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During the period of this S corporation tax update (July 9, 2009–July 9, 2010), numerous developments occurred in the area of S corporation taxation. This two-part article discusses recent legislation, cases, rulings, regulations, and other developments in the S corporation area. Part I covers new tax laws, court cases, regulations, revenue procedures, and rulings on various S corporation operating provisions.
Zero Capital Gain Rate in 2009 and 2010
The potential zero capital gain rate for 2009 and 2010 continues to be an attractive tax planning tool that may affect S corporations and their shareholders’ behavior. Because the capital gain tax rate for individual taxpayers in the lower two tax brackets is zero in 2009 and 2010, 1 many taxpayers are (or were) gifting appreciated S corporation stock to their children, grandchildren, or parents. In 2008, the tax law extended 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 students 2 and do not provide more than half of their own support. 3 Thus, the 0% tax rate generally will not be available to students through age 23 unless they have significant earned income or possibly trust fund 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% self-support test but not so much that they exceed the first two bracket limits ($34,000 for single taxpayers in 2010), including the capital gains generated. (The parents will also lose the dependency exemption.)
Example 1: 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 March 2010, C’s parents give him stock worth $26,000, with a basis of $6,000 and a holding period of at least one year. He has a standard deduction and personal exemption that puts his 2010 taxable income in the first two tax brackets. Assuming that C sells the gifted stock in 2010, 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 × 15%).
Example 2: The taxable income limit for the first two brackets for a married couple in 2010 is $68,000. Couple A and B, who are retired, defer pension distributions and invest primarily in tax-exempt bonds, and they live off the interest. Their S corporation Schedule K-1 shows ordinary income of $40,000, and they receive distributions of $50,000 during the year. They have itemized deductions of $30,000. Their net ordinary income is $10,000 ($40,000 – $30,000). Therefore, if they recognized $200,000 in capital gains or dividend income through the S corporation or otherwise, $58,000 of the gain would be subject to a 0% tax rate. The other $142,000 would be subject to the normal 15% tax rate. This results in a federal tax savings of $8,700.
IRS Audit Rates and NRP Studies
The IRS released its yearly statistical report that includes details about its audit rates from the last quarter of 2008 through the first three quarters of 2009. In addition, the IRS has released preliminary information about the National Research Program (NRP) regarding S corporations audited for tax years 2003 and 2004 and has announced a new NRP on compensation, independent contractors, etc., relative to S corporations.
IRS Audit Rates
To put S corporations and their individual shareholders’ audit rates in perspective, it helps to see what other business entities’ audit rates are. For the audit period October 1, 2008–September 20, 2009, the results were generally slightly lower than the prior audit period, with the exception of Schedule Cs with more than $200,000 of gross revenue, which was significantly higher. For C corporations with less than $10 million of assets, the audit rate was 0.9%, while those with more than $10 million of assets were audited 14.5% of the time. This is to be contrasted with S corporations and partnerships, which had a 0.4% audit rate. For individual tax returns, 1.4 million out of 154 million filed were audited, for a less than 1% audit rate. Farm activity was audited at a 0.3% rate, while Schedule C businesses with less than $25,000 in gross receipts were audited at a 1.1% rate. Those Schedule C businesses with $25,000 to $100,000 in gross receipts were audited 1.9% of the time, those with $100,000 to $200,000 in gross receipts were audited at 4.2%, and those over $200,000 at 3.2%.
NRP on S Corporations
At an IRS Tax Research Conference (July 8–9, 2009), the preliminary results of the National Research Program on S corporations, which audited 1,200 S corporations for tax year 2003 and 3,700 for tax year 2004, were reported. The program found 12% underreporting for 2003 and 16% for 2004. It also discovered that small S corporations (defined as having less than $200,000 in assets) had a higher percentage of underreporting than large S corporations. The results showed that this underreporting mirrored underreporting by Schedule C businesses.
New NRP on Wages and Self-Employment Taxes
Tax advisers should be aware of a new NRP being planned for 2010–2012 (2,000 returns per year) that will focus on employment status: employee vs. independent contractor, reasonable compensation, S corporation distributions vs. salary, and matching taxpayer identification numbers. Of the 2,000 returns, 1,500 per year will be from the Small Business/Self-Employed (SB/SE) division. The program began in February 2010.
The Watson case 4 represents exactly what the government is trying to ferret out with this new NRP. A seasoned professional (in this case an accountant) worked 35–40 hours per week, 46 weeks a year, but took a salary of only $24,000. In addition, he distributed more than $200,000 in cash to himself. This taxpayer behavior echoes a long line of cases going back to Radtke, 5 Spicer Accounting Corp., 6 Joseph M. Grey Public Accountant, 7 etc., in which the taxpayers all failed in their attempts to avoid paying Social Security taxes by undercompensating themselves and taking the money out as distributions. Unfortunately this behavior, especially given the current situation of serious budget deficits and Congress hunting for revenue sources, has led to a serious threat to an advantage S corporations have over partnerships.
Having a much larger possible impact on S corporations is a provision that was embedded in various versions of tax extender legislation that would subject certain S shareholders to self-employment (SECA) taxes on their pro-rata share of S income or loss (other than, for example, interest, dividends, capital gains, or real estate investments). The provision would apply to S corporations that are principally partners in partnerships that are in a professional service trade or business if substantially all the S corporation activity is conducted by the partnership. It would also apply to an S corporation engaged in a professional service business if the principal asset of the business is three or fewer employees’ skills and reputations. The definition of a professional service business is much broader than existing law defines it. It includes the normal professions of medicine/health, law, accounting, engineering, architecture, and actuarial services and expands it to include lobbying, performing arts, athletics, investment advice, and management or brokerage services as well as consulting. The effective date of this provision, if enacted, would be tax years beginning after December 31, 2010. This provision also attributes the pro-rata share of income or loss of any relative defined in Sec. 318(a)(1) to the professional service provider. Such relatives include a spouse, parent, child, or grandchild.
Example 3: D, a doctor, owns 4% of an S corporation medical practice, and C, his son (a nonphysician), owns 40%. The other 56% is owned by two other doctors. Because 60% of the assets are related to three or fewer owners’ skills, this S corporation is considered a “disqualifying S corporation” subject to these proposed new SECA rules. No matter how fair the salaries were in the past, beginning in 2011 C’s pro-rata income would be attributed to D for SECA purposes (but not for income tax purposes).
Proposed Tax Return Disclosures
On January 26, 2010, IRS Commissioner Douglas Shulman made a surprise announcement that for large and mid-size business (LMSB) entities (more than $10 million in gross assets), for tax returns in tax years beginning in 2010, 8 the business entity will need to disclose uncertain tax position information. This proposal was supposed to include S corporations; however, only S corporations that have built-in gains tax, excess net passive income tax, or questionable S status would have been subject to these rules. 9 The friction between substantial authority (40% probability) to sign a tax return by a preparer and the more-likely-than-not (greater than 50%) criterion of FIN 48 10 will obviously cause issues between auditors and their clients as well as between the IRS and the company’s representative. There may be more spin-offs to avoid LMSB status. However, for now the new Schedule UTP does not need to be filed by S corporations. 11
Due Dates of Flowthrough Entity Tax Returns
Calendar-year extended partnership and trust tax returns for 2009 were due September 15, 2010. The AICPA is petitioning Treasury and Congress to modify original due dates and extensions relative to passthrough entities to make the busy season a bit more sane and logical. Under this proposal, calendar-year partnership returns would be due March 15, with extensions due September 15. The theory is that many other entities require the Schedule K-1 from partnerships to file their own returns. Calendar-year S corporation returns would be due March 31, with an extension to September 30. Trust returns would be due April 15, with extensions due September 30. Individual and C corporation returns are proposed to be due April 15 and October 15. However, these changes are just proposals at this point. Any change to the original due dates requires congressional action, but changes to extension dates are the prerogative of Treasury.
Health Care Legislation
The health care legislation 12 effective in 2013 requires an additional 0.9% Medicare tax on employees (but not employers) on the combination of wages and self-employment income that exceeds $250,000 (married taxpayers filing jointly) or $200,000 (single taxpayers). 13 There is no self-employment deduction for this amount as it is an employee burden. Payment of estimated taxes would be required.
In addition, the new law imposes a post-2012 3.8% Medicare tax on the lesser of net investment income or modified adjusted gross income (AGI) greater than $250,000 (married taxpayers filing jointly) or $200,000 (single taxpayers). 14 Again, estimated taxes would be due on this amount. This brings up several issues about what constitutes investment income: Rental and royalty income? Yes. Capital gains, interest, dividends, and annuities? Yes. S corporation and partnership income? Only for passive investors in an active trade or business. Tax-exempt income? No, because this concept is based on gross income. Pension plan distributions? No. 15 These rules will apply to individuals, trusts, and estates. 16
Example 4:
H and W have $1 million in wages, $150,000 in
net investment income, and modified AGI of $900,000 in 2013.
They will owe an additional $6,750 ($750,000 × 0.9%), plus
3.8% × the lower of $150,000 or ($900,000 – 250,000) =
$5,700. Thus, the total tax increase would be $12,450.
Example 5: J and M, a married couple, have a combined self-employment income and salary of $230,000, net investment income of $40,000, and modified AGI of $260,000 in 2013. They will owe no additional salary tax because their earned income is below $250,000. They will owe net investment income tax to the extent of the lesser of $40,000 or $10,000 (260,000 – 250,000); $10,000 × 3.8% = $380.
HIRE Act
The HIRE Act 17 extended to 2010 the increased $250,000 limit on the amount of the Sec. 179 expense deduction and the $800,000 phaseout threshold for the deduction. Interestingly, it did not extend the 50% bonus depreciation. It also provided a payroll (Social Security) tax holiday for employers for each new nonrelated hire that has been unemployed 60 days or longer. 18 As an additional sweetener, if the employee continues to be employed for 52 weeks, there is a $1,000 credit. 19
Other S Corporation Current Operating Developments
Losses and Limitations
A major motivation for a corporation choosing S status is the ability to flow entity-level losses through to its shareholders. There are several hurdles 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 court cases and rulings were issued relative to these loss limitation rules.
To nobody’s great surprise except the taxpayer, guaranteeing a loan does not create basis for purposes of deducting an S corporation loss until the shareholder fulfills the guarantee. In Weisberg, 20 the shareholders argued increased basis, and the court not only disallowed the loss but imposed Sec. 6662 penalties, stating that there was no substantial authority—or even reasonable basis—and there clearly was no good-faith position.
In a clever attempt to increase basis for loss, two brothers tried a unique strategy. 21 They made a capital contribution of $1.4 million to their S corporation and argued that this contribution was tax-exempt income under Sec. 118 and therefore increased their basis in debt. They then paid off that debt, the basis of which had been reduced by entity-level losses. By increasing their basis in the debt, the brothers argued, they should not be taxed on the note repayment. Neither the Tax Court nor the Second Circuit allowed the capital contribution to increase their basis in the debt.
Penalties for Nontimely Filing of Form 1120S or Missing Information
In what will probably be a surprise to many tax practitioners, the Mortgage Forgiveness Debt Relief Act of 2007 22 enacted a new provision that imposes a penalty of $85 per shareholder per month (not to exceed 12 months) if the S corporation does not timely file its corporate return or fails to provide information required on the return. 23 The law is effective for 2007 Forms 1120S, U.S. Income Tax Return for an S Corporation, 24 and is imposed on the S corporation. For returns required to be filed after December 31, 2008 (2008 Forms 1120S), the penalty was raised to $89 per shareholder per month. 25 The Worker, Homeownership, and Business Assistance Act 26 (signed into law on November 6, 2009) upped the Sec. 6699 penalty to $195 beginning for late filing or nondisclosing S corporations in 2011.
For purposes of computing the amount of the penalty, shareholder husbands and wives count as two; the act counts the sale or gifting by one shareholder to another as two different shareholders. It is unclear how it would treat community property state ownership where actual ownership may be in one person’s name.
Example 6: H and W and their two children own all the stock of XYZ Corp. In October 2009, the two children gift some stock to their spouses. In 2010, the S corporation forgets to include the distribution amount on the Schedules K and K-1 on the 2009 Form 1120S. The S corporation could be liable for a penalty of $6,408 ($89 × 6 × 12) for this innocent mistake.
What is particularly disturbing about this provision is that, in the authors’ experience, rarely if ever is the date of distributions included on Schedule K and related K-1s. Yet according to Secs. 6037(a) and (b), this information is supposed to be reported to the government and the shareholders.
Built-in Gain Tax Holiday
The American Recovery and Reinvestment Act of 2009 27 enacted Sec. 1374(d)(7), which has somewhat reduced the stress and impact of Sec. 1374 for 2009 and 2010. This provision exempts Sec. 1374’s built-in gain (BIG) tax from being imposed if the S corporation is in its eighth, ninth, or tenth year of the recognition period. Nonetheless, there are some tax planning or unanswered questions that need to be considered. For example, if an installment sale of BIG property occurred in a prior year, it may be advisable to recognize the gain in 2009 or 2010, assuming it qualifies as an eligible year. It may even be prudent to trigger the installment gain by using the installment note as collateral for a loan.
If the taxpayer’s net recognized BIG is limited by taxable income in its eighth recognition period year (2009) and in 2011 it is subject to BIG, is the 2009 suspended gain forgiven or subject to Sec. 1374 tax? There also seems to be a difference between which years qualify as eighth, ninth, or tenth for Sec. 1374 vs. the carryover basis rules of Sec. 1374(d)(8). For the former, tax year seems to be the criteria, so in switching from a C fiscal year to an S calendar year a corporation may have had a short tax year. For the carryover basis provisions, the law seems to look to 12-month periods. Former House Ways and Means chair Charles Rangel introduced a technical correction bill 28 to make the rule 12-month periods, but it has not been enacted.
What if a taxpayer sold an asset in 2009 or 2010 on an installment basis that would be covered by these rules but recognized gain in 2011? It may be prudent in this situation to elect out of the installment sales treatment to avoid the potential double tax in 2011 and beyond. Since the BIG installment sales rules actually allow double tax treatment beyond the 10-year recognition period, by treating the installment gain as recognized in the year sold, this logic may help to include the 2010 gain as covered by the tax holiday. Nonetheless, it would be helpful to have some guidance from Treasury.
Ringgold Telephone Co. 29 dealt with a C corporation that converted to S status on January 1, 2000. It appraised a significant partnership interest asset at $2.6 million at the date of conversion. Seven months later, it sold the interest for $5 million. The issue was how much of the gain was built-in gain, with the government arguing that the sale for $5 million so soon after the conversion must be the value at the date of conversion. The taxpayer argued that it received a fair valuation at the date of conversion and that the $2.4 million appreciation in the asset occurred after the conversion. The Tax Court made a Solomon-like decision and split the baby in half by valuing the asset at the date of conversion at $3.7 million. The court ruled that a recent sale would normally help determine the true value, but in this case the buyer had made a strategic acquisition and avoided some right of first refusal terms that motivated the buyer to pay a premium. The court held that his premium should not be included in the date of conversion value.
LIFO Recapture
Letter Ruling 201010026 30 presents an unusual fact pattern. A sole proprietor on the LIFO inventory method incorporated as an S corporation that will use the LIFO inventory method. Is the S corporation subject to Sec. 1363(d) LIFO recapture? The answer is no because there was no avoidance of the Sec. 1374 BIG tax, as the sole proprietor was subject to only one tax in the first place.
Banks and Sec. 291(a)(3)
When a corporation converts from C to S status, it needs to be aware of the impact of Sec. 291. This provision is a carryover from the old corporate add-on minimum tax days, but it still applies today. For example, Sec. 291(a)(1) requires an S corporation that sells real estate within three years after converting to S status to characterize 20% of the lower of gain recognized or straight-line depreciation as ordinary income.
In Vainisi, 31 a lower court held that Sec. 291(a)(3), which requires a 20% disallowance on interest expense related to tax-exempt income, applies to a qualified S subsidiary (QSub) bank, even more than three years after conversion. The Seventh Circuit overturned the lower court finding and held that Sec. 291(a)(3) applies only for three years after the bank converted from C to S status. 32
Structuring Deals Using ESOPs
In order to sell the Chicago Tribune tax free but still get cash, the owners of a C corporation formed an employee stock ownership plan (ESOP) and sold at least 30% of the stock to the trust under Sec. 1042. 33 As long as the sellers reinvested the proceeds in publicly traded stocks and bonds, they would not recognize the realized gain on the sale to the ESOP. The buyers then converted the C corporation to an S corporation, where the income allocated to the ESOP would not be taxable. However, tax professionals should be aware of the Sec. 409(p) rules when dealing with S corporation ESOPs, which limit the ownership of plan assets by certain disqualified persons.
IC-DISC Tax Rate Arbitrage
Most practitioners are aware that in the right situation (investment interest expense being less than net investment income), there can be a tax planning opportunity of increasing investment interest expense and investing in dividend-paying stocks to play the tax rate differential. Less well known is utilizing an interest charge domestic international sales corporation (IC-DISC) to net the same results for companies that produce products in the United States (more than one-half) but sell them overseas.
IRS statistics 34 show an increase in the number of IC-DISCs from 2004 (425 taxpayers) to 2006 (1,209 taxpayers), and gross revenue increased from $5.3 billion to $19.3 billion in that time. Considering that there are over 4 million S corporations, obviously a very small percentage is taking advantage of these provisions.
Essentially the IC-DISC receives commissions based on the greater of 50% of net export income or 4% of gross revenue. Dividends to the shareholder qualify for the Sec. 1(h) 15% tax rate, and the producing entity corporation gets a deduction at 35%. To sweeten the deal, the producing entity (if eligible) can use the Sec. 199 domestic production activities deduction as well.
QSubs and Foreign Corporations
Reflecting the increased sophistication and complexity for which S corporations and their disregarded subsidiaries (QSubs) are being used is a series of 14 private letter rulings issued in 2010 dealing with 6 QSubs, a foreign partnership, and 15 foreign corporations. 35 The rulings dealt with whether an S corporation could make a qualified election fund (QEF) election under Regs. Sec. 1.1295-3(f) for a private foreign investment company (PFIC) retroactively. In each ruling, the IRS granted the taxpayer consent to make a retroactive QEF election with respect to the foreign corporation because the taxpayer satisfied the rules under Regs. Sec. 1.1295-3(f). The IRS determined that:
- The taxpayer had reasonably relied on a qualified tax professional;
- Granting consent would not prejudice the government’s interests;
- The request was made before the IRS raised the PFIC status of the corporation; and
- The taxpayer satisfied procedural requirements.
Corporate Division
The flexibility engendered by the QSub disregarded entity rules generated merger and acquisition activity involving S corporations. In one ruling, an S corporation wanted to simplify its corporate structure and reduce some administrative costs, so it wished to merge a disregarded entity into the S corporation. 36 However, for various contractual and legal reasons the S corporation could not do an upstream merger. So instead it did a downstream merger into its QSub in an A reorganization. 37 The IRS treated this transaction as an F reorganization. 38 Adjusted basis of the shareholders’ stock, accumulated adjustments account, and basis in assets would all stay the same.
Another letter ruling discusses the proper treatment of an S corporation QSub split-off. 39 Interestingly, a D reorganization 40 was required because the disregarded entity did not count as preexisting. The business reason for the split-off was key employee incentives, and—a bit unusual for an S corporation without shareholder disputes—the transaction was non–pro rata.
Part II of this article, in the November issue, will focus on eligibility, elections, and termination issues.
Footnotes
2 This assumes that the children aged 19–23 are not married. If they are, the new expanded kiddie tax will not apply (Sec. 1(g)(2)(C)).
4 David E. Watson, P.C., No. 4:08-cv-442 (S.D. Iowa 5/27/10).
5 Radtke, 895 F.2d 1196 (7th Cir. 1990).
6 Spicer Accounting Corp., 918 F.2d 90 (9th Cir. 1990).
7 Joseph M. Grey Public Accountant, P.C., 119 T.C. 121 (2002).
8 Announcement 2010-9, 2010-7 I.R.B. 408.
9 This is because FIN 48 disclosures would apply only to income taxes imposed at the entity level. Announcement 2010-30, 2010-19 I.R.B. 668, makes it clear, as do the draft Schedule UTP instructions, that S corporations are not yet subject to the uncertain tax position disclosure reporting.
10 Financial Accounting Standards Board (FASB) Interpretation No. 48, Accounting for Uncertainty in Income Taxes, codified in FASB ASC topic 740-10.
11 Schedule UTP, Uncertain Tax Positions Statement, draft instructions, which specify that the schedule is to be used only with Forms 1120, 1120-F, 1120-L, and 1120-PC.
12 Patient Protection and Affordable Care Act, P.L. 111-148, and Health Care and Education Reconciliation Act of 2010, P.L. 111-152.
17 Hiring Incentives to Restore Employment Act, P.L. 111-147.
20 Weisberg, T.C. Memo. 2010-55.
21 Nathel, No. 09-1955-ag (2d Cir. 6/2/10), aff’g 131 T.C. 262 (2008).
22 Mortgage Forgiveness Debt Relief Act of 2007, P.L. 110-142.
24 S corporation tax returns required to be filed after December 20, 2007.
25 Worker, Retiree, and Employer Recovery Act, P.L. 110-458, §128(a).
26 Worker, Homeownership, and Business Assistance Act of 2009, P.L. 111-92.
27 American Recovery and Reinvestment Act of 2009, P.L. 111-5, §1251.
28 Tax Technical Corrections Act of 2009, H.R. 4169, §2.
29 The Ringgold Tel. Co., T.C. Memo. 2010-103.
30 IRS Letter Ruling 201010026 (3/12/10).
31 Vainisi, 132 T.C. No. 1 (2009), rev’d, No. 09-3314 (7th Cir. 3/17/10).
32 Vainisi, No. 09-3314 (7th Cir. 3/17/10), rev’g 132 T.C. No. 1 (2009).
33 See Knoll, “Samuel Zell, the Chicago Tribune, and the Emergence of the S ESOP: Understanding the Tax Advantages and Disadvantages of S ESOPs,” Scholarship at Penn Law 228 (2008).
34 IRS, Statistics of Income Bulletin 173 (Winter 2010).
35 IRS Letter Rulings 201025005–201025017 and 201025025 (6/25/10).
36 IRS Letter Ruling 201007043 (2/19/10).
37 A merger or consolidation under Sec. 368(a)(1)(A).
38 A “mere change in identity, form, or place of organization of one corporation, however effected” under Sec. 368(a)(1)(F).
39 IRS Letter Ruling 201010023 (3/12/10).
40 A transfer of assets by the corporation in a transaction that qualified under (in this case) Sec. 355 (Sec. 368(a)(1)(D)).
EditorNotes
Stewart Karlinsky is a professor emeritus at San José State University in San José, CA, and a member of the AICPA Tax Division’s S Corporation Taxation Technical Resource Panel. Hughlene Burton is an associate professor in the Department of Accounting at the University of North Carolina–Charlotte in Charlotte, NC, and chair of the AICPA Tax Division’s Partnership Taxation Technical Resource Panel. For more information about this article, contact Dr. Karlinsky at karlin_s@cob.sjsu.edu or Dr. Burton at hughlene.burton@uncc.edu.
