Important Developments in the Federal Income Taxation of S Corporations

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1 American Bar Association Section of Taxation S Corporation Committee Important Developments in the Federal Income Taxation of S Corporations Grand Hyatt Washington, D.C. May 6, 2011 Dana Lasley Tax Director Deloitte Tax LLP St. Louis, MO dlasley@deloitte.com William Klein Principal Gray Plant Mooty Minneapolis, MN william.klein@gpmlaw.com

2 Important Developments in the Federal Income Taxation of S Corporations I. Proposed Legislation TABLE OF CONTENTS II. Court Opinions A. Nathel v. Commissioner, 105 AFTR 2d (2 nd Cir. 2010) **UPDATE** III. Treasury Regulations A. Treas. Reg Application of insolvency and bankruptcy provisions of section 108 to disregarded entities and grantor trusts IV. S Corporation Private Letter Rulings A. Private Letter Ruling (November 9, 2010) (Ineligible Shareholder) B. Private Letter Ruling (November 4, 2010) (Disproportionate Distributions) V. Other Administrative Guidance A. Chief Counsel Advice (December 2, 2010) (Section 1367 Basis Adjustment) B. Comments Requested Circular 230 Notice Any tax advice included in this written communication was not intended or written to be used, and it cannot be used by the taxpayer, for the purpose of avoiding any penalties that may be imposed by any governmental taxing authority or agency. 1

3 Important Developments in the Federal Income Taxation of S Corporations ABA Tax Section S Corporations Committee May 2011 I. Proposed Legislation H.R S Corporation Modernization Act of 2011 (April 12, 2011) - Introduced by Rep. David G. Reichert, R-Wash. and Rep. Ron Kind, D-Wis. To amend the Internal Revenue Code of 1986 to provide for S corporation reform and for other purposes. 1. Reduced recognition period for built-in gains made permanent (5 years). 2. Repeal of excessive passive investment income as a termination event. 3. Increase the limit relating to tax imposed when passive investment income of a corporation having accumulated earnings and profits exceeds 60% of gross receipts. 4. Expand qualifying beneficiaries of an electing small business trust. 5. Expand S corporation eligible shareholders to include IRAs and exempt from prohibited transaction rules sale of stock in IRA relating to S corporation election. 6. Allow deduction for charitable contributions for electing small business trusts. 7. Rule regarding basis adjustment to stock of S corporation making charitable contributions of property made permanent. II. Court Opinion Nathel v. Commissioner, 105 AFTR 2d (2 nd Cir. 2010) **UPDATE** The Nathels have petitioned the Supreme Court to review the Second Circuit decision holding that capital contributions made to S corporations could not be treated as tax-exempt income under section 1367 to increase their tax bases in loans made to the corporation. Specifically, the questions presented include: 1. Whether Gitlitz v. Commissioner, 531 U.S. 206 (2001), requires the Second Circuit to rule that a shareholder's capital contribution to a corporation, excluded from income by Section 118(a), is an item of tax-exempt income for purposes of the basis adjustment rules of Section 1366(a)(1). 2. Whether the Second Circuit's exclusion of capital contributions from Section 61(a) income is in direct conflict with Commissioner v. Glenshaw Glass Co, 348 U.S. 426 (1955) and Commissioner v. Kowalski, 434 U.S. 77 (1977). For a discussion of the Second Circuit case, see Important Developments in the Federal Income Taxation of S Corporations Fall 2010 ABA Section of Taxation Meeting. 2

4 III. Treasury Regulations On April 13, 2011, the Internal Revenue Service issued proposed regulations under section 108 income from discharge of indebtedness (REG ). Specifically, the regulations address the application of the insolvency and bankruptcy provisions of section 108 to disregarded entities and grantor trusts. For purposes of these regulations, a disregarded entity is any entity that is disregarded as an entity separate from its owner for Federal income tax purposes, including a single member LLC, a qualified REIT subsidiary and a qualified subchapter S subsidiary. The proposed regulations provide that the term taxpayer, as used in section 108(a)(1) and (d)(1) through (3), refers to the owner(s) of the disregarded entity or grantor trust. They make clear that neither a disregarded entity nor a grantor trust is considered an owner. In the case of a partnership, the owner rules apply at the partner level to the partners of the partnership to whom the discharge of indebtedness income is allocable. Thus, if any partner is itself a disregarded entity or grantor trust, the proposed regulations look through such entity or trust to the ultimate owner(s) of the partner. The Preamble to the proposed regulations notes that some taxpayers have taken the position that the insolvency exception is available to the extent a disregarded entity or grantor trust is insolvent, even if its owner is not. The proposed regulations provide, however, that if the owner of the disregarded entity or grantor trust is not insolvent, then the insolvency exception under section 108(a)(1)(B) will not apply. Similarly, if the disregarded entity or grantor trust is under the jurisdiction of the court in a Title 11 case, but the owner of the disregarded entity or grantor trust is not, the bankruptcy exception under section 108(a)(1)(A) will not apply to the discharge of indebtedness income. Neither the Preamble nor the proposed regulations comment on Gracia v. Commissioner, TC Memo In Gracia, the general partner, who had guaranteed certain of the partnership s debts, entered into a settlement agreement with the partnership s Title 11 bankruptcy trustee to make a payment in exchange for release of all claims against him relating to the partnership. The bankruptcy court asserted jurisdiction over the partner and released him from any claims of the partnership s creditors. The Tax Court concluded that the partner s debts were discharged in a Title 11 case and held that his discharge of indebtedness income was excludable from gross income under the bankruptcy exception. IV. S Corporation Private Letter Rulings A. Private Letter Ruling (November 9, 2010) (Ineligible Shareholder) Release Date: February 11, 2011 Issued By: CC:PSI:B03 Summary of Facts: Company, an S corporation, started an equity incentive plan ( Plan ) under which key employees of Company are awarded participation units. Under the Plan, if an employee 3

5 holds a certain number of participation units, the employee is entitled to both cash and Company stock. One of the employees, a citizen of Country, became entitled under the Plan to receive cash and Company stock. Before any shares of Company stock were transferred to Individual, however, Company became aware of Individual's ineligibility as a shareholder. Under a shareholders' agreement between Company and its shareholders, Company is prohibited from making any transfer of Company stock that would terminate its S corporation election without certain approval. Issue: Whether Company s S corporation election was terminated due to an ineligible shareholder. Law: Under section 1361(b)(1), a small business corporation cannot have a shareholder who is a nonresident alien. Ruling: The IRS concluded that the Company s S corporation may have been terminated due to an ineligible shareholder but further concluded that such possible termination was inadvertent within the meaning of section 1362(f). B. Private Letter Ruling (November 4, 2010) (Disproportionate Distributions) Release Date: February 4, 2011 Issued By: CC:PSI:03 Summary of Facts: Company, an S corporation, remitted to State 2 tax on behalf of its shareholders who were not residents of State 2. While Company provided each of its shareholders who were not residents of State 2 with the amount of State 2 tax paid on their behalf, Company did not treat those payments as constructive distributions to such shareholders. The State 2 tax payments were made from Year 1 through Year 2. Company represents such payments should have been treated as constructive distributions, which caused the distributions made to its shareholders to be disproportionate in those years. Issue: Whether Company s S corporation election was terminated because failure to treat the State 2 tax payments as constructive distributions could cause Company to be treated as having more than one class of stock. Law: Treas. Reg (l)(1) provides, in part, that a corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds. Under Treas. Reg (l)(2)(i), the 4

6 determination of whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds is made based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (collectively, the governing provisions). Although a corporation is not treated as having more than one class of stock so long as the governing provisions provide for identical distribution and liquidation rights, any distributions (including actual, constructive, or deemed distributions) that differ in timing or amount are to be given appropriate tax effect in accordance with the facts and circumstances. It should be noted that while Treas. Reg (l)(2)(ii) provides that state laws may require a corporation to pay or withhold state income taxes on behalf of some or all of the corporation s shareholders, such laws are disregarded in determining whether all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds, provided that, when the constructive distributions resulting from the payment or withholding of taxes by the corporation are taken into account, the outstanding shares confer identical rights to distribution and liquidation proceeds. Ruling: The IRS concluded that if Company had more than one class of stock, Company s S corporation election was terminated in Year 1 when Company first made the State 2 tax payments on behalf of its shareholders who were not State 2 residents. The IRS further concluded, however, that if Company s S corporation election was terminated, such termination was inadvertent within the meaning of section 1362(f). V. Other Administrative Guidance A. Chief Counsel Advice (December 2, 2010) (Section 1367 Basis Adjustment) Release Date: April 8, 2011 Issued By: CC:PSI:03:ARCARMODY- POSTS Summary of Facts: Taxpayers formed Parent and made an election to treat Parent as an S corporation. Taxpayers also contributed to Parent all of the shares of a C corporation they had previously owned outright, Sub, and Parent filed an election to treat Sub as a QSub. Such election is treated as a deemed liquidation of Sub into Parent. One day after filing the QSub election for Sub, Parent and Taxpayers signed a letter of intent to sell Parent's stock to Purchaser, contingent on the parties obtaining various regulatory approvals. Six months later, Taxpayers sold all of Parent s stock to affiliates of Purchaser in exchange for a combination of notes, stock, and cash. Taxpayers take the position that the QSub election for Sub increased their bases in Parent stock under section 1367(a)(1)(A) of the Code by an amount equal to the excess of the Sub stock value over its basis. Therefore, Taxpayers recognized a loss rather than a gain on the 5

7 sale of their Parent stock to Purchaser. Taxpayers argument has two parts: (1) the nonrecognized gain on the Sub stock at the time of the deemed liquidation produced an item of income under section 1366(a)(1), and (2) the income is tax-exempt income by application of section 332 because this nonrecognition provision causes a permanent exclusion of that income. Issue: Whether, upon the election by an S corporation to treat its wholly owned subsidiary as a qualified subchapter S subsidiary (QSub), the shareholders of the S corporation increase their stock bases under section 1367(a)(1)(A) by the amount of the S corporation s built-in gain in the stock of the subsidiary as a result of the subsidiary s deemed liquidation under section 332? Law and Analysis: Section 1366(a)(1) provides that an S corporation shareholder s tax liability is determined by taking into account the shareholder s pro rata share of the corporation s (A) items of income (including tax-exempt income), loss, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder, and (B) nonseparately computed income or loss. Section 1367 provides that a shareholder s basis in the stock of an S corporation is increased by the items of income described in section 1366(a)(1)(A) and any nonseparately computed income determined under section 1366(a)(1)(B). The CCA states that [b]ecause the Code does not define income or item of income, we must look to section 332 to determine whether a liquidation of a subsidiary into its parent generates income that should be taxed. The legislative history of section 332 makes clear that a section 332 liquidation changes only the form of property ownership and, therefore, provides no section 1366 item of income. The CCA, citing Conference Report No , 99 Cong., 2d Sess. II-202 (1986), then interprets Congress intentions with respect to section 332: The legislative history to section 332 gives no indication that Congress intended the nonrecognition of gain on the subsidiary stock (whose basis disappears) to be an item of income. Instead, Congress intended that gain may be produced later, when the assets distributed in the section 332 liquidation are disposed of.... [Emphasis added.] The CCA provides that its interpretation is consistent with the Supreme Court s description of the definition of gross income. See Commissioner v. Glenshaw Class Co., 348 U.S. 426 (1955) (defining gross income to include instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion. ). Applying this definition to a section 332 liquidation, the CCA concludes that such a liquidation is merely a continuing 6

8 investment in property that provides no accession to wealth, no economic benefit, and thus no section 1366 item of income tax-exempt or otherwise. It also distinguishes the instant case from that of Gitlitz v. Commissioner, 531 U.S. 206 (2001). In Gitliz, the Supreme Court held that cancellation of indebtedness income excludible under section 108 is an item of income that increases an S corporation shareholder s stock basis under section The CCA states that the Court s decision in Gitlitz concerned the section 108 exclusion of cancellation of indebtedness income, an item that produces a clear accession of wealth to a taxpayer that has been relieved of a debt. Gitlitz did not create any new item of income, it only held that the nature of the discharge of indebtedness income was not changed by the exclusion under section 108. The CCA goes on to note that the Tax Court and the Second Circuit in Nathel v. Commissioner, 131 T.C. 262 (2008), aff d, 615 F.3d 83 (2d Cir. 2010) refused to apply Gitlitz broadly to extend the definition of income under section 1366(a)(1). Conclusion A QSub election and the resulting deemed section 332 liquidation do not give rise to an item of income under section 1366(a)(1)(A) and therefore, do not increase the electing S corporation shareholders stock bases under section 1367(a)(1)(A). B. Comments Requested 1) The IRS requested comments concerning Form 2553, Election by Small Business Corporation, filed by a qualifying corporation to elect to be an S Corporation. Written comments should have been received on or before April 18, 2011 to be assured of consideration. 2) The IRS requested comments concerning Treas. Reg (QSub), which provides the procedures and the statements to be filed by certain individuals for making the election under section 1361, the refusal to consent to the election, or the revocation of that election. Written comments should have been received on or before April 18, 2011 to be assured of consideration. 3) The IRS requested comments concerning the requirement under Treas. Reg (c)(2) to provide a statement attached to the return of an S corporation shareholder containing information establishing that gain recognized on the sale or exchange of S corporation stock is not gain attributable to section 1254 costs (Gain from disposition of interest in oil, gas, geothermal, or other mineral properties). Written comments should be received on or before June 13, 2011 to be assured of consideration. 7