2001-2002 S corporation update

2001-2002 S Corporation Update*

The following is a summary of some of the recent S Corporation developments during 2001-2002.

NEW LEGISLATION

Gitlitz Result Reversed - Basis No Longer Increased By Discharge Of Indebtedness Income

The issue of whether discharge of indebtedness income, not recognized to an S corporation because of the insolvency or bankruptcy exception, increases 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).

On March 9, 2002, President Bush signed the Job Creation and Worker Assistance Act of 2002. Section 402, however, of that Act has the effect of reversing the result in Gitlitz, so that income from the discharge of indebtedness of an S corporation that is excluded from the S corporation's income is no longer taken into account as an item of income by any shareholder and thus does not increase the basis of any shareholder's stock in the S corporation. The provision generally applies to discharges of indebtedness after October 11, 2001. However, it does not apply to any discharge of indebtedness before March 1, 2002 pursuant to a plan of reorganization filed with the bankruptcy court on or before October 11, 2001.

Amended Returns - Gitlitz Fallout

Prior to the Supreme Court's decision in Gitlitz, cited above, some taxpayers had elected to first reduce the basis of depreciable property before reducing net operating loss (NOL) carryovers. After the Gitlitz decision, some of these taxpayers sought to revoke their prior elections in order to utilize the newly created basis under Gitlitz to deduct their accumulated NOLs. In Letter Rulings 200208016 and 200210044, the IRS granted permission to two taxpayers to withdraw their prior elections so that they could utilize the excluded income from cancellation of indebtedness to increase basis, thus allowing them to deduct their net operating loss carryovers. Both rulings granted taxpayers thirty days from the date of the ruling letters in which to revoke the elections. Each revocation was required to be made in a written statement to be filed with the taxpayer's amended return, attaching a copy of the private letter ruling.

Economic Growth And Tax Relief Reconciliation Act Of 2001 - Clarification

S Corporation ESOPs

The Economic Growth and Tax Relief Reconciliation Act of 2001 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.

Notice 2002-2, 2002-2 IRB 285 (1/14/2002) provides guidance regarding the effective date of this provision regarding the allocation of stock in an S corporation held by an ESOP. The Notice provides that for the purposes of the effective date, a corporation does not have an election in effect on March 14, 2001 unless the election was actually filed on or before that date and is effective on or before that date. For example, a corporation that filed an S election on March 15, 2001 to be treated as an S corporation effective as of January 1, 2001 did not have an election in effect on March 14, 2001. Accordingly, the new provisions would apply to an ESOP maintained by that corporation beginning with the first plan fear ending after March 14, 2001.

FINAL REGULATIONS

Section 444 Elections

Generally, an S corporation must use a calendar year. S corporations may use a fiscal year ending in September, October or November if they make a Section 444 election and make the applicable payments required. If the S corporation is part of a tiered structure composed of one or more deferral entities, all mist use the same taxable year. Temp. Regs. Section 1.444-2T(b)(2) excludes grantor trusts and qualified Subchapter S trusts from the definition of deferral entities. Since the regulation was promulgated before Electing Small Business Trusts (ESBTs) were permitted to be S corporation shareholders, the regulation did not refer to ESBTs.

Regulation 1.444-4 was adopted on May 14, 2002. It excludes ESBTs from the definition of deferral entities and provides a procedure for relief to permit an S corporation to retroactively reinstate a Section 444 election that it had terminated because of the operation of Temp. Reg. Section 1.444-2T. If an S corporation requests, the prior termination of a Section 444 election caused by this situation will be disregarded. The final regulations provide a procedure for such requests.

Electing Small Business Trusts (ESBTs)

The Federal Register of May 14, 2002 adopted final regulations relating to ESBTs. These regulations provide that a wholly or partially grantor trust may make an ESBT election. However, if it does, income allocable to the portion of the trust that is treated as a grantor trust will still be taxed to the deemed owner and not to the ESBT. The new regulation supersedes previous guidance for taxable years of ESBTs beginning on and after May 14, 2002 with respect to the following:

1) Notice 97-12 (1997-1 CB 385);

2) Notice 97-49 (1997-2 CB 304); and

3) Rev. Proc. 98-23 (1998-1 CB 662).

New Regulation 11.1361-1 covers ESBTs. It provides that:

1) Each potential current beneficiary (PCB) counts for the number of shareholders test;

2) Conversions of QSSTs to ESBTs are permitted; and

3) Subsection (m) contains ESBT rules, definitions, and permission for conversions to QSSTs.

ESBT Regs sec 1.641(c)-1 (1) Example 1

Reg sec 1.641(c)-1 governs the taxation of ESBTs. The S portion of an ESBT is taxed at the highest individual tax rate for ordinary income and for capital gains. The comprehensive example of how ESBT income is allocated is from subsection (1) of the new regulation. It is assumed that the grantor is the deemed owner of 10% of the trust. Details of the comprehensive example are appear in the box on the previous page.

The portion of the regulations involving the taxation of the grantor, S portion, and non-S portions of an ESBT are effective for taxable years of ESBTs that end on or after December 29, 2000, the date that proposed regulations were published in the Federal Register. The remainder of the regulations involving ESBTs are effective on and after May 14, 2002, the date the final regulations were published in the Federal Register.

May 17, 2002 Federal Register - Annual Accounting Periods

General rules for taxable years appeared in updates of he following regulations:

A. Reg sec 1.441-0, -1, -2, -3, and -4 General Rules

B. Reg sec 1.442-1 changes in accounting periods

C. Reg sec 1.706-1 Partnerships

D. Reg sec 1.1378-1 S Corporations taxable years

Other Guidance on Accounting Periods (Taxable Years)

Announcement 2002-53, 2002-22 IRB 1063, was published on June 3, 2002 regarding finalizing Notices 2001-34 and 2001-35 proposing changes in getting IRS approval to adopt, change or retain annual accounting periods under IRC secs 441 and 442 and regulations thereunder

Rev. Proc. 2002-37, 2002-22 IRB 1030, June 3, 2002, Automatic approvals for changes in tax year for corporations, but generally Not S corporations

Rev. Proc. 2002-38, 2002-22 IRB 1037, June 3, 2002, Automatic approvals for S corporations, supersedes Rev. Proc. 87-32 but retains 25% natural business year test

Rev. Proc. 2002-39, 2002-22 IRB 1046, June 3, 2002, Procedures for obtaining IRS approval for change in tax year, including S corporations

OTHER DEVELOPMENTS

Tax Returns - IRS Reduces Paperwork Burden on Small Businesses

In News Release No. IR-2002-48, released April 10, 2002, the IRS announced that starting with the 2002 tax year, S corporations with less than $250,000 of gross receipts and less than $250,000 in assets will no longer have to complete Schedules L and M-1 of Form 1120S.

The IRS Commissioner, Charles 0. Rossotti, stated "This is part of an on-going effort by the IRS to ease the burden on America's taxpayers wherever possible."

US Supreme Court - Allocation Between Purchase Price of Stock and Covenant Not to Compete.

The US Supreme Court denied certiorari in a case involving the allocation of the amount paid to the seller of S corporation stock between the cost of the stock and a covenant not to compete in Miner v. Commissioner, TC Memo 1999-358, affirmed 2001-2 USTC Para50,752 (9th Cir. 11/7/01), cent. denied, 122 S. Ct. 1964 (5/20/02). An S corporation redeemed all the stock of one of its shareholders. It claimed that a portion of the payment was for a covenant not to compete and amortized that portion of the cost over a seven year period. The Tax Court concluded that nothing should be allocated to a covenant not to compete because the documents did not reflect any allocation of the payment in that manner. The Ninth Circuit affirmed the Tax Court and the US Supreme Court denied cert.

Section 1374 Built-In Gains Tax -Timber, Coal, or Domestic Iron Ore Property

In Rev. Rul. 2001-50, 2001-43 IRB 343, the IRS held that built-in gains from the sale of wood products from cutting timber, produced coal, or produced iron ore are normal operating business income in the nature of rents and royalties and therefore not subject to the built-in gains tax of Section 1374. At the same time this revenue ruling was issued, the IRS issued Rev. Proc. 2001-51, 2001-43 IRB 369, which modified Rev. Proc. 2001-3, 2001-1 IRB 111, by deleting the section stating that the IRS would not rule on this issue.

Sale Of Crushed Minerals Not Subject To Built-In Gains Tax

In Letter Ruling 200205028, the IRS ruled that income recognized from the sale of crushed minerals that are mined and processed during the ten year recognition period of Section 1374 will not constitute recognized built-in gain within the meaning of Section 1374(d)(3). The letter ruling cited example 1 of Regs. sec 1.13744(a)(3) dealing with a working interest in an oil and gas property and Rev. Rul. 2001-50, 2001-43 IRB 343 dealing with timber property as authority for this letter ruling.

Built-in Gains Tax is a Subchapter S Item

For purposes of the tax administration provisions effective for tax years before 1997, the term "Subchapter S item" was defined by Section 6245 to mean any item of an S corporation that is more appropriately determined at the corporate level rather than at the shareholder level. In New York Football Giants, Inc. v. Commissioner, 117 TC #15 (10/30/2001), the issue was whether the built-in gains tax was a Subchapter S item. Temporary Regulation sec 301.6245-IT defined Subchapter S items, in part, as including taxes imposed at the corporate level such as the tax imposed by Section 1374. The taxpayer challenged the validity of this regulation. The Tax Court upheld the validity of the regulation and concluded that the Section 1374 built-in gains tax is a Subchapter S item because it is determined solely based on events at the corporate level (as opposed to an affected item or nonsubchapter S item that requires a factual determination at the shareholder level).

In KRP, Inc. v. Commissioner, TC Memo 2002-126, the Tax Court again held that the section 1374 built-in gains tax is a "Subchapter S item" under the unified tax administration provisions effective for tax years before 1997. Thus, under the TEFRA provisions applying to the taxpayer's 1995 tax year, the issue of built-in gains tax was correctly raised in a Notice of Final S Corporation Administrative Adjustment and did not require a separate statutory notice of deficiency.

IRS Updates List of Areas in Which it Will Not Issue Letter Rulings or Determination Letters

Rev. Proc. 2002-3, 2002-1 IRB 117, updates Rev. Proc. 2001-3, 2001-1 IRB 111, as amplified and modified by subsequent revenue procedures, by providing a revised list of those areas of the Internal Revenue Code relating to issues on which the Internal Revenue Service will not issue letter rulings or determination letters. Three of the areas listed have to do with S corporations.

Under Section 4. Areas in Which Rulings or Determination Letters Will Not Ordinarily be Issued, item (42) is Section 1362--Election; Revocation; Termination. This item includes all situations in which an S corporation is eligible to obtain relief for late S corporation, qualified subchapter S subsidiary, qualified subchapter S trust, or electing small business trust elections under Sections 4 and 5 of Rev. Proc. 98-55, 1998-2 CB 643.

Section 5 of the revenue procedure includes 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. Subsection .04 of that section is Section 1361--Definition of a Small Business Corporation. The issue is whether a state law limited partnership, electing under the check the box regulations (301.7701-3) to be classified as an association taxable as a corporation, has more than one class of stock for purposes of Code Section 1361(b)(1)(D). The IRS 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 Section 1361 (b)(1)(D).

Section 6 of the revenue procedure includes areas covered by automatic approval procedures in which rulings will not ordinarily be issued. Subsection .04 is labeled Section 1362--Election; Revocation; Termination. This refers to all situations in which an S corporation qualifies for automatic late S corporation relief under Rev. Proc. 97-48, 1997-2 CB 521, or for automatic inadvertent termination or invalid election relief under Section 6 of Rev. Proc. 98-55, 1998-2 CB 643.

Purported Loan Treated As A Sale or Redemption of S Corporation Stock

In Rogers v. US, 281 F.3d 1108 (10th Circuit, 2/22/02), the Tenth Circuit Court of Appeals affirmed a Kansas District Court in treating a purported loan to a shareholder as a sale or redemption of his interest in the S corporation. Because the shareholders treated the redeemed shareholder as owning 50% of the stock, 50% of the losses were allocated to him. When the District Court treated the purported loan as a sale, taxpayers tried to reallocate the 50% of losses to the other shareholder. However, the statute of limitations had expired and the Court ruled that equitable recoupment was not proper in these circumstances. A protective claim for refund should have been filed to preserve the chance of reallocating the losses.

Corporation Payment of Shareholder Legal Fees Not Deductible By Corporation and Treated as Constructive Distribution

In Capitol Video Corporation v. Commissioner, TC Memo 2002-40, aff'd 1st Circuit, 11/27/02, the Tax Court disallowed legal fees paid by an S corporation to defend its sole shareholder against various criminal indictments. The corporation and the shareholder had made "tribute payments" to the Gambino crime family in exchange for protection from other organized crime families. During those years, the shareholder conspired with a Gambino crime family member to obstruct the IRS in collecting his taxes by issuing false Forms 1099. The corporation attempted to deduct as ordinary and necessary business expenses the $423,101 it had paid as legal fees in connection with the above criminal charges against its shareholder.

The Tax Court disallowed the legal fees as business expenses of the corporation. It found that the legal fees were related to the conspiracy to evade income taxes and were not related to the tribute payments made on behalf of the corporation. Therefore, the expenses were disallowed to the corporation. Furthermore, they were treated as constructive distributions to the shareholder. In addition, the same reasoning that prevented the corporation from deducting the payments also apply to the individual shareholder's tax return so that he could not deduct the legal fees as business expenses to him. The First Circuit Court of Appeals affirmed the Tax Court on both grounds.

Basis Increase In Post-Termination Transition Period Allows Loss Deduction Pass-Through

In IRS Field Service Advice Memorandum FSA 200207015, the IRS concluded that additional basis could arise during the post-termination transition period on the purchase of additional stock. The corporation's Subchapter S election had terminated and the first posttermination transition period had expired. The second post-termination transition period arose following the IRS audit that increased the taxable income of the corporation. During that second period, the shareholder purchased additional stock of the corporation from third parties. The question arose as to whether the losses that were previously not deductible because of insufficient basis could be deducted only to the extent of the additional taxable income resulting from the audit or whether the amount should include the additional basis for the new stock purchased during the second posttermination transition period. The Field Service Advice Memorandum, which is not binding as precedent, concluded that there is nothing to prevent the additional stock basis from being included, thus allowing the greater amount of losses to be deducted by the shareholders.

Lack of Basis May Prevent 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.

The Eighth Circuit Court of Appeals affirmed the Tax Court in the Estate of Bean v. United States, 268 F.3d 553 (101/01) affirming T.C. Memo 2000-35. The taxpayers had argued that basis was transferred by them for partnership assets that were transferred to the S corporation. The court held that if there was any equity in the assets, that would inure to the benefit of the partnership and not to the benefit of the individual partners. Thus, they were not permitted to obtain basis and their losses were not deductible in that year.

Cox v. Commissioner, TC Memo 2001-196, also involved the question of basis for the loss-pass-through. Here, two of the three shareholders were unable to establish basis for the warehouse that was used as security for the corporate loan. However, one of the shareholders was able to convince the court that the loan was really a personal loan to him and that loan proceeds paid to the corporation established basis for him with respect to $148,000 of the $220,000 loan proceeds. Furthermore, the court held that merely signing as a borrower on the promissory note memorializing the loan did not confer basis on a shareholder in the absence of proof of any economic outlay with respect to the loan.

In Yates v. Commissioner, TC Memo 2001-280, transfers were made from a related entity to the S corporation. The court was convinced that the transfers from the related entity were in substance transfers to the shareholder and then transfers from him to the corporation that increased his basis in the S corporation stock.

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.

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. This portion of the Tax Court's decision was approved by the Third Circuit Court of Appeals on January 7, 2002 at 2002-1 USTC Para 50,200.

Corporation Shareholder-Employee Fails to Avoid Payroll Taxes

In two cases, both decided on October 15, 2001, the Tax Court held that distributions from S corporations were disguised dividends and were subject to payroll taxes. In Veterinary Surgical Consultants, P.C. v. Commissioner, 117 TC #14, and in Yeagel Drywall Company, Inc. v. Commissioner, TC Memo 2001-284, the cases were before the Tax Court on petitions for redetermination of Notices of Determination Concerning Worker Classification Under Section 7436. Both cases were fully stipulated. The court held that in both cases, the shareholders were employees of the corporation and that purported Subchapter S distributions were really disguised salaries that were subject to payroll taxes. Both cases held that the corporations had no reasonable basis for not treating the shareholders as employees.

Taxpayers succeeded in avoiding self-employment tax on income from their wholly owned C corporation in Robinson v. Commissioner, 117 TC #25 (12/19/01). The court found that the shareholders were employed by the corporation and thus income received from the corporation was reclassified as wages from the corporation, not self-employment income.

Valuation of S Corporations

In Walter L. Gross, Jr. et al. v. Commissioner, 272 F.3d 333 (6th Circuit, 11/19/2001), aff'g TC Memo 1999-254, the Sixth Circuit affirmed a Tax Court decision holding that it was not appropriate to tax affect the stock in order to determine its fair market value. The case involved the valuation of an S corporation for gift tax purposes. Because the corporation had made an S election, no corporate income taxes are imposed on its earnings. In a battle of experts, the Tax Court and the Sixth Circuit agreed with the expert who testified that the earnings should not be reduced by a fictitious corporate tax.

*Portions of this outline are adapted from Panel Publishers loose-leaf tax service entitled The S Corporation: Planning & Operation, written by Sydney S. Traum.

by

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. in the Miami, Florida area. He is Board Certified by The Florida Bar in Taxation and also in Wills, Estates & Trusts. 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 AttorneyCertified 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. He received a BBA degree from CCNY, a JD degree from Harvard Law School, and an LLM in Taxation degree from New York University Law School.

Copyright American Association of Attorney-Certified Public Accountants Dec 2002
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