Current developments.

• Author: Karlinsky, Stewart S.
• Position: S Corporations, part 1

This two-part article discusses recent cases, rulings, regulations and other developments in the S corporation area. Part I focuses on S operational aspects, such as K-1 compliance, S employee stock ownership plans, tax shelter rules, loss limits, reorganizations and acquisition rulings.

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During the period of this update (July 1, 2003-June 30, 2004), important and sophisticated S corporation operational issues were addressed by the courts and Treasury. This year the focus is on S corporation ESOPs (SESOPs), a new temporary regulation covering synthetic equity, nonallocation year and disqualified persons; informal IRS guidance that affects accrual-basis S employers; listed transactions applying to S activities; built-in gain (BIG); Schedule K-1 matching; and the often-seen adjusted-basis issue, in its various permutations. Also, several cases and rulings involved S corporations and airplanes.

Interestingly, an IRS statistical report (1) showed that of the 2,986,486 Forms 1120-S, U.S. Income Tax Return for an S Corporation, filed for 2001, 56% (1,684,861) showed one shareholder, 30% (886,673) showed two shareholders and fewer than 20,000 returns (0.67%) reflected more than 10 shareholders.

K-1 Compliance

Six days before the 2004 busy season was over and almost a month after K-1s were due, the IRS issued IR 2004-51, (2) to alert tax preparers that it will be again matching K-1s and that there are some common mistakes that preparers should avoid, such as netting; not segregating K-1 net income from unreimbursed and Sec. 179 expenses; not listing currently recognizable suspended carryforwards on a separate line; and not clearly identifying income reportable under the four-year spread of Rev. Proc. 2003-79. (3)

The IRS also has a K-1 project fairly along in the process, to convert the traditional K-1 into a computer-readable format, which will require tax advisers to continually refer to the formatting instructions and identification letters on various information disclosures.

SESOPs

Normally, S status would terminate if a retired employee rolled over stock distributed from a SESOP into an IRA, because an IRA is not an eligible shareholder. However, Rev. Procs. 2004-14 (4) and 2003-23 (5) held that a SESOP or S corporation could buy back the stock from the IRA, without loss of S status.

Another SESOP issue that arises for accrual-basis S corporations is Sec. 267(e)'s potential override of the Sec. 404 deferred-compensation rules. If a cash-basis S employee performs services in 2004, but is not paid until January 2005, the corporation would normally take a deduction in 2004 under Sec. 404'S 2 1/2-month rule. However, if the employee is covered by a SESOE the IRS has stated informally that it will apply the Sec. 267(e)(1)(B) rules to postpone the corporation's deduction until the payment year (2005).

Another recent SESOP development was the issuance of Temp. Regs. Sec. 1.409(p)-1T, the violation (6) of which may subject an S corporation to a Sec. 4979A 50% excise tax. The temporary regulation defines several important terms, including "synthetic equity" (Temp. Regs. Sec. 1.409(p)-1T(f)) and how it applies in defining a "nonallocation year" (Temp. Regs. Sec. 1.409(p)-1T(c)), and a "disqualified person" (Temp. Regs. Sec. 1.409(p)-1T(d)). It is effective for all SESOPs beginning in 2005 (and in some cases, earlier). (7)

Tax Shelters/Listed Transactions/Disclosures

Unfortunately, S corporations are hitting Treasury's radar screen, as are investment baulks and accounting and law firms. Several recent Treasury pronouncements highlight the increased frequency (8) of SESOPs and some aggressive behaviors being used by promoters. Rev. Rul. 2004--4 (9) elaborates on one type of scheme that involves SESOPs and qualified subchapter S subsidiaries (QSubs). Notice 2004-30 (10) and IR 2004-44 (11) describe another S scheme that is a reportable listed transaction--for the first time, nonprofit organizations are listed as participants and, thus, required to disclose. (12)

Loss Limits

A major motivation for choosing S status in a business cycle's early years is the ability to pass through entity-level losses to shareholders. With the recent changes to depreciation enacted by the Jobs and Growth Tax Relief Reconciliation Act of 2003 and the Jobs Creation and Worker Assistance Act of 2002, and the increased carry-back provisions (five years back instead of two, and 100% offset for alternative minimum tax purposes for or from 2001 and 2002), the use of losses is more important than ever.

There are several hurdles that a shareholder must overcome before these losses are deductible, including the Sec. 183 hobby-loss rules, Sec. 1366 adjusted basis rules, Sec. 465 at-risk rules and Sec. 469 passive activity loss (PAL) rules. In many of this year's cases and rulings, Sees. 1366 and 465 issues were at hand.

Economic Outlay

This year saw several court cases in which substance over form determined whether there was an economic outlay that gave an S shareholder basis for loss under Sec. 1366(d). Donald Oren (13) was appealed to the Eighth Circuit, which upheld the lower court's decision upholding the IRS's position. Basically, Oren owned three S corporations, two showing losses due to large depreciation deductions on trucks and trailers and one showing profits. The profitable corporation lent Oren funds. He lent the money to the loss corporation, which lent it back to the profitable corporation. Although the corporations performed all the legal niceties, the court held that there was no actual economic outlay by Oren. Thus, Secs. 1366 and 465 basis was not increased by the circular loan strategy employed among the related parties.

An interesting unanswered...