Chapter 1
S Corporation Current Developments
Learning Objectives
Upon completion of this chapter, you will

Understand the new rules relating to S corporations.

Be aware of any new rulings or court cases that impact S corporations.
Introduction
In this chapter, we will discuss the following:

Changes made by the American Recovery and Reinvestment Act of 2009

Changes made by the Tax Extenders and AMT Relief Act

Changes made by the 2008 Economic Stimulus Bill

Changes made by the Small Business and Work Opportunity Tax Act of 2007
(SBWOTA)

Changes made by the Gulf Opportunity Zone Act of 2005 (GOZA)

Changes made by the American Jobs Creation Act of 2004 (AJCA)

Changes made to depreciation deductions

Domestic Production Activities Deduction

New rulings concerning S corporations

Potential S corporation changes in the future
The rules governing the taxation of S corporations were originally enacted in 1958. Substantive
revisions were made by the Subchapter S Revision Act of 1982 (SSRA). Additional revisions
were made by the tax acts in 1986, 1987, 1996, and 2002. The Small Business and Work
Opportunity Tax Act of 2007 (SBWOTA) and the American Jobs Creation Act of 2004 (AJCA)
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are the latest tax acts to have a major impact on the rules regarding the taxation of S
corporations.
In this chapter we will review the changes made by the SBWOTA and the AJCA, as well as
changes made by the American Recovery and Reinvestment Act of 2009, the Tax Extenders and
AMT Relief Act, the 2008 Economic Stimulus Act and the Gulf Opportunity Zone Act of 2005.
In addition, some of the latest rulings by Treasury, the Internal Revenue Service, and the Court
system will be discussed.
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American Recovery and Reinvestment Act of 2009
The American Recovery and Reinvestment Act of 2009 (ARRA) was signed into law on
February 17, 2009. ARRA affects S corporations and their shareholders in several ways. First,
due to the economic problems that many companies are facing, Congress allowed regular tax and
AMT net operating losses (NOLs) arising in tax years ending in 2008 to be carried back three, four,
or five years if the taxpayer is eligible and so elects. To be an eligible small business, the business’s
average gross receipts for 2008, 2007, and 2006 must be less than $15 million. In the case of an S
corporation and its shareholders, both must meet the eligible small business test. Note that gross
receipts includes net sales, unreduced by cost of goods sold, tax-exempt income, cancellation of
debt (COD) income, original issue discount, etc.
Second, Sec. 1374(d)(7) was enacted, which exempts for 2009 and 2010 Sec. 1374’s built-in gain
(BIG) imposition if the S corporation is in its eighth, ninth, or tenth year of the recognition period.
This will result in a significant cash flow savings for some S corporations and will require
substantial tax planning from the tax adviser. For example, if an installment sale of BIG property
had occurred in a prior year, it may be advisable to recognize the gain in 2009 or 2010, assuming it
qualifies as an eligible year. It may even be prudent to trigger the installment gain by using the
installment note as collateral for a loan.
The AICPA’s S Corporation Technical Resource Panel is requesting clarification from Treasury on
a number of issues related to this BIG holiday. For example, if the taxpayer’s net recognized built-in
gain is limited by taxable income in its eighth recognition period year (2009) and in 2011 it is
subject to BIG, is the 2009 suspended gain forgiven or subject to Sec. 1374 tax? In addition, there
seems to be a difference in which years qualify as eighth, ninth, or tenth for Sec. 1374 as opposed to
the carryover basis rules of Sec. 1374(d)(8). For the former, tax year seems to be the criterion. Thus,
in switching from a C fiscal year to an S calendar year, a corporation may have had a short tax year.
For the carryover basis provisions, the law seems to look to 12-month periods. Whether this is a
drafting error or the intention of Congress remains to be seen.
Third, Sec. 108(i) was enacted to allow COD income normally recognized in 2009 or 2010 to be
deferred to 2014, when it will be taxed over five years. This is available when the borrower or a
party related to the borrower buys back the debt. The tax adviser must be aware of a variety of
events that may trigger early recognition of the deferred gain, including passthrough entity owners’
sale of their interest. This may not be an optimal election if NOLs are available to offset the (COD)
income. In addition, if the taxpayer is bankrupt, the (COD) income is not taxable, but if the taxpayer
elects to postpone the gain under Sec. 108(i), it would be taxable. Unfortunately, there are many
unanswered questions that will arise relative to this deferral, and the AICPA’s S Corporation
Technical Resource Panel has asked Treasury to clarify many of these issues.
Fourth, private activity bond interest is exempt from AMT for bonds issued in 2009 and 2010,
which may affect investment strategies of S corporations and their shareholders.
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2008 Tax Extenders and AMT Relief Act
The 2008 Tax Extenders and AMT Relief Act (TEARA) was signed into law on October 3,
2008, and had a significant direct and indirect impact on S corporations and their shareholders.
Tax Preparer Penalty
Tax advisers are likely aware that for tax returns prepared after May 22, 2007, the substantial
authority standard continues to apply, rather than the more-likely-than-not (MLTN) requirement
for returns that are not considered tax shelters or that contain listed transactions. If the position is
disclosed, the reasonable basis standard is sufficient to avoid penalties. Also note that the
extension of tax preparer penalties to gift tax returns, estate tax returns, payroll taxes, etc., has
not been repealed.
Research and Development Credit
Some S corporations are performing Sec. 174 R&D and are eligible for Sec. 41 R&D credits that
would pass through to their shareholders. TEARA extended the R&D credit for 2008 and 2009
and repealed the alternative incremental credit for tax years beginning after December 31, 2008.
For tax years ending after December 31, 2008, it also increased the simplified credit now being
used by many taxpayers to 14% from 12%.
TEARA also includes provisions that extend to 2008 and 2009 the expensing of environmental
remediation costs and the 15-year amortization of qualified restaurant and leasehold
improvements.
Charitable Contribution of Appreciated Property and Stock Basis
The IRS issued Rev. Rul. 2008-16 to clarify the adjustments to S stock basis for the contribution
of appreciated property by an S corporation to a qualified charitable organization. Essentially,
the treatment is that a shareholder’s adjusted basis in stock is increased by the appreciation
embedded in the gifted property and is then reduced by the fair market value (FMV) of the
property gifted (but not below zero). Originally, these rules applied only to 2006 and 2007, but
TEARA extended their application to 2008 and 2009. It should be noted that the charitable
contribution is still subject to Sec. 1366(d) limitations and Sec. 170 50% or 30% adjusted gross
income limits.
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The Small Business and
Work Opportunity Tax Act of 2007
The SBWOTA ’07 had several provisions that affected S corporations. For the most part these
provisions were pro-taxpayer and, unless otherwise noted, will be effective for years beginning
after December 31, 2006. Some of these will be presented here and others will be discussed in
Part II of the article.
Bank S Corporations
Two provisions of the new law relate to banks that have elected to be S corporations. As of
March 2005, 2,237 banks had switched to S corporation status. However, only banks (usually
community banks) that do not use the reserve method of accounting for bad debts can elect to be
S corporations. If the bank changes from the reserve method of accounting for bad debts, a Sec.
481 adjustment must be made; this adjustment generally is included in income over four years.
New Sec. 1361(g) allows the bank to elect to take into account 100% of the adjustment the year
before it changes to an S corporation, when it is still a C corporation. Therefore, the bank takes
the adjustments into account at the entity level (where it enjoyed the benefit of the previous
deduction) rather than at the shareholder level.
A second provision helpful to bank S corporations relates to bank director shares. National and
state banking laws require a bank’s director to own stock. In some cases, a bank will enter into
an agreement in which the bank will reacquire the stock when the director ceases to hold the
office. Requiring all directors to own stock could create a problem with the shareholder limit,
while the repurchase agreement could create a second class of stock. Both of these issues would
cause the termination of an S election. New Sec. 1361(f)(1) clarifies that qualifying “restricted
bank director shares” are not recognized for any subchapter S provisions. New Sec. 1368(f)(1)
also treats any distributions on this restricted stock as income to the director and deductible to the
bank.
Note. An interesting question is whether this restricted-bank-director-stock-disregarded status
would allow directors to own stock in a qualified subchapter S subsidiary (QSub) and not
disqualify the subsidiary bank.
Accumulated Earnings and Profits
If an S corporation has accumulated earnings and profits (AE&P) at the end of the year and more
than 25% of its gross receipts are from passive investment income (PII), the S corporation will
be subject to a corporate-level tax. The 2007 act reduces the possibility of an S corporation being
subject to this tax. Under new Sec. 1362(d)(3), capital gains on stocks and securities will not be
treated as PII under Secs. 1362(d) and 1375. In a related provision, the new law eliminates S
corporation previously taxed income (PTI) attributable to pre-1983 years for corporations that
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were not S corporations for their first taxable year beginning after December 31, 1996. These
two provisions apply to tax years beginning after May 25, 2007.
Electing Small Business Trust
Another new provision makes an S corporation a slightly more attractive vehicle for investments.
Sec. 641(c)(2)(C)(iv) allows an electing small business trust (ESBT) to deduct any interest
expense it incurs when it borrows funds to purchase S stock. This provision places an ESBT on
par with all other taxpayers, including qualified subchapter S trusts (QSST), for the deduction.
Because ESBT income is taxed at the highest individual rate, this change allows a tax deduction
at a 35% tax rate.
More Likely Than Not Standard
A far more anti-taxpayer provision that affects all taxpayers (including S corporations and their
shareholders, as well as tax practitioners) is the expansion of Sec. 6694, under which tax
practitioners must use a “more likely than not” standard on undisclosed positions for returns
prepared after May 25, 2007. (This is in contrast to the “realistic possibility of success” standard
that practitioners previously used.) In addition, the amount of the Sec. 6694 penalty has been
increased. The revisions to Sec. 6694 constitute major changes to practice standards and
penalties that have been in place for many years. Two instances in which this new provision
could affect S corporations are (1) basis in debt due to back-to-back loans and (2) the calculation
of built-in gain under Sec. 1374.
Qualified Subchapter S Subsidiaries
The SBWOTA has both direct and indirect impact on S corporation tax planning. First, a trap
for the unwary has been eliminated. Some S corporations have set up 100%-owned qualified
subchapter S subsidiaries (QSubs) for various business, liability protection, and state tax reasons.
If the Parent S corporation were to sell more than 20% of the QSub stock, a taxable sale would
occur, causing recognition of all of the appreciation (not just the part sold), as Sec. 351 would
not be available to shield the unsold portion of the assets. The new law treats the sale of more
than 20% of the stock as a deemed pro rata sale of the assets (Sec. 1361(b)(3)(C)(ii)).
Consider an S corporation that is setting up a strategic alliance with another company and sells
49% of the stock of its existing QSub to a new partner. Before the 2007 law change, 100% of the
gain would have been recognized because the S corporation did not own 80% of the company.
Under the new law, if 49% of the stock were sold, only 49% of the appreciation would be
recognized. The S corporation would still be deemed to own 100% of the stock, and Sec. 351
would protect the remaining 51% of the gain from being recognized. This tax law change is
effective for transactions after December 31, 2006.
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The American Jobs Creation Act of 2004
S Corporations and Shareholders
The AJCA contains several taxpayer-friendly S corporation provisions. Unfortunately, there is a
trade-off; the rules are a bit more complicated and, in some cases, may help only a handful of
taxpayers. Most of the changes relate to banks that are S corporations.
Increase in the Number of S Shareholders
Prior to the AJCA, an S corporation could have no more than 75 shareholders. For this purpose, a
husband and wife (and their estates) were treated as one shareholder. This limit is increased to
100 under AJCA Section 232(a). According to AJCA Section 231(a), all family members are
counted as one shareholder, if a family member so elects.
A family, for this purpose, consists of a common ancestor, and his or her lineal descendants and
their spouses (and former spouses). The common ancestor can be no more than six generations
removed from the youngest generation of family members who are shareholders. Indirect
ownership, such as a beneficiary of an ESBT or QSST will also be included in the one family
member count. Importantly, the “oneness” of husband and wife and of family members applies
only to the 100-shareholder limit. Thus, each shareholder (including each family member), as
well as husband and wife, who owns stock on the S election date, must consent to the election.
This liberalized treatment does not include nephews, nieces, and cousins as they are not lineal
descendants. These provisions apply to tax years beginning after 2004.
The Gulf Opportunity Zone Act of 2005 eliminated the requirement of an election in order for a
family to be treated as one shareholder, providing instead that members of a family would
automatically be treated as one shareholder for purposes of Code Section 1361(b)(1)(A).
Another change related to the number of shareholders an S corporation can have can be found in
Section 231 (b) of the AJCA. This section amends Sec. 1362(f) to provide that an inadvertently
invalid election or termination under this rule may be waived by the IRS. However, the
conditions of Sec. 1362(f) (e.g., inadvertence, corrective steps, and agreement to IRS conditions)
must be met.
IRA as a Bank S Shareholder
Congress was concerned that the strict rules regarding S corporation shareholders prevented
small and community banks from qualifying as S corporations. One of the prohibited S
shareholders is an IRA. This prohibition comes from Revenue Ruling 92-73.1 Based on this
ruling a trust was permitted to be a shareholder of an S corporation only if the trust was
1
Rev. Rul. 92-73; 1992-2 C. B. 224; July 1992.
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described in Section 1361(c)(2)(A)(i) or was a qualified subchapter S trust (QSST) that was
treated as a trust described in Section 1361(c)(2)(A)(i) because the beneficiary so elected under
Section 1361(d). In either case, the beneficiary was taxed currently on the trust's share of S
corporation income, deductions, and credits. By contrast, the beneficiary of an IRA which is a
Section 408(a) trust was taxed when distributions were made from the trust and taxed in the
manner provided under Section 72. Thus an IRA could not be a trust described in I.R.C. Section
1361(c)(2)(A)(i) or a QSST treated as a trust because the rules that applied to a trust described in
Section 1361(c)(2)(A)(i) or a QSST treated as such a trust were incompatible with the rules that
applied to an IRA. Some relief was provided by Revenue Procedure 2004-142 which provided
that if certain requirements are met [including immediate repurchase of the stock by the S
corporation or employee stock ownership plan (ESOP)], a corporation's S status will not
terminate on a direct rollover of the corporation's stock from the ESOP to a participant's IRA.
AJCA Section 233 now allows certain IRAs (including a Roth IRA) to be shareholders of a bank
S corporation. However, this provision applies only to the extent of bank stock held by an IRA
on Oct. 22, 2004. Under these rules, for most purposes, an IRA beneficiary is deemed the
shareholder of the bank S corporation. Thus, the beneficiary, and not the IRA, is the consenting
authority for purposes of (1) an S election, (2) revocation of an S election, (3) rescission of a
revocation and (4) the election not to allocate income on the pro rata method during an S
termination year. Presumably, the beneficiary is the consenting authority for other subchapter S
elections made by the bank that require shareholder consent.
Unfortunately, the IRA's interest in the bank S is treated as an interest in an unrelated trade or
business; thus, all items of income, loss, or deduction that flow through to the IRA from the bank
S and the gains and losses on the IRA's disposition of the bank's stock, are taken into account in
computing the IRA's unrelated business taxable income.
Important Note. The allowance of IRAs as S shareholders applies only to bank S corporations.
This relaxing of the rules does not apply to any other type of S corporation. Each year there are
several private letter rulings (PLRs) requesting inadvertent termination relief because S
corporation stock was transferred to an IRA. To date, the IRS has allowed inadvertent
termination in most instances but there is no guarantee that will continue. Practitioners should
make sure their clients that own S corporation stock understand that it cannot be put in an IRA.
Below are a few of the PLRs that were issued in the last few years regarding IRAs.
An IRA,3 an ineligible shareholder, acquired an S corporation’s stock pursuant to a court order
regarding the dissolution of the shareholder’s marriage. The shareholder had held the S stock in
a 401(k) account and was required to transfer it to his ex-wife’s IRA. When the problem was
discovered, the shares were transferred to the ex-wife. Since the issuance was not for tax
avoidance or retroactive tax planning purposes, the IRS ruled that the termination was
inadvertent.
2
3
Rev. Proc. 2004-14; 2004-1 C. B. 489; February 17, 2004.
IRS Letter Ruling 200621003 (2/8/06).
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In Letter Ruling 2006190184 an S corporation issued stock to two IRAs. When the company
discovered the problem, the shares were transferred to the beneficiaries of the IRAs. The IRS
determined that the termination of the S corporation election was inadvertent contingent on the S
corporation treating the beneficiaries of the IRAs as the shareholders from inception.
In another instance5 S corporation stock was inadvertently issued to an IRA rather than to the
individual that owned the IRA. When the error was found the corporation redeemed all the stock
issued to the IRA. In addition, the corporation treated the owner of the IRA as the owner of the
stock. The Service concluded that the termination of the S election was inadvertent and the IRA
owner would be treated as the owner of the stock.
Sale of IRA’s Stock
Under new Internal Revenue Code (IRC) Section 4975(d)(16), as added by AJCA Section
233(c), the IRA's sale of the bank's S stock to the IRA beneficiary is not a prohibited transaction
after October 22, 2004, assuming the

Stock is held by the IRA on Oct. 22, 2004;

Sale is pursuant to an S election by the bank;

Sale is for FMV (as established by an independent appraiser). In addition, the terms of
the sale must be at least as favorable to the IRA as they would be on a sale to an unrelated
party;

IRA incurs no commissions, costs or expenses in connection with the sale; and

Stock is sold in a single transaction for cash, not more than 120 days after the S election
is made.
Note. The effective date of the S election is not relevant.
Passive Investment Income Exclusions for Bank S Corporations
If an S corporation has Subchapter C accumulated earnings and profits (AEP), it must carefully
monitor the composition of its gross receipts. An S corporation with positive E&P and excessive
passive investment income (PII) may encounter negative consequences – the Sec. 1375 tax and
Sec. 1362(d)(3) termination of S status if the S corporation has excess PII for three consecutive
years. The AJCA changed the definition of passive income for banks and bank holding
companies that are S corporations. Effective for tax years beginning after 2004, for certain
banks, bank holding companies and financial holding companies, PII does not include (1)
4
5
IRS Letter Ruling 200619018 (5/12/06).
IRS Letter Ruling 200542007 (10/21/06).
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interest income and (2) dividends on assets required to be held by such bank or company (e.g.,
Federal Reserve, FHLB stock, or participation certificates).
Electing Small Business Trust (ESBT) Potential Current Beneficiary
Under Sec. 1361(c)(2)(A)(v), an electing small business trust (ESBT) is an eligible S
shareholder. According to Sec. 1361 (e)(2), an ESBT's potential current beneficiary (PCB) for
any period is any person who at any time during that period is entitled to receive, or at the
discretion of any person may receive, a distribution from the trust's principal or interest. In
determining whether a corporation is a small business corporation, each PCB is treated as a
shareholder. Thus, a PCB who is a nonresident alien will terminate the S election. In addition,
each PCB counts toward the shareholder limit unless it is part of an electing family.
Under Regs. Sec. 1.1361-1(m)(4)(vi), any person to whom a distribution is or may be made
during a period, pursuant to a power of appointment, is a PCB. Even if the power were
unexercised, a person who may have been designated to receive a current distribution was a
PCB. Thus, if A, a trust beneficiary, has a current power to appoint income or principal of the
trust to anyone except A, A's creditors, A's estate and creditors of A's estate, everyone in the
world would be a PCB except for A and the aforementioned estate and creditors. As a result, the
100-person S shareholder limit would be exceeded and the S election would terminate. Example
7 of Regs. Sec. 1.1361-1(m)(8) explains the problems that the excess number of shareholders
could cause. However, for tax years beginning after 2004, unexercised powers of appointment
are ignored for PCB purposes under Sec. 1361(e)(2), as amended by AJCA Section 234. The
new law also extends the period during which an ESBT can dispose of S stock after an ineligible
person becomes a PCB (and, thus, avoid S termination) from 60 days to one year. This change
overrides Regs. Section 1.1361-1(m)(4)(vi). New proposed regulations would remove and
replace sections of the old regulations that are inconsistent with current law.
In addition, the proposed regulations amend the definition of “potential current beneficiary” to
provide that all members of a class of unnamed charities permitted to receive distributions under
a discretionary distribution power held by a fiduciary that is not a power of appointment, will be
considered, collectively, to be a single PCB for purposes of determining the number of
permissible shareholders under Section 1361(b)(1)(A) unless the power is actually exercised, in
which case each charity that actually receives distributions will also be a PCB. The amended
PCB definition does not apply to a power to make distributions to or among particular named
charities.
The proposed regulations also provide that a power to add beneficiaries, whether or not
charitable, to a class of current permissible beneficiaries, whether or not charitable, is generally a
power of appointment and thus will be disregarded to the extent it is not exercised.
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Transfers of Suspended Losses to Spouse or Former Spouse
Sec. 1366(d) generally provides that if an S shareholder is allocated losses that exceed the sum of
his or her S stock and debt basis, the excess is suspended and carried forward. Under prior law,
the suspended loss was personal to the shareholder and could not be transferred to another
person. This limitation resulted in a fairly common problem when stock was transferred to a
spouse in a divorce. Section 1366(d)(2)(B), as amended by AJCA Section 235(a), makes an
exception to the nontransferability rule for certain stock transfers to a shareholder's spouse (or
former spouse) incident to a divorce, for tax years beginning after 2004. Under the new rule any
suspended loss under Section 1366(d)(2)(B) related to stock that is transferred under Sec.
1041(a) will carry over to the transferee or former spouse.
Final regulations were issued in August 2008 dealing with the appropriate treatment of a divorce
where S corporation suspended losses exist. Basically, in the year of the divorce and the dividing
of the S corporation shares per Sec. 1041, each party picks up his or her share of current year
activity, and the transferor gets all the suspended losses, if sufficient basis exists in the year of
transfer. In the year after transfer, the suspended losses are split between the transferor and
transferee by their respective ownership at the beginning of that year.
Example 1-1
A owns 100% of X Corp., an S corporation, in 2007. X has current and suspended
losses of $100,000, and A has no basis in stock or debt. In 2008, X has a loss of
$80,000, and in July A and B divorce, and A transfers one-half of the X stock to B. B is
entitled to $20,000 in losses (½ year × ½ stock × $80,000), and A is entitled to all the
$100,000 suspended losses from 2007 and $60,000 of the current-year loss, subject to
having sufficient basis for loss purposes. In 2009, X has a $70,000 loss. B would be
entitled to $35,000 of the 2009 loss plus $50,000 of the suspended loss plus $20,000 of
the 2008 loss. A would be entitled to a $35,000 2009 loss plus a $50,000 2007 and
before suspended loss plus his $60,000 2008 loss.
Example 1-2
Assume the same facts as in Example 1-1, but A contributes $10,000 in 2008. Then he
would be able to use current and suspended losses against his basis. Thus, $6,250
($100,000 ÷ $160,000 × $10,000 basis) would be losses allocated to A from the
suspended account and $3,750 ($60,000 ÷ 160,000 × $10,000) would be allocated to A
from the current loss and be deductible to A at the individual level. Therefore, B would
be allocated in 2009 half of the $93,750 suspended loss.
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Use of Passive Activity Losses and At-risk Amounts by a QSST
Beneficiary
Under Sec. 1361(d)(1), a qualified subchapter S trust (QSST) is a permitted S shareholder, and
its current income beneficiary is treated as the Sec. 678 owner of the portion of the trust
consisting of S stock. Thus, the trust's share of the S corporation's income, loss, and deduction
items flows directly to the current income beneficiary.
However, under Regs. Sec. 1.1361-1(j)(8), the QSST, not the current income beneficiary, is
treated as the S stock owner in determining and attributing the tax consequences of a stock
disposition. This interpretation created problems when S losses flowed through to the current
income beneficiary, only to be suspended by the passive activity loss (PAL) or at-risk rules. A
taxpayer's suspended PAL associated with an activity is generally freed up under Sec. 469(g) on
the taxpayer's sale of the entire activity in a fully taxable transaction to an unrelated party.
However, because the QSST's sale of the S stock was attributed to the trust, not the current
income beneficiary, it was unclear under prior law whether the current income beneficiary's PAL
would be freed up on such sale.
As amended by AJCA Section 236, effective for transfers after 2004, a QSST's disposition of S
stock is treated as a disposition by the current income beneficiary when applying the at-risk and
PAL rules, under Sec. 1361(d)(1)(C). Thus, any PAL (with respect to the S activity) of the
current income beneficiary would be freed up under Sec. 469(g), if the QSST were to sell all its
S stock. Presumably, any gain recognized by the trust on such sale would also increase the
current income beneficiary's at-risk amount, thereby freeing up any losses that had been limited
because the current income beneficiary was not at-risk for the loss. The new proposed
regulations add conforming language to Regs. Sec. 1.1361-1(j)(8).
QSub Relief
The AJCA made two changes for qualified subchapter S subsidiaries (QSubs). First, under AJCA
Section 238, the IRS can waive inadvertently invalid QSub elections and terminations that occur
after 2004, if the conditions of Sec. 1362(f) (e.g., the invalid election or termination was
inadvertent, the QSub and S corporation took corrective steps to correct the error, and they
agreed to the IRS’s conditions) are met. Second, under Sec. 1361(b)(3)(A), as amended by AJCA
Section 239, Treasury can provide guidance on QSub information returns for tax years beginning
after 2004. Prior to this change this was an area where Treasury would not issue a ruling.
Sec. 357(c)
AJCA Section 898(b) makes a taxpayer-friendly amendment to Sec. 357(c) which, among other
things, eliminates a trap for certain common QSub transactions.
For example if Individual F owns all of the stock of two corporations, X and Y. X is an S
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subsidiary, rather than as brother-sister corporations. Thus, pursuant to a plan, F contributes all
the Y stock to X and X then makes a QSub election for Y.
Under the step transaction doctrine, this transaction would be deemed a nondivisive D
reorganization, assuming the other conditions for a reorganization (e.g., continuity of business
enterprise) are met. An explanation of how this would work can be found in Example 3 of Regs.
Sec. 1.1361-4(a)(2)(ii). Under prior law, this could have been a trap if the liabilities of Y
deemed assumed by X exceeded Y's total basis in its assets. Such excess would have been
recognized as a gain under Sec. 357(c). Effective for transactions after October 21, 2004,
however, Sec. 357(c) (this rule applies to all corporations in general, not just to QSubs) no longer
applies to nondivisive D reorganizations. Sec. 357(c) gain is now limited to property transferors
in Sec. 351 transactions and divisive D reorganizations, thus deactivating the aforementioned
QSub trap.
Repayment of Loans for Qualifying Employee Securities
Prior to 2004, an S corporation maintained ESOP could be deemed to create a second class of
stock if the proceeds received from a distribution under Section 1368(a) were used to make
principal and interest payments on a loan used to acquire the employer securities. AJCA Section
240(a) adds new Section 4975(f)(7), which provides that an S corporation maintained ESOP does
not violate any Code qualification requirement or engage in a prohibited transaction merely
because the proceeds from a distribution were used in this manner. This new relief provision is
retroactively effective for distributions on S stock made after 1997, and is analogous to one for C
corporations with ESOPs.
Audit-Related PTTP
After an S election terminates, any suspended Sec. 1366 losses can be claimed only during a
post-termination transition period (PTTP), up to the amount of stock basis as of the last day of
the PTTP. Also, under Sec. 1371(e), cash distributions by the former S corporation to
shareholders during a PTTP generally are deemed made first out of the corporation's
accumulated adjustments account (AAA). The PTTP begins on the day after the last day a
corporation is an S corporation and end the later of one year after termination, the due date
(including extensions) of the final S return, or 120 days after a final determination (e.g., court
decision) that the S election was terminated.
The PTTP rules were amended, not by the AJCA, but by the Working Families Tax Relief Act of
2004 (WFTRA), effective retroactively to tax years beginning after 1996. WFTRA Section
407(a) focuses solely on the 120-day audit-related PTTP. Under new Sec. 1377(b)(3), suspended
losses do not carry over to the 120-day, audit-related PTTP. Essentially, if adjustment to S
taxable income increases shareholder basis, any suspended losses can be deducted only on prior
shareholder tax years. In addition, cash distributions during the 120-day, audit-related PTTP are
deemed to come from AAA only to the extent of any increase in AAA due to the audit
adjustments.
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During 2007, Treasury issued final regulations that provide guidance on changes made by the AJCA
and the GO Zone Act to the rules governing S corporations. Specifically, the regulations address
three S corporation issues:
1. The S corporation family shareholder rules;
2. The definition of “powers of appointment” and “potential current beneficiaries” regarding
an electing small business trust (ESBT); and
3. The allowance of suspended losses to the former spouse of an S corporation shareholder.
A major change in the AJCA was to treat family members as one shareholder. Notice 2005-91 was
issued to give guidance on who would be treated as a family member. The regulations retain the
provisions of Notice 2005-91 that describe certain entities other than individuals that will be treated
as members of the family. In addition, the regulations clarify that the “six-generation” test is applied
on the latest of (1) the date the S election is made; (2) the earliest date an individual who is a
member of the family holds S stock; or (3) October 22, 2004.
A question that arises related to an ESBT is what provisions qualify as a power of appointment. The
regulations state that the ability to add beneficiaries to an ESBT is generally a power of appointment
but will be disregarded to the extent it is not exercised. Another important issue for ESBTs is who is
considered a potential current beneficiary. The regulations amend the definition of “potential current
beneficiary” to provide that all members of a class of unnamed charities that may receive
distributions are to be treated as one potential current beneficiary. However, each named charity is
treated as a separate potential current beneficiary and thus a separate shareholder.
Finally, the AJCA allowed ex-spouses to use suspended losses if the ex-spouse received the S stock
under a divorce decree. The regulations explain how the suspended losses should be allocated
between the two spouses. The transferor spouse will be allowed to use all of a suspended loss from
previous years in the year the stock is transferred. Any loss that is not used in the year the stock is
transferred must then be prorated between the shares owned by the transferor spouse and the
transferee spouse based on their ownership at the beginning of the succeeding tax year.
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Example 1-3
A owns all 100 shares of an S corporation. As of December 31, 2006, A has a zero basis
in his S corporation shares. For 2006, the S corporation has $100 in losses, which A
cannot use because of the basis limitation under Sec. 1366(d)(1). On July 1, 2007, A
transferred 50 shares to B, A’s former spouse pursuant to a divorce that qualified under
Sec. 1041(a). The S corporation has an $80 loss in 2007.
For 2007, the year of the transfer, A may deduct the entire $100 suspended loss from
2006 and his share of the 2007 loss [$60 = (80 × .50 for the first half of the year) + (80 ×
.25 for the second half of the year)] if he has acquired sufficient basis in the S corporation
stock. B can deduct her share of the 2007 loss ($20 = 80 × .25) assuming she has
sufficient basis in the stock.
However, if A cannot use any of the 2006 disallowed loss in 2007, that loss is prorated
between A and B based on their stock ownership at the beginning of 2008. In this case, A
will be deemed to have a $50 suspended loss from 2006 and a $60 suspended loss from
2007 at the beginning of 2008, while B will have a $50 suspended loss from 2006 and a
$20 suspended loss from 2007.
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Cost Recovery
Bonus Depreciation and Sec. 179
The 2002 tax act had introduced a 30% or 50% bonus cost recovery regime which allowed
businesses to write off an additional amount of the purchase price instead of having to capitalize
the asset and depreciate it over the MACRS life. Surprisingly, the AJCA did not extend the 30%
or 50% bonus cost recovery regime, thus subjecting assets placed in service after 2004 to the
modified accelerated cost recovery system for depreciation and AMT adjustments.
The 2002 tax act also increased the amount that could be written off under Section 179 to
$100,000 per year assuming the business met the requirements. AJCA Section 201 extended the
increased Sec. 179 first-year expense election to 2006 and 2007. Thus, if new or used tangible
personal property (or certain computer software) is acquired, $100,000 ($105,000, as indexed for
2005) of these capital costs can be expensed in the year placed in service, assuming that the total
of qualified property acquired that year does not exceed $400,000 ($420,000 as indexed for
2005). For example, if the amount of qualified property acquired in 2005 equals or exceeds
$525,000 ($105,000 + $420,000), no Sec. 179 expense would be allowed. The Section 179
expense is also limited to taxable income from all of a taxpayer’s trades or businesses.
On May 17, 2006, President Bush signed into law the Tax Increase Prevention and
Reconciliation Act of 2006. The Section 179 $100,000 (inflation adjusted) immediate expensing
was extended to 2008 and 2009. Also, the capital gain/dividend rates for taxpayers below the
25% marginal tax rate (in 2006, $30,650 for single and $61,300 for married filing jointly) that
was 5% and will be zero in 2008 was extended to 2009 and 2010.
The SBWOTA extended the Section 179 deduction rules for one more year – through tax years
beginning in 2010. For tax years beginning in 2007, the maximum Section 179 deduction is
generally increased to $125,000 (from the $112,000 figure that applied before the new law). For
tax years beginning in 2008-2010, the $125,000 amount will be indexed for inflation.
If a taxpayer adds qualifying Section 179 property (typically equipment and software) in excess
of the annual threshold, the maximum Section 179 deduction for the year gets reduced (phased
out). For tax years beginning in 2007, the phase-out threshold was increased to $500,000 of
qualifying property (up from the $450,000 threshold that applied before the SBTA). For tax
years beginning in 2008-2010, the $500,000 amount will be indexed for inflation.
The provision that allows Section 179 deductions for the cost of most off-the-shelf software
products is extended through tax years beginning in 2010 (i.e., by one additional year).
In January 2008, President Bush signed the Economic Stimulus Act, which is best known for the
$600 stimulus checks distributed to lower- and middle-income taxpayers in spring and summer
2008. Receiving much less fanfare but probably more important for small businesses is a large tax
cut involving an expanded Sec. 179 depreciation provision as well as first-year bonus depreciation.
Under these new rules, which apply only to assets placed in service in 2008, Sec. 179 limits are
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increased to $250,000 for new or used tangible personal property and shrink-wrap software, and the
phaseout threshold is raised to $800,000.
Example 1-4
In 2008 S, an S corporation, places in service $600,000 of equipment with a five-year
class life. S may pass through to its shareholders $250,000 of Sec. 179 depreciation and
$210,000 of bonus and regular depreciation. Thus, the combination of Sec. 179, bonus,
and modified accelerated cost recovery system (MACRS) depreciation results in 77% of
the asset being depreciated in the year placed in service. The shareholders would reflect
their share of $250,000 Sec. 179 on their individual tax returns, but not the $600,000 asset
acquisitions for the threshold limit. Also note that the shareholders and S each must have
sufficient trade or business income (including salary) to use their Sec. 179 amount.
An interesting, related side issue that the S corporation tax adviser must be aware of is that in
Example 1-4, if S were owned by the same people that owned a C corporation, the rules of Secs.
1561 and 1563 as well as Sec. 179(d)(6) would not apply because the S corporation is an excluded
corporation for purposes of “component members of a controlled group.” This means that a related
C corporation can use the full Sec. 179 $250,000 expensing amount, and the S corporation
shareholders may also benefit from Sec. 179 to the extent of an additional $250,000, assuming
sufficient business income.
Signed into law on February 17, 2009, the American Recovery and Reinvestment Act of 2009
extended the increased Sec. 179 deduction limits ($250,000/$800,000) to 2009. Second, it also
extended the 50% bonus depreciation rules (Sec. 168(k)) to 2009.
Example 1-5
In 2009, an S corporation places in service $600,000 of equipment with a five-year class
life. The S corporation may pass through to its shareholders $250,000 of Sec. 179
depreciation and $210,000 of bonus and regular depreciation. Thus, the combination of
Sec. 179, bonus depreciation, and MACRS results in 77% of the asset being expensed in
the year placed in service. The shareholders would reflect their share of the $250,000 Sec.
179 deduction on their individual tax returns but would not have to count the $600,000
asset acquisitions for the $800,000 threshold limit. Note that the shareholder and the S
corporation each must have sufficient trade or business income (including salary) to utilize
their Sec. 179 amount.
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Section 179
A new final regulation6 addresses an important small business issue – first-year expensing under
Sec. 179 of new or used tangible personal property or off-the-shelf computer software. Basically
the regulation explains the procedures (1) for amending a tax return to elect Sec. 179, (2) to
change the amount of the election, or (3) to revoke the election. It allows the taxpayer to change
the assets to which Sec. 179 will apply or to increase or reduce the amount expensed, as long as
an amended return is filed within the statutory limits (generally three years after the original
return is filed). Interestingly, all the examples in the regulation use Form 1040, Schedule C. It
would seem that flow-through entities like S corporations and LLCs would require amended
returns too. Here are some examples of how the rules work.
Superexpensing Provision Related to Movie/TV and Other Accelerated
Depreciation Rules
In the past, the $15 million superexpensing provision of Sec. 181 was all or nothing. That is, if
the cost of an otherwise qualified movie exceeded $15 million, nothing was allowed to be
expensed under Sec. 181. Instead, the normal income forecast method depreciation rules would
apply. TEARA of 2008 allows a phase-out of the expensing if the cost of a movie exceeds $15
million. Sec. 199 qualified wages will also now include loan-out payments. Many loan-out
companies are established as S corporations to avoid the personal holding company rules
applicable to C corporations. Loan-out companies are incorporated vehicles for talent to work for
a movie or television production company.
Sport Utility Vehicles (SUVs)
Under Sec. 280F, taxpayers are prohibited from using the full benefit of Sec. 179 for “luxury
automobiles.” However, there was an exception for heavy trucks (which are defined as vehicles
with a gross vehicle weight (GVW) greater than 6,000 lbs.). This definition meant that some
SUVs qualified for Section 179 as a truck. To close this loophole, AJCA Section 910(a) added
Section 179(b)(6) for purchases after Oct. 22, 2004. This new section does not allow the full
$100,000 Section 179 deduction for this type of vehicle, instead it caps the deduction at the old
Section 179 limit of $25,000 (not indexed). There are exceptions for vehicles with GVW greater
than 14, 000 lbs. and for certain pick-up trucks, delivery vans, and passenger vans (carrying
more than nine passengers behind the driver), which would be eligible for the $100,000
(indexed) expensing limit.
Leasehold/Restaurant Improvements
AJCA Section 211 contains a short window of which nonresidential real estate property owners
need to be aware. Basically, for qualified leasehold improvement property placed in service
between October 23, 2004, and December 31, 2005, it authorizes a 15-year recovery period,
6
TD 9209 (7/12/05).
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rather than 39 years, using the straight-line method. To qualify, improvements must not be
attributable to (1) a building less than three years old, (2) an enlargement of the building, (3) the
building's internal structural framework, (4) a structural component benefiting common areas, or
(5) an elevator or escalator.
Similar rules and effective date apply to “qualified restaurant property.” This term is new and
denotes an improvement to a building more than three years old, for which more than half of its
square footage is devoted to the restaurant business. This would seem to favor standalone
restaurants, rather than those in a commercial building. The AJCA made such improvements
eligible for 50% bonus depreciation through the end of 2004.
Organization and Start-up Costs
Prior to October 22, 2004, S corporations had to capitalize organization and start-up costs and if
proper elections were made under Sections 195 and 248 these costs could be amortized over 60
months beginning with the month the company started business. AJCA Section 902 changed
IRC Section 195 and 248, as well as Section 709 relating to partnerships, to allow taxpayers to
elect to deduct up to $5,000 of organization costs and $5,000 of start-up costs in the year in
which business begins, rather than amortizing them over 60 months, as under pre-AJCA Sections
195, 248 and 709. However, $1 of the $5,000 expensing limit is lost for every such dollar spent
over $50,000. Any amount of the start-up or organization costs that cannot be currently expensed
has to be amortized over 180 months. This rule is effective for expenditures paid or incurred
after October 22, 2004. Total cumulative expenditures include expenditures that occur before and
after the enactment date for purposes of the $50,000 test.
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Domestic Production Activities Deduction
To avoid the tariffs the World Trade Organization (WTO) had imposed on certain U.S.-produced
goods, because it deemed that the U.S. was violating international tariffs and trade agreements,
AJCA Section 102 added IRC Section 199. The WTO had imposed the tariffs because it thought
the U.S. was violating international trade agreements by enacting rules that favored U.S.
production. The latest of the rules were the rules giving favorable tax treatment for
extraterritorial income (ETI). Section 102 of the AJCA phases out the ETI provisions. In their
place will be Section 199. This code section allows a deduction for U.S. production activities for
all domestic producers. The deduction when fully phased in will be 9%. For tax years beginning
in 2005 and 2006, the deduction percentage is 3%; for tax years beginning in 2007-2009, it is
6%; and for 2010 and thereafter, it is 9% of the smaller of the taxpayer's qualified production
activities income or taxable income.
Applicability
The deduction is a percentage of the taxpayer's “qualified production activities income” for the
tax year (or taxable income, if smaller). Qualified activities are broadly defined to include gross
receipts derived from any sale, exchange, disposition, lease, rental, or license of qualifying
production property manufactured, produced, grown, or extracted by the taxpayer, in whole or in
significant part, within the U.S.; certain films produced by the taxpayer; and electricity/natural
gas/potable water produced by the taxpayer in the U.S. Domestic production gross receipts also
include gross receipts derived from U.S. construction and engineering and architectural services
related to domestic real estate. The only explicitly excluded categories are retail sales of food or
beverages prepared by the taxpayer; transmission of electricity/natural gas/potable water; or a
lease, license, or rental of property to a related party.
Qualified Production Activities Income
This term is defined as domestic production gross receipts, less the cost of goods sold properly
allocable to those receipts, less directly and indirectly related expenses, deductions and losses
allocable to such receipts. The allocation of indirectly related expenses requires significant
guidance from Treasury. The IRS issued Notice 2005-14,7 providing broad interim guidance on
most aspects of the domestic production activities deduction, which may be relied on until
regulations are issued. The Service expects that regulations will incorporate the rules set forth in
the notice and will be effective for tax years beginning after 2004. The notice requests comments
on the interim guidance and any additional guidance that should be provided in regulations.
7
Notice 2005-14; 2005-7 IRB 498; February 14, 2005.
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Limits
Two limits apply to Sec. 199. First, a taxpayer's qualified production activities income and
taxable income (without regard to the Sec. 199 deduction) must both be positive. If either reflects
a loss, no Sec. 199 deduction or carryover is permitted. Second, the deduction may not exceed
one-half of the W-2 wages (not necessarily from the production activity) reported in the calendar
year that ends in the tax year of the deduction.
Example 1-6
X Corp. has (1) a September 30, 2006 year-end that reflects $400,000 in net profit from
a manufacturing activity, (2) W-2 wages of $10,000 from production salaries in 2005
and (3) $100,000 from nonproduction salaries in 2005. X's Sec. 199 deduction is
$12,000 ($400,000 × 0.03), which does not exceed $55,000 ($110,000 W-2 wages in
2005 × 0.50).
The limit on wages could be a problem for partnerships, LLCs, and sole proprietors, because
guaranteed payments are not deemed W-2 wages, partners/members are not deemed employees,
and sole proprietors cannot pay salaries to themselves. However, it favors S corporations,
because an owner may also be an employee. As a result, the employment of spouses or adult
children in the business may become more common, although the effect of Social Security taxes
is also a consideration. Treasury is in the process of writing regulations to help explain how
Section 199 will apply to pass-through entities.
An interesting issue is whether the Sec. 199 deduction for individuals is above or below the line.
There seems to be a disconnect between the Conference Report language and the statute;
hopefully, proposed technical corrections or future regulations will clarify that the deduction is
above the line for individuals.
Tax Increase Prevention and Reconciliation Act of 2006
The Tax Increase Prevention and Reconciliation Act of 2006 clarified that Section 199’s
application and computations are to be computed at the S shareholder level. The new law states
that the 50% of wage limitation only applies to wages generated in the qualified domestic
production activity. This means that wages paid to executives who are not involved in the
domestic production activity would not count when computing the 50% of W-2 wages limit.
Treasury issued Rev. Proc. 2007-348 under the authority of Temp. Regs. Secs. 1.199-5T(b)(1)
and (c)(1), which allows S corporations (and partnerships) to elect at the entity level certain
optional methods for cost allocation related to Sec.199, including choosing between and applying
the Sec. 861, simplified deduction, or small business overall methods. W-2 wages and qualified
production activities income may also be computed at the entity level.
8
Rev. Proc. 2007-34 IRB 1345 (5/11/2007), effective for tax years beginning after 5/17/07.
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Other Current Developments
LIFO Recapture Tax
Section 1363 (f) imposes a LIFO recapture tax upon election of S status by a C corporation. The
recapture amount is the excess of the value of the company’s inventory computed using FIFO
over the value computed using LIFO. The tax is paid over a four-year period. The LIFO
recapture tax is effective for elections filed after December 17, 1987.
Treasury promulgated Regs. Sec. 1.1363-2 to address the perceived problem with Coggin
Automotive Corp.9 and, using Sections 337(d) and 1374(c) Congressional authority, Treasury in
effect overturned the Eleventh Circuit’s holding. In Coggin, the Tax Court had held that the
aggregate theory applied to LIFO inventory sitting in limited liability companies (LLCs) in
which Coggin was a limited partner (after a restructuring); thus, the taxpayer was subject to Sec.
1363(d) LIFO recapture tax. The Eleventh Circuit reversed the lower court ruling reading the
statute literally. Thus, because the S corporation owned no inventory directly, Section 1363(d)
could not apply. Under Regs. Sec. 1.1363-2, LIFO recapture rules apply to a C corporation
holding a look-through partnership interest when the corporation elects S status or transfers the
partnership interest to an S corporation in a nonrecognition transaction. This rule applies to
transfers after August 12, 2004.
Late Election of S Corporation
The IRS announced that it has expanded the situations in which taxpayers can seek relief for late
S corporation elections and late corporate classification elections without having to incur the
costs associated with seeking a private letter ruling from the IRS National Office. Rev. Proc.
2007-6210 provides an additional simplified method for taxpayers to request relief for late S
corporation elections and supplements Rev. Proc. 2003-43. Rev. Proc. 2007-62 also provides a
simplified method for a late corporate classification election intended to be effective on the same
date that the S corporation election was intended to be effective and supplements Rev. Proc.
2004-48. This revenue procedure is effective for taxable years ending on or after December 31,
2007.
Generally, an entity can request relief for late S corporation elections or for a late corporate
classification election related to a late S corporation election under Rev. Proc. 2007-62 if the
entity seeking the election has not filed a tax return for the first taxable year in which the election
was intended, the application for relief is filed no later than 6 months after the due date of the tax
return of the entity seeking to make the election, and no taxpayer whose tax liability or tax return
would be affected by the S corporation election has reported anything inconsistent with the S
corporation election.
9
Coggin Automotive Corp., 292 F3d 1326 (11th Cir. 2002), rev’g 115 TC 349 (2000).
Rev. Proc. 2007-62, 2007-41 IRB 786 (10/5/07).
10
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A taxpayer who discovers a failure to have timely filed an S corporation election or a late
corporate classification election related to a late S corporation election should review Rev. Proc.
2007-62 to determine if it can meet the procedural requirements for Service Center relief. If an
entity does not qualify for relief for a late S corporation election or a late corporate classification
election related to a late S corporation election under Rev. Proc. 2007-62 it may qualify under
Rev. Proc. 97-48, Rev. Proc. 2003-43 or Rev. Proc. 2004-48, as appropriate. If relief is not
available under any of these revenue procedures, taxpayers may seek relief from the National
Office through the letter ruling process.
IRS Coordinated Issue Papers
S corporations are being scrutinized more than ever as to potential tax shelter activities.11 In the
past year or so, there were two S corporations Coordinated Issue Papers (CIPs) issued of which
the tax adviser needs to be aware. In May 2005, the IRS issued a CIP 12 related to Notice 200265,13 in which a newly formed S corporation enters into foreign currency straddles, closes the
profit leg first, redeems all but one gain-seeking shareholder, makes a closing-of-the-books
election and then sells the loss leg. All the losses are recognized on the sole shareholder’s return.
This is now a listed transaction with filing requirements and potential penalties.
The second CIP14 derives from Notice 2004-30,15 in which an S corporation issued nonvoting
stock and warrants thereon equal to roughly 90% of the stock. The shareholders or the
corporation contribute the nonvoting stock and warrants to charities (presumably with negative
unrelated business taxable income), then take a deduction for the value of the gift, or they
contribute the stock to their retirement plans. The S corporation allocates 90% of the income to
tax-exempt shareholders, but defers paying any distributions until the nonvoting stock is
redeemed. This is now categorized as a listed transaction.
In May 2007, the IRS issued new Appeals Settlement Guidelines that expand on Notice 2004-30,
attacking the donation of S stock to a tax-exempt organization in which the shareholders retain
the economic benefits of the company activity through issued warrants but allocate the income to
the nonprofit. The guidelines list several issues, including disregarding the S stock transfer as a
sham, arguing the creation of more than one class of stock due to the warrants being “in the
money,” etc.
In addition, on June 6, 2007, the IRS issued IR-2007-113, noting that it is in the final stages of
completing an S corporation research project, based on audits of 5,000 S returns for tax years
2003 and 2004. In the same release, the Service also announced that it will implement a new
National Research Project that will extensively audit 13,000 randomly selected 2006 individual
tax returns, which will include S pass-through K-1 information. Taxpayers whose returns are
See Karlinsky and Burton, “S Corporations: Current Developments (Part1),” 35 The Tax Adviser 636 (October
2004).
12
See “Notice 2002-65 Tax Shelter” (5/9/05).
13
Notice 2002-65, 2002-2 CB 690.
14
See “S Corporation Tax Shelter ‘Notice 2004-30’” (11/18/04).
15
Notice 2002-30, 2002-1 CB 797.
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selected will be notified in October 2007. It is interesting to note that the audit rate for S
corporations was .38% of returns filed for fiscal year 2006 (compared with .19% for 200455).
This is very similar to partnership audit rates of .36% and .26%, respectively, and contrasts with
small C corporations with audit rates of .8% and .32% for those years.
Beneficial Interest in an S Corporation
Recently there have been several cases involving judgment as to when ownership of an S
corporation ends if there are disputes and disagreements between the parties. Dunne involved a
taxpayer who was an S corporation’s sole shareholder. For various reasons he brought in another
person who became a 50% shareholder. After several years the two individuals had disputes and
disagreements about the future direction of the company. The option of Dunne selling his half to
the new shareholder was informally discussed in 1996, but no agreement as to price or other
terms was negotiated at that time. In January 1997, Dunne rejected the price offered, and he
continued to receive distributions and shared in the economic benefits and burdens of the S
corporation. He also held himself out to be the chairman of the board and secretary.
In early 1997, the other shareholder fired Dunne as an employee, and in May 1997 they came to
a formal agreement on the buyout price, including a portion of the price determined by future
revenue from a particular government contract. Even after the May 1997 agreement, Mr. Dunne
continued to represent himself to third parties as an officer and owner of the company. The Tax
Court held that May 1997 was when the economic benefits and burdens of Dunne’s ownership
were terminated and therefore only the K-1 income through May was taxable to Dunne.
Hightower is another case dealing with beneficial ownership. Two 50-50 shareholders of a
software S corporation had a dispute that resulted in Mr. Hightower being forced to resign as
chairman of the board and losing control of the company. The other shareholder offered and paid
him $47 million, per the company’s buy-sell agreement. Even though Hightower still was
fighting the arbitration decision in state court, he took the sale proceeds. The court ruled that
Hightower was no longer a shareholder as of October 2000 when he surrendered his stock and
accepted payment.
In an extreme abusive version of the beneficial ownership issue, Julie McCammon was a
physician who conducted business as a solely owned S corporation. In one year she earned
$380,000 in income before owner’s salary and paid herself $190,000, for which she filed a W-2.
The other $190,000 was reflected on her Schedule K-1. She argued that she had no “income in a
constitutional sense” and reported none of the income earned by her S corporation or the salary
paid by her S corporation. (She also argued in court that the Code is “too complex.”) The judge
threw the book at her, imposing a frivolous claim penalty of $25,000 and various other penalties.
The Supreme Court has denied certiorari in the Hightower case.
Klaas involves a 100% shareholder of an S corporation where the entity sold an RV park, but the
owner did not want it taxed at the shareholder level. After the fact, the owner changed the order
of events such that an offshore corporation was deemed to have sold the assets. The court held
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that the reality of the transaction was that the S corporation sold the property, and the
shareholder had to include the gain in his taxable income.
FIN 48 and Private Companies
The Financial Accounting Standards Board (FASB) postponed for one year for private
companies the effective date of complying with FASB Interpretation No. 48 (FIN 48),
Accounting for Uncertainty in Income Taxes, until periods beginning after December 15, 2008.
This means that for 2009, these rules will affect GAAP financial statements for private
companies. Generally, Financial Accountings Standard No. 109 (FAS 109), Accounting for
Income Taxes, and FIN 48 will not affect S corporations because the tax liability is incurred at
the shareholder level. However, if the company has a corporate-level tax, such as Sec. 1374
built-in gain, it would be subject to these complicated rules. Currently, the FASB has postponed
the effectiveness of FIN 48 for flow-through entities and nonprofit corporations.
Penalties for Nontimely Filing of 1120S Tax Return Information
The Mortgage Forgiveness Debt Relief Act of 200716 enacted a new provision, Sec. 6699, that
imposes a penalty of $85 per shareholder per month (not to exceed 12 months) if the S
corporation does not timely file its corporate return or fails to provide information required on
the return. This would seem to be going after tax protesters, but in the one tax protester case
discussed above (McCammon), the corporation filed all the relevant information in a timely
manner, however, the shareholder did not include it in income. Thus, this new penalty provision
would not apply even to an obviously abusive situation.
The law is effective for returns required to be filed after December 20, 2007, and is imposed on
the S corporation. For returns required to be filed after December 31, 2008, the penalty was
raised to $89 per shareholder per month. For purposes of calculating the amount of the penalty,
a husband and wife count as two shareholders and when one shareholder sells his or her interest
to someone else, they count as two different shareholders.17 It is unclear how the law would treat
community property state ownership where actual ownership may be in one person’s name.
16
17
Mortgage Forgiveness Debt Relief Act of 2007, P.L. 110-142.
Sec. 6699(b)(2).
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Example 1-7
Husband and wife M and F and their two children own 100% of the stock of XYZ Corp.
In October 2009, the two children gift some stock to their spouses. In 2009, the S
corporation forgets to include the distribution amount on Schedules K and K-1 of the
2009 Form 1120S, U.S. Income Tax Return for an S Corporation. It could be liable for a
penalty of $6,408 ($89 × 6 × 12) for this innocent mistake. The S corporation is liable
and, even though M and F are considered to be one shareholder for the 100shareholder requirement, each is treated as a separate shareholder for purposes of
Sec. 6699.
For self study participants only, the CPE Standards require the inclusion of review
questions that provide periodic learning feedback. Please go to the review section at
the end of the course to access the review questions for this chapter.
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