Current developments in S corporations

By Andrew M. Brajcich, CPA, J.D., LL.M.; Kristin Hill, CPA; Robert W. Jamison Jr., CPA, Ph.D.; Robert S. Keller, CPA, J.D., LL.M.; Kirk T. Mitchell, CPA; Kenneth N. Orbach, CPA, Ph.D.; Alexander Scott, J.D., LL.M.; and Kevin J. Walsh, CPA, CGMA



  • Three revenue procedures addressed the timing of tax-exempt income and corresponding basis inclusion from forgiven Paycheck Protection Program loans.
  • With respect to the federal cap on state and local tax deductions, the IRS issued a notice and announced that it intends to propose regulations concerning creditable passthrough entity taxes that many states have enacted.
  • The Service issued a notice addressing whether a majority owner's (or spouse's) compensation constitutes qualified wages in calculating the employee retention credit.
  • New final regulations provide relief from classification as a syndicate, which can cause an entity to lose its ability to use the cash method of accounting, among other things.
  • A recent revenue procedure reduces the user fee for private letter rulings requesting late S corporation election relief.
  • The Tax Court ruled on how to characterize the economic benefits of a split-dollar life insurance arrangement. In another case, the court addressed issues surrounding S corporation distributions and compensation for services of a shareholder.

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 February 2022, some of 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; a restriction of eligible shareholders to individuals, estates, and certain trusts; and the requirement that there may 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.

Second class of stock created by LLC operating agreement: In a letter ruling released March 12, 2021,1 the IRS addressed the issue of whether a limited liability company (LLC) that elected S corporation status had just one class of stock for purposes of Sec. 1361. The focus of the letter ruling was on the provisions of the LLC's operating agreement and whether they created a second class of stock. The operating agreement included partnership provisions that applied irrespective of whether the entity was a partnership or S corporation. For instance, one part of the operating agreement provided that in the event the LLC might be liquidated "within the meaning of § 1.704-1(b)(2)(ii)(g) of the Income Tax Regulations," then liquidating distributions "shall be made to the members who have positive capital accounts in compliance with § 1.704-1(b)(2)(ii)(b)(2)."

In the letter ruling, the IRS concluded that the terms of the operating agreement created a second class of stock for the S corporation. Although the letter ruling does not describe whether the provision above would have resulted in a liquidating distribution that was not proportionate to ownership, 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.

If a second-class-of-stock issue exists, it may be possible, as the taxpayer in this case did, to obtain Sec. 1362(f) relief from the IRS through the private letter ruling process for an inadvertently invalid S election or an inadvertent termination of an initially valid election. However, that relief generally must be sought at the time the issue is discovered.

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 in certain cases where S corporations have failed to meet eligibility requirements, either at the time of the S corporation election or after the election took effect.

Reduced user fee for private letter rulings: In Rev. Proc. 2022-1, the IRS reduced the user fee for private letter rulings seeking late S corporation election relief. Requests under Sec. 1362(b)(5) for an extension of time for making an S corporation election are now subject to the same user fee as requests for relief under Regs. Sec. 301.9100-3: that is, $12,600.2 However, there are reduced fees for taxpayers whose "gross income" does not exceed certain levels. The reduced fee is $3,000 if the gross income is less than $250,000. If the gross income is at least $250,000 but less than $1 million, the user fee is $8,500.3

For an S corporation, the term "gross income" for purposes of this test is total income (line 6 on Form 1120-S, U.S. Income Tax Return for an S Corporation), plus cost of goods sold (line 2). The corporation must also include gross rents reported on Form 8825, Rental Real Estate Income and Expenses of a Partnership or an S Corporation. The period for testing is the last full (12-month) tax year ending before the date the request is filed. Moreover, if one shareholder owns more than 50% of the corporation's stock, the corporation must include the gross income of the shareholder.4

Consent to corporation's S election: Letter Ruling 202205018 addressed a situation involving a spouse's failure to consent to an S election. Under Sec. 1362(a)(2), each person who owns stock on the date the corporation files its S election must consent to the election.5 If there are joint owners of any block of stock, all the owners must consent.6 The IRS, by regulation, has permitted late consents if there is reasonable cause for the delinquency.

When the joint ownership is a result of a community property law, Rev. Proc. 2004-35 allows the couple to file a statement with the service center where the corporation files its returns.7 Unlike Rev. Proc. 2013-30, which deals with certain late elections, there is no time limit on the consent for the community interest holder.8 Conceivably, the joint owner could have been required to consent to a Subchapter S election in the year 1958 and would still be within the domain of Rev. Proc. 2004-35. Moreover, since the service center administers the relief, there is no need to apply for a letter ruling or pay a user fee. Despite this, Letter Ruling 202205018 requested relief for failure of a spouse to file a timely consent. The problem with the situation here was that there was no joint ownership. The corporation issued stock to one spouse, but the other spouse consented to the corporation's S election. The IRS treated the election as inadvertently invalid and granted the corporation's election.

Sec. 1366: Passthrough of items to shareholders

Sec. 1366 provides that shareholders include their ratable share of separately and nonseparately stated items for the tax year on a per share, per day basis, whether or not any income is actually distributed. Tax-exempt income is among the separately stated items. Generally, ordinary and necessary business expenses paid by the S corporation, including state and local taxes and employee compensation to shareholders, are deducted against nonseparately stated items of income and pass through to the shareholder(s) as net ordinary income or loss.

Timing of PPP deductions and effect on AAA, AE&P, and OAA

Issued Nov. 18, 2021, Rev. Procs. 2021-48, 2021-49, and 2021-50 addressed the timing treatment of tax-exempt income and corresponding basis inclusion from forgiven Paycheck Protection Program (PPP) loans under the Consolidated Appropriations Act, 2021 (CAA).9 As background to understanding these three revenue procedures, Section 276 of the COVID-related Tax Relief Act of 2020, enacted as part of the CAA, provided that expenses paid with forgiven PPP funds are deductible, that PPP borrowers are not to reduce any tax attributes, and that no basis increase shall be denied by reason of the exclusion of PPP forgiveness from gross income. Section 276 also provided S corporation and partnership PPP borrowers instructions for the tax treatment of the amount excluded from gross income due to PPP loan forgiveness.

Under the CAA, however, numerous timing issues arose if the eligible PPP expenses were deducted in year 1 and the PPP loan was forgiven in year 2. This mismatch created possible basis and at-risk limitations, led to implications for buyers or sellers of S corporation interests in cases where the timing of the basis inclusion could artificially increase or decrease the taxable amount and, in certain situations, produced a taxable dividend out of the S corporation due to the accounting treatment of tax-exempt income between the accumulated adjustments account (AAA) and the other adjustments account (OAA) due to accumulated earnings and profits (AE&P).

These matters were addressed in the revenue procedures issued in November 2021.

Timing issues under the CAA: Before describing the revenue procedures in more detail, it may be helpful to illustrate the timing issues arising under the CAA.

Example 1. Suspended loss carryovers: X, Y, and Z are each one-third shareholders in an S corporation. Assume that the S corporation does not have AE&P from a C corporation year. The three shareholders differ in their beginning-of-the-year stock basis. The S corporation borrows $105,000 from the PPP program in 2020, spending it on qualified expenses. Otherwise, the S corporation breaks even for the year. The PPP loan is forgiven in 2021. Distributions of $20,000 are paid during 2020 to each shareholder. Z's share of the distributions exceeds Z's tax basis, triggering capital gain of $5,000. Because the $105,000 operating loss (due to the deducted PPP expenditures) exceeds their tax bases in the stock, the operating loss allocated to Y and Z creates suspended loss carryovers of $20,000 and $35,000, respectively, as shown in the table "Suspended Loss Carryovers in Example 1" (below).


This unexpected outcome — where shareholders have different tax outcomes — could occur if the qualified PPP expenses were deducted and the S corporation had inadequate AAA and also AE&P. The situation in the example results in two levels of tax, counter to both Subchapter S and congressional intent in expressly mandating that qualified PPP expenses be deductible and that the loan forgiveness be exempted from income. This taxable event could occur because, although associated with tax-exempt income, these qualified expenses are not separately stated items on the S corporation tax return. The AAA is reduced by any nonseparately computed loss and items of loss or deduction described in Sec. 1366(a)(1). Nondeductible expenses related to tax-exempt income do not reduce AAA.11

Example 2. S corporation with accumulated earnings and profits: Assume the same shareholder basis, distributions, and operating loss as in Example 1. The S corporation has AE&P of $40,000 from periods it operated as a C corporation. It also has AAA of $57,000. (See the table "S Corporation With AE&P in Example 2," below.)


The AAA may be negative due to the operating loss. Assume the shareholders receive a basis increase when the PPP loan is forgiven in 2021, which may free up the suspended loss. However, because distributions exceeded AAA, the shareholders have received taxable dividends, despite X's having sufficient tax basis in X's stock. This results in X's receiving a second level of tax due to the PPP, likely an unintended result.12

The November 2021 revenue procedures: To highlight the problems arising under the CAA, the AICPA submitted a comprehensive comment letter on March 15, 2021, raising these issues of timing and proper reporting while also proposing practical solutions. One of the recommendations included a "matching" principle where the tax-exempt income (and corresponding basis inclusion) would occur as the eligible PPP expenses were deducted. The comment letter also recommended solutions for matching the eligible expenses and tax-exempt income in the OAA to allow the deductions to properly reduce the basis inclusion due to the tax-exempt income, and for the proper reporting of forgiven PPP loans on Form 1120-S.

The three revenue procedures the IRS ultimately issued in November 2021 were taxpayer-friendly and provided multiple options to account for the tax-exempt income, specific instructions regarding partnership basis adjustments and special issues related to consolidated groups, and the option to file amended returns in lieu of an administrative adjustment request (AAR).13

More specifically, Rev. Proc. 2021-48 provided for the following accounting treatments regarding the timing of tax-exempt income and basis inclusion:14

  1. As eligible expenses are paid or incurred (the AICPA's recommendation);
  2. When loan forgiveness application is filed; or
  3. When forgiveness is formally granted by the U.S. Small Business Administration.

Further guidance was issued in the final 2021 Form 1120-S instructions that provided for deducted eligible PPP expenses to be accounted for in the OAA in order to match the tax-exempt income included from the forgiven PPP loan and allow the basis inclusion to properly offset those deductions. The instructions also provided for a "true-up" mechanism if treatment differed on an originally filed return to alleviate the need to amend that return (in most situations).

Additionally, Rev. Proc. 2021-49 provided guidance on corresponding basis adjustments for partnerships (and partners) under Sec. 704 and Sec. 705. The revenue procedure addressed other basis discrepancies that may occur during sales or exchanges and flexibility in properly allocating these items. Rev. Proc. 2021-49 also provided rules for the corresponding stock basis adjustments that consolidated groups would take into account as upper-tier owners due to the forgiven loans (and initial basis inclusion).

Rev. Proc. 2021-50 provided the special amended return procedures that may be used if taking advantage of Rev. Proc. 2021-48 or 2021-49 in lieu of filing an AAR.

State and local taxes paid by the S corporation

Of all the IRS guidance over the last year and a half, none has raised more questions than Notice 2020-75, issued Nov. 10, 2020. In this notice, issued in response to several states' enactment of creditable passthrough entity taxes, the IRS announced that it intended to issue regulations to clarify the following matter: that state and local income taxes imposed on and paid by a partnership or an S corporation on its income are allowed as a deduction by the entity, resulting in an above-the-line federal deduction for the partners or shareholders. States enacted these laws in response to the provision in the 2017 law known as the Tax Cuts and Jobs Act, P.L. 115-97, that limited state and local tax deductions on personal returns from adjusted gross income to $10,000 per year. The state tax, which is referred to as a "PTE tax," is paid by the passthrough entity (PTE). A credit against state taxes is then allowed to the PTE owners.

More than 20 states have now passed PTE tax laws, and each state has its own rules for its PTE tax. The rules vary across states as to eligibility, election method and date, frequency of election, the tax base and rate, forms, payment requirements, allowance of state credit on the individual return for entity tax paid to another state, and more. In addition, practitioners will need to know if the PTE tax is elective or mandatory. The tax is elective in most states.

Shareholders eligible for the credit may or may not include trusts, estates, tax-exempt organizations, and single-member LLCs owned by an individual. Entities eligible to make the election may or may not include entities with such shareholders. Practitioners will need to be very diligent in researching the exact rules on eligibility for their state's tax as well as the rules on deadlines for elections and calculation of payments, and in projecting the effect on each shareholder's taxes. Proper documentation should be maintained for shareholder consents in the format required by the state.

The following are some of the areas in which questions are still being raised.

Passive or nonpassive character: According to Temp. Regs. Sec. 1.469-2T(d)(2)(vi), deductions for state, local, or foreign income taxes are specifically identified as nonpassive. Thus, even for a partner or shareholder who does not participate in the activity, state taxes, like charitable contributions and miscellaneous itemized deductions, are not limited by the passive loss rules. Under Notice 2020-75, the "specified income tax payment" allowed to be deducted by the PTE includes only state and local taxes described in Sec. 164(b)(2).15 Therefore, the PTE tax appears to also be nonpassive, whereas the rest of the business income reported on line 1 and rental income on line 2 or 3 of Schedule K-1, Partner's [Shareholder's] Share of Income, Deductions, Credits, etc., may be passive income or loss depending on the partner or shareholder.

Reduction to net investment income: Under Regs. Sec. 1.1411-4(f), above-the-line deductions are allowed to reduce rental income and business income that is net investment income. Under Sec. 62(a)(4), the deductions allowed to reduce rental income include taxes under Sec. 164. Therefore, the PTE tax appears to reduce rental income for calculating the net investment income tax, even though it will not be included in the passive activity income of the rental.

Similarly, Regs. Sec. 1.1411-4(f)(2)(ii) provides that deductions described in Sec. 62(a)(1) allocable to a trade or business described in Regs. Sec. 1.1411-5 are taken into account in determining net investment income, to the extent they have not been taken into account for self-employment income. Under Regs. Sec. 1.1411-5, a trade or business for net investment income tax is one that is either a passive activity with respect to the taxpayers under Sec. 469 or is the trade or business of a trader trading in financial instruments or commodities, as defined in Regs. Sec. 1.1411-5(c). Therefore, the PTE tax appears to reduce passive business income and income of a trader.

However, for investment income, above-the-line deductions do not reduce net investment income. Only itemized deductions reduce net investment income from interest, dividends, and capital gains. While the PTE payment may be deductible as an itemized deduction (and limited under Sec. 164(b)(6)), there does not appear to be any advantage to the PTE paying the PTE tax as opposed to the shareholders paying the tax directly. The notice does not appear to contemplate the application of this rule to investment income. If the S corporation has both investment and business or rental income, practitioners should consider using the rules in the regulations under Sec. 1411 to allocate the PTE tax using a reasonable method.

Where to report: The notice instructs taxpayers to include the PTE tax in the partner's or shareholder's nonseparately stated income or loss, i.e., line 1 of the Schedule K-1. However, if no disclosure is provided with the Schedule K-1, the partner or shareholder may not have enough information to take the PTE deduction as a nonpassive deduction or to reduce rental income or trader income. The partner or shareholder may not have enough information to recharacterize PTE tax allocable to investment income as an itemized deduction. Particularly in cases where there is more than one type of income, it would be helpful to identify the PTE tax amount so that it can be allocated appropriately.

In addition, under Regs. Sec. 1.702-1(a)(8) partnerships must separately state any item that, if separately taken into account by any partner, would result in a tax liability for that partner, or for any other person, different from that person's liability if the partner did not take the item into account separately. The rules for S corporations follow the partnership rules.16 Because the PTE tax may be treated differently by passive and nonpassive shareholders, it would seem to be more appropriate to separately state the deduction. The notice does not appear to contemplate this situation.

If including the PTE tax on line.1, practitioners may wish to consider including a statement with the Schedule K-1 disclosing the amount of the PTE tax. If practitioners report on some other line, such as "Other Deductions," and disclose the character of the item, they may also wish to consider whether this disclosure meets the requirements of Rev. Proc. 2021-52, Section 4.02(f), to avoid penalties.

Timing of deduction: The notice is very clear that the PTE is allowed the deduction in the year in which the payment is made. For cash-method taxpayers, estimated state tax payments are deductible when paid, as long as the taxpayer has a reasonable basis for belief that the tax reflects a liability. This also applies to advance payments, as long as the taxing authority accepts it as an actual payment and not merely a deposit.17

Tax shelters are prohibited from using the cash method. Under the definition at Sec. 448,18 a partnership or S corporation with more than 35% of losses for the year allocated to limited partners or limited entrepreneurs is a "tax shelter."

An exception is provided under Sec. 1256(e)(3)(C) for an individual, who will not be considered as holding an interest in an entity as a limited partner or limited entrepreneur, if the individual or his or her spouse, children, grandchildren, or parents actively participated in management for the year, the individual actively participated in management for five years, and for estates of an individual who actively participated in management or whose spouse, children, grandchildren, or parents at any time actively participated in management. In addition, taxpayers can make an annual irrevocable election under Regs. Sec. 1.448-2(b)(2)(iii)(B) to test for allocation of losses in the immediately preceding year rather than the current year's allocation.

If the exception described above does not apply and the election does not provide relief, a PTE falling into the tax shelter definition must use the accrual method. Accrual-method taxpayers are permitted to take deductions for taxes under Sec. 461(h) and Regs. Sec. 1.461-4(g)(6)(i) upon meeting three tests: (1) all the events have occurred that fix the fact of the liability; (2) the amount can be determined with reasonable accuracy; and (3) payment has occurred. Accrual-method taxpayers can adopt the recurring-item exception of Regs. Sec. 1.461-5 and deduct taxes paid within 8½ months after the end of the tax year.

For states like New York in which the PTE election is made within the tax year, there does not seem to be any bar to meeting the first test. By making the election, the liability is fixed. However, in states like California where the election is made the next year on a timely filed (with extensions) return, the liability is not fixed as of the end of the year. Thus, the first test is not met and therefore economic performance, and the recurring-item exception, would normally be irrelevant. The notice appears not to take the general rules for accrual-method taxpayers into account. Practitioners will need to assess the level of risk they and the client are comfortable with in claiming the deduction for accrual-method taxpayers.

Character of PTE tax payment on the state return: Unlike a composite or withholding payment, which is treated as a distribution for both the federal and state returns and does not reduce any sort of income, the PTE tax is designed to reduce federal taxable income as a deduction. It would appear, then, that similar to an entity-level state income or franchise tax, the PTE tax will normally be added back to arrive at state taxable income and be reported on the state Schedules K-1 as a permanently nondeductible item.

For S corporations, such nondeductible expenses reduce shareholder stock basis after distributions and before losses and deductions. If basis is less than the nondeductible expenses, the portion in excess of basis is not carried forward.19 Thus, in the right circumstances, the shareholder's state stock basis may avoid a reduction for this item.

Other issues: In addition to the above issues, S corporations may have a particular consideration with regard to the allocation of the PTE tax deduction and the credit on the state return. S corporations are required to allocate income on a "per share, per day" method. If all shareholders are eligible to consent to the PTE tax, and the deduction can be allocated in this way, no problems arise. However, if one or more shareholders are not eligible, the question arises as to whether a second class of stock will be created by allocating the PTE tax and credit only to the electing shareholders.

Similarly, where one or more shareholders are nonresidents of the PTE tax state, the state may allow a credit against tax only on apportioned income of the S corporation. This will result in a non-pro rata allocation of the PTE tax deduction and the credit.

For example, if Jim is a nonresident of California and Mary is a resident, and they own JM S corporation 50-50, then if JM's total net income is $1,000 and California-source income is $800, Jim will be taxed in California on $400. His PTE tax under California rules would be 9.3% of $400, or $37.20. Mary's PTE tax would be $46.50.

The notice does not provide guidance on whether allocating the PTE tax according to these calculations will create a second class of stock. Unless additional guidance is issued, practitioners should be cautious about PTE elections for similar fact patterns.

General considerations: Unfortunately, the above does not exhaust the list of areas practitioners need to be concerned about. Additional areas include:

  • Is the PTE tax refundable to the S corporation, or to the shareholders, if overpaid?
  • Are PTE tax underpayments by the S corporation subject to penalties and interest?
  • Is the PTE tax credit refundable to the shareholders if they are not able to use it all? Does it carry over, and for how long?
  • Do deductions such as charitable contributions reduce the PTE tax base?
  • Do deductions that are classified as nonbusiness under the state rules reduce the PTE tax base?
  • Are there limits on the shareholders' ability to use the PTE tax credit on their state returns?
  • What is the effect on the Sec. 199A qualified business income deduction?
  • Does having the tax paid by the entity affect estate planning for the shareholder? Specifically, if installment sales to defective grantor trusts have been planned based on distributions from the S corporation, what will the impact be when part of the planned distribution for taxes is diverted to the PTE tax?

Had the state and local taxes deduction cap been increased in legislation last year, many clients and practitioners would be sitting out the PTE tax election until the technical questions were resolved. Since it was not increased, practitioners need to tread carefully and evaluate each client's situation.

Reporting of compensation, passthrough of income must be consistent

In Ward,20 the Tax Court addressed familiar issues surrounding S corporation distributions and compensation for services of a shareholder. Ward was the sole shareholder and officer of an S corporation operating as a litigation law firm in Minnesota. She had one salaried associate attorney, for whom applicable taxes were withheld and properly reported. Ward's reported salary, however, was inconsistent on Form 1120-S; Form 941, Employer's Quarterly Federal Tax Return;and Form 1040, U.S. Individual Income Tax Return. Specifically, Ward failed to pay employment tax on amounts designated as officer compensation, failed to report wages for income tax purposes, and failed to properly report passthrough income from the S corporation.

Generally, officers are employees of a corporation unless they do not provide services to the company or solely provide minor services not entitled to remuneration.21 Compensation paid to an officer as an employee are wages. The court, finding that Ward failed to provide a reasonable basis to treat her status as anything other than an employee, held that employment taxes were due from the S corporation on Ward's officer compensation. Further, the court found Ward as an individual failed to include these wages for income tax purposes.

Ward's failure to properly report the passthrough of income from the S corporation on the individual return stemmed from confusion on her part. As sole shareholder, Ward should report all S corporation nonseparately computed income or loss on Schedule E, Supplemental Income and Loss, of Form 1040. At trial, she argued that distributions from an S corporation were tax-free to the extent of basis and therefore reduced the share of income reported on Schedule E. Here, the court properly distinguished between income and distributions of capital. Ward was also denied a variety of expenses for lack of substantiation and held to have cancellation-of-debt income because she failed to show she was insolvent at the time of discharge.

Sec. 1368: Distributions

The tax treatment of distributions from an S corporation depend on whether the corporation has AE&P. For corporations with no earnings and profits (E&P), distributions are first a tax-free return of capital to the extent of basis. Once a shareholder's stock basis is reduced to zero, any additional distributions are capital gain. When a corporation has E&P, distributions first come from the corporate AAA and are tax-free to the extent thereof, provided the shareholder has enough stock basis available. Once AAA is fully distributed, any additional distributions are a dividend to the extent of E&P. S corporations with E&P typically have a C corporation history or may acquire it through the liquidation of a C corporation subsidiary, including a qualified Subchapter S subsidiary (QSub) election, or through a merger.

Courts split on split-dollar

In De Los Santos,22 the taxpayer was a medical doctor who conducted his practice as the sole shareholder of an S corporation. The corporation employed the doctor, his wife, and four other individuals. The corporation adopted an employee welfare plan that provided benefits to its six employees. For their services to the S corporation, the plan provided the employees with life insurance, among other benefits, pursuant to a compensatory split-dollar life insurance arrangement under Regs. Sec. 1.61-22.

The issue before the Tax Court was whether the economic benefits that Ruben De Los Santos received from the arrangement were taxable as ordinary compensation income (compensatory arrangement) or treated in a more taxpayer-friendly manner as a Sec. 1368(b) distribution (corporation/shareholder arrangement). In a recently decided case with similar facts, the Sixth Circuit adopted the taxpayer-friendly approach. The Tax Court in De Los Santos strongly stated its disagreement with the Sixth Circuit.23

As pertinent to this case, a split-dollar life insurance arrangement is generally any arrangement between an owner of a (nongroup-term) life insurance contract (here, the S corporation24) and a nonowner of the contract (here, De Los Santos) under which either party to the arrangement (here, the S corporation) pays all or part of the policy premiums and is entitled to recover all or a portion of those premiums from the proceeds of the contract.25

The tax consequences to the parties of a split-dollar arrangement depend on which of two mutually exclusive regimes applies — an economic benefit regime or a loan regime. Because in this case the S corporation was the owner of the policy, the economic benefit regime applies. Thus, the owner of the policy (here, the S corporation) is treated as providing economic benefits to the nonowner (here, De Los Santos), and these benefits must be accounted for consistently by both parties. The value of the benefits, reduced by any payments by the nonowner to the owner, is treated as provided by the owner to the nonowner.

The tax consequences of the provision of economic benefits, in turn, depend on the relationship between the owner and the nonowner. In this regard the relationship generally can be either compensatory or corporation/shareholder (Sec. 1368(b) distribution). If compensatory, there would be ordinary compensation income. If a Sec. 1368(b) distribution, there would only be return of capital to the extent of outside basis, any excess being capital gain.

From the facts of the case, the split-dollar arrangement was clearly compensatory; even De Los Santos conceded as much. He nevertheless argued that corporation/shareholder distribution treatment was appropriate, relying on recent Sixth Circuit precedent. That appellate court ruled in Machacek26 that under Regs. Sec. 1.301-1(m)(1)(i) (formerly Regs. Sec. 1.301-1(q)(1)(i) during the tax years at issue) corporation/shareholder treatment was appropriate — even though it is black letter law that Sec. 301 (and therefore Sec. 1368 for S corporations) applies only to shareholders in their capacity as shareholders and not to shareholders in their capacity as employees.27

The Sixth Circuit opined that the cross-reference in Regs. Sec. 1.301-1(m)(1)(i) includes any split-dollar amount, whether compensatory or corporation/shareholder. The court recognized that the regulations associated with Sec. 301 generally deem that section28 to apply only if the distribution were paid to the shareholder in his or her capacity as such.29 Notwithstanding this, the court concluded that the specific rule of Regs. Sec. 1.301-1(m)(1)(i) regarding the benefit of split-dollar life insurance must override any general rule, such as Regs. Sec. 1.301-1(d).

The issue with the Sixth Circuit's reasoning, as the Tax Court emphatically pointed out, is that it failed to consider that the statute prevails over the regulations where there is a conflict. The court found that Sec. 301 clearly applies only to distributions by a corporation to a shareholder with respect to its stock.30 Thus, the Tax Court ruled that the word "shareholder" in Regs. Sec. 1.301-1(m)(1)(i) means "shareholder in his capacity as such." Consequently, the court concluded that Sec. 301 (and Sec. 1368(b)) did not apply to the arrangement. Having concluded what did not apply to the arrangement, the Tax Court next had to decide what did apply.

Under Sec. 1372, an S corporation is treated as a partnership, and a 2% shareholder31 is treated as a partner of the partnership for purposes of applying income tax provisions that relate to employee fringe benefits. The economic benefits that the taxpayer received under the compensatory split-dollar life insurance arrangement, pursuant to Tax Court precedent, are "employee fringe benefits" for purposes of Sec. 1372.32 And those benefits are therefore taxed as guaranteed payments (ordinary income) under Sec. 707(c). However, these guaranteed payments are treated as self-employment income only where, as here, the entity is engaged in a trade or business.33

To conclude, the Tax Court treated De Los Santos as receiving split-dollar benefits as a guaranteed payment. He therefore recognized ordinary income.34 In contrast, the Sixth Circuit would have treated his split-dollar benefits as a Sec. 1368(b) distribution, which would have been tax-free to the extent of his outside basis, and capital gain on the excess, if any.

Sec. 1378: Tax year of S corporation

Under Sec. 1378, the tax year of an S corporation must be a permitted year. A permitted year is the calendar year, a valid tax year elected under Sec. 444, a 52—53-week tax year ending with reference to the required tax year or a tax year elected under Sec. 444, or any other accounting period for which the corporation establishes to the satisfaction of the IRS a "business purpose."35

Expediting refund not a valid business purpose to change accounting period

In Chief Counsel Advice (CCA) 202141023, the IRS decided that an inquiry by an S corporation exploring the possibility of obtaining a "refund sooner than usual" by changing its accounting period was not a "viable solution." Because the taxpayer already had a Dec. 31 year end, the taxpayer would need to change to some other accounting period but would need to establish a business purpose that would satisfy the IRS as required under Sec. 444 and the regulations thereunder.

The CCA cited Rev. Proc. 2006-46, which provides the exclusive procedures for obtaining automatic approval to adopt, change, or retain an annual accounting period by various types of taxpayers including S corporations. Specifically, the pertinent section of the revenue procedure (§2.01(3)(c)) provides:

S corporations. Sec. 1378 and § 1.1378-1(a) provide that the taxable year of an S corporation must be a permitted year. The term "permitted year" means (1) the required taxable year (i.e., a taxable year ending on December 31), (2) a taxable year elected under § 444, (3) a 52—53-week taxable year ending with reference to the required taxable year or a taxable year elected under § 444, or (4) any other accounting period for which the corporation establishes to the satisfaction of the Commissioner a business purpose.

The Chief Counsel took the position here that a change in accounting period simply to get a refund sooner than usual (even recognizing the sympathetic nature of this case) was not a business purpose that would satisfy the IRS.

Sec. 409: Qualifications for tax credit employee stock ownership plans

Sec. 409 provides the rules for an employee stock ownership plan (ESOP). Sec. 409(p) is an anti-abuse provision targeting the use of ESOPs to accrue certain tax benefits to a concentrated group of individuals.

Shifting of income to abusive ESOP-owned S corporation disallowed

In Ryder, 36the taxpayer, a tax attorney and former CPA, spent 20 years leveraging his ERISA expertise to develop and market six tax-reduction strategies, among them two products that used ESOP-owned S corporations: a staffing services product and a general counsel office product. Additionally, Ernest Ryder attempted to shift income from his C corporation law firm to a related S corporation using creative accounting, according to the Tax Court.

Until 2011, Ryder offered a staffing services product where he would establish an ESOP-owned S corporation that would acquire a client's employees and then lease them back to the client. Any profits flowing through the S corporation to the ESOP would not be taxed and would provide a retirement benefit for employees. The clients themselves would serve as entity officers and transfer funds from their business to the ESOP-owned S corporation. A percentage of the money was "sluiced" to Ryder in addition to a documentation fee, the court said. This product produced over $6 million for his law firm. Ryder then assigned the income from his law firm to another shell entity he owned.

As a result of "incorporation-palooza in early 2001," Ryder had hundreds of shell S corporations at the ready for which he was sole director, vice president, and general counsel, while an employee of his legal firm was appointed vice president of ESOP administration. The mass incorporation was apparently an attempt to establish these entities before they would be required to have more than 10 participants under a new ESOP anti-abuse provision.37 For access to one of the S corporations and its ESOP owner, clients would hire Ryder for his general counsel services. Similar to his staffing product, Ryder would charge clients a documentation fee and a percentage of operating revenue.

Despite the fact that this initial strategy quickly earned the status of listed transaction due to the lack of substantial benefits or participation by initial ESOP participants,38 Ryder was not deterred and moved forward with a similar plan using backdated agreements where fees were retitled as "budget allotments." In total, these general counsel agreements generated more the $3.5 million.

In 2002, Ryder organized an S corporation with himself as the controlling shareholder to serve as the employee staffing corporation for his law firm, a C corporation. This new S corporation also had varying levels of ESOP ownership over the years. In exchange for a note from himself, Ryder would then draw money from various entities he had organized to sell his tax-saving products and services. After some "unorthodox" journal entries, that note was ultimately used to pay the S corporation for the services Ryder provided to his C corporation law firm. He would then distribute the note to himself from the S corporation, claiming sufficient basis for a tax-free distribution. Once his own note was in Ryder's hands, it became null for tax purposes. The basis in S corporation stock, Ryder claimed, came from other promissory notes he contributed in exchange for stock.

Using the assignment-of-income doctrine, the Tax Court found that income from the staffing and general counsel products belonged to Ryder's C corporation law firm and that the leasing arrangement used for his firm was "nothing more than a mechanism to produce deductions."39 In dicta, the court also noted that Sec. 482 could likewise apply and achieve the same result.

Sec. 448: Limitation on use of cash method of accounting

Generally, S corporations may use the cash method of accounting, regardless of gross receipts. Sec. 448, however, denies the use of the cash method for any S corporation determined to be a tax shelter.

New regulations provide relief from classification as syndicate

In 2021, the Treasury finalized several regulations that could allow some 2021 calendar-year partnerships and S corporations to retain the cash method that might otherwise lose it. The regulations have effective dates for years beginning after Jan. 5, 2021, but allow the provisions to be applied to earlier years.40

The trap these regulations allow taxpayers to avoid is referred to as the syndicate rule. This artifact of the anti-tax shelter rules put in place decades ago requires any partnership or S corporation that allocates more than 35% of losses in a year to limited partners or limited entrepreneurs to change from the cash method. Limited entrepreneurs are those owners not active in management. This category includes owners of voting stock and even members of the board of directors. For this purpose, the actual participation in management, rather than the ability to do so, governs the classification. There are rules that ease this requirement for family-held corporations.41

An entity classified as a syndicate loses more than just the ability to use the cash method. Classification as a syndicate also limits the ability of the entity to use the small business exception for several other Code provisions including the Sec. 163(j)(3) business interest deduction, the Sec. 460(e)(1)(B) percentage-of-completion method for construction contracts, the Sec. 263A(i) UNICAP exception, and the Sec. 471(b) inventory rules exception.

Under the newly finalized regulations, if an S corporation would be classified as a syndicate using its current year's allocations, it can elect to use the prior year.42 This election is irrevocable but applies only to the year for which the corporationelects.

An entity-level profit in the prior year will also allow an election to be made to continue using the cash method.

Example 3: Assume a partnership or S corporation using the cash method is profitable in 2020. In 2021, the entity has a loss, and more than 35% of that loss will be allocable to limited partners or limited entrepreneurs. The entity would, under the rules in place prior to this change, be required to change from the cash method for 2021. Under the new rule, the entity can elect to use the 2020 allocations instead of the 2021 allocations. Syndicate status is avoided for 2021, and the cash method can continue to be used.

The S corporation must make the election on a timely filed return (including extensions) and must state the authority under which it is being made, Regs. Sec. 1.448-2(b)(2)(iii)(B). The election is irrevocable.

The regulation restates, without change, the method for determining if a loss exists. The regulation initially provides the same language as the prior regulation:

the losses of a partnership, entity, or enterprise (entities) means the excess of the deductions allowable to the entities over the amount of income recognized by such entities under the entities' method of accounting used for Federal income tax purposes (determined without regard to this section). For this purpose, gains or losses from the sale of capital assets or assets described in Sec. 1221(a)(2) are not taken into account.

However, the newly finalized regulations add a new provision: the computation is to be done without regard to the interest expense limitations of Sec. 163(j).

This election gives tax advisers planning opportunities. For this purpose, profits, no matter how small, are always good, and losses, no matter how small, are bad if more than 35% would go to limited partners or owners not active in management. To the degree one can legitimately time income recognition or expense deductions to result in an entity showing a profit, the cash method, and other methods mentioned, are protected both for the current year and the following year.

Sec. 3134: Employee retention credit for employers subject to closure due to COVID-19

An extension and modification of the employee retention credit (ERC) allowed it to be claimed for qualified wages paid during 2021.43 However, Congress later (and retroactively) terminated the credit a quarter early, making it inapplicable to wages paid after Sept. 30, 2021.44

ERC wage notice for S corporation owners

On Aug. 4, 2021, the IRS issued Notice 2021-49 pertaining to the ERC. Section IV.D of the notice is guidance that affects many closely held family-owned businesses; the result of the guidance is not favorable to majority owners (except in rare circumstances). The main issues addressed by this section are identifying a majority owner and determining whether a majority owner's (or spouse's) compensation is considered qualified wages in calculating an ERC.

The IRS began its analysis by noting that Section 2301(e) of the CARES Act (which created the ERC),45 along with Sec. 3134(e), provides rules similar to those of Sec. 51(i)(1), which provides that wages paid to certain related individuals are not taken into account for purposes of the work opportunity credit. More specifically, Sec. 51(i)(1) and Regs. Sec. 1.51-1(e)(1) provide that wages paid to individuals who bear any of the following relationships as described in Secs. 152(d)(2)(A)-(H) are not considered:

  1. To the taxpayer; or
  2. If the taxpayer is a corporation, to an individual who owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation (majority owner of a corporation); or
  3. If the taxpayer is an entity other than a corporation, to any individual who owns, directly or indirectly, more than 50% of the capital and profits interests in the entity (majority owner of a noncorporate entity).

The notice further states that Sec. 51(i)(1)(A) includes a parenthetical at the end of the subparagraph indicating that an individual's ownership is determined by applying Sec. 267(c). Therefore, the IRS concludes that the rules of that section apply for purposes of determining an individual's ownership of stock of a corporation (and an individual's capital and profits interests in a partnership or other entity), consistent with Regs. Sec. 1.51-1(e)(1)(iii) and Sec. 51(i)(1)(A).

Additionally, simply applying the Secs. 152(d)(2)(A)-(H) rules for purposes of the ERC, the wages paid to employees with the following relationships to a majority owner of a corporation or partnership are not qualifying wages for purposes of claiming an ERC:

  1. A child or a descendant of a child.
  2. A brother, sister, stepbrother, or stepsister.
  3. The father or mother, or an ancestor of either.
  4. A stepfather or stepmother.
  5. A son or daughter of a brother or sister of the taxpayer [i.e., a niece or nephew].
  6. A brother or sister of the father or mother of the taxpayer [i.e., an aunt or uncle].
  7. A son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law.
  8. An individual (other than a spouse, determined without regard to section 7703, of the taxpayer) who, for the taxable year of the taxpayer, has the same principal place of abode as the taxpayer and is a member of the taxpayer's household.46

Caution: While the notice refers to item (H) above, the statutory language of Sec. 51(i)(1)(A) only refers to subparagraphs (A) through (G) by reference to Sec. 152(d)(2). Tax advisers finding their clients with this situation may want to further consider the application of the rules.

Applying a circular analysis of the rules of Secs. 152(d)(2)(A)-(H) coupled with the Sec. 267(c)(4) constructive ownership rules, the IRS concluded in the notice that a majority owner of a corporation does not have qualified wages that are ERC-eligible when the majority owner has a spouse, brother or sister (whether by whole or half-blood), ancestor, or lineal descendant. The reason is because, under Sec. 267(c), each of those family members is considered to own more than 50% of the stock of the corporation.

Likewise, the IRS concluded that a spouse of a majority owner is a related individual for purposes of the ERC, whose wages are not qualified wages when the majority owner has a family member who is a brother or sister (whether by whole or half-blood), ancestor, or lineal descendant (and the spouse bears a relationship described in Secs. 152(d)(2)(A)-(H)). The notice provides an example in the flush language of the explanatory paragraph concluding:

A direct majority owner's brother would be a constructive majority owner under section 267(c)(2) and (4) and the spouse of the direct majority owner would be considered a related individual to the constructive majority owner by virtue of the in-law relationship described in section 152(d)(2)(G).

In summary, owners can be deemed to own more than 50% of an S corporation through the interplay of Sec. 51, Sec. 152, and the constructive ownership rules of Sec. 267(c) (via family members, trusts, and other business relationships), and their compensation earned is ineligible to be included in the ERC calculation. Accordingly, tax advisers must fully understand the client's often complex ownership structures in determining whether owners' wages are eligible to be used in the ERC calculation.


1 IRS Letter Ruling 202110010.

2 Rev. Proc. 2022-1, Appendix A (Schedule of User Fees), clause (A)(3)(c)(i).

3 Rev. Proc. 2022-1, Appendix A, clause (A)(4).

4 Rev. Proc. 2022-1, Appendix A, clauses (B)(4) and (5).

5 Regs. Sec. 1.1362-6(b)(3), effective for tax years beginning after 1992 (T.D. 8449, issued Nov. 24, 1992).

6 Regs. Sec. 1.1362-6(b)(2)(i).

7 Rev. Proc. 2004-35.

8 Rev. Proc. 2013-30 limits the period in which a service center can grant relief to three years and 75 days from the effective date of the election.

9 Consolidated Appropriations Act, 2021, P.L. 116-260.

10 Note, of the $20,000 distribution to Z, $15,000 reduces basis with the remaining $5,000 treated as a capital gain.

11 Regs. Secs. 1.1368-2(a)(3)(i)(A) and (C).

12 In this example shareholder Y also has a taxable event.

13 The special amended return procedures expired Dec. 31, 2021.

14 Caution should be used if the S corporation previously elected the safe harbor method provided for in Rev. Proc. 2021-20.

15 Foreign taxes are excepted from this category, as the deduction is disallowed under Sec. 703(a)(2)(B) and Sec. 1363(b)(2).

16 See S. Rep’t No. 97-640, 97th Cong., 2d Sess. (1982) (P.L. 97-354).

17 See Rev. Rul. 82-208 and Rev. Rul. 71-190.

18 Referencing Sec. 461(i)(3), which includes as a tax shelter any syndicate as defined in Sec. 1256(e)(3)(B).

19 Unless the election under Regs. Sec. 1.1367-1(g) is made.

20 Ward, T.C. Memo. 2021-32.

21 Sec. 3121(d)(1) and Regs. Sec. 31.3121(d)-1(b).

22 De Los Santos, 156 T.C. No. 9 (2021), reviewed by the court.

23 That De Los Santos was “reviewed by the court,” with all judges agreeing with Judge Albert Lauber’s opinion, also demonstrates the court’s strongly held belief in this regard.

24 Generally, the person named as the policy owner of the contract is the owner of the contract for purposes of the split-dollar regulations (Regs. Sec. 1.61-22(c)(1)(i)). However, although the welfare benefit trust actually owned the policy, the S corporation is deemed the owner for split-dollar purposes (Regs. Sec. 1.61-22(c)(1)(iii)(C)).

25 Regs. Sec. 1.61-22(b)(1). Certain compensatory and certain corporation/shareholder relationships, as described later, are automatically splitdollar (Regs. Sec. 1.61-22(b)(2)).

26 Machacek, 906 F.3d 429 (6th Cir. 2018), rev’g and remanding T.C. Memo. 2016-55. The IRS nonacquiesced in the Sixth Circuit’s opinion (AOD 2021-02).

27 Sec. 301(a).

28 And therefore Sec. 1368 in the Subchapter S context (Sec. 1368(a) and Regs. Sec. 1.1368-1(a)).

29 Regs. Secs. 1.301-1(a) and (d).

30 In particular, there is nothing in Sec. 301 that alludes to compensation. See Haber, 52 T.C. 255, 267-8 (1969), aff’d per curiam, 422 F.2d 198 (5th Cir.1970). Interestingly, an appeal of De Los Santos would lie to the Fifth Circuit, the affirming court of Haber.

31 A 2% shareholder generally is defined to include any person who owns more than 2% of the S corporation’s stock (Sec. 1372(b)).

32 Our Country Home Enterprises, 145 T.C. 1, 51 (2015). See also Hurst, 124 T.C. 16 (2005).

33 Regs. Sec. 1.1402(a)-1(b).

34 The S corporation is generally allowed no deduction for premiums paid or benefits transferred to the taxpayer, unless there is a transfer of ownership of the contract (Regs. Secs. 1.61-22(f)(2)(ii) and 1.83-6(a)(5)(i)).

35 Sec. 1378 and Regs. Sec. 1.1378-1(a).

36 Ryder, T.C. Memo. 2021-88.

37 See Sec. 409(p).

38 See Rev. Rul. 2003-6.

39 Ryder, T.C. Memo. 2021-88, at *132.

40 T.D. 9942 and T.D. 9943.

41 Sec. 1256(e)(3)(C).

42 Regs. Sec. 1.448-2(b)(2)(iii)(B).

43 American Rescue Plan Act, P.L. 117-2.

44 Infrastructure Investment and Jobs Act, P.L. 117-58, §80604.

45 Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136.

46 Sec. 152(d)(2).


Andrew M. Brajcich, CPA, J.D., LL.M., is the Jud Regis endowed chair of accounting, associate professor of accounting, and graduate accounting director at Gonzaga University in Spokane, Wash. Kristin Hill, CPA, is the owner of Kristin Hill, CPA, P.C. in Berkeley, Calif. 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. Robert S. Keller, CPA, J.D., LL.M., is a partner in KPMG’s Washington National Tax practice. Kirk T. Mitchell, CPA, MST, is a tax senior manager at Schneider Downs & Co. Inc. in Pittsburgh. 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. Each of the 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 staff liaison for the panel. For more information about this article, contact



Warley, et al., “Tax Issues That Arise When a Shareholder or Partner Dies,” 53 The Tax Adviser 20 (March 2022)

Alberty, “S Corporation Shareholder Recomputation of Basis,” 53 The Tax Adviser 27 (February 2022)

Samtoy, “Complying With New Schedules K-2 and K-3,” Tax Insider (Feb. 11, 2022)

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