In this Part XII of my multi-part series on some of the not-so-obvious aspects of S corporations, I explore a consistent theme – taxpayers lose fights with taxing authorities when they fail to maintain adequate records. Keeping adequate records is vitally important to S corporations and their shareholders or, for that matter, all taxpayers.
Background
Time and time again, taxpayers lose their battles with the IRS and other taxing authorities for the same reason – failure to maintain adequate records. One of the greatest services that tax advisers can provide their clients is preaching the virtues of maintaining good records.
I am excited to share that the 83rd Institute on Federal Taxation (IFT) will be held in New York City on October 20-25, 2024, and in San Diego, California on November 17-22, 2024.
This year, I will present my latest white paper, “A Magical Mystery Tour Through Subchapter S – A Look At Some Of The Twists and Turns.” During our session, we will take a deep dive into some of the interesting, yet deceptive and/or obscure, provisions of Subchapter S that could catch the unwary off guard. Our tour will take us on a journey through some of the treacherous terrain containing the built-in gains tax, shareholder eligibility, the impact of excessive passive income on S corporations with C E&P and the impact of a fraudulent S corporation return on the shareholders, and we will end our journey frolicking through the beauty created by some interesting cases and rulings.
In this Part XI of my multi-part series on some of the not-so-obvious aspects of S corporations, I explore a topic that should be obvious but which appears to be ignored by many taxpayers and their tax advisers – accurate computation of shareholder basis for purposes of taking losses flowing through from the S corporation is important.
Background
In 2005, the Internal Revenue Service launched a study to assess the reporting compliance of S corporations. The study, carried out under the National Research Program (“NRP”), involved the examination of roughly 4,800 randomly selected S corporation returns from tax years 2003-2004. Based upon the portions of the study disclosed by the Service to the public, six major areas of noncompliance in the S corporation arena were detected:
Introduction
When considering converting a C corporation to an S corporation, tax advisers and taxpayers need to pay careful attention to the many perils that exist. Failure to pay close attention to the road in this area could result in a disaster. This Part X of my multi-part series on Subchapter S is designed to illuminate some of the road hazards that exist along the roadway traveling from Subchapter C to Subchapter S.
Before converting an existing C corporation to an S corporation, an analysis of several matters should be undertaken, including the impact of the election on the shareholders and the corporation. These matters include, but are not limited to, the topics briefly discussed below.
Unlike the rules contained in Subchapter K surrounding partnership distributions, which tend to be somewhat complex, the distribution rules contained in Subchapter S are fairly straightforward. Nevertheless, from time to time, taxpayers and tax advisers appear to experience difficulty navigating through the applicable S corporation distribution rules. This Part IX of my multi-part blog series on S corporations is designed to take some of the mystery out of the S corporation distribution rules. The following is a brief overview of the S corporation distribution rules.
Background
The purpose of pass-thru taxation under Subchapter S is to avoid the imposition of an entity-level tax. Shareholders of S corporations are taxed on their proportionate share of the corporation’s income, regardless of whether it is actually received; therefore, distributions from S corporation income should not be taxed again, otherwise there would be a second tax on such income, undercutting the purpose of pass-thru taxation. IRC §1368 allows for shareholder distributions in a manner that avoids double-taxation of S corporation income, but it still imposes an entity-level tax on the earnings and profits (“E&P”) remaining from any prior operations as a C corporation. Much of the complexity within the Subchapter S distribution rules is due to these latter rules, which are designed to prevent C corporations from avoiding double-taxation on C corporation earnings by simply electing S corporation status.
At a fundamental level, distributions from S corporations must be analyzed in one of two categories: S corporations without E&P and S corporations with E&P.
On June 28, 2024, in Loper Bright Enterprises v. Raimondo,[1] the U.S. Supreme Court overruled the landmark case of Chevron U.S.A. v. Natural Resources Defense Council, Inc. et. al.[2] Interestingly, the Loper decision was rendered exactly 40 years and three days after the U.S. Supreme Court had decided Chevron.
I expect there will be a slew of law review and other scholarly journal articles that will examine in detail the court’s decision and its impact on American jurisprudence. This blog article is not designed to provide that type of commentary. Rather, my aim is to provide readers with a succinct but clear understanding of the Loper ruling and its likely implications relative to the administration of our federal tax laws.
Overview
In the S corporation arena, tax advisors and taxpayers generally do not focus a lot of attention on the S corporation shareholder eligibility rules other than at the time the S election is made. As we dive into shareholder eligibility rules in this Part VIII of my multi-part series on Subchapter S, it should become apparent that the eligibility rules can be complex and require that S corporations and their shareholders keep a close eye on shareholder eligibility after the S election is made.
Instances where S corporations and their shareholders may find the S election in peril for violating the shareholder eligibility rules include: (i) when a shareholder sells or otherwise transfers shares to a person or entity other than an existing eligible shareholder; (ii) when the corporation issues shares to a new shareholder; and (iii) when an existing shareholder transfers shares to a vehicle intended to be used for estate planning and/or creditor protection purposes. Failure to pay close attention to the eligibility rules can result in disastrous consequences to the S corporation and its shareholders.
As reported last week, opponents of the Washington state capital gains tax, after ultimately losing in the courts to have the legislation stricken as unconstitutional, decided to take the matter to the voters. They have proposed a ballot measure which if successful, among other things, will repeal the tax.
As part of the presentation of the ballot measure in the voters’ pamphlet, the State of Washington election officials recently announced that the explanation of the ballot measure must include a disclosure of the revenue impact its passage would have on the state’s revenue – a drop of roughly $1 billion per year. Proponents of the ballot measure promptly filed a lawsuit in the Superior Court of Washington for Thurston County (“Court”) to block the inclusion of the revenue impact in the voter packets. A hearing in the case occurred on June 7, 2024.
Judge Allyson Zipp, appointed to the Court by Governor Jay Inslee in 2021, presided over the case. The oral arguments were interesting.
I have reported in several prior blog posts the significant events impacting the newly enacted Washington state capital gains tax. The turbulent ride of this legislation continues!
The Colorful Journey
The colorful journey of the Washington capital gains tax started with Senate Bill 5096 ("SB 5096"). The bill was originally introduced to the Washington State Senate on January 6, 2021. It was passed by the Senate on March 6, 2021, after a hearing in the Senate Committee on Ways and Means, three readings and some floor amendments. The bill's passage margin in the Senate was narrow, receiving 25 affirmative votes and 24 negative votes.
SB 5096 continued its journey to the Washington State House of Representatives, where the bill was introduced on March 9, 2021. After three readings and two separate votes, as well as some amendments, the bill was passed in the House on April 21, 2021. As was the case in the Senate, its passage margin in the House was narrow, receiving 52 affirmative votes and 46 negative votes.
Overview
In the S corporation arena, tax advisors generally do not focus much attention on unreasonable compensation. As we delve into the issue in this Part VII of my multi-part series on Subchapter S, it will become apparent that reasonableness of compensation in the S corporation setting is important. Failure to pay attention to the issue can place S corporations and their shareholders in peril.
Closely held C corporations have historically been incentivized to distribute profits as compensation to shareholder employees. A corporation is allowed, under IRC § 162(a)(1), to deduct “a reasonable allowance for salaries or other compensation for personal services actually rendered.” There is, however, no corresponding deduction for dividend distributions, which end up being taxed twice: once at the corporate level upon earning the income that funds the dividend, and again at the shareholder level upon receipt of the dividend. Consequently, treating distributions of profits as compensation for services rendered could significantly reduce a corporation’s tax liability.
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Larry J. Brant
Editor
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.
