Current developments.

• Author: Burton, Hughlene A.
• Position: S Corporations, part 2

EXECUTIVE SUMMARY

* The TIPRA will affect S corporation operations in several important ways, both immediately and in the near future.

* The Tax Court's decision in Ruckriegel discards one of the IRS's fundamental criteria for establishing shareholder basis.

* Sec. 409A may apply to some fairly common S corporation deferred-compensation and business practices

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This two-part article discusses recent legislation, cases, rulings, regulations and other developments in the S corporation area. Part II covers operational issues in the Tax Increase Prevention and Reconciliation Act of 2005, final regulations on built-in gains and LIFO recapture tax, Sec. 409A and many other cases and rulings.

During the period of this S corporation update (July 15, 2005-July 15, 2006), one of the biggest developments affecting S corporation operations was the passage of the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA).Two temporary regulations were finalized. A slew of court cases and rulings were issued on an S shareholder's adjusted basis for loss purposes. The IRS issued guidance on new Sec. 409A (deferred compensation); the effect on S shareholders is highlighted. In addition, an unusually large number of letter rulings were issued dealing with spinoffs for various corporate business purposes.

The last 20 years have seen an explosive growth in S corporation filings. According to the latest IRS Statistics of Income report, (48) S corporations continue to grow as the most common form of doing business. In 1985, there were 727,000 S corporations; in 2003, there were over 3.3 million, which represented 60% of all corporate returns filed. This growth has not gone unnoticed. The IRS National Research Program, which was initiated with individual tax returns, was instituted for 5,000 S corporation returns for tax years 2003 and 2004. At the same time this audit program was announced, the Treasury Inspector General for Tax Analysis reported (49) that there has been an "acute decline" in audits of small businesses and small S corporations, from 19,379 in 2001 to 7,328 in 2004. Interestingly, S corporations with greater than $10 million in gross assets have grown more than 1,000% from 1985-2003 (2,305 to 26,096). Also, for large S corporations, Schedule M-3, Net Income (Loss) Reconciliation for Corporations with Total Assets of $10 Million or More, will be required, beginning with 2006 returns.

TIPRA

On May 17, 2006, President Bush signed the TIPRA into law. It has several important effects on S corporation operations, both immediately and in the near future. First, under TIPRA Section 510, the "kiddie tax," which taxed unearned income above $1,700 at the parents' rate, was extended to children under age 18, up from under 14 years old. This somewhat limits the planning opportunity of gifting S stock to high-school students.

This rule change is effective starting in 2006.

Second, under TIPRA Section 514, the Sec. 199 domestic production activities deduction's application was clarified; the deduction is to be computed at the S shareholder level. Section 514 states that the 50%-of-wage limit only applies to wages generated in the qualified production activity (QPA). This means that officers' wages not involved in the QPA would not count for limitation purposes.

Third, TIPRA Section 517 eased the ability to accomplish tax-deferred spinoffs under Sec. 355 with an S holding company and active qualified subchapter S subsidiaries (QSubs), effective on the enactment date.

The Sec. 179 $100,000 (inflation-adjusted) expensing deduction has been extended to 2008 and 2009, under TIPRA Section 101. Also, the capital gain and dividend rate for taxpayers below the 25% marginal tax rate (in 2006, $30,650 for single and $61,300 for married filing jointly), which is currently 5% (zero in 2008), has been extended to 2009 and 2010, under TIPRA Section 102.

BIG

With many companies having converted from C to S status, one of the more important and complicated provisions is the Sec. 1374 built-in gain (BIG) rules. This year, Treasury issued guidance under authority granted in Sec. 337(d).

Final regulations were issued on the application of Sec. 1374 to an S corporation that switched from C to S status and back. This is basically a revisit of the Colorado Gas Compression, Inc. (50) case reported Last year. A C corporation was created in 1977. In February 1988, it elected to be an S corporation. It then revoked its 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 new Sec. 1374 BIG rules or the old capital gain hales applied.

The Tax Court ruled for the IRS that the most current S election is considered in determining whether a corporation is eligible for the Tax Reform Act of 1986 Section 633(d) transition rules applicable to small businesses. As reported last year, the Tenth Circuit reversed and remanded the case to the Tax Court, holding that, as long as a pre-1989 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), regulations (51) were issued on Dec. 20, 2005 that overturned the Tenth Circuit's decision.

LIFO Recapture Tax

Treasury finalized (52) Regs. Sec. 1.1363-2 to address a perceived problem with the Coggin Automotive (53) case. Again, using Secs. 337(d) and 1374(e) authority, Treasury in effect overturned the Eleventh Circuit's holding. The Tax Court held that the aggregate theory applied to LIFO inventory sitting in limited liability companies (LLCs) in which Coggin Automotive was a limited partner (after the restructuring). Thus, the taxpayer was subject to Sec. 1363(d) LIFO recapture tax. The Eleventh Circuit reversed the lower court's ruling, reading the statute literally. Became the S corporation owned no inventory directly, Sec. 1363(d) could not apply. Under the final regulation, effective for transfers after Aug. 12, 2004, a "lookthrough LIFO recapture" concept applies.

Losses and Limits

A major motivation for choosing S status is the ability to flow through entity-level losses...