Come join me at the NYU Summer Institute In Taxation this July in New York City. I am honored to be presenting a paper on qualified S corporation subsidiaries on July 28 as part of the “Wealth Planning for High Net-Worth Individuals and Owners of Closely-Held Companies” panel. The program looks terrific this year. You can pick and choose which panel sessions you would like to attend. The conference brochure and registration details are available here. I hope to see you in New York City.
The Extender’s Bill impacts Subchapter S in at least two respects. It amends IRC Section 1374(d)(7) and IRC Section 1367(a)(2). Both of these amendments are temporary. Unless extended, they only live until the end of this year. Yes, they only apply to tax years beginning in 2014.
I. IRC Section 1374(d)(7).
In the last five (5) years, we have seen at least three temporary amendments to the built in gains tax recognition period.
I was recently interviewed by Ama Sarfo, a reporter for Law360 (a national legal publication of LexisNexis). I discussed some of the audit risks Subchapter S corporations and their shareholders face these days. Below is an excerpt of the Article.
Audit Risk: It's estimated that the U.S. has a $450 billion gap between taxes that are owed to the government and taxes that are actually paid on time. This staggering number, despite significant budgetary constraints, has put taxpayer compliance back in the forefront for the IRS. In the 1990s, the Service was forced to move its focus from the audit function to information and technology as its systems were terribly out of date. Taxpayers need to be on their game because the IRS is back in the audit business, and noncompliance penalties are stronger than they've ever been before.
If this case was made into a movie, the name of the movie would tell the entire story – S corporation shareholders are not allowed to just make up the basis adjustment rules! Also, as I have repeatedly stated, poor records lead to disastrous results. The DC Circuit affirmed the US Tax Court in April of 2013 to finally put an end to the case.
S corporations and their shareholders must keep track of stock and debt basis. Failure to do so can lead to disastrous results. Nathel v. Commissioner, 105 AFTR 2d 2010-2699 (2d Cir 2010), illustrates this point.
In Nathel, the government and the taxpayer stipulated to the facts. Two brothers and a friend formed three separate S corporations to operate food distribution businesses in New York, Florida and California. All three shareholders made initial capital contributions to the corporations. The brothers also made loans to two of the corporations.
In 2001, one corporation was liquidated. In a reorganization of sorts, the friend ended up owning 100% of the second corporation and the two brothers ended up equally owning the third corporation.
In late 2000, before the reorganization, the brothers made loans to the corporations totaling around $1.3 million. In 2001, they made capital contributions totaling approximately $1.4 million. Also, in 2001, they received loan repayments combined in excess of $1.6 million.
Immediately before the repayment of the loans, the brothers had zero basis in their stock and only nominal basis in the loans. Ouch! To avoid the ordinary income tax hit on the delta between the $1.6 million in loan repayments and their nominal loan basis, the brothers, with the likely help of their handy dandy tax advisor, asserted the $1.4 million in capital contributions was really tax-exempt income to the corporation, excludable under IRC Section 118(a), but which, under IRC Section 1367(b)(2)(B), increased their loan basis. Therefore, the ordinary income tax hit on the loan repayments was nominal.
Please join me for the NYU 73RD Institute on Federal Taxation. This year’s Institute will be held in San Diego at the Hotel Del Coronado November 16 – 21, and in New York City at the Grand Hyatt New York October 19 – 24. Please see the attached brochure. The coverage of tax topics is both timely and broad. This year’s presentations will cover topics in the areas of: executive compensation and employee benefits; partnerships and LLCs; corporate tax; closely held businesses; and trusts and estates. What is so terrific about the Institute, in addition to a wonderful faculty and the interesting current presentation topics, you can choose the presentations you want to attend. In other words, you can pick and choose the topics that relate to your tax practice.
This is my second time speaking at the Institute. My topic this year is: "Developments In The World Of S Corporations." I plan to deliver a White Paper that will provide attendees with an historic overview of Subchapter S and a look through a crystal ball at the future of Subchapter S, including a review of the recent cases, rulings and legislative proposals impacting Subchapter S.
I hope to see you in either San Diego or New York.
Robert Southey’s fairy tale, Goldilocks and the Three Bears, which was first published in 1837, provides tax practitioners with the proper analysis to determine whether compensation is reasonable. Compensation cannot be too high and compensation cannot be too low. It must be just right to be considered reasonable for tax purposes. Unfortunately, the determination is subjective in nature. Consequently, it may be subject to debate.
Code Section 162 is the starting point in every reasonable compensation case. Code Section 162 provides:
There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including--(1) a reasonable allowance for salaries or other compensation for personal services actually rendered***.
The Treasury Regulations, Section 1.162-7, expand the focus into 2 parts:
- The first part of the analysis is the “Intent Test.” Under this test, the compensation payments must be intended to be made solely as payment for services rendered. In other words, the payments cannot be intended as consideration for anything other than for personal services.
- The second part of the analysis is the “Amount Test.” Under this test, the compensation payments must be reasonable in amount. The payments cannot be greater in amount than what is reasonable under the circumstances for the services actually rendered.
Most S corporation reasonable compensation cases involve allegations of unreasonably low compensation. There are, however, at least four (4) circumstances where taxpayers may be motivated to pay unreasonably high compensation in the S corporation context, including:
- BUILT-IN GAINS TAX AVOIDANCE. The first circumstance is where a taxpayer wishes to avoid the application of the built-in gains tax under Code Section 1374 by zeroing out the corporation’s taxable income determined as if it were a C corporation. Remember, the net recognized built-in gain under Code Section 1374(d)(2)(A) can never exceed the taxable income of the S corporation, determined as if it were a C corporation. So, if the taxable income of the C corporation is zero for the taxable year, there can be no built-in gains tax liability for the year. As a result of TAMRA 1988, however, if the taxable income for the taxable year is zero, the built-in gain gets carried over to future years and gets recognized to the extent of taxable income in the future years. But, if income is zeroed out for each of the remaining years during the built-in gains tax recognition period (by expenses such as compensation), the built-in gain tax is avoided forever. Under current law, Code Section 1374 (d)(7), the built-in gains tax recognition period is ten (10) years. As you recall, Congress shortened the recognition period to as little as five (5) years for tax years 2009, 2010, 2011, 2012 and 2013, in the name of economic stimulus. The law reverted back to ten (10) years on January 1, 2014. An interesting side note: Ways and Means Committee Chairman Dave Camp proposed, as part of his tax simplification legislation that he distributed to members of the House in early February of this year, to permanently reduce the recognition period to five (5) years.
- MAXIMIZE RETIREMENT PLAN CONTRIBUTIONS. The second circumstance is where the taxpayer wishes to maximize shareholder/employee earned income so that it may maximize contributions to a retirement plan. Retirement plan contributions are based on wages. Increasing wages allows the shareholder/employee to maximize the amount contributed to his or her retirement account.
- AVOID VIOLATING THE SINGLE CLASS OF STOCK REQUIREMENT. The third circumstance is where the taxpayer wishes to avoid violating the single class requirement of Code Section 1361(b)(1)(D). If the taxpayer desires to treat shareholders differently, it may attempt to use compensation to meet this objective. When that is done, the Service may throw out the reasonable compensation flag on audit to attack the validity of the S election. The Service generally only prevails in these cases when the fact pattern is egregious. Nevertheless, you need to be aware of the issue and be cautious so that compensation is reasonable and is paid for actual services rendered.
- AVOIDING THE APPLICATION OF CODE SECTION 1411. The fourth circumstance was given life by the Affordable Care Act. S corporation taxpayers may now be motivated to pay compensation to shareholders who do not actively participate in the business of the S corporation in an attempt to avoid the application of the 3.8% Net Investment Tax under Code Section 1411. This new 3.8% tax applies to what is called “net investment income.” Included in the definition of “net investment income” is pass-through income from an S corporation in which the shareholder does not actively participate. So, if there is no colorable argument that the shareholder materially participates in the business of the S corporation, there may be the motivation to pay wages to the shareholder. If the shareholder does not perform work for the corporation, the Service will be able to successfully attack the payment on the theory of unreasonable compensation.
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.
Montgomery v. Commissioner, T.C. Memo. 2013-151 (June 17, 2013) illustrates what appeared to be the obvious – neither a guaranty of the corporation’s debt by a shareholder nor an unpaid judgment against a shareholder for the S corporation’s debt creates basis.
In Montgomery, the taxpayers, Patrick and Patricia Montgomery, claimed a net operating loss on their 2007 joint return, which they carried back to 2005 and 2006. In the calculation of their net operating loss, they included: losses UDI Underground, LLC (“UDI”), incurred in 2007 that were passed through to Patricia Montgomery as a 40% member; and losses Utility Design, Inc., an S corporation (“Utility Design”), incurred in 2007 that were passed through to Patrick and Patricia Montgomery as shareholders.
The IRS challenged the amount of the net operating loss for 2007 on two grounds:
- First, the IRS asserted Patricia Montgomery did not materially participate in UDI during 2007.
- Second, the IRS asserted portions of the losses from Utility Design were disallowed under Section 1366(d)(1).
- The IRS asserted Patricia Montgomery’s share of the 2007 losses from UDI were losses from a passive activity. Specifically, the IRS argued Patricia Montgomery did not materially participate in UDI.
The Tax Court disagreed, holding Patricia Montgomery did materially participate in UDI. In 2007, Patricia Montgomery handled all of the office functions, managed payroll, prepared documents, met with members of the company and attended business meetings. Additionally, she continuously worked on company matters and daily discussed the company's business with Patrick Montgomery. The court ultimately concluded Patricia Montgomery participated in UDI for more than 500 hours during 2007 and her participation was regular, continuous, and substantial. Thus, Patricia Montgomery’s UDI activity was a non-passive activity.
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.
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; 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.
Upcoming Speaking Engagements
- "Entity Classification – The Check-The-Box Regulations Revisited," New York University 81st Institute on Federal TaxationNew York, NY, 10.23.22-10.28.22
- "Entity Classification – The Check-The-Box Regulations Revisited," New York University 81st Institute on Federal TaxationSan Diego, CA, 11.13.22-11.18.22