, consent of all shareholders is needed if the shareholder redeemed his shares.
SBJPA Section 1311 eliminates pre-1983 S corporation E&P, which will simplify current recordkeeping requirements. Also, SBJPA Section 1307 extends the post-termination transition period and repeals the audit provisions of the Tax Equity and Fiscal Responsibility Act of 1982 that applied to S corporations.
In several ways, the new law conforms S corporation transactions to partnership treatment. The adjustments to stock basis by S income, losses and distributions is changed to the partnership rule of income, distributions, then losses, by SBJPA Section 1309. Similarly, under SBJPA Section 1313, the receipt of S income in respect of a decedent reduces the basis of inherited S stock, so that a capital loss is not immediately created.
Expanded capital structure: SBJPA Section 1308 allows an S corporation to own up to 100% of a C corporation, but the S corporation cannot be included in a consolidated return. Thus, S corporations could establish foreign subsidiaries and foreign sales corporations. Dividends from the subsidiary are not PII for Secs. 1362 and 1375 purposes, nor is a dividends-received deduction available. This provision may help minimize exposure to lawsuits and reduce state income taxes. It remains to be seen whether the affiliated group rules will be abused by transferring BIG and non-BIG property between the parent and subsidiary, and selling or spinning off either entity.
SBJPA Section 1308 also creates a "qualified subchapter S subsidiary" (QSSS), which is a domestic wholly owned subsidiary of an S corporation that otherwise would be eligible to be an S corporation, if the parent's owners were the subsidiary's shareholders. Essentially, the QSSS is ignored for tax purposes and the group is treated as a single entity. This eliminates the need for the inactive subsidiary provisions, because the QSSS may be active. This provision will help S corporations do business in foreign countries, reserve names in multiple states, facilitate state income tax planning or protect the parent's assets from creditors or lawsuits.
Currently, a financial institution that lends money to an S corporation is not eligible for the straight-debt safe harbor rules of Sec. 1361(c)(5)(B), so that the loan creates a second class of stock. SBJPA Section 1304 allows financial institutions to qualify for the safe harbor.
SBJPA Section 1310 enacted a provision that has long been defacto law--an S corporation will be treated like a C corporation in most reorganization or liquidation transactions; thus, Secs. 332, 338, 355 and 368 can apply. Now that an S corporation can be a parent or a subsidiary, the momentary control rules are less crucial than in the past.
Two provisions of the HIPAA bear mention; each applies to tax years beginning after 1996. First, HIPAA Section 311 (a) increases the Sec. 1624) deduction for medical insurance premiums paid by SE individuals as follows:
Year Portion of premium deductible
2005 70% 2006 and thereafter 80%
Second, HIPAA Section 311(b) extends the Sec. 104(a)(3) exclusion from gross income for accident and health insurance benefits to amounts received under certain self-insured plans.
RELATED ARTICLE: EXECUTIVE SUMMARY
* Proof of timely mailing of the S election has been made easier: the Taxpayer Bill of Rights 2 allows the use of certain preapproved private delivery services (e.g., Federal Express, DHL, United Parcel Service, etc.) to be treated as the use of regular mail. The IRS has not yet specified the pre-approved carriers. * Although S corporations can now be members of affiliated groups, they still cannot join in the filing of a consolidated return.
* To take more immediate advantage of the various benefits provided under the Small Business Job Protection Act, C corporations that converted from S status in a tax year beginning before 1997 can automatically re-elect S status without waiting the five-year period required by Sec. 1362(g).
(1) See Gill and Wittman, "S Corporation Returns, 1993," IRS Statistics of Income Bulletin (Spring 1996), pp. 27, 31. (2) See Karlinksy and Burton, "S Corporation Current Developments," 26 The Tax Adviser 590 (Oct. 1995). (3) See "Tax Currents: IRS Indefinitely Postpones TCMP Audits," 26 The Tax Adviser 697 (Nov 1995); AICPA Tax Division Financial Status Audit Working Group, "AICPA Offers Guidance on IRS Financial Status Auditing," 27 The Tax Adviser 218 (Apr. 1996). (4) Rev Proc. 94-23, 1994-1 CB 609 (providing automatic inadvertent termination relief if trust failed to timely file QSST election). (5) PS-43-95 (S/9/96). (6) See S. Rep. No. 97-640, 97th Cong., 2d Sess. 12-13 (1982), 1982-2 CB 718, 723-24, which provides that the IRS is to be reasonable in granting a waiver. (7) Brian Miller, 784 F2d 728 (6th Cir. 1986)(57 AFTR2d 86-928, 86-1 USTC [paragraph]9261), cert. denied. (8) David Deutsch, 399 F2d 44 (2d Cir. 1979)(44 AFTR2d 79-5063, 79-1 USTC [paragraph]9407). (9) Est. of Leonard A. Wood, 92 TC 93 (1989), aff'd, 909 F2d 1155 (8th Cir. 1990)(66 AFTR2d 90-5987, 90-2 USTC [paragraph]50,488). (10) Lois Anderson, 966 F2d 487 (9th Cir. 1992)(70 AFTR2d 92-5010, 92-1 USTC [paragraph]50,308). (11) James R. Carroll, 71 F3d 1228 (6th Cir. 1995)(76 AFTR2d 95-8115, 96-1 USTC [paragraph]50,010), aff'g TC Memo 1994-229. (12) IRS Letter Ruling 9608012 (11/13/95). (13) IRS Letter Ruling 9601049 (10/11/95). (14) IRS Letter Ruling 9609022 (11/29/95). (15) IRs Letter Ruling 9626025 (3/28/96). (16) IRS Letter Ruling 9625041 (3/26/96). (17) IRS Letter Ruling 9626031 (3/29/96). (18) IRS Letter Ruling 9211027 (12/13/91). (19) IRS Letter Ruling 9602029 (10/17/95). (20) IRS Letter Ruling 9611020 (12/13/95). (21) IRS Letter Ruling 9602008 (9/28/95). (22) John M. Cameron, 105 TC 380 (1995). (23) IRs Letter Ruling 9616022 (1/18/96). (24) IRS Letter Ruling 9603014 (10/18/95). (25) IRS Letter Ruling 9621027 (2/23/96). (26) Rev Rul. 92-73, 1992-2 CB 224. (27) IRS Letter Ruling 9627006 (3/28/96). (28) IRS Letter Ruling 9603007 (10/13/95). (29) IRS Letter Ruling 9603028 (10/23/95). (31) IRS Letter Ruling 9613017 (12/27/95); see also IRS Letter Ruling 9623008 (2/28/96). (31) IRS Letter Ruling 9625008 (3/18/96). (32) IRS Letter Ruling 9621014 (2/20/96). (33) IRS Letter Ruling 9625021 (3/20/96). (34) IRS Letter Ruling (TAM) 9627004 (3/15/96). (35) David Miller, 65 F3d 687 (8th Cir. 1995)(76 AFTR2d 95-6193, 95-2 USTC [paragraph]50,485). (36) H.A. True, Jr, DC Wyo., 1993 (72 AFTR2d 93-5660, 93-2 USTC [paragraph]50,461), aff'd without published opinion, 35 F3d 574 (10th Cir. 1994). (37) James E. Redlark, 106 TC No. 2 (1996). (38) H. Rep. No. 99-841, 99th Cong., 2d Sess. 11-154 (1986). (39) See Karlinsky and Burton, "Can an Individual Deduct Interest Paid on a Business-Related Tax Deficiency?," 27 The Tax Adviser 430 (July 1996). (40) Charles A. Ballard, TC Memo 1996-68. (41) General K. Hilliard, TC Memo 1995-473. (42) IRS Letter Ruling (TAM) 9552001 (8/31/95). (43) IRS Letter Ruling (TAM) 9628002 (10/10/95). (44) Paul Gubbini, TC Memo 1996-221. (45) Ansley-Sheppard-Burgess Co., 104 TC 367 (1995); see Tax Clinic, "Hybrid Cash-Accrual Method Found to Clearly Reflect Income," 27 The Tax Adviser 326 (June 1996). (46) Thompson Electric, Inc., TC Memo 1995-292. (47) Antonio R. Durando, 70 F3d 548 (9th Cir. 1995)(76 AFTR2d 95-5644, 951 USTC [paragraph]50,615). (48) IRs Letter Ruling 9530005 (4/26/95). (49) IRS Letter Ruling 9541006 (TAM) (10/13/95). (50) IRS Letter Ruling (TAM) 9423003 (2/28/94); see Pollack, "Sec. 108(a)(1) Excluded COD Income," 26 The Tax Adviser 259 (May 1995). (51) See AICPA letter to the IRS, dated Apr. 5, 1995; BNA Daily Tax Report (4/10/95), at G-2. (52) Argo Sales Co., 105 TC 7 (1995). (53) See, e.g., IRS Letter Rulings 9615025 (1/2/96) and 9609039 (12/4/95). (54) IRS Letter Ruling 9536007 (6/6/95). (55) IRS Letter Ruling 9536008 (6/6/95). (56) Rev Rul. 72-30, 1972-1 CB 270. (57) GCM 39768 (12/1/88). (58) IRs Letter Ruling 9625038 (3/25/96). (59) IRS Letter Ruling 9602019 (10/12/95). (60) IRS Letter Ruling 9625036 (3/22/96). (61) Rev Proc. 96-30, IRB 1996-19 8. (67) IRs Letter Ruling 9607003 (11i3/95). (63) See Joint Committee on Taxation, Law and Proposals Related To Subchapter S Corporations and Home Office Deductions (JCS-16-95), 5/24/95, Table 3.
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|Title Annotation:||S corporations|
|Author:||Karlinsky, Stewart S.|
|Publication:||The Tax Adviser|
|Date:||Oct 1, 1996|
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