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Posts tagged S corporation.

Overview

In the S corporation arena, tax advisors generally do not focus much attention on unreasonable compensation.  As we delve into the issue in this Part VII of my multi-part series on Subchapter S, it will become apparent that reasonableness of compensation in the S corporation setting is important.  Failure to pay attention to the issue can place S corporations and their shareholders in peril.

Closely held C corporations have historically been incentivized to distribute profits as compensation to shareholder employees.  A corporation is allowed, under IRC § 162(a)(1), to deduct “a reasonable allowance for salaries or other compensation for personal services actually rendered.”  There is, however, no corresponding deduction for dividend distributions, which end up being taxed twice:  once at the corporate level upon earning the income that funds the dividend, and again at the shareholder level upon receipt of the dividend.  Consequently, treating distributions of profits as compensation for services rendered could significantly reduce a corporation’s tax liability. 

S corporation revocationThis sixth installment of my multi-part series on Subchapter S is focused on the revocation of an S corporation election.[1]  While the rules relating to revocation are fairly straightforward, there are a few nuances that may create traps for unwary taxpayers and their tax advisers.

Background

An S election may be revoked with the consent of greater than 50 percent of the shares held on the date of revocation.[2] 

Revocation of an S election does not require the Secretary’s consent.  Rather, to revoke an S election, the corporation simply must file a written statement with the Service Center where it files its IRS Form 1120S.  The statement must include:

married couple on beachThis fifth installment of my multi-part series on Subchapter S is focused on married individuals who own shares of an S corporation.  While the rules relating to shareholder eligibility seem straightforward, their application relative to spouses may create traps for unwary taxpayers and their tax advisers.

BACKGROUND

Number of Shareholders Limitation

Prior to 1996, an S corporation could have no more than 35 shareholders.  The Small Business Job Protection Act of 1996 (“SBJPA”) amended Code Section 1361(b)(1)(A), increasing the maximum number of permitted shareholders of an S corporation to 75.  In 2004, Congress enacted the American Jobs Creation Act (“AJCA”). The AJCA further amended Code Section 1361(b)(1)(A), increasing the maximum number of permitted shareholders of an S corporation to 100.  This change was effective for tax years beginning in 2005.  Today, the maximum number of permitted shareholders of an S corporation remains at 100.

LossesThis fourth installment of my multi-part series on Subchapter S is focused on suspended losses of an S corporation.  While the rules seem straightforward, their application can be tricky, especially given legislative changes made in recent years.

Background

In general, S corporation shareholders, like the owners of entities taxed as partnerships, are allocated their share of the entity’s losses for the taxable year.  A number of rules, however, may limit the ability of the owners to deduct these losses.

This third installment of my multi-part series on Subchapter S is focused on a single Code Section, namely IRC Section 1361(b)(1)(C) and the ineligibility of nonresident aliens as shareholders of Subchapter S corporations.

Background

business travelerAs we all have come to understand, nonresident aliens are ineligible S corporation shareholders.  If a nonresident alien were to become a shareholder of an S corporation, the result is straightforward – as of the date the nonresident alien became a shareholder, the corporation’s S election is terminated. There are, however, some obscure aspects of this well-known rule that are worthy of discussion.  One of the obscurities has to do with a 2018 change in the law resulting from the Tax Cuts and Jobs Act.  Additionally, there have long existed hidden traps for unwary taxpayers and their advisers as well as some twists and turns in the road in this area of Subchapter S that are also worthy of discussion.

S CorporationsThis second installment of my multi-part series on Subchapter S is focused on two Code Sections, namely IRC Section 1375 and IRC Section 1362(d)(3).

Background

While most of my readers are all quite familiar with these two Code sections, there are some obscure practical implications of these provisions that I want to bring to your attention or remind you. 

These Code Sections only apply to S corporations that have retained earnings and profits from C corporation years (“C E&P”).  In a nutshell, under Code Section 1375, S corporations that have C E&P at the close of the taxable year and “passive investment income” totaling more than 25 percent of gross receipts will be subject to a tax imposed at the highest corporate income tax rate under Code § 11 (which is currently a flat 21 percent).  The tax is based upon the lessor of the corporation’s “taxable income” or its “excess net passive investment income.”

journeyIn October 2023, I authored a new White Paper, A Journey Through Subchapter S / A Review of The Not So Obvious & The Many Traps That Exist For The Unwary.  This year, in a multi-part article, I intend to take our blog subscribers through some of the most significant changes made to Subchapter S over the past 40 years, (i) pointing out some of the not-so-obvious aspects of these developments, (ii) alerting readers to some of the obscure traps that were created by these changes, and (iii) arming readers with various methods that may be helpful in avoiding, minimizing or eliminating the adverse impact of the traps.  This first installment is focused on one area of Subchapter S – the Built-In-Gains Tax.

Brief History of Subchapter S

In 1954, President Eisenhower recommended legislation that would minimize the influence federal income tax laws had on the selection of a form of entity by closely held businesses.  Congress did not act on the president’s recommendation, however, until 1958.  Interestingly, the new law was not contained in primary legislation.  Rather, the first version of Subchapter S was enacted as a part of the Technical Amendments Act of 1958.  The legislation was, at best, an afterthought.  

booksThe original legislation contained numerous flaws and traps that often caught the unwary, resulting in unwanted tax consequences.  Among these flaws and traps existed: (i) intricate eligibility, election, revocation and termination rules; (ii) complex operational priorities and restrictions on distributions; (iii) a harsh rule whereby net operating losses in excess of a shareholder’s stock basis were lost forever without any carry forward; and (iv) a draconian rule whereby excessive passive investment income caused a retroactive termination of the S election (i.e., all of the way back to the effective date of the S election).  Due to these significant flaws, tax advisers rarely recommended Subchapter S elections.

New York and San FranciscoThe NYU 76th Institute on Federal Taxation (IFT) is taking place in New York City on October 22-27, 2017, and in San Francisco on November 12-17, 2017.  This year, I will be presenting my latest White Paper, The Built-in Gains Tax Revisited.  My presentation will include a discussion about the history of the tax; application and impact of the tax; ways to avoid or potentially minimize the tax; the complexities of Code Section 1374 and the regulations promulgated thereunder; valuation issues; planning opportunities; traps that exist for the unwary; relevant cases and rulings; and practical tax practitioner guidance.

The IFT is one of the country's leading tax conferences, geared specifically for CPAs and attorneys who regularly are involved in federal tax matters.  The speakers on our panel include some of the most preeminent tax attorneys in the United States, including Jerry August, Terry Cuff, Wells Hall, Karen Hawkins, Stephen Looney, Stephen Kuntz, Mark Peltz and Bobby Philpott.  I am proud to be a part of IFT.

This will be my fifth year as an IFT presenter, and I am speaking as part of the Closely Held Business panel on October 26 (NYC) and November 16 (San Francisco).  As in previous years, the IFT will cover a wide range of fascinating topics, including tax controversy, executive compensation and employee benefits, international taxation, corporate taxation, real estate taxation, partnership taxation, taxation of closely-held businesses, trusts and estates, and ethics.

I hope you will join us this year for what will be a terrific tax institute.  Looking forward to seeing you in either New York or San Francisco!

View the complete agenda and register at the NYU 76th IFT website.

The Service Continues its Warm Approach to Taxpayers with S Corporation Inadvertent Terminations (PLR 201340001) 

As we know, in accordance with Code Section 1362(f) and the corresponding Treasury Regulations, a corporation will continue to be treated as a Subchapter S corporation during a period of termination, if:

    1. The election was terminated, either because the corporation was disqualified as an electing small business corporation, or as a result of running afoul of the passive investment income rule;
    2. The Service determines the termination as inadvertent;
    3. The corporation promptly takes steps to correct the defect after discovery; and
    4. The corporation and its shareholders acted as if the election was continuously in effect.

To qualify as an S Corporation for the current tax year, a corporation must make an election: (1) at any time during the entity’s preceding tax year; or (2) at any time before the 15th day of the 3rd month of the current tax year.  If a corporation fails to make a timely election, it is considered a “late S election” and it will not qualify as an S Corporation for the intended tax year.

The consequences of a late S election or failing to file an S election can be severe.  First, the corporation will be taxed as a C Corporation and subject to corporate income taxes.  Second, the corporation may be subject to late filing and payment penalties, and interest on unpaid taxes.  Finally, if the corporation filed IRS Forms 1120S as if it were an S Corporation, then all prior tax years would be subject to IRS examination because the tax years remain open.

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Larry J. Brant
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Larry J. Brant is a Shareholder and the Chair of the Tax & Benefits practice group at Foster Garvey, a law firm based out of the Pacific Northwest, with offices in Seattle, Washington; Portland, Oregon; Washington, D.C.; New York, New York, Spokane, Washington; Tulsa, Oklahoma; and Beijing, China. Mr. Brant is licensed to practice in Oregon and Washington. His practice focuses on tax, tax controversy and transactions. Mr. Brant is a past Chair of the Oregon State Bar Taxation Section. He was the long-term Chair of the Oregon Tax Institute, and is currently a member of the Board of Directors of the Portland Tax Forum. Mr. Brant has served as an adjunct professor, teaching corporate taxation, at Northwestern School of Law, Lewis and Clark College. He is an Expert Contributor to Thomson Reuters Checkpoint Catalyst. Mr. Brant is a Fellow in the American College of Tax Counsel. He publishes articles on numerous income tax issues, including Taxation of S Corporations, Reasonable Compensation, Circular 230, Worker Classification, IRC § 1031 Exchanges, Choice of Entity, Entity Tax Classification, and State and Local Taxation. Mr. Brant is a frequent lecturer at local, regional and national tax and business conferences for CPAs and attorneys. He was the 2015 Recipient of the Oregon State Bar Tax Section Award of Merit.

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