Current developments (Part II: this two-part article discusses recent legislation, cases, rulings, regulations and other developments in the S corporation area. Part II focuses on operational issues, including built-in gains, loss limits, Social Security, bankruptcy and reorganizations.).

• Author: Burton, Hughlene A.
• Position: Part 2 - Recent legislation, cases, rulings, regulations and other developments in the S corporation area

EXECUTIVE SUMMARY

* The Tenth Circuit's decision in Colorado Gas Compression was essentially overruled by a new regulation.

* The issuance of Regs. Sec. 1.1363-2 overruled the Eleventh Circuit's decision in Coggin Automotive.

* IRS coordinated issue papers will listed transactions involving corporations.

This two-part article addresses recent developments in the S corporation area. Part II, below, discusses S operational issues. During the period of this update (July 1, 2004-July 15, 2005), the biggest single development was the passage of the American Jobs Creation Act of 2004 (AJCA), (53) on Oct. 22, 2004. Also, there was an unusually active issuance of regulatory guidance, including coverage of Sec. 1374 built-in gain (BIG) issues, LIFO recapture tax and employee stock ownership plans (ESOPs).

The IRS Statistics of Income (SOI) bulletin (54) shows that S corporations continue to grow as a form of doing business. For tax year 2002, 3.2 million S returns were filed, up 5.6% from tax year 2001 and comprising 60% of all corporate returns filed. SOI data also showed that an additional 333,000 new S corporations were filed for 2002, of which 90,000 converted from C to S; the rest were new businesses. The largest growth of S corporations was in the construction, professional, scientific and technical areas.

Sec. 1374 BIG Rules

With many companies having converted from C to S status, one of the more complicated provisions that needs to be addressed is the Sec. 1374 BIG rules. The IRS and Treasury issued significant guidance in this area.

Temporary and final regulations issued on Dec. 22, 2004 (55) discuss two important issues: (1) the application of Sec. 1374 to an S corporation switching back and forth from C to S status (56) and (2) an S corporation acquiring assets in a carryover-basis transaction (either a tax-deferred reorganization or a subsidiary converting to a qualified subchapter S subsidiary (QSub)).

Colorado Gas Compression

The first issue revisits Colorado Gas Compression, Inc., (57) in which the taxpayer incorporated in 1977 and elected S status in February 1988. It revoked the election in December, 1989 and re-elected S status effective Jan. 1, 1994. The key issue for 1994 and 1995, when the company sold assets that it owned in 1988, was whether the Sec. 1374 BIG rules or the old capital gain rules applied. The Tax Court had ruled for the IRS; the most current S election is considered in determining whether a corporation is eligible for transition rules applicable to small businesses under Section 633(d) of the Tax Reform Act of 1986. The Tenth Circuit had reversed and remanded the case to the Tax Court, holding that as long as a pre-1989 S election existed, it did not have to be in effect for the company to qualify for the transition rules; thus, the old capital gain rules applied. Under Secs. 337(d) and 1374(e),Treasury has significant latitude to promulgate regulations that enforce the repeal of the General Utilities (58) doctrine. Under this authority, final and temporary Regs. Sec. 1.1374-10 was issued on Dec. 24, 2004 (59) to, in effect, overrule the Tenth Circuit's decision.

Carryover-Basis Rules

At the same time, Treasury also addressed the Sec. 1374(d)(8) carry-over-basis rules. Basically, it is irrelevant that an S corporation has never been a C corporation or whether it converted to S status before or after 1986 or 1988. If an S corporation acquires C corporation assets under a carryover-basis provision, (60) then it will be subject to Sec. 1374. Also, it will have a separate determination of its net unrealized BIG (NUBIG) and tax attribute carryovers, (61) which may reduce its exposure to the tax. If it acquires several businesses this way, each pool will have its own NUBIG, 10-year recognition period and tax attributes. Also, the taxable income limit will need to be allocated among each pool by its relative recognized BIG.

Example 1: Calendar-year C corporation X elected to convert to S status in 1999. It has a 100% C corporation subsidiary, Z, that conducts business in the western states. X decided to convert Z into a QSub on June 16, 2005.

A deemed Sec. 332 liquidation is triggered by this election. X Hill have two 10-year recognition periods that need to be tracked--one from Jan. 1, 1999-Dec. 31, 2008 and one from June 15, 2005--June 14, 2015. Z's tax attributes can only be applied to Z's BIGs, and X's tax attributes can only be applied to X's BIGs. Also, the taxable income must be allocated to the two BIG pools by the relative BIGs recognized, so that the taxable income limit may be applied properly. Thus, for example, if X had $40,000 recognized BIG in 2006 and Z had $60,000, 40% of 2006 taxable income would be allocated to the X pool and 60% of taxable income to the Z pool. Note: X's NUBIG would be reduced by the Z stock's BIG, because it is now reflected as a separate pool.

Tax planning: If appropriate from a business perceptive, it may pay to liquidate a subsidiary immediately so that there is no need for a separate (1) determination of the BIG embedded in the corporate entity nor (2) recognition period.

Example 2: A calendar-year S corporation that has always been an S corporation acquired a C corporation in a statutory merger (under Sec. 368(a)(1)(A)) on Jan. 1, 2005. It will have to plan for the BIG tax on the difference between adjusted basis and fair market value (FMV) of the acquired assets in this carryover-basis transaction. The recognition period will extend until Dec. 31,2014. C corporation tax attributes, such as NOLs, capital loges, GBCs and MTCs, will be...