Taproot Administrative Services v. Commissioner, 133 TC 202 (2009), 679 F3d 1109 (9th Cir. 2012), is an S corporation shareholder eligibility case. It was decided by the US Tax Court in 2009 and eventually made its way to the 9th Circuit Court of Appeals, where a decision was rendered in 2012.
Prior to the enactment of the American Jobs Creation Act of 2004, only the following were eligible S corporation shareholders:
- US citizens and resident individuals;
- Tax-exempt 501(c) charities and 401(a) retirement plans; and
- Certain trusts, including QSSTs, ESBTs and grantor trusts
As a result of the lobbying efforts of family-owned rural banks, as of October 22, 2004 (the effective date of the American Jobs Creation Act), a new eligible shareholder was added to the list, IRAs, including Roth IRAs, provided two criteria are met:
- The S corporation must be a bank, as defined in Section 581 of the Code; and
- The shares must have been owned by the IRA on October 22, 2004, the enactment date of the American Jobs Creation Act.
As you might imagine, having an eligible IRA shareholder will be rare. The exception to the S corporation eligibility rules provided by the American Jobs Creation Act is quite narrow.
The Service Continues its Warm Approach to Taxpayers with S Corporation Inadvertent Terminations (PLR 201340001)
As we know, in accordance with Code Section 1362(f) and the corresponding Treasury Regulations, a corporation will continue to be treated as a Subchapter S corporation during a period of termination, if:
- The election was terminated, either because the corporation was disqualified as an electing small business corporation, or as a result of running afoul of the passive investment income rule;
- The Service determines the termination as inadvertent;
- The corporation promptly takes steps to correct the defect after discovery; and
- The corporation and its shareholders acted as if the election was continuously in effect.
To qualify as an S Corporation for the current tax year, a corporation must make an election: (1) at any time during the entity’s preceding tax year; or (2) at any time before the 15th day of the 3rd month of the current tax year. If a corporation fails to make a timely election, it is considered a “late S election” and it will not qualify as an S Corporation for the intended tax year.
The consequences of a late S election or failing to file an S election can be severe. First, the corporation will be taxed as a C Corporation and subject to corporate income taxes. Second, the corporation may be subject to late filing and payment penalties, and interest on unpaid taxes. Finally, if the corporation filed IRS Forms 1120S as if it were an S Corporation, then all prior tax years would be subject to IRS examination because the tax years remain open.
Section 336(e)1 expressly delegates authority to Treasury to issue regulations, allowing taxpayers to elect to treat the sale, exchange or distribution of corporate stock as a deemed sale of the corporation’s underlying assets. On May 15, 2013, Treasury finalized regulations under Section 336(e).
What is the 336(e) Election?
A Section 336(e) election allows certain taxpayers to treat the sale, exchange or distribution of corporate stock as an asset sale. The benefit of an asset sale is obvious—the basis of the target corporation’s assets is stepped up to fair market value.
If an election is made, “old target” is treated as selling all of its assets to “new target.” New target is treated as purchasing those assets, resulting in a step-up in basis of the assets. Old target recognizes the gain or loss from the deemed asset sale immediately before the close of the stock transaction.
Section 336(e) is intended to provide taxpayers relief from multiple levels of tax on the same economic gain—economic gain attributable to the appreciation of assets held in corporate solution. Such multiple levels of tax can result from the taxable transfer of appreciated corporate stock where the assets in corporate solution do not receive a corresponding step-up in basis.
Larry J. Brant
Larry J. Brant is a Shareholder in 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; and Beijing, China. Mr. Brant practices in the Portland office. 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.