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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.

Larry

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.

  • The first amendment is found in Section 1251 of the American Recovery and Reinvestment Tax Act of 2009.  This provision shortened the ten (10) year recognition period for tax years 2009 and 2010 to seven (7) years.
  • The second amendment is found in Section 2014 of the Small Business Jobs Act of 2010.  This provision extended the built in gains tax relief to 2011 and further shortened the recognition period to five (5) years.  For tax year 2012, it appeared we would be back to the old ten (10) year recognition period.
  • With the passage of the Taxpayer Relief Act of 2012, however, a third amendment to Code Section 1374 was given life.  As a result, the five (5) year recognition period was extended to the end of last year.

Unfortunately, it looked like we were back to the ten (10) year built in gains tax recognition period.  Lawmakers saved the day one more time, at least temporarily, when both the Senate and the House passed the 2014 Tax Increase Prevention Act on December 16, 2014.  President Obama signed the bill into law on December 19, 2014.  So, for your clients that dispose of built in gains assets this year, they are subject to a five (5) year built in gains tax recognition rule.  For dispositions of built in gains tax property next year, unless Congress acts for a fifth time, we are subject to the old ten (10) year recognition period rule.

II.  IRC Section 1367(a)(2).

Section 1367(a)(2) was added to the Code in 2006.  It was set to sunset at the end of 2011.  Section 325 of the 2012 Taxpayer Relief Act, effective January 1, 2013, however, extended the life of Code Section 1367(a)(2) to the end of 2013.  It appeared IRC Section 1367(a)(2) was no longer in existence for 2014.  The 2014 Tax Increase Prevention Act gave this provision one more year of life.

So, at least for 2014, shareholders of a S Corporation get to reduce their stock basis by the adjusted basis of property contributed by the S Corporation to a charity, even though the full fair market value of the property passes through to the shareholder as a charitable contribution deduction on their IRS Form K-1.

If any of your S Corporation clients made charitable contributions this year, they may be able to take advantage of this law.  Unless extended again, Section 1367(a)(2) will no longer be law on January 1, 2015.

Year end is almost here.  For your S Corporation clients, it is worth looking to determine if either of these provisions, amended by the 2014 Tax Increase Prevention Act, apply.  Time is running out!

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.

Compensation Documentation:  Subchapter S corporation exams often lead to a review of shareholder compensation.  The focus is generally on whether the compensation is unreasonably low  —   an amorphous label that lacks a uniform standard within the courts and instead depends on questions of facts and circumstances.  I advise S corporation clients, among other things, to annually document their compensation decisions and their rationale for establishing shareholder employee compensation.  This would include developing a compensation methodology based on qualifications, nature of work and information about what other like companies pay similar employees.  It's an art.

Loss Deductions:  Shareholder basis calculations used for the purpose of absorbing losses passed through from the corporation are often reviewed in S corporation examinations.  S corporations aren't required to track and report shareholder basis on IRS Form K-1 issued to shareholders each year.  According to IRS studies, in a large number of cases, errors are made in this computation (it is usually user error).  So, the IRS is closely scrutinizing this issue in its audits.   Don’t be surprised if, in the future, S corporations are required to track and report basis calculations on IRS Form K-1, just like partnerships are required to track and report capital account changes.

The law governing S corporations is ever changing.  As tax practitioners, we need to keep abreast of these developments.  I try to report important developments in this area of tax law on the blog.

If you would like to read the complete Article, it is available at www.Law360.com.

Barnes v. Commissioner, 712 F.3d 581 (D.C. Cir. 2013) aff’g T.C.M. 2012-80 (2012) is illustrative of the point that understanding the basis adjustment rules is vital.

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.

Marc and Anne Barnes, husband and wife, are entrepreneurs.  They were engaged in several businesses, including restaurants, nightclubs and entertainment promotion.  These businesses were operated through a sole proprietorship and several entities they owned 100% of, including two S corporations and a C corporation.

The tax returns at issue were the 2003 returns.  One of the Barnes’ S corporations was Whitney Restaurants, Inc. which operated a Washington DC restaurant and nightclub called Republic Gardens (Whitney has since sold Republic Gardens).  Upon audit of the Barnes’ 2003 tax return, the Service pulled in the 1120S of Whitney Restaurants.

In addition to some smaller items, the Service disallowed a $123,006 loss stemming from Whitney on the ground the Barnes’ had insufficient basis to take the losses.  In addition, the Service assessed an IRC Section 6662 accuracy related penalty and an IRC Section 6651 late filing penalty.

The Barnes’ contested the assessment, including the penalties, and filed a petition in the US Tax Court.  Prior to the court’s ruling, however, they conceded liability for the late filing penalty.  The return was eight months late.  So, the Court was left to decide whether the assessment of taxes and the accuracy related penalty were appropriate.

The facts are a little convoluted.  In 1995, the Barnes’ had a $22,282 loss from Whitney, suspended due to lack of basis.  On their 1996 joint return, they reported the $22,282 loss even though their 1996 K-1 showed an additional $136,229 loss for the tax year.  In 1997, they contributed $278,000 in capital to Whitney, enabling them to finally take the suspended losses from 1995 and 1996, which totaled $158,511, but in fact they only deducted the current 1997 loss of $52,594 on the 1997 return.  USER ERROR!

To follow the story, we must fast forward to 2003.  The taxpayers awake from the sleep they were in and with the help of a new accountant, they determine they should have deducted the losses on the 1997 return.   Guess what; that year is closed.  Ouch!

Sounds bad; but, the Barnes’ find a way to relieve some of the pain.  They claim, since they did not use the basis for the losses from 1995 and 1996, they can take a deduction for the losses resulting from the current year on the current return – tax year 2003 -- using the unused basis from 1997.  They make three arguments in favor of this position:

First, they argue IRC Section 1367(a)(2)(B) only requires you to reduce basis for losses you actually report on your return.  So, since they did not take the losses on the 1997 return, there should be no reduction in basis.  WRONG!

IRC Section 1367(a)(2)(B) requires an S corporation shareholder to reduce stock basis by any losses that a shareholder should have taken into account under IRC Section 1366(a)(1)(A), even if the shareholder did not actually claim the benefit of the pass-through of the losses on his/her return.

Next, the Barnes’ argued the tax benefit rule allowed them to claim a deduction in 2003 for the loss they should have deducted in 1997.  WRONG AGAIN!

The tax benefit rule generally only applies when taxpayers recover amounts they deducted in a prior year.  When that situation arises, the taxpayer may exclude the recovered income to the extent the prior deduction did not give rise to a tax benefit.  The tax benefit was inapplicable in the Barnes case.

Last, the Barnes argued that their failure to properly deduct the losses in 1997 caused them to compute an incorrect amount of losses that could be used to offset income in 2003.  I do not understand the argument.  It makes no sense.  Guess what, the Tax Court did not understand it either.  The Barnes’ lose the battle!

The Barnes’ do not go down for the count.  Instead, they turn on their CPA and claim they relied upon professional advice.  So, no penalties for accuracy or negligence are appropriate.  Unfortunately, the court concluded they did not provide evidence to show they acted in good faith in relying upon professional advice. In fact, the evidence showed the accounting firm’s advice was limited by the Barnes’ inadequate accounting records and erroneous basis information from prior years in which it did not represent the taxpayers.

The result is simple:  The Barnes’ were stuck with the tax and penalty assessment and a boat load of interest as the case muddled through the IRS and the court system for over nine years.

There are two pearls of wisdom to take away from the case:

  1. You reduce stock basis by the losses allowable under IRC Section 1366 even if you fail to report the losses on your return; and
  2. If a taxpayer does not provide you with adequate records, they will not likely prevail in a dispute over negligence or accuracy related penalties.

CPAs and other tax advisors need to be careful.  You want to resist the temptation to represent or continue to represent clients that do not maintain adequate records.

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.

Best,

Larry

Introduction 

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.

Background

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;
    • Estates;
    • 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.

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Larry J. Brant
Editor

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.

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