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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.


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

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.

The Nathel brothers were correct about one point - - under IRC Sections 1366 and 1367, if the corporation had income, including tax-exempt income, such would restore debt basis to the extent of their share of that income.  The Service pointed out to the Nathel brothers, however, that they were wrong about the most important point:  capital contributions, in accordance with IRC Section 118, are not income to the recipient corporation.  So, since the corporation had no income, there was no loan basis restoration.  The additional capital contributions did, however, increase their stock basis, which may be of help to the Nathel brothers down the road.  Additional stock basis, however, was of no help to the Nathel brothers as it did not reduce the tax burden resulting from the loan repayment.

  • The taxpayers lose the debate;
  • The IRS issues a 90-day letter; and
  • The Nathel brothers are off to Tax Court.

The Nathel brothers, of course, lose again!  Rather than stay down for the count, they proceed forward to the Second Circuit Court of Appeals, where they lose a third time.

There are two morals to this story:

  1. Capital contributions are not income to the recipient corporation for purposes of IRC Sections 1366 and 1367; and
  2. Shareholders of S corporations need to keep track of stock and debt basis to avoid the unpleasant tax news the Nathel brothers received in this case.

In a recent GAO report that looked at tax years 2006 through 2008, the government found that losses deducted by S corporation shareholders that exceeded basis limitations totaled around $10,000,000, or amounted to about $21,600 per shareholder/taxpayer. The GAO concluded that this non-compliance is the consequence of the actions of the shareholder, not the corporation.  In other words, it is the shareholders’, not the corporation’s, duty to track and compute stock basis.  Don’t be surprised, however, if Congress does not amend the law, requiring S corporations to compute each shareholder’s basis and include it on the IRS Form K-1 each year.  Partnerships already have this duty in that they have to report the partner’s beginning and ending capital account balances on the IRS Form K?1 each year.

S corporations and their shareholders must track both stock and debt basis.  It is that simple.

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:

  1. 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.
  2. 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:

  1. 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.
  2.  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.
  3. 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.
  4. 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.

 Watson, P.C. v. U.S.

Watson, P.C. v. U.S., 668 F.3d 1008 (8th Cir. 2012), affirming 107 AFTR 2d 2011-311 (DC IA December 23, 2010), is an unreasonable compensation case in the context of a personal service S corporation.  The taxpayer, David E. Watson, graduated from the University of Iowa with a bachelor’s degree in business administration and a specialization in accounting.  He became a CPA in 1983.  In 1996, Watson incorporated DEWPC, a professional corporation, which elected to be treated as an S corporation.  Watson is the sole officer, shareholder, director and employee of DEWPC.  In 2003 and 2004, the tax years at issue, he was the only person to whom DEWPC distributed money.  His annual salary in both years was $24,000.  In arriving at his $24,000 annual salary figure, Watson had only considered what he thought he could pay an employee on a regular and continuous basis, regardless of the “seasonality” of the business or whether it was a good economy or bad economy.  He did not consider what comparable businesses paid for similar services.  During 2003 and 2004, Watson received distributions totaling roughly $320,000.

For each tax year, the Service reclassified $67,044 of the distributions as wages, stating DEWPC structured Watson’s salary and distribution payments to avoid federal employment taxes. The Service’s re-characterization resulted in a $48,519 employment tax assessment against DEWPC.  After making a few payments toward the assessment, DEWPC filed a claim for refund.  The IRS denied the claim and DEWPC sued in the US District Court for the District of Iowa, located in Des Moines, about 1 hour and 45 minutes away from Iowa City, the home of Watson’s alma mater, the fighting University of Iowa Hawkeyes.

The District Court held in favor of the Service. It reasoned that Watson was an exceedingly qualified accountant. He has both a bachelor’s degree and an advanced degree, and approximately 20 years of experience in accounting and taxation. During 2002 and 2003, Watson worked approximately 35 to 45 hours per week for his reputable and well-established firm which had over $2 million and nearly $3 million in gross revenue, respectively, during those years. The court further reasoned that any reasonable person in Watson’s role as DEWPC’s sole shareholder, officer, and employee would have earned more than $24,000, particularly in light of the large distributions he received. Based on these facts and circumstances, the court was convinced that DEWPC structured Watson’s salary and dividend payments in an effort to avoid federal employment taxes, with full knowledge that the distributions to Watson were actually “remuneration for services performed.”

Watson appealed the District Court decision to the Eighth Circuit Court of Appeals, where he asserted at least two alternative positions:

  • The government’s expert on the issue of reasonable compensation should not be relied upon; and
  • The focus should be on the corporation’s intent with respect to compensation rather than on the reasonableness of compensation.

After much discussion, the Eighth Circuit found both of the taxpayer’s arguments meritless.

DEWPC asserted the government’s expert, among other things, was not qualified to render a reliable opinion on reasonable compensation.  He was a certified business valuation analyst, but had no credentials specifically relating to compensation.  The court concluded the taxpayer’s argument was not convincing.  The expert was an experienced “general engineer” for the IRS; he spent 40% of his time dealing with compensation issues.  In fact, he had worked on 20 to 30 reasonable compensation cases.  In accordance with Rule 702 of the Federal Rules of Evidence, a witness may qualify as an expert by “knowledge, skill, experience, training or education.”

DEWPC also argued the government’s expert witness should not be relied upon because he changed his opinions during the lower court proceeding, failed to consider important facts in rendering his opinion, and he adopted flawed methods to arrive at his conclusions.  Unfortunately, DEWPC never raised these objections in the lower court, nor did it introduce evidence through its own expert witness to contradict the government’s position.

To address DEWPC’s second argument, the Eighth Circuit surveyed the cases on reasonable compensation.  “[A] business may deduct a ‘reasonable allowance for salaries or other compensation for services actually rendered’ as ordinary and necessary business expenses.”  The determination of reasonableness requires an analysis of all of the facts and circumstances.  The lower court considered the relevant facts and circumstances.  Nevertheless, DEWPC asserts, rather than focus on reasonableness, the court should have focused on the taxpayer’s intent; that is—did the taxpayer have compensatory intent in making the distributions to Watson?

The court quickly set aside the taxpayer’s argument.  It stated a deduction for compensation is allowed if it is reasonable and the payments are for actual services rendered.  Citing the Ninth Circuit Court of Appeals in Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1243 (9th Cir. 1983), the court concluded the reasonableness inquiry is so broad, it most often subsumes the intent inquiry.  The lower court correctly analyzed the matter with its focus on reasonableness.

Last, DEWPC argued the lower court should have applied the principles of Pediatric Surgical Assocs., P.C. v. Commission, T.C. Memo 2001-81 (2001).  DEWPC specifically asserted Watson’s reasonable compensation should have been limited to his personal billing receipts less expenses attributable to those receipts.  The Eighth Circuit quickly pointed out that Watson was not the only person generating revenue.  Non-shareholder employees were also generating revenue.  So, merely focusing on Watson’s personal time-keeper receipts and expenses attributable thereto was not appropriate in this case.  Other evidence is relevant to the inquiry of reasonableness.  This additional evidence likely includes, but is not limited to, business generated by the shareholder employee, and his/her experience, expertise, hours worked, and education; lack of arms-length negotiation; compensation history; and the financial ability of the corporation.

The Eighth Circuit concluded the lower court’s decision was based upon the proper legal standards.  It was affirmed.

The court totally ignored the analysis adopted by the US Tax Court in Pediatric Surgical Associates (discussed below) and concluded that you do not simply look at the income derived from the shareholder/employee’s personal services less a reasonable allocation of overhead to conclude what constitutes reasonable compensation.  Rather, the Eighth Circuit, recognizing that closely held businesses do not run themselves, took a much broader view and concluded you must look at all of the facts and circumstances, including:

  1. the business generated by the shareholder/employee;
  2. the shareholder/employee’s experience and expertise;
  3. the number of hours worked by the shareholder/employee;
  4. the shareholder/employee’s education;
  5. the non-income generating services performed by the shareholder/employee (such as management services, business marketing activities and administrative services);
  6. the compensation history of the shareholder/employee (was he or she undercompensated in prior years);
  7. the financial ability of the corporation to pay; and
  8. the compensation paid to similarly skilled and experienced employees in similar corporations within the same geographic region.

Watson stands for the proposition, at least in the Eighth Circuit, that you take a broader view (even in sole service provider cases), and focus on all of the facts and circumstances to determine what constitutes reasonable compensation.  The US Tax Court, as suggested by it in Pediatric Surgical Associates, seems to take a much narrower view in professional service cases, especially where the corporation employs both shareholder and non-shareholder employees.

While taxpayer motivations are generally the same in the context of personal service corporations as they are in the context of business corporations, these added wrinkles increase the complexity of the analysis as to what constitutes reasonable compensation.  Personal service corporations, however, create a unique dilemma when looking at reasonable compensation.  In both the C and S corporation contexts, if the income of the corporation is derived solely from the services of the shareholders, any attack by the Service that the compensation being paid to the shareholders is too high will not be very strong.  On the other hand, in the S corporation context, if the income of the corporation is derived solely from the services of the shareholders, the shareholders will have a difficult time justifying low compensation and high distributions.


Radtke v. United States, 63 AFTR2d 89-1469, 712 F.Supp. 143 (1989), aff’d per curiam, 65 AFTR2d 90-1155, 895 F.2d 1196 (7th Cir. 1990), is a case involving an attorney who was the sole billing service provider for his wholly-owned S corporation.   While the case is extreme in its facts, it illustrates the fact that, in the case where a shareholder provides all of the services for the corporation, low compensation will not prevail.

Mr. Radtke took all of the profits from the corporation as distributions.  He paid himself zero compensation.  Mr. Radtke worked full-time for the corporation.  No other service providers generated income for the corporation.  The old adage, pigs get fat and hogs get slaughtered, definitely applied to this case.  As you would suspect, Mr. Radtke got slaughtered by the court.  The Service knocked him out in the first round.  He should have stayed down for the count rather than get himself humiliated by the District Court for the Eastern District of Wisconsin and again by the Seventh Circuit Court of Appeals.

In the case where the personal service corporation employs non-shareholders who generate income for the corporation from their services, we encounter another dilemma – whether the reasonable compensation of a shareholder/employee may exceed his or her personal service collections, less a reasonable allocation of overhead.  In the C corporation context, the US Tax Court was faced with this situation in Pediatric Surgical Associates.

Pediatric Surgical Associates

Pediatric Surgical Associates, P.C., TCM 2001 -81, involved a Texas professional corporation that employed four (4) shareholder/employee surgeons and two (2) non-shareholder/employee surgeons.  The surgeons were the only income generating employees of the corporation.  Upon audit, the Service argued that a portion of the compensation paid to the shareholder/employee surgeons was actually distributions of profits; that is, profits attributable to the services of the non-shareholder/employee surgeons.  On audit, the IRS also threw out a Code Section 6662 penalty flag.

The taxpayer appealed the case.  After not receiving a warm welcome in the Office of IRS appeals, the taxpayer filed a petition in the US Tax Court.

It turns out, Judge Halpern was not much friendlier to the taxpayer than the auditor or the IRS appeals officer.   Writing a 35-page opinion, the court upheld the IRS assessment of both the taxes and the accuracy related penalty.

The tax years at issue were 1994 and 1995.  The aggregate tax and penalty at issue was around $600,000, plus or minus a few dollars.  The Service disallowed around $600,000 of compensation in 1994 and $800,000 of compensation in 1995.  In the US Tax Court, the Service retreated from its audit position and agreed to reduce its compensation disallowance from $600,000 in 1994 to $140,000 and from $800,000 in 1995 to $20,000.  But, it did not walk away from the Code Section 6662 penalty.  Rather than accept the concessions offered by the IRS and call it a day, the taxpayer continued to fight it out in the US Tax Court.

The Service’s position was simple:  A portion of the amount claimed by the taxpayer as a deduction under Section 162 for compensation paid to shareholder/employees was disguised dividends.  It was profits attributable to the services of the non-shareholder/employees.  The court ultimately agreed with the IRS.

In a rather strange opinion, the court focused its analysis on the collections of the taxpayer during the tax years at issue directly attributable to the services of the shareholder/employees and the overhead properly allocable to the shareholder/employees.  The court held that, in the personal service context, a shareholder’s collections, less a reasonable allocation of overhead, is the proper method to determine the shareholder/employee’s level of reasonable compensation.

So, the US Tax Court ruled that the amount paid as compensation to the shareholder/employees of Pediatric Surgical Associates, but attributable to the income generated from the services of non-shareholder employees, was not reasonable.  Judge Halpern completely ignored the fact that shareholder/employees do more than just bill for their patient or client services.  They build the goodwill of the organization, and they actively participate in administrative matters such as recruiting and hiring professional and nonprofessional staff, overseeing management, finance and operations, and training professional staff.

This case is cited often for the proposition that, in the context of professional service businesses that employ both shareholder and non-shareholder professional service providers,  we must look at each shareholder/employee’s personal billing receipts, less a reasonable allocation of overhead, to come up with what constitutes reasonable compensation for that shareholder/employee.

Many commentators believe the US Tax Court’s decision in Pediatric Surgical Associates is wrong.  Nevertheless, you need to be aware that the case is out there.  You need to consider its implications when advising clients.


Each case requires an analysis of all facts and circumstances.  Unfortunately, there is no bright line test.  After an audit commences, tax advisors are quite late in the game; the facts are etched in stone.  At that point, you have to search the facts and be ready to present all of the facts surrounding your case.  Hopefully, the good facts overshadow the bad facts.

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;
  • 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:

  1. The S corporation must be a bank, as defined in Section 581 of the Code; and
  2. 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 facts of the case are simple and straight forward. The taxpayer thought it was an S corporation. The tax year at issue was 2003. The taxpayer’s sole shareholder was a custodial Roth IRA account held for the benefit of an individual (who was an eligible S corporation shareholder). The Service audited the S corporation and eventually issued a notice of deficiency for tax year 2003, determining, among other things, that the corporation was taxable as a C corporation because it had an ineligible shareholder. The taxpayer asserted, in somewhat of a convoluted and unintelligible manner, that an IRA was an eligible S corporation shareholder. After being unable to convince the auditor of this argument, the taxpayer appealed. Unfortunately for the taxpayer, the argument did not favorably resonate with the Appeals Officer. The law seems clear: no IRA (for tax year 2003 or earlier) is an eligible S corporation shareholder. After losing in the IRS Office of Appeals, the taxpayer filed a petition in the US Tax Court.

The tax year at issue, 2003, predates the American Jobs Creation Act by one year. Furthermore, the taxpayer was not a bank. So, even if the provisions of the American Jobs Creation Act were applicable, they would not save the day for Taproot Administrative Services (“Taproot”).

Ruling against the taxpayer, the US Tax Court, citing Revenue Ruling 92-73, concluded:

“Unlike grantor trusts, traditional and Roth IRAs exist separate from their owners for Federal income tax purposes….Because the tax-free accrual of income and gains is one of the cornerstones of traditional and Roth IRAs, it would make no sense to treat IRAs as grantor trusts thereby ignoring one of their quintessential tax benefits. As it stands, an IRA—and not its grantor or beneficiary—owns the IRA’s income and gains….”

The Tax Court also stated there was no indication Congress (prior to the American Jobs Creation Act) ever intended to allow IRAs to own S corporation stock. While it could have, it did not list IRAs as eligible S corporation shareholders in Code Section 1361. Had Congress intended to make IRAs eligible S corporation shareholders, it could have done so explicitly, as it had in the limited case of banks desiring to elect S corporation status. Consequently, the court concluded a Roth IRA is not eligible to own shares of an S corporation. The taxpayer was taxable as a C corporation.

Judge Holmes wrote a dissenting opinion. He pointed out that an IRA is owned by a custodian for the benefit of an individual. Judge Holmes asserted the individual, not the IRA, should be considered the shareholder for purposes of the analysis.

With its loss in the Tax Court, the taxpayer could have licked its wounds, packed up and returned home. Rather, Taproot appealed to the Ninth Circuit Court of Appeals. Jumping on Judge Holmes’s dissenting opinion, the taxpayer argued the owner of an IRA, rather than the IRA itself, should be considered the shareholder of the S corporation. An IRA is a custodial account, and with respect to custodial accounts, the person for whom the account is held is the owner of the shares held in the account. Put in the simplest terms, Taproot argued an IRA should be ignored; it is simply a custodial account. The only hope for this taxpayer was convincing the court that the proper analysis was to ignore the IRA and look at the beneficiary as the shareholder.

Unfortunately, the Ninth Circuit concluded that this argument lacked legal authority. If the assertion that we look through an IRA and look at the beneficiary to determine whether the S eligibility requirements are met was correct, why did Congress specifically have to amend Code Section 1361(c) (2) to allow IRAs to be eligible S corporation shareholders provided the corporation was a bank and the stock was owned by the IRA on October 22, 2004? Taproot’s argument did not hold water. Consequently, it lost at the Ninth Circuit. The saga is over unless Congress amends Code Section 1361 to allow IRAs to be eligible S corporation shareholders.


There is one moral to this story: Even today, IRAs and Roth IRAs, absent meeting the narrow American Jobs Creation Act rural bank exception, are not eligible S corporation shareholders.

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.

Next, the Tax Court considered whether the taxpayers’ portion of the net operating loss attributable to Utility Design was limited by Section 1366(a).  Section 1366(a) requires an S corporation shareholder, when calculating his or her taxable income for the year, to take into account his or her pro rata share of the S corporation's items of income, loss, deduction, or credit for the S corporation's tax year that ends in the tax year of the shareholder.  However, the S corporation's loss taken into account by a shareholder cannot exceed the limitation amount calculated under Section 1366(d)(1), which is equal to the shareholder’s adjusted basis in the S corporation stock increased by the shareholder’s adjusted basis of any indebtedness of the S corporation to the shareholder.

The Tax Court concluded Patrick Montgomery’s basis in the Utility Design stock was zero at the beginning of 2007.  It then considered basis adjustments.  In 2006 and 2007, Utility Design borrowed the following amounts:  $1 million from SunTrust Bank on August 25, 2006, (which was personally guaranteed by the taxpayers); $60,000 from Patrick Montgomery on September 26, 2007; $30,000 from Patrick Montgomery on October 5, 2007; and $15,000 from Patrick Montgomery on November 13, 2007.

In 2008, Utility Design defaulted on the $1 million loan.  The bank proceeded to pursue claims against the taxpayers on the personal guarantees.  The taxpayers failed to pay the debt under the guarantees, despite repeated demand and the filing of a lawsuit against them.  Ultimately, in November 2009, a judgment was entered in favor of the bank against them for $425,169.54.  The taxpayers took the position that their basis in the Utility Design shares was increased by the amount of the judgment (i.e. $425,169.54).

The IRS contended the judgment amount did not increase the taxpayers’ stock basis.  When an S corporation shareholder guarantees a loan of the corporation, no debt has been created between the S corporation and the shareholder.  However, once the shareholder pays the bank pursuant to the guarantee, the S corporation becomes indebted to the shareholder and the shareholder obtains basis.

Accordingly, the court held that, because the taxpayers, Patrick and Patricia Montgomery, did not make any payments under the guarantee, their guarantee did not increase share basis.  To put salt on the wound, the court upheld the Service’s imposition of a Code Section 6651(a)(1) penalty against the taxpayers for late filing.

The moral to this story is simple:  You do not get basis merely by guaranteeing the corporation’s debt.  Also, unless you pay the debt, a judgment against you will not give you basis.  Last, but certainly not least, failure to follow these clear rules could result in penalties.

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.

Prior Revenue Procedures

In 1996, Congress recognized the failure to timely file an S election could lead to severe consequences and gave the IRS authority to issue rules providing relief for late S elections.  In 1997, the IRS issued Rev. Proc. 97-40 and Rev. Proc. 97-48.  In later years, the IRS expanded late filing relief in Rev. Proc. 98-55, Rev. Proc. 2003-43, Rev. Proc. 2004-48, and Rev. Proc. 2007-62.

Generally, these Revenue Procedures applied to late S corporation, Electing Small Business Trust, Qualified Subchapter S Trust, and Qualified Subchapter S Subsidiary elections.  The requirements were fairly straightforward and each subsequent Revenue Procedure expanded the leniency for late elections.

Rev. Proc. 2013-30

Effective September 3, 2013, Rev. Proc. 2013-30 simplifies how to obtain late filing relief and increases the time period for which retroactive relief may be obtained.

Pursuant to Rev. Proc. 2013-30, the time period for which retroactive relief may be obtained for late S elections is extended to 3 years and 75 days after the intended effective date of the S election.  Revenue Procedure 2013-30 also provides similar relief for late:

Qualified Subchapter S Trust elections;

Electing Small Business Trust elections;

Subchapter S Subsidiary elections; and

Corporate classification elections.

The requirements for relief in these situations are similar to the requirements discussed below for late S elections.  However, there are some differences.  If you are faced with any of these late filings, a careful review of Rev. Proc. 2013-30 is required.

Late S Election Relief Requirements

To obtain relief for a late S election, the corporation must file IRS Form 2553 and include at the top of the form “FILED PURSUANT TO REV. PROC. 2013-30.”  In addition, the following requirements must be satisfied:

  • Late filing is the sole defect;
  • The entity qualified as an S Corporation for the period relief is sought;
  • The entity intended to be an S Corporation;
  • The request for relief is filed within 3 years and 75 days after the intended effective date of the S election;
  • The request for relief contains a statement describing why reasonable cause exists for the late election and the entity acted diligently to correct the mistake upon discovery; and
  • All shareholders reported their income on all affected returns consistent with an S election in effect and statements from all shareholders attesting to this must be attached.

There is also relief available if the request is made more than 3 years and 75 days after the intended effective date of the S election.  In such instances, in addition to satisfying the above requirements, the following requirements must be met:

  • At least 6 months have elapsed since the corporation filed its IRS Form 1120S for the first tax year it intended to be an S Corporation;
  • Neither the corporation nor any shareholder was notified by the IRS of any problems regarding S Corporation status within 6 months of the filing of its IRS Form 1120S for the first tax year it intended to be an S Corporation; and
  • The entity is not seeking a late entity classification election (e.g., an LLC that “checks-the-box” to be taxed as a corporation and then makes an S election).

Reasonable Cause

While most of the requirements are objective in nature, an entity must demonstrate reasonable cause as to why a timely S election was not filed.  This is a subjective inquiry.

Historically, the IRS has placed a low threshold on the reasonable cause requirement.  Examples of situations where the IRS has found reasonable cause include: (1) the entity’s responsible person failed to file the S election; (2) the entity’s tax professional failed to file the S election; and (3) the entity did not know it needed to affirmatively file an S election.

Prior IRS Forms 1120S

If the corporation has filed all IRS Forms 1120S for tax years it intended to be an S Corporation, IRS Form 2553 requesting late filing relief can be attached to the current tax year’s IRS Form 1120S, provided the forms are filed within 3 years and 75 days from the intended effective date of the S election.  An extension of time to file the current tax year’s IRS Form 1120S will not extend the 3 year and 75 day period.

No Prior IRS Forms 1120S Filed

If the corporation has not filed an IRS Form 1120S for the tax year it intended to be the effective date of the S election, then IRS Form 2553 requesting late filing relief may be attached to IRS Form 1120S for the first intended S Corporation tax year, provided:

  • IRS Form 1120S for the intended effective date of the S election must be filed less than 3 years and 75 days from the intended S election date; and
  • All other delinquent IRS Forms 1120S must be filed simultaneously and consistently with the requested relief.

Rev. Proc. 2013-30 greatly expands the situations where late filing relief may be available.


If you discover an S election was not filed or was not timely, there may be hope.  If you don’t qualify for assistance under Rev. Proc. 2013-30, relief may still be available through a private letter ruling.  This process, however, is time consuming and costly.

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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.

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