Since the inception of subchapter S in 1958, the relationship of this part of the Code to other tax rules governing corporations has been unclear. In 1982, Congress stated that the rules of subchapter C apply to S corporations unless those rules are inconsistent with the purposes of subchapter S. (1) However, one of the basic rules regarding the taxation of S corporations is that the corporation computes its income in the same manner as an individual. (2) Since the adoption of these two provisions more than 30 years ago, no regulations have amplified them, and cases and rulings have been few and narrow in scope.
The gray areas become even grayer when a particular rule is not within subchapter C and is clearly inapplicable to individuals. Examples include the income exclusion under Sec. 118 for contributions to capital. This provision applies specifically to corporations but is not within suhchapter C. Cases and rulings have implicitly allowed S corporations to exclude contributions to capital from income. (3)
Controlled Groups of Corporations
Another area of importance is the controlled group problem. Secs. 1561 and 1563, which define and limit tax benefits of certain controlled corporations, are not within subchapter C and are not relevant to the individual taxpayer. Thus there is no direct link from any provision in subchapter S to these Code sections.
Sec. 1561 enumerates certain attributes, such as the graduated corporate rate structure, as items that members of a controlled group must share. However, the sharing is limited to the "component" members and does not apply to "excluded" members. Sec. 1563, which defines the relationships necessary for two or more corporations to be included in a controlled group, does not specifically include or exclude S corporations.
Historically, the regulations have not been terribly helpful in providing guidance. Before December 2006, only one terse statement dealt with the status of S corporations and the controlled group rules. Regs. Sec. 1.15631(b)(2)( ii)(c) (4) cexcluded an electing small business corporation (S corporation) if it was "not subject to the tax imposed by section 1378." (5) That tax, on "certain capital gains," was the predecessor of the current built-in gains (BIG) tax and required an S corporation to use the graduated Sec. 11 rate schedule in certain instances when it was subject to the tax.
By the end of 2006, almost 24 years had passed since the effective date of the Subchapter S Revision Act of 1982. Moreover, 20 years had elapsed since Congress had replaced the S corporation capital gain tax with the BIG tax. Treasury finally in December 2006 issued temporary and proposed regulations that correspond with the changed nomenclature and cross references, as well as recognize that the passive investment income tax and the BIG tax did not use the graduated rate structure of Sec. 11.
The preamble to the 2006 temporary and proposed regulations stated:
Since an S corporation is not currently subject to any tax to which either the tax bracket amounts of section 11(b) apply, or any other tax benefit item to which section 1561(a) applies, it is appropriate to treat that corporation as an excluded member of a controlled group. (6) These proposed regulations were adopted as final without substantive change in May 2009, and the temporary regulations were removed. (7)
If one were to read the preamble to the temporary and proposed regulations before seeing the regulations, one would expect to see that the regulations would treat S corporations as excluded members without further qualification. However, the operative language of the regulation defining excluded members contains a clause that the preamble does not explain: An excluded member includes "Fain "[a]n corporation (as defined in section 1361) for purposes of any tax benefit item described in section 1561(a) to which it is not subject" (8 )(emphasis added).
Thus, the regulation implies that an S corporation might be a component member of a controlled group of corporations when another Code provision apportions any attribute among such members. However, the description of component members in the same regulation makes no mention of S corporations. Thus, a reasonable interpretation of the regulation would be that an S corporation is a component member for purposes of Code provisions...