S corporation current developments: S corporation eligibility, elections and terminations; operations; reorganizations; and proposed legislative changes.
A recent joint Committee on Taxation study(2) of S corporations revealed that in 1993, over 1.9 million S returns were filed; almost 99% of such corporations had fewer than 1 1 shareholders and only 800 had more than 30 shareholders. Beginning in December 1995, the IRS will be conducting Taxpayer Compliance Measurement Program audits on 12,500 1994 S returns nationwide.(3)
With all these new or converted S corporations filing returns, it is not surprising that there were a number of court cases dealing with invalid filings of Form 2553, Election by a Small Business Corporation (under Section 1362 of the Internal Revenue Code), and Sec. 183 and 119 issues. There continue to be a number of letter rulings opining on proposed corporate divisions (Sec. 355) of S corporations, fewer letter rulings involving qualified subchapter S trust (QSST) beneficiaries failing to make timely elections (due to Rev. Proc. 94-23(4)), and less activity on the passive nature of rental income, due to the liberalized regulations under Sec. 1362. Of course, letter rulings are not precedential for anyone but the requesting taxpayer, but they signal the direction in which the Service is moving, and are substantial authority for taking tax return positions.
This update is presented in four major categories: eligibility, elections and terminations; operations; reorganizations; and proposed legislative changes affecting S corporations.
Eligibility, Elections and Terminations
The general definition of an S corporation in Sec. 1361 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 these restrictions, its S election will be automatically terminated; 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., Each year, the IRS issues numerous rulings on eligibility, elections and terminations. In addition, this year, final regulations were issued relating to the definition of an S corporation under Sec. 1361.
* Shareholder eligibility
Final Sec. 1361 regulations: There are significant limitations on who can be an eligible S shareholder; final Regs. Sec. 1.1361-1, effective July 21, 1995, clarifies the definition. The issue of trusts as shareholders presents great confusion. Regs. Sec. 1.1361-1(h)(1)(v) indicates that voting trusts are permitted shareholders. In addition, Regs. Sec. 1.1361-1(j)(4) allows a qualified terminable interest property trust to function as a QSST, if it otherwise qualifies. Under Sec. 1361(d)(3), a QSST can have only one income beneficiary; Regs. Sec. 1. 1361 -1 (j) 12)(i) provides that if a husband and wife are both beneficiaries of a trust, they will be treated as one beneficiary for QSST purposes.
Regs. Sec. 1.1361-1(j)(2)(ii)(B) points out that the reasons for setting up a QSST can be crucial. If the trust is set up to provide funds for a beneficiary that are legal support obligations of the grantor, the trust does not qualify as an S shareholder. Regs. Sec. 1.1361-1(j)(8) overturns Rev. Rul. 92-84,(5) which required a QSST's current income beneficiary to recognize any gain on the sale of S stock by the trust; now, the QSST recognizes such gain. Thus, if a sale was made on the installment method, the election must be made by the trust.
Permitted shareholders under Regs. Sec. 1.1361-1(j)(2)(ii) include shareholders who have legal life estates or usufruct interests in the S stock, and, under Regs. Sec. 1.1361-1(e)(1), a partnership that holds such stock as a nominee for an individual. Regs. Sec. 1. 1361-1(g)(1)(i) clarifies the issue of nonresident alien (NRA) spouses who have a current ownership interest in the shareholder's stock under applicable local law. NRA spouses are ineligible shareholders, even if they do not directly own the stock. This provision has grave consequences for S corporations with shareholders living in community property states with NRA spouses.
Trusts: In addition to the Sec. 1361 final regulations, the IRS also issued several letter rulings concerning the eligibility of trusts. From those final regulations and past rulings, it is clear that voting trusts and revocable living trusts qualify as S shareholders, while individual retirement accounts (IRAs) do not. If S stock is transferred to a nonqualifying shareholder, the S election terminates.
In Letter Ruling 9526007,(6) a husband and wife transferred S stock to separate grantor trusts. During the grantor's lifetime, he or she will retain all rights to the trust. At death, the stock will pass to a trust for the benefit of the decedent's spouse. If there is no surviving spouse, the stock will pass to a trust for the benefit of the decedent's son; if the son dies before his parents, the stock will be distributed to a foundation. The IRS ruled that all four trusts will be eligible S shareholders. Although no ruling was requested as to the eligibility of the foundation as an S shareholder, the IRS ruled that the foundation would not qualify.
In Letter Ruling 9528008,(7) an S corporation issued shares to a stockbroker as custodian for the benefit of a shareholder; in fact, this transfer was to a self-directed IRA. The broker was not aware that IRAs are ineligible shareholders. When the S corporation hired a new accountant, he discovered the IRA shareholder; steps were then taken to transfer the stock from the IRA and reissue the stock to the shareholder individually. The IRS ruled the issuance of stock to the IRA was an inadvertent termination and the shareholder would be treated as the owner of the S stock during the period the IRA held the stock. This approach differs from the IRS position in the past; now, the IRA potentially will not be subject to unrelated business income tax (UBIT).
QSSTs: S status terminates if a QSST beneficiary does not elect to be an S shareholder, but the S corporation can request relief under Sec. 1362(f). Rev. Proc. 94-23 allows S corporations automatic inadvertent termination relief when a trust beneficiary fails to file a timely QSST election. This procedure significantly reduced the number of ruling requests. However, the IRS issued several letter rulings(8) indicating that the failure of the trust beneficiary to file a QSST election was an inadvertent termination under Sec. 1362(f). In each case, the beneficiary was not aware of the filing, requirement and a QSST election was filed as soon as the oversight was discovered.
In a related development, in Letter Ruling 9523003,(9) the IRS ruled that an inadvertent termination occurred when stock was transferred to a NON-QSST trust. In the ruling, stock was transferred to two trusts that counsel advised were QSSTs; after the transfer, proper QSST elections were filed. Later, new counsel determined the trusts did not qualify under Sec. 1361(d)(3). As soon as this error was discovered, the S stock was distributed to each of the trusts' beneficiaries. The IRS ruled that S status inadvertently terminated when the stock was transferred to the trusts, so that S status was maintained.
Number of shareholders: To maintain administrative simplicity, Sec. 1361 limits the number of S shareholders to 35. This eligibility requirement was at issue in Letter Ruling 9526021,(10) in which a group of S shareholders included a husband and wife, their seven children and 12 grandchildren. In addition, shares of the corporation were held by 14 separate QSSTs for the children's benefit. The husband planned to establish 19 additional QSSTs for the benefit of his children and grandchildren. The issue was the number of S shareholders. The IRS ruled that the 19 individuals (seven children and 12 grandchildren) would be treated as 19 shareholders even though they owned stock both individually and through QSSTs; thus, the S corporation had only 20 shareholders.
* Corporate eligibility
Affiliated corporations: To retain S status, Sec. 1361(b)(2)(a) provides that an S corporation cannot be a member of an affiliated group. This requirement applies to both domestic and foreign subsidiaries. The purchase by an S corporation of 80% or more of the stock of another corporation terminates the S election. In Letter Ruling 9524011,(11) X, an S corporation, owned less than 80% of Y corporation. As part of a plan for Y to go public, X transferred two of its divisions to Y in exchange for Y stock. After the transaction, X owned 88% of Y. Momentarily after the transfer of X's divisions, Y went public and X's ownership in Y decreased to 52%. The IRS ruled that because the transaction was part of a plan that did not contemplate more than a momentary affiliation, X's S election was not terminated.
A related situation occurred in Letter Ruling 9528011,(12) in which an S corporation entered into two separate disqualifying transactions. In the first, it purchased 100% of a corporation without knowing the effect of the purchase on its S status. The assets of the subsidiary were later sold and the subsidiary dissolved. In the second (unrelated) transaction, the S corporation purchased 100% of the stock of a second corporation and merged the subsidiary into the taxpayer shortly thereafter. The IRS ruled in both instances that the termination was inadvertent.
In a third ruling, Letter Ruling 9517012,(13) an S corporation acquired 86.5% of a new corporation when its partner in an investment failed to raise enough capital to purchase at least 20% of that corporation (a separate corporation was to receive 2% 1. The S corporation did not know that the purchase of 80% or more of the corporation would terminate its S status. As soon as the S corporation became aware of the disqualifying transaction, it transferred enough shares to a limited partnership to reduce its ownership below 80%. The IRS ruled the purchase caused an inadvertent termination.
The IRS denied an inadvertent termination request in Letter Ruling 9523004,(14) in which an S corporation used the cash method of accounting. It filed corporate returns indicating that it had revoked its S election and filed a Form 1120 for eight years, as well as acquired wholly owned subsidiaries during its C period. The IRS disallowed its use of the cash method on audit. The corporation argued, to no avail, that it never really terminated its S status and thus should be allowed to continue using the cash method.
One class of stock: Sec. 1361(b)(1)(D) bars an S corporation from issuing more than one class of stock; all shares of stock in an S corporation must have identical rights to distribution and liquidation proceeds. The IRS issued several rulings during 1995 on this issue. In Letter Ruling 9528024,(15) an S corporation issued additional shares of stock that were authorized by an amendment to the corporation's articles of incorporation; the amendment was never filed with the state corporation commission. Accordingly, it was not clear what rights, if any, were conferred to the holders of the issued but unauthorized stock. The IRS rliled that if the rights to liquidation or distribution differed from the original stock, the S election would be terminated, because there would be two classes of stock; however, the termination would be inadvertent.
In Letter Ruling 9529020,(16) an S corporation issued preferred stock, terminating its S election. When the corporation's accountant learned of the issuance, the corporation redeemed the preferred stock and issued nonvoting common stock instead. The IRS ruled the issuance of the preferred stock wag an inadvertent termination. The redemption of the preferred, stock would be governed by Sec. 302 and possibly, Sec. 306. As a planning note, S corporations in this situation could consider an E reorganization, which would be tax free.
Letter Rulings 9519036(17) and 9519048(18) dealt with S corporations that made disproportionate distributions for several years. In each instance, the corporation made a distribution that equalized the cumulative amount of per share distributions. The IRS ruled that the disproportionate distributions did not create a second class of stock.
Partnerships and corporations: Sec. 1361(b)(1)(B) limits who may be an S shareholder. The IRS has issued several recent rulings concerning partnerships and corporations that owned S stock. Because ineligible shareholders apparently are a continuing problem, an S corporation may want to include on its stock certificates a statement that the corporation is an S corporation and the transfer of the stock is restricted. A statement to this effect may help eliminate the following types of situations.
In Letter Ruling 9527017,(19) an S shareholder transferred his stock to a partnership without the corporation's knowledge or approval. When the S corporation found out about the transfer, it redeemed the stock from the partnership. The IRS ruled that the transfer to the partnership was an inadvertent termination of the S election, but that the transferring shareholder was deemed to own the stock during the period the stock was held by the partnership. Therefore, that shareholder would have to report the income on his individual income tax return for this period, rather than the income being allocated to all the partners. This ruling is consistent with some other rulings issued during 1995, but is a change from earlier ones.
Likewise, in two additional rulings, Letter Rulings 9524006(20) and 9520043,(21) the IRS similarly concluded when shareholders erroneously transferred S stock to a C corporation and a nonprofit corporation, respectively. In each situation, the S corporation took remedial steps as soon as it knew of the transfer. In each case, the corporation that received the transferred interest was deemed the shareholder during the period it held the S stock. This position is similar to rulings from prior years.
In Letter Ruling 9522052,(22) 100% of an S corporation's stock was transferred to a bank when it foreclosed on a loan, terminating the S election. One year later, an individual purchased the stock from the bank and made a new S election. The IRS allowed the new election because more than 50% of the stock was owned by persons who were not shareholders when the original election was terminated. To avoid this situation, banks and S corporations may want to use the underlying assets as collateral for loans instead of stock.
To qualify as an S corporation, the taxpayer and all shareholders on the date of the election (as well as other affected shareholders) must file a valid and timely Form 2553. It is in the taxpayer's best interest to send the election by certified mail with a return receipt or by registered mail. Several recent decisions were decided in the IRS's favor when the taxpayer claimed to have sent the form by regular mail, but it was never received. Individual taxpayers had to forgo losses equaling hundreds of thousands of dollars at the individual level because of this procedural flaw.
In Huff,(23) the Huffs formed an S corporation. The IRS never received the Form 2553 and notified the taxpayers that their S election was invalid. To complicate matters, Mrs. Huff did not sign the election; the government thus argued that even if it had received a timely filed election, it, was nonetheless invalid. In Elbaum,(24) Form 2553 was never filed; the taxpayer asserted and the Tax Court rejected the argument that the filing of Form 1120-S, U.S. Income Tax Return f or an S Corporation, constituted an election by the sole shareholder to classify the, entity as an S corporation. In Cabintaxi Corp.,(25) the Form 2553 was timely but incomplete as to consent, so there was
no valid S election. In Smith,(26) the Tax Court rejected the taxpayers' assertion that they had mailed the Form 2553, because no certified or registered proof of mailing was offered. Tax practitioners should note that in a community property state, it is appropriate to have the spouse sign the election as well, even if he or she is not a direct shareholder, and to ascertain that the spouse is a U.S. citizen or resident.
A recent letter ruling also shows how invaluable it is to use certified mail. In Letter Ruling 9433025,(27) the postmark showed that under the transition rules, the Sec. 1374 built-in gains tax was not applicable because the Form 2553 was deemed filed on the postmark date (Dec. 31, 1986) rather than on the IRS receipt date (Jan. 1, 1987).
One of the more common motivations for electing S status versus C status is the ability to flow through entity-level losses to the shareholders. Shareholders face three hurdles before a loss can be used at the individual level: the hobby loss rules (Sec. 183), basis for loss purposes (Sec. 1366) and the passive activity rules (Sec. 469).
* Hobby losses
Several cases disallowed S losses due to lack of a profit motive. De Mendoza, III(28) involved a Florida attorney who used an S corporation to operate a business of buying and selling polo horses. Over 11 years, he lost more than $2 million. The Tax Court examined a multitude of business factors in deciding that the activities were not profit motivated; thus, the losses were disallowed.
* Guarantors and co-borrowers
A standard S corporation problem is how a shareholder can generate stock and debt basis to use entity-level losses. Being a guarantor or co-borrower is not sufficient to give a shareholder basis for loss purposes until the shareholder has an economic outlay le.g., pays the liability). This contrasts with the partnership or limited liability company (LLC), in which guaranteeing, co-borrowing or, in the case of real estate, using qualified nonrecourse debt adds basis for loss purposes.
The longstanding judicial rule of law is that one must have an economic outlay before S corporation basis is increased. Meissner(29) is the latest in a long line of cases that maintain that an economic outlay is a condition precedent for obtaining basis for loss purposes. In Meissner, the taxpayer solely owned two S corporations, and one company lent the other funds. The taxpayer increased his basis for loss purposes by the amount of the loans from one controlled corporation to the other; the Tax Court disallowed this increase because the taxpayer lacked an economic outlay.
Hitchins(30) examined the effect of the assumption of a loan by an S corporation on a shareholder's basis. The taxpayer, who owned stock in a C corporation, made a loan to it. Later, the taxpayer formed an S corporation, which paid the C corporation for services rendered, in part, by assuming the C corporation's indebtedness to the taxpayer. The original debt was not canceled and the S corporation did not issue a new note. The Tax Court ruled that the shareholder was simply a creditor of the S corporation and any rights were derived through the C corporation. Thus, the taxpayer could not include the loan in the basis of his S corporation stock. It is not clear from the case whether the individual would have been able to increase his stock basis if the C corporation loan had been canceled and the note reissued by the S corporation.
* Passive activities
Generally, Sec. 469 limits the amount of losses from passive activities that a taxpayer can deduct. A passive activity is defined in Sec. 469(c) as any trade or business in which the taxpayer does not materially participate, or a rental activity. See. 1368(b)(2) provides that if an S corporation has no accumulated earnings and profits (E&P), a distribution that exceeds the shareholder's adjusted stock basis will be treated as a gain from the sale or exchange of property. The IRS ruled in Rev. Rul. 95-531 that such gain will be treated as passive income. This classification allows the taxpayer to deduct additional passive activity losses. Another development was the issuance of final Regs. Sec. 1.469-4, defining an activity. Generally effective for tax years ending after May 10, 1992,
the regulation adopts a facts-and-circumstances approach to identifying a taxpayer's activities. According to Regs. Sec. 1.469-4(c)(2), a taxpayer may group separate businesses into one activity based on type of business, common control, common ownership, geographical location and business interdependencies, allowing a taxpayer to combine two or more S corporation interests into one activity if the interests have common factors.
* Sec. 119
In Di]ts,(32) a district court held that the Sec. 119 meals and lodging exclusion was not available to an S corporation's shareholder-employees. In this case, the shareholders lived and worked on a ranch; the court held that there was no formal requirement that they live there and that they were not employees.
* LIFO inventory
When a C corporation switches to S status and uses the LIFO inventory method, Sec. 1363(d) requires a LIFO recapture amount to be computed in the final C year, and to be paid over four years. Rev. Proc. 94-61(33) was issued in question-and-answer format to amplify several procedural issues. For example, Q&A-3 indicates that financial accounting inventory conformity will not be violated by the FIFO inventory amount being used as the opening balance; Q&A-4 provides that no negative adjustment is allowed. if the LIFO value is higher than the FIFO value. The procedure confirms that a C corporation net operating loss can offset the LIFO recapture amount (Q&A-and 5), that no estimated taxes are due on the four LIFO recapture tax installments (Q&A-7).
In the S corporation arena, overcompensation is usually not an issue, except possibly when computing taxable income for Sec. 1374 or 1375 purposes. More typically, undercompensation is a hot issue, primarily concerned with the imposition of the proper amount of Social Security and unemployment taxes. The Dunn & Clark(34) case is a repeat of Radtke,(35) in that two lawyers, shareholders of an S corporation, did not pay themselves a salary, but took the profits out in distributions. The court held that the payments were disguised salaries for which employment taxes were due.
* Self-employed health insurance
In April 1995, the Self-Employment Health Insurance Act of 1995(36) was enacted, permanently extending the above-the-line deductibility of a self-employed taxpayer's health insurance premiums. For 1994, 25% of premiums were deductible, rising to 30% in 1995 and thereafter. In a news release,(37) the Service reiterated that for purposes of this deduction, a 2% S shareholder is deemed to be self-employed.
* Built-in gain
Sec. 1374 imposes a tax on an S corporation's net built-in gain for any tax year beginning in the 10-year recognition period following the conversion to S status or the acquisition of C assets in a carryover transaction,
To date, very few built-in gains tax cases have been litigated. An exception is Leou,(38) in which a doctor argued that his accounts receivable existing on the day he switched his professional corporation from C to S status were not subject to such tax. The Tax Court held that even if there was doubt under the Tax Reform Act of 1986 that the built-in gains tax applied to such assets, Section 1019 of the Technical and Miscellaneous Revenue Act of 1988 clarified that the built-in gains tax so applied.
Reliable Steel Fabricators, Inc.(39) examined the valuation method used to determine built-in gain on work-in-process (WIP) inventory. The IRS determined that a built-in gain existed on unfinished inventory on the date the corporation converted from C to S status, by including in the value of the WIP a percentage of the profit on the preconversion sale of inventory, linked to a percentage of the work completed preconversion. The taxpayer maintained the WIP should be valued at either replacement cost or scrap value, and should not include a profit element. If replacement cost or scrap value was used, there would be no built-in gain. The Tax Court ruled for the government, noting that if the taxpayer had made a reasonable calculation of -- fair market value f or such inventory (including a profit factor), it would have considered that calculation.
In contrast, three letter rulings(40) held that if standing timber is owned before the switch from C to S status, but is cut after the conversion, there is no built-in gain. This ruling favors the conversion of a timber business from C to S status. The rulings do not indicate why standing timber is not subject to built-in gains tax; query whether there are similar assets to which these rulings may apply.
Final Sec. 1374 regulations: Final regulations under Sec. 1374 were issued on Dec. 27, 1994, effective for tax years ending on or after that date, but only when the return for the tax year is filed pursuant to an S election or a Sec. 1374(d)(8) transaction occurring on or after that date. These regulations clarify the acceptable accounting methods and recognition period to be used when determining built-in gain. Under the final regulations, a corporation should use the accounting methods it actually uses as an S corporation to determine taxable income. The 10-year recognition period starts on the first day of the conversion to S status and the corporation's books should be closed at the end of the recognition period to determine the total income and gain for that year. Additionally, each acquisition of assets from a C corporation is subject to a separate determination of built-in gain.
To determine the total built-in gain or loss, the final regulations adopt the proposed regulations' accrual method and extend the realized built-in deduction treatment for certain amounts deducted under Secs. 267(al and 404(a)(5). These expenses will be included in the calculation if all events have occurred that establish the fact of the liability and the exact amount can be determined; for Sec. 267(a)(2), an amount is included if paid in the first 21/2 months of the recognition period. The final regulations also modify the accrual method for items deducted under Regs. Sec. 1.461-4(g); the exception for items deducted under Sec. 469 has been eliminated.
Also addressed are certain special situations; for example, the final rules provide that any Sec. 481(a) adjustments are recognized built-in gains or losses to the extent the adjustments relate to items attributable to the period before the recognition period. The final regulations retain the installment method rule, which requires that a tax be levied on income reported on the installment method both during and after the recognition period if the tax would have been imposed had the income been reported in the year of sale.
Also retained are the look-through rules regarding partnerships; the final rules require an S corporation that owns an interest in a partnership to treat its distributive share of the partnership's items in the calculation of built-in gain or loss as if the corporation owned the items directly. However, there is a de minimis exception for a lessthan-10% partnership interest with a value under $100,000.
The final regulations clarify that inventory should be valued as if the entire business of the S corporation has been sold to a buyer who expects to operate that business. The regulations treat such valuation like a bulk sale, which usually results in a value less than retail but more than replacement cost.
* Passive investment income
If an S corporation either switches from C to S status or acquires trade or business assets tax free under Sec. 381, the Sec. 1375 tax on passive investment income (PII) and/or the Sec. 1362(d)(3) termination rules may come into play.
Sec. 1362(d)(3) provides that if, for three consecutive years, an S corporation has C E&P and more than 25% of its gross receipts are PII, S status terminates as of the fourth year. Sec. 1362(d)(3)(d) defines PII as gross receipts derived from rents, royalties, interest, annuities, and the sale or exchange of stocks or securities. For tax years beginning after 1992, Regs. Sec. 1.1362-2(c)(5)(ii)(B)(2) provides that "rents" do not include gross receipts from the active trade or business of renting property (i.e., the corporation provides significant services or incurs substantial costs in the rental business).
Several recent letter rulings addressed active rental income;(41) essentially, the IRS held that such income was derived from a trade or business and, thus, was not PII. The rulings had several common factors indicating that the S corporation provided significant services or incurred substantial costs. In each case, the S corporation provided day-to-day management of the rental property, approved and negotiated leases, and supervised and paid for the maintenance and repair of common areas. In many cares, the S corporation paid property taxes, insurance and utilities on the property. Additionally, none of the leases were net leases. Some of the rulings addressed rents from real estate and equipment leasing,(42) from low-income housing(43) and from an arm's-length lease to a related tenant.(44)
Two of the rulings(45) extended the analysis to the S corporation's distributive share of a partnership's rental income. In each instance, the S corporation owned an interest in a partnership that engaged in a rental business. The S corporation was a general partner that actively managed the properties held by the partnership. The IRS made no distinction between rents received by the partnership and rent received directly by the S corporation in ruling that the partnership's rents were not PII. In effect, the government chose to use the "aggregate" theory of partnerships, instead of the "entity" theory.
Because the S corporation is the vehicle of choice for many small businesses, it is only natural that there is more activity currently in the area of splitoffs, acquisitions and other restructurings.
A fundamental issue in the restructuring area is whether an S corporation should be treated as a corporation or as an individual under Sec. 1371(a) 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 corporation in a Sec. 338(h)(10) election or the distributing corporation in a corporate division. In the past year, the government continued to affirm its longstanding position in Rev. Rul. 72-30(46) and GCM 39768(47)that an S corporation can be treated as a corporation in the liquidation and reorganization areas, because its momentary ownership of the stock of another corporation does not terminate its S election.
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 9526025,(48) 9519019,(49) 9515020(50) and 9510043(51) all hold that an S corporation may spin off, split off or split up, and remain or create a new S corporation, assuming the business purpose test and the other Sec. 355 requirements are met.
Letter Ruling 9517009(52) reaffirmed the currency of Rev. Rul. 69-566(53) in ruling on the merger of a C corporation into an S corporation with exactly the same ownership. S status did not terminate, but Sec. 1374 would apply to the target's assets acquired tax free under Sec. 362. A major issue in the ruling was whether the cash method would be allowed for the combined farming company, because the target used the accrual method and the acquirer used the cash method. The IRS held that the combined company would meet the Sec. 447(c) integrated company exceptions both as to farming and gross receipts, so that the cash method was allowable.
In an interesting present-day application of Court Holding Co.,(54) McMorrow(55) exemplifies that form matters. In this case, the major shareholder of an S corporation died and his wife received a step-up in basis of the stock (outside basis). However, the death did not affect the inside basis of the corporation's assets. Rather than liquidating the corporation and selling the assets, which would have resulted in offsetting gains and losses in the same tax year, the corporation sold all the assets, but did not liquidate. A capital gain was recognized without any offsetting loss. A district court dismissed for lack of subject matter jurisdiction, because the taxpayer had claimed a refund from the IRS based on an adjustment to capital gain on the sale of the S corporation assets to reflect the basis step-up, but in district court, the taxpayer argued that a gain on liquidation of the S corporation had occurred.
In Mandelbaum, the court examined the valuation of S corporation stock gifts between family members and granted a 30%: lack of marketability discount, in addition to a minority discount. This case should provide, support for other taxpayers who want to take both a marketability and a minority interest discount when valuing closely held businesses for gift and estate tax purposes. The logic and holding of this ruling may also be important for valuing interests in family partnerships.
Rev. Rul. 95-14(57) involved a taxpayer who redeemed stock of an S corporation, but, due to family attribution, the distribution was deemed a dividend under Sec. 302(d). The accumulated adjustments account (AAA) was greater than the dividend; thus, under Sec. 1368(b), the full distribution was not taxable to the shareholder, but reduced the AAA instead.
The S Corporation Reform Act of 199558 (SCRA) was introduced in May 1995 by Senators Hatch (R-Utah) and Pryor (D-Ariz.) to encourage the use of S status. Some of the SCRA's provisions will simplify the S rules or eliminate procedural traps, while others will significantly complicate the S provisions to benefit a small subset of S corporations. Some view these proposals as a good way to implement corporate integration or enact a set of parallel LLC provisions for corporations, by allowing more businesses to be eligible for S status. The major changes proposed are highlighted below.
* Increasing the number of eligible shareholders
Currently, under Sec. 1361(b)(1)(A), an S corporation may have no more than 35 qualified shareholders at a time (70, if all the shareholders are married). SCRA Sections 101 and 102 increase the permissible number of sharcholders to 50 and allow one family per S corporation to elect to count six generations as one shareholder. As was previously discussed, only 800 out of 1.9 million 1992 S corporation returns indicated having more than 30 shareholders.
* Redefining eligible shareholders
Under SCRA Section 111, exempt organizations under Secs. 401(a) and 501(c)(3) (e.g., charitable organizations, private foundations, pension funds and employee stock option plans) would be eligible S shareholders, but IRAs and charitable remainder trusts would not. The shareholder would be subject to UBIT on the passthrough income. According to SCRA Section 226, charitable contributions of S stock would be allowed; the S corporation would be treated the same as a C corporation with respect to charitable contributions of certain (1) inventory used by the donee solely for the care of the ill, needy or infants and (2) scientific property used for research.
NRAs would also be eligible shareholders, under SCRA Section 113. U.S. withholding tax rules, similar to the existing rules regarding NRA partners in U.S. partnerships, would apply. Also, permanent establishment rules would apply to the foreign investor.
To facilitate estate planning, a new category of trust, "electing small business trust" (ESBT), would be an eligible shareholder, but interests in such trusts could not be acquired by purchase. This type of trust could have multiple beneficiaries (each would count as an S shareholder) and could accumulate trust income;(59) the trustee would be allowed to sprinkle income among the beneficiaries. QSSTs would not qualify as ESBTs. Given the experience with QSSTs relative to their required affirmative election, the ESBT concept will keep the IRS personnel who draft inadvertent termination rulings busy.
Another SCRA provision would extend the period certain testamentary and grantor trusts may own S stock from 60 days to two years.
* Streamlining administrative procedures
Inadvertent termination relief is provided in SCRA Section 211 such that the IRS could waive the effect of an inizalid and/or untimely S election. This would alleviate many of the QSST failure-to-obtain-consent problems discussed above, as well as the Form 2553 cases, and would represent progress toward simplification.
Generally, when a shareholder sells S stock during the year, a pro rata allocation of the corporation's income is made; there is an election available to close the entity's books as of the date of the disposition, to which the corporation and all shareholders must consent. SCRA Section 212 would require only the buying and selling shareholders to make the election.
The SCRA also proposes major changes in the Sec. 1375 passive income tax. SCRA Section 214 would exclude gains on the sale of capital assets from the definition of PII, and increase the 25% threshold to 50% of gross receipts. Also, inadvertent termination would not result, but a higher tax rate would, if the corporation had excess PII for three consecutive years. Given taxpayers' ability to keep taxable income low, the increased tax rate provision would not have much impact. Query whether this provision would lead to the IRS litigating more overcompensation cases.
SCRA Section 225 would eliminate pre-1983 S corporation E&P, which would simplify current recordkeeping requirements. SCRA Section 223 would statutorily allow consent dividends, which are currently permitted only by Regs. Sec. 1. 1368-1(f)(3).
SCRA Sections 227 and 301 provide that, for fringe benefit purposes, an S corporation would be treated like a C corporation rather than as a partnership; this would serve to codify in the reorganization area the holdings of many revenue and letter rulings. In the fringe benefit area and on loans from pension plans to shareholder-employees, this would make S corporations more attractive. However, due to revenue loss considerations, 2%-or-greater shareholders would have to deduct health insurance premiums as if self-employed.
* Expanding S capital structure
SCRA Sections 201 and 202 would expand the definition of safe harbor straight debt to allow convertible debt. S corporations would be permitted to issue qualified nonvoting, nonconvertible preferred stock; the dividends therefrom would be treated like interest to both the corporation and the shareholder.
SCRA Section 221 would allow an S corporation to own 80% or more of a C corporation (or up to 100% of a "qualified subchapter S subsidiary"); the consolidated return rules would not apply. Generally, the subsidiary would be ignored for tax purposes and the group would be treated as a single entity. (1) Gill, "S Corporation Returns, 1992," IRS Statistics of Income Bulletin (Spring 1995), p. 73. (2) Joint Committee on Taxation, Present Law and Proposals Relating To Subchapter S Corporations and Home Office Deductions (JCS-16-95), 5/24/95, Table 3. (3) See Tax Practice Management, "The Audit Lottery, or Preparing for the TCMP Audit--Again!," 26 The Tax Adviser 377 (June 1995). The audits were scheduled to begin on Oct. 1, 1995; the IRS subsequently informally indicated they would begin on Dec. 1, 1995. (4) Rev. Proc. 94-23, 1994-1 CB 609. (5) Rev. Rul. 92-84, 1992-2 CB 216. (6) IRS Letter Ruling 9526007 (3/17/95). (7) IRS Letter Ruling 9528008 (4/12/95). (8) IRS Letter Rulings 9515022 (1/12/95), 9515015 (1/11/95), 9518016 (2/2/95), 9522014 (3/1/95) and 9527018 (4/6/951.) (9) IRS Letter Ruling 9523003 13/3/95). (10) IRS Letter Ruling 9526021 (4/3/95). (11) IRS Letter Ruling 9524011 (3/16/95). (12) IRS Letter Ruling 9528011 (4/13/95). (13) IRS Letter Ruling 9517012 (1/25/95). (14) IRS Letter Ruling 9523004 (3/5/95). (15) IRS Letter Ruling 9528024 (4/17/95). (16) IRS Letter Ruling 9529020 (4/24/95). (17) IRS Letter Ruling 9519036 (2/14/95). (18) IRS Letter Ruling 9519048 (2/14/95). (19) IRS Letter Ruling 9527017 (4/4/95). (20) IRS Letter Ruling 9524006 (3/8/95). (21) IRS Letter Ruling 9520043 (2/21/95). (22) IRS Letter Ruling 9522052 (3/8/95). (23) Lyouglas B. Huff, TC Memo 1994-477. (24) Saul Elbaum, TC Memo 1994-439. (25) Cabintaxi Corp., TC Memo 1994-316. (26) Robert L. Smith, TC Memo 1994-270. (27) IRS Letter Ruling 9433025 (5/20/94). (28) Mario G. De Mendoza, III, TC Memo 1994-314. See also Rohland v. Syn-Fuel Assoc., 879 F Supp 322 (S.D. N.Y. 1995); Michael J. Houston, TC Memo 1995-159. (29) Douglas Wayne Meissner, TC Memo 1995-191. (30) F. Howard Hitchins, 103 TC 711 (1994). (31) Rev. Rul. 95-5, 1995-2 IRB 5. (32) Jerry Dilts, 845 F Supp 1505 (DC Wyo. 1994)(73 AFTR2d 94-1633, 94-1 USTC 950,162). (33) Rev. Proc. 94-61, 1994-38 IRB 56. (34) Dunn & Clark, P.A., 853 F Supp 365 (DC Idaho 1994)(73 AFTR2D 94-1860, 94-2 USTC [paragraph] 50,447). (35) Joseph Radtke, S.C., 895 F2d 1996 (7th Cir. 1990)(65 AFTR2d 90-1155, 90-1 USTC [paragraph]50,113). (36) HR 831, 104th Cong., 1st Sess. (1995). (37) Jif-05-34 (4/11/95). (38) Frank J. Leou, TC Memo 1994-393. (39) Reliable Steel Fabricators, Inc., TC Memo 1995-293. (40) IRS Letter Rulings 9520044 (2/21/95), 9519024 (2/9/95) and 9430026 (5/2/94). (41) See IRS Letter Rulings 9529036 (4/27/95), 9527029 (4/10/95), 9528031 (4/19/95), 9523017 (3/10/95), 9523016 (3/10/95), 9523015 (3/10/95) and 9523014 (3/10/95). (42) IRS Letter Ruling 9527029, id. (43) IRS Letter Ruling 9523014, note 41. (44) IRS Letter Ruling 9523016, note 41. (45) IRS Letter Rulings 9527029 and 9523017, note 41. (46) Rev. Rul. 72-30, 1972-1 CB 270. (47) GCM 39768 (12/1/88). (48) IRS Letter Ruling 9526025 (4/4/95). (49) IRS Letter Ruling 9519019 (2/7/95). (50) IRS Letter Ruling 9515020 (1/12/95). (51) IRS Letter Ruling 95 10043 (12/12/94). (52) IRS Letter Ruling 9517009 (1/24/95). (53) Rev. Rul. 69-566, 1969-2 CB 165. (54) Court Holding Co., 143 F2d 823 (5th cir. 1944)(32 AFTR 1088, 44-2 USTC [paragraph] 9404). (55) Mary Ann G. McMorrow, N.D. Ill., 1994 (75 AFTR2D 95-801, 95-1 USTC [paragraph] 50, 108). (56) Bernard Mandelbaum, TC Memo 1995-255. (57) Rev. Rul. 95-14,1995-6 IRB 29. (58) S 758, 104th Cong., 1st Sess. (1995). (59) Under the SCRA, the portion of the ESBT consisting of S stock would be treated as a separate trust for purposes of computing the income tax attributable to such stock; the trust would be subject to the highest individual tax rate on the S stock portion of its income.
Editor's note: Dr. Karlinsky is a member of the AICPA Tax Division Tax Simplification Committee.
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|Author:||Burton, Hughlene A.|
|Publication:||The Tax Adviser|
|Date:||Oct 1, 1995|
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