Form 1120S Challenges
Amanda Wilson
Orlando, Florida
www.lowndes-law.com
(407) 418-6220
Amanda.Wilson@lowndes-law.com
February 5, 2013
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Part IV.
Fringe Benefits
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General Rule for C Corporations
One of the tax benefits of a C corporation is that an owner/shareholder
can be treated/respected as an employee of the corporation. This
contrasts to the partnership area which does not allow an
owner/partner to be treated as an employee.
As a result, an owner/shareholder can participate in certain fringe
benefits offered to employees. The C corporation can generally deduct
the cost of fringe benefits provided to employee owners without the
employee owner having to include the value of the fringe benefits in
taxable income.
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Special Rule for S Corporations
While the rules applicable to C corporations generally apply to S
corporations as well, Section 1372 provides that, in applying the rules
applicable to employee fringe benefits
º An S corporation is treated as a partnership, and
º any 2% or more shareholder is treated as a partner of the
partnership.
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Special Rule for S Corporations
A 2% shareholder is any person who on any day of the corporate year
owns more than 2% of the outstanding stock or more than 2% of the
voting power of all of the stock.
The constructive ownership rules of Section 318 apply. As a result, a
person can be a 2% shareholder even if he does not own any stock
directly.
º
For example, Father owns 5% of stock in Y. Son works for Y but holds no stock.
Under Section 318, stock ownership is attributed between members of a family
(spouses, children, grandchildren and parents). Son is treated as a 2%
shareholder because the stock of Father is attributed to Son.
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What Does This Mean?
2% shareholders generally do not get the benefit of excluding fringe
benefits from income, since the fringe benefit exclusion provisions
generally only apply to “employees”.
Note that this rule is for 2% shareholders only. Less than 2%
shareholders are caught by Section 1372.
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What Fringe Benefits Are Covered?
Section 1372 does not specifically define what fringe benefits are
covered. What does appear to be covered based on legislative history:
º
Exclusion from income amounts received under accident and health plans
(Section 105) (See Part V).
º
Exclusion from an employee’s income employer-provided coverage under an
accident and health plan (Section 106) (See Part V).
º
Exclusion from employee’s taxable income of the cost (up to $50,000) of group
term life insurance provided by an employer on employee’s life. (Section 79).
º
Exclusion from employee’s taxable income of meals or lodging provided by an
employer to an employee for the convenience of the employer (Section 119).
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What Fringe Benefits Are Not
Covered/Impacted
The following benefits are generally not covered/impacted, as these
provisions specifically define employees to include self-employed
individuals (including partners).
º
Defined contribution plans and defined benefit plans, including employee stock
ownership plans (Sections 401-417).
º
Qualified group legal services plans (Section 120).
º
Dependent care assistance programs (Section 129).
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Cafeteria Plans
A cafeteria plan allows employees to pay certain qualified expenses on
a pre-tax basis (i.e., flexible spending accounts).
Section 125 provides that employee benefits provided under a cafeteria
plan are not included in an employee’s income merely because the
employee had the chance, before the cash became available, to chose
to receive the cash or nontaxable benefits under the cafeteria plan.
Section 125 requires that all participants in the cafeteria plan be
employees. Based on Section 1372, the IRS has issued proposed
regulations under Section 125 stating that 2% shareholders are not
employees and thus cannot participate in cafeteria plans.
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Part V.
Health Related Fringe Benefits
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Revenue Ruling 91-29
The IRS addressed how to apply Section 1372 to payments of health
insurance premiums by an S corporation in Revenue Ruling 91-29.
In that ruling, the S corporation paid accident and health insurance
premiums for both 2% shareholder employees and a less than 2%
shareholder employee. The IRS held:
º
The employee fringe benefits paid or furnished for the benefit of 2% shareholder
employees were to be treated like a guaranteed payment under Section 707(c).
º
The 2% shareholders had to include cost of the premiums in their gross income.
º
The less than 2% shareholder employee could exclude the cost from income
under Section 106.
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Revenue Ruling 91-29
In addition, the IRS held that the S corporation could deduct the cost of
providing the employee fringe benefits if the requirements under
Section 162(a) were satisfied (i.e., if the cost was an ordinary and
necessary expense paid or incurred in carrying on trade or business).
The IRS also stated that the 2% shareholders could deduct the cost of
the insurance premiums if they satisfied the requirements of Section
162(l).
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Announcement 92-16
In Announcement 92-16, the IRS reiterated its holding in Revenue
Ruling 91-29.
It then stated that while the premium payments by the S corporation are
included in the 2% shareholder’s wages for income tax withholding
purposes (i.e., listed on the W-2), they are not wages subject to the
Social Security and Medicare taxes.
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Notice 2008-1
The IRS provided rules regarding when a 2% shareholder is entitled to
deduct accident and health insurance premiums under Section 162(l) in
Notice 2008-1.
Section 162(l) provides that an employee (including a self-employed
individual such as a partner) may deduct amounts paid for medical care
insurance subject to the following limitations:
º
Deduction shall not be allowed to the extent the deduction exceeds the
individual’s earned income from the trade or business with respect to which the
plan providing the medical care coverage is established.
º
Deduction is not allowed for amounts during a month in which the individual is
eligible to participate in any subsidized health plan maintained by an employer of
the individual or their spouse.
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Notice 2008-1 Requirements
In addition to the Section 162(l) requirements, Notice 2008-1 requires:
º
Plan providing medical coverage must be established by the S corporation. Either
• S corporation makes the premium payments for the accident and health
insurance policy in the current taxable year, or
• 2% shareholder makes the premium payments and furnishes proof of
payment to the S corporation and S corporation then reimburses the 2%
shareholder in the current taxable year.
If premiums are not paid or reimbursed by S corporation and included in 2%
shareholder’s gross income, requirement is not satisfied and no deduction.
º
S corporation must report the accident and health insurance premiums paid or
reimbursed as wages on the 2% shareholder’s Form W-2.
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Earned Income
Section 162(l) provides that the deduction is limited to the amount of the
individual’s earned income from the trade or business with respect to
which the plan providing the medical care coverage is established.
Wages paid to a 2% shareholder are deemed to be earned income for
purposes of this Section 162(l) limitation.
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Health Savings Account
An individual can generally, under Section 223, deduct contributions
made to a health savings account (HSA) established to pay for qualified
medical expenses. If the employer makes the contribution, the
contribution is generally excluded from income and wages under
Section 106(d).
In Notice 2005-8, the IRS stated that an S corporation’s contribution to
HSA of 2% shareholder is treated as a guaranteed payment under
Section 707(c). The S corporation can deduct the contribution under
Section 162 and the 2% shareholder must include it in gross income.
The deduction must be included in wages on W-2, but not subject to
Social Security or Medicare tax.
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In Short
2% shareholders often do not get the benefit of excluding fringe
benefits from income, since the fringe benefit exclusion provisions
generally only apply to “employees”.
The 2% shareholders must generally include the fringe benefit in gross
income. A deduction may be available in some cases (e.g., Section
162(l)).
The S corporation should issue the 2% shareholder a W-2 with respect
to the fringe benefits, although Social Security and Medicare generally
do not apply.
The S corporation may be able to deduct the cost of the fringe benefits
as a business expense under Section 162.
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Part VI.
Common S Corporation Mistakes
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Payroll Requirements
Shareholders will receive a Schedule K-1 showing the shareholders’
pro rata share of S corporation items. However, if the shareholders
are also employees, the S corporation must appropriately apply the
payroll provisions to the employee shareholders.
This includes making payroll tax deposits, filing quarterly payroll tax
returns, and issuing W-2s.
Employee shareholders must be paid reasonable compensation.
If there are fringe benefits, S corporation should include the fringe
benefits in the W-2 as discussed earlier in the presentation.
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Subchapter S Election
Certain elections, such as the REIT election, are made when you file
the tax returns. This is not the case with the S election.
Form 2553 (the election form) provides that the effective date for the
election may be no more than 75 days prior to the date that the
election was filed.
File the Form 2553 before the start of the tax year to which you want
the election to apply or within the first 75 days of that tax year.
For newly formed entities, file the election within 75 days of the date
that the entity was formed. Do not file before the entity is formed as
the election will not be valid.
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Subchapter S Election
Form 2553 must be signed by all shareholders to be effective.
If the entity is an LLC, the check the box regulations by default treat
the LLC as a partnership or a disregarded entity. However, the filing
of the Form 2553 will result in a deemed corporate election for the
LLC. A separate Form 8832 will not be required. Treas. Reg. sec.
301.7701-3(c)(1)(v)(C).
Late elections may qualify for relief under the provisions found in
Treas. Reg. sec. 301.9100-1 et seq.
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QSUB Election
An S corporation can elect to treat eligible subsidiaries as a qualified
subchapter S subsidiary (QSUB), which means that it is disregarded
as a separate corporation for federal income tax purposes.
Election is made by filing Form 8869 with IRS.
Election can be made any time, but it can be effective no more than 75
days before the date on which the election is filed or more than twelve
months after the election is filed.
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QSST Election
Only certain trusts can be shareholders in an S corporation, and these
trusts include a qualified Subchapter S trust (QSST) and an electing
small business trust (ESBT).
A QSST is a trust all of which is treated as owned by an individual that
is a U.S. citizen or resident (i.e., treated as a grantor trust). The
beneficiary must make an election to treat the trust as a QSST.
The election must be made within 16 days and 2 month period (i.e., of
the entity becoming an S corporation, of the stock being transferred to
the trust, etc.).
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QSST Election
Form 2553 is also used to make the QSST if the entity is making an S
election.
If a Form 2553 is not being filed, then the election must be made by
filing a statement with the IRS Service Center where the S corporation
files its federal income tax return.
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QSST Statement
Statement is signed by the income beneficiary or his representative
and includes:
º
contains the name, address, and taxpayer identification number of the current
income beneficiary, the trust, and the S corporation,
º
identifies the election as an election under Section 1361(d)(2),
º
specifies effective date of election,
º
specifies date of stock transfer to trust, and
º
provides certain information and representations establishing that the trust
should be treated as a grantor trust.
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ESBT
An ESBT is a trust that
º
does not have beneficiaries other than individuals, estates or certain charitable
organizations,
º
no interest in the trust may have been acquired by purchase,
º
no QSST election has been made with respect to any stock held by the trust,
º
the trust is not tax-exempt, a charitable remainder annuity trust or a charitable
remainder unitrust, and
º
an ESBT election has been made.
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ESBT Statement
Election statement is signed by trustee and filed with IRS Service
Center where the S corporation files its federal income tax return
within 16 days and 2 month period:
º
contains the name, address, and taxpayer identification number of all potential
current beneficiaries,
º
identifies the election as an election under Section 1361(e)(3),
º
States the first date on which the trust owned stock in S corporation,
º
specifies effective date of election (no earlier than 75 days), and
º
representations that (a) trust meets all requirements of an ESBT and (b) that
the potential current beneficiaries meet the shareholder requirements.
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ESBT Statement
ESBT can hold stock in more than one S corporation.
If it does, may have to file election statement with multiple IRS Service
Centers depending on where S corporations file their federal income
tax returns.
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Disproportionate Distributions
One of the requirements for an S Corporation is that the entity have
only one class of stock. This requires that all corporate distributions to
shareholders be pro rata.
Providing benefits to certain shareholders (e.g., use of corporate
property) or excessive compensation to certain shareholders may
result in the transaction being recharacterized as a distribution to
those shareholders.
Disproportionate distributions could result in the entity having more
than one class of stock and losing its S qualification. If S status is
revoked, there is a 5 year waiting period to reelect.
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Section 1366 Basis Limitation
Section 1366(d) provides that a shareholder may not utilize losses or
deductions in excess of the shareholder’s basis in (i) its stock of the S
corporation, and (ii) any debt owed by the S corporation to the
shareholder.
Simply because the shareholder’s K-1 shows a pro rata share of items
of deductions and losses does not mean they can be utilized.
Losses and deductions in excess of basis will be suspended until the
shareholder has sufficient basis. However, if the shareholder sells or
transfers its interest without utilizing the suspended losses or
deductions, they are permanently lost.
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Stock Basis
• Generally, initial basis equals the cost paid for the stock. If
property was contributed for stock, then basis equals basis of
property contributed, adjusted for gain recognized and boot
distributed.
• Increased by
º
º
º
Additional capital contributions
Share of S corporation income (including exempt income)
Excess of depletion deductions over basis
• Decreased by
º
º
º
Share of S corporation losses, deductions, and depletion
Share of noncapital, nondeductible expenses (e.g. penalties or bribes).
Certain distributions
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Debt Basis
Debt basis – General rule
º
º
º
Initial basis equals the cost of the debt.
Decreased by the repayment of principal.
Reduced to zero if the debt becomes worthless.
When making the adjustments listed in the previous slide, the
adjustments are generally made to the shareholder’s stock basis, not
its debt basis. However, stock basis can only be reduced to zero. If
there are additional decreasing adjustments to be made, the
adjustments will then be made to reduce debt basis. If this occurs,
when the S corporation later has income items, the basis increase will
first restore the debt basis before increasing stock basis.
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Debt Basis
For example, Shareholder A has stock basis of $25 and debt basis of
$100. A’s pro rata share of loss items is $50.
A’s stock basis is reduced to $0, and A’s debt basis is then reduced to
$75.
In the next year, A has a pro rata share of income items of $30.
The first $25 of the $30 of income is applied to increase A’s debt basis
back to $100. The remaining $5 is then applied to increase A’s stock
basis.
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Debt
Shareholders get basis for debt owed by the S corporation to the
shareholder, not for debt owed by the S corporation to some party
other than the shareholder. This is the case even if the shareholder
guarantees the debt. This is a substantial divergence from
partnerships.
If an S corporation is incurring debt to make acquisitions such as to
purchase equipment, consider having the shareholder incur the debt
then loan the money to the S corporation, especially if (i) Section 1366
is hindering the shareholder’s ability to utilize losses and deductions
and (ii) lender is requiring personal guarantee from shareholder
anyway.
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Debt
Be careful that the terms of the loan are respected as debt. If debt is
recharacterized as equity, the result is often a second class of stock
(revoking S status). For example, debt with an annual interest
payment of 8% could be treated as preferred stock if it has many
equity features.
Section 1361(c)(5) provides straight debt safe harbor.
º
º
º
Interest rate and payments not contingent on profits or borrower’s discretion,
No convertibility of debt into stock or equity, and
Creditor is an individual, estate, ESBT, QSTT or a person (other than an
individual) that is actively and regularly engaged in business of lending money.
Any shareholder loans should be properly reflected on Schedule L.
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Circular 230
To comply with Treasury Department regulations, we inform you that,
unless otherwise expressly indicated, any tax advice contained in this
communication (including any attachments) is not intended or written to
be used, and cannot be used, for the purpose of (i) avoiding penalties
that may be imposed under the Internal Revenue Code or any other
applicable tax law, or (ii) promoting, marketing or recommending to
another party any transaction, arrangement, or other matter.