Current developments.

• Author: Karlinsky, Stewart S.
• Position: Part 1 - Developments in S corporation taxation in switching from accural to cash method accounting

EXECUTIVE SUMMARY

* After losing many court cases, the IRS will now permit certain companies to automatically switch from accrual- to cash-method accounting.

* Pension plans may now lend up to $50,000 to S shareholders.

* The Tax Court ruled on several cases on undercompensation.

This two-part article addresses recent developments in the S corporation area. Part I, below, discusses S operational issues. Part II, in the next issue, will examine S eligibility, elections and terminations.

Operations

During the time frame of this S tax update (July 1, 2001-June 30, 2002), the courts and Treasury continued to address S operational issues. The Job Creation and Worker Assistance Act of 2002 (JCWAA) will have three significant effects on the computation of S taxable income (in many cases, retroactive to already filed 2001 entity- and shareholder-level returns). The changes involve S cancellation-of-debt (COD) income, additional first-year depreciation and a five-year net operating loss (NOL) carry-back. (1)

Further, many S corporations will now be able to switch automatically from the accrual to the cash method of accounting. A LIFO recapture tax case yielded a taxpayer-favorable result. Other issues involved undercompensation, mergers and acquisitions (M&A) of S corporations and qualified subchapter S subsidiaries (QSubs), and use of S losses.

Cash Method

A common reason to elect S status is that Sec. 448(c) does not apply, allowing use of cash accounting. Most service companies prefer that accounting method. Historically, the IRS had argued vigorously that the accrual method better reflects income and that supplies related to the delivery of services were really merchandise or inventory; thus, use of the cash method was not permissible. After losing many court cases, Treasury has now allowed certain businesses to switch automatically from the accrual to the cash method.

The IRS issued a series of pronouncements (2) that essentially allow S corporations with less than $10 million in average annual gross receipts for the three prior years to use the cash method; if they were using the accrual method, they can automatically switch to the cash method. Although there are some limits, the rules cover service businesses, contractors (e.g., roofers, electricians, floor-tilers, plumbers) and custom manufacturers and fabricators (e.g., asphalt, concrete, custom jewelers, custom home builders, granite and marble fabricators, infusion therapy pharmacies, etc.). Rev. Proc. 2002-19 (3) requires a one-year catch-up for negative Sec. 481 adjustments and a four-year spread for most positive ones.

Loss Limits

S status offers the ability to flow through entity-level losses to shareholders. As discussed below, the loss attribute is more important after the JCWAA changes to first-year depreciation and NOL carrybacks.

A shareholder must overcome several hurdles before such losses are deductible. In numerous cases and rulings, the shareholder's adjusted basis in stock and debt was the relevant issue. In Gitlitz, (4) the Supreme Court held that an insolvent S corporation's Sec. 108 COD income increased the shareholders' stock basis, because it was tax-exempt income. JCWAA Section 402(a) and (b) overturned the Supreme Court's decision, effective for debt discharges occurring after Oct. 11, 2001. Discharges occurring before Oct. 12, 2001 increase stock basis, perhaps requiring amended returns.

Economic Outlay

Several court cases addressed whether an economic outlay occurred to give an S shareholder basis for loss under Sec. 1366(d). In Yates, (5) a profitable S corporation lent money directly to a...