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EXECUTIVE SUMMARY |
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The
American Taxpayer Relief Act of 2012
extended the five-year recognition
period for the Sec. 1374 built-in
gains tax to 2012 and 2013. This article discusses major changes and developments that directly affect S corporations and their tax advisers during the period of this update (July 10, 2012–July 9, 2013). It also presents tax planning ideas for S corporations and their shareholders concerning several provisions, including the 3.8% net investment income tax.
Sec. 1374(d)(7) BIG Tax Holiday
The Sec. 1374 built-in gain (BIG) rules were significantly and favorably liberalized by the American Taxpayer Relief Act of 2012 (ATRA). 1 ATRA also added certainty to several lingering issues. For tax years beginning in 2012 or 2013, if the prior year was the fifth calendar year or later in the recognition period, then any recognized gain is not subject to the BIG tax (the BIG tax holiday). Note that this rule requires five 12-month periods and not necessarily five tax years; the latter often are a shorter period. The built-in gains period will be 10 years for years after 2013. The new law clarified two important issues concerning the BIG tax holiday: First, it allows gain from an installment sale of qualified property to be exempt from Sec. 1374 tax, even if it is recognized in a year after 2013 in which the BIG tax applies. Second, a technical amendment to Sec. 1374(d)(2) provides that the rule requiring the excess of net recognized built-in gain over taxable income for a tax year to be carried over and treated as recognized built-in gain in the succeeding tax year applies only to gain recognized within the recognition period. For example, built-in gain recognized in a tax year beginning in 2013, from a disposition in that year that occurs beyond the end of the temporary five-year recognition period, will not be carried forward under the income limitation rule and treated as recognized built-in gain in the tax year beginning in 2014 (after the recognition period is again 10 years).
Example 1 : In January 2007, a calendar-year C corporation switches to S status. In 2013, it is qualified for the BIG tax holiday, since six calendar years have elapsed in the recognition period. It sells a BIG asset on the installment basis in 2013, with gain recognized in 2015, a nonexempt year. The recognized gain in 2015 will not be subject to Sec. 1374.
Example 2: In January 2007, a calendar-year C corporation switches to S status. In 2013, it is qualified for the BIG tax holiday. In 2013 it has recognized BIG of $200,000 and taxable income of $140,000. Normally, the $60,000 difference would be subject to BIG tax in 2014, but the technical amendment to Sec. 1374(d)(2) exempts the $60,000 carryover from Sec. 1374 tax in 2014.
Chief Counsel Advice (CCA) 201324013 2 opines against an attempt to use the partnership and S corporation rules to circumvent Sec. 1374 BIG tax. Essentially, one party contributed money (and received property), and the other party contributed property and received the cash funds. It is widely speculated that the ruling involved the Tribune Co., which publishes the Chicago Tribune newspaper, divesting itself of the Long Island Newsday newspaper similarly to how it divested itself of the Chicago Cubs a few years earlier. The IRS ruled that Sec. 707(a)(2)(B) and Regs. Sec. 1.752-2(j) should be applied to treat the transaction as a disguised sale, and hence the Sec. 1374 rules would apply to the taxpayer.
S Corporation Data
The 2012 Data Book 3 reports that the number of S corporation tax returns filed increased 0.8% in 2012 over 2011; partnerships and LLCs increased by 1.5%; and C corporations decreased by 2.2%. S corporations and partnerships were audited 0.5% of the time, while small business C corporations were audited at a rate of between 0.9% and 2.6%, depending on their asset size. Interestingly, individual returns with nonfarm business income (and without an earned income tax credit) were audited between 1.2% and 3.6% of the time, depending on gross receipts reported.
Qualifying as an S Corporation
To qualify as an S corporation, a corporation must meet requirements concerning its type, number and type of shareholders, type of stock, and type of income. In addition, the corporation must elect to be treated as an S corporation. If applicable, it may also elect to treat a subsidiary as a qualified subchapter S subsidiary (QSub), and certain trusts may elect to be treated as eligible shareholders. If any of the requirements are not met at any time, the corporation’s S election is terminated. However, the taxpayer can request an inadvertent termination relief ruling under Sec. 1362(f) and, subject to IRS approval, retain its S status continuously. Congress asked the IRS to be lenient in granting inadvertent election and termination relief, and it is clear from numerous letter rulings that the IRS has abided by congressional intent.
Elections
In all of the recent letter rulings on failures to make a timely election by, or related to, an S corporation, if the taxpayer could establish reasonable cause and show that granting the relief would not prejudice government interests, the taxpayer was granted inadvertent termination relief, as long as a proper election was filed within 120 days of the ruling. These rulings applied to the failure to file Form 2553, Election by a Small Business Corporation ; Form 8832, Entity Classification Election ; and Form 8869, Qualified Subchapter S Subsidiary Election ; 4 as well as the elections required by the beneficiary of a qualified subchapter S trust (QSST) and the trustee of an electing small business trust (ESBT) to be an eligible S corporation shareholder. Nontimely filing was deemed inadvertent in a number of rulings. 5 The IRS also granted inadvertent termination relief involving trusts that were intended to be ESBT trusts but whose trustees failed to make the election. 6
Likewise, in at least two letter rulings, 7 a shareholder transferred S stock to a grantor trust. When the shareholder died, the irrevocable trust was a qualified shareholder for two years. After that, the stock was transferred to a QSST, but the beneficiary failed to sign the election. The IRS allowed the S status to continue under Sec. 1362(f) without a termination. The IRS also forgave the termination of a corporation’s S status due to a trust’s failure to satisfy the QSST requirements. 8 Unlike baseball, in an example of three strikes and you are not out, two letter rulings 9 involved an S corporation that filed Form 2553 with the wrong date and a wrong signature on behalf of one of its two shareholders and failed to properly file an ESBT election, and yet it was permitted to be an S corporation from inception.
Eligible Shareholders
Sec. 1361(b) restricts ownership in an S corporation to U.S. citizens and resident individuals, estates, certain trusts, certain pension plans (but not individual retirement accounts (IRAs)), and certain tax-exempt charitable organizations.
Historically, S corporations have been more successful if they are proactive and request inadvertent termination relief from the IRS before they are audited and the issue is decided in court. The IRS issued inadvertent termination relief to S corporations that had various ineligible shareholders. Letter Rulings 201245001 and 201245002 10 involved shareholders that were partnerships. In other rulings, 11 the IRS did not make it clear why the shareholder was ineligible, but it allowed continued S status. In Letter Ruling 201325003, 12 an LLC elected to be treated as an S corporation. At one point, an ineligible shareholder had ownership, but the error was corrected when recognized. The IRS allowed continuous S status, but the eligible shareholders had to include the ineligible person’s income on their tax returns.
One Class of Stock
Sec. 1361(b)(1)(D) prohibits an S corporation from having more than one class of stock, defined as equal rights to distributions and liquidations (but not necessarily equal voting rights). Regs. Sec. 1.1361-1(l) provides that a corporation generally is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds. Whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds is determined based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (collectively, the governing provisions). However, any distributions (including actual, constructive, or deemed distributions) that differ in timing or amount are given appropriate tax effect in accordance with the facts and circumstances.
In Santa Clara Valley Housing Group , 13 a family used a marketed tax shelter called the S Corporation Charitable Contribution Strategy to transfer millions of dollars in income from an S corporation the family owned to a Los Angeles public employees’ pension plan for tax purposes but to keep control of the S corporation and receive virtually all the distributions of the income. The family used stock warrants to maintain control. The key issue was whether the warrants were a second class of stock and, therefore, invalidated the corporation’s S status and caused the distributions to be subject to tax under Sec. 301. A district court in California originally decided that the stock warrants were a second class of stock but agreed to reconsider their terms under the safe-harbor rules of Regs. Sec. 1.1361-1(l)(4). In August 2012, the court denied the corporation’s motion to bifurcate the tax and penalty phases of the trial.
In Letter Ruling 201309003, 14 the taxpayer originally had a typical buy-sell agreement based on fair market or book value purchase price that would not cause a violation of the one-class-of-stock requirement. However, the taxpayer had amended the agreement in relation to a third-party claim and created a bonus plan related to any future recovery the taxpayer might receive from the claim. In Letter Ruling 201308008, 15 the taxpayer asked the IRS to rule on the effect of its redemption agreement. In both cases, the IRS ruled that the agreements did not create a second class of stock.
In Letter Ruling 201306004, 16 the shareholders of the taxpayer entered into an agreement that allowed varying income distributions to be made to the shareholders. A governing provision does not alter the rights to liquidation and distribution proceeds merely because it provides that, as a result of a change in stock ownership, an S corporation makes distributions in a tax year on the basis of the shareholders’ varying interests in the S corporation’s income in the current or immediately preceding tax year. In this case, the IRS ruled that the agreement to make varying interest distributions did not create a second class of stock.
Letter Ruling 201326012 17 involved a corporation that issued convertible debenture notes to employees at zero interest and to the employees’ IRAs at a market interest rate. Under Regs. Sec. 1.1361-1(l)(4), debt can be treated as equity for purposes of the second-class-of-stock rule. In this case, the IRS ruled that the issuance of debentures did not create a second class of stock.
Letter Ruling 201246008 18 presents a plethora of issues related to potentially creating a second class of stock, including computational errors and improperly characterizing a loan as a distribution. The IRS held that two of the taxpayer’s actions might have created a second class of stock that caused an S status termination, but if they did, the termination was inadvertent.
A common way that a second class of stock is created is through disproportionate distributions to shareholders. In Letter Ruling 201234001, 19 an S corporation made disproportionate distributions. The IRS ruled that the disproportionate distributions would not be treated as a second class of stock if the taxpayer made corrective distributions within 120 days. Letter Ruling 201322036 20 involved an S corporation that made disproportionate distributions to various shareholders related to paying state and local taxes and corrective distributions at different times. The IRS concluded that because the taxpayer’s stock had identical distribution and liquidation rights under its governing provisions, the difference in timing between the disproportionate distributions and the corrective distributions did not cause the taxpayer to have more than one class of stock.
Earnings and Profits
An S corporation that has subchapter C accumulated earnings and profits (E&P) may be subject to a tax under Sec. 1375 on its excess net passive investment income if its total passive investment income exceeds 25% of its gross receipts. In addition, if these conditions persist for three consecutive years, its S election automatically terminates the first day of the fourth year. In IRS Letter Rulings 201248001 21 and 201320008, 22 the S corporations met these criteria, and therefore their S elections were technically terminated. The IRS allowed the shareholders to make an election under Regs. Sec. 1.1368-1(f)(3) to make a deemed distribution of accumulated E&P so that the corporations no longer violated the rules of Sec. 1362(d)(3) and thus could continue their S status uninterrupted. The government did require the payment of Sec. 1375 tax and amended returns by the shareholders to reflect the dividend. In Letter Ruling 201232023, 23 the IRS found that rental income that involved significant services was active income, and therefore the S corporation election was not terminated under Sec. 1362(d)(3). This was despite a former accountant’s filing a statement with the corporation’s tax return revoking the S election, because it was not properly prepared or signed by shareholders.
Final Regulations on Controlled Corporations
Final regulations 24 were issued effective for tax years beginning on or after April 11, 2011, that distinguish a controlled group under Sec. 1563 from affiliated group rules of Sec. 1561. In general, for purposes of Sec. 179, all component members of a controlled group are treated as a single taxpayer. Many practitioners believed that because S corporations were defined as “excluded corporations,” and thus were not component members of a controlled group, two S corporations that were members of a controlled group could each take a maximum Sec. 179 deduction and pass it through to their shareholders. There was concern that these new regulations would have an impact on this position. An IRS Information Letter released June 28, 2013, 25 confirmed that the regulations were not meant to limit the Sec. 179 deduction and that each S corporation would in fact be entitled to its own $500,000/$2 million limitation .
Wages and Self-Employment Taxes
Tax advisers should be aware of a National Research Program (NRP) for 2010–2012 (2,000 returns per year) on employment status (employee vs. independent contractor), reasonable compensation, S corporation distributions vs. salary, and matching tax identification numbers. Fifteen hundred of the 2,000 returns per year are from the Small Business/Self-Employed Division.
The Watson case 26 represents exactly what the government is trying to ferret out with the NRP. A seasoned accountant worked 35 to 45 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. The taxpayer’s behavior echoes a long line of cases going back to Radtke, 27 Spicer Accounting, 28 and Joseph M. Grey Public Accountant, 29 which all failed in their attempt to avoid taxes by undercompensating themselves and instead taking money out of the entity through distributions. The court reclassified $67,000 of Watson’s distributions as salary. It should not be a surprise for the reader to learn that the wage limit subject to Social Security tax for the relevant year was approximately $91,000. The Eighth Circuit 30 affirmed the district court decision, and, recently, the Supreme Court denied the writ of certiorari, 31 so the Eighth Circuit decision stands.
On the good-news side, CCA 201228037 32 allows 2% shareholder-employees to take a Sec. 162(l) above-the-line deduction of all Medicare premiums paid or reimbursed by the S corporation if the premiums are reported as wages on the shareholder/employee’s W-2 and are reported as gross income on his or her tax return.
In one of the stranger cases in recent history, Stephens, 33 a taxpayer incorporated his trucking business as an S corporation. Each year, the business earned around $120,000 in taxable income, and in 2008 the taxpayer paid himself $136 in wages. The government did not argue undercompensation, and the court did not allow any penalties to be assessed. The court upheld the IRS’s assessments based on unreported S corporation income and unreported wages but did not uphold the penalty assessment because the IRS did not produce evidence to prove that the penalties were appropriate.
Basis, Losses, and Limitations
A major motivation for a corporation choosing S status is the ability to flow entity-level losses to its shareholders. To be able to use this benefit, shareholders must keep careful track of their stock and debt basis. As a matter of fact, in discussions with IRS personnel, the hottest area for IRS review is adjusted basis. A shareholder must overcome several hurdles before losses are deductible, including Sec. 183 (hobby loss), Sec. 1366 (adjusted basis), Sec. 465 (at-risk), and Sec. 469 (passive activity loss). Several court cases, proposed regulations, and rulings were issued relative to these loss limitation rules.
Prop. Regs. Secs. 1.1366-2 and -5 34 were promulgated on June 12, 2012, and, when finalized, may be helpful to many taxpayers that use related entities to fund loss S corporation activities. Essentially, the regulations move away from the “economic outlay”/poorer in a material sense criterion of many court cases and instead use a “bona fide debt” criterion. This may make it easier to use funds from related parties, back-to-back loans, and even in some cases the “incorporated pocketbook” concept. It may also allow “round tripper” lending where each leg of the transaction is bona fide. For example, if an individual owns both a partnership interest and an S corporation interest, and the S corporation leases property from the partnership, the shareholder/partner may be able to borrow from the partnership (or receive a distribution), lend to the S corporation on bona fide terms, and have the S corporation pay the rent. The crucial concept is: What is bona fide debt under general tax principles? The authors would argue that if the terms of the loan/note are similar to what an unrelated third party would lend at, then the loan/note is a bona fide debt.
The proposed regulations also explicitly point out that guarantees and recourse debt arrangements will not give rise to Sec. 1366 basis for loss until they are actually paid. In Montgomery , 35 an S shareholder guaranteed an entity loan and the entity failed to pay. The debt was recognized by the shareholder but not paid, so it was not available to increase basis for Sec. 1366(d) loss purposes until paid. The regulations’ preamble also states that Rev. Rul. 81-187 36 still applies to limit the ability to increase basis by contributing a self-written note.
Barnes 37 involved a trap for the unwary, in which the S corporation had suspended losses due to insufficient basis. In a prior year, there had been sufficient income to absorb the suspended losses, but the shareholder did not take the losses. The statute of limitation had lapsed on those years, and currently the taxpayer wanted to take the losses. The taxpayer argued no deduction, no reduction in basis. The Tax Court and D.C. Circuit came up with their own assertion: Use your losses when they are available or lose them.
Ball 38 involved an S corporation that made a QSub election that included a Sec. 332 tax-deferred liquidation. The taxpayers argued that this event created tax-exempt income that would increase the shareholders’ basis under Sec. 1366(a)(1)(A). The court ruled that this was not tax-exempt income, and therefore no upward basis adjustment was allowed.
In Powers , 39 a CPA did not have sufficient basis for a loss, as notes between a commonly controlled partnership and S corporation did not give basis, and the check deposits contributed of more than $145,000 did not reflect the more than $503,000 withdrawn during the same year. Therefore, the Tax Court held, there was no adjusted basis to absorb the entities’ losses.
Cancellation-of-Debt Income
Final regulations 40 under Sec. 108(i) deal with reacquisition of debt in 2009 or 2010 and an available election to defer the gain over five years. One of the dangers of this election is that several fairly common events may accelerate the deferral into a year when the taxpayer may have profits but no cash to pay the tax on the accelerated income.
For example, switching from C to S status triggers an acceleration of deferred cancellation-of-debt income in the last C year. Also, a sale of substantially all assets or the sale or exchange or redemption of S stock accelerates this noncash income. A shareholder’s death also triggers the acceleration provision. The final regulations noted that earnings and profits are increased in the year the income is realized.
Sec. 83 Compensation
Davis 41 involved an S corporation in which there was a dispute among the shareholders, and one of them, the father of the corporation’s founders, exercised his restricted stock rights. The corporation deducted the $36.9 million under Sec. 83(h), but the father did not include the proceeds in gross income. The Eleventh Circuit, affirming the Tax Court decision, required the shareholder to include the amount in ordinary income because, it held, he was granted the option in connection with the performance of services, and allowed the corporation a corresponding deduction.
Trust Expenses
CCA 201327009 42 dealt with a QSST that acquired S corporation stock from a third party with a note. The issue was whether the interest on the note was deductible by the beneficiary under the grantor trust rules or should be allocated to the nongrantor portion of the trust. The government ruled that it was deductible, as it was directly traceable to the acquisition of the S stock.
Tax-Deferred Reorganizations
The flexibility engendered by the QSub disregarded-entity rules generated some merger-and-acquisition activity involving S corporations. In IRS Letter Ruling 201308017, 43 for business reasons of management stability and resolving disputes of differing business philosophies, the IRS approved an S corporation’s dropping assets into a controlled corporation and doing a split-off to one shareholder and his grantor trust under the divisive D reorganization rules. Similarly, due to shareholder disagreements about the running of the business , Letter Ruling 201234009 44 allowed a divisive D reorganization, but as a condition precedent, the shareholders had to distribute accumulated E&P. Note that a recent government announcement 45 states that the ruling division of Treasury will no longer issue a letter ruling after Aug. 23, 2013, on the qualification of a transaction under Sec. 332, 351, 355, or 1036 or whether a transaction constitutes a reorganization within the meaning of Sec. 368, but will rule on significant issues.
CCA 201326014 46 involved a complex set of facts in which an S corporation owned a number of QSubs that were treated as disregarded entities for federal tax purposes. In all but two cases the subsidiaries had liabilities in excess of the basis of the assets. The S corporation formed an LLC and contributed the stock of the subsidiaries. In addition, C , an unrelated party, contributed a note to the LLC. The result of this transaction was to convert the LLC from a disregarded entity to a partnership, a regarded entity. Because the LLC was now a separate entity for tax purposes, the subsidiaries’ QSub status would be terminated. However, the IRS ruled that there would be a taxable formation of new C corporations under Sec. 1001 before the termination of the QSub status, because the S corporation was not in control (as defined in Sec. 368(c)) of the C corporation “immediately after the exchange.”
In a situation 47 where an S corporation did a tax-deferred spinoff, two issues arose. One was whether transitory ownership by a C corporation would end the S status, and the second was whether there was more than one class of stock. The government held that neither terminated the S election.
Letter Ruling 201232003 48 involved an S corporation that sold the stock that was to be treated under Sec. 338(h)(10) as a deemed asset purchase. One of the shareholders was a QSST, and the issue was which would include the gain on the sale in income—the trust or the beneficiary. The ruling held that the trust would, under Regs. Sec. 1.1361-1(j)(8).
Bankruptcy and Fraudulent Tax Returns
Three bankruptcy or fraud-related developments occurred in this article’s time frame. CCA 201238026 49 dealt with a two-shareholder S corporation in the real estate repair and remodeling business. One shareholder billed the S corporation for subcontractor work done for him individually, thus lowering corporate taxable income. This fraudulent behavior triggered an unlimited statute of limitation under Sec. 6501(c)(1) for the S corporation and that shareholder. The CCA stated that the innocent shareholder would not have his statute of limitation extended.
In Kenrob Information Tech Solutions, 50 an S corporation had a long-standing agreement that it would pay the federal taxes of the shareholders on undistributed profits so that the corporation could retain funds for operations and expansion. The Chapter 7 bankruptcy trustee tried to claw back the funds as fraudulent conveyances, but the judge held for the S corporation and its shareholders.
In The Majestic Star Casino v. Barden Development , 51 a parent S corporation revoked its S status, thus ending a subsidiary corporation’s QSub status. The subsidiary, which was in bankruptcy, went to court seeking to have the revocation of the parent’s S corporation status voided. The subsidiary argued that its QSub status was property that belonged to the subsidiary, and the revocation of the parent’s S corporation status resulted in an invalid post-petition transfer of property of the subsidiary’s bankruptcy estate. The Third Circuit, vacating and remanding a bankruptcy court decision, held that the subsidiary’s QSub status was not property, and even if it were, it would be the parent’s property.
Tax Planning
American Taxpayer Relief Act of 2012
The American Taxpayer Relief Act of 2012 maintained the capital gain and dividend zero and 15% tax rates for 2012 and 2013, but, effective 2013, also created another capital gain/dividend bracket at 20% for certain levels of adjusted gross income (AGI). It also enacted a permanently inflation-adjusted alternative minimum tax exemption for 2013 on. The two-percentage-point Social Security tax reduction for employees and self-employed taxpayers for 2011 and 2012 was not continued in 2013. The law reimposed the Pease phaseout of itemized deductions and personal exemptions. For assets acquired and placed in service on or after Sept. 9, 2010, and before Jan. 1, 2012, Sec. 168(k) allowed 100% expensing for new tangible personal property. For 2012 and 2013, a 50% deduction is allowed.
This law also extended to 2012 and 2013 the $500,000 limit of new or used tangible personal property that may be expensed in the year placed in service under Sec. 179. The phaseout of this tax benefit starts at $2 million and is fully phased out for property acquired in the tax year that exceeds $2.5 million. Tax professionals should note that the taxable business income limitation still applies. If the deduction is limited due to the taxable income limitation, then a carryforward is allowed. In an expansion of the Sec. 179 provision, $250,000 of the $500,000 property acquired can apply to qualified leasehold, retail, and restaurant improvement property. This category of assets has a 15-year class life. If the income limitation applied for 2012, this category of asset carryover may be used in 2013 but, unless extended, not beyond 2013. This is a trap for the unwary.
Zero Capital Gain Rate in 2012 and 2013
Because of the extension of the zero capital gain rate for individual taxpayers in the lower two tax brackets in 2012 and 2013, taxpayers should consider gifting appreciated S corporation stock to their children, grandchildren, or parents. In 2007, the Small Business and Work Opportunity Tax Act 52 extended the “kiddie tax” to income (including capital gains and dividends) of 18-year-olds (or 19- to 23-year-olds who are full-time students 53 ) whose earned income does not exceed half of their support. Thus, the zero tax rate generally is not available to students through age 23 unless they have significant earned income. This leads to a balancing act. Parents may legitimately hire their children 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. Also, the parent will lose the dependency exemption.
Example 3: 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 May 2013, C’s parents give him stock worth $26,000, with a basis of $6,000 and that has met a holding period of at least one year. C has a standard deduction and personal exemption that put his 2013 taxable income in the first two tax brackets. (The taxable income bracket limit for the first two brackets in 2013 for single filing status is $36,250.) The income of C’s parents places them in the highest income tax bracket.
Assuming that C sells the gifted stock in 2013, he will pay no tax (zero 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 $5,000 ($25,000 × 20%) as well as avoiding the 3.8% net investment income tax on the $25,000 for a further savings of $950.
Example 4: Retired couple A and B take a required minimum pension distribution of $10,000 and invest primarily in tax-exempt bonds whose interest they are living off. Their S corporation Schedule K-1, Shareholder’s Share of Income, Deductions, Credits, etc., shows ordinary income of $30,000, and they receive distributions of $40,000 during the year. They have total 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 2013 for a married couple filing jointly is $72,500. Therefore, if they recognized $200,000 in capital gains or dividend income through the S corporation or otherwise, $62,500 of the gain ($72,500 – $10,000 ordinary income) would be subject to a zero tax rate. The other $137,500 would be subject to the normal 15% tax rate. This results in a federal tax savings of $9,375.
IC-DISC Tax Rate Arbitrage (Qualified Dividend Rate 15%, Tax Deduction 35%)
Most practitioners are aware of the tax planning opportunity in the right situation (investment interest expense being less than net investment income) of 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 achieve the same results for companies that produce products in the United States but sell them overseas. IRS statistics show a 119% increase in the number of IC-DISCs from 2005 (876 returns) to 2008 (1,917 returns), during which gross export receipts more than tripled from nearly $12 billion to nearly $37 billion. 54 Considering that there are more than 4 million S corporations, there is obviously a very small percentage 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 shareholders qualify for the Sec. 1(h) 15% tax rate, and the producing entity corporation gets a deduction of 35% of commissions. To sweeten the deal, the producing entity can use Sec. 199 as well.
Net Investment Income Tax
The Health Care and Education Reconciliation Act of 2010 55 imposes a net investment income tax of 3.8% of the lower of net investment income or modified AGI over a base amount for tax years beginning in 2013. The key term is net investment income and how is it defined relative to S corporations. If the S corporation has income such as interest, dividends, certain royalties and rents, and capital gains (other than those derived in the ordinary course of, or from property held in, a trade or business that is not a passive activity with respect to the shareholder or a trade or business of trading in financial instruments or commodities), it is part of net investment income. Net investment income also includes other gross income from a trade or business that is a passive activity with respect to the shareholder or a trade or business of trading in financial instruments or commodities. If the shareholder is considered not materially participating in the S corporation’s trade or business activities under the rules of Sec. 469, then the income reported on line 1 of Schedule K-1 will be considered net investment income. The S shareholder should note that estimated taxes are required for this Sec. 1411 tax. If the shareholder is an ESBT, the 3.8% tax will more likely apply because the modified AGI threshold for trusts is $11,950, while for individuals it is $250,000 (married filing jointly) or $200,000 (single).
Example 5: An ESBT has no non-S portion of net investment income. Its share of net investment income consists of $10,000 of dividends, $5,000 of interest, $25,000 of rental income, and $12,000 of capital gains. Its modified AGI is $52,000, as is its net investment income. The lower of $52,000 or $40,050 ($52,000 – $11,950) is $40,050, which multiplied by 3.8% equals a Sec. 1411 tax of $1,522 on the ESBT. If it were an individual, a threshold of $200,000 or more would have been available.
In addition, a hospital insurance tax 56 beginning in 2013 imposes a 0.9% tax on wages and self-employment income above the same thresholds as those for the net investment income tax.
Employee Stock Ownership Plans
To facilitate the generation of cash in a tax-free manner, a C corporation might form an employee stock ownership plan (ESOP) and sell at least 30% of the stock to the trust, utilizing Sec. 1042. As long as the sellers reinvested the proceeds in publicly traded stocks and bonds, the realized gain on the sale to the ESOP would not be recognized. The buyers then might convert the C to an S corporation, where the income allocated to the ESOP would not be taxable. However, there are some fairly complicated provisions to prevent abuses of these very favorable rules. In particular, the tax professional should be aware of the normal fiduciary rules that apply to trusts, as well as the Sec. 409(p) disqualified person rules, when dealing with S corporations . It is important to note that the corporation should set up the ESOP before it elects to be an S corporation.
Footnotes
1 American Taxpayer Relief Act of 2012, P.L. 112-240.
2 CCA 201324013 (6/14/13).
3 IRS Data Book, 2012, Tables 2 (p. 4) and 9a (p. 22); see also IRS News Release IR-2013-32.
4 See, e.g., IRS Letter Rulings 201306020 (2/8/12), 201314006 (4/5/13), 201314012 (4/5/13), and 201320011 (5/17/13).
5 See, e.g., IRS Letter Rulings 201302013 (1/11/13), 201314036 (4/5/13), and 201311005 (3/15/13).
6 IRS Letter Ruling 201308022 (2/22/13).
7 IRS Letter Rulings 201306015 (2/8/13) and 201302004 (1/11/13).
8 See IRS Letter Ruling 201245014 (11/9/12), among many such rulings.
9 IRS Letter Rulings 201323012 (6/7/13) and 201323013 (6/7/13).
10 IRS Letter Rulings 201245001 (11/9/12) and 201245002 (11/9/12).
11 See, e.g., IRS Letter Ruling 201303009 (1/18/13).
12 IRS Letter Ruling 201325003 (6/21/13).
13 Santa Clara Valley Housing Group, Inc., No. 08-05097 (N.D. Cal. 8/6/12, 1/18/12, and 9/21/11).
14 IRS Letter Ruling 201309003 (3/1/13).
15 IRS Letter Ruling 201308008 (2/22/13).
16 IRS Letter Ruling 201306004 (2/8/13).
17 IRS Letter Ruling 201326012 (6/28/13).
18 IRS Letter Ruling 201246008 (11/16/12).
19 IRS Letter Ruling 201234001 (8/24/12).
20 IRS Letter Ruling 201322036 (5/31/13).
21 IRS Letter Ruling 201248001 (11/30/12).
22 IRS Letter Ruling 201320008 (5/17/13).
23 IRS Letter Ruling 201232023 (8/10/12).
24 T.D. 9522.
25 IRS Information Letter 2013-0016 (6/28/13).
26 Watson, P.C., 714 F. Supp. 2d 877 (S.D. Iowa 2010).
27 Joseph Radtke, S.C., 712 F. Supp. 143 (E.D. Wis. 1989), aff’d, 895 F.2d 1196 (7th Cir. 1990).
28 Spicer Accounting, Inc., 918 F.2d 90 (9th Cir. 1990).
29 Joseph M. Grey Public Accountant, P.C., 119 T.C. 121 (2002), aff’d, 93 Fed. Appx. 473 (3d Cir. 2004).
30 Watson, 668 F.3d 1008 (8th Cir. 2012).
31 Watson, Sup. Ct. Dkt. 12-174 (U.S. 10/1/12).
32 CCA 201228037 (7/13/12).
33 Stephens, T.C. Memo. 2013-47.
34 REG-134042-07.
35 Montgomery, T.C. Memo. 2013-151.
36 Rev. Rul. 81-187, 1981-2 C.B. 167.
37 Barnes, 712 F.3d 581 (D.C. Cir. 4/5/13), aff’g T.C. Memo. 2012-80.
38 Ball, T.C. Memo. 2013-39.
39 Powers, T.C. Memo. 2013-134.
40 T.D. 9622.
41 Davis, No. 12-10916 (11th Cir. 5/16/13), aff’g T.C. Memo. 2011-286.
42 CCA 201327009 (7/5/13).
43 IRS Letter Ruling 201308017 (2/22/13).
44 IRS Letter Ruling 201234009 (8/24/12).
45 Rev. Proc. 2013-32, 2013-28 I.R.B. 55.
46 CCA 201326014 (6/28/13).
47 IRS Letter Ruling 201314031 (4/5/13).
48 IRS Letter Ruling 201232003 (8/10/12).
49 CCA 201238026 (9/21/12).
50 In re Kenrob Information Tech. Solutions, Inc., 474 B.R. 799 (Bankr. E.D. Va. 7/10/12).
51 The Majestic Star Casino, LLC v. Barden Dev., Inc., 716 F.3d 736 (3d Cir. 5/21/13).
52 Small Business and Work Opportunity Tax Act of 2007, P.L. 110-28.
53 This assumes that the children age 19–23 are not married. If they are, then the expanded kiddie tax does not apply.
54 Holik, “Interest-Charge Domestic International Sales Corporations,” Tax Year 2008, Statistics of Income Bulletin 116 (Summer 2011).
55 Health Care and Education Reconciliation Act of 2010, P.L. 111-152; Sec. 1411.
56 Secs. 1401(b)(2) and 3101(b)(2).
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EditorNotes |
| Stewart Karlinsky is professor emeritus at San José State University in San José, Calif., 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, N.C., and is a member of the AICPA Tax Executive Committee. For more information about this article, contact Dr. Karlinsky at stewart.karlinsky@sjsu.edu or Dr. Burton at hughlene.burton@uncc.edu . |
