Current developments in S corporations

By Laura Howell-Smith, J.D.; Robert W. Jamison Jr., CPA, Ph.D.; Bryan Keith, J.D.; Robert S. Keller, CPA, J.D., LL.M.; Laura MacDonough, CPA; Sarah P. McGregor, CPA; and Tawnya D. Nyman, CPA



  • Changes made by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, include special distribution rules for eligible terminated S corporations. Also, nonresident aliens now may be potential current beneficiaries of electing small business trusts (ESBTs), which are subject to the same charitable contribution rules as individuals.
  • Other TCJA changes, while not specific to S corporations, have important implications for them, including the new qualified business income deduction and a limitation on the deductibility of business interest paid or incurred.
  • Tax Court opinions issued in 2018 and late 2017 include cases addressing assignment of income and accrual of expenses to S corporation shareholders, shareholders' stock and debt basis, and whether disproportionate distributions to shareholders create a prohibited second class of stock, among others. IRS letter rulings issued during the period addressed issues including transfers of stock from an ESBT to a voting trust, creation of an ESBT pursuant to a divorce, and several instances of inadvertent terminations of S elections.
  • The IRS designated as a "no-rule" area whether a state-law limited partnership electing to be classified as an S corporation has more than one class of stock.
  • A bankruptcy court in the Fourth Circuit held that a corporation's S corporation status was not property of the corporation under federal tax law.

Although the law known as the Tax Cuts and Jobs Act (TCJA)1 has demanded most of tax practitioners' attention since its enactment in late 2017, there have been other important developments in the S corporation area. Twenty sections of the Internal Revenue Code are central to the taxation of Subchapter S corporations. Over the last 12—18 months, a number of cases have been decided and IRS guidance issued touching on these sections. The AICPA S Corporation Taxation Technical Resource Panel, a volunteer group of practitioners who pay close attention to these sections of the Code, offer the following summary of selected provisions of the TCJA, case law, and IRS guidance from these sections — and a few extra — that affect S corporations and their shareholders.

Selected updates from the TCJA

Sec. 163(j): Business interest limitation

Beginning in 2018, certain taxpayers are subject to a limitation on deductible interest paid or incurred in a trade or business. This limit applies to both S corporations and shareholders if they meet certain criteria. The amount of business interest deduction for a tax year cannot exceed the sum of the taxpayer's business interest income for the tax year, plus 30% of the taxpayer's adjusted taxable income2 for the tax year, plus the taxpayer's "floor plan financing interest"3 for the tax year.4

The limitation on the deduction for business interest expense does not apply to certain trades or businesses: providing services as an employee, electing real property businesses, electing farming businesses, and certain regulated utilities.5 In addition, the limit does not apply to any entity or person with less than $25 million in gross receipts (subject to aggregation rules) for the immediately preceding three years, unless the entity is considered a tax shelter.6 The aggregation rules and the inclusiveness of the term "tax shelter" could prove troublesome for S corporations and their shareholders. The gross receipts need to be aggregated for the S corporation and all businesses that are under common control.7 The term "tax shelter" encompasses any passthrough entity that allocates more than 35% of a loss to a limited partner or a limited entrepreneur in the current year.8

The limits apply to an S corporation when computing its taxable income. Any interest expense in excess of the deduction limit is carried forward.9 The corporation may be able to deduct this interest in a future year even if it is no longer an S corporation.10 There are also reporting requirements unique to S corporations.

Sec. 199A: Qualified business income deduction

New Sec. 199A provides a deduction of 20% against certain forms of income from passthrough entities, including S corporations. The role of the S corporation in the scheme of the qualified business income (QBI) deduction is that of a reporting entity. This is not a trivial role, since the regulations prescribe harsh penalties for noncompliance. The failure to report positive items of qualified income from the corporation's activities, W-2 wages attributable to this income, and unadjusted basis immediately after acquisition of qualified property, as well as income passing through from qualified real estate investment trust dividends and qualified publicly traded partnership income received by the S corporation, may result in the presumption that a shareholder's portion of these items is zero.11 The 2018 version of the Form 1120S, U.S. Income Tax Return for an S Corporation, Schedule K-1, Shareholder's Share of Income, Deductions, Credits, etc., has several codes that the corporation will use to report these items to shareholders.

Sec. 641(c): Charitable contributions and ESBTs

Before 2018, electing small business trusts (ESBTs) were subject to charitable contribution rules governing trusts. However, the TCJA changed the rules so that ESBTs are now subject to the same charitable contribution rules as individuals.12

Sec. 1361: Nonresident alien as potential current beneficiary of an ESBT

Before 2018, the Code required that a potential current beneficiary of an ESBT must have been eligible to hold S corporation shares directly. Thus, only a U.S. citizen or resident was an eligible potential current beneficiary of an ESBT.13 The TCJA removed this requirement, effective Jan. 1, 2018. Accordingly, a nonresident alien now may be a potential current beneficiary and the ESBT will not become a disqualified shareholder.

Sec. 1371(f): Eligible terminated S corporation

Newly enacted Sec. 481(d)(2) defines an "eligible terminated S corporation." To fit within this definition, a corporation must have been an S corporation on the day before the enactment of the TCJA (Dec. 21, 2017) and must revoke its S election before Dec. 22, 2019. The shareholders on the date of revocation must be the same persons who held the shares on Dec. 22, 2017, and must hold stock in the same proportions. The special distribution rule states that the post-termination transition period distribution rules govern the distributions during that period. After the period ends, the corporation is to prorate distributions between the corporation's accumulated adjustments account (AAA) and accumulated earnings and profits (AE&P), based on the ratio of AAA to AE&P.14 An eligible terminated S corporation that changes from the cash to the accrual method of accounting may use a six-year period in which it includes its Sec. 481(a) adjustment.

Selected non-TCJA updates

Sec. 61: Assignment of income

In Smith, a retired couple worked as a handyman and an office manager for a country club.15 They established an S corporation, which was authorized to enter into employment contracts. However, there were never any actual employment agreements between the corporation and the taxpayers. The husband also performed handyman services for other businesses and individuals. Although the couple issued invoices under the business's name, they deposited checks from their clients into their personal bank accounts. The S corporation reported these income items on Form 1120S and issued Schedules K-1 to the shareholders. The corporation did not provide or report any compensation to the taxpayers. The IRS reconstructed the income onto a Schedule C, Profit or Loss From Business, for each shareholder and treated it as self-employment income. One of the principal points relied on by the court in the case was that the country club and other clients assumed that they were dealing with the individuals and not with a corporation. The country club issued Form 1099-MISC, Miscellaneous Income, which it would not have issued to a business entity.16 Therefore, the income from these activities was properly reported on Schedule C rather than Schedule E, Supplemental Income and Loss. Accordingly, the income would be subject to self-employment tax.

Sec. 267(a)(2): Accruals to shareholders

In Petersen, the Tax Court considered whether an accrual-based S corporation could deduct accrued but unpaid expenses relating to an employee stock ownership plan (ESOP) shareholder.17 The S corporation had accrued but unpaid payroll expenses, a portion of which were attributable to the ESOP employee participants. In timely filed tax returns, the accrual-based S corporation claimed these amounts as deductions for accrued but unpaid payroll expenses under Sec. 461 and reported the deductions to the shareholders on a pro rata basis. The IRS disallowed these deductions, based upon the rationale that the ESOP participants were beneficiaries of a trust.

Sec. 267(c) deems participant-employees as constructive owners of S stock held by an ESOP and, hence, the ESOP participants and S corporation were related persons for purposes of Secs. 267(b) and (a)(2). Sec. 267(a)(2) requires deferral of deductions for expenses paid by a taxpayer to a related person until the payments are includible in the related person's gross income. Such related-person relationships are defined in Secs. 267(b) and 267(e), including an S corporation and any person who owns (directly or indirectly) any of the stock of the corporation. Sec. 267(c) provides that trust beneficiaries constructively own stock owned by a trust. Sec. 267(e)(1) treats any person who owns (directly or indirectly) any of the stock as related for purposes of Sec. 267(b). The Tax Court agreed with the IRS and concluded that an ESOP is a trust within the meaning of Sec. 267(c)(1) and that stock held by the ESOP was owned by the trust's beneficiaries. Further, the Tax Court asserted that the ESOP participants and the S corporation were related persons for purposes of Secs. 267(b) and 267(e). Accordingly, the Tax Court held that the taxpayers could not deduct accrued expenses attributable to ESOP participants until paid.

Sec. 1361: Eligible shareholders

Transfer of stock from ESBT to voting trust: In a letter ruling, the IRS addressed the transfer of S corporation stock from an ESBT to a voting trust.18 It appears that the parties were concerned that the ESBT might be divided into separate shares and the vote for the stock held by the trust would become fragmented. The same person was trustee of both trusts. The IRS ruled that the voting trust would be a permissible shareholder and that the potential current beneficiaries of the ESBT would still be treated as shareholders for purposes of the 100-shareholder limit.

Creation of ESBT pursuant to divorce: In three sequentially numbered, identical letter rulings,19 S corporation stock had been held by a revocable trust of which one spouse was the grantor. Pursuant to a divorce decree, the stock was to be transferred to a trust of which both spouses were beneficiaries. The trust was to be treated as two separate shares for administrative purposes. The distribution rights were not identical with respect to each of the beneficiaries. The IRS ruled that the possible unequal distributions did not rise to the level of a binding agreement to alter the shares' rights. Thus, the agreement did not create multiple classes of stock.

The IRS also ruled on whether the nongrantor spouses' portion of the trust was eligible for ESBT status. The agreement regarding distributions did not create a transfer by purchase, which would have invalidated the trust as an ESBT. Therefore, the IRS concluded the trust was an eligible S corporation shareholder.

Sec. 1361: Classes of stock

No-rule status for limited partnership interests: The IRS declared a no-rule area for the question of whether a state-law limited partnership electing to be classified as an S corporation has more than one class of stock.20 These entities should evaluate the partners' rights carefully. In particular, a partnership agreement that provides for liquidating distributions based on capital accounts should be modified so that each unit of ownership has equal preference and priority.

Inadvertent termination on issuance of preferred stock: According to the facts in an IRS letter ruling,21 on date 1, X was incorporated, issued common stock equally to two shareholders, and made a timely S corporation election. On date 2, X amended its corporate articles to authorize issuance of preferred stock and sold preferred stock to a third shareholder. On dates 3 and 4, X sold shares of preferred stock to a fourth shareholder. In a subsequent year, when X became aware that the issuance of preferred stock might have inadvertently terminated its S election, X entered into agreements to exchange all the preferred stock for common stock and amended its corporate articles to authorize only a single class of stock. All preferred stock shares were then canceled and retired. X represented that all shareholders had properly reported pro rata income and distributions and adjusted their stock bases accordingly. The IRS ruled that, based on the facts and representations made, the taxpayer did have an inadvertent termination of its S election and would continue to be treated as an S corporation effective as of date 2 and thereafter.

Disproportionate distributions did not give rise to second class of stock: In Mowry, the taxpayer owned 49% of the stock in an S corporation construction company.22 The taxpayer's brother owned the remaining 51% of the stock. During the years at issue, 2011 and 2012, the taxpayer failed to report both flowthrough income from the S corporation as well as distributions received from the S corporation on his personal returns.

The S corporation did not file its tax returns or distribute Schedules K-1 to the taxpayer during these tax years. The IRS agent examining the taxpayer's returns generated substitute tax returns for the construction company and Schedules K-1 for the shareholders. From these, the IRS agent assessed additional tax, penalties, and interest to the taxpayer. Because of the income flowthrough on the recreated Schedules K-1, the IRS agent was also able to determine that the distributions from the S corporation to the taxpayer did not exceed his basis in the stock, and therefore, in accordance with Sec. 1368, the distributions were not taxable gains to the taxpayer.

The taxpayer took issue with the assessments for the income flowthrough and challenged the findings. The taxpayer argued that the S corporation had made disproportionate distributions between the two brothers during the years examined and had in effect created a second class of stock. In 2011 and 2012, the brother received distributions totaling approximately $736,000, and the taxpayer received a total of nearly $125,000. The taxpayer argued that this disparity in payments evidenced a second class of stock that terminated the S election. If the election had terminated, the construction company was taxable as a C corporation. The taxpayer, in turn, did not report tax for the flowthrough income from the construction company but only dividend income for the distributions received.

The Tax Court considered whether the payment of distributions to one shareholder and not to the other shareholder over multiple years resulted in the creation of a second class of stock. However, the court determined that this single factor was insufficient on its own to establish that a separate class of stock was created and that the taxpayer presented no other proof of a second class of stock. Rather, the court found it had to consider what the corporate documents, binding agreements, and any other "governing provisions" declared as shareholder rights to distributions.23 Reviewing these factors, the court concluded:

  • When the corporation was formed, the shareholders intended to have one class of stock;
  • The shareholders signed the original organizing documents that fixed the identical shareholder rights to distributions;
  • The board of directors/shareholders did not have a formal meeting to discuss distributions; and
  • The shareholders never reached or even considered a new binding agreement to change their relative rights to distributions.

Thus, the Tax Court held in favor of the IRS, determining that the S corporation election remained in effect during the years of the extraordinary distributions to the brother. The court remarked that the taxpayer should have sought remedies under state law to determine whether there was a second class of stock, or that he may have suffered a theft loss.

Sec. 1361: Passthrough of qualified dividend

A Tax Court case, Smith,24 involved Hopper U.S., an S corporation. Hopper owned all of the stock in a Hong Kong controlled foreign corporation (CFC). Under Sec. 1373(a), Hopper was treated as a partnership for purposes of Subpart F. Therefore, the shareholders of Hopper were required to take all of the Subpart F income into account.25 As the Hopper shareholders began to wind down business operations, they sold the operating assets of the U.S. S corporation and the Hong Kong subsidiary. The Hong Kong subsidiary's only asset was now cash, and the owners planned to distribute this as a dividend. However, since there is no tax treaty between the United States and Hong Kong, the CFC could not be a "qualified" foreign corporation, and its dividends could not be treated as qualified dividends subject to the long-term capital gain tax rate. Therefore, the shareholders moved the Hong Kong corporation to Cyprus, which had a valid income tax treaty with the United States. The shareholders elected to treat the Cyprus corporation as a domestic corporation under Sec. 962. They treated the dividends as qualified dividends by virtue of the Sec. 962 election. However, the IRS determined, and the Tax Court agreed, that the distributions were received from the Hong Kong subsidiary, even though they were funneled through the Cyprus subsidiary. Thus, they could not be qualified dividends and were subject to the ordinary income tax rates.

Sec. 1362: Passive investment income

Secs. 1362(d)(3) and 1375: In an IRS letter ruling, an S corporation's principal business activities included farming and managing real property.26 The S corporation was the lessor of farm property. Some of the leases provided that the lessor was responsible for the cropland and had authority to enter into government programs. In other leases the lessor and tenant shared certain expenses. The lessor agreed to supervise the harvest in another lease arrangement. The IRS ruled that none of the income from these leases would be treated as passive investment income.

As a side note to this ruling, the arrangements would most likely be treated as trades or businesses for purposes of the QBI deduction. Therefore, the lessor's shareholders might be able to claim a deduction under Sec. 199A for this income, at least if any shareholder's taxable income was less than the threshold level at which the W-2 wage and qualified property limits would apply. Unless the S corporation owned depreciable property and not merely the farmland, it would not have any qualified property associated with these leases. Moreover, unless some of the shared costs included W-2 wages paid to employees, the corporation would not be able to pass any wage base through to its shareholders for purposes of the Sec. 199A deduction.

Sec. 1362(f): Inadvertent termination of S election

Ineligible shareholdersIn another letter ruling, when X (an S corporation) was incorporated, its three shareholders immediately made an S election.27 At a later date, those three shareholders each transferred their ownerships to single-member limited liability companies (LLCs), which were disregarded for federal income tax purposes. A disregarded entity is allowed to own shares in an S corporation if the owner of the disregarded entity is an eligible person.28 Therefore, this action did not jeopardize the corporation's S status. In a subsequent year, following the advice of a tax professional, C, the owner of one of the LLCs, made an election to have his LLC taxed as an S corporation. Both C and his adviser were unaware that this action would terminate X's S election. Furthermore, X's other shareholders were unaware that C had made this election on behalf of his LLC. On an unrelated fourth date, all ownership in X was sold to Y, an ineligible shareholder.

The IRS held that, based on the facts and representations made, the S election did terminate with C's election to treat his LLC as an S corporation while owning X's stock. However, this termination was ruled to be inadvertent under the provisions of Sec. 1362(f). Thus, X was treated as an S corporation until the date on which it was sold toY.

Inadvertent transfer of interest to partnershipIn another letter ruling describing an inadvertent termination,29 X, an S corporation, was incorporated on date 1 and made an S election on date 2. On date 3, all shares in X were transferred to a partnership, an ineligible S corporation shareholder. Shortly thereafter, that partnership transferred all of its shares in X to a second partnership, which was also an ineligible shareholder. When X learned that the first transfer terminated its S election, it took corrective action and had the second partnership transfer all of its shares to Y, an eligible shareholder.

The IRS concluded that X's S election terminated on date 3 when the shares of X stock were transferred to the first partnership and that this termination was inadvertent. Accordingly, X was treated as continuing to be an S corporation on and after date 3. The partnerships were treated as shareholders from date 3 until date 4, when Y became the sole shareholder.

Sec. 1362(f) and Regs. Sec. 1.1362-4: Inadvertently invalid QSub election

Inadvertent failure to file proper qualified Subchapter S subsidiary (QSub) electionA letter ruling, while light on details, involved several tax transactions.30 The facts are assumed to be quite straightforward. Two shareholders formed a corporation, B, which made a valid S election. At a later date, the two shareholders formed another corporation, A, which also filed an S election. Corporation A formed a single-member LLC in another state (entity C). In what was represented to be a Type F reorganization, the two shareholders contributed all of their stock in B (the original corporation) to A. In a Type F reorganization, there can be no addition to the assets and no new shareholders.31 Therefore, the second corporation must have been a shell, with no assets other than the disregarded entity, at the time of the contribution.

After A owned all of the stock of B, corporation B merged into disregarded entity C.32 At this time, A filed a QSub election for B (effective the date that the shareholders contributed their B stock to A), but the election was ineffective for reasons not specified in the letter ruling. The outcome was that all of the assets and liabilities that had been in the original corporation B were now in disregarded entity C, wholly owned by corporation A. Because the QSub election for B was ineffective, B remained a C corporation, and its merger into disregarded entity C constituted a taxable liquidation.33 However, if the QSub election had been effective, there would have been a deemed tax-free liquidation of B into A, and B would have become a disregarded entity at that point. The merger of one disregarded entity into another disregarded entity under the same ownership is not a recognized tax event, so the merger of B and C would have been a tax-free event.

In the letter ruling, the IRS ruled that A's failure to file a proper QSub election for B was inadvertent and that B would be treated as a QSub as of the originally intended effective date of the QSub election. Therefore, the entire set of transactions was treated as a tax-free transfer of assets from B to A, and not a taxable transfer from B toC.

Sec. 1366(d): Losses limited to stock and debt basis

Is the "actual economic outlay" doctrine still alive?: An S corporation shareholder's ability to claim flowthrough losses from the corporation is generally limited to the extent of the shareholder's stock basis and debt basis in the corporation. Sec. 1366(d)(1) provides that the aggregate amount of losses and deductions taken into account by a shareholder under Sec. 1366(a) for any tax year must not exceed the sum of (1) the adjusted basis of the shareholder's stock in the S corporation and (2) the shareholder's adjusted basis of any indebtedness of the S corporation to the shareholder.

In Meruelo, the Tax Court determined that a shareholder did not have sufficient basis to deduct passthrough losses from an S corporation.34 The debt basis in question was an advance from another S corporation controlled by the same shareholders. The result was not surprising and was consistent with decisions in cases dating from the 1960s. However, some statements in the opinion were surprising.

The Tax Court considered both the judicially developed "actual economic outlay" doctrine and the "back-to-back loan" regulations promulgated in final form in 2014 as Regs. Sec. 1.1366-2(a)(2) that purported to replace the actual-economic-outlay doctrine. The judge correctly pointed out that the years in the case occurred before the changes to the regulation were effective, so that the regulations would not apply, and the actual-economic-outlay doctrine applied in the taxpayer's case. However, the court further stated that it did not matter whether the regulations applied, because the test under the regulations for determining whether debt is bona fide indebtedness running directly to the shareholder that gives rise to debt basis was the same as it had been under prior case law. Thus, a taxpayer might still be required to have made an actual economic outlay.

Based on the 2014 regulations and the preamble to them, many practitioners were under the impression that the bona-fide-debt standard had replaced the actual-economic-outlay rule. It appears that the Tax Court may not agree.

Secs. 1368: Distribution vs. compensation

In the Sixth Circuit case of Machacek,35 the taxpayers, a husband and wife, were the sole shareholders of an S corporation. The S corporation employed the husband and paid a $100,000 life insurance premium on the husband's policy under a "compensatory split-dollar arrangement." Each premium payment by the S corporation generated an economic benefit to the husband because the value of the life insurance policy increased. The question at issue in this case on appeal from the Tax Court was whether this economic benefit to the husband, an employee/shareholder, was taxable income to him as an employee (the IRS's position) or reportable as an S corporation distribution of property to him as a shareholder (the taxpayer's position). The Tax Court had held that the arrangement was compensatory.36

However, the Sixth Circuit determined that Regs. Sec. 1.301-1(q)(1)(i) was controlling. This regulation states that the economic benefits described in Regs. Sec. 1.61-22(d) provided by a corporation to its shareholder pursuant to a split-dollar life insurance arrangement, as defined in Regs. Sec. 1.61-22(b)(1) or (2), are treated as a distribution of property. Thus, the court reversed the Tax Court and held that premiums paid on the husband's policy were distributions of property.

Sec. 1368(b): Distribution vs. loan

The taxpayer in Sarvak was the sole shareholder of an S corporation.37 During the years at issue, the S corporation distributed large cash payments to the taxpayer. The taxpayer did not report the distributions as income on his personal returns. The IRS determined that the distributions exceeded the taxpayer's basis in his S corporation stock and declared the payments as taxable gains in the years received and assessed tax, interest, and penalties.

The taxpayer challenged the IRS's determination in Tax Court, offering a novel, if incorrect, argument in his defense. The taxpayer claimed that he was personally liable to the S corporation for the distributions, since he received them in violation of the California Corporations Code. This state law requires a shareholder to return a distribution if the corporation has no retained earnings at the time of the distribution. The S corporation had negative retained earnings (and no AE&P) when the distributions were made. The taxpayer argued that his liability to the S corporation to repay amounts distributed to him increased his debt basis in the S corporation. He claimed that when this increased debt basis was taken into account, he had sufficient basis to absorb the distributions without taxable gain.

The Tax Court found that the taxpayer's claims were off-base and upheld the IRS's determination that the taxpayer had taxable gains. First, the taxpayer did not understand that his obligation to the S corporation did not establish or increase debt basis. Only an obligation from the S corporation directly to the shareholder can establish or increase debt basis. The taxpayer never argued that he loaned money to the S corporation or assumed a direct liability to creditors from the S corporation to establish a supportable lending arrangement.

Second, if a lending arrangement could be verified, Secs. 1367 and 1368 define the treatment of S corporation distributions. Basis in debt is never a consideration when determining whether distributions are taxable. Sec. 1368(b)(1) limits the application of distributions to the adjusted basis of stock only. Any excess of distributions above stock basis is reportable gain.

Sec. 6037: Return of S corporation

Shareholder's return must be consistent with corporate return or IRS notified of inconsistency: Sec. 6037(c) requires a shareholder to report income consistently with that shown by the corporation or notify the IRS of the inconsistency. In Rubin, the taxpayer was the sole shareholder of an S corporation that was in bankruptcy.38 After filing his initial tax returns on which his treatment conformed to that of the corporation, he discovered that the bankruptcy trustee had incorrectly calculated the corporation's cancellation-of-debt income. He filed amended returns with approximately 20 pages of notes detailing the inconsistency. The IRS did not accept this as sufficient notice and rejected the amended returns. A California district court agreed with the IRS in an unpublished opinion.39 However, the Ninth Circuit found that the taxpayer's disclosure met the requirements for justifying the inconsistent position.

Bankruptcy Code Sections 544(b) and 548(a)(1): S corporation status as 'property'

The exemption from federal income tax at the corporate level may be an asset of measurable value. When an S corporation is undergoing a bankruptcy proceeding, the corporation's S election remains in effect unless the corporation revokes that status and becomes a C corporation. The corporation's trustee may be able to enjoin the shareholders from committing any acts that diminish the value of the corporation. Various courts have held that S corporation status is an item of value and that the shareholders cannot revoke the election for an S corporation in bankruptcy or in anticipation thereof.40

In late 2017, a bankruptcy court addressed this problem and came to the opposite conclusion from those in earlier cases. In re Health Diagnostic Laboratory, Inc.,was a case where the shareholders of an S corporation had revoked S corporation status.41 The trustee was hoping to force S status on the corporation by avoiding the termination of the corporation's S status under the fraudulent-transfer provisions of Sections 544(b) and 548(a)(1) of the Bankruptcy Code. If the termination were avoided, the corporate losses would have passed through to the shareholders, who would have reported net operating losses and received income tax refunds. The trustee would have been able to claim the refunds as property of the corporation. However, the judge weighed the definitions of property rights, as adopted by the Fourth Circuit, and determined that S corporation status was not property of the corporation under federal tax law and, consequently, could not be considered "property" for purposes of Sections 544(b) and 548(a)(1) of the Bankruptcy Code.  


1P.L. 115-97.

2Sec. 163(j)(8).

3Used to acquire motor vehicles or farm equipment held for sale or lease. See Sec. 163(j)(9).

4Sec. 163(j)(1).

5Sec. 163(j)(7).

6Secs. 163(j)(3) and 448(c)(1).

7Sec. 448(c)(2).

8Temp. Regs. Sec. 1.448-1T(b)(3).

9Sec. 163(j)(2) and Prop. Regs. Sec. 1.163(j)-6(l)(5).

10Prop. Regs. Sec. 1.163(j)-6(l)(5). Prop. Regs. Sec. 1.163(j)-5(b)(1) implicitly permits a former C corporation to take into account excess business interest after it becomes an S corporation.

11Regs. Sec. 1.199A-6(b)(3)(iii).

12Sec. 641(c)(2)(E), as amended by TCJA §13542(a).

13Sec. 1361(c)(2)(B)(v), before amendment by the TCJA.

14Sec. 1371(f).

15Smith,T.C. Memo. 2018-170.

16Other issues in the case included disallowance of claimed deductions and failure to report some bank deposits as income.

17Petersen, 148 T.C. 463 (2017).

18IRS Letter Ruling 201837012.

19IRS Letter Rulings 201834007, 201834008, and 201834009.

20Rev. Proc. 2018-3, §3.01(96).

21IRS Letter Ruling 201751007.

22Mowry, T.C. Memo. 2018-105.

23Regs. Sec. 1.1361-1(l)(2)(i).

24Smith, 151 T.C. No. 5 (2018).

25Sec. 1373(a).

26IRS Letter Ruling 201812003.

27IRS Letter Ruling 201727001.

28See IRS Letter Rulings 9745017, 200107025, 200303032, and 200513001.

29IRS Letter Ruling 201801007.

30IRS Letter Ruling 201821011.

31Regs. Sec. 1.368-2(m).

32Most states permit mergers of corporations into LLCs and vice versa.

33Regs. Sec. 301.7701-3(g).

34Meruelo, T.C. Memo. 2018-16.

35Machacek, No. 17-1131 (6th Cir. 10/12/18).

36Machacek, T.C. Memo. 2016-55.

37Sarvak, T.C. Memo. 2018-68.

38Rubin, 904 F.3d 1081 (9th Cir. 2018).

39Rubin, No. CV 16-02567-RGK (C.D. Cal. 10/14/16).

40E.g., Parker v. Saunders, 226 B.R. 227 (B.A.P. 9th Cir. 1998), and In re Frank Funaro, Inc., 263 B.R. 892 (B.A.P. 8th Cir. 2001). However, the Third Circuit held to the contrary in In re Majestic Star Casino, LLC, 716 F.3d 736 (3d Cir. 2013).

41In re Health Diagnostic Laboratory, Inc., 578 B.R. 552 (Bankr. E.D. Va. 2017).



Laura Howell-Smith, J.D., is director at Deloitte & Touche LLP in Washington. Robert W. Jamison Jr., CPA, Ph.D., is author of CCH's S Corporation Taxation and professor emeritus of accounting at Indiana University in Indianapolis. Bryan Keith, J.D., is managing director, Washington National Tax Office, at Grant Thornton LLP in Vienna, Va. Robert S. Keller, CPA, J.D., LL.M., is managing director, Washington National Tax, at KPMG LLP. Laura MacDonough, CPA, is executive director in the National Tax Department of Ernst & Young LLP in Washington. Sarah P. McGregor, CPA, is director, tax services, at Cherry Bekaert LLP in Greenville, S.C. Tawnya D. Nyman, CPA, MSAT, is principal at The Nichols Accounting Group PC in Nampa, Idaho. Ms. MacDonough is the chair, Mr. Keller is the vice chair, and the other authors are members of the AICPA S Corporations Taxation Technical Resource Panel. For more information on this article, contact


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