American Bar Association Section of Taxation S Corporation Committee. 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 Hyatt Regency Denver, Colorado October 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. Proposed Legislation TABLE OF CONTENTS II. Court Opinions & Orders A. Recovery Group, Inc. v. Commissioner, T.C. Memo , aff d. F.3d (1 st Cir. July 26, 2011) B. Viewtech, Inc. v. United States, 108 AFTR 2d (9 th Cir. 2011) C. Santa Clara Valley Housing Group v. United States, 108 AFTR 2d (N.D. CA 2011) D. Broz v. Commissioner, 137 T.C. 5 (2011) E. Smith v. Commissioner, No , Order of U.S.T.C. (2011 TNT ) III. S Corporation Private Letter Rulings A. Private Letter Ruling (Affiliated Group) B. Private Letter Ruling (Second Class of Stock) IV. 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 October 2011 I. Proposed Legislation H.R Tax Return Due Date Simplification and Modernization Act of 2011 (June 24, 2011) - Introduced by Rep. Lynn Jenkins, R-Kan. To amend the Internal Revenue Code of 1986 to provide for a logical flow of return information between partnerships, corporations, trusts, estates, and individuals to better enable each party to submit timely, accurate returns and reduce the need for extended and amended returns, to provide for modified due dates by regulation, and to conform the automatic corporate extension period to longstanding regulatory rule. For S corporation (1) In General So much of subsection (b) of 6072 as precedes the second sentence thereof is amended to read as follows: (b) Returns of Certain Corporations Returns of S corporation under sections 6012 and 6037 made on the basis of the calendar year shall be filed on or before the 31 st day of March following the close of the calendar year, and such returns made on the basis of a fiscal year shall be filed on or before the last day of the third month following the close of the fiscal year. (2) Conforming Amendments to be made to section 1362(b) & (d). II. Court Opinion A. Recovery Group, Inc. v. Commissioner, T.C. Memo , aff d. F.3d (1 st Cir. July 26, 2011) Issue Whether a covenant not to compete, entered into in connection with the acquisition of a portion of the stock of an S corporation that is engaged in a trade or business, is considered a section 197 intangible, within the meaning of section 197(d)(1)(E), regardless of whether the portion of stock acquired constitutes at least a substantial portion of such corporation s total stock. Facts In 2002, James Edgerly -- one of Recovery Group s employees and minority shareholders -- informed its president that he wished to leave the company and to have the company buy out his 2

4 shares, which represented 23% of Recovery Group s outstanding stock. Mr. Edgerly entered into a buyout agreement whereby Recovery Group agreed to redeem all of Mr. Edgerly s shares for a price of $255,908. In addition, Mr. Edgerly entered into a noncompetition and nonsolicitation agreement that prohibited Mr. Edgerly from engaging in competitive activities from July 31, 2002 through July 31, The amount paid by Recovery Group to Mr. Edgerly for this covenant not to compete (the Covenant ) amounted to $400,000, which was comparable to Mr. Edgerly s annual earnings. In its corresponding income tax returns, Recovery Group claimed deductions for its payments under the Covenant by amortizing such payments over the twelve-month duration of the Covenant. The IRS determined that the Covenant was an amortizable section 197 intangible, amortizable by Recovery Group over fifteen years (beginning with the month of acquisition) and not over the duration of the Covenant, as had been reported by Recovery Group in its corresponding income tax returns. Law & Analysis After reviewing the statutory language, its purpose, and legislative history, the First Circuit rejected Recovery Group's contention that, in the context of stock acquisitions, section 197(d)(1)(E) only applies to acquisitions considered at least substantial. The court explained that the statute illustrates Congress recognition that the difficulty and uncertainty in the valuation of corporate stock, combined with the rule allowing taxpayers to deduct and amortize covenants not to compete over their usually short useful lives, provided too much of an incentive for stock buyers, who entered into a covenant not to compete in connection with the acquisition of such stock, to overstate the cost of the covenant and understate the price of the stock. These concerns, the court wrote, are present both where the taxpayer acquires a substantial and a less than substantial portion of a corporation s stock; the fact that a taxpayer acquires a nonsubstantial portion of corporate stock does not make the value of such stock any less difficult to quantify than a substantial portion because the goodwill and going concern components are still present even where a non-substantial portion of stock is transferred. The situation is different in the case of asset acquisitions, and the difference explains why Congress chose different tax treatments for (1) covenants executed in connection with the acquisition of at least a substantial portion of assets constituting a trade or business, as opposed to (2) covenants executed in connection with the acquisition of less than a substantial portion of assets constituting a trade or business. Conclusion The Covenant was an amortizable section 197 intangible subject to the fifteen-year amortization period set forth under section 197(a). B. Viewtech Inc. v. United States, 108 AFTR 2d (9th Cir. 2011) 3

5 Issue Whether the IRS is required to notify the taxpayer and a related third party of the service of a summons to a bank for the third party s account information. Facts After the IRS assessed the taxpayer for some $3 million in federal income taxes for the year ending December 31, 2007, the IRS s efforts to locate assets to satisfy this assessment led it to Viewtech, a California Subchapter S corporation, in which the taxpayer had extensive involvement. The government s investigation showed that Viewtech s finances were significantly intertwined with those of the taxpayer. The taxpayer owned 100 percent of the shares of Viewtech in 2007, and 97 percent of its shares in The taxpayer received almost $14 million in income, interest, expenses, and wages from Viewtech in 2007, and some $1.7 million in In addition to these payments to the taxpayer, Viewtech directly paid more than a million dollars of the taxpayer s personal federal income tax for 2007 and In addition, in 2007 and 2008, the taxpayer deposited significant sums of cash into Viewtech s Wells Fargo account. The next year, in addition to paying the taxpayer his regular salary, Viewtech transferred $180,000 from its own bank account into the taxpayer s personal bank account. Law & Analysis Section 7609 provides generally that if the IRS asks the person summoned (here, the third party s bank) for specified information relating to a person identified in the summons (the third party account owner), the IRS must give that third person notice of the summons. The general rule is inapplicable when an IRS summons is issued in aid of the collection of (i) an assessment made or judgment rendered against the person with respect to whose liability the summons is issued or (ii) the liability of any transferee or fiduciary of any person referred to in clause (i). The issue of who gets notice is significant because only a person who is entitled to notice may bring a proceeding to quash such a summons. The court based its decision on the analysis applied in Ip v. United States, 205 F.3d 1168 (9th Cir. 2000). In Ip, the court concluded that a third party was entitled to notice because she was not the taxpayer, was not a fiduciary or transferee of the taxpayer, and had no legal interest in the object of the summons. Applying the rule of Ip, the appeals court held that no notice was required in this case because the taxpayer had a significant interest ( percent) in the S corporation that was seeking to quash the summons, the taxpayer was at times an employee and an officer of the S corporation, and the evidence showed that the taxpayer had use of the funds in the S corporation s bank account and that the S corporation was the taxpayer s fiduciary or transferee. For other reasons, the appeals court held that the taxpayer also was not entitled to notice and lacked standing to quash the summons. Conclusion The Ninth Circuit has held that an S corporation was not entitled to notice of an IRS summons served on a bank for information about the corporation s account, where the summons was part of the IRS s effort to locate an individual taxpayer s assets. Accordingly, the corporation lacked standing to quash the summons. 4

6 C. Santa Clara Valley Housing Group v. United States, 108 AFTR 2 nd (N.D. CA 2011) Issue Whether the issuance of warrants resulted in termination of the taxpayer s status as an S corporation. Facts The taxpayer entered into a tax shelter know as S Corporation Charitable Contribution strategy ( SC2 ). Pursuant to SC2, an S corporation's shareholders temporarily transfer most of the corporation's stock to a tax-exempt charitable entity via a donation. The donated shares remain parked in the charity for a pre-determined period of time. During this period, the S corporation's income accumulates in the corporation; distributions are minimized or avoided. After the pre-determined period of time has elapsed, the charity sells the donated shares back to the original shareholders. Tax has been avoided for the period of time that the shares were parked in the charity, and the accumulated income of the S corporation may be distributed to the original shareholders either tax-free or at the favorable long-term capital gains rate. The original shareholders retain control over the S corporation by donating only non-voting stock while retaining all shares of voting stock. Moreover, to protect against the possibility that the donee charity might refuse to sell its majority stock back to the original shareholders after the agreed-upon length of time, warrants are issued to the original shareholders prior to the donation. The warrants enable the original shareholders to purchase a large number of new shares in the corporation; if exercised, the warrants would dilute the stock held by the charity to such an extent that the original shareholders would end up owning approximately ninety percent of the outstanding shares. Thus the warrants allow the original shareholders to retain their equity interest in the corporation even though the charity nominally is the majority shareholder. Law & Analysis In general, [i]nstruments, obligations, or arrangements are not treated as a second class of stock. Treas. Reg (l)(4)(i). The regulations set forth two exceptions to this general rule. As relevant here, one of these exceptions provides that an instrument, obligation, or arrangement issued by a corporation is treated as a second class of stock if: (1) the instrument constitutes equity or otherwise results in the holder being treated as the owner of stock under general principles of Federal tax law ; and (2) a principal purpose of issuing the instrument is to circumvent the rights to distribution or liquidation proceeds conferred by the outstanding shares of stock. Treas. Reg (l)(4)(ii). The warrants obviously were designed to permit the shareholders to retain nominal ownership of approximately 90% of the corporation even though 90% of the actual shares had been donated to the charity. If the charity refused to sell the shares back, the shareholders could exercise the warrants, thereby diluting the charity s shares such that the charity would go from owning ninety percent to approximately ten percent of the outstanding shares. Accordingly, it fairly may be said that the warrants constitute equity, and were intended to prevent the charity from enjoying the rights of distribution or liquidation that ordinarily would come with ownership of the majority of 5

7 a successful company s shares. There is no evidence that the warrants were issued for any purpose other than to protect the shareholder s equity in the taxpayer for the period of time that the majority shares were parked in the charity. Conclusion The Court concluded that under the circumstances at issue here the warrants constitute a second class of stock pursuant to Treas. Reg (l)(4)(ii). D. Broz v. Commissioner, 137 T.C. 5 (2011) Issues (1) Whether Petitioner had sufficient debt basis under section 1366 in stock of Alpine PCS, Inc. ( Alpine ), an S corporation, to claim flow-through losses. (2) Whether Petitioner s pledge of stock in a related S corporation is excluded from the at risk amount under section 465 because it was property used in the business. Facts Petitioner organized RFB Cellular, Inc. ( RFB ), an S corporation, to engage in providing wireless cellular services. Later when he sought to expand RFB s existing cellular business to new license areas, RFB s lenders agreed to fund the expansion. Petitioner organized Alpine, an S corporation, to bid on FCC licenses and to construct and operate digital networks to service the new license areas. CoBank was the main commercial lender to RFB and Alpine during the years at issue. RFB used CoBank loan proceeds to expand its existing business through Alpine. CoBank specifically acknowledged that RFB would advance the proceeds directly or indirectly to Alpine. Petitioner pledged his RFB stock as additional security but he never personally guaranteed the CoBank loan. The loan was secured by the assets of Alpine, and Alpine guaranteed the loan. RFB recorded the advances on its general ledger as advances to Alpine PCS. Alpine recorded the same advances as notes payable. RFB and Alpine made year-end adjusting entries reclassifying the advances as loans from a shareholder. Alpine reflected the advances as longterm liabilities on the returns for the years at issue. Promissory notes were executed between Petitioner and RFB, and between Petitioner and Alpine, to reflect accrued but unpaid interest on the purported loans. RFB indicated in financial statements for the years at issue that it would not demand repayment of any of the advances. No security was provided with respect to the promissory notes. No cash payments of either principal or interest were ever made by any of the parties with respect to the promissory notes. Petitioner nevertheless reported interest income and income expense from the promissory notes on his individual returns. Law & Analysis 6

8 Issue 1 Basis Limitations on Flow-through Losses A shareholder of an S corporation can deduct his or her share of entity-level losses to the extent that such losses do not exceed the sum of the shareholder's adjusted basis in his or her stock and the shareholder s adjusted basis in any indebtedness of the S corporation to the shareholder. I.R.C. 1366(d)(1)(A) & (B). A shareholder who makes a loan to an S corporation generally acquires debt basis if the shareholder makes an economic outlay for the loan. The indebtedness must run directly from the S corporation to the shareholder and the shareholder must make an actual economic outlay for debt basis to arise. Kerzner v. Commissioner, T.C. Memo When the taxpayer claims debt basis through payments made by an entity related to the taxpayer and then from the taxpayer to the S corporation (back-to-back loans), the taxpayer must prove that the related entity was acting on behalf of the taxpayer and that the taxpayer was the actual lender to the S corporation. Ruckriegel v. Commissioner, T.C. Memo If the taxpayer is a mere conduit and if the transfer of funds is in substance a loan from the related entity to the S corporation, the court will apply the step transaction doctrine and ignore the taxpayer's participation. Id. The court found that there was no evidence that Alpine was indebted to Petitioner rather than to RFB. Moreover, Petitioner did not establish that RFB habitually or routinely paid Petitioner s expenses so as to make RFB an incorporated pocketbook. Finally, Petitioner did not satisfy the economic outlay requirement. He did not show that he had incurred any costs with respect to the loan or his pledge of RFB stock and he did not personally guarantee or otherwise incur personal liability on the loan. Issue 2 At Risk Limitation on Flow-through Losses The at-risk rules ensure that a taxpayer deducts losses only to the extent he or she is economically or actually at risk for the investment. I.R.C. 465(a). Pledges of personal property as security for borrowed amounts are also included in the at-risk amount. I.R.C. 465(b)(2)(B). The taxpayer is not at risk, however, for any pledge of property used in the business. Id. The court found that the RFB stock was related to Alpine. The court further found that even if the RFB stock was unrelated to the cellular phone business, Petitioner was not economically or actually at risk with respect to the investment in Alpine because he never personally guaranteed the CoBank loan nor was he personally liable on the purported loans to Alpine. Conclusions Issue 1 Applying the step transaction doctrine, the court ignored Petitioner s participation in the advances from RFB to Alpine and found that Petitioner had insufficient debt basis in Alpine to claim flow-through losses. Issue 2 The court found that Petitioner s pledge of the RFB stock did not put him at risk in Alpine to allow the pass-through of losses. 7

9 E. Smith v. Commissioner, No , Order of U.S.T.C. (2011 TNT ) Issue Whether the net worth of shareholders or their S corporation determines who qualifies as the prevailing party for purposes of recovering litigation and administrative costs under section Facts The deficiencies originally placed in dispute, and ultimately conceded by the IRS, result from adjustments (increases) to the shareholder s pro rata share of income claimed on their 2003 and 2004 Federal income tax returns from their wholly-owned S corporation. Certain deductions disallowed during the examination of the S corporation were ultimately allowed and the resultant increases to the shareholders pro rata share of income were reversed. The shareholder argued that the S corporation is the party whose net worth much be taken into account for purposes of section Law & Analysis Under section 7430, a prevailing party is entitled to recover reasonable litigation and administrative costs incurred in a Tax Court proceeding. A party who does not satisfy the relevant net worth requirements does not fit within the definition of prevailing party. The word party, is defined in section 2412(d)(1)(B) to mean (i) an individual whose net worth did not exceed $2,000,000..., or (ii) any owner of an unincorporated business, or any partnership, corporation..., the net worth of which did not exceed $7,000,000..., and which had not more than 500 employees. The court stated that party means a party to the proceeding in which the costs are sought. Each petitioner, i.e., the shareholders, is a party within the meaning of section 7430(c)(4), not the S corporation. The shareholders did not establish that that the net worth of either of them did not exceed $2,000,000 as required under section The petitioners argued that in the income tax context an S corporation could never be a petitioner and therefore a party to the litigation. The court disagreed, citing Recovery Group, Inc. v. Commissioner, T.C. Memo , aff d. F.3d (1 st Cir. July 26, 2011). The court further stated that even if an S corporation would not be a party in disputes in an income tax context that was one of the consequences of a corporation s election to be treated as an S corporation. Conclusion Neither petitioner established that the net worth requirements set forth in section 7430 were satisfied; therefore neither of them is a prevailing party within the meaning of the statute. Because neither was a prevailing party, they were not entitled to recover their litigation and administrative costs. III. S Corporation Private Letter Rulings A. Private Letter Ruling (February 11, 2011) (Affiliated Group) 8

10 Release Date: June 3, 2011 Issued By: CC:PSI:B02 Summary of Facts: Company was formed on D1 and made an election to be treated as a subchapter S corporation on D2. On D3, Company formed Y, a wholly-owned subsidiary, under the law of Country, which caused Company to become a member of an affiliated group under section At the time of Y s formation, a corporation that was a member of an affiliated group was an ineligible corporation under section 1361(b)(2)(A). As a result, Company s subchapter S election terminated under section 1362(d)(2) on D3 when Y was formed. On D4, Company formed Z, a wholly-owned subsidiary, under the law of Country and Company s S corporation election would have terminated under section 1362(d) had the election not already terminated on D3. Issue: Whether the termination of Company s S corporation election was inadvertent. Law: Section 1361(b)(2)(A), as in effect for taxable years beginning on or before December 31, 1996, provided that for purposes of section 1361(b)(1), the term ineligible corporation means any corporation that is a member of an affiliated group (determined under section 1504 without regard to the exceptions contained in section 1504(b)). Effective for taxable years beginning after December 31, 1996, however, the term ineligible corporation no longer includes a corporation that is a member of an affiliated group. Ruling: Company s S corporation election under section 1362(a) was terminated when Company formed Y. This termination of Company s S election on D3 was an inadvertent termination within the meaning of section 1362(f). Moreover, had Company s S corporation election not already terminated, it would have terminated on D4. Similarly, this termination of X s S election on D4 would have been an inadvertent termination within the meaning of section 1362(f). B. Private Letter Ruling (May 3, 2011) (Second Class of Stock) Release Date: August 12, 2011 Issued By: CC:PSI:B02 Summary of Facts: X is a limited liability company that made an election to be treated as an association taxable as a corporation and an S corporation election under section The members of X executed an agreement ( Agreement ) that provided that each member that contributed capital to X would receive membership, percentage, and voting interests, that 9

11 those membership interests would be of one class and that all distributions were to be made according to the members percentage interests in X. Later the members adopted an amendment to the Agreement that provided that nonliquidating distributions would be made according to a member s percentage interest multiplied by the average base hours the member worked for X during the calendar year and that liquidating distributions would be made according to the member s percentage interest multiplied by the number of years the member had worked for X. Issue: Whether X s S corporation election was terminated because the amendment to the Agreement could be treated as causing X to have more than one class of stock. Law: Treas. Reg (l)(2)(i) provides that the 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). Ruling: The IRS concluded that if X s S corporation election was terminated, such termination was inadvertent within the meaning of section 1362(f). IV. News and Commentary Kenneth N. Orbach, IRS Misinterprets S Corporation Ordering Rule, TAX NOTES TODAY, July 6, 2011, available in LEXIS, Tax Library, Tax Analysts File. 10