Fourteen sections of the Internal Revenue Code are central to the taxation of Subchapter S corporations and their shareholders. Over the 12-month period ending March 2021, these sections and others affecting S corporations have been addressed by recent legislation, court cases, and IRS guidance. The AICPA S Corporation Taxation Technical Resource Panel, a volunteer group of practitioners who pay close attention to matters affecting S corporations and their shareholders, offers the following summary of recent developments relating to this tax area. The items are arranged by Code section and often contain a short description of the relevant provision.
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 only be one class of stock outstanding. There are also specified ineligible corporations, but these are limited to certain banks, life insurance companies, domestic international sales corporations (DISCs) or former DISCs, and corporations that have terminated S corporation or qualified Subchapter S subsidiary status within the past five years. The statute does not specifically address other entities, such as not-for-profit corporations.
Not-for-profit corporation was not allowed to make S election: In Deckard,1 the Tax Court addressed the ability to make an S election for a nonstock, not-for-profit corporation.
In 2012, Clinton Deckard organized Waterfront Fashion Week Inc. (Waterfront), a nonstock, not-for-profit corporation under Kentucky law. The intended charitable and educational purposes of the organization failed to develop, and Waterfront suffered losses during its first two years in existence (2012 and 2013). Waterfront was dissolved twice under state law for failure to file its annual reports (once in 2013 and again in 2014). Deckard had Waterfront reinstated for 2013 but did not seek reinstatement for 2014. Deckard subsequently filed a retroactive S corporation election for Waterfront and attempted to claim operating losses for 2012 and 2013, as he had funded approximately $275,000 of Waterfront's expenditures via capital contributions.
The Tax Court held that Deckard had no beneficial ownership rights as a shareholder under state law and the articles of incorporation because Waterfront's articles of incorporation provided, among other things, that:
- "No part of the net earnings of the Organization shall inure to the benefit of, or be distributable to its directors, officers or other private persons."
- "The Organization is organized exclusively for charitable and educational purposes";
- "The Organization shall not have members"; and
- "Upon dissolution of the organization, its assets shall be distributed as directed by a two-thirds majority vote of the directors in office for (i) one or more exempt purposes . . ., or (ii) any other federal, state, or local government entity or enterprise established exclusively for a public purpose."
Deckard was thus prohibited from making an S election for Waterfront and was not permitted to claim any losses of Waterfront on his individual return.
Second class of stock created by partnership operating agreement: An S corporation cannot have more than one class of stock (Sec. 1361(b)(1)(D)). 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.2 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 (collectively, the "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.
Not treated as a second class of stock are instruments, obligations, or arrangements including: many call options; certain short-term unwritten advances and proportionately held debt; straight debt; certain buy-sell and redemption agreements; and certain deferred compensation plans.3
In a private letter ruling,4 the IRS addressed the issue of whether a limited liability company (LLC) had just one class of stock outstanding. As expected, the IRS's focus was on the provisions of the LLC's operating agreement. The operating agreement was drafted as though the entity would be a partnership for federal tax purposes, so it included provisions such as the allocation of profits among members in proportion to their negative capital balances (if any), the allocation of losses among members in proportion to positive capital account balances, and the requirement that liquidating and nonliquidating distributions be made in proportion to capital account balances.
In the letter ruling, the IRS concluded that the terms of the operating agreement created a second class of stock. This was the case even though the LLC elected S status at the time of its formation. Thus, if all parties contributed capital to the entity pro rata in accordance with their percentage interest in the LLC and all allocations of income were made pro rata to the members, then presumably the dollar figures that the members ultimately were entitled to through ordinary or liquidating distributions would be identical. Although the letter ruling does not describe the relative contributions by the parties, the IRS appears to have concluded that the mere existence of the partnership provisions described above in the operating agreement caused the LLC to have a second class of stock — regardless of whether any real differences in economic entitlement existed.
If a second-class-of-stock issue exists, it may be possible to obtain Sec. 1362(f) relief for an inadvertently invalid S election or an inadvertent termination of an initially valid election from the IRS through the private letter ruling process. However, that relief generally must be sought at the time the issue is discovered.
Second class of stock not created by mixed-use opportunity fund: The law known as the Tax Cuts and Jobs Act (TCJA)5 established the opportunity zone program under new Sec. 1400Z-1. Under this regime, a taxpayer that realizes an eligible capital gain prior to Dec. 31, 2026, may defer federal income tax on that gain, or a portion of it, by investing the amount of the gain, or a portion of it, in a qualified opportunity fund (QOF). If the amount invested in a QOF exceeds the amount of eligible gain, then the taxpayer may have a nonqualifying investment for the amount of gain in excess of eligible gain invested in the QOF and a qualifying investment for the amount of eligible gain invested in the QOF. This is referred to as a "mixed-fund" investment, and separate tracking may be required between the nonqualifying and qualifying portions of the QOF.
Regs. Sec. 1.1400Z2(b)-1(c)(7)(iv), which became effective in March 2020, addresses an S corporation operating a mixed-funds investment in a QOF. Under the regulation, if different blocks of stock are created for separate qualifying investments to track basis in such qualifying investments, the separate blocks are not treated as different classes of stock for purposes of S corporation eligibility under Sec. 1361(b)(1).
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) contains a restriction that prevents a former S corporation from reelecting S corporation status 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.
Merger caused inadvertent termination of S election: A private letter ruling6 involved an inadvertent termination of S corporation status that occurred when several companies merged. 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' S elections. In year 2, upon notification of the termination, Z's member represented 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 (QSubs). The stock of Y was transferred to eligible S shareholders.
The IRS concluded that Z's ownership of W, X, and Y caused an 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.
Sec. 1363: Effect of election on corporation
Although an S corporation is a passthrough entity, it must compute its taxable income and observe the rules for inclusion or exclusion of income items, as well as the deductibility or nondeducibility of expenses. Several issues came to light when Congress enacted the Coronavirus Aid, Relief, and Economic Security (CARES) Act.7
The CARES Act's effect on income, deductions: The CARES Act created the Paycheck Protection Program (PPP), which allows employers and some self-employed individuals to receive loans from the U.S. Small Business Administration. If the borrower meets certain conditions, the U.S. government forgives the loan, essentially converting the loans to nontaxable emoluments.8
If the loan did not qualify for forgiveness, the expenses paid therefrom would be potentially deductible, subject to the usual capital expenditure rules.9 The loan proceeds would not give the shareholders any basis, since Subchapter S permits basis only for "indebtedness of the S corporation to the shareholder."10 However, the forgiveness of debt under the PPP posed additional questions and issues.
The trade-off for the exclusion seemed to be that the wages and other expenses paid with the proceeds from the canceled loans would not be deductible.11 The IRS based this position on Sec. 265(a)(1), which disallows a deduction for any expense allocable to tax-exempt income. The IRS opined that the cancellation of debt under the PPP is a "class" of tax-exempt income and that the payments made from the proceeds are allocable to this class.12
From an accounting viewpoint, this position made sense: Gross income − deduction = Exclusion − nondeductible expense.
However, it was politically unpopular. In the S corporation context, uncertainties included:
- Although neither the loan nor the forgiveness would create shareholder basis, would the nondeductible expenses reduce basis?
- Although neither the loan nor the forgiveness would add to the corporation's accumulated adjustments account (AAA), would the nondeductible expenses reduce the AAA?
- How might these problems be compounded if the expenses were paid in 2020 and the forgiveness occurred in 2021?
There were no apparent unambiguous answers to these and other issues.
In the Consolidated Appropriations Act, 2021 (CAA),13 Congress added several provisions to the PPP forgiveness rules. The CAA reiterated the rule that forgiveness of loans is exempt from tax.14 However, the CAA specified that forgiven loan amounts are tax-exempt income, within the meaning of Secs. 705 (partnerships) and 1366 (S corporations).15
Therefore, these forgiven amounts are treated as increases in basis to the owners. In addition, any amounts paid from the funds of the forgiven PPP loans are not subject to disallowance as deductions merely due to the tax-exempt source of funds.16
Moreover, these rules will apply to any subsequent PPP loans, unless the legislation should specifically provide otherwise. Therefore, Treasury does not have the authority to disallow basis to partners or shareholders, or to disallow deductions for payments resulting from forgiven loan proceeds, under any current or prospective PPP loan forgiveness law.17
As of this writing, there remain some open questions.18 Payment of expenses in 2020 and debt forgiveness in 2021 still leave the possibility that a shareholder may have insufficient basis, or amount at risk, to claim a deduction in 2020, but will need to carry excess losses forward until basis augmentation happens in 2021. If a taxpayer has already filed a return and did not deduct expenses paid from PPP loans, it may be necessary to file an amended return. The IRS said in Rev. Proc. 2021-20 that fiscal-year taxpayers who filed a 2020 return on or before Dec. 27, 2020, can deduct eligible expenses on their 2021 return, rather than filing an amended 2020 return.
Finally, since the tax-exempt income resulting from the forgiven loans will add to the other adjustments account (OAA), the now deductible expenses paid from the PPP loan proceeds will reduce the AAA, possibly causing some distributions to be taxable dividends from the corporation's accumulated earnings and profits (AE&P). Tax professionals must be on the alert for rulings or other announcements from the IRS that may address these issues.
On March 15, 2021, the AICPA Tax Executive Committee sent a letter to IRS Associate Chief Counsel's office recommending that an S corporation should recognize the forgiveness of a PPP loan when it has made the required expenditures from the loan proceeds. At that time, the corporation has completed all of the substantive requirements for forgiveness. The letter also recommends that the expenses paid from these loans should reduce the OAA, rather than the AAA, account.19
Sec. 1366: Passthrough of income and losses
An S corporation shareholder increases basis for his or her allocable share of tax-exempt income. However, this does not include any cancellation-of-debt (COD) income excluded by the corporation pursuant to Sec. 108(a). The PPP rules, as discussed previously, specifically provide that a shareholder's portion of excluded PPP loan forgiveness passes through to each shareholder as tax-exempt income, within the meaning of Sec. 1366(a)(1)(A). However, this provision applies only to PPP loans and does not apply to any other COD income exclusions.20
No economic substance to business partners' transactions: In Kechijian,21 two business partners engaged in a series of complex structuring and restructuring transactions to ultimately decrease the tax liability on shares of stock once it became substantially vested. The Fourth Circuit upheld the Tax Court's ruling under the economic substance doctrine, holding that the complex transactions were undertaken solely to reduce tax liability and did not have a reasonable expectation of economic profit.
Larry Austin and Arthur Kechijian were partners in distressed loan portfolio businesses beginning in 1990.In 1998 they consolidated their businesses under an S corporation, UMLIC-S. As part of the restructuring, the taxpayers executed with UMLIC-S a five-year earnout agreement under which each taxpayer would lose 50% of the value of his shares if he voluntarily terminated his employment with UMLIC-S before Jan. 1, 2004. Later in 1998 (after employee stock ownership plans (ESOPs) became eligible S corporation shareholders), the taxpayers caused UMLIC-S to form an ESOP for its employees, including the taxpayers.22 The ESOP purchased 5,000 shares of UMLIC-S stock. At the end of 1998, the two taxpayers each owned 47.5% of the corporation, and the ESOP owned 5%.
In late 2003 the taxpayers decided to reorganize again. The taxpayers formed UMLIC Holdings LLC (Holdings) in which they each held a 50% interest. Still in 2003, UMLIC-S sold all its operating assets to Holdings in exchange for a note and the assumption of liabilities. UMLIC-S elected out of installment sale treatment under Sec. 453(d), realizing a capital gain of $175 million.
On Jan. 1, 2004, the restrictions on the five-year earnout agreement lapsed and the shares became substantially vested. At that time, the value of the shares held by each taxpayer was $46 million. Three months later, the taxpayers attempted to reduce their tax liability on the $46 million of income they each would have to recognize under Sec. 83 by entering into identical "surrender" and "subscription" agreements with UMLIC-S, whereby each taxpayer purported to (1) return all their newly vested shares to the corporation and (2) simultaneously repurchase an identical number of shares back in exchange for $42 million. Each taxpayer reported income of $4 million ($46 million − $42 million) rather than $46 million. The taxpayers contended, based on a rescission theory, that the "surrender" transaction effectively negated and reversed $42 million of their compensation income.
The courts held that the restricted stock received by the taxpayers in 1998 was subject to a substantial risk of forfeiture (and was presumably nontransferable) at that time due to the five-year earnout agreement and thus was substantially nonvested.23 As a result, the taxpayers were able to defer the compensation income from the receipt of the restricted stock until the stock became substantially vested (namely, when the restriction lapsed) on Jan. 1, 2004.
Second, because the taxpayers' stock was substantially nonvested, the stock was not considered outstanding for purposes of Subchapter S.24 Thus, the only stock outstanding for the tax years 2000-2003 was the 5% owned by the ESOP. The taxpayers, therefore, did not report any income from UMLIC-S; all of the income (including the $175 million capital gain realized by UMLIC-S in 2003 on the installment sale of its operating assets to Holdings) passed through to the ESOP and was tax-free. The courts rightly countenanced this remarkable result.
Third, each of the taxpayers had to recognize the $46 million value of his shares on Jan. 1, 2004, when the restriction lapsed and the stock became substantially vested. The Fourth Circuit did not accept the taxpayers' contention that their surrender agreements effectively rescinded all but $4 million of the $46 million of income that the taxpayers would otherwise have to recognize under Sec. 83. The court, quoting from Rev. Rul. 80-58, stated that the surrender agreement did not restore taxpayers "to the relative positions that they would have occupied had no contract been made." It is essentially impossible for an individual who renders services, such as the taxpayers, to be "returned" to their original position prior to their services. In any event, both courts agreed that the simultaneous "surrender" and "subscription" agreements lacked economic substance and must be disregarded for income tax purposes, and sustained a Sec. 6662 penalty on the taxpayers for the 2004 tax year.
Character of shareholders' income: Whether S corporation shareholders correctly characterized certain income they received was at issue in two recent cases. In Liu,25 the Tax Court recharacterized as ordinary income certain qualified dividend income reported by a married couple with respect to their ownership in an S corporation. The taxpayers owned all of the stock of LB Education Corp. (LB), an S corporation. For the years 2012 and 2013, respectively, LB issued Schedules K-1, Shareholder's Share of Income, Deductions, Credits, etc., to the shareholders, who reported ordinary operating income of approximately $250,000 and $180,000. However, on their joint individual income tax returns for the years at issue, the taxpayers reported the income as qualified dividend income. The court held that the income was ordinary.
In McKenny,26 the issue involved how to characterize a payment received in settlement of a malpractice lawsuit against a CPA firm. A married couple hired an international CPA firm to provide tax planning and preparation advice regarding their car dealership consulting business. The CPA firm recommended that the couple's consulting business elect S corporation status and that the S corporation be wholly owned by an ESOP. Since ESOPs are tax-exempt retirement plans and taxation only occurs upon distribution to the beneficiaries, the McKennys would pay no tax on the S corporation's earnings. This strategy was legal in 2000 when initiated by the McKennys. However, Congress eliminated the use of ESOPs for closely held S corporations, effective in 2005. The McKennys were audited in 2005 and assessed additional tax of $2.2 million. The McKennys sued the CPA firm for malpractice in the amount of the tax, penalties and interest, legal fees, and punitive damages. The suit was settled in 2009 for $800,000.
In 2009, the McKennys:
- Excluded the $800,000 from income as return of capital;27
- Deducted the legal fees as a Sec. 162 ordinary business expense of the S corporation consulting business; and
- Deducted an unreimbursed loss equal the net tax paid on audit.
On the three issues:
- The district court followed Clark28 and ruled the settlement payment was a return of capital;
- The legal fees were deemed personal and not business legal fees; and
- The unreimbursed loss deduction was precluded due to an agreement with the IRS.
The Eleventh Circuit affirmed the nondeducibility of the legal fees and unreimbursed loss but reversed the lower court regarding the settlement payment. The court found the payment to be includible in taxable income under Sec. 61. The court noted that the Clark case has never been applied by the court and is limited to malpractice related to tax preparation, which does not include the planning and advice services provided by the CPA firm. Moreover, the taxpayer did not sustain the burden of proof that Clark applied to the facts of the case.
Deducting a loss in excess of basis: Although it is not a current development, per se, Field Service Advice Memorandum (FSA) 200230030 has become the subject of recent scrutiny. The memorandum held that when a shareholder deducted a loss in excess of basis, the IRS does not adjust the loss deduction, and the loss year has closed, the shareholder must reduce basis in future years. Sec. 1367(a)(2) requires that a shareholder reduce basis for losses, deductions, and nondeductible expenses, but does not condition the reduction of basis to this shareholder claiming the losses on a tax return. The effect of FSA 200230030 is to impute a negative basis when an S corporation shareholder has claimed losses in excess of basis and the IRS no longer has the ability to adjust the tax for the year in which the shareholder claimed the losses or deductions.
The May 2020 S corporations update article in The Tax Adviser29 contained a discussion of the Tomseth case.30 One of the issues in this case was the IRS's contention that excess distributions from an S corporation to its shareholders in a closed year created a negative balance in the corporation's AAA. The district court held that the negative balance in the AAA should have no tax significance after a corporation has terminated its S corporation status. The court relied on Regs. Sec. 1.1368-2, which provides the narrow circumstances under which AAA can be negative. The court found the government's "recalculation" theory did not fit within the limited circumstances permitted by the regulations. The court also dismissed the government's claim that the "recalculations" were analogous to adjustments, due to errors in closed years, made to current-year net operating losses (NOLs) or investment credit carryovers.
Now compare the court's reasoning in this case with the government's opinion in FSA 200230030 that basis can be negative. In spite of a statutory rule — Sec. 1367(a)(2) — stating that basis cannot be negative at the end of any period, the government opinion in the FSA states that basis in an open period can be reduced by "recalculations" involving losses in excess of basis erroneously deducted in a closed period. The Tomseth decision would appear to call the reasoning of the FSA into question.
Sec. 1367: Adjustments to basis of stock of shareholders, etc.
Effect of the CARES Act and CAA: In general, a shareholder in an S corporation includes tax-exempt income of the corporation in adjusting basis for a tax year.31 However, if an S corporation excludes COD income under Sec. 108(a), there is no adjustment to shareholder basis.32 The CARES Act stated that the forgiveness would not be taxable.33 The CAA specified that forgiven loan amounts are tax-exempt income, within the meaning of Secs. 705 (partnerships) and 1366 (S corporations).34 Therefore these forgiven amounts are treated as increases in basis to the owners. See the discussion above under Sec. 1363.
Sec. 1368: Distributions
IRS releases practice units on distributions: On July 14, 2020, the IRS released three practice units on S corporation distributions: General Overview of Distributions and Accumulated Earnings & Profits, Distributions With Accumulated Earnings & Profits, and Property Distribution[s].35 The practice units highlight audit steps that IRS examiners should consider when reviewing certain distributions made by S corporations to their shareholders. The units recite the law, as interpreted by the IRS. But perhaps more importantly, the units reveal the issues examiners should be cognizant about and the documentation they should require of taxpayers. For taxpayers and their advisers: Forewarned is forearmed.
The units examine the proper determination of the S corporation's items of income, loss, deduction, and distribution amounts; and the amount of the corporation's AE&P as well as shareholder stock basis (in particular the requirement that shareholders maintain adequate books and records to substantiate stock basis). If there is a property distribution, the units examine the proper recognition of corporate-level gain; the character of the gain; the proper distribution amount in a bargain sale; and whether a transfer is subject to the built-in gains tax.
The IRS describes the source rule for an S corporation with AE&P: AAA, previously taxed income (PTI) (rarely applicable), AE&P, OAA, return of capital, and capital gain. OAA has no legal significance; its only purpose, according to the IRS, is to help the S corporation determine the source of the distribution that is not from AAA, PTI, or AE&P. Also described is how the S corporation may electively change the ordering rule and the consents required to do so. The IRS also examines the AAA ordering rule and the ability to elect to terminate the tax year (for purposes of allocations to shareholders) in the case of a qualifying disposition.
The IRS advises examiners of common errors made by taxpayers in their computation of AAA, for example:
- Improper inclusion of tax-exempt income and related expenses in AAA;
- Failure to reduce AAA by other nondeductible expenses; and
- Failure to properly account for such extraordinary transactions as capital gain redemptions, liquidations, reorganizations, and divisions.
The IRS also advises its examiners that a significant difference between retained earnings and AAA is an indication of the existence of positive AE&P, that an S corporation may estimate its AE&P based on retained earnings as of its last C year, and that the duty of consistency precludes an S corporation from changing the character of distributions reported in closed statute years from nondividend to dividend. The IRS recommends that fair market value (FMV) may be corroborated using third-party resources like the Kelley Blue Book or comparable sales.
Although not the law, these practice units serve as a primer on the tax consequences of distributions in kind or of cash to shareholders by an S corporation with positive AE&P. Moreover, practice units alert tax professionals to the substance of the training of IRS personnel.
GILTI inclusions of S corporation shareholders: Notice 2020-69, issued Sept. 1, 2020, applies to S corporations that hold stock in controlled foreign corporations (CFCs). Sec. 951A, commonly known as the global intangible low-taxed income (GILTI) regime, generally requires U.S. shareholders that own at least 10% of any CFC to include in income an amount of GILTI for that year, also referred to as a GILTI inclusion amount. Unlike Subpart F, GILTI may include ordinary business income of a CFC, so it is likely to touch many more taxpayers than the Subpart F income rules. Because Sec. 1373 treats S corporations as partnerships for many international provisions of the Code, including Sec. 951A, S corporation shareholders are treated as shareholders of the CFC and must consider any GILTI inclusion.
The final GILTI regulations covered the determination of pro rata shares of income inclusions but did not completely address their application to passthrough entities. The regulations generally adopted an "aggregate" approach for both partnerships and S corporations. Under the aggregate method, S corporation shareholders that have a GILTI inclusion will increase their stock basis in the S corporations. This will generally be shareholders who, "looking through" the S corporation, own 10% or more of the underlying CFC stock. However, shareholders that are not required to include a GILTI amount in income (for example, because they do not meet the 10% threshold) will not increase their stock basis until and unless the CFC distributes a dividend to the S corporation. No increase to AAA is made for any GILTI inclusion.
Notice 2020-69 announced Treasury and the IRS's intention to issue regulations for S corporations with AE&P and provided an election for S corporations with AE&P to elect "entity" treatment of GILTI. This provision is intended to address concerns that when S corporations with AE&P make distributions to cover shareholders' tax liabilities, including GILTI, they may not have enough AAA to make pro rata distributions without dipping into AE&P. Notice 2020-69 does not address the consequences of pro rata distributions to shareholders that do not have a stock basis increase as a result of a GILTI inclusion.
The election is only available to S corporations that made S elections before June 22, 2019; owned CFC stock as of that date; had AE&P at Sept. 1, 2020, that has not been reduced to zero by subsequent distributions (transition AE&P); and maintain records supporting the determination of transition AE&P. The determination of whether any transition AE&P remains is made at the beginning of each subsequent year.
Once transition AE&P is reduced to zero, the S corporation must use the aggregate method. For example, if a calendar-year S corporation made the election for 2020 and distributed all transition AE&P before Jan. 1, 2021, it would use the aggregate method for 2021. Transition AE&P is also not increased for any transactions or entity classification elections after Sept. 1, 2020, and it cannot be transferred in any corporate transaction.
The effect of the election is to treat the CFC GILTI inclusion amount as an item of income of the S corporation itself, increasing AAA and shareholder stock basis. All shareholders take their share of the GILTI into account. The S corporation makes the entity treatment election for the first tax year ending on or after Sept. 1, 2020, on its timely filed (including extensions) tax return, or on an amended return filed by March 15, 2021. The election, which is irrevocable for all future years, must state:
- The entity election for GILTI inclusion amounts is being made; and
- The amount of transition AE&P.
The return, including Schedules K-1 and Form 8992, U.S. Shareholder Calculation of Global Intangible Low-Taxed Income (GILTI), must be consistent with the election. According to the notice, no Sec. 250 deduction is allowed for any GILTI inclusion amount.
The AICPA has submitted comments respectfully requesting Treasury and IRS to:
- Provide appropriate transition rules relating to the Notice 2020-69 election, which is restricted to only certain S corporations;
- Issue further guidance on how best to administer the aggregate method;
- Allow all S corporations to elect an entity method; and
- Consider allowing S corporations to make a Sec. 962 election.36
The issue of GILTI lookthrough extends beyond S corporations with AE&P. It also affects the calculation of shareholder basis and can disadvantage minority shareholders. For example, if the stock basis of all shareholders is zero, and a shareholder with 95% ownership in the lower-tier CFC increases his or her stock basis by the GILTI inclusion amount, that shareholder can receive cash to cover taxes. However, a 5% shareholder, who does not meet the 10% threshold, but who will participate in the pro-rata distribution, will have capital gain on this distribution in excess of basis. If this outcome can be mitigated by considering cash distributions up to the amount of total GILTI as not being made under the normal rules of Sec. 1368, the aggregate method would be more appealing. The AICPA recognizes that there might need to be additional reporting at the S corporation level to enable the IRS and shareholders to keep track of this special provision.
Alternatively, allowing all S corporations to elect an entity method would greatly simplify reporting for both S corporations and shareholders. This election would allow a basis and AAA increase to cover distributions and would not cause minority shareholders to be taxed on an unexpected capital gain. In order to preserve the advantages to the majority shareholders of the aggregate method, shareholders should be permitted to make a Sec. 962 election if they would be eligible under the aggregate method.
Finally, although extending the Sec. 962 election to S corporations might require legislative action, such an election would further simplify reporting for shareholders. The GILTI inclusion could be trapped at the S corporation level as a deemed C corporate subsidiary and would not affect AAA or basis or shareholder-level income whatsoever.
Secs. 1371 and 1377(b): Post-termination transition period
Final regulations issued on PTTP: After an S corporation terminates its S election and becomes a C corporation, there is a post-termination transition period (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:
- 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)).
- 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)).
Before amendment in 2020, Regs. Sec. 1.1377-2 stated 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.37
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 AAA, not just those who were shareholders as of the final day of the last S corporation year. The final regulations apply the PTTP distribution rules to all shareholders. (See the "no-newcomer" rule discussed under Sec. 1371(f).)38 The effective date of the new rule is for tax years beginning after Oct. 20, 2020. However, a corporation may elect to apply the new rule to distributions in any prior years that are not closed by the statute of limitation on Oct. 20, 2020.39
Final regulations issued on eligible terminated S corporations (ETSCs): On Sept. 20, 2020, Treasury and the IRS issued final regulations40 concerning rules around ETSCs. These rules were published in the Federal Register on Oct. 20, 2020, and became effective for tax years beginning after that date.
In general, an ETSC 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 ETSCs. 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 ETSC, 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 ETSC following its conversion to C corporation status. Under this new provision, in the case of a distribution of money by an ETSC (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 AAA bears to the amount of AE&P.
With respect to the latter provision, two issues from the final 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 regulations adopt a "snapshot approach" under which an ETSC 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 ETSCs.
In addition, the final regulations provide 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 ETSC's ability to exhaust its AAA (as well as impose an administrative burden on ETSCs and create complexity). Thus, the final regulations do not impose a no-newcomer rule with respect to the ETSC period.
Accordingly, new shareholders, whether eligible S corporation shareholders or not, that acquire stock of an ETSC 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 final regulations revise those rules, as well, to be consistent with the rules applicable to distributions during the ETSC period.
Sec. 162: Trade or business expense
Sec. 162 allows deductions for ordinary and necessary business expenses. There are special rules for certain types of expenses, and certain statutory and judicial restrictions on deductibility. Among these are the overall rules requiring taxpayers to maintain books and records to substantiate business deductions.
Taxpayer failed to substantiate expenses: In Sellers,41 the taxpayer owned various entities in both an S corporation and partnership structures. On his 2013 and 2014 individual returns, the taxpayer took various deductions and losses from the passthrough entities including a deduction for self-employed health insurance from the S corporation and nonpassive activity losses. The IRS issued a notice of deficiency recharacterizing the losses as passive and denied the deduction for self-employed health insurance. The taxpayer timely petitioned the Tax Court to reverse the deficiency and associated accuracy-related penalties. The Tax Court upheld the notice of deficiency and accuracy-related penalties due to lack of substantiation by the taxpayer. The taxpayer had direct control over all of the entities but did not present any of those records at trial to substantiate material participation, basis in the entities, or the cost of the health insurance paid by the S corporation on his behalf.
Sec. 163: Interest expense
Sec. 163(j) limits the deduction for business interest payments. For many business taxpayers, the limit on the deduction of business interest expense is:
- 100% of business interest income, plus
- 30% of adjusted taxable income (ATI), plus
- Floor plan interest paid on vehicle inventory held for sale or lease.42
For all taxpayers affected by the restriction, except for partnerships, the CARES Act increased the limit from 30% of ATI to 50% of ATI for the year 2019. However, certain partners have special relaxation rules for 2019. For 2020, any taxpayer may elect to base the deduction limit on the 2019 ATI.
Final regulations issued: In July 2020, the IRS and Treasury released final regulations under Sec. 163(j) (the 2020 final regulations) addressing what constitutes interest for purposes of the Sec. 163(j) limitation, how to calculate the Sec. 163(j) limitation, which taxpayers and trades or business are subject to the limitation, and how the limitation applies in certain contexts (e.g., consolidated groups and passthrough entities such as S corporations and partnerships).43 The 2020 final regulations generally apply to tax years beginning on or after Nov. 13, 2020. The extent to which taxpayers can apply the 2020 final regulations, proposed regulations issued in 2018, and the statute is a complex and nuanced analysis.
The 2021 final regulations44 adopt the self-charged lending rule from the 2020 proposed regulations without substantive changes. The IRS and Treasury declined to broaden the scope of the rule to tiered partnerships, S corporations, or loans to partnerships by other members of the same consolidated group as a corporate partner. Therefore, the self-charged lending rule does not apply to S corporations.
Sec. 164: Taxes
Guidance issued on SALT deduction limitation: Sec. 164(b)(6) limits the itemized deductions for personal property taxes, state or local taxes, foreign taxes, and state and local sales taxes in lieu of state and local income taxes (SALT) to $10,000 per year ($5,000 if married filing a separate return), after 2017 and before 2026.
On Nov. 9, 2020, the IRS issued Notice 2020-75, which announces that Treasury and the IRS intend to issue proposed regulations to clarify that certain state and local income taxes imposed on and paid by a passthrough entity, such as a partnership or an S corporation, are allowed as a deduction by the partnership or S corporation in computing its nonseparately stated taxable income or loss for the tax year of payment. According to Notice 2020-75, the proposed regulations also are intended to clarify that certain state and local income tax payments, described in the notice and made by a partnership or an S corporation, are not taken into account in applying the state and local tax deduction limitation under Sec. 164(b)(6) at the individual level.
If a partnership or an S corporation makes a "specified income tax payment" during a tax year, the partnership or S corporation is allowed a deduction for the specified income tax payment in computing its taxable income for the tax year in which the payment is made. Any specified income tax payment made by a partnership or an S corporation during a tax year does not constitute an item of deduction that a partner or an S corporation shareholder takes into account separately under Sec. 702 or Sec. 1366 in determining the partner's or S corporation shareholder's own federal income tax liability for the tax year.
Instead, specified income tax payments must be reflected in a partner's or an S corporation shareholder's distributive or pro rata share of nonseparately stated income or loss reported on a Schedule K-1 (or similar form). Any specified income tax payment made by a partnership or an S corporation is not taken into account in applying the SALT deduction limitation to any individual who is a partner in the partnership or a shareholder of the S corporation.
The proposed regulations described in Notice 2020-75 will apply to specified income tax payments made on or after Nov. 9, 2020. Partnerships or S corporations may apply the rules described in the notice to specified income tax payments made in a tax year of the partnership or S corporation ending after Dec. 31, 2017, and made before Nov. 9, 2020, provided that the specified income tax payment is made to satisfy the liability for income tax imposed on the partnership or S corporation pursuant to a law enacted prior to Nov. 9, 2020. Prior to the issuance of the proposed regulations, taxpayers may rely on the provisions of the notice with respect to specified income tax payments.
Sec. 165: Losses
Real estate developer denied NOL deductions: In Sage,45 the Tax Court held that the transfers of parcels of real estate by a real estate developer to liquidating trusts (for the benefit of mortgage holders) did not have the effect of producing the losses claimed for the years because there were no bona fide dispositions or completed transactions regarding the property transfers to the liquidating trusts.
The taxpayer (a real estate developer) owned, through an S corporation, three parcels of real estate in Oregon that were encumbered by liabilities in excess of their FMVs. In response to the 2008 recession, the S corporation in December 2009 engaged in a series of transactions designed to transfer the parcels to three separate liquidating trusts for the benefit of the mortgage holders. These were unilateral transactions in which the properties were placed in the trusts without any involvement from the beneficiaries. Between 2010 and 2012, the liquidating trusts disposed of the parcels, and the mortgage holders applied the proceeds from these dispositions against the outstanding liabilities of the S corporation and its wholly owned LLC. The S corporation reported significant losses as a result of the 2009 transactions — losses that the shareholder claimed on his 2009 individual tax return. These losses gave rise to an NOL, which the taxpayer carried back to his 2006 tax year as an NOL carryback deduction and carried forward to his 2012 tax year as an NOL carryover deduction. Through exam, the IRS disallowed the losses reported by the S corporation and claimed by the taxpayer for the 2009 tax year; made correlative adjustments to the 2006 and 2012 NOL deductions; and determined deficiencies for 2006 and 2012. The taxpayer timely filed a petition with the Tax Court.
The Tax Court held the NOL deductions were properly disallowed, finding that the proceeds of the Oregon parcels held by the liquidating trusts were applied to discharge certain liabilities of the S corporation and its wholly owned LLC between 2010 and 2012, and the S corporation and the LLC were the owners of the corresponding liquidating trusts during those years under the "grantor trust" provisions of Secs. 671-679. Because the S corporation and the LLC owned the liquidating trusts beyond the close of the 2009 tax year, the losses reported by the S corporation and claimed by the shareholder for 2009 were not bona fide dispositions and not "evidenced by closed and completed transactions, fixed by identifiable events, and actually sustained during" that year pursuant to Regs. Sec. 1.165-1(b). The Tax Court sustained the deficiencies and also the assessment of an accuracy-related penalty under Sec. 6662.
Sec. 6037: Return of S corporation
Sec. 6037 requires that each S corporation submit an annual return and gives the IRS the authority to prescribe forms and regulations. In addition, the corporation must furnish information to each shareholder. Certain changes have gone into effect for 2020 returns, and others will begin in tax year 2021.
Schedule B-1/K-1 reporting (beginning in 2020):Beginning with the 2020 tax returns (2021 filing season) each S corporation that has as a shareholder a disregarded entity, a trust, an estate, or a nominee or similar person at any time during the tax year will have to report additional information on Schedule B-1, Information on Certain Shareholders of an S Corporation, accompanying the taxpayer's Form 1120-S, U.S. Income Tax Return for an S Corporation. This schedule requires disclosure of the name, tax identification number (TIN) and type, (trust, estate, etc.) and the name and TIN of the person responsible for reporting the nominal shareholder's items on a tax return. The IRS requires attachment of this schedule to Form 1120-S even if the reporting shareholder's TIN appeared on Schedule K-1 (Form 1120-S). Furthermore, Schedule K-1 (Form 1120-S) also requires reporting of the beginning and ending number of shares held by each person. There is also required reporting of beginning and ending shareholder loans to the corporation.
International reporting (beginning in 2021): On July 14, 2020, Treasury and the IRS proposed changes to Form 1065, U.S. Return of Partnership Income, for tax year 2021 (filing season 2022) and noted that such changes were also intended to apply to S corporations.46 The TCJA enacted numerous international tax changes. S corporations currently report information to shareholders on Schedule K-1 (Form 1120-S), and information supporting certain amounts reported on the Schedule K-1 (Form 1120-S) are often supplemented by numerous footnote statements and schedules to provide additional detail to shareholders. Due to the complexity in the international tax arena, these white paper statements are often necessary for S corporations with international transactions.
The updates are intended to provide greater clarity for shareholders on how to compute their U.S. income tax liabilities with respect to international tax matters, including how to compute deductions and credits. The draft Schedules K-2 and K-3 intend to standardize the way an S corporation reports international tax information to shareholders, offering greater transparency to the IRS and clarity to both S corporations and their shareholders.
The new draft schedules are lengthy and complex. Specifically, new Schedule K-2 would replace portions of Schedule K, while new Schedule K-3 would replace portions of Schedule K-1. Certain other sections expand types of international tax information not currently reported on Schedule K-1 (e.g.,Schedule K-2, Part IV, Section 3, "Distributions for Foreign Corporation to Partnership," and Schedule K-3, Part IX, "Foreign Partner's Character and Source of Income and Deductions").
The AICPA submitted a comment letter on the proposed draft schedules recommending transmittal of only relevant portions of the schedules and minimizing overreporting by allowing S corporations the ability to determine the reporting needs of its shareholders. More detailed information regarding these draft schedules may be found in the comment letter.47
1Deckard,155 T.C. No. 8 (2020).
2Secs. 1361(b)(1)(D) and (c)(4), and Regs. Sec. 1.1361-1(l)(1).
3Regs. Secs. 1.1361-1(l)(4) and (5).
4IRS Letter Ruling 202010001.
6IRS Letter Ruling 201908019.
7Coronavirus Aid, Relief, and Economic Security Act, P.L. 116-136.
9Rev. Rul. 2020-27.
12Regs. Sec. 1.265(a)-1.
13Consolidated Appropriations Act, 2021, P.L. 116-260.
18See Scott, "PPP Expense Deductibility and Forgiveness Raises Basis, Other Issues," The Tax Adviser (Dec. 27, 2020 ).
20See the comprehensive discussion under Sec. 1363, above.
21Estate of Kechijian, 962 F.3d 800 (4th Cir. 2020), aff'g Austin, T.C. Memo. 2017-69.
22The ESOP in question was in existence before 2001 and therefore was not subject to the nonallocation rules of Sec. 409(p)(1).
23See Regs. Secs. 1.83-3(b), (c), and (d).
24Regs. Sec. 1.1361-1(b)(3).
25Liu, T.C. Memo. 2020-31.
26McKenny, 973 F.3d 1291 (11th Cir. 2020).
27Relying on Clark, 40 B.T.A. 333, 335 (1939), and Rev. Rul. 57-47.
28In Clark, 40 B.T.A. 333 (1939), a payment received from negligent tax counsel was held to be excludable. Although this decision is over 80 years old, there have been few citations. Later cases tend to limit tax-free receipts of damages to cases involving physical injury or recovery of capital.
30Tomseth, 413 F. Supp. 3d 1018 (D. Or. 2019).
33CARES Act, §1106(i).
34Consolidated Appropriations Act, 2021, §276(a)(1)(i)(3)(A).
37Regs. Sec. 1.1377-2(b).
39Regs. Sec. 1.1377-3.
41Sellers, T.C. Memo. 2020-84.
45Sage, 154 T.C. No. 270.
46The forms have yet to be finalized as of this writing.
|Kristin Hill, CPA, is the owner of Kristin Hill, CPA, PC, in Berkeley, Calif. Robert W. Jamison Jr., CPA, Ph.D., is the author of CCH's S Corporation Taxation and professor emeritus of accounting at Indiana University in Indianapolis. Robert S. Keller, CPA, J.D., LL.M., is a partner in KPMG's Washington National Tax practice. Kenneth N. Orbach, CPA, Ph.D., is a professor of accounting at Florida Atlantic University in Boca Raton, Fla. Alexander Scott, J.D., LL.M., is a senior manager with AICPA Tax Policy & Advocacy in Washington, D.C. Kevin J. Walsh, CPA, CGMA, is a partner in Walsh, Kelliher & Sharp, CPAs, APC, in Fairbanks, Alaska. Sheryll Wilson, CPA/ABV,is retired. Mr. Keller is the chair, and each of the other authors, except for one, is a member of the AICPA S Corporation Taxation Technical Resource Panel. Other members of the panel also contributed to this material. Mr. Scott serves as the AICPA tax policy adviser for the panel. For more information about this article, contact email@example.com.