This third installment of my multi-part series on Subchapter S is focused on a single Code Section, namely IRC Section 1361(b)(1)(C) and the ineligibility of nonresident aliens as shareholders of Subchapter S corporations.
As we all have come to understand, nonresident aliens are ineligible S corporation shareholders. If a nonresident alien were to become a shareholder of an S corporation, the result is straightforward – as of the date the nonresident alien became a shareholder, the corporation’s S election is terminated. There are, however, some obscure aspects of this well-known rule that are worthy of discussion. One of the obscurities has to do with a 2018 change in the law resulting from the Tax Cuts and Jobs Act. Additionally, there have long existed hidden traps for unwary taxpayers and their advisers as well as some twists and turns in the road in this area of Subchapter S that are also worthy of discussion.
This second installment of my multi-part series on Subchapter S is focused on two Code Sections, namely IRC Section 1375 and IRC Section 1362(d)(3).
While most of my readers are all quite familiar with these two Code sections, there are some obscure practical implications of these provisions that I want to bring to your attention or remind you.
These Code Sections only apply to S corporations that have retained earnings and profits from C corporation years (“C E&P”). In a nutshell, under Code Section 1375, S corporations that have C E&P at the close of the taxable year and “passive investment income” totaling more than 25 percent of gross receipts will be subject to a tax imposed at the highest corporate income tax rate under Code § 11 (which is currently a flat 21 percent). The tax is based upon the lessor of the corporation’s “taxable income” or its “excess net passive investment income.”
In October 2023, I authored a new White Paper, A Journey Through Subchapter S / A Review of The Not So Obvious & The Many Traps That Exist For The Unwary. This year, in a multi-part article, I intend to take our blog subscribers through some of the most significant changes made to Subchapter S over the past 40 years, (i) pointing out some of the not-so-obvious aspects of these developments, (ii) alerting readers to some of the obscure traps that were created by these changes, and (iii) arming readers with various methods that may be helpful in avoiding, minimizing or eliminating the adverse impact of the traps. This first installment is focused on one area of Subchapter S – the Built-In-Gains Tax.
Brief History of Subchapter S
In 1954, President Eisenhower recommended legislation that would minimize the influence federal income tax laws had on the selection of a form of entity by closely held businesses. Congress did not act on the president’s recommendation, however, until 1958. Interestingly, the new law was not contained in primary legislation. Rather, the first version of Subchapter S was enacted as a part of the Technical Amendments Act of 1958. The legislation was, at best, an afterthought.
The original legislation contained numerous flaws and traps that often caught the unwary, resulting in unwanted tax consequences. Among these flaws and traps existed: (i) intricate eligibility, election, revocation and termination rules; (ii) complex operational priorities and restrictions on distributions; (iii) a harsh rule whereby net operating losses in excess of a shareholder’s stock basis were lost forever without any carry forward; and (iv) a draconian rule whereby excessive passive investment income caused a retroactive termination of the S election (i.e., all of the way back to the effective date of the S election). Due to these significant flaws, tax advisers rarely recommended Subchapter S elections.
The Internal Revenue Service (“IRS”) announced in IR News Release 2023-247 (December 21, 2023) its new Voluntary Disclosure Program (“ERC VDP”) that allows employers who may have received questionable Employee Retention Credits (“ERCs”) to pay them back at a discount. The ERC VDP is a part of the government’s ongoing fight against questionable ERC claims.
As you may recall, on November 7, 2022, the IRS issued COVID Tax Tip 2022-170. It warned employers to be wary of third-party vendors offering assistance in applying for ERCs. In fact, the IRS stated in that notice:
“Employers should be wary of third parties advising them to claim the employee retention credit when they may not qualify. Some third parties are taking improper positions related to taxpayer eligibility for and computation of the credit.
These third parties often charge large upfront fees or a fee that is contingent on the amount of the refund. They may also fail to inform taxpayers that wage deductions claimed on the business’ federal income tax return must be reduced by the amount of the credit.
If the business filed an income tax return deducting qualified wages before it filed an employment tax return claiming the credit, the business should file an amended income tax return to correct any overstated wage deduction.
Businesses should be cautious of schemes and direct solicitations promising tax savings that are too good to true. Taxpayers are always responsible for the information reported on their tax returns. Improperly claiming the ERC could result in taxpayers being required to repay the credit along with penalties and interest.”
The government’s stated goal of the ERC VDP is twofold:
For so many of us, 2023 has been a difficult year. The so-called end of the COVID-19 pandemic looked to be a bright spot in our lives, but with wars raging in Ukraine and Gaza and dramatic social unrest at our doors, we continue to face difficult times.
I am extremely grateful for the unwavering support of family, friends, clients, and my law colleagues, especially in these troubling times!
During these trying times, we have had to be mindful of the good that surrounds us. As the Ancient Greek philosopher Aristotle is accredited with saying:
“It is during our darkest moments that we must focus to see the light.”
During 2023, I was able to speak in person at several tax conferences. It was wonderful to actually see and visit with conference attendees rather than delivering a lecture into a computer screen’s virtual abyss. This year, I was fortunate to have the opportunity to speak at the following tax conferences:
The 82nd Institute on Federal Taxation (IFT) will be held in New York City on October 22-27, 2023, and in Berkeley, California, on November 12-17, 2023.
This year, I will be presenting my latest white paper, “A Journey Through Subchapter S / A Review of the Not So Obvious & The Many Traps That Exist for the Unwary.” Our discussion will examine the potpourri of issues arising from Subchapter S that may not be readily apparent to the tax practitioner, such as matters arising from the single class of stock requirement, the built-in-gains tax, the interplay between Subchapter C and Subchapter S, lingering E&P, and late (or never made) elections. The session will also alert tax practitioners to traps that exist for the unwary and, in some cases, possible ways to avoid or remedy falling into one of these traps.
I am pleased to announce that I will be presenting at the 49th Annual Notre Dame Tax & Estate Planning Institute in South Bend, Indiana. The Institute this year will occur on September 20-22.
I will be presenting my white paper "Entity Classification – The Check-The-Box Regulations Revisited." My discussion will cover recent developments in the law relating to entity classification, limitations under the check-the-box regulations, flexibility and planning opportunities created by the regulations, traps that exist for the unwary, and practical planning strategies for tax advisers.
I am extremely grateful to have the opportunity to speak at the Notre Dame Tax & Estate Planning Institute and present among a tremendous panel of speakers, including Jerry Hesch, Paul Lee, Jonathan Blattmachr and Stephen Breitstone. It looks to be a terrific program for income tax and estate tax attorneys.
As you may be aware, the Corporate Transparency Act (the “CTA”) is a new federal law that requires most U.S.-based companies, including corporations, partnerships and limited liability companies, to report information regarding their “beneficial owners” to the federal government through the Financial Crimes Enforcement Network (“FinCEN”) and a new FinCEN IT system known as the Beneficial Ownership Secure System (“BOSS”). The intent of the CTA and the reporting to FinCEN is to combat money laundering, tax fraud and other illegal activities.
The CTA reporting requirements will become effective on January 1, 2024, for newly formed companies (which do not otherwise qualify as exempt); provided, however, existing non-exempt companies have until January 1, 2025 to comply.
On April 5, 2023, Commissioner Daniel I. Werfel issued the Internal Revenue Service Inflation Reduction Act Strategic Operating Plan (“Plan”). The Plan, which spans over 145 pages, is a roadmap to how the Service will deploy over the next decade the approximately $80 billion in supplemental funding it will receive as a result of the Inflation Reduction Act enacted by Congress last year (“IRA”).
In the Plan, Commissioner Werfel sums up the strategic goals for the IRS as follows:
“We will make it easier for taxpayers to meet their tax responsibilities and receive tax incentives for which they are eligible. We will adopt a customer-centric approach that dedicates more resources to helping taxpayers get it right the first time, while addressing issues in the simplest ways appropriate. We will address noncompliance, using data and analytics to expand enforcement in certain segments. We will become an employer of choice across government and industry. These changes will enable us to serve all taxpayers more equitably and in the ways they want to be served.”
It is a rainy day in the Pacific Northwest with chances of snow showers. For those taxpayers that reside in the state of Washington or own highly appreciated capital assets located in the state, their day just got a bit gloomier.
Earlier today, the Washington Supreme Court, in a 7-2 opinion, overturned the Douglas County Superior Court decision that had ruled the state capital gains tax enacted by the legislature in 2021 violates the Washington State Constitution.
In its 50-plus page opinion written by Justice Debra L. Stevens, the majority of the court concludes:
“The court below [the Douglas County Superior Court] concluded the tax is a property tax that violates article VII’s uniformity requirement. In light of this ruling, the court did not address Plaintiffs’ additional constitutional challenges. We accepted direct review and now reverse. The capital gains tax is appropriately characterized as an excise because it is levied on the sale or exchange of capital assets, not on capital assets or gains themselves. This understanding of the tax is consistent with a long line of precedent recognizing excise taxes as those levied on the exercise of rights associated with property ownership, such as the power to sell or exchange property, in contrast to property taxes levied on property itself. Because the capital gains tax is an excise tax under Washington law, it is not subject to the uniformity and levy requirements of article VII. We further hold the capital gains tax is consistent with our state constitution’s privileges and immunities clause and the federal dormant commerce clause. We therefore reject Plaintiffs’ facial challenge to the capital gains tax and remand to the trial court for further proceedings consistent with this opinion.”
Larry J. Brant
Larry J. Brant is a Shareholder and the Chair of the Tax & Benefits practice group at Foster Garvey, a law firm based out of the Pacific Northwest, with offices in Seattle, Washington; Portland, Oregon; Washington, D.C.; New York, New York, Spokane, Washington; Tulsa, Oklahoma; and Beijing, China. Mr. Brant is licensed to practice in Oregon and Washington. His practice focuses on tax, tax controversy and transactions. Mr. Brant is a past Chair of the Oregon State Bar Taxation Section. He was the long-term Chair of the Oregon Tax Institute, and is currently a member of the Board of Directors of the Portland Tax Forum. Mr. Brant has served as an adjunct professor, teaching corporate taxation, at Northwestern School of Law, Lewis and Clark College. He is an Expert Contributor to Thomson Reuters Checkpoint Catalyst. Mr. Brant is a Fellow in the American College of Tax Counsel. He publishes articles on numerous income tax issues, including Taxation of S Corporations, Reasonable Compensation, Circular 230, Worker Classification, IRC § 1031 Exchanges, Choice of Entity, Entity Tax Classification, and State and Local Taxation. Mr. Brant is a frequent lecturer at local, regional and national tax and business conferences for CPAs and attorneys. He was the 2015 Recipient of the Oregon State Bar Tax Section Award of Merit.