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During the period of this S corporation tax update (July 10, 2010–July 9, 2011), several tax law and administrative changes have affected S corporations and their shareholders. There were some major administrative changes that directly affect S corporations and their tax advisers. One key development is that the potential zero capital gain rate (available since 2008) was extended through 2011 and 2012 and continues to be an attractive tax planning tool that may affect S corporations and their shareholders’ behavior.
Examinations and Information Reporting
Audit Rates
Generally, a smaller percentage of S corporation returns is examined than those of individuals. For individual tax returns filed in 2009 and audited in fiscal year 2010, the coverage rates were generally equal to or slightly lower than in the prior audit period, with the exception of wealthy taxpayers and those filing a Schedule C with more than $100,000 of gross revenue. Basically, the IRS audited 1.1% of filed Forms 1040, with 30% of those audited including an earned income credit. Of individual returns examined in 2010, 78% were correspondence audits. The audit rate was 4.7% for nonfarm business returns with gross receipts of between $100,000 and $200,000 (and no earned income tax credit), up slightly from the previous year’s rate of 4.2%. The IRS audited individual taxpayers with total positive income of greater than $1 million at a rate of 8.4%, up significantly from 6.4% in 2009. S corporation and partnership returns were audited at a much lower overall rate of 0.4%, unchanged from 2009.
Fast Track Settlement Program Extended to SB/SE Taxpayers
Many S corporations are clients of the IRS’s Small Business/Self-Employed (SB/SE) Division (i.e., they have less than $10 million in gross assets). Previously, the Fast Track Settlement Program was generally available only to clients of the Large and Mid-Size Business (LMSB) Division. 1 With Announcement 2011-5 2 issued in late 2010, the IRS expanded the program to include SB/SE taxpayers at IRS offices in eight locations: Chicago, Houston, St. Paul, Philadelphia, central New Jersey, and three California cities: San Diego, Laguna Niguel, and Riverside. This program is intended to facilitate efforts by certain taxpayers and the IRS to resolve factual and legal unagreed issues in open tax years under exam, with an auditor and Appeals together in the same room. The expansion was effective December 1, 2010.
Capital Structure Reporting
Another important administrative change was the January 1, 2011, effective date of Sec. 6045B, which requires any change in the capital structure of a corporation (including S corporations) to be reported within 45 days to the government and by January 15 of the following year to each holder of stock, bonds, or notes (specified securities) or their nominees. 3 The report must describe any organizational action that affects the basis of the specified security, the resulting quantitative effect on the specified security’s basis, and any other information the IRS may prescribe. Notice 2011-18 4 allows taxpayers to delay reporting to the government for organizational actions occurring in 2011 until the IRS issues a reporting form, provided that the corporation informs the government no later than January 17, 2012. Reporting to shareholders is still required on a timely basis.
These rules clearly would cover corporate spin-offs and reorganizations. What is unclear is what other actions affect shareholder basis through the interaction of corporate and individual tax rules in the context of an S corporation. For example, a distribution out of accumulated earnings and profits would presumably not be a covered transaction. But what if the S corporation distributes cash out of its accumulated adjustments account, which clearly affects shareholder basis under Sec. 1368? What if the company distributes appreciated property?
The government recently revised Form W-9, Request for Taxpayer Identification Number and Certification, to better distinguish S corporations from C corporations. This was done because beginning in 2012, under the Sec. 6045 disclosure rules, if a “covered security” (including specified securities acquired through a transaction in the account in which such security is held) is acquired by an S corporation, adjusted basis reporting is required.
Increase in Penalties for Nontimely Filing of Form 1120S or Missing Information
For tax years beginning after December 31, 2009, the Worker, Homeownership, and Business Assistance Act of 2009 5 more than doubled the Sec. 6699 penalty, from $89 to $195 (on top of the increase from $85 before 2009). This penalty applies per shareholder per month (not to exceed 12 months) if the S corporation does not timely file its Form 1120S, U.S. Income Tax Return for an S Corporation, or fails to provide information required on the return. For this purpose, shareholder husbands and wives count as two; the law also counts a 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 only one person’s name.
Example 1: Husband and wife H and W and their two children own all the stock of X Corp., an S corporation. In October 2010, the two children gift some stock to their spouses. In 2011, X forgets to include the distribution amount on Schedules K and K-1 of 2010 Form 1120S. X could be liable for a penalty of $14,040 ($195 × 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 distribution 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. This provision is a trap for the unwary, since anything left off the Schedule K-1, whether intentionally or not, could trigger the penalty.
Uncertain Tax Position Disclosures
On January 26, 2010, the IRS announced that beginning with the 2010 tax year, LMSB entities (those with more than $10 million in gross assets) would need to disclose on their tax returns FIN 48 6 uncertain tax position information. 7 In a subsequent announcement, the IRS increased the initial gross asset threshold for reporting to $100 million, with a phased-in reduction to $50 million starting with 2012 tax years and $10 million starting with 2014 tax years. 8 Before a draft form was issued on April 19, 2010, 9 the proposal was to apply to business taxpayers generally, including S corporations (although only S corporations with built-in gain (BIG) tax or excess net passive income tax or those with questionable S status would have been subject to these rules). However, the final instructions to the new Schedule UTP, Uncertain Tax Position Statement, do not require S corporations to file the schedule.
For corporations to which the requirement does apply, 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 will obviously cause issues between auditors and their clients, as well as between the IRS and companies’ representatives. Some observers are predicting more spin-offs to avoid LMSB status as a result.
Final Regulations
Controlled Groups
T.D. 9522 was finalized on April 8, 2011, and became effective on April 11, 2011. It distinguishes a controlled group under Sec. 1563 from the affiliated group rules of Sec. 1561 and has an important impact on S corporations. Many practitioners believed that because S corporations were defined as “excluded corporations,” two controlled S corporations could each take a maximum Sec. 179 deduction and pass those through to their shareholders. The new final regulations under Regs. Sec. 1.1563-1 make this treatment inadvisable in light of Mayo Foundation for Medical Education and Research 10 (discussed below) unless the contrary tax return position taken is disclosed on the tax return. Basically, the new rules state that S corporations are excluded corporations for Sec. 1561 purposes, such as Sec. 11 tax rates or accumulated earnings tax and the alternative minimum tax (AMT) exemption (which would not apply anyway). However, S corporations are members of a controlled group for Sec. 1563 purposes (see Regs. Sec. 1.1563-1(b)(4), Example (4)), which would also cover Sec. 179, Sec. 41, and other areas of the tax law. The only small ray of hope in this area is that to be a controlled group under these provisions, a company must meet the test of having five or fewer shareholders that own 80% of the stock or its voting power, as well as the 50% identical ownership test.
Due Dates of Flowthrough Entity Tax Returns
The IRS issued final regulations changing the extension due date of calendar-year partnership, trust, and estate income tax returns to September 15. 11 However, the change does not apply to the original due date, nor does it apply to S corporations. The AICPA is petitioning Treasury and Congress to modify both the original due dates and extensions for all passthrough entities, to make the busy tax season a bit more logical. Under the AICPA proposal, calendar-year partnership returns would continue to be due on March 15, with an extension to September 15, because many other entities require the Schedule K-1 from partnerships to file their own returns. Calendar-year S corporation returns would be due on March 31, with an extension to September 30. Trust returns would be due on April 15, with an extension to September 30. Individual and C corporation returns would be due April 15, with an extension to October 15.
New Law
Tax Relief Act
The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (Tax Relief Act) 12 was signed into law on December 17, 2010. It extended the capital gain and dividend 15% tax rates for 2011 and 2012 and extended the AMT patch for 2010 and 2011 ($47,450 for single filers and $72,450 for married filing jointly for 2010). It reduced the Social Security rate for employees and the self-employed for 2011 and extended the suspension of the itemized deduction and personal exemption phaseout for 2011 and 2012. Notably, for assets acquired and placed in service on or after September 9, 2010, and before January 1, 2012, it allows Sec. 168(k) bonus depreciation at 100% instead of the previous 50%.
Zero Capital Gain Rate
Besides extending the 15% capital gain rate, the Tax Relief Act also extended the zero rate for individual taxpayers in the lower two tax brackets. Consequently, taxpayers should consider 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 own support and to 19- to 23-year-olds who are full-time students 13 and do not provide more than half of their own support. Thus, the zero 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 their children legitimately to work for them and pay them enough to meet the 50% self-support test but not so much that they exceed the first two bracket limits ($34,500 in 2011). The parent will also lose the dependency exemption.
Example 2: 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. C is helping his parents with computer work in their business. His total support is $18,000. In May 2011, C’s parents give him stock worth $26,000, with a basis of $6,000 and a holding period of at least one year. C has a standard deduction and personal exemption that put his 2011 taxable income in the first two tax brackets. Assuming that C sells the gifted stock in 2011, he will pay no tax (zero tax rate) on the $20,000 capital gain and the $5,000 dividend income, for a tax saving on the dividend and capital gain (over his parents’ hypothetical tax) of $3,750 ($25,000 × 15%).
The zero capital gain rate can also be advantageous for retired taxpayers whose ordinary income may be within the first two tax brackets and therefore can realize tax savings on gains or dividends from S corporation stock.
Example 3: Couple A and B take the required minimum distribution from their pension, invest primarily in tax-exempt bonds, and 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). The taxable income limit for the first two brackets in 2011 for a married couple filing jointly is $69,000. Therefore, if they recognized $200,000 in capital gain or dividend income through the S corporation or otherwise, $59,000 of the gain would be subject to a zero regular and AMT tax rate. The other $141,000 would be subject to the normal 15% tax rate. This results in a federal tax saving of $8,850.
Small Business Jobs Act
The Small Business Jobs Act of 2010 14 expanded the dollar amount of new or used tangible personal property that a taxpayer may expense in the year placed in service under Sec. 179 to $500,000 for 2010 and 2011. The deduction phases out between $2 million and $2.5 million in property acquired in the tax year. Tax professionals should note that the requirement of sufficient positive business income still applies. If the income (including salary) is not sufficient, a carryforward is permitted. In an expansion of the provision, $250,000 of the $500,000 property acquired can apply to qualified leasehold, retail, and restaurant improvements. This category of assets has a 15-year life, so taxpayers will probably choose to apply Sec. 179 to these assets first. If the income limitation is applied for 2010, this category of asset carryover may be used in 2011, but unless the provision is extended, the carryover may not be used beyond 2011.
Another major change enacted by the Small Business Jobs Act is the ability to carry back eligible small business general business credits, such as research and development or rehabilitation credits created in 2010, for five years instead of the normal one, and they may offset AMT liabilities. An eligible small business includes non–publicly traded corporations (including S corporations), partnerships, and sole proprietorships with less than $50 million in gross receipts in the three years prior to 2010. However, S corporation shareholders and partners of a partnership must meet the gross receipts test as well.
HIRE Act
The Hiring Incentives to Restore Employment Act of 2010 (the HIRE Act) 15 provided a payroll tax holiday 16 from March 19, 2010, to December 31, 2010, for employers for each new nonrelated hire between February 4 and December 31, 2010, that had not been employed more than 40 hours during the previous 60 days or longer. As an additional incentive, if the employee continues to be employed for 52 weeks, the employer receives a credit of the lesser of 6.2% of the wages paid to the retained employee during the 52-week period or $1,000. Because the credit is taken in the first tax year that the 52-week requirement is met, calendar-year taxpayers will take the credit in 2011.
Court Cases and IRS Guidance and Rulings
Basis Overstatement and Statute of Limitation
The IRS and taxpayers in various courts have been dueling for the past few years over whether an overstatement of basis will lead to a six-year statute of limitation rather than the normal three. As of this writing, Intermountain Insurance Service and UTAM Ltd. 17 are the latest in a long line of appellate cases that deal with the Sec. 6501(e)(1)(A) 25% omission of gross income provision allowing the six-year statute of limitation.
With the Supreme Court’s recent Mayo Foundation decision giving greater deference to Treasury regulations, tax professionals should be even more diligent about calculating the basis of S corporation or partnership interests. The Sec. 6501(e) cases have primarily arisen out of the tax shelter area, but they might apply where S shareholders overstate their Sec. 1366(d) basis for loss or overstate their basis when they sell their S corporation shares. It is interesting to note that in recent discussions with IRS S corporation technical advisers at both the SB/SE and LB&I levels, the top three field issues were basis, basis, and basis.
The authors predict that the Mayo Foundation opinion will be game changing. While the subject of the decision—medical residents’ status as students who work versus employees who study—is relatively narrow, the Court’s discussion of the deference due to interpretative regulations is key. Basically, the Court held that it was appropriate to give interpretative regulations the deferential standard employed in Chevron 18 rather than the less deferential standard of National Muffler Dealers Ass’n, Inc. 19 Thus, if the law is silent or ambiguous, the Court held, the regulations should be applied unless they are arbitrary, capricious, or manifestly contrary to the law.
Wages and Self-Employment Taxes
Tax advisers should be aware of the National Research Program the IRS is implementing for 2010–2012 (2,000 returns audited per year), focusing on employee vs. independent contractor status, reasonable compensation, S corporation distributions vs. salary, and matching taxpayer identification numbers. Of the 2,000 returns per year, 1,500 will be SB/SE taxpayers. The program began in February 2010.
The Watson case 20 represents exactly what the government is trying to ferret out with this program. A seasoned accountant worked 35–45 hours per week, 46 weeks a year, but took a salary of only $24,000. He also distributed more than $221,000 in cash to himself. This taxpayer behavior echoes a long line of cases, including Radtke, 21 Spicer Accounting Inc., 22 and Joseph M. Grey Public Accountant, 23 in all of which taxpayers failed to avoid Social Security taxes by undercompensating themselves and taking the money out as distributions. In Watson, the court reclassified more than $67,000 of distributions as salary and concluded that a reasonable annual salary would have been more than $91,000.
Similarly, Cave 24 involved a sole shareholder attorney who treated himself and all his associates as independent contractors. The court held that all parties involved were statutory or common-law employees and that the company should therefore have withheld Social Security. The taxpayer argued that the safe harbor of Section 530 of the Revenue Act of 1978 25 should have protected him, but the court held that because he was a statutory employee, Section 530 did not apply to him.
Is a Business Purpose Needed to Incorporate?
In another attack on the avoidance of self-employment taxes, the court held in Robucci 26 that a taxpayer had no business purpose to establish multiple corporations other than to avoid self-employment taxes, so the corporate form should be ignored. There has always been a strong business purpose requirement for tax-deferred reorganizations, but some tax commentators have opined that for a corporate formation, none is really needed. Black & Decker and Coltec 27 are relatively recent court cases that require business purpose and economic substance to justify the forming of a special purpose subsidiary. Tax advisers should counsel clients to have a valid business purpose other than saving federal income or self-employment taxes to avoid the corporate entity’s being disregarded for tax purposes.
In one recent case, however, the relationship of an S corporation with its owner worked in the taxpayer’s favor. Morton 28 involved a cofounder of Hard Rock cafes and hotels who established multiple S corporations to conduct his various business enterprises. To accommodate the travel he required, one of the S corporations owned a Gulfstream III jet, and Peter Morton, the business owner, personally paid many of the expenses related to the jet. The Court of Federal Claims held that under the unified business enterprise theory, Morton could deduct the expenses even though he did not own the plane. The government argued that under the Supreme Court’s Moline Properties decision, 29 each of Morton’s business entities was separate, so Morton should not be allowed to deduct the expenses. The court stated that while the Moline doctrine applies to C corporations, it does not necessarily apply to S corporations.
Losses and Limitations
A major motivation for a corporation choosing S status is the ability to flow entity-level losses to its shareholders. A shareholder must overcome several hurdles before losses are deductible, however, including rules in Secs. 183 (hobby loss), 465 (at-risk), 469 (passive activity loss), and 1366 (adjusted basis). Several court cases and rulings have been issued relative to these loss limitation rules.
A recent Chief Council Advice (CCA) 30 dealt with whether a QSub’s deemed Sec. 332 election created tax-exempt income that could then increase shareholders’ basis under Secs. 1366(a)(1)(A) and 1367(a)(1). The CCA held that it could not. Similarly, and as an example that persistence does not always pay, the Supreme Court denied the Nathel brothers a writ of certiorari on their appeal of the Second Circuit’s 31 affirmation of an unfavorable Tax Court decision. The Nathels had argued that a capital contribution to an S corporation was tax exempt under Sec. 118 and therefore should increase their basis in loans they had made to the S corporation (which had been reduced by losses); thus, when the corporation paid back the loans, they should have recognized no gain.
In United Energy Corp., 32 the Eighth Circuit held that certain loans to an S corporation from banks and related entities did not create Sec. 1366(d) basis for loss for its shareholders because there was no economic outlay by the shareholders with respect to the loans.
In Technical Advice Memorandum 201035016, 33 the IRS ruled that recharacterization of an activity from nonpassive to passive was not an accounting method change and therefore did not require a Sec. 481 adjustment.
BIG Tax Holiday
The Small Business Jobs Act also modified Sec. 1374 for 2011. If 2010 was the fifth tax year in the recognition period, no tax would be imposed on recognized BIGs for 2011. For 2009 and 2010, the American Recovery and Reinvestment Act of 2009 34 enacted Sec. 1374(d)(7), which also somewhat reduced the stress and impact of Sec. 1374. This provision exempted Sec. 1374’s BIG tax from being imposed in the tax year that was preceded by the S corporation’s seventh year of the recognition period.
The favorable provisions, however, leave some unanswered questions about their application in tax planning. The AICPA’s Corporations and Shareholders Taxation Technical Resource Panel (TRP)and Tax Executive Committee submitted suggestions for Treasury’s business plan, 35 and these open issues were ranked as some of their highest priorities. Specifically, the TRP requested further guidance on recognized BIG that is deferred in 2009, 2010, or 2011 as a result of an income limitation or installment sale and later recognized during the recognition period under Sec. 1374(d)(2)(B) or under the installment sale rules. Until Treasury issues such guidance, tax advisers may wish to consider these points:
- If an installment sale of BIG property occurred in a prior year, it may be advisable to recognize the gain in 2010 or 2011, 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 an asset sold in 2011 on the installment basis is covered by these rules but is recognized in 2012, would it be subject to Sec. 1374 gain recognition? Until this point is clarified, it may be advisable to elect out of Sec. 453 treatment for the exempt year, 2011.
- If the taxpayer’s net recognized BIG is limited by taxable income in its sixth recognition period year (2011) and in 2012 it is subject to BIG, is the 2011 suspended gain forgiven or subject to Sec. 1374 tax?
- There seems to be a difference between which years qualify as eighth, ninth, or tenth for Sec. 1374 generally in light of the carryover basis rules of Sec. 1374(d)(8). For the former, tax year seems to be the criterion, 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. For the 2011 sixth-year BIG tax holiday, the law makes it explicit that five 12-month periods are required.
- Another issue is determining when the 10-year recognition period starts and ends. For example, if a substituted basis transaction (e.g., a like-kind exchange) occurs with BIG assets, Sec. 1374(d)(6) will apply the remaining recognition period to the new asset. On the other hand, if a carryover basis transaction occurs, Sec. 1374(d)(8) requires a new 10-year holding period, which may create multiple recognition periods with various endpoints.
Thus, in CCA 201049025, 36 a company converted from C to S status and elected QSub status for its subsidiary. On a subsequent date, it was the target of a taxable merger (cash and marketable securities). Not surprisingly, the government held that Sec. 1374 applied to the transaction because the assets were deemed sold within the Sec. 1374(d)(8) recognition period.
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 tax provision is a vestigial organ of the pre-1986 corporate add-on minimum tax, but it still applies today. In Vainisi , 37 the Tax Court held that Sec. 291(a)(3) required a 20% disallowance on interest expense related to tax-exempt income and applied to a QSub bank more than three years after conversion. The Seventh Circuit overturned the Tax Court’s finding and, citing the rule of Sec. 1363(b)(4), held that Sec. 291(a)(3) applied only for three years after the bank converted from C to S status. In Action on Decision 2010-6, 38 the government acquiesced to the results.
ESOP Strategy
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. As long as the sellers reinvested the proceeds in publicly traded stock and bonds, the realized gain on the sale to the ESOP would not be recognized. The buyers then converted the C corporation to an S corporation, where the income allocated to the ESOP would not be taxable. However, there are some fairly complicated rules to prevent abuses of these favorable provisions. In particular, when dealing with S corporation ESOPs, tax professionals should be aware of the normal fiduciary rules that apply to trusts, as well as the special Sec. 409(p) disqualified-person rules.
Letter Ruling 201117047 39 held that when an S corporation with ESOP shareholders sold or exercised warrants, no “synthetic equity” was created and no Sec. 409(p) treatment of a warrant holder or other person as a disqualified person was triggered.
On the other hand, in a recent Tax Court case, 40 a law firm specially allocated 41 87% of the company’s income to an S corporation that was 10% owned by an ESOP whose beneficiaries were the attorney partners. The court rejected the special allocation for lack of economic substance and imposed self-employment taxes on the partners. This case has provoked an uproar from some segments of the tax community because technically, under Kansas state law, the partners were designated limited partners, which are normally excepted from self-employment tax exposure under Sec. 1402(a)(13). In this case, however, the partners were actively practicing in the tax law area and, although their professional liability exposure may have been somewhat limited by the LLP rules, they were actively involved in the trade or business and were personally liable for entity activities other than the other partners’ professional actions.
This decision is the logical extension (or the flip side) of a line of cases 42 holding against the government’s position that the passive activity loss rules automatically apply to a state-designated limited partner that is actively involved in farming or other trades or businesses. Those cases dealt with Sec. 469 and held that even if taxpayers are designated limited partners on the tax return, what they do relative to the partnership’s trade or business determines the application of the passive activity loss rules.
In another case dealing with a taxpayer trying to exploit the ESOP exemption from unrelated business income tax, 43 the sole shareholder of a travel trailer company set up an employee leasing company to hire all his employees and thereby maximize his personal benefit from an ESOP that owned a substantial portion of the S corporation. There were also issues involving the corporation lending money at zero tax rates (Sec. 7872) to the shareholder and the deductibility of individually paying for things such as corporate airplane or boat expenses.
Inconsistent Reporting of K-1 Information
In Winter, 44 an S shareholder was in dispute with the company and its other owners. He reported on his individual tax return his $1.2 million share of a financial statement loss rather than the $820,000 profit reflected on his Schedule K-1. The IRS issued a notice of deficiency with respect to the tax arising from the inconsistent reporting and then subsequently summarily assessed the tax. The Tax Court held that under Sec. 6037(c) the inconsistent tax position error was a matching or clerical error, so the error was subject to summary assessment and no 90-day letter was necessary. However, the Tax Court further held that because the amount of tax resulting from the inconsistent reporting was included in the deficiency notice, it had jurisdiction over the tax. Tax advisers need to be careful in these situations, because if no 90-day letter is issued, there will not be a Tax Court avenue for appeal; to get its day in court, the taxpayer would have to pay and go to district court or Claims Court.
In Rocchio, 45 the Tax Court held that a taxpayer had to report his share of S corporation income even though he had filed to force the corporation to judicially dissolve and was barred from involvement in the management of the company.
IC-DISC Tax Rate Arbitrage
Most practitioners are aware that when investment interest expense is less than net investment income, a tax planning opportunity can be exploited by increasing investment interest expense and investing in dividend-paying stocks to play the tax rate differential. Less well known is using an interest charge domestic international sales corporation (IC-DISC) to net the same results for companies that produce products in the United States that they sell overseas.
The winter 2010 IRS Statistics of Income showed an increase in the number of IC-DISCs from 2004 (425) to 2006 (1,209), and their gross export revenue increased 266% from $5.27 billion to $19.29 billion in that time. Considering that there are over 4 million S corporations, obviously only 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 export revenue. Dividends to shareholders are qualified for the Sec. 1(h) 15% tax rate, and the producing entity corporation gets a deduction at 35%. As a further incentive, the producing entity can use Sec. 199 as well.
Tax-Deferred Reorgs.
The flexibility engendered by the QSub disregarded entity rules generated some merger and acquisition activity involving S corporations. For example, Letter Ruling 201115016 46 involved an S corporation that wanted to sell some but not all of its assets in a tax-deferred manner. The corporation proposed to form a QSub and undertake a type F reorganization so that the assets to be sold would be in the QSub and the rest in the parent S corporation. Relying on Rev. Ruls. 96-29 and 2008-18, 47 the government held that this was a valid F reorganization even though it was an integral part of a larger transaction.
In Letter Ruling 201126023, 48 a foreign corporation owned by two trusts wanted to domesticate under state corporate law. It also wanted to elect S status and have the two owners be treated as electing small business trusts. Treasury held that this would be treated as an F reorganization and would not be subject to any tax under Secs. 357 and 361. However, it presumably would be subject to a Sec. 1374 potential tax liability.
Footnotes
1 Rev. Proc. 2003-40, 2003-1 C.B. 1044. The LMSB Division has been renamed the Large Business and International (LB&I) Division.
2 Announcement 2011-5, 2011-4 I.R.B. 430.
3 If a change in basis occurs in December, the due date for reporting to the government is also January 15 of the next year.
4 Notice 2011-18, 2011-11 I.R.B. 549.
5 Worker, Homeownership, and Business Assistance Act of 2009, P.L. 111-92.
6 Financial Accounting Standards Board (FASB) Interpretation No. 48, Accounting for Uncertainty in Income Taxes, codified in FASB Accounting Standards Codification Topic 740.
7 Announcement 2010-9, 2010-7 I.R.B. 408; Announcement 2010-17, 2010-13 I.R.B. 515.
8 Announcement 2010-75, 2010-41 I.R.B. 428.
9 Announcement 2010-30, 2010-19 I.R.B. 668.
10 Mayo Found. for Med. Educ. and Research, 131 S. Ct. 704 (2011).
12 Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312.
13 This assumes that the children aged 19–23 are not married and filing a joint return. If they are, the expanded kiddie tax will not apply.
14 Small Business Jobs Act of 2010, P.L. 111-240.
15 Hiring Incentives to Restore Employment Act of 2010, P.L. 111-147.
17 Intermountain Ins. Serv. of Vail, No. 10-1204 (D.C. Cir. 6/21/11), and UTAM Ltd. and DDM Mgmt. Inc., No. 10-1262 (D.C. Cir. 6/21/11). See also Grapevine Imports Ltd., 636 F.3d 1368 (Fed. Cir. 2011), and Salman Ranch Ltd., No. 09-9015 (10th Cir. 5/31/11), in which the Tenth Circuit reversed the Tax Court’s decision in a son-of-boss transaction and applied Regs. Sec. 301.6501(e)-1 for a six-year statute of limitation.
18 Chevron U.S.A. Inc. v. Natural Res. Def. Council Inc., 467 U.S. 837 (1984).
19 National Muffler Dealers Ass’n, 440 U.S. 472 (1979).
20 Watson P.C., 757 F. Supp. 2d 877 (S.D. Iowa 2010).
21 Joseph Radtke, S.C., 712 F. Supp. 143 (E.D. Wis. 1989).
22 Spicer Accounting Inc., 918 F.2d 90 (9th Cir. 1990).
23 Joseph M. Grey Public Accountant, P.C., 93 Fed. Appx. 473 (3d Cir. 2004).
25 Revenue Act of 1978, P.L. 95-600.
26 Robucci, T.C. Memo. 2011-19.
27 The Black and Decker Corp., 436 F.3d 431 (4th Cir. 2006); Coltec Indus. Inc., 454 F.3d 1340 (Fed. Cir. 2006).
28 Morton, No. 08-804C (Fed. Cl. 4/27/11).
29 Moline Properties Inc., 319 U.S. 436 (1943).
31 Nathel, 615 F.3d 83 (2d Cir. 2010), aff’g 131 T.C. 262 (2008).
32 United Energy Corp., 19 F.3d 908 (8th Cir. 2010).
33 Technical Advice Memorandum 201035016 (9/3/10).
34 American Recovery and Reinvestment Act of 2009, P.L. 111-5.
35 AICPA Comments on Notice 2011–39, Recommendations for 2011–2012 Guidance Priority List (6/1/11).
37 Vainisi, 132 T.C. 1 (2009), rev’d, 599 F.3d 567 (7th Cir. 2010).
38 Action on Decision 2010-6 (12/13/10).
39 IRS Letter Ruling 201117047 (4/29/11).
40 Renkemeyer, Campbell & Weaver LLP, 136 T.C. No. 7 (2011).
42 Garnett, 132 T.C. 368; Thompson, 87 Fed. Cl. 728 (2009); Hegarty, T.C. Summ. 2009-153; Newell, T.C. Memo. 2010-23.
43 Weekend Warrior Trailers, T.C. Memo. 2011-105.
44 Winter, 135 T.C. 238 (2010).
45 Rocchio, T.C. Summ. 2011-58.
46 IRS Letter Ruling 201115016 (4/15/11).
47 Rev. Rul. 96-29, 1996-1 C.B. 50; Rev. Rul. 2008-18, 2008-1 C.B. 674.
48 IRS Letter Ruling 201126023 (7/1/11).
| Editor Notes |
Stewart Karlinsky is professor emeritus at San Jose State University in San Jose, CA, and is an associate member of the AICPA Tax Division’s S Corporation Taxation Technical Resource Panel. Hughlene Burton is an associate professor and chair of the Department of Accounting at the University of North Carolina–Charlotte in Charlotte, NC, and is the former chair of the AICPA Tax Division’s Partnership Taxation Technical Resource Panel. For more information about this article, contact Dr. Karlinsky at stewart.karlinsky@sjsu.edu or Dr. Burton at hughlene.burton@uncc.edu. |
