1999 update on S corporations

Since Subchapter S was added to the Internal Revenue Code in 1958, S corporations have undergone many changes. This update will reflect some of the changes that have occurred in the last year prior to the due date for this article.

Fiscal Year 1997-1998 S Corporations May Need To File Amended Returns.

Announcement 99-11, 1999-5 IRB 64, advises S corporations that the 1997 Schedule D and instructions used by 1997-1998 fiscal year filers do not reflect the changed holding period for certain long term capital gains. That is because the Internal Revenue Code was modified to eliminate the more than 18 month longterm holding period for sales and exchanges after December 31, 1997. The announcement advises taxpayers that fiscal year filers who have already filed a 1997-1998 fiscal year return may need to file an amended return for that year to reflect this change in law.

Employment Tax Guidance for Qualified Subchapter S Subsidiaries (QSubs)

The IRS has issued Notice 99-6, 1999-3 IRB 12, soliciting comments from taxpayers and practitioners regarding issues related to employment tax reporting and payment by QSubs. In addition, it provided temporary procedures under which a QSub has the option of reporting and paying employment tax obligations either through the QSub or through its parent S corporation.

Proposed Legislation

President Clinton's fiscal year 2000 budget proposal contains two provisions directly affecting S corporations. The first would repeal the ability of C corporations valued at $5,000,000 or more to convert tax free to S corporations. In such cases, the conversion from C corporation status to S corporation status would be treated as a liquidation followed by a contribution of capital to the S corporation. This would cause taxable income to the corporation and also taxable income to the shareholders. The second proposal would modify the treatment of an employee stock ownership plan (ESOP) that owns stock in an S corporation so that the S corporation income would be taxed to the ESOP as unrelated business taxable income.

In addition, Representative Clay Shaw and Senator Orrin Hatch have introduced a proposed Subchapter S Revision Act of 1999. The proposal would treat members of a family as one shareholder for the number of shareholders test, permit nonresident aliens to be shareholders, allow the issuance of certain preferred stock, allow certain convertible debt not to be treated as a second class of stock, repeal as a terminating event the existence of excess passive investment income, allow additional charitable contribution deductions of inventory and scientific property to S corporations, and repeal the limitation on fringe benefits for S corporations.

Excluded Discharge of Indebtedness Income Did Not Increase Basis

Although tax exempt income increases basis of S corporation stock, the Tax Court continues to hold that income from discharge of indebtedness excluded under Code (sec)108 is not treated as tax exempt income and therefore does not increase shareholders' bases of S corporation stock. The most recent case was William C. Witzel, TC Memo 1999-64, which followed Mel T. Nelson, 110 TC 114 (1998), in denying a basis increase. Three cases with the same result were decided by the Tax Court in the space of three weeks: Jerome B. Cronin, TC Memo 1999-22, James H. Pugh, Jr., TC Memo 1999-38, and Michael A. Conviser, TC Memo 1999-47. Also, in Salvador A. Gaudiano, TC Memo 1998-408, the Tax Court held that when an S corporation realized excluded COD income, it was not tax-exempt income that would increase basis of shareholders' stock. The Court saw no need to repeat its detailed analysis on that issue contained in the Nelson case. The same result was reached in Chesapeake Outdoor Enterprises, Inc., TC Memo 1998-175. A district court in Pennsylvania that also followed Nelson was US v. Farley, 99-1 USTC (para)50, 370 (W.D. Pa. 3/9/99). On July 6, 1999 the Tenth Circuit Court of Appeals affirmed both the Nelson decision and the Tax Court's Winn decision in Gitlitz v Commissioner. The Tenth Circuit assumed that the nonrecognized discharge of indebtedness income is tax exempt income but nevertheless refused to allow it to increase basis. It reasoned that the corporation's indebtedness to third parties, requiring no economic outlay by the shareholders, should not be permitted to create a windfall for the shareholders.

Coroorate E v. Shareholder Exnense

An S corporation paid the legal expenses of a lawsuit brought against it and its sole shareholder by a former shareholder. IRS said these were personal expenses of the shareholder and therefore not deductible. In Dennis W. Stark, TC Memo 1999-1, the Tax Court held that they were expenses of the corporation but required the expenses to be capitalized because they related to the stock of the corporation having been redeemed.

Health Insurance Premium Deduction

S corporation shareholders may be eligible for a deduction for a part of their health insurance premiums. The Tax and Trade Relief Extension Act of 1998 accelerated the full deductibility of this expense. For taxable years beginning in calendar year 1999 through 2001 the deductible amount will be 60% of health insurance premiums paid for medical care. For the taxable year beginning in 2002, the deductible percentage will be 70%. Beginning in 2003 and thereafter, 100% will be deductible.

Relief for Late Elections

Rev. Proc. 98-55, 199846 I.R.B. 27, provides guidance for requesting relief for late S corporation elections and also for late elections for Qualified Subchapter S Trusts (QSSTs), Electing Small Business Trusts (ESBTs), and Qualified Subchapter S Subsidiaries (QSubs). It provides an alternate procedure so that some taxpayers will not need to apply to the National Office of the IRS for relief. This saves time and also the user fee required for a National Office ruling request. In cases involving QSSTs and ESBTs, automatic relief will be granted if certain requirements are met.

S Corporation Acquired by a Consolidated Group

When 80% or more of the stock of an S Corporation is acquired by a member of a consolidated group, the interaction of the consolidated return regulations and the Subchapter S rules requires the filing of a separate one-day return for the day of acquisition. Regulations proposed under Code Section 1502 would eliminate the need for a separate one-day return in such cases except when an election under Code Section 338(g) is made.

Bankrupt S Corporation Shareholders Liable for Gains on Sales of Assets

A corporation that is in Bankruptcy Court may be required to sell its assets in order to pay creditors. Gains resulting from the sales of assets will be taxable to the shareholders if the corporation is an S corporation.

In an attempt to avoid this result, before the corporation's bankruptcy petition was filed, the shareholders revoked their Subchapter S election in the manner provided in the Internal Revenue Code. The United States Bankruptcy Appellate Panel of the Ninth Circuit held that a trustee in bankruptcy could avoid the revocation and thus require the shareholders to pay tax on any gains realized by the corporation during the bankruptcy proceeding. (Parker v. Saunders [In re: Bakersfield Westar, Inc., Debtor], 9th Cir. BAP 1998).

Election to Distribute Earnings and Profits (E & P) Before Accumulated Adjustments Account (AAA)

Code Section 1368(e)(3) allows a corporation to distribute accumulated E & P prior to AAA. In James L. Thurman, TC Memo 1998-233, the IRS attempted to use the doctrine of substantial compliance against the taxpayer's wishes to treat an S corporation as having made a valid election under Section 1368(e)(3)(A). The corporation prepared the election but did not attach the election to its income tax return. The shareholders filed amended tax returns treating the election as not having been made. Under these circumstances, the Tax Court held that the facts of the case did not warrant an application of the substantial compliance doctrine to require the corporation to treat its distributions as coming first from earnings and profits.

Who is the Shareholder?

Because the shareholders of an S corporation are required to report their shares of S corporation income on their individual income tax returns, the question of who is a shareholder has great tax significance. Two recent cases involved that question.

In Pahl v. Commissioner, 150 F3d 1124 (9th Cir. 1998), the Ninth Circuit Court of Appeals affirmed the Tax Court in holding that Mr. Pahl was a beneficial shareholder even though he had not paid for his shares. In McMichael v. US (District Court Florida, 6/10/98) a district court held that the taxpayer was the beneficial owner of shares after the signing of a "Release and Settlement Agreement" and prior to the date his shares were actually purchased by other individuals.

No Basis for Loss Deduction

Losses are deductible by the shareholders of an S corporation only to the extent of their bases in stock of the corporation and loans made by the shareholders to the corporation. If there is not sufficient basis, the losses are not deductible in the current year. Several recent cases have involved this point.

In Bill L. Spencer, 110 TC 62 (1998), a case that would be appealable to the Eleventh Circuit that decided the Selfe case, the Court denied shareholders basis. The taxpayers had failed to follow the form of the transaction that they were advocating and the Tax Court distinguished. Selfe on its facts.

In Abdul Hafiz, TC Memo 1998-104, the Tax Court followed Estate of Leavitt, 90 TC 206 (1988), aff'd 875 F2d 420 (4th Cir. 1989), cert. den. 492 US 958 (1989), in requiring an economic outlay on the part of the shareholder. Although the shareholder was a comaker of the loan with the corporation, the corporation's books and records reflected the loan as being from the bank and not from the shareholders. On these facts, the Tax Court held that the shareholders did not obtain any basis for the purpose of the loss deduction. Administration Procedures

The S corporation audit and litigation procedures enacted in 1982 and repealed for years beginning after 1996 are still relevant for open years. In Chesapeake Outdoor Enterprises, Inc., TC Memo 1998-175, the Tax Court held that it had jurisdiction in a corporate level proceeding to decide the issue of whether excluded cancellation of indebtedness income is a separately stated item of tax exempt income that affects the basis of S corporation stock.

Dividends As Passive Investment Income

Proposed regulations under Section 1362 were issued dealing with the receipt of dividends by an S corporation from a C corporation subsidiary when the S corporation owns 80% or more of the stock of the subsidiary. Dividends received from such subsidiaries are not treated as passing-investment income for purposes of Sections 1362 and 1375 to the extent the dividends are attributable to the earnings and profits of the C corporation derived from the active conduct of a trade or business. The proposed regulations provide guidance for attributing dividends to the active conduct of a trade or business.

Excessive Payments To Related Corporation Disallowed

Deductions for rental payments made by an S corporation to a C corporation owned by the same shareholder were disallowed as being excessive in Randy L. Wysong, TC Memo 1998-128. The Tax Court judge pointed out that Dr. Wysong was the sole shareholder of both corporations and there were no arm's-length negotiations between the two entities. The taxpayer did not consult with a real estate appraiser to determine fair rental rates in the area and he did not investigate the rental rates of comparable properties. As a result, deductions were disallowed to the S corporation and its shareholder's taxable income was increased.

Qualified Subchapter S Trust (QSST) Taxed On Sale Of Assets By S Corporation.

If a QSST sells its stock in an S corporation, Reg. (sec)1.1361-1(j)(8) provides that the trust and not the beneficiary will be taxed on any gain or loss recognized on the sale. Letter Ruling 199905011 takes this a step further. That ruling held that a sale of substantially all of the corporation's operating assets pursuant to a plan of complete liquidation, together with a liquidating distribution, is treated the same as a disposition of stock within the meaning of Reg. (sec)1.1361-1(j)(8). Therefore, the ruling concluded: (1) that the trust's pro rata share of gain or loss resulting from the sale of the S corporation's assets pursuant to the plan of liquidation should be allocated to the trust and not to the beneficiary; and (2) any gain or loss recognized on the liquidation of the corporation under both Sections 331 and 336 as a result of distributions from the corporation to the trust will be taxed to the trust and not to the beneficiary.

Loans Recharacterized as Salaries

The Bankruptcy Court for the District of Hawaii recharacterized loans made to the sole shareholder of a law corporation as salaries in Robert Allen Smith v. U.S. (Bankr. Haw., No. 95-0042, 1/28/99). This was just another case in which an S corporation shareholder-employee attempted to avoid payroll taxes.

ESOP Considered as One Shareholder

An Employee Stock Ownership Plan (ESOP) may be a shareholder of an S corporation effective for taxable years beginning after December 31, 1997. Private Letter Ruling 199906044 held that despite the fact that an ESOP has many participants, for purposes of the number of shareholders limitation and shareholder eligibility, the ESOP, and not its participants, will be treated as the shareholder of the S corporation stock owned by the ESOP.

Charitable Contribution Deduction

Technical Advice Memorandum (TAM) 199908039 takes the position that the special rule for charitable contribution deductions by accrual-basis corporations in Section 170(a)(2) does not apply to S corporations. Thus, it concludes that an accrued charitable contribution deduction may not be taken by S corporation shareholders until the year in which the contribution is actually paid. The reasoning expressed in the TAM is that the taxable income of an S corporation is computed in the same manner as an individual with certain exceptions. The TAM states that the legislative history of Section 1366 provides that the corporate limitations on charitable contributions will no longer apply. Instead, charitable contributions by S corporations will pass through to the shareholders and be subject to the individual limitations on deductibility. The election under Section 170(a)(2) that allows accrual-basis corporations to deduct charitable contributions in the year accrued provided they are paid by the l5th day of the third month after the close of the taxable year does not apply to an individual. Therefore, the TAM concludes that the individual shareholder may deduct the charitable contribution only in the year in which it is paid by the corporation.

The TAM fails to discuss the fact that Section 170(a)(2) refers to a corporation on the accrual basis without distinguishing between S corporations and C corporations. Other parts of the same Code section, Section 170(e)(3) and Section 170(e)(4), dealing with contributions of appreciated inventory, specifically refer to a corporation other than one which is an S corporation. The fact that Congress specifically excluded S corporations from one part of Section 170, without making any reference to S corporations in the part of Section 170 dealing with accrued contribution deductions, implies that S corporations should be included in the class of corporations entitled to accrue contribution deductions. Additional reasons why the TAM is wrong are stated in Kenneth Orbach's contribution to the Tax Clinic at pages 562 and 564 of the August 1999 issue of The Tax Adviser, a publication of the AICPA.

Controlled Foreign Corporation Rules Apply to S Corooration Shareholders

If an S corporation sells shares of a controlled foreign corporation, Section 1248 may require some of the gain to be treated as dividend income to the extent of the controlled foreign corporation's earnings and profits allocable to the stock sold. Private Letter Rulings 199908044 and 199908045 hold that the rules of Section 1248, including the limitation of tax payable by an individual, will apply to S corporation shareholders just as if they owned the stock of the controlled foreign corporation directly instead of through the S corporation.

Momentary Ownership Disregarded

An S corporation may not have another corporation as a shareholder. However, when this occurs in the course of a D reorganization, will the momentary ownership of stock by another corporation cause the former subsidiary to have an ineligible shareholder under Code Section 1361(b)(1)(B)?

A corporation that has held two active businesses for more than five years is generally eligible for a tax free divisive reorganization as defined in Code Section 368(a)(1)(D). D reorganizations are often used to split a corporation that has two businesses between two unhappy shareholders. Typically, the S corporation forms a subsidiary and transfers one of the businesses to the subsidiary in exchange for all of its stock. Then it transfers the subsidiary's stock to one of the shareholders in exchange for all of that shareholder's stock in the parent S corporation. As a result, each of the two shareholders owns a separate corporation with one business.

In Private Letter Rulings 199907023 and 199908010 this type of situation occurred. The new corporation was held to be eligible for a Subchapter S election, ignoring the momentary ownership of its stock by the existing S corporation.

Conclusion

With the increasing popularity of limited liability companies, new businesses may decide against using S corporations. However for many existing corporations, Subchapter S may be the only way to avoid double tax on corporate earnings. Therefore, it is important to be aware of new developments involving S corporations.

Sydney S. Traum*

Zack Kosnitzky, P.A.

Miami, Florida

About the Author

Sydney S. Traum practices law as owner of Sydney S. Traum, PA, which is of .to the law firm Zack Kosnitzky, P.A. in Miami, Florida. He is licensed as a CPA and an attorney in both New York and Florida. Mr. Traum is president of the Florida Association of

Attorney-CPAs and past president of the American Association of Attorney-Certified Public Accountants, the Greater Miami Tax Institute, and the FICPA Dade County chapter. He is author of The S Corporation, Planning and Operation, as well as The S Corporation Answer Book, both published by Panel Publishers, a division of Aspen Publishers, Inc. Mr. Traum has lectured extensively on S Corporations and presented continuing education programs at AAA-CPA meetings. He received a BBM degree from CCNY, a JD degree from Harvard Law School and a LLM degree in Taxation from NYU Law School.

* All rights reserved by author. Portions of this article are adapted from The S Corporation Planning dE Operation, Panel Publishers' quarterly supplemented loose-leaf tax service.

Article reprinted with permission from the Florida Institute of CPAs. Copyright 1999. Statements expressed within this article should not be considered endorsements of products or procedures by the FICPA.

Copyright American Association of Attorney-Certified Public Accountants 1999
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