S Corporation update

The following is a summary of some of the Subchapter S developments that have occurred since the article that appeared in the July 1999 issue.

Final Regulations on Pass-through Items

Final regulations relating to the pass-through of items of an S corporation to its shareholders, the adjustments to the basis of stock of the shareholders, and the treatment of distributions by an S corporation were issued on December 22, 1999.

FInal QSub Regulations

Regulations under Section 1361 dealing with qualified subchapter S subsidiaries (QSubs) were issued on January 20, 2000. The regulations deal with the resuits of making a QSub election and of terminating a QSub election. Special rules are provided for banks. Discharge of Indebtedness Income as an Adjustment to Stock Basis

While tax exempt income of an S corporation increases a shareholder's basis in S corporation stock, there have been a number of cases holding that discharge of indebtedness income that is excluded from an S corporation's taxable income under Section 108 is not treated as tax exempt income for Subchapter S purposes and does not increase tax basis of Subchapter S stock. Several new developments have occurred in this area.

Two cases decided early in 1999 denied an increase in the basis of S corporation stock for discharge of indebtedness income excluded under Section 108(a) from the gross income of an S corporation. They were William C. Witzel, T.C. Memo 1999-64, and United States v. Farley (W.D. Pa., 1999). Both cases cited Nelson, 110 TC 114 (1998), with approval.

But Farley was reversed on January 27, 2000 in United States v. Farley, 202 F. 3d 198 (3rd Cir., 2000), when the Third Circuit Court of Appeals permitted taxpayers to increase their basis of S corporation stock due to their S corporation's non-recognized discharge of indebtedness income. The appeals court cited the unambiguous language of the statute and refused to amend the Code, leaving that job to Congress.

A District Court in Oregon held for the taxpayers in Hogue v. United States on January 3, 2000. On January 18, 2000, the Seventh Circuit held for the Government in Witzel v. Commissioner, 200 F. 3d 496, affirming T.C. Memo 1999-64. On January 19, 2000 the U.S. Tax Court decided two cases in favor of the Government: Richard T. Mullen, T.C. Memo 2000-21, and Stephen L. Goodman, T.C. Memo 2000-23. On January 21, 2000 the Tax Court decided Robert H. Bettisworth, T.C. Memo 2000-30, in favor of the Government.

On December 22, 1999, the IRS finalized its regulations under Section 1366, originally proposed on August 18, 1998, that define tax-exempt income for purposes of Subchapter S as not including income from discharge of indebtedness that is excludable from gross income under Section 108.

Due to the conflicting opinions cited above, on May 1, 2000 the U.S. Supreme Court agreed to resolve this issue. On January 9, 2001, the U.S. Supreme Court ruled in Gitliz v. US resolving the question in favor of the taxpayer.

S Corporation Acquired by a Consolidated Group

When 80% or more of the stock of an S corporation was acquired by a member of a consolidated group, the interaction of the consolidated return regulations and the Subchapter S rules used to require the filing of a separate one-day return for the day of the acquisition. Final regulations adopted on November 10, 1999 eliminated the need for a separate one-day return in such cases except when an election under Section 338(g) is made.

Losses Limited to Tax Bases of Stock and Loans

A number of additional cases have been decided involving the question of whether taxpayers had sufficient bases in their S corporation stock and/or loans to the S corporation in order to deduct their shares of losses and deductions passed through to them.

The Eleventh Circuit affirmed two Tax Court decisions denying basis for loans that were guaranteed by the shareholders in Spencer v. Commissioner, 194 F.3d 1324 (11th Cir. 1999), and in Sleiman v. Commissioner, 187 F.3d 1352 (11th Cir. 1999).

In Thomas E. Hogan III, T.C. Memo 1999-- 365, the Tax Court held that a shareholder was unable to prove any basis in his stock and loans to the corporation. However, it declined to impose the accuracy related penalties, stating that a taxpayer's basis in S corporation stock and indebtedness is a fairly complicated subject.

In Thomas F. Grojean, T.C. Memo 1999-425, the Tax Court disallowed loss deductions flowing through to a shareholder from his S corporation because he lacked basis. The taxpayer had purchased a participation in a loan made to the corporation by a bank. The court held that this was a disguised guarantee and that the shareholder could not get tax basis for this arrangement.

In Francis L. Miller, Jr. v. U.S., 39 F.Supp.2d 678 (N.D.W.Va. 1999), the shareholder of an S corporation argued that basis for stock was created from gain on the sale of S corporation stock. He argued that the losses from operations that were not deductible because of a zero basis in the stock could offset gain on the sale of the stock. The shareholder also argued that the passive activity loss rules of Code Section 469 and the atrisk rules in Code Section 465 allow him to offset the gain from the complete redemption of S corporation stock against the loss relating to his shareholder's interest in that entity. The District Court pointed out that the passive activity loss and the at-risk rules do not create basis but are limitations on the amount of deductible flow-through losses that S corporation shareholders may deduct on their individual tax returns. Furthermore, the Court pointed out that the shareholder made no outlay to increase his adjusted basis. He neither made a capital contribution nor loaned any money to the corporation.

The reverse type of situation from the usual one occurred in Gerald S. Robinson v. US, 84 F.Supp.2d 1124 (D. Ct. Oregon, 11/8/99). In that case, the taxpayer claimed that previously incurred losses of his S corporation were not deductible because he did not have sufficient basis in the earlier year. However, the Court found that loans made from the bank to the shareholder that were immediately deposited by him into the corporation's bank account were contributions to capital that increased his basis so that the losses were really deductible in the earlier year and not in the year the taxpayer claimed them.

Second Class of Stock Issue

Revenue Procedure 2000-3 includes among the list of areas under extensive study in which rulings or determination letters will not be issued until the Service resolves the issue through publication of a revenue ruling, revenue procedure, regulations or otherwise the following item with respect to S corporations' second class of stock questions:

"Whether a state law limited partnership electing under (sec) 301.7701-3 to be classified as an association taxable as a corporation has more than one class of stock for purposes of (sec) 1361(b)(1)(D). The Service will treat any request for a ruling on whether a state law limited partnership is eligible to elect S corporation status as a request for a ruling on whether the partnership complies with (sec) 1361(b)(1)(D)."

Automatic Change in Accounting Period Permitted in Order to Elect Subchapter S Status

Revenue Procedure 2000-11, 2000-3 IRB 309, eliminates the prohibition of an automatic accounting period change for a corporation making a Subchapter S election effective for the taxable year immediately following the change, provided the corporation is changing to a permitted S corporation taxable year.

Requirement to File Form 2553 Subchapter S Election

In two recent Tax Court cases, the petitioners were denied deductions on their personal returns for corporate expenses. In Xavier J.R. Avula, T.C. Memo 2000-97, the corporation did not file Form 2553 and the record did not disclose any other attempt to make an election to be treated as an S corporation. In Victor L Rosenberg, T.C. Memo 2000-108, the result was the same.

S Corporation Income Does Not Affect Self Employment Income

The Ninth Circuit Court of Appeals affirmed the Tax Court in Ding v. Commissioner, 200 F.3d 587 (9th Cir. 1999), affirming T.C. Memo 1997-435, holding that a taxpayer must compute his net earnings from self employment for the purposes of self employment tax without taking into consideration any pass-through losses from his S corporation.

Five Year Waiting Period for New Election

Code Section 1362(g) provides that if an S corporation terminates its election, it cannot make a new election for any taxable year before its fifth taxable year for which such termination is effective unless the IRS consents to the new election.

In Letter Ruling 199952072 the IRS refused to grant such permission.. The corporation revoked its S corporation election just prior to a sale of its stock to an ESOP in order to allow the shareholder to obtain the benefits of Section 1042. That Section allows a taxpayer to defer recognition of long-term capital gain on a sale of qualified securities to an ESOP if the taxpayer purchases qualified replacement property, but only if the corporation is a C corporation. After the sale, the corporation sought to reinstate its S corporation status. To allow the corporation to reelect S corporation status would be contrary to the Congressional intent to prohibit the benefit of Section 1042 to shareholders of S corporations.

Dividends Reclassified as Salaries

Another case has arisen where a taxpayer sought to avoid payroll taxes by taking unreasonably small salaries and having his S corporation pay large dividends. In Eugene G. Ziobron, Inc. v. U.S., 172 F.3d 53 (7th Cir. 1998), the Seventh Circuit Court of Appeals affirmed the District Court because the taxpayer failed to affirmatively allege specific facts to overcome the government's presumption of correctness.

An attorney in Hawaii also failed to avoid payroll taxes by following the familiar pattern of other taxpayers who have lost in this area. He claimed that he was receiving no salaries but only "loans" from the corporation. After a payroll audit, the LR.S. reclassified the loans as salaries and held the individual personally liable as a "responsible person" for the trust fund portion of the payroll taxes.[In Re: Robert Allan Smith, debtor. Robert Allan Smith v. U.S., 243 B.R. 89, 99-2 USTC (para) 50,998 (D. Ct. Hawaii, 10/27/99), affirming a Bankruptcy Court decision 99-1 USTC (para) 50,278.]

Payroll Tax Refunds

Field Service Advice 199937003 considered the question of whether an S corporation could recover payroll taxes on amounts that were deemed to be excessive compensation. The conclusion reached in the FSA, which is not binding and may not be cited as precedent, is that the S corporation may not receive any refunds of income taxes withheld from an employee. However, the S corporation could recover the employer's share of the FICA tax.

Interest Deduction Disallowed. When a shareholder pays interest on additional taxes caused by additional income from an S corporation, the question arises as to whether this is nondeductible personal interest. Temporary Regulation 11.163-9 T(b)(2)(i)(A) provides that nondeductible personal interest includes interest on income taxes regardless of the source of the income generating the tax liability. This means that an S corporation shareholder may not deduct interest on a tax deficiency even when the additional tax on which the interest is based arises from S corporation income.

Recent cases holding for the government that the temporary regulation is a reasonable construction of Code Section 163(h) were Kirk v. U.S., 99-2 USTC (para)50,687 (E.D. Ky 6/16/99) and Davis v. U.S., 71 F.Supp. 2d 622 (W.D. Tex. 7/30/99).

In Richard R. Allen Sr. v. US, 173 F.3d 533 (4th Cir. 1999), the Fourth Circuit joined the Eighth Circuit and the Ninth Circuit in upholding the validity of Temporary Regulation 11.163-9 T(b)(2)(i)(A). Thus, the interest deduction was disallowed.

Similarly, in McDonnell v. US, 180 F.3d 721 (6th Cir. 1999), the Sixth Circuit held that the Temporary Regulation is valid citing with approval the Ninth Circuit's opinion in Redlark v.Comm'r., 141 F.3d 936 (9th Cir. 1998).

In Kikalos v. Commissioner, 190 F.3d 791 (7th Cir. 1999), another Court of Appeals reversed the Tax Court on the question of whether interest expense will be deductible when it arises from a tax deficiency on business income. So far, every Circuit Court of Appeals that has considered the matter has ruled in favor of the LR.S.

An analogous situation arose in Robert W. Carlson, 112 TC 240 (1999). In that case, a shareholder of an S corporation paid interest on a deferred tax liability in accordance with an installment sale of residential timeshare units made by an S corporation of which he was a shareholder. The Tax Court disallowed the interest deduction because it held that the interest had to be allocable to a trade or business of the taxpayer. In this case, the trade or business was that of the S corporation and not of the taxpayer. Therefore, it disallowed the deduction without addressing the question of whether the temporary regulation discussed above is valid.

Section 179 Regulation Upheld

In Dennis L. Hayden, 112 TC 115 (1999), affd 204 F. 3d 772 (7th Cir. 2000), the Tax Court upheld the validity of Regulation (sec) 1.179-2(c)(2) imposing the taxable income limitation on Section 179 depreciation to a partnership as well as to each partner. The Regulation provides that a partnership may not allocate any Section 179 expense deduction to its partners for any taxable year in an amount more than the partnership's taxable income. Regulation (sec) 1.179-2(c)(3) applies similar rules to S corporations and their shareholders. Therefore, an S corporation may not pass any Section 179 depreciation deductions to its shareholders if the S corporation does not have any taxable income. The Appeals Court pointed out that regulations are entitled to be enforced if they are reasonable interpretations of the law.

In Marion Wilson, TC Memo 1999-141, Section 179 depreciation deductions could not be passed through an S corporation to its shareholders because the corporation had no taxable income.

Section 338(h)(10) Election Treated as a Sale of stock.

Code Section 338(h)(10) permits certain qualified stock purchases to be treated as asset acquisitions if certain requirements are met. Regulation (sec)1.338(h)(10)-1(a) provides that if a Section 338(h)(10) election is made, the sale of target stock in the qualified stock purchase is ignored and the target corporation generally is deemed to sell all of its assets and distribute the proceeds in complete liquidation. In two recent private Letter Rulings, IRS treated the Section 338(h)(10) election as a sale of stock.

In Letter Ruling 199918050, involving a reverse subsidiary cash merger, the merger agreement provided that if a Section 338(h)(10) election was made, the shareholders of the S corporation would each receive a payment to compensate them for any increased liability for federal and state income taxes or a reduction in selling price that results from the Section 338(h)(10) election. The amount of these payments, per share of S corporation stock, will vary among the shareholders. Solely for purposes of the determining whether this was a violation of the second class of stock prohibition, the IRS ruled that the transaction will be treated as a sale of stock by the shareholders and not as a liquidating distribution. Thus, the S corporation was not treated as having a second class of stock by reason of the unequal payments to the shareholders and the Section 338(h)(10) election.

In Letter Ruling 199920007, the IRS ruled that gain to an S corporation and its shareholders on the deemed sale of assets resulting from a Section 338(h)(10) election allocable to shares of S corporation stock owned by a qualified subchapter S trust (QSST) is taxable to the QSST and not to the income beneficiary of the QSST.

At Risk Limitations of Section 465 The at risk limitations of Section 465 apply to S corporation shareholders. Several recent developments have denied deductions to shareholders.

In Larry W. Van Wyk, 113 T.C. No. 29 (1999), a taxpayer was denied deductions when he borrowed money from a related party who was also a shareholder of their S Corporation.

In TAM 199951035, circular loans among three S corporations and a shareholder were held not to be at risk because there was no realistic possibility of economic loss.

In Ronald Kimmich, T.C. Memo 1999-349, the Tax Court found that the circularity of payments, the bookentry payment mechanism, and the indemnity clause in a lease, when taken together, effectively immunized petitioner from any realistic possibility of suffering an economic loss. Therefore, the petitioner was held to be not at risk and was not entitled to the deductions in question.

Qualified Oil Corporations

Certain oil corporations that were using Subchapter S prior to the Subchapter S Revision Act of 1982 are still governed by the pre-1982 law. In National Office Field Service Advice 199940009, the IRS concluded that such corporations may continue to file their income tax returns using the 1982 Forms 11205.

Regs. Issued on Sales or Exchanges of S Corporation Stock

Proposed regulations dealing with sale of S corporation stock when the S corporation holds collectibles as defined in Section 408(m) were published in the August 9, 1999 Federal Register. Final regulations were published in the September 21, 2000 Federal Register. Under the regulations, a portion of the long-term capital gain on the sale of the S corporation stock will not be subject to the 20% maximum longterm capital gains rate but instead will be subject to the 28% maximum rate that applies to sales of collectibles.

Life Insurance Premiums Affect on Basis

When an S corporation pays premiums on a life insurance policy under which the corporation is a beneficiary, no deduction is permissible. The question arises as to whether this is a nondeductible noncapitalizable expense that reduces the shareholders' bases in their S corporation stock. To the extent that the premium creates a capital asset (e.g. cash value) the expense is capitalizable and does not reduce basis. In Field Service Advice 1999-832, the IRS permitted the settlement of a case which allocated the premium payment between the insurance (nondeductible expense) and the investment feature of a policy. It allowed the portion of the premium equal to the increase in the cash surrender value to be treated as an investment, capitalizable and not affecting basis. The remaining portion of the premium was the nondeductible noncapitalizable expense for insurance coverage and did reduce stock basis. The Field Service Advice recognized that this method of allocation is imperfect and may be inappropriate in some circumstances. It also pointed out that the issue is being considered for publication as a revenue ruling.

Electing Small Business Trusts (ESBTs)

Letter Ruling 199930035 deals with the definition of an ESBT. The trust document in question gave the trustee discretion to make distributions to descendants of the settlor, either outright or in trust. Citing Notice 97-49, the letter ruling noted that the term beneficiary does not include a distributee trust, but does include those persons who have a beneficial interest in the property held by the distributes trust. Furthermore, Notice 97-49 provides that for purposes of the definition of a potential current beneficiary under Code Section 1361(e)(2) if a distributes trust becomes entitled to, or at the discretion of any person may receive, a distribution from principal or income of an ESBT, then the trust will become a potential current beneficiary and the S corporation election will terminate unless the distributes trust is a grantor type trust described in Section 1361(c)(2)(A). Accordingly, the letter ruling concluded that for purposes of the ESBT definition, the beneficiaries of the trust are the individuals and thus are qualified beneficiaries. Furthermore, the ruling concluded that the power given to the trustee to subdivide the trust into sub-trusts does not affect the trust's qualification as an ESBT.

On December 29, 2000 the IRS issued proposed and temporary regulations dealing with ESBTs. These proposals would allow grantor trusts to make ESBT elections.

Reprinted with permission from the Florida Institute of CPAs. Copyright 2000. Statements expressed within this article should not be considered endorsements of products or procedures by the FICPA. Author's updates since the original publication of the article appear in a different font.

by

Sydney S. Traum, BBA, JD, LLM, CPA

Miami, Florida

About the Author

Sydney S. Traum practices law as owner of Sydney S. Traum, P.A., which is of counsel 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 BBA degree from CCNY, a JD degree from Harvard Law School, and a LLM degree in Taxation from NYU Law School.

*Portions of this article are adapted from Panel Publishers loose-leaf tax service entitled The S Corporation: Planning & Operation.

Copyright American Association of Attorney-Certified Public Accountants 2000
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