Important Developments in the Federal Income Taxation of S Corporations

Transcription

1 American Bar Association Section of Taxation S Corporation Committee Important Developments in the Federal Income Taxation of S Corporations Boca Raton, Florida January 21, 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. Recent Legislation TABLE OF CONTENTS II. Court Opinions A. Winter v. Commissioner, 135 T.C. No. 12 (2010) III. S Corporation Private Letter Rulings A. Private Letter Ruling (09/24/10) B. Private Letter Ruling (11/12/10) IV. Other Administrative Guidance A. Chief Counsel Memorandum (12/10/10) B. Action on Decision , IRB 1 (12/27/2010) C. Legal Memorandum (12/23/2010) D. ECC (11/03/2010) E. ECC (09/27/2010) F Priority Guidance Plan Subchapter S Corporations G. Requests for Comments V. News and Commentary 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 January 2011 I. Recent Legislation Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (P.L ) (Act Sec. 752): The amount of a shareholder's basis reduction in the stock of an S corporation by reason of a charitable contribution made by the corporation is equal to the shareholder's pro rata share of the adjusted basis of the contributed property. For contributions made in taxable years beginning after December 31, 2009, the amount of the reduction is the shareholder's pro rata share of the fair market value of the contributed property. Section 752 of the Act, however, retroactively extends for two years the rule relating to stock basis reduction equal to the adjusted basis of such property, so that it applies for charitable contributions made in tax years beginning before January 1, II. Court Opinions A. Winter v. Commissioner, 135 T.C. No. 12 (2010) (Inconsistent Reporting) Issue: Whether the Tax Court has jurisdiction to review de novo adjustments arising from inconsistencies between the return of a shareholder and that of the S corporation. Facts: Winter was a shareholder in Builders Financial Corp. ( BFC ), an S corporation and parent of Builder s Bank, a subchapter S bank. Winter reported his share of the company s earnings from its regulatory financial filings and not from the Schedule K-1, which the bank prepared for him. He did not notify the Service of this inconsistent reporting; and only after the issuance of the notice of deficiency did the Service assess the income tax resulting from this inconsistent treatment. Accordingly, the Service contends, among other things, that Winter should have reported his shareholder income consistently with the bank s Schedule K-1 and that he failed to include some dividend, interest, and gambling income on his return. Law: 2

4 Under section 6037(c), a shareholder of an S corporation must treat on such shareholder s return all Subchapter S items consistently with such items treatment on the S corporation s return or file a statement with the Service identifying the inconsistency. If such shareholder fails to notify the Service of any inconsistency, then any adjustment required to make the treatment of the items by such shareholder consistent with the treatment of the items on the corporate return are to be treated as arising out of mathematical or clerical errors and assessed according to section 6213(b)(1). I.R.C. 6037(c)(3). In general, section 6213(b) provides that if a taxpayer is notified that, on account of a mathematical or clerical error appearing on the return, an amount of tax in excess of that shown on the return is due, such notice shall not be considered as a notice of deficiency and the taxpayer shall have no right to file a petition with the Tax Court based on such notice. Conclusion: Nevertheless, the majority concluded that the Tax Court has jurisdiction to consider Winter s claim principally on two alternative grounds. First, the notice of deficiency gives the Tax Court jurisdiction over all the issues needed to redetermine Winter s entire tax liability, including the portion resulting from his inconsistent reporting. Specifically, section 6211(a) defines deficiency as the amount by which the correct tax imposed by the Internal Revenue Code exceeds the amount of tax shown on the return plus the amount of tax previously assessed less any rebates. The amount of tax resulting from the inconsistent treatment was included in the calculation of the deficiency, and the merits of this tax liability are before the Tax Court by the parties pleadings. Therefore, section 6213 gives the Tax Court jurisdiction to redetermine a deficiency when a petition is filed timely in response to a notice of deficiency. Second, the overpayment jurisdictional provisions of section 6512 provide the Tax Court with authority to decide all issues necessary to determine the correct amount of income tax for the taxable year in issue. Winter s has claimed an overpayment in his amended petition. In order to determine whether there is an overpayment, the Tax Court must determine the correct tax that should have been paid. The correct tax for determining overpayment even includes unassessed tax, the assessment of which is barred by the statute of limitations. Bachner v. Commissioner, 109 T. C. 125 (1977), affd. without published opinion 172 F.3d 859 (3d Cir. 1998). Even if the Service made the adjustment based on the Schedule K-1 as a mathematical adjustment, the correctness of the adjustment can still be placed in issue, as can any other previously assessed tax, in order to determine the correct amount of the deficiency or overpayment. III. S Corporation Private Letter Rulings A. Private Letter Ruling (Second Class of Stock) Release Date: 09/24/10 Issued By: CC:PSI:BO3 3

5 Summary of Facts: Company was taxed as a C corporation from its incorporation until it elected to be treated as an S corporation. While it was still taxed as a C corporation, Company adopted an employee stock ownership plan, ESOP. The ESOP purchased a minority interest in Company's stock ( First Purchase Shares ). Later, Company undertook a series of transactions that resulted in ESOP becoming the sole owner of Company's outstanding stock. First, Company made a loan, secured by Company stock, to ESOP ( ESOP Loan ). Next, ESOP used the ESOP Loan proceeds to purchase all of the remaining outstanding shares of Company stock ( Second Purchase Shares ). Among its provisions, ESOP provides generally that benefits are distributed to participants at stated periods of time following their termination of employment due to retirement, disability, death, or other reason. Provision A of ESOP provides that an independent appraiser calculates the fair market value of ESOP's assets and reduces that value by any liabilities of ESOP, including the outstanding balance of the ESOP Loan. Provision B of ESOP provides a special valuation rule with respect to First Purchase Shares for purposes of distributions under the plan. Provision B provides that the value of Company shares purchased in connection with the First Purchase Shares will not be decreased or otherwise affected by the outstanding balance of the ESOP Loan proceeds used to purchase the Second Purchase Shares. Company represents that the purpose of Provision B is to protect the value of the First Purchase Shares from a steep decline in value that is normally associated with a highly leveraged employee stock ownership plan transaction. According to Company, First Purchase Shares continue to fluctuate in value with the fortunes of Company and general market conditions, as would occur in the absence of a leveraged employee stock ownership plan transaction. Issue: Whether Company is considered to have a second class of stock in violation of section 1361(b)(1)(D) solely as a result of Provision B. Law: Treas. Reg. section (l)(1) provides that a corporation that has more than one class of stock does not qualify as a small business corporation. 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. Treas. Reg. section (l)(2)(iii)(B) provides that bona fide agreements to redeem or purchase stock at the time of death, divorce, disability, or termination of employment are disregarded in determining whether a corporation s shares of stock confer identical rights. In disregarding agreements that provide for redemption upon termination of employment, Treas. Reg. section (l)(2)(iii)(B), in effect, distinguishes between redemption agreements for stock of employee shareholders and redemption agreements for stock of 4

6 investor shareholders. In this case, the shareholders whose First Purchase Shares are redeemed through the special valuation rule in Provision B are employee shareholders, rather than investor shareholders. In addition, a redemption agreement is disregarded under section (l)(2)(iii)(A) where the principal purpose of the agreement is not to avoid the one class of stock requirement or when the agreement sets a purchase price that does not greatly vary from the fair market value of the stock. Ruling: Provision B will be disregarded in determining whether the outstanding shares of Company stock confer identical rights, and accordingly, Company will not be considered as having more than one class of stock as a result of ESOP s adopting Provision B. B. Private Letter Ruling (Inadvertent Termination) Release Date: 11/12/10 Issued By: CC:PSI:BO2 Summary of Facts: Each year, S Corp. declared a dividend at the end of the year in an amount equal to S Corp. s estimated taxable income for such year. Such dividends were pro-rata based upon the shareholders proportionate ownership interest in S Corp. In the years in which S Corp. s cash flow was inadequate to cover the amount of the declared dividend, however, S Corp. treated the amount of the shortfall as a deemed distribution to its shareholders, followed by a loan from such shareholders back to S Corp. (the Shareholder Loans ). For Shareholder Loans made in Year 1 and Year 2, S Corp. intended to pay n1% interest to Shareholder Loans from C, D, E, and F and n2% interest on Shareholder Loans from A and B. For Shareholder Loans made in Year 3 and thereafter, S Corp. intended to continue to pay disparate rates of interests to its shareholders. Prior to Year 6, all Shareholder Loans from C, D, E, and F were repaid during the year, while Shareholder Loans from A and B were often carried forward from year to year. During Year 6 and Year 7, Shareholder Loans generally remained outstanding for more than a year. During Year 5, S Corp. loaned funds to B (the B Loans ), and B paid simple interest on the B Loans. B made a significant payment on the B Loans by offsetting the dividend otherwise due to B for Year F, and the B Loans were fully satisfied by offsetting the dividend due to B for Year 6. S Corp. became aware that the Shareholder Loans or the B Loans may have created a second class of stock thereby terminating its S election. S Corp. has either taken corrective action, or represented that it will take such action, to pay the appropriate shareholders a consistent rate of interest on the Shareholder Loans for all Years. 5

7 Ruling: Based solely on the facts submitted and the representations made, S Corp. s S election may have been terminated in Year 1 because S Corp. may have had more than one class of stock. If it s S election as terminated, however, such a termination was inadvertent within the meaning of section 1362(f). IV. Other Administrative Guidance A. Chief Counsel Memorandum (Consolidated Group s Acquisition of S Corporation s Assets) Release Date: 12/10/10 Issued By: CC:CORP:2 Summary of Facts: Oldco, a C corporation, made an election to be treated as an S corporation and elected to treat its subsidiary, Sub 1, as a qualified subchapter S subsidiary, i.e., a QSub. Parent, a limited liability company, owned Holdco, a C corporation, and Holdco owned Newco, which was also C corporation. Under an agreement among Parent, Holdco, Newco, Oldco, and Oldco shareholders, Oldco merged with and into Newco, (the Transaction ). The separate corporate existence of Oldco ceased, and Newco continued as the surviving wholly-owned subsidiary of Holdco. In exchange for all of their stock, Oldco shareholders received cash and promissory notes, and the Oldco stock was cancelled. The Transaction agreement (the Agreement ) provided that the parties intended for the Transaction to qualify as: (1) a merger under the state law, and (2) an asset sale for federal tax purposes. Moreover, the Agreement included a provision that required Oldco shareholders to indemnify Holdco and its affiliates for any pre-closing taxes, which were defined to include any built-in gain tax arising under section Oldco timely filed a final Form 1120S for a short taxable year in which it reported net unrealized built-in gain and the resulting tax due under section 1374(a). Exam proposed to adjust Oldco's tax liability due on its final return based on its determination of additional recognized built-in gain, (the Proposed Adjustment ). Issues: 1. Whether the Proposed Adjustment was attributable to Oldco s final taxable year? 2. Whether Newco is the appropriate entity to whom a statutory notice of deficiency with respect to the Proposed Adjustment should be sent. 3. When did Sub 1 become a member of the Holdco Group. 6

8 4. Whether the overlap in short taxable years of Oldco and the Holdco Group affects which entity is liable for the additional tax arising from the Proposed Adjustment or which entity should receive the related statutory notice of deficiency. Law and Analysis: Issue 1 Built-in Gain Tax Section 1374 provides that [i]f for any taxable year beginning in the recognition period an S corporation has a net recognized built-in gain, there is hereby imposed a tax... on the income of such corporation for such taxable year. The merger constituted a disposition of Oldco s section 1374 assets on Date 5. 1 The 10-year recognition period for Oldco began on Date 0, and the disposition occurred on Date 5, which was within Oldco s recognition period. Notwithstanding termination of Oldco s corporate existence and the termination of its S election, any resulting section 1374 tax is still attributable to Oldco s final taxable year. Issue 2 Successor-in-Interest Liability Under the statute of Newco s state of incorporation, the surviving entity in a merger is responsible for all the liabilities and obligations of each of the constituent entities. Oldco and Newco were the constituent entities, and Newco was the surviving entity under state law. Thus Newco is the legal successor-in-interest, which is liable for Oldco s tax deficiency arising from the Proposed Adjustment subject to any applicable limitations on assessment and collection. Although the indemnification provision in the Agreement determined the rights and obligations of the signing parties among themselves, it has no effect on which party is liable under state law. Accordingly, the statutory notice of deficiency should be issued to Newco, as successor-in-interest to Oldco. Issue 3 End-of-the-Day Rule Under the end-of-the-day rule, set forth in Treas. Reg. section (b)(1)(ii)(A) for C corporations and in Treas. Reg. section (a)(4), Ex. 5 for certain former QSubs, a subsidiary becomes a member of a consolidated group at the end of the day on which its status as a member changes, and its tax year ends at that time for all federal income tax purposes. Accordingly, Sub1 s QSub election terminated as of the effective date of the merger. At the end of that day, Newco is treated as transferring Sub 1 s assets to a newly formed corporation in exchange for Sub 1 stock, at which time the newly formed Sub 1 became a member of the Holdco consolidated group. Issue 4 No Several Liability Oldco was never a member of the affiliated group. Consequently, the gain from the sale of Oldco s section 1374 assets was only includible in Oldco s final taxable year. Notwithstanding the overlap of Oldco s final taxable year and the Holdoc Group s initial 1 For federal income tax purposes, the forward triangular merger of Oldco into Newco constituted a sale of Oldco s assets to Newco followed by a liquidation of Oldco. See Rev. Rul. 69-6, C.B

9 consolidate return year, the rules under Treas. Reg. section , which provide for a member of a consolidated group during any part of the consolidated return year to be severally liable for the resulting tax, do not apply to hold the Holdco Group severally liable for the tax deficiency arising from Oldco s sale or to treat Holdco as Oldco s agent. Rather, as explained under Issue 2 above, Newco, as successor-in-interest to Oldco, is primarily liable for any tax deficiency arising from the Proprosed Adjustment. Accordingly, the statutory notice of deficiency should be issued to Newco. B. Action on Decision , IRB 1 (12/27/2010) (Bank Interest Expenses) The Service will acquiesce in the result only in Vainisi v. Commissioner, 599 F.3d 567 (7 th Cir. 2010) involving an S corporation bank s treatment of interest expenses. Issue: Whether section 291 applies to a bank that converted in 1997 from a C corporation to a qualified subchapter S subsidiary( QSub ) as defined in section 1361(b)(3)(B). Discussion: The QSub bank held debt obligations that, pursuant to section 265(b)(3)(B), were qualified tax-exempt obligations ( QTEOs ) subject to a 20-percent interest expense disallowance rule under section 291(a)(3) and (e)(1)(b). Although banks that hold QTEOs typically are subject to the 20-percent disallowance rule, section 1363(b), which sets forth the computation of an S corporation s taxable income, provides in subsection 1363(b)(4) that section 291 shall apply if the S corporation was a C corporation for any of the three immediately preceding taxable years. The Service s position was that section 291(a)(3) applied to the QSub bank, regardless of section 1363(b)(4), because Treas. Reg. section (a)(3) provides that special bank rules continue to apply separately to each QSub that is a bank. Thus, the Service argued that QSub banks must determine income and deductions by employing special bank rules such as section 291(a)(3) before the QSub bank s income and deductions can be treated as income and deductions of the S corporation parent. The Seventh Circuit concluded that section 1363(b)(4) precluded application of section 291 to the S corporation bank, because it had not been a C corporation for any of the three preceding years. The Service will not apply section 291(a)(3) and (e)(1)(b) to a QSub bank or an S corporation bank unless the bank (or any predecessor) was a C corporation for any of the three immediately preceding taxable years. C. Legal Memorandum (12/23/2010) 8

10 This legal memorandum addresses the application of the section 179D deduction to certain S corporations 2. Issues: Where a government entity allocates a section 179D deduction for energy efficient commercial buildings an S corporation "designer" pursuant to section 179D(d)(4 1. Are the shareholders of the designer required to reduce the adjusted bases in their S corporation stock by the amount of the section 179D deduction? 2. Do the provisions of section 1366(d) limit the benefit of the section 179D deduction to the shareholders' adjusted bases in their S corporation stock? Law: Section 179D(d)(4) provides that in the case of energy efficient commercial building property that is installed on or in property owned by a Federal, State, or local government or a political subdivision thereof, the Secretary shall promulgate a regulation to allow the allocation of the Section 179D deduction "to the person primarily responsible for designing the property [the designer] in lieu of the owner of such property." A designer is a person that creates the technical specifications for installation of energy efficient commercial building property for which a deduction is allowed under section 179D. If a government entity hires a designer to perform work on energy efficient commercial building property, and that designer is organized as an S corporation, the contract for services runs between the government entity and the S corporation, regardless of which individual members of the S corporation personally perform the services under the contract. If the government entity allocates a deduction to the designer pursuant to section 179D(d)(4), it is the S corporation that receives the allocation of the section 179D deduction allocation. Although certain deductions of an S corporation may be claimed directly by its shareholders, in those instances, there exists explicit authority providing for such a result. No such authority is provided under section 179D. Accordingly, the deduction, like any other S corporation item of deduction, is used to calculate the entity's ordinary income or loss. Each shareholder's share of that income or loss requires an adjustment to the shareholders' bases in their ownership interests under section 1367(a), and the shareholders' ability to claim any ordinary loss generated by the deduction is limited to the basis in their ownership interest under section 1366(d). Conclusions: 1. The shareholders of the designer must reduce the adjusted bases in their interests or S corporation stock by the amount of the section 179D deduction. 2 This memorandum also applies to partnerships. 9

11 2. Section 1366(d) limits the benefit of the section 179D deduction to the shareholders' adjusted bases in their S corporation stock. D. ECC (11/03/2010) A corporate officer must sign a power of attorney on behalf of an S corporation. Being a stockholder does not give a person authority to act on behalf of the corporate entity. E. ECC (09/27/2010) A purported loan of securities did not create indebtedness for purposes of section 1366(d)(1)(B), citing Deputy v. Du Pont, 308 U.S. 488 (1940) for the proposition that an obligation to close a short sale is not indebtedness. F Priority Guidance Plan Subchapter S Corporations 1. Guidance under sections1362 and 9100 regarding elections of S corporations. 2. Guidance under section Regulations under section 1367 regarding S corporations and back-to-back loans. G. Comments Requested The IRS has requested comments concerning Revenue Procedure , Late Election Relief for S Corporations and Revenue Procedures , Deemed Corporate Election for Late Electing S Corporations. Written comments should be received on or before February 14, 2011 to be assured of consideration. V. News and Commentary Amy S. Elliott, Economic Substance Concerns Over Common Planning Tool may be Legitimate, Official Says, TAX NOTES TODAY, Nov. 9, 2010, available in LEXIS, Tax Library, Tax Analysts File. Donald T. Williamson, S Corporation Stock Basis in Measuring Ordinary Loss, TAX NOTES TODAY, Oct. 6, 2010, available in LEXIS, Tax Library, Tax Analysts File. 10