Current developments.

• Author: Karlinsky, Stewart S.
• Position: Part 1 - In S Corporation taxation issues

EXECUTIVE SUMMARY

* The JGTRRA will have a significant positive effect on S status and encourage C-to-S conversions.

* Two Treasury pronouncements discussed the interplay of ESOPs and S corporations.

* Two rulings dealt with an interesting convergence of the disregarded-entity concept, reorganizations and the step-transaction doctrine.

This two-part article discusses recent legislation, cases, rulings, regulations and other developments in the S corporation area.

Part I focuses on S operational aspects, such as the effect of the Jobs and Growth Tax Relief Reconciliation Act of 2003, undercompensation cases, employee stock ownership plans and reorganization rulings.

During the period of this S corporation tax update (July 1, 2002-June 30, 2003), the courts and Treasury continued to address important operational issues. There was a slew of recent undercompensation cases, IKS guidance on the interplay between employee stock ownership plans (ESOPs) and 8 corporations, and several rulings on S merger and acquisition (M&A) activity. The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTKRA) will also have a dramatic positive effect on S corporations. Part 1, below, discusses these recent developments. Part II, in the November 2003 issue, will address S eligibility, elections and terminations.

Interestingly, a June 2003 IIK8 study (1) showed that 56.7% of all corporate returns filed in 2000 were flora S corporations, up 4.9% from 1999. The study found that there were 292,800 new S corporations filed, of which 211,300 were newly organized companies, and 81,500 were converted C corporations. Returns filed in 2001 comprised 2,165,011 partnership returns, 2,411,981 C returns and 3,022,589 S corporation returns.

The IRS announced (2) that it is implementing an enhanced K-1 matching compliance effort for 2001 S, partnership and trust returns. It reminded tax preparers that they should not aggregate items from Forms K-1, as it plans to better match K-1 information with Schedule E reporting.

Legislation

As was mentioned above, the JGTRRA will have a significant positive effect on 8 status and encourage the conversion of C corporations to S status, for severa1 reasons.

First, the 35% maximum individual tax rate is now virtually the same as the normal small business corporate rate of 34%. This is in contrast to an almost 6% differential in the recent past (39.6% vs. 34%). Second, the 15% qualified dividend rate will allow newly converted S corporations to pay out their earnings and profits, thus avoiding the Sec. 1375 tax and potential S status termination under Sec. 1362(d)(3). The new 15% dividend and capital gain tax rate in JGT1K1KA Sections 302(a) and 301 (b) will also make the pass through nature of S corporations more attractive, as compared to C corporations. In addition, Section 105(a)'s reduction in the marginal tax rates at each income bracket will reduce the advantage that C corporations had in reinvesting their earnings. Third, as the economy has declined in the past few years, many asset values are depressed, which is helpful in minimizing Sec. 1374 built-in gain (BIG) tax exposure.

Fourth, the new, liberal depreciation rules make passthrough entities particularly attractive. JGTRRA Section 202 allows an increased Sec. 179 deduction of up to $100,000, assuming that there is sufficient taxable income at the entity and shareholder levels; Section 201 provides 50% bonus first-year depreciation on new tangible property and certain software (above and beyond Sec. 179 and the normal modified accelerated cost recovery allowances). (3) The phaseout amount for the Set. 179 deduction was also doubled to $400,000, which should cover most small business activities. (4)

Due to these changes, the number of S returns filed should significantly increase in the next few years.

Loss Limits

Another motive for choosing S, rather than C, status is the ability to flow through entity-level losses to shareholders. The use of losses is more important due to the bonus depreciation provisions (including relief from the alternative minimum tax adjustment) enacted by the JGTRRA and the Job Creation and Worker Assistance Act of 2002.

A shareholder still must overcome several hurdles before losses are deductible. In many cases...