S Corporations: Current Developments 2010

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1 S Corporations: Current Developments S CORPORATIONS: CURRENT DEVELOPMENTS Background and Environment Popularity of the S Corporation New Legislation American Recovery and Reinvestment Act of Built-in Gains Tax... 1 Elective Deferral of Cancellation of Debt Income Worker, Homeownership, and Business Assistance Act of Small Business Lending Fund Act of Provisions Not Yet Extended as of November Pension Protection Act of Tax Technical Corrections Act of Energy and Tax Extenders Act of Proposed Changes Regarding Self Employment Income The December 2009 GAO Report American Jobs and Closing Tax Loopholes Act of New Regulations Basis and Open Account Loans from Shareholders... 5 Recent Case Law: Brooks v. Commissioner... 6 Reaction of the IRC: the anti-brooks Regulation Cancellation of Debt Income of S Corporations... 7 Exclusions in Code Sec Regulation Interpreting the Reduction of Attributes Proposed Regulations Deferred COD Income Regulation S Corporations and Controlled Groups Background Proposed Regulations Interpreting the Rule Cases and Rulings Invalid S Election not Accepted Distributions and Stock Classes Payment of State Tax of Shareholder by S Corporation Damages from S Corporation to Shareholder Class of stock Loss Protection Arrangement Disproportionate Distributions Avoiding Payroll Taxes by Using Distributions Intent to Compensate: The Watson Case Variation on the Theme: Avoidance of Self-employment Tax Health Insurance of Shareholder-employees Deduction for Medical Insurance Cost Complications with Single Employee Plans Basis Issues Circular Loans: Kerzner v. Commissioner Nathel v. Commissioner Russell Riggins Negligent Record Keeping - Riggins Bank Rules Passive Activity Loss No Offset Built-In Gains Tax Recognition Period... 20

2 Ten Year Recognition Period Seven Year Recognition Period Five Year Recognition Period Built-In Gains Tax Valuation Abusive Schemes Too Good to be True Ownership of Stock by Exempt Organization Parallel C Corporations Roth S Corporations Offshore Diversions Purchase and Sale of an S Corporation Treatment of Redemption as Acquisition of Trade or Business Ownership of Goodwill Nullification of Corporate Ineligibility This material is based on the author s work in preparing annual updates for S Corporation Taxation, revised annually by CCH, Incorporated. The book may be ordered at , or at

3 1. S CORPORATIONS: CURRENT DEVELOPMENTS BACKGROUND AND ENVIRONMENT Popularity of the S Corporation The 2007 IRS Data Book yields the following information about the business tax returns filed in the Federal Government s fiscal year 2006: 1 Entity Thousands of Returns Percent of Total Partnership 2, S corporation 3, C or other corporation 2, Total 9, Thus, the S corporation continues to grow in greater numbers than the partnership, in spite of predictions to the contrary. (In one IRS study, the text claimed that partnerships were displacing S corporations, but the data in the same study indicated otherwise.) 102 NEW LEGISLATION American Recovery and Reinvestment Act of 2009 Built-in Gains Tax This act made one direct change to Subchapter S, by reducing the recognition period to 7 years for purposes of the built-in gains tax of Thus, property that has been held by the S corporation for more than 7 years is not subject to the tax. However, this reduced recognition period applies only to gains recognized in S corporation tax years beginning in 2009 and Observation If Congress does not further amend the built-in gains recognition period, corporations whose S elections took effect in 1998, 1999 and 2000 will be subject to the 7-year period permanently. However, corporations with effective S elections that occurred in 2001 and 2002 will see the recognition period end in 2009 or 2010, but then reappear for the remainder of the 10-year term in Elective Deferral of Cancellation of Debt Income The American Recovery & Reinvestment Act of 2009 added a new provision to Section Internal Revenue Service Data Book 2007, Publication 55B, Washington, DC, issued March 2008: Table 2. Number of Returns Filed, by Type of Return, Fiscal Years 2006 and P.L , Sec 1251(a), amending Code Sec. 1374(d)(7).. Copyright Robert W. Jamison

4 S Corporations: Current Developments A debtor who reacquires a debt instrument may elect to defer the income, rather than claim one of the exclusions. The deferral is five years if the debtor reacquires the debt in 2009 and four years if the reacquisition occurs in The statue refers to the calendar year in which the debtor requires the debt, but the recognition commences with the tax year beginning in The recognition then occurs ratably over the five-year period beginning in Recognition accelerates if the debtor dies, is liquidated, or is relieved of substantially all of its assets in a Title 11 case. 5 If the debtor is a partnership or S corporation the acceleration would occur to a shareholder if the shareholder died or declared bankruptcy, 6 Observation The decision to claim an exclusion or the deferral will require careful planning for each situation. In some cases, the S corporation and shareholders may benefit from the deferral since they will not be required to reduce any tax attributes Worker, Homeownership, and Business Assistance Act of 2009 Prior to 2008 there was no late filing penalty associated with Form 1120S or an associated Schedule K-1. 7 The Mortgage Forgiveness Debt Relief Act of 2007 enacted a penalty for late filing of S corporation returns. 8 The penalty was $85 per month per shareholder (any person who is a shareholder at any time in the tax year for which the return should be filed). 9 The Worker, Retiree, and Employer Recovery Act of 2008 increased the penalty for late filing of S corporation returns from $85 to $89 per month. 10 The $89 penalty was in effect for returns required to be filed after December 31, 2008 (Fiscal October 2008 and later). However, the $89 penalty was short-lived. The Worker, Homeownership, and Business Assistance Act of 2009 raised the penalty to $195 per return, effective for tax returns for years beginning after The penalty is based on the number of late Schedule K-1s Small Business Lending Fund Act of 2010 This act reduced the built-in gain recognition period to five years, for recognition events occurring in taxable years beginning in However, the recognition period is scheduled to revert to ten years for taxable years beginning after Code Sec. 108(i). 4 Code Sec. 108(i)(1). 5 Code Sec. 108(i)(5)(D)(i). 6 Code Sec. 108(i)(5)(D)(ii). 7 There was such a penalty for partnerships, but it did not include S corporations. 8 Code Sec Code Sec. 6699(b). 10 P.L , Sec. 128(a), amending Code Sec. 6699(b)(1). 11 P.L , Sec. 16(a), amending Code Sec. 6699(b)(1).

5 S Corporations: Current Developments Provisions Not Yet Extended as of November 2010 Pension Protection Act of 2006 The Pension Protection Act of 2006 contained several small business provisions, other than those that affect only pensions. Charitable Contributions of Food Inventory In general, taxpayers are allowed to deduct cash or property contributed to qualifying recipients. Except for capital gain property (discussed infra,) the deduction for noncash property is limited to the basis or the fair market value of the property, whichever is less. There are some additional limits for contributions of inventory and some scientific equipment. However, these special rules applied only to C corporations until The Pension Protection Act of 2006 extended this benefit to all entities for contributions of apparently wholesome food to taxpayers other than corporations. 12 However, this provision was only in effect for contributions made in 2006 and Charitable Contributions of Capital Gain Property by S Corporations The Conference Committee Report to the Pension Protection Act of 2006 indicates the clear opinion of Congress that existing law request shareholders to reduce basis for the fair market value of property contributed to charity by the S corporation. 13 The Pension Protection Act of 2006 contains a temporary provision specifying that a shareholder must reduce his or her S corporation basis for the allocable portion of the basis of property contributed by the S corporation to charity. 14 However, this provision was only in effect for contributions made in 2006 and Tax Technical Corrections Act of 2007 As noted supra, the Pension Protection Act of 2006 (PPA6) specifically stated the rule that shareholders are to reduce their stock basis for the basis (rather than the fair market value) of capital gain property contributed by S corporations to qualifying charitable organizations. However, the PPA6 did not explicitly deal with the relationship of the S corporation s charitable contribution to the basis limitation for pass through of losses. The Tax Technical Corrections Act of added a companion provision that disregards the excess of fair market value over basis of contributed capital gain property when applying the basis limitation for deductibility of losses, Code Sec. 170(e)(3)(c). 13 Technical Explanation of H.R. 4, the Pension Protection Act of 2006, p P.L , Sec. 1203(a), amending I.R.C. 1367(a)(2). 15 P.L

6 S Corporations: Current Developments The IRS has provided operating rules that apportion the shareholder s portion of the basis of the contributed property pro rata with other losses and deductions when the total of these amounts exceeds the shareholder s basis in stock and debt. However, the excess of the contributed property s fair market value over its adjusted basis to the corporation is allowed to the shareholder as a charitable contribution, without being limited by the shareholder s basis. 17 Observation The Tax Technical Corrections Act of 2007 did not extend the effective dates of the basis reduction rule, which is only for contributions made by the S corporation between January 1, 2006 and December 31, However, in Rev. Rul it IRS states that The IRS and Treasury Department are considering issuing guidance on the treatment of charitable contributions made by S corporations in taxable years beginning after December 31, The Energy and Tax Extenders Act of 2008 extends this rule through Energy and Tax Extenders Act of This act was one of several bills passed in late 2008 that had some tax legislation. This Act of 2008 extends the rule regarding charitable contributions of capital gain property through It also extends the rule allowing the enhanced deduction for contributions of food inventory through PROPOSED CHANGES REGARDING SELF EMPLOYMENT INCOME The December 2009 GAO Report In December 2009, the United States Government Accountability Office issued a report on tax noncompliance of S corporations and their shareholders. 21 This report discussed several problem areas. Some, such as understating income or overstating deductions are problems common to all tax entities and other taxpayers. However, the two areas of greatest noncompliance are special S corporation problems: Failure to treat compensation of shareholders as wage or salary, thus avoiding FICA, Medicare and FUTA taxes. Deducting S corporation losses in excess of a shareholder s stock and debt basis. The IRS has attempted to take some steps to clarify the tax treatment of these issues. However, the GAO is concerned that the IRS efforts have been insufficient to curb widespread noncompliance, be it actual tax evasion or mere misunderstanding. 16 Code Sec. 1366(d)(4), as added by the Tax Technical Corrections Act of 2007, Sec. 3(b). 17 Rev. Rul , IRB P.L , Sec. 307(b) Div C. 19 P.L , Sec. 307(b) Div C. 20 P.L , Sec. 323(a)(1) Div C. 21 United States Government Accountability Office, Actions Needed to Address Noncompliance with S Corporation Tax Rules, GAO , December 2009.

7 S Corporations: Current Developments American Jobs and Closing Tax Loopholes Act of 2010 The American Jobs and Closing Tax Loopholes Act of 2010 would have treated certain undistributed income from disqualified S corporations as selfemployment income to some shareholders. 22 A disqualified S corporation includes the following: An S corporation that is a partner in a partnership in a professional service business. 23 Any other professional service corporation if the principal asset is the reputation and skill of three or fewer employees. 24 The shareholders would need to treat their portions of S corporation income as self-employment income if they provided substantial services to the corporation. 25 The list of services performed by the corporation in question has been expanded from earlier definitions, and would include (for purposes of this provision only): Health, law, lobbying, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, investment advice or management, or brokerage services. For purposes of the self-employment tax, such shareholders would also need to include the portions of income allocable to family members who do not provide substantial services to the corporation. This Act was blocked by the Senate and has not been enacted. Legislation in the late summer and early fall of 2010 did not contain this provision or anything that would have similar effects. 104 NEW REGULATIONS Basis and Open Account Loans from Shareholders Generally, there is no adjustment to debt basis at any time when the shareholder has basis in his or her stock. When losses pass through to the shareholder, and the losses exceed stock basis, however, debt basis is reduced. When a shareholder has made multiple loans to a corporation, any basis reduction for losses is prorated among the various loans. 26 If the shareholder owns stock at the end of the loss year, the basis reduction is allocated in proportion to the debts outstanding from the corporation to the shareholder at year-end. 27 If the shareholder has disposed of his or her stock during the loss year, the allocation of loss to debt is based on the loans outstanding from the corporation to the shareholder on the last date the person owns shares H.R Code Sec. 1402(m)(1)(C)(i), proposed amendment in American Jobs and Closing Tax Loopholes Act of 2010, Sec Code Sec. 1402(m)(1)(C)(ii), proposed amendment in American Jobs and Closing Tax Loopholes Act of 2010, Sec Code Sec. 1402(m)(1)(A), proposed amendment in American Jobs and Closing Tax Loopholes Act of 2010, Sec Reg (b)(3). 27 Reg (b)(1). 28 Reg (b)(2).

8 S Corporations: Current Developments The measure used for allocation is the shareholder's basis in each loan, after adjustment for prior years' losses. After debt basis has been reduced, there may be subsequent income. Such income will first restore debt basis before it is allocated to stock basis, to the extent that the income exceeds distributions for the year. The Code is completely silent on the adjustment to basis of a loan in the year in which it is repaid. According to the Regulations if any portion of the debt has been repaid, the corporation's income restores that basis before any other debt or stock. 29 Recent Case Law: Brooks v. Commissioner In the case of Brooks v. Commissioner the shareholders loaned the S corporation large sums as the corporation needed funds, and the corporation repaid those loans when money was available. 30 In some of these years, the corporation s income was not sufficient to restore basis. One of the series of transactions in question was: 1. Prior to 1999, the shareholders had advanced funds, the basis of which had been reduced to zero by In early 1999 the corporation repaid some of the advances 3. In 1999, the corporation did not have net income, so there was no basis restoration to the debt repaid early in the year. 4. In late 1999, the shareholders advanced the corporation enough to cover the prior repayments and the 1999 losses. According to the IRS, each advance was a distinct transaction. Thus, the IRS reasoned that the earlier advances had been repaid while their basis was still zero, resulting in taxable gain. Moreover, since open advances do not constitute capital assets, the gain must be ordinary income. The IRS also relied on the case of Cornelius v. Commissioner However, in the Cornelius decision each advance and repayment was treated by the Court as a separate transaction. In the Brooks case, the IRS stipulated that the advances and repayments were open account. The Court used this distinction from the Cornelius case to hold that advances could offset earlier repayments in the same year and give the shareholder basis to avoid gain on repayment. The Court also pointed to the language of Regulations , which treated all open account advances from any one shareholder as a single debt instrument. Reaction of the IRC: the anti-brooks Regulation According to the IRS, the avowed intention of the Regulation s treatment of open account debt was administrative simplicity Reg (d)(1). 30 Brooks v. Comm r, TC Memo , 31 Prop Regs. 4/12/2007. Fed. Reg. Vol. 72, No. 70, p

9 S Corporations: Current Developments The deferral achieved in Brooks was not an intended interpretation of existing Regulations The IRS proposed to amend Regulations to limit the current rule to years in which the aggregate balance of loans outstanding does not exceed $10,000 (the same as the de-minimis rule for imputed interest under Code Sec. 7872) 32 However, the Final Regulation adopted in October 2008 is somewhat more liberal in two respects: To comply with this rule the shareholder/creditor will need to keep a running balance of all debts from the corporation (including written instruments). If the total of this running balance exceeds $25,000 on the last day of the year, the advances and repayments will each constitute a separate indebtedness from that day forward Cancellation of Debt Income of S Corporations In general, gross income includes cancellation or reduction of debt. Exclusions in Code Sec. 108 There are exceptions, in IRC 108: There is no gross income from discharge of debt in a federal or state bankruptcy proceeding. 34 A taxpayer who is insolvent after the cancellation of debt recognizes no gross income from the debt cancellation. 35 When a seller of property finances the purchase, and later reduces the debt balance, there is no gross income to the borrower. If the borrower is a farmer, and the debt is related to the farming business, the forgiveness by the lender may be a reduction of qualified farm indebtedness, and excluded from gross income. 36 If the debt is discharged after December 31, 1992, it may not be included in gross income if it is qualified real property business indebtedness. 37 The bankruptcy and insolvency exceptions require reduction of certain favorable tax attributes. For discharges of indebtedness in taxable years beginning after 1993, the attributes to be reduced are, in the following order: Net operating loss of the year of discharge 2. Net operating loss carryover to that year 3. General business credit carryforward 4. Alternative minimum tax credit carryforward from years prior to discharge 5. Capital loss of the year of discharge 32 Prop. Reg (a)(2)(i). 33 Prop. Reg (d)(2)(ii). 34 Code Sec. 108(a)(1)(A). 35 Code Sec. 108(a)(1)(B). 36 Code Sec. 108(a)(1)(C). 37 Code Sec. 108(a)(1)(D). 38 Code Sec. 108(b)(2), as amended by the Revenue Reconciliation Act of 1993.

10 S Corporations: Current Developments Capital loss carryover to the year of discharge 7. Reduction of basis of all property held by the taxpayer 8. Passive activity loss and credit carryforwards from the year of the discharge 9. Foreign tax credit carryover. The unique nature of the S corporation requires some special calculations. The required reduction of tax attributes is generally applied at the corporate level. 39 There is one shareholder level attribute, however, for which reduction is required. The net operating loss for the year of discharge is the loss for the year that is disallowed to the shareholders under their basis limitations. 40 The shareholder level loss carryforward that must be reduced under this rule includes all losses from previous years, as well as the current year's loss. Therefore, all cumulative losses that have exceeded a shareholder s basis in years prior to the discharge or reduction of debt are treated as if they were losses incurred in the year of discharge. Regulation Interpreting the Reduction of Attributes In 2008 the IRS issued a Temporary Regulation that set forth the allocation rules for treatment of the shareholders when the S corporation excludes income under the bankruptcy or insolvency rules. In 2009 the IRS adopted this change as a final regulation, with little modification 41. The rules are relatively straightforward: 1 In a year when the corporation excludes cancellation of debt income each shareholder must determine any losses, from the current and prior years, that have not been deductible due to the basis limit of Code Sec. 1366(d)(1). 42 The Regulation defines the total of the disallowed shareholder losses as the deemed NOL. 2 The S corporation then compares the aggregate deemed NOL with the cancellation of debt income excluded in the year. a If the excluded cancellation of debt income exceeds the deemed NOL, all of the deemed NOLs are eliminated for the year after the debt discharge, b and all future years. If the deemed NOLs exceed the excluded cancellation of debt income, the excess, termed the excess deemed NOL, is allocated back to the shareholders. 43 The allocation formula requires apportionment according to 3 The corporation allocates any excess deemed NOL back to the shareholders, who may be allowed to claim their portions as deductions for the year following the debt discharge Code Sec. 108(d)(7)(A). 40 Code Sec. 108(d)(7)(B). 41 Reg (d). 42 Reg (d)(4). 43 Reg (d)(2)(ii)(A). 44 Reg (d)(2)(i).

11 S Corporations: Current Developments PROPOSED REGULATIONS Deferred COD Income Regulation In 2010 the IRS promulgated Temporary Regulations concerning the five year deferred recognition rule of Code Sec. 108(i). Much of the text is concerned with the events that accelerate recognition. Some of the more important provisions include: If a C corporation defers income under this provision and then converts to S corporation status, it must include all of the deferred income immediately before the conversion. 45 If an S corporation defers income under this provision and then terminates its S corporation status, it must include all of the deferred income immediately before the conversion. 46 If a C corporation transfers its assets to another C corporation in a tax free liquidation or reorganization, it does not accelerate its deferred income. 47 If an S corporation transfers its assets to another S corporation in a tax free liquidation or reorganization, it does not accelerate its deferred income. 48 If a C corporation transfers its assets to an S corporation in a tax free liquidation or reorganization, it must accelerate its deferred income. 49 Thus whenever a corporation moves between S and C corporation status, it must accelerate any deferred COD income. Moreover an entity must accelerate deferred cancellation of debt income if it disposes of substantially all of its assets. 50 For this purpose, substantially all means at least 90% of the fair market value of the net assets and 70% of the gross assets. 51 An entity must also accelerate all of its cancellation of debt income if it files a bankruptcy petition. 52 There are also some shareholder events that may trigger recognition of all or a portion of the deferred COD income. When a shareholder dies or disposes of all of its stock by sale or gift, abandonment or a redemption treated as an exchange via Section 302, the corporation must accelerate all of the deferred COD income attributable to that particular shareholder. 53 When an S corporation shareholder transfers part, but not all, of his or her stock, there is a proportional acceleration. Thus a gift, redemption or sale of a fractional interest by a shareholder accelerates the portion of the deferred COD income attributable to the shares transferred. 45 Temp. Reg (i)-1T(b)(2)(i)(B). 46 Temp. Reg (i)-2T(c)(3)(i)(A)(4). 47 Temp. Reg (i)-1T(b)(2)(ii)(B)(1). 48 Temp. Reg (i)-2T(c)(3)(iii)(C). 49 Temp. Reg (i)-1T(b)(2)(ii)(B)(1)(i). 50 Temp. Reg (i)-2T(c)(3)(i)(A)(2). 51 Temp. Reg (i)-2T(c)(3)(i)(B). 52 Temp. Reg (i)-2T(c)(3)(i)(A)(5). 53 Temp. Reg (i)-2T(c)(3)(ii)(A).

12 S Corporations: Current Developments However, if a shareholder disposes of stock in a tax free reorganization, liquidation or deemed liquidation into another S corporation, there is no acceleration of income. 54 There are also several look-through rules for assets held by partnerships in which the S corporation is a partner S Corporations and Controlled Groups Background Section 1563 requires that component members of controlled groups of corporations be treated as a single taxpayer for certain limits. Most of the limits, such as apportionment of the graduated rate schedule and alternative minimum tax exemption, have no application to S corporations. It may be important to distinguish a member of a controlled group of corporations from a component member of such a group. Certain rules are applicable to members, and other rules are applicable only to component members. Some rules, such as the required apportionment of a Section 179 election, may affect the taxable income of an S corporation, as well as other corporations controlled by the same shareholders. Unfortunately, neither Section 1563 nor any provision in Subchapter S explicitly includes or excludes S corporations from treatment as component members. All members are subject to certain rules for related party dealings. The Regulations under Section 1563 state that an S corporation is generally not subject to inclusion as a component member of a controlled group. 55 Proposed Regulations Interpreting the Rule A proposed amendment to Reg clearly states that an S corporation is a member of a controlled group, even though it is not a component member for purposes of the 1563 attributes that are relevant only to C corporations. 56 However, if a rule, such as aggregation of receipts for accounting method purposes, uses the controlled group definition without explicitly including S corporations, an S corporation should assume that it is subject to inclusion. The IRS held that acquisition of one S corporation s debt by another S corporation, when the two S corporations were controlled by the same family, fell within certain controlled group dealing rules. 57 The tax benefits listed specifically in 1561 are the corporate graduated rate brackets, the accumulated earnings tax credit, the alternative minimum tax exemption and the environmental tax exemption. An S corporation is not subject to any of these rules even when it is subject to the built-in gains tax or the passive investment income tax. 54 Treas. Reg (i)-2T(c)(3)(iii)(C). 55 Reg (b)(2)(ii)(c). 56 Proposed Regulation (b)(4) Example TAM

13 S Corporations: Current Developments However, the tax law applies the controlled group rules to limit certain other tax benefits. The regulations under 1563 do not address any of these other benefits, such as the 179 deduction specifically. The basic rule that the S corporation computes its taxable income in the same manner as an individual should limit the applicability of any tax benefit that controlled groups of corporations must allocate CASES AND RULINGS Invalid S Election not Accepted In one of the few cases dealing with a post 1996 election, the Tax Court upheld the IRS s refusal to accept a late election. In the case of Dansby v. Commissioner, the shareholder had not taken any reasonable steps to procure S corporation status, and the IRS had no record of ever having received Form The corporation had filed Form 1120 for the years in question. The shareholder testified that he had filed this form because he had not heart from the IRS about the corporation s status. However, when he discovered that the corporation sustained a loss, he decided that it should have been an S corporation. He had no credible claim that he had ever filed Form 2553 or anything else to indicate that he believed the corporation was an S corporation. 59 Similarly, in Ward v. U. S. a District Court upheld the IRS s disallowance of losses from a corporation when the shareholder had never filed Form 2553 or Form 1120S Distributions and Stock Classes Occasionally there is a concern that distributions might be indicative that a corporation has more than one share of stock. However, this problem has not resulted in termination of S status in recent years. In the case of Minton v. Commissioner a shareholder tried to recharacterize certain payments to other shareholders as distributions that were not proportionate to stock. This case involved a dysfunctional family corporation and the shareholder in question was refusing to report income from the corporation. However, the Tax Court and the Fifth Circuit held that the payments were for legitimate other purposes, even though they were made to other shareholders, Code Sec. 1363(b). 59 Dansby v. Comm r, TC Memo Ward v. U.S., 106 AFTR 2d (S.D. TX). 61 Minton v. Comm r, TC Memo , aff d 103 AFTR 2d (5 th Cir.).

14 S Corporations: Current Developments Payment of State Tax of Shareholder by S Corporation Another corporation was concerned that payments to a state taxing authority on behalf of its shareholders might cause trouble. The payments cleared up a prior year s state tax liabilities on behalf of both the corporation and the shareholders. The payments were the same amounts that would have been distributed to the shareholders to enable them to pay their own liabilities for the year in question and the IRS ruled that this transaction was not indicative that there was more than one class of stock. 62 Damages from S Corporation to Shareholder One S corporation received some inadequate advice, which cased some of its shareholders to sue for financial damages. Apparently, not all of the shareholders planned to sue. The IRS ruled that payment of damages to the aggrieved shareholders would not be indicative of a second class of stock. 63 Class of stock Loss Protection Arrangement In one instance an ESOP held two blocks of stock, acquired at different times. After acquisition of the second block, the ESOP held all of the shares of the S corporation. Apparently, the corporation was anticipating a decline in the value of its stock. There was a provision in the ESOP that protected the first block purchased from certain market declines. There was no equivalent protection for the second block. However, the IRS ruled that the arrangement did not create a second class of stock. 64 Disproportionate Distributions In one instance a corporation had made disproportionate distributions to its two shareholders. When they discovered this problem they had already sold all of their stock. The IRS waived any possible termination, on the condition that one of the shareholders and the corporation would make corrective payments and distributions. 65 Apparently, the shareholder who had received too much was to reimburse the corporation for the excess and the corporation was to distribute the same amount to the underpaid shareholder, although the ruling does not give sufficient information to literally support this conclusion. 62 Ltr. Rul Ltr. Rul Ltr. Rul Ltr. Rul

15 S Corporations: Current Developments In another situation, the disproportionate distributions did create a second class of stock, and the corporation lost its S status. However, the IRS treated the termination as inadvertent, but required that the corporation make corrective distributions Avoiding Payroll Taxes by Using Distributions In contrast to a partnership, no self-employment income passes from an S corporation to its shareholders. Several taxpayers have attempted to use this provision in order to avoid social security and other payroll taxes. The rationale is that if the shareholder-employee receives no salary, then the corporation is not liable for payroll taxes and is not obligated to withhold employee FICA or income tax. Although this scheme may work if the corporation makes no distribution, the IRS has long exercised its power to treat distributions from S corporations to shareholder-employees as salary, if the distributions are, in substance, compensation to the shareholder-employee. A 2001 case gives a clear description of the approach that the IRS may take in recharacterizing distributions. In the case of Barron v. Commissioner, a shareholder had received minimal compensation in one year and note in the other years. The corporation was an accounting practice. 67 The sole shareholder was the only CPA employed by the firm. The IRS employment tax division used a survey from a placement firm to determine a reasonable level of compensation. The amounts claimed as compensation, and the amounts actually distributed to the shareholder are compared to the reasonable level imputed by the IRS. Year Claimed IRS Compensation Distribution reasonable 1994 $2,000 $56,352 $45, ,257 $47, ,341 $49,000 Intent to Compensate: The Watson Case Watson, P.C, v. U.S. involved an accounting partnership, with each partner being a corporation owned by one CPA. Watson, P.C. was one of those partners. 68 The corporation agreed to compensate Mr. Watson, its shareholder, $24,000 per year. In 2002 and 2003 the corporation made frequent distributions to Mr. Watson, which exceeded $200,000 per year. 66 Ltr. Rul Wiley L. Barron, CPA, Ltd. v. Comm r, TC Summ Watson, P.C, v. U.S., 105 AFTR 2d (S.D. IA).

16 S Corporations: Current Developments The IRS examined the two years and restated the 2002 compensation as approximately $130,000. The IRS determined that $175,000 was appropriate for However, after negotiations, the IRS took the position than $67,000 was the appropriate compensation amount for each of the two years. The corporation moved for summary judgment. The court found this motion to be unusual for a party who bore the burden of proof. Watson cited several cases where the IRS had disallowed deductions for excessive compensation, or was treating purported loans to shareholders as compensation. In arguing those cases, the IRS had contended that some of the payments to the shareholder-employees were not made with the intent to compensate for services. 69 Thus Mr. Watson reasoned that the IRS had no right to recharacterize any of the distributions as compensation unless the IRS could find evidence that the corporation intended to compensate Mr. Watson for services. The court pointed out that the IRS was free to raise the issue of intent when it was not in accordance with the evidence, but the same argument would have little credibility of raised by the taxpayer. The court cited numerous cases that held that tax consequences of transactions between related parties are governed by economic realities rather than nominal characterizations. In brief, the court reiterated the traditional substance over form principle of tax law. Thus the court denied the motion for summary judgment. Variation on the Theme: Avoidance of Self-employment Tax On occasion, taxpayer uses an S corporation as a diversionary entity to reduce self-employment income from other sources. The self-employed person forms an S corporation but continues to use the proprietorship or other unincorporated entity to conduct business. The taxpayer writes a check (or merely uses a bookkeeping entry) to shift income to the S corporation. This strategy involves no underreporting of taxable income, but reduces or eliminates self-employment tax liability. Unlike the cases discussed supra, these do not involved characterization of actual or constructive distributions from the S corporation. Arnold v. Commissioner involved a husband (tax practitioner) and wife (real estate sales) who each owned an S corporation. 70 Each S corporation appears to have had negligible (if any) activity. 69 Electric & Neon, Inc. v. Comm r, 56 T.C (1971), Paula Construction Co. v. Comm r, 58 T.C (1972), Pediatric Surgical Associates, P.C. v. Comm r, T.C. Memo TC Memo

17 S Corporations: Current Developments However, the Arnolds reported income from their respective businesses via the S corporations, and paid no self-employment tax. The Court found that they were each liable for self-employment tax. In the case of Jarrett v. Commissioner, 71 a tax preparer and his son (a carpenter) formed an S corporation, ostensibly as a tax preparation business. The corporation never had a bank account or commenced business operations of any kind. However, the tax preparer deducted $7,000, and the carpenter deducted $7,200, for payment to the S corporation, allegedly for professional services. Each shareholder was able to diminish his Schedule C income by the amount claimed as a deduction. The S corporation issued a Schedule K-1 to each shareholder, which allocated Schedule E income, equal to the amount each claimed to have paid, rather than in proportion to stock ownership. The IRS recalculated the self-employment income of each shareholder by disallowing the deduction. The Tax Court upheld the redetermination to self-employment tax, as well as a 20% negligence penalty on each Health Insurance of Shareholder-employees Deduction for Medical Insurance Cost. Health and accident insurance is allowed as a deduction to the self-employed. 72 Although this provision does not cover employees, per se, a shareholderemployee of an S corporation is able to deduct his or her portion of the cost of insurance provided by the S Corporation. Beginning in 2003 the allowable deduction is 100% of the cost of the premiums, limited to the amount of W-2 income. Complications with Single Employee Plans An IRS internet based news release in 2006 that states an opinion on the deductibility of the health insurance premium by S corporation shareholderemployees. 73 This headliner states that the deduction for S corporation shareholderemployees is keyed to the treatment of the health insurance as a fringe benefit covered by section Accordingly, for section 1372 to come into play the corporation must own the policy and pay the premiums thereon. Thus the premiums appear as part of the compensation on the shareholderemployee s W-2, and the W-2 wages are the earned income for purposes of the medical insurance deduction. 71 TC Summary Opinion Code Sec. 162(l)(1)(B), as amended by Tax and Trade Relief Extension Act of 1998 Code Sec. 2002(a). 73 Internal Revenue Service Headliner Volume 163, May 15, 2006

18 S Corporations: Current Developments However, there are states that do not permit a group health insurance plan if there is only one participant in the plan. In late 2007 the IRS issued Notice , which states the criteria for a single member (and multiple member) health insurance plan to qualify for the IRC 162(l) deduction 74 A plan providing medical care coverage for the 2-percent shareholder-employee in an S corporation is established by the S corporation if: (1) the S corporation makes the premium payments for the accident and health insurance policy covering the 2-percent shareholder employee (and his or her spouse or dependents, if applicable) in the current taxable year; or (2) the 2-percent shareholder makes the premium payments and furnishes proof of premium payment to the S corporation and then the S corporation reimburses the 2-percent shareholder-employee for the premium payments in the current taxable year. If the accident and health insurance premiums are not paid or reimbursed by the S corporation and included in the 2-percent shareholder-employee s gross income, a plan providing medical care coverage for the 2-percent shareholder-employee is not established by the S corporation and the 2-percent shareholder-employee in an S corporation is not allowed the deduction under 162(l) Basis Issues Circular Loans: Kerzner v. Commissioner This case was decided by the Tax Court in However, the IRS had already addressed the same situation in TAM Marvin and Thelma Kerzner, husband and wife, were each 50% shareholders of an S corporation (HCI) and also were each 50% partners in a partnership (HCA). The partnership, Kerzners and the S corporation engaged in a pattern of transactions in multiple years. Four of those years were the subject of the case. The S corporation paid rent to the partnership. The partnership then loaned money to the two partners. These loans were subject to approval by third party lenders and were made from HCA s net profits for the year. The partner/shareholders then loaned the same amounts to HCI. The loans to the partner/shareholders, loans to the S corporation and rent all occurred within three days, towards the end of each calendar year. The IRS reasoned that the transactions were essentially circular as in Oren v. Commissioner and thus did not create debt basis in the S corporation. 75 The Tax Court found it unlikely that the partnership would ever require payment of the loans to the partner/shareholders. Thus they were no poorer in an economic sense and there was no economic outlay. 74 Notice , IRB. 75 Kerzner v. Comm r, TC Memo

19 S Corporations: Current Developments Nathel v. Commissioner The case of Nathel v. Commissioner demonstrates that open account loans and contributions to capital can provide some unfortunate tax results. 76 Ira and Sheldon Nathel had been shareholders in three S corporations, at least two of which had sustained losses. The Nathels and the third shareholder had decided to split up ownership of the corporations. As a result the Nathels were to be the sole shareholders of one corporation, the other party was to be the sole shareholder of a second corporation, and the third corporation was to be liquidated. The two corporations in which the Nathels would no longer be shareholders each had sustained losses. As part of the deal, the Nathels made substantial contributions to the capital of both corporations momentarily before their shares were redeemed. They received nothing in exchange for their stock in either corporation. The Nathels had loaned substantial amounts to both of the corporations from which they were exiting. They did not structure the loans as securities, but had strictly used open accounts. Early in the final year of the Nathels ownership, one of the corporations had repaid substantial loans to the Nathels. Apparently there was not sufficient income for the remainder of the year to allocate enough to the Nathels to restore basis in the repaid loans. Thus the Internal Revenue Service treated the repayment of those loans as ordinary income. The Nathels made an interesting argument, treating the contributions to capital as income, which should have restored their basis. The borrowed from the Supreme Court s language in Gitlitz v. Commissioner, 77 which gave a rather broad interpretation to the term taxexempt income. The Nathels reasoned that the term was broad enough to cover contributions to capital, which Section 118 excludes from gross income. Thus the contributions they made shortly before their exit should flow back as restorations of stock or debt basis. However, the Tax Court relied on case law to reach the conclusion that a contribution to capital was not income, in any sense of the word. In contrast, cancellation of debt income, which was the issue in Gitlitz, is gross income unless specifically excluded. Thus, although a contribution to capital should add to a shareholder s stock basis, it does not create any flow through income exempt or otherwise. 76 Nathel v. Comm r, 131 TC No. 17 (2008) aff d at 105 AFTR 2D (2 nd Cir.) AFTR 2d (S. Ct.).

20 S Corporations: Current Developments Observation The Nathel case illustrates the principle that form and substance may be equally important to achieve the desired results in transactions between an S corporation and its shareholders. Had the shareholders contributed the debts to capital, or had characterized the repayments as distributions, rather than as contributions to capital, they might have avoided reporting the income. Although the disposition of their stock in the two corporations was not an issue in the case, it seems likely that the Nathels were caught in a squeeze. The repayment of the loan by the corporation generated ordinary income, since they had not used notes. The disposition of stock most likely resulted in a capital loss. Russell Riggins The case of Russell v. Commissioner illustrates a paradox, where a tax free contribution of debt may actually yield taxable gain. 78 In this case, shareholders of an S corporation held debt from the corporation and had reduced basis for losses in excess of their stock basis. Then the shareholders terminated the S election, and contributed all of their stock and debt to another corporation, which became the parent corporation of the former S corporation. At the same time as the contribution of stock, the shareholders also contributed their debt instruments from the former S corporation to the parent corporation. The contribution of both the former S corporation stock and the former S corporation debt were governed by Section 351, and neither shareholder recognized gain on the transfer. The parent then elected to file consolidated returns with its subsidiaries, including the former S corporation. The debt that now ran from the subsidiary to the parent became intercompany debt. Under the consolidated return regulations the difference between principal and the holder s basis is recognized when the debt instrument becomes and intercompany obligation. 79 Observation If the shareholders in the Russell case had continued to hold the debt, rather than contributing it to the parent corporation, there would have been no instant gain recognition. Moreover, the notes were demand notes and the shareholder-creditors could have timed the recognition of gain, and subjected it to capital gain rates. However, since the debtor corporation was no longer an S corporation, the shareholder-creditors would never have been able to restore basis in the debt instruments. 78 Russell v. Comm r, TC Memo Reg (g)(4)(ii)(B).

21 S Corporations: Current Developments Negligent Record Keeping - Riggins In Riggins v. Commissioner, an S corporation had minimal records. The corporation had estimated that it had a loss of approximately $40,000. However, the IRS determined that it actually had net income in excess of $50,000. In addition to tax the IRS imposed a negligence penalty. 80 The Tax Court pointed out that failure to keep records is an offense to which the negligence penalty specifically applies Bank Rules Final Regulations (a)(3) states certain bank tax rules as they apply to S corporations and QSubs. When there are members of a parent and QSub group that are banks, the bank rules apply separately to each corporation. 82 Thus 265, 291 and 582 apply to the parent and QSubs if they are banks. These rules do not apply to the parent or any QSub that is not a bank. Moreover, each of the separate corporations must make a separate determination of the disallowance of interest required by However, the Code specifies that Section 291 applies only during the first three taxable years of a former C corporation. 84 In the case of Vainisi v. Commissioner, the parent S corporation was not a bank. However, a QSub owned by the parent was a bank. The taxpayers argued that the bank rules could not apply to the parent, which was not a bank. Moreover, since the QSub was a disregarded entity, all of its activities must be considered as those of the parent. Thus bank rules could not apply. The Tax Court upheld the clear language of the regulation separating banks from nonbanks for purposes of the special banking rules of the Code. 85 However, the Seventh Circuit held that the statute, which expressly limits the applicability of Section 291 to the first three taxable years of S corporation status, did not permit the IRS to write a regulation holding otherwise Passive Activity Loss No Offset The case of Willock v. Commissioner involved a dentist and his wife. There were several issues in the case, including deduction of personal expenses, hobby losses and vehicle use. One if the issues in the case involved renal of two properties to the husband s S corporation dental practice. 80 Riggins v. Comm r, TC Summ See Reg (b)(1). 82 Reg (a)(3). 83 Reg (a)(3)(ii), Example (1). 84 Code Sec. 1363(b)(3). 85 Vainisi v. Comm r, 132 T.C. No Vainisi v. Comm r, 105 AFTR 2d (7 th Cir.)