The changes to the kiddie tax rules may affect young S shareholders.
The back-to-back loan strategy was again affirmed by the courts as an economic outlay.
Sec. 409(p) S corporation ESOP regulations were finalized.
During the period of this S corporation tax update (July 15, 2006–July 15, 2007), the Small Business and Work Opportunity Tax Act of 2007, P.L. 110-28 (SBWOTA, enacted May 25, 2007), has had an immediate impact on S corporation tax planning, as did the passage of three different 2006 tax acts. Proposed regulations were finalized, several sets of regulations were proposed, and a number of court cases and rulings on an S shareholder’s adjusted basis for loss were issued. The IRS also provided significant guidance related to S corporation mergers and acquisitions as well as a unique built-in-gain (BIG) planning technique.
The last 20 years have seen an explosive growth in S corporation filings. The latest IRS Statistics of Income Bulletin (Spring 2007) shows that S corporations continue to grow as the most common form of doing business. For the 2004 tax year there were more than 3.5 million S corporation tax returns filed, representing over 6 million shareholders and accounting for 63% of all corporate returns filed.
The SBWOTA has both direct and indirect impacts on S corporation tax planning. First, a trap for the unwary has been eliminated. Some S corporations have set up 100%-owned qualified subchapter S subsidiaries (QSubs) for various business, liability protection, and state tax reasons. If the parent S corporation were to sell more than 20% of the QSub stock, a taxable sale would occur, causing recognition of all of the appreciation (not just that associated with the assets sold), as Sec. 351 would not be available to shield the unsold portion of the assets. The new law treats the sale of more than 20% of the stock as a deemed pro-rata sale of the assets (Sec. 1361(b)(3)(C)(ii)).
Consider an S corporation that is setting up a strategic alliance with another company and sells 49% of the stock of its existing QSub to a new partner. Before the 2007 law change, 100% of the gain would have been recognized because the S corporation did not own 80% of the company. Under the new law, if 49% of the stock were sold, only 49% of the appreciation would be recognized. The S corporation would still be deemed to own 100% of the stock, and Sec. 351 would protect the remaining 51% of the gain from being recognized. This tax law change is effective for transactions after December 31, 2006.
The Sec. 179 expense deduction has been increased beginning in 2007. Basically, the first-year deduction allowed is $125,000 (vs. $112,000 under the old law). This deduction is phased out beginning at $500,000 ($450,000 under the old law) in new or used tangible personal property or shrink-wrap software acquisitions in a given year. (These limits are adjusted for inflation beginning in 2008.) The recent law change also codifies and extends the ability to revoke the Sec. 179 election in a later year or to change which assets are covered by the election.
The work opportunity tax credit (WOTC) (Sec. 51) has been extended and expanded and, most important, it may offset alternative minimum tax (AMT) liability rather than just regular tax liability (see Sec. 38(c)(4)(B)(iv)). Thus, if an S corporation in the retail business generates these work hiring credits, the shareholders may use the credits against their individual tax liability, including their tentative minimum tax (TMT).50
Because the capital gains rate for individual taxpayers in the lower two tax brackets goes to zero in 2008, many taxpayers are (or were) contemplating gifting appreciated stock (including S stock) to their children, grandchildren, or parents. For 2007, this planning will still be effective if the donee is over age 17 by the end of the year. Thus, in 2007, a 5% capital gains tax rate will apply for those with taxable income under $31,850 (single) or $63,700 (married filing jointly). In 2008, the new law extends the kiddie tax to income (including capital gains and dividends) of 18-year-olds who do not provide more than half of their support, and to 19- to 23-year-olds who are full-time students51 and do not provide more than half of their own support. Thus, the 0% tax rate generally will not be available to students through age 23 unless they have significant earned income that contributes to their own support. This leads to a balancing act. Parents may hire a child to legitimately work for them and pay him or her enough to meet the 50% support test but not so much that they exceed the first two bracket limits ($31,850), including the capital gains generated. Also, the parent will likely lose the dependency exemption.
Example 1: Assume a $33,000 taxable income bracket limit in 2008. Child C, age 22, is in graduate school and has $5,000 dividend income and $2,000 ordinary income from an S corporation, plus $10,000 earned income from summer work and from helping his parents with computer work in their business. His total support is $18,000. In February 2008, C’s parents give him stock worth $24,000, with a basis of $4,000 and a holding period of at least one year. He has a standard deduction and personal exemption that puts his 2008 taxable income in the first two tax brackets. Assuming that C sells the stock in 2008, he will pay no tax (0% tax rate) on the $20,000 capital gain and the $5,000 dividend income, for a tax savings over his parents’ hypothetical tax on the dividend and capital gains of $3,750 ($25,000 3 15%).
With the exception of the kiddie tax, most of the 2007 changes were pro-taxpayer. However, the tax preparer penalty rules have been severely tightened; the needed level of confidence that a position will be sustained on audit (moved from “substantial authority” to “more likely than not”) and the penalties for nondisclosure have been raised substantially. The tax practitioner needs to be aware of these stricter guidelines (see Part I of this article and Messier, Tax Clinic, “New Rules Govern Practice Before the IRS,” in the October 2007 issue of The Tax Adviser).
2006 Tax Laws
Three tax acts52 were enacted in 2006 that tax professionals should review. Some of the changes made by these acts were expanded or tightened under the SBWOTA, including Sec. 179, capital gains rate, and kiddie tax changes.
The Tax Increase Prevention and Reconciliation Act clarified that the Sec. 199 domestic production activity deduction’s application and computation are at the S shareholder level. The 2006 changes require that the 50%-of-wage limitation applies only to wages generated in the qualified production activity.
The Tax Relief and Health Care Act of 2006 extended a number of existing provisions. The new research and development credit extension and simplified method will be particularly helpful to start-up technology companies, which very often are S corporations. The work opportunity credit extension and the allowance of worker certification after the employment period commences will also be helpful for small businesses. Two other changes that may affect some S corporations were the extension of Sec. 198 environmental remediation for two more years and, for the same time period, extension of the qualified leasehold and restaurant improvements favorable amortization rules under Sec. 168.
At the entity level, an S corporation generally does not have to worry about the AMT, but its shareholders definitely do. The new 2006 tax law allows 20% of mature minimum tax credits (MTCs) (i.e., older than three years) to be refundable credits if the taxpayer’s adjusted gross income (AGI) is below $234,600 (married filing jointly) and $156,400 (single) beginning in 2007 and ending in 2012 (see Sec. 53(e)). This will be an area of immediate tax planning for S corporation shareholders. See The Tax Adviser (October 2007), p. 579, for more on this issue.
The IRS (in IR-2007-37 (2/20/07)) listed a dozen tax scams for 2007, and no S corporation issues were on the list. However, in May 2007, the IRS issued new Appeals Settlement Guidelines that expand on Notice 2004-30,53 attacking the donation of S stock to a tax-exempt organization in which the shareholders retain the economic benefits of the company activity through issued warrants but allocate the income to the nonprofit. The guidelines list several issues, including disregarding the S stock transfer as a sham, arguing the creation of more than one class of stock due to the warrants being “in the money,” etc.
In addition, on June 6, 2007, the IRS issued IR-2007-113, noting that it is in the final stages of completing an S corporation research project, based on audits of 5,000 S returns for tax years 2003 and 2004. In the same release, the Service also announced that it will implement a new National Research Project that will extensively audit 13,000 randomly selected 2006 individual tax returns, which will include S passthrough K-1 information.54 Taxpayers whose returns are selected will be notified in October 2007. It is interesting to note that the audit rate for S corporations was .38% of returns filed for fiscal year 2006 (compared with .19% for 200455). This is very similar to partnership audit rates of .36% and .26%, respectively, and contrasts with small C corporations with audit rates of .8% and .32% for those years.
Sec. 1374 Built-In Gain Tax
With many companies having converted from C to S status, one of the more important and complicated provisions that needs to be addressed and planned for is the Sec. 1374 built-in gain (BIG) tax rules. This year, the Service issued a ruling that contains a potentially interesting tax planning technique. Letter Ruling 20064401356 involved a commercial and residential real estate management and development C corporation that switched to S status and, within the 10-year recognition period, gave BIG appreciated real estate to a charitable remainder unitrust (CRUT). The ruling held that the S corporation was not subject to BIG treatment on either the contribution or the sale of the property by the trust. The trust corpus was converted to stocks and bonds, and the annuitant was to receive interest and dividends. The ruling further held that the trust’s annuity income attributed to the S corporation was not subject to Sec. 1374. The corporation would recognize BIG treatment only if the CRUT had sold some BIG property and the corporation had received distribution of the corpus. Potentially, this allows charitably minded S shareholders to substitute their passthrough entities’ charitable contribution for their own and so avoid the onus of the double tax on BIG income.
Letter Ruling 20072502757 addresses the 10-year recognition period issue that sometimes arises.
Example 2: H Corp., an existing C corporation, switched to S status in year 2. In year 4, H formed a new corporation, S, to conduct business, including some BIG assets transferred from H. A proper and timely QSub election was made for S. In year 6, the S shareholders formed B, a holding company that would own stock of both H and S. A QSub election was made for H.
Normally, under Sec. 1374(d)(8), there would be a fresh recognition period for a carryover-basis asset. Because all of these assets were in the same corporate arrangement and just moved around within legal entities, the ruling held that the 10-year holding period for S would include the years that it was held by H. Thus, at the date of S’s incorporation (year 4), it would have 8 rather than 10 years remaining under the 10-year recognition period. Similarly, B would have 6 years remaining, rather than starting again on the tolling of the 10-year period. Obviously, this ruling is very beneficial to taxpayers.
Sec. 199 Domestic Production Activities Deduction
Treasury issued Rev. Proc. 2007-3458 under the authority of Temp. Regs. Secs. 1.199-5T(b)(1) and (c)(1), which allows S corporations (and partnerships) to elect at the entity level certain optional methods for cost allocation related to Sec. 199, including choosing between and applying the Sec. 861, simplified deduction, or small business overall methods. W-2 wages and qualified production activities income may also be computed at the entity level.
ESOP Ownership of S Corporations
Final employee stock ownership plan (ESOP) regulations (TD 9302) were issued on December 19, 2006, regarding Sec. 409(p), which for the most part adopt and slightly modify the 2004 temporary regulations issued under TD 9164. The final regulations are effective for plan tax years after 2005. In particular, a right of first refusal will not generally be treated as synthetic equity if it is not deemed a second class of stock under the Sec. 1361 regulations. The final regulations also clarify the family attribution rules’ application.
Losses and Limitations
A major motivation for a corporation choosing S status is the ability to flow entity-level losses through to its shareholders. For tax year 2003, 37% of all S corporation tax returns filed reported a loss. There are several hurdles that a shareholder must overcome before losses are deductible, including Sec. 183 (hobby loss), Sec. 1366 (adjusted basis), Sec. 465 (at-risk), and Sec. 469 (passive activity loss) rules. Several recent cases and rulings involved these loss limitations.
Section 183 Hobby Loss
In Topping,59 a designer of horse barns and homes for wealthy equestrian families also raised, rode, and showed horses, which was reflected on two separate Schedule Cs. The issue was whether these two activities (building design and horses) were a single undertaking or multiple activities. The court held that they were an integrated activity, given their organizational and economic interrelationships, and that the horse activity was therefore not a hobby loss. In these situations an S corporation might have been used to better integrate the two activities.
As discussed in the 2006 S corporation current developments article (The Tax Adviser (November 2006), p. 670), the Brooks case60 involved open-account debt. Specifically, two brothers owned 50% and 49% of an S corporation and lent it money on open account.61 In 1997, the brothers advanced $1 million to the corporation, and, in January 1999, it repaid the advance. On December 31, 1999, the brothers advanced $1.6 million, which the corporation repaid on January 3, 2000. On December 29, 2000, the brothers advanced $2.2 million. Thus, at the end of any given year, the shareholders had basis in the loans so that they could deduct the S corporation’s losses.
The IRS maintained that the debt repayments should be treated separately, like notes, so that the repayment resulted in income to the brothers at the time of the repayment, when the loan basis was zero. The court held that there was no income recognition required because the loans were open advances.
With the verdict in this case in mind, Treasury has issued a proposed regulation that would limit open-account debt amounts to $10,000. Interestingly, it was not issued as a temporary regulation. It is not clear how the $10,000 limit was determined. It may be from Sec. 7872(c)(3), which requires imputing of interest income and expense between the parties if loans are interest free, or from the short-term unwritten-advances safe harbor related to a second class of stock (per Regs. Sec. 1.1361-1(l)(4)(ii)(B)).
Guarantees and Co-borrowing
It is clear from the consistent holdings of various courts that guarantees or co-borrowing will not give rise to basis for loss under the economic outlay concept adopted by the courts. Maloof 62 is the latest appeals court decision upholding this concept.
In Gleason, 63 the taxpayer had unreported income that was taxable but also increased the shareholder’s basis for loss and distributions. Because distributions were made that year, the character of the distribution under Sec. 1368 was held to be a return of capital, not taxable income. Significantly, the back-to-back loan strategy of the taxpayer and bank was honored.
Proof of Adjusted Basis and Other Issues
Several cases this year dealt with proof of adjusted basis for loss purposes. In Ellinger, 64 the taxpayer could not provide proof of its stock and debt basis, so its losses were disallowed. In Alpert, 65 the Sixth Circuit affirmed a district court holding that denied an S shareholder an increase of basis for cancellation of indebtedness income and questioned in which year the events occurred. In Wright, 66 just about anything that should not be done was done, resulting in fraud penalties. Among other problems, the taxpayer failed to report entity-level income, failed to report distributions greater than shareholders’ basis, and had offshore bank accounts with suspicious activities.
The use of S corporations also minimizes self-employment taxes. In Arnold, 67 one taxpayer was an accountant and tax practitioner and the other was a real estate agent. Each had set up an S corporation to which they assigned their income and took no salary from their corporations. The court found the assignments invalid; there was no contract with the entities, the income was not earned by the entities, and the taxpayers never acknowledged to their clients that they worked for an entity other than themselves. Self-employment tax was therefore imposed on the two individuals’ net earnings. This IRS line of argument counteracts a scheme similar to the Radtke 68 line of cases, but with a more dramatic and drastic result.
Kosinski 69 is a fascinating tax fraud case that exhibits ingenuity in taking a noncash business and making it into a cash business in which costs of goods sold are manufactured to decrease S corporation income and money is pocketed in three different ways. The case involved an employee of a large public company who could decide which contractor received million-dollar construction projects and wanted to be influenced with cash payments, a commission agent who had the contact, and a contractor who did the work. The latter two parties received checks, and $9,500 in cash (just under the $10,000 bank reporting requirement) was siphoned off. These cash payments totaled millions of dollars. It is instructive because the taxpayers tried to blame their CPA preparer for their improper treatment (but were unsuccessful).
Because of the increased use of S corporations and the flexibility engendered by the QSub disregarded-entity rules, there was significant merger and acquisition activity involving S corporations.
Rev. Rul. 2007-8 deals with the overlap between an A, C, or D reorganization and Sec. 351, particularly when there may be liabilities greater than basis involved. In the ruling, Treasury gave two examples to show that the reorganization sections override the incorporation section and that even if there are liabilities greater than basis, no gain will be recognized. The first situation is a fairly common S transaction in which a shareholder owns two corporations in a brother-sister setup and wants to change to a parent-subsidiary relationship. The target corporation’s adjusted basis in its assets is less than the liabilities, but their fair market value is higher. The ruling held that Sec. 357(c) does not apply.
The second situation involves an A reorganization, in which 50% cash and 50% stock are given to the target’s shareholder and the merger occurs under state law provisions. The acquiring corporation shareholder also contributes property for stock in the subsidiary to maintain a controlling interest. Once again, the assets’ adjusted basis is below its liabilities, but the ruling holds that the reorganization rules override the Sec. 357(c) rules, and no gain is recognized.
Similarly, there is a potential overlap between a qualified stock purchase (QSP) and a tax-deferred reorganization. Regs. Sec. 1.338(h)(10)-1 was issued on July 5, 2006, and is effective for transactions after that date. The regulations provide that the step-transaction doctrine will not be involved when a Sec. 338(h)(10) liquidation occurs after a QSP and that the tax-deferred reorganization rules will not apply. However, the step-transaction doctrine will apply when a Sec. 338(g) transaction occurs.
In another overlap case, Letter Ruling 20071801470 involved an S corporation that merged under state law into a limited liability company (LLC) and elected under the check-the-box rules of Regs. Sec. 301.7701-3 to be treated as a corporation. The shareholders received LLC member interests for their S stock, and no boot was involved. This transaction involved the overlap of an A and an F reorganization. The ruling held that this transaction should be treated as an F reorganization and that no gain or loss would be recognized to the corporation or the shareholders. It went on to state that, under Rev. Rul. 73-526, the new entity should use the same taxpayer identification number as the former entity. It also stated that the LLC agreement would be a governing provision for purposes of determining if there was more than one class of stock.
In Letter Ruling 200701017,71 the sole shareholder of an S corporation formed a holding/parent company by contributing all the shares to a newly formed entity, and it elected QSub status for the subsidiary and S status for the holding company. The S corporation then transferred assets from the QSub to the parent company that it wanted protected from the potential liabilities of the subsidiary business. The IRS held that this was a valid F reorganization.
Letter Ruling 20070302672 granted a purchasing S corporation a 45-day extension on its Sec. 338 election involving five controlled foreign corporation targets.
In Letter Ruling 200728039,73 the government permitted zero basis to be allocated to future contingent payouts on an installment sale of S corporation assets. The contingent payout was shown to be unlikely to be received in the contractual next two years. A 65% increase in earnings before interest, depreciation, taxes, and amortization in the buyer’s and seller’s combined business activity was required before any of the contingent selling price was due. The allocation of zero basis was permitted under Regs. Sec. 15A.453-1(c)(7)(ii). The ruling held that for purposes of the Sec. 453A deferred tax interest charge (which is imposed at the shareholder level if the outstanding installment payments at year end exceed $5 million), the amount of the earnout expected to be received (in this case, $0) will be treated as the face amount of the installment obligations.
In a trap for the unwary that should be avoided, Letter Ruling 20062800874 involved a forward triangular cash merger of two S corporations into a disregarded entity and resulted in the double gain scenario depicted by Rev. Rul. 69-6. The target S corporations were treated as though they had sold their assets on both the merged assets and the distributed assets, which potentially could trigger Sec. 1374 tax and the S shareholder’s recognition of gain (as well as any additional gain on the deemed liquidation of the two S corporations).
Another interesting development this year is exhibited in TD 9330,75 in which Treasury stated that deferred prepaid income76 is not eligible for net unrealized BIG treatment under Sec. 382. Prepaid income is defined as the situation in which cash is received before the change date but the activity performed occurs after the change date. Temp. Regs. Sec. 1.382-7T applies in several ways to S corporations. First, because net operating losses and other tax attributes may be used to offset Sec. 1374 taxable income, a change in ownership will affect the computation of the Sec. 1374 tax. Second, it affects which election a taxpayer makes (Sec. 338 or Sec. 1374) in using BIGs. Third, it would solidify the position that prepaid income is not included when computing Sec. 1374 net unrealized BIG and thus reduce exposure to the BIG tax for applicable taxpayers.
This year in the S corporation context, the most common reason for a split-off was to allow key employees or new investors to buy stock. In Letter Ruling 200716017,77 an S corporation owned a C corporation that the owners wanted to convert to a QSub. A key employee of the C corporation wanted to own stock in the controlled corporation but would be unable to under the QSub rules. Therefore, the owners arranged a split-off under Sec. 355 and elected to convert the C corporation to an S corporation, in which the employee immediately bought shares. The controlled corporation had provided services to the controlling corporation but also to third parties both before and after the corporate division.
Similarly, in Letter Ruling 200722002,78 the S corporation taxpayer formed Controlled Corporation with assets of one of two businesses it owned and conducted a divisive D split-off to cut costs and diffuse conflicts among shareholders. Both Distributing and Controlled were S corporations immediately after the corporate division.
Editor’s note: Dr. Karlinsky is a member of the AICPA Tax Division’s S Corporation Taxation Technical Resource Panel (TRP). Dr. Burton is a member of the AICPA Tax Division’s Partnership Taxation TRP.
50 This is accomplished by making the WOTC a “specified credit” under Sec. 38(c)(4)(B). The specified credits are not subject to the limit on the general business credit in Sec. 38(c)(1).
51 This assumes that the children aged 19–23 are not married. If they are, then the new expanded kiddie tax will not apply.
52 Tax Relief and Health Care Act of 2006 (P.L. 109-432), Pension Protection Act of 2006 (P.L. 109-280), and Tax Increase Prevention and Reconciliation Act of 2005 (P.L. 109-222).
53 See Karlinsky & Burton, “Current Developments (Part I),” 35 The Tax Adviser (October 2004): 637.
54 For more on this, see Carlton, Tax Practice & Procedures, “IRS Announces New Approach to the National Research Program,” 38 The Tax Adviser (October 2007): 616.
55 2006 Data Book, Publication 55B, March 2007; IR-2007-63.
56 IRS Letter Ruling 200644013 (11/3/06).
57 IRS Letter Ruling 200725027 (6/22/07).
58 Rev. Proc. 2007-34, 2007-23 IRB 1345 (5/11/2007), effective for tax years beginning after May 11, 2007.
59 Topping, TC Memo 2007-92.
60 Brooks, TC Memo 2005-204.
61 Under Regs. Sec. 1.1367-2(a), shareholder advances not evidenced by separate written instruments and repayment on the advances are referred to as open-account debt and are treated as a single indebtedness.
62 Maloof, 456 F3d 645 (6th Cir. 2006).
63 Gleason, TC Memo 2006-191.
64 Ellinger, 470 F3d 1325 (11th Cir. 2006).
65 Alpert, 481 F3d 404 (6th Cir. 2007).
66 Wright, TC Memo 2007-50.
67 Arnold, TC Memo 2007-168.
68 Radtke, 895 F2d 1196 (7th Cir. 1990).
69 Kosinski, TC Memo 2007-173.
70 IRS Letter Ruling 200718014 (5/4/07). See also Letter Rulings 200719005, 200719006, and 200719007 for similar holdings.
71 IRS Letter Ruling 200701017 (1/5/07).
72 IRS Letter Ruling 200703026 (1/19/07).
73 IRS Letter Ruling 200728039 (7/13/07).
74 IRS Letter Ruling 200628008 (7/14/06).
75 TD 9330 (6/14/07), adding Temp. Regs. Sec. 1.382-7T.
76 Received, for example, under the provisions of Rev. Proc. 2004-34 or Sec. 455.
77 IRS Letter Ruling 200716017 (4/20/07).
78 IRS Letter Ruling 200722002 (6/1/07).