Current developments in S corporations

By Robert W. Jamison Jr., CPA, Ph.D.; Bryan D. Keith, CPA, J.D.; Robert S. Keller, CPA, J.D., LL.M.; Laura M. MacDonough, CPA; Tawnya D. Nyman, CPA; Kenneth N. Orbach, CPA, Ph.D.; and Horacio E. Sobol, CPA



  • Regulations were issued implementing the statutory change made by the law known as the Tax Cuts and Jobs Act (TCJA) permitting nonresident aliens to be potential current beneficiaries of electing small business trusts.
  • The IRS issued a number of letter rulings excusing S corporation inadvertent terminations due to the corporations' having a second class of stock. Other letter rulings excused terminations due to ineligible shareholders and allowed S corporations to reelect S status before five years had passed since a prior termination.
  • In Tomseth, a federal district court rejected the taxpayer's argument that an S corporation that had been in and out of S status could include in its most recent S period's accumulated adjustment accounts (AAA) undistributed AAA from prior S periods.
  • Last year, the IRS proposed to amend a regulation to state that any shareholder who receives distributions during the post-termination transition period (PTTP) is permitted to treat the distributions as coming from the AAA.
  • The IRS issued proposed regulations that provide rules relating to distributions of money by an eligible terminated S corporation after the PTTP and extending the treatment of distributions of money during the PTTP to all shareholders of the corporation.

Fourteen sections of the Internal Revenue Code are central to the taxation of Subchapter S corporations and their shareholders. Over the last 12 months, significant guidance has been released under these Code sections, including the issuance of proposed and final regulations, several court opinions, and IRS rulings that interpret those provisions. The AICPA S Corporation Taxation Technical Resource Panel, a volunteer group of practitioners who pay close attention to guidance under Subchapter S, offers the following updates from this past year, as summarized below by Code section.

Sec. 641(c): Electing small business trust

From its enactment in 1996 until it was amended by the law known as the Tax Cuts and Jobs Act (TCJA),1 an electing small business trust (ESBT) could not have any potential current beneficiary who was ineligible to hold stock directly.2 Thus, a nonresident alien could not be a potential current beneficiary. Before the TCJA changed the law, regulations provided that any portion of the trust over which any person held grantor-type powers would not be treated as an ESBT. Instead, the grantor or deemed grantor would be treated as the owner of that portion, and any income from the S corporation attributable to this portion would be taxable to the person holding the power.3

The change to Sec. 641(c) from the TCJA — specifically, to allow nonresident aliens as potential current beneficiaries — necessitated two changes to the regulations, which were implemented in T.D. 9868. First, the final regulations remove any language in the text or examples in Regs. Sec. 1. 1361-1(m) that explicitly or implicitly prohibit a nonresident alien from potential current beneficiary status. Second, they modify the language in Regs. Sec. 1.641(c)-1 that shifted income to a person holding grantor powers so that it did not apply to nonresident aliens.

Sec. 1361: S corporation defined

Sec. 1361(b) lists several conditions that are necessary for a corporation to be eligible for S corporation status. Among these are a limitation on the number of shareholders at any given time; the limitation of eligible shareholders to individuals, estates, and certain trusts; and the requirement that there may only be one class of stock outstanding.

Sec. 1361(b)(1)(D): Class of stock

An S corporation can have only one class of stock. For this purpose, a corporation is treated as having one class of stock if all outstanding corporate shares of stock confer identical rights of distribution and liquidation proceeds. Differences in voting rights are disregarded.4 The determination of whether all outstanding shares meet this condition is based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (governing provisions). Commercial agreements, such as contractual agreements, leases, and loan agreements, are not governing provisions unless a principal purpose of an agreement is to circumvent the one-class-of-stock requirement.

Other instruments, obligations, or arrangements that are not treated as a second class of stock include many options; certain short-term unwritten advances and proportionately held debt; straight debt; certain buy-sell and redemption agreements; and certain deferred compensation plans.5 For this purpose, under Regs. Sec. 1.1361-1(b)(4), a deferred compensation plan is not outstanding stock (and therefore cannot be a second class of stock) provided it (1) does not convey the right to vote; (2) is an unfunded and unsecured promise to pay in the future; (3) is issued to an individual who is an employee or independent contractor in connection with services provided to the corporation; and (4) is issued pursuant to a plan with respect to which the employee or independent contractor is not taxed currently on the service income (although certain current payment features are permitted).

Deferred compensation agreement is not a second class of stock

A recent letter ruling illustrates a permitted deferred compensation arrangement that was not deemed to create a second class of stock. In IRS Letter Ruling 201926008, the IRS ruled that two arrangements between an S corporation X, its sole shareholder individual A, and service provider individual B were deferred compensation plans. A, B, and X originally entered into Agreement 1 in which A agreed to sell a percentage of stock to B upon the satisfaction of certain conditions. Before any stock was sold, the agreement was replaced by Agreement 2. This latter agreement generally provided B with payment rights upon the occurrence of certain "liquidation" events, such as the sale by X of a majority of its assets; the lease, exchange, or license of substantially all of X's assets; a merger or consolidation in which the legacy shareholders of X lost control of X; or an IPO of X stock. Agreement 2 also contemplated a possible buyout of B's rights, secured by A's X stock, prior to a liquidation event.

The IRS ruled that both Agreement 1 and Agreement 2 were deferred compensation plans under Regs. Sec. 1.1361-1(b)(4) and were therefore not prohibited second classes of stock.

Sec. 1362: Election; revocation; termination

Sec. 1362 describes the procedures for electing or revoking S corporation status. It also states some rules for terminating S corporation status if the corporation fails to meet one or more of the eligibility requirements of Sec. 1361. Sec. 1362(g) includes a restriction for former S corporations that decide to reelect S corporation status, prohibiting a new election for five tax years unless the IRS consents to a new election. An often-used provision within this section provides relief for corporations that have failed to meet eligibility requirements, either at the time of the S corporation election or after the election took effect.

Sec. 1362(f): Inadvertent defective election

A corporation that filed an election to become an S corporation may find that its election was ineffective, for one of two reasons: either (1) it was ineligible to be an S corporation when it filed the election, or (2) the information in the Form 2553, Election by a Small Business Corporation, was incorrect, not all shareholders consented to the election, or the form was filed late. The following discussion addresses several recent letter rulings on these issues.

Multiple classes of stock

IRS Letter Ruling 201935010 addressed an inadvertent defective election from multiple classes of stock. A corporation filed an S election and had filed S corporation returns. Assuming that the election was valid, all of the shareholders filed their individual income tax returns including their pro rata shares of S corporation items. In a later due-diligence study, a potential purchaser discovered that the corporation had two classes of stock when the corporation filed its S election. One class was voting stock, and the other was nonvoting. Although Subchapter S allows a difference in voting rights, each shareholder must nonetheless have equal distribution and liquidation rights. However, the directors of this corporation had amended the liquidation rights, causing the corporation to be in violation of the single-class-of-stock requirement. After discovering the problem, the corporation amended its articles of incorporation so that both classes of stock had equal liquidation rights. The IRS ruled that the invalidity of the election was inadvertent and that the corporation had been an S corporation since the effective date of the election.

IRS Letter Ruling 201949009 concerned a limited liability company (LLC) that had filed an election to be an S corporation. The operating agreement stated that the company was to be a partnership for federal income tax purposes and the members were to be treated as partners. In addition, there were two classes of ownership interests — a capital interest and a profits interest. Upon liquidation of the partnership, the profits interest could only receive the assets attributable to income after the issuance of the profits interests. Since the capital and profits interests were not entitled to equal amounts pro rata, the company had violated the single-class-of-stock rule. The entity in question merged into another corporation in a Type F reorganization, in which there is a mere change in identity, form, or place of organization of one corporation before the merger. The surviving corporation represented that all of the entity and owner returns from the initial date of the S election were filed consistently as if an S election had been in effect. The IRS treated the merged entity as if the S election had been in effect from the initial date of the election until the merger. It declined to rule on whether the F reorganization was valid and whether the entity was otherwise a valid S corporation.

Ineligible shareholder: Transfer of interest to LLC

IRS Letter Ruling 201908019 involved an inadvertent termination. Z, a single-member LLC, acquired portions of the stock in corporations W, X, and Y, all of which had previously made timely S corporation elections at incorporation. Although Z had also made an election to be treated as an S corporation, its fractional ownership in the other corporations is not permitted under the S corporation rules, and this resulted in inadvertent terminations of those corporations. In year 2, upon notification of the termination, Z's member represents that the company relied on its tax and legal advisers to take corrective action, but no action was taken. However, a new tax adviser was obtained in year 3 who informed Z's member that the restructuring had not been done. Therefore, a restructuring occurred in year 4 whereby Z acquired all the stock of W and X, with the intention to treat them as qualified Subchapter S subsidiaries (QSub). The stock of Y was transferred to eligible S shareholders.

The IRS concluded that Z's ownership of W, X, and Y caused inadvertent termination of those corporations' S elections. However, the corporations will all continue to be treated as S corporations effective as of their respective dates of incorporation, provided they take the appropriate corrective measures as indicated above.

Creation of second class of stock due to agreements

Two letter rulings provided relief to corporations for inadvertent terminations due to agreements signed subsequent to their valid S elections, which created a second class of stock.

In IRS Letter Ruling 201930023, an LLC, X, was organized on date 1 and made elections to be taxed as an S corporation on date 2. On date 3, the original founding members entered into an agreement providing that all distributions would be made according to their membership interests. However, on date 4, this agreement was amended to indicate that liquidating distributions would be paid in accordance with positive capital account balances under Sec. 704. On date 5, the amendment was corrected to remove the language for the separate liquidating provision and to provide that all distributions will be made in accordance with ownership percentages.

X represents that all distributions made since date 2 have been consistent with members' pro rata ownership. The IRS held that based on provisions in the amendment, the S election did terminate on date 4. However, this termination was ruled to be inadvertent, and X will continue to be treated as an S corporation.

In IRS Letter Ruling 201919005, entity X incorporated on date 1 with shares of voting and nonvoting common stock. The stock shares were identical other than the difference in voting rights. On date 2, X made an election to be treated as an S corporation. As of date 3, A, B, and C have been the only shareholders of X. Although the ownership percentages were not provided, the letter indicates that A and B have identical ownership and C has a different percentage. On date 4, the shareholders entered into an agreement providing that (1) if a shareholder's voting stock was sold, a corresponding percentage of that shareholder's nonvoting stock must be canceled and, if the remaining shareholders have unequal ownership of the remaining nonvoting stock, the shareholder would be entitled to distributable earnings pro rata in accordance with the nonvoting shares; and (2) in the event of a sale of X, C would receive a payment in excess of the payments to A and B. On date 5, the agreement was amended to remove both of those provisions. No shares were sold between dates 4 and 5. The IRS concluded that X's election was terminated on date 4 due to the provisions in the agreement. However, this termination was ruled to be inadvertent, and therefore X will continue to be treated as an S corporation from date 4.

Creation and issuance of preferred stock shares

IRS Letter Ruling 201949003 addressed an S corporation that amended its articles of incorporation to authorize and issue shares of preferred stock to Trust, an eligible shareholder. The preferred stock shares provided for different dividend and liquidation rights. The corporation issued preferred stock shares to Trust on two dates. Upon learning that the preferred stock might have terminated its S election, X converted the preferred stock to common stock and amended and restated its articles of incorporation to authorize only a single class of stock. X represented that all shareholders had taken into account their pro rata shares of income and distributions and properly adjusted their stock basis as required under Sec. 1367. Based on these representations, the IRS ruled that the S election was inadvertently terminated and X will continue to be treated as an S corporation.

Multiple classes of stock and lack of proper consent

IRS Letter Ruling 201936005 addressed an inadvertent defective election where there were four violations of the S corporation eligibility rules. There were two causes of ineffectiveness of the S election. However, inadvertent defective election relief would have become undone, since another action after the election would have taken effect would have resulted in termination of the S election. The events are summarized in the table "S Election Termination Issues" (below).

S election termination issues

The entity was a limited partnership that had filed an entity election and Subchapter S election simultaneously. The partnership agreement provided that profit and loss sharing was to be based on the various partners' ratios, which could change over time. The ratios were to be based on the substantial-economic-effect rules of Regs. Sec. 1.704-1(b)(2)(iv). Since this allocation would not necessarily be the same as it would be for a corporation with a single class of stock, the entity potentially had more than one class of "stock" (actually, ownership interests, since it was a partnership).

Moreover, one of the interest owners, an LLC with multiple owners, did not consent to the S corporation election. The owner was treated as a partnership for federal income tax purposes, rendering it ineligible to hold shares in an S corporation. The members of the ineligible shareholder were other shareholders in the limited partnership that had elected S corporation status.

Later the entity redeemed one of the other owner's interests. The remaining owners, including the ineligible owner, signed a new income allocation agreement, in accordance with the substantial-economic-effect rules of Regs. Sec. 1.704-1(b)(2)(iv). This was the second time the entity violated the single-class-of-stock rule. To rectify these problems, two of the owners in the ineligible entity assigned their interests to the third member, so the entity was now a disregarded entity. This removed the shareholder eligibility problem. The entity then converted to a corporation under state law, thus terminating the partnership agreement on profit and loss sharing.

The IRS ruled that the initial flaws concerning the class of stock and the ineligible shareholder were inadvertent, so the entity could be treated as an S corporation from the initially intended effective date. The IRS also ruled that the second profit and loss sharing agreement was an inadvertent violation, so the S election continued to be in effect. The IRS conditioned relief on the corporation's filing a new Form 2553 within 120 days of the ruling, specifying the effective date as the initial intended date of the first election.

Sec. 1362(g): Election after prior termination

In IRS Letter Ruling 201908009, a corporation's sole shareholder elected to terminate the company's S election shortly before dying. Upon receipt of the corporate stock shares, the two beneficiaries of the estate requested permission for the company to reelect to be an S corporation before the expiration of the five-year waiting period for reelecting S status. Under Regs. Sec. 1.1362-5(a), a more-than-50% change in stock ownership from the ownership on the date of termination tends to establish that consent should be granted. Accordingly, the IRS granted permission to file a new S election.

Sec. 1366: Passthrough of income and losses

In Nzedu,6 the taxpayers filed a joint individual income tax return with several problems, including omission of some income. Among the issues were losses deducted from a purported S corporation. However, the taxpayers could not prove they filed Form 2553 at any time. Therefore, the IRS disallowed the loss on the taxpayers' individual return. The Tax Court upheld the disallowance.

In Bonilla,7 the taxpayer-wife was awarded 100% of an S corporation in a divorce decree. Although the corporation was dissolved administratively under state law, it continued to carry on a business. Moreover, Bonilla never received any stock certificates, although she did receive Schedule K-1 (Form 1120-S), Shareholder's Share of Income, Deductions, Credits, etc., for each of the years in question. The IRS and the district court required her to report the income from the corporation on her personal tax returns.

Sec. 1368(e): Distributions; accumulated adjustments account

In Tomseth,8 three corporations had each twice elected S corporation status and three times terminated S corporation status, observing the five-year minimum period between terminating and reelecting S status. The taxpayers were individual shareholders in three S corporations that transitioned between S corporation and C corporation status several times. For the year at issue, the corporations were S corporations that made distributions that significantly exceeded the accumulated adjustment accounts (AAAs) arising from their most recent periods as S corporations. In addition, one of the S corporations made distributions that exceeded its AAA during a prior S period, which the shareholders treated as nontaxable distributions. The year in which the distributions should have been included in the shareholders' taxable income was closed by the statute of limitation on assessment. The IRS made the following arguments:

  1. If the available AAA exceeded the distributions for an S period (including the post-termination transition period (PTTP) for each) the AAA would reset to zero; and
  2. If distributions exceeded the AAA balance for an S period, the AAA would permanently become negative.

The federal district court granted partial summary judgment for the government on the first argument, concluding that the AAAs of corporations with terminated S elections reset to zero after the expiration of the corporations' PTTPs. Thus, when the corporations reelected S status, their beginning AAA balances were zero. However, the court also held that S corporation distributions made in a closed year that exceeded the corporation's AAA and were not included in shareholders' income did not create a negative AAA balance to be taken into account when the corporation reelected S status.

An S corporation that was previously a C corporation must maintain an AAA. The AAA generally approximates undistributed S corporation earnings and represents the amount that the corporation can distribute to its shareholders (generally tax-free) before the corporation's accumulated earnings and profits (AE&P) (generally taxable as dividends).

The AAA is defined as an account of the S corporation that is adjusted for the S period in a manner similar to a basis adjustment (with certain exceptions). The term "S period" is generally defined as the most recent continuous period during which the corporation has been an S corporation. Regulations provide that on the first day of the first year for which the corporation is an S corporation, the AAA balance is zero.9

Generally, distributions are sourced from the AAA only while the corporation is an S corporation. This general rule, however, has two exceptions. First, if a corporation's S election has terminated, any distribution of money by the corporation with respect to its stock during a PTTP is applied against and reduces the adjusted basis of the stock to the extent that the amount of the distribution does not exceed the AAA. Second, if an eligible terminated S corporation within the meaning of Sec. 481(d)(2) distributes money after the PTTP, the AAA is allocated to the distribution and the distribution is chargeable to AE&P in the same ratio as the amount of the AAA bears to the amount of AE&P.

A PTTP arises either when a corporation's S election terminates or after a termination when, under an audit, the IRS adjusts a Subchapter S item of income, loss, or deduction arising during the S period (and with respect to distributions, results in an increase in the corporation's AAA).

The taxpayers argued that, in determining an S corporation's AAA, the corporation's undistributed AAA from prior S periods should be taken into account. The government argued that the AAA is determined only by reference to a corporation's most recent S period and that a significant portion of the distributions received by the taxpayers were therefore taxable as dividends. Regarding the S corporation whose distributions exceeded its AAA in a closed year, while the government acknowledged that it was too late to assess the tax that should have been paid in the closed year, it argued that the S corporation should be treated as having a negative beginning balance in its AAA upon reelecting S status in an amount equal to the distributions made in excess of the AAA in the closed year.

The taxpayers, in support of their position that a corporation's undistributed AAA from prior S periods should be taken into account in determining the S corporation's AAA, argued that Sec. 1368(e) (providing that the AAA is adjusted for the S period, and defining the S period as the most recent continuous period during which the corporation has been an S corporation) does not require the AAA to be reset to zero at the start of a new S period; rather, it simply means that adjustments to the AAA are only permissible during an S period. The taxpayers also argued that the legislative history to the Subchapter S Revision Act of 1982 (SSRA)10 supported their position, citing the language from the House Report stating that, "under the bill, shareholders of subchapter S corporations with accumulated earnings and profits will be assured of tax-free treatment with respect to distributions, regardless of when made."11 Finally, the taxpayers noted that newly enacted Sec. 1371(f), which sources cash distributions from an eligible terminated S corporation after the PTTP to AAA, supported their position because any AAA that expires after the PTTP cannot logically be available for distribution under Sec. 1371(f).

The government, in support of its position, cited Chief Counsel Advice 201440621 and three tax treatises: Mertens Law of Federal Income Taxation (Thompson Reuters); Standard Federal Tax Reporter (CCH); and S Corporations: Federal Taxation (Thomson Reuters).

The court rejected the taxpayers' arguments that a corporation's AAA from prior S periods can be taken into account, finding that an AAA, as "an account of the S corporation," can only exist while an S corporation exists. Further, the court found the word "continuous" in the definition of the S period as significant. Congress's decision to include that word, the court stated, implies that the AAA is eliminated once an S period ends; "[o]therwise, Congress could have chosen to define an S-period as any period that a corporation operates as an S-corp without regard to whether that period has been continuous."12 If any AAA survived the termination of a corporation's S election, the court observed, there would be no point in having a PTTP.

While acknowledging that the SSRA legislative history cited by the taxpayers supported their position, the court determined that the history could not resolve the statute's meaning, absent more evidence. The court also dismissed the taxpayers' arguments based on Sec. 1371(f), noting that Sec. 1371(f) was an apparent "prophylactic measure against unwanted consequences of the [TCJA] for certain S corporations. It is a narrow exception for certain S-corps that were not prepared for the effect of the new legislation."13 Finally, the court found the authorities cited by the government compelling and the CCA "worthy of deference."14

While holding against the taxpayers generally, the court did hold in their favor in rejecting the government's position that an S corporation's beginning AAA could be negative if, in a closed year, the S corporation made distributions in excess of its AAA and the shareholders did not include the excess distributions in their taxable income. The government's argument was based primarily on the fact that Sec. 6501 does not bar recalculations, despite barring tax assessments outside of the statute of limitation.

The government then cited authorities under which it could adjust net operating losses and tax credit carryforwards available in open tax years, for adjustments to amounts in closed tax years. The court did not find the government's arguments compelling. While accepting the government's position on recalculations, it noted that any AAA could not be reduced below zero as a result of distributions and that the recalculation rules would not change this result. Even if the recalculation rules would allow an S corporation's AAA to be reduced below zero as a result of distributions, the rules resetting a corporation's AAA to zero at the beginning of a new S period would preclude a beginning negative balance in the AAA. The district court's decision has been appealed to the Ninth Circuit.15

Sec. 1371: Cash distributions in PTTP

After an S corporation terminates its S election and becomes a C corporation, there is a PTTP. This period generally ends one year after the last day of the last S corporation year or the due date for filing the return for that year, whichever is later. Special rules apply for S corporations that were unaware of the termination until a subsequent audit. There are two important rules for the PTTP:

  1. A shareholder who had insufficient basis to deduct losses while the S election was in effect may acquire additional basis by cash contributions to the capital and use that additional stock basis to deduct losses suspended before the S election terminated (Sec. 1366(d)(3)(B)).
  2. Distributions to shareholders during the PTTP are treated as reductions of basis (or gain if the distribution exceeds a shareholder's basis) to the extent of the corporation's AAA balance on the last day of the final S corporation year (Sec. 1371(e)).

Regs. Sec. 1.1377-2 states that only persons who were shareholders on the final day of the last S corporation year are eligible to characterize PTTP distributions as if they were from the corporation's AAA.16

In 2019, the IRS proposed an amendment to this regulation to state that any shareholder who receives distributions during the PTTP treats the distributions as coming from the AAA, not just those who were shareholders as of the final day of the last S corporation year. (See the "no newcomer" rule discussed under Sec. 1371(f)).17 The effective date of the new rule would be for tax years beginning after the date the proposed regulations are finalized. However, a corporation could elect to apply the new rule to distributions in any prior years that are not closed by the statute of limitation when the final regulations become effective.18

Rev. Rul. 2019-13: Stock redemptions in PTTP

In May 2019, the IRS released Rev. Rul. 2019-13. This ruling clarified the application of Sec. 1371(e) to a cash redemption of C corporation stock treated as a distribution under Sec. 301 pursuant to Sec. 302(d). Sec. 1371(e) provides that, in general, distributions of cash by a former S corporation made during the PTTP are applied against and reduce the adjusted basis of stock to the extent of the AAA as of the last day of the S corporation. Under current regulations, that treatment is only available to shareholders that were shareholders at the time of the S termination.19 The ruling concludes that these "distribution equivalent redemptions" are afforded the same treatment under Sec. 1371(e) as actual cash distributions under Sec. 301.

The ruling cites Sec. 1368(e), which states that the AAA is an account of the S corporation, which is adjusted for the S period similarly to adjustments made under Sec. 1367. It further notes that Sec. 1368(e)(2) defines the S period as the most recent continuous period during which the corporation has been an S corporation. Notwithstanding the above statutory references, the IRS ruled that the C corporation(former S corporation) must reduce its AAA to the extent of the distribution. Neither the statute nor the current regulations contain any example whereby the AAA is adjusted when the corporation is not an S corporation; however, proposed regulations providing guidance under Sec. 1371(f) do call for adjustments to AAA for distributions covered by Sec. 1371(f). While the adjustment to AAA under the holding of the revenue ruling arrives at an appropriate policy result, it is not readily clear under what authority such an adjustment is permitted or required.

Sec. 1371(f) proposed regulations: Eligible terminated S corporation

On Nov. 7, 2019, Treasury and the IRS issued proposed regulations20 concerning rules around an eligible terminated S corporation. An eligible terminated S corporation is any C corporation (1) that was an S corporation on the day before the date of enactment of the TCJA and revoked its S corporation election in the two-year period beginning on the date of enactment; and (2) the owners of the stock of which (determined on the date on which such revocation is made) were the same as, and those owners held the stock in the same proportions as, on the date of enactment.

The TCJA provided two generally favorable provisions applicable to eligible terminated S corporations. The first provision — Sec. 481(d) — relates to accounting method changes required as a result of an S corporation's conversion to a C corporation. Specifically, the 2017 tax law provides that, in the case of an eligible terminated S corporation, any Sec. 481 adjustment arising from an accounting method change attributable to the corporation's revocation of its S corporation election will be taken into account ratably during the six-tax-year period beginning with the year of the method change. Thus, a corporation that must change a method of accounting as a result of the revocation of its S corporation election within the prescribed period would include any income resulting from that change over six tax years (as opposed to four years under the normal rule).

The second provision — Sec. 1371(f) — revised the treatment of distributions made by an eligible terminated S corporation following its conversion to C corporation status. Under this new provision, in the case of a distribution of money by an eligible terminated S corporation (as defined in Sec. 481(d)) after the PTTP, AAA is allocated to the distribution, and the distribution is chargeable to AE&P, in the same ratio as the amount of the AAA bears to the amount of the AE&P.

With respect to the latter provision, two issues from the proposed regulations are worth highlighting. As noted, Sec. 1371(f) specifically requires calculating a ratio between a corporation's AAA and AE&P for purposes of determining the federal tax consequences of distributions after the PTTP. The proposed regulations adopt a "snapshot approach" under which an eligible terminated S corporation generally calculates AAA and AE&P only once at the beginning of the day on which revocation of the corporation's S status is effective (as opposed to recalculation of amounts before each qualified distribution). At that time, the ratio of AAA and AE&P is determined and continues to apply to all distributions until the corporation's AAA is exhausted. This generally will provide for favorable treatment of distributions by eligible terminated S corporations.

In addition, the preamble to the proposed regulations explains that a no-newcomer rule imposed on qualified distributions from the S corporation would not be consistent with congressional intent to ease the transition of former S corporations to full C corporation status because such a rule would impede an eligible terminated S corporation's ability to exhaust its AAA (as well as to impose an administrative burden on eligible terminated S corporations and create complexity). Thus, the proposed regulations do not impose a no-newcomer rule with respect to the eligible terminated S corporation period.

Accordingly, new shareholders, whether eligible S corporation shareholders or not, that acquire stock of an eligible terminated S corporation on or after the date that the revocation was made may receive qualified distributions, all or a portion of which may be sourced from AAA. Because this rule differs from that currently applicable to distributions made by a corporation during the entity's PTTP, the proposed regulations would revise those rules, as well, to be consistent with the rules applicable to distributions during the eligible terminated S corporation period (see discussion above under "Sec. 1371: Cash Distributions in PTTP").

The regulations are proposed to apply to tax years beginning on or after the date when the regulations are published as final in the Federal Register. The preamble, however, states that corporations may elect to apply certain measures as final provided all shareholders of the corporation report consistently.

Sec. 162: Trade or business deduction on Schedule C

In Morowitz,21 an attorney incorporated his law practice and, from 1999 until 2009, he was the sole shareholder. Then he agreed to admit another shareholder. The new shareholder received 50% of the stock. The two attorneys agreed that Morowitz would collect fees and pay expenses that arose from cases in existence prior to the new shareholder's admission. Morowitz paid expenses relating to preexisting cases from the corporation's bank account but claimed them as deductions on his Schedule C, Profit or Loss From Business. He also compensated the corporation's legal secretaries out of pocket for work performed on these cases. The IRS and the district court disallowed both types of deductions because he could not establish that he practiced as a sole proprietor and therefore was entitled to take Schedule C deductions.

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

The Tax Court case Petersen was discussed in the 2019 article "Current Developments in S Corporations."22 In 2019, the Tenth Circuit upheld the Tax Court decision, finding that an S corporation and the participants in an employee stock ownership plan (ESOP) established by the S corporation are related persons for purposes of applying Sec. 267(a)(2).23

Sec. 267 contains constructive ownership rules, under which a person not actually owning stock in a corporation may nevertheless be treated as a shareholder. Relevant here is Sec. 267(c)(1), which provides in part that stock owned by a trust shall be considered as being proportionately owned by its beneficiaries. The taxpayer argued that an ESOP is not a trust and that the participants are not beneficiaries, so Sec. 267(a)(2) should not apply to defer the S corporation's deduction for wages payable to the participants until paid. The court dismissed the taxpayer's arguments, holding that the assets of the ESOP are clearly held in trust, and in the context of an ESOP, there is no meaningful distinction between "participants" and "beneficiaries" and that the participants in the ESOP are clearly beneficiaries of the trust.


1P.L. 115-97.

2Sec. 1361(c), before amendment by TCJA §13541.

3Regs. Sec. 1.641(c)-1(b)(1).

4Sec. 1361(b)(1)(D), Sec. 1361(c)(4), and Regs. Sec. 1.1361-1(l)(1).

5Regs. Secs. 1.1361-1(l)(4) and (5).

6Nzedu, T.C. Summ. 2019-22.

7Bonilla, No. 3:17-CV-212(JCH) (D. Conn. 3/22/19).

8Tomseth, No. 6:17-cv-02017-AA (D. Or. 9/27/19).

9Regs. Sec. 1.1368-2(a)(1).

10Subchapter S Revision Act of 1982, P.L. 97-354.

11H.R. Rep't 97-286, 97th Cong., 2d Sess., p. 19 (Sept. 16, 1982).

12Tomseth, slip op. at 11.

13Id. at 17-18.

14Id. at 22.

15Tomseth, No. 19-35979 (9th Cir. 12/13/19) (appeal filed).

16Regs. Sec. 1.1377-2(b).

17REG-131071-18, Part II.A.

18Prop. Regs. Sec. 1.1377-3.

19Regs. Sec. 1.1377-2(b). However, proposed regulations issued in November 2019 extend this treatment to any shareholder who receives a distribution during the post-termination transition period.


21Morowitz, No. 1:17-CV-00291 (D.R.I. 3/7/19).

22Howell-Smith et al., "Current Developments in S Corporations," 50 The Tax Adviser 184 (March 2019).

23Petersen, 924 F.3d 1111 (10th Cir. 2019), aff'g in part and remanding in part 148 T.C. 463 (2017).



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 D. Keith, CPA, 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 M. MacDonough, CPA, is executive director in the National Tax Department of Ernst & Young LLP in Washington. Tawnya D. Nyman, CPA, MSAT, is managing tax principal at The Nichols Accounting Group PC in Nampa, Idaho. Kenneth N. Orbach, CPA, Ph.D., is a professor of accounting at Florida Atlantic University in Boca Raton, Fla. Horacio E. Sobol, CPA, is a partner in Pricewaterhouse-Coopers LLC National Tax Services Office in Washington.Mr. Keller is the chair, Ms. MacDonough is the immediate past chair, and the other authors are members of the AICPA S Corporation Taxation Technical Resource Panel. For more information about this article, contact


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