2000-2001 S Corporation update

Traum, Sydney S

2000-2001 S Corporation Update*

The following is a summary of some of the recent S Corporation developments during 2000-2001.

New Legislation

Economic Growth and Tax Relief Reconciliation Act of 2001

On June 7, 2001, President Bush signed the Economic Growth and Tax Relief Reconciliation Act of 2001. The reduction of individual tax rates will affect all S corporation shareholders. The following two provisions relate specifically to S corporations.

Loans to Shareholder-Employees of S Corporations

The new law generally eliminates the present-law prohibition against plan loans made to owner-employees of S corporations. Thus, S corporation qualified plans will be permitted to lend money to more than 5 percent shareholder-participants under the same terms as loans for C corporation plans. The provision is effective for tax years beginning after Dec. 31, 2001.

S Corporation ESOPs

The new law prohibits ESOP allocations to certain S corporation shareholder-employees during nonallocation years. A nonallocation year is defined as any plan year of an ESOP holding shares in an S corporation if, at any time during the plan year, disqualified persons own at least 50 percent of the number of outstanding shares of the S corporation. In the case of a prohibited allocation, the S corporation will be liable for an excise tax equal to 50 percent of the amount of the prohibited allocation. The new ESOP provisions are generally effective with respect to plan years beginning after Dec. 31, 2004. The new law is effective with respect to plan years ending after March 14, 2001 for an ESOP established after March 14, 2001, or an ESOP established on or before that date if the employer maintaining the plan was not an S corporation on that date.

Joint Committee On Taxation Recommendations For Tax Simplification

Included in the study of the overall state of the Federal tax system and recommendation for simplification pursuant to Section 8022(3)(B) of the Internal Revenue Code of 1986, the staff of the Joint Committee on Taxation of the Congress made certain recommendations relating to Subchapter S. The staff recommended eliminating the excess passive investment income S termination rule and proposed modifying the tax on excess passive investment income by raising the percentage of such income required for tax to more than 60 percent of gross receipts instead of the present 25 percent. The staff also recommended that the taxation rules for electing small business trusts (ESBTs) should be eliminated and that the regular rates of Subchapter J should apply to these trusts and their beneficiaries.

Other Developments

Form 2553 Revised

Form 2553, Election by a Small Business Corporation, and its instructions were revised Jan. 2001. The revised instructions indicate that corporations may be mailing forms and elections to different service centers in 2001 and again in 2002 because the IRS has changed the filing locations for several areas.

Effect of Discharge of Indebtedness Income on Basis

The issue of whether discharge of indebtedness income not recognized to an S corporation, because of insolvency or bankruptcy exception increases in a shareholder's basis in his stock, was decided in favor of the taxpayers on Jan. 9, 2001 by the U.S. Supreme Court in Gitlitz v. Commissioner, 531 U.S. 206 (2001).

Proposed Revenue Procedures Affecting Annual Accounting Periods

In Internal Revenue Bulletin 2001-23 (June 4, 2001) the IRS issued two Notices affecting accounting periods of S corporations. Notice 2001-34 contains a proposed revenue procedure that would provide the procedures under Code Section 442 and regulations thereunder to establish a business purpose and request the approval of the IRS to adopt, change or retain a taxpayer's annual accounting period. Notice 2001-35 contains a proposed revenue procedure that would provide procedures under Code Section 442 and the regulations thereunder for S corporations, C corporations making an S corporation election, and certain other corporations and partnerships to obtain automatic approval of the IRS to adopt, change or retain their annual accounting periods. These proposed revenue procedures are intended to be issued concurrently with new proposed regulations under Sections 441, 442, 706, and 1378. The new proposed regulations were published in the June 13, 2001 Federal Register.

One Class Of Stock Limitation

The Feb. 13, 2001 Federal Register amended Treasury Regulations 11.13 61 -1 to provide a special rule for Section 338(h)(10) elections. This election allows an acquiring corporation that has purchased the stock of a target corporation to obtain basis for the target's assets equal to the price paid for the target stock. It does this by treating the target as if it sold all of its assets (recognizing gain) and then liquidated. The amended regulation states that when S corporation shareholders sell their stock in a transaction for which a Section 338(h)(10) election is made, the receipt of different amounts per share by some shareholders will not cause the S corporation to have more than one class of stock, provided that the varying amounts are determined in arm's length negotiations with the purchaser.

Interest On Tax Deficiencies

Another court has held that interest raid bv a shareholder as a result of subchapter S corporation tax deficiencies in prior years is not a deductible expense. Michael E. Fitzmaurice v. United States, (S.D. Tex, 1/2/01, 2001-1 USTC 50,198), upheld the validity of Treasury Regulations sec 1.163-9T(b)(2)(i)(A) and held that the interest was nondeductible personal interest.

Built-in Gains Tax Transitional Relief Applies Only to Most Recent S Corporation Election

Under 1986 Tax Reform Act Section 633(d), certain qualified corporations that had made their Subchapter S elections before Jan. 1, 1989 were not subject to the built-in gains tax on long-term capital gains. In Colorado Gas Compression, Inc. v. Comissioner, 116 TC No. 1 (1/2/01), the Tax Court was faced with a situation in which the corporation had made a Subchapter S election before Jan. 1, 1989. However, the corporation revoked its S election effective Dec. 1, 1989, and was a C corporation until the beginning of 1994. Effective Jan. 1, 1994, it made a new Subchapter S election. The IRS and the Tax Court.held that the transitional relief applies only to the most recent S election. Therefore, the corporation did not qualify for transitional relief and sales of its assets were subject to the built-in gains tax of Section 1374.

Shareholder Not Entitled To Corporate Distribution

Although shareholders pay tax on the S corporation income, they are not automatically entitled to receive distributions of that income. State law formalities must be followed. In Federal Trade Commission v. Med Resorts International, ;Inc., (N.D. Illinois, Dec. 27, 2000), the District Court directed a receiver to deny a shareholder's request for a distribution from the S corporation in order to pay the shareholder's tax liability on the corporation's income.

Theft Loss Denied for Undistributed Taxable Income

In United Stated v. Larry C. Johnson, 2000-1 USTC 50,415 (N. D. Georgia, March 30, 2000), an Atlanta District Court affirmed a bankruptcy court decision denying a theft loss deduction to an S corporation shareholder who claimed a loss deduction for undistributed taxable income of an S corporation upon which he paid tax. The taxpayer claimed that his S corporation was required to distribute the amount on which he was taxable under the general pass-through rules. Because no such distributions were made, he claimed a theft loss. The court found that this claim is completely unsupported by either the record in the case or the Internal Revenue Code.

Diversion of S Corporation Income

In U.S. v. Donald Newell, 239 F.3d 917 (7th Circuit, Feb. 9, 2001) affirming 192 F.R.D. 587 (N.D. Illinois, April 25, 2000), the taxpayer's conviction by the District Court for filing false federal income tax returns for both himself and a Subchapter S corporation of which he was 50 percent shareholder was affirmed. Taxpayer had formed a Bermuda corporation and diverted income from his S corporation to the Bermuda corporation without reporting that income.

Lack of Basis Prevents Loss Pass-Through

Under Section 1366, an S corporation shareholder may deduct his or her pro-rata share of losses and deductions of the S corporation, limited to the sum of the adjusted basis of the shareholder's stock in the corporation and the adjusted basis of any indebtedness of the corporation owed to the shareholder. Shareholder guarantees do not generally create basis until the shareholders make payments under the guarantees.

In Guerrero v. Commissioner, TC Memo 2001-44, and Jackson v. Commissioner, TC Memo 2001-61, the taxpayers failed to prove basis and thus could not deduct losses from their S corporations.

In the Estate of Alton Bean, Deceased, T.C. Memo 2000-355, the Tax Court denied basis for shareholders' personal guarantees of the corporation's indebtedness on bank loans, the transfer of partnership assets to the S corporation, and unreported income. However, the taxpayers were able to avoid the accuracy related penalty because they relied upon an accountant to prepare the tax returns for the years in issue.

In Franklin W. Briggs, T.C. Memo 2000-380, basis for stock was denied for shareholders' guarantees of third party loans to an S corporation. The court distinguished Selfe on its facts because the creditor looked to the corporation and not to the shareholders for repayment of the loan.

The Seventh Circuit of Appeals affirmed the Tax Court in Grojean v. Commissioner, 248 F.3d 572 (7th Cir, April 13, 2001). The taxpayer had borrowed money from a bank which he used to purchase a part of a loan (a loan participation) made by that bank to his S corporation. The Tax Court and the Seventh Circuit treated the participation in the bank loan as a mere guarantee, not giving the taxpayer any basis in loans to the S corporation. Thus, his losses and deductions were limited to basis, without consideration of the amount paid for the loan participation.

In Kandiah Jeyapalan, TC Memo 2000-207, taxpayers attempted to ignore corporate existence and treat the S corporation as a partnership. Several years before, the petitioners had incorporated their partnership and since then had filed tax returns showing the income from the real estate operations on the Forms 1120-S. Even though the title to the real estate was never legally transferred to the corporation, because the taxpayers recorded the income on the corporate tax return for so many years, the Tax Court would not allow them to disregard the corporate entity. Having insufficient basis, the losses were disallowed.

Similarly, in Richard D. Nelson, TC Memo 2000212, the Tax Court refused to ignore the existence of the S corporation and treat it as a partnership. In addition, the Court distinguished the fact pattern in this case from Selfe, the Eleventh Court opinion which allowed basis in certain circumstances to a guarantor when the creditor always looked to the' guarantor for repayment. Thus, the shareholders' losses Were not deductible.

In Angelo F. DeJoy, TC Memo 2000-162, the taxpayer was unable to prove tax basis in his stock of the S corporation. Therefore, he could not claim the losses and deductions of the S corporation.

Payments from Related Corporation treated as Payments by Shareholder

Payments made to an S corporation from a related corporation on behalf of its sole shareholder were treated as having been made by the shareholder and thus gave him adequate basis for the deduction of S corporation losses. The books and records and tax returns of both corporations, as well as testimony of witnesses, supported the taxpayer's contention that the payments by the related corporation, were loans to the shareholder and investments by him in the S corporation. Daniel J. Culnen, TC Memo 2000-139.

S Corporation Non-Deductible Expenses Paid to Shareholder as Income

In Patrick E. Catalano v. Commissioner, 240 F.3d 842 (9th Circuit, Feb. 15, 2001), affirming T.C. Memo 1998-447, the shareholder of an S corporation leased three boats to the corporation. The corporation's deductions for the rental expense were disallowed because the boats constituted entertainment facilities and deductions were prohibited by Section 274(a)(1)(B). Nevertheless, the shareholder was required to include the rental income that he received in his taxable income. The Ninth Circuit agreed with the Tax Court that disallowance of the corporate level deduction does not result in an offsetting adjustment to the individual shareholder's income, even when the individual owns 100 percent of the stock of the S corporation. An S corporation is a separate entity from its shareholders.

Loss From Farm Operations Disallowed

Another S corporation was denied losses from farm operations that the court found were not conducted with a profit motive. In Robert O'Connor, T.C. Memo 200190, the Tax Court found that the corporation did not possess the requisite intent to profit from its farm operations. Thus, they were subject to the restrictions set forth in Section 183 for activities not engaged in for profit.

Momentary Ownership of Stock Ignored

In Letter Ruling 200122034, the IRS ruled that on distribution of S corporation stock from an employee stock ownership plan (ESOP) to an IRA that was subject to immediate repurchase by the corporation, the momentary designation of the custodian of the IRA as the owner of stock would not cause the Subchapter S election to terminate.

In Letter Ruling 200036036, the IRS ignored the momentary ownership of stock by another corporation as part of a "D" reorganization. Ignoring that momentary ownership of its stock by another corporation permitted the corporation to make an S corporation election for its first taxable year.

Charitable Contributions

Revenue Ruling 2000-43, 2000-41 IRB 333, holds that an accrual basis S corporation may not elect under Section 170(a)(2) to treat a charitable contribution as paid in the year authorized by the S corporation's Board of Directors if the contribution is paid by the S corporation after the close of the taxable year.

Who Is The Shareholder?

In Frank J. Feraco, T.C. Memo 2000-312, one of the issues involved the identity of the shareholders and the question of whether a certain individual was a shareholder of the S corporation. Even though no stock was issued to him, the Tax Court found that he was a beneficial owner and therefore a portion of the corporation's income, deduction and loss must be allocated to the individual in question.

Private Letter Ruling 200025034 examined the situation when a shareholder filed a complaint for corporate dissolution. Under state law (state undisclosed), the corporation could make an irrevocable election to purchase the shares from the disgruntled shareholders. This was done. Also under state law, if the parties could not agree on the purchase price, the court could make a determination of the price to be paid. This procedure for determining the purchase price would extend beyond the due date for filing an S corporation election. Citing Ragghianti v. Commissioner, 71 TC 346 (1978), acq. 1979-2 CB 2, the IRS held that for purposes of Subchapter S, the selling shareholders are not considered shareholders within the meaning of Section 1362(a)(2); therefore their consents to the subchapter S election are not required.

In a criminal tax case, the Second Circuit Court of Appeals affirmed a District Court in dismissing the portion of an indictment against a defendant for filing a false Schedule K-1 in which he listed himself as a 90 percent shareholder when, in fact, another person was a 45 percent owner of the corporation. Both courts held that there is no known legal duty to declare an alleged "ownership interest" of an individual (to whom no stock certificates were issued) as a shareholder's interest on a Schedule K-1. United States v. Pirro, 96 F.Supp.2d 279 (S.D.N.Y., 12/9/99), affirmed 212 e3d 86, (2nd Cir., May 3, 2000).

LIFO Recapture Tax

When a C corporation uses the LIFO inventory method for its last taxable year before an S corporation election becomes effective, it must include the difference between FIFO and LIFO (the LIFO recapture amount) in income for its last C corporation taxable year.

Letter Ruling 200050043 holds that the LIFO recapture tax will not apply in a divisive reorganization vertically dividing an S corporation's business into two businesses under Section 368(a)(1)(D) when its newlyformed subsidiary is immediately distributed to its sole shareholder and the former subsidiary makes an S election for its first taxable year.

Coggin Automotive Corporation, 115 T.C. 349 (2000), involved a situation where a C corporation was a partner in several partnerships that owned LIFO inventory. Upon the corporation's election of S corporation status, it was required to include in its gross income its ratable share of the partnership's LIFO recapture amounts.

Refunds of Section 7519 Required Payments Subject to Statute of Limitations

In a Chief Counsel Advice memorandum, CCA 200050014, the Office of Chief Counsel took the position that the refund of a required payment under Section 7519 (when an S corporation has made a Section 444 election to have a taxable year other than a required taxable year) is subject to the statute of limitations under Internal Revenue Code Section 6511(a). Thus, the claim for credit or refund should be filed within three years from the time the Form 8752 was filed or within two years from the time the tax was paid, whichever is later. Taxation of Distributions.

In Frank J. Feraco, T.C. Memo 2000-312, the shareholder of an S corporation that had no earnings and profits received a distribution in excess of his basis. This excess distribution was taxable as a capital gain.

In Franklin W. Briggs, T.C. Memo 2000-380, gas rebate payments that should have been paid to the corporation were paid directly to the shareholders. These payments were treated as income to the corporation and then ordinary income to the shareholders.

In Gerald E. Toberman, T.C. Memo 2000-221, the taxpayer was unable to prove that the S corporation did not have accumulated earnings and profits. Nor was he able to prove that the corporation had a positive Accumulated Adjustments Account. As a result, distributions were taxed to him as ordinary income.

Failed Spin-off Treated As Distribution

In Douglas P. Mclaulin, Jr, et al.,115 T.C. 255 (2000), an S corporation distributed its 50 percent share of a C corporation claiming that it was a nontaxable transaction under Code Section 355. Because it failed the five-year active trade or business requirement, Section 355 did not apply. Therefore, the distribution produced taxable income under Section 311 (b) -that provides for a distributing corporation's recognition of gain on its distribution of appreciated property as if the property was sold at its fair market value. This gain flowed through to the shareholders and was taxed to them under the distribution rules.

Final Regulations Issued on Sales or Exchanges of S Corporation Stock

The Federal Register dated Sept. 21, 2000 contained final regulations dealing with the sale of S corporation stock when the S corporation holds collectibles as defined in Section 408(m). Under these final regulations, a portion of the long-term capital gain on the sale of the S corporation stock will not be subject to the 20 percent maximum long-term capital gains rate, but instead will be subject to the 28 percent maximum rate that applies to sales of collectibles. These regulations finalized those that were proposed on Aug. 9, 1999.

Accounting Expenses Related to S Corporation Election and Merger Were Capitalized

In United Dairy Farmers, Inc. v. US, 2000-1 USTC 50,538 (D. Ct. Ohio, May 22, 2000) accounting expenses paid to Ernst & Young relating to an S corporation election and merger treated as an "F" reorganization were not currently deductible and were required to be capitalized under Code Section 263.

New Form 8082 Issued

Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR), was revised Jan. 2000. This form is used by an S corporation shareholder who does not receive a Schedule K-1 or who disagrees with the amounts shown on the Schedule K-1 that he or she has received.

Merger of A Qualified Subchapter S Subsidiary (Qsub)

Proposed regulations in the May 16, 2000, Federal Register would, if adopted, provide that a merger under state or federal law between two entities, one of which is a corporation and the other of which is a QSub, does not qualify as a statutory merger tax-free under Section 368(a)(1)(A). However, the preamble to the proposals state that the transaction may still be tax-free either under Section 351 or under Section 368(a)(1)(C), (D), or (F) if all applicable requirements are met.

Corporation Shareholder-Employee Fails to Avoid Payroll Taxes

The Sixth Circuit, in an unpublished opinion, offirmed the Tax Court decision in Joly v. Commissioner, 211 F 3d 1269, 2000-1 USTC 50,315 (6 Cir, March 20, 2000), affirming T.C. Memo 1998-361. Joly argued that the payments he took from his corporation were Subchapter S distributions and not salaries. The Tax Court held for the Commissioner and the Sixth Circuit affirmed the Tax Court.

Inadvertent Termination Status Refused

In Letter Ruling 200021028, the IRS denied inadvertent termination status after the corporation's Subchapter S election was revoked by a letter signed by its sole shareholder. The intentional revocation was not an inadvertent termination.

Innocent Spouse Relief Denied

Jean Butler was denied innocent spouse relief by the Tax Court when her husband failed to report income from an S corporation in which he was a shareholder on their joint income tax return. Because she was a shareholder and an operator of her own S corporation and because she was involved in preparing their joint tax returns, the Tax Court held that she should have known of the understatement of her husband's income on the joint return. Accordingly, she was denied innocent spouse relief under Section 6015(b)(1). Butler v. Commissioner, 114 TC 276 (2000).

Proposed Legislation

Small Business and Financial Institutions Tax Relief Act of 2001

Legislation has been introduced that would expand and improve Subchapter S. Similar legislation has been introduced over the last few years. This proposal would benefit many small businesses, but some of its provisions are particularly applicable to banks. The proposed legislation:

* Permits S corporation shares to be held by Individual Retirement Accounts (IRAs), and permits IRA shareholders to purchase their shares from the IRA in order to facilitate a Subchapter S election.

Clarifies that interest and dividends on investments maintained by a bank for liquidity, safety and soundness purposes shall not be passive investment income. increases the number of S corporation eligible shareholders from 75 to 150.

* Provides that any stock that bank directors must hold under banking regulations shall not be a disqualifying second class of stock. Such bank directors would not be shareholders for Subchapter S purposes by reason of holding such qualifying director shares.

* Permits banks to Great bad debt charge-offs as items of built-in loss over the same number of years that the accumulated bad debt reserve must be recaptured (four years) for built-in gains tax purposes. This provision is necessary to properly match built-in gains and losses relating to accounting for bad debts. Banks that are converting to S corporations must convert from the reserve method of accounting to the specific charge-off method, and the recapture of the accumulated bad debt reserve is built-in gain. Presently the presumption that a bad debt charge-off is a built-in loss applies only to the first S corporation year.

* Clarifies that the general three-year S corporation rule for certain "preference"' items applies to interest deductions by S corporation banks, thereby providing equitable treatment for S corporation banks. S corporations that convert from C corporations are denied certain interest deduction preference items for up to three years after the conversion. At the end of three years the deductions are allowed.

* Provides that non-health care related fringe benefits such as group-term life insurance will be excludable from wages for "more-than-two-percent" shareholders. Current law taxes the fringe benefits of these shareholders. Health care related benefits are not included because their deductibility would.increase the revenue impact of the legislation.

* Permits family partnerships to be shareholders in Subchapter S corporations. Many family-owned small businesses are organized as family partnerships or controlled by family partnerships for a variety of reasons. A number of small banks have family partnership shareholders, and this legislation would for the first time permit those partnerships to be S corporation shareholders.

* Permits S corporations to issue nonvoting preferred stock in addition to common. Current law permits S corporations to have only one class of stock. Because of limitations on the number of common shareholders, S corporations (especially banks) need to be able to issue preferred stock in order to have adequate access to equity.

* Facilitates charitable giving by S corporation shareholders by providing an increase in S corporation stock basis for the excess of a charitable contribution deduction over the basis of property contributed. Current law may penalize a shareholder who makes a charitable contribution of appreciated property through an S corporation because stock basis is generally reduced by the fair market value of the donated property. The charitable contribution that flows through to an S corporation shareholder is limited to stock basis. Without the proposed change, a shareholder might not get the benefit of a contribution deduction for the appreciation in the donated property's value.

* Reduces the required level of shareholder consent to convert to an S corporation from unanimous to 90 percent of outstanding shares.

* Clarifies that Qualified Subchapter S Subsidiaries (QSubs) provide information returns under their own tax identification number. This can help avoid confusion by depositors and other parties over the insurance of deposits and the payer of salaries and interest.

Reprinted with permission from the Florida Institute of CPAs. Copyright 2001. Statements expressed within this article should not be considered endorsements of products or procedures by the FICPA.

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

Sydney S. Traum, Esq., 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 Date 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 NY Law School.

Copyright American Association of Attorney-Certified Public Accountants Dec 2001
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