Current developments in S corporations.

• Author: Karlinsky, Stewart S.
• Position: Part 1

During the period of this S corporation tax update (July 9, 2009-July 9, 2010), numerous developments occurred in the area of S corporation taxation. This two-part article discusses recent legislation, cases, rulings, regulations, and other developments in the S corporation area. Part I covers new tax laws, court cases, regulations, revenue procedures, and rulings on various S corporation operating provisions.

Zero Capital Gain Rate in 2009 and 2010

The potential zero capital gain rate for 2009 and 2010 continues to be an attractive tax planning tool that may affect S corporations and their shareholders' behavior. Because the capital gain tax rate for individual taxpayers in the lower two tax brackets is zero in 2009 and 2010, (1) many taxpayers are (or were) gifting appreciated S corporation stock to their children, grandchildren, or parents. In 2008, the tax law extended the kiddie tax to income (including capital gains and dividends) of 18-year-olds who do not provide more than half of their support and to 19- to 23-year-olds who are full-time students (2) and do not provide more than half of their own support. (3) Thus, the 0% tax rate generally will not be available to students through age 23 unless they have significant earned income or possibly trust fund income that contributes to their own support. This leads to a balancing act. Parents may hire a child to legitimately work for them and pay him or her enough to meet the 50% self-support test but not so much that they exceed the first two bracket limits ($34,000 for single taxpayers in 2010), including the capital gains generated. (The parents will also lose the dependency exemption.)

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Example 1: Child C, age 22, is in graduate school and has $5,000 dividend income and $2,000 ordinary income from an S corporation, plus $10,000 earned income from summer work and from helping his parents with computer work in their business. His total support is $18,000. In March 2010, C's parents give him stock worth $26,000, with a basis of $6,000 and a holding period of at least one year. He has a standard deduction and personal exemption that puts his 2010 taxable income in the first two tax brackets. Assuming that C sells the gifted stock in 2010, he will pay no tax (0% tax rate) on the $20,000 capital gain and the $5,000 dividend income, for a tax savings over his parents' hypothetical tax on the dividend and capital gains of $3,750 ($25,000 x 15%).

Example 2: The taxable income limit for the first two brackets for a married couple in 2010 is $68,000. Couple A and B, who are retired, defer pension distributions and invest primarily in tax-exempt bonds, and they live off the interest. Their S corporation Schedule K-1 shows ordinary income of $40,000, and they receive distributions of $50,000 during the year. They have itemized deductions of $30,000. Their net ordinary income is $10,000 ($40,000 - $30,000). Therefore, if they recognized $200,000 in capital gains or dividend income through the S corporation or otherwise, $58,000 of the gain would be subject to a 0% tax rate. The other $142,000 would be subject to the normal 15% tax rate. This results in a federal tax savings of $8,700.

IRS Audit Rates and NRP Studies

The IRS released its yearly statistical report that includes details about its audit rates from the last quarter of 2008 through the first three quarters of 2009. In addition, the IRS has released preliminary information about the National Research Program (NRP) regarding S corporations audited for tax years 2003 and 2004 and has announced a new NRP on compensation, independent contractors, etc., relative to S corporations.

IRS Audit Rates

To put S corporations and their individual shareholders' audit rates in perspective, it helps to see what other business entities' audit rates are. For the audit period October 1, 2008-September 20, 2009, the results were generally slightly lower than the prior audit period, with the exception of Schedule Cs with more than $200,000 of gross revenue, which was significantly higher. For C corporations with less than $10 million of assets, the audit rate was 0.9%, while those with more than $10 million of assets were audited 14.5% of the time. This is to be contrasted with S corporations and partnerships, which had a 0.4% audit rate. For individual tax returns, 1.4 million out of 154 million filed were audited, for a less than 1% audit rate. Farm activity was audited at a 0.3% rate, while Schedule C businesses with less than $25,000 in gross receipts were audited at a 1.1% rate. Those Schedule C businesses with $25,000 to $100,000 in gross receipts were audited 1.9% of the time, those with $100,000 to $200,000 in gross receipts were audited at 4.2%, and those over $200,000 at 3.2%.

NRP on S Corporations

At an IRS Tax Research Conference (July 8-9, 2009), the preliminary results of the National Research Program on S corporations, which audited 1,200 S corporations for tax year 2003 and 3,700 for tax year 2004, were reported. The program found 12% underreporting for 2003 and 16% for 2004. It also discovered that small S corporations (defined as having less than $200,000 in assets) had a higher percentage of underreporting than large S corporations. The results showed that this underreporting mirrored underreporting by Schedule C businesses.

New NRP on Wages and Self-Employment Taxes

Tax advisers should be aware of a new NRP being planned for 2010-2012 (2,000 returns per year) that will focus on employment status: employee vs. independent contractor, reasonable compensation, S corporation distributions vs. salary, and matching taxpayer identification numbers. Of the 2,000 returns, 1,500 per year will be from the Small Business/Self-Employed (SB/SE) division. The program began in February 2010.

The Watson case(4) represents exactly what the government is trying to ferret out with this new NRP. A seasoned professional (in this case an accountant) worked 35-40 hours per week, 46 weeks a year, but took a salary of only $24,000. In addition, he distributed more than $200,000 in cash to himself. This taxpayer behavior echoes a long line of cases going back to Radtke, (5) Spicer Accounting Corp., (6) Joseph M. Grey Public Accountant, (7) etc., in which the taxpayers all failed in their attempts to avoid paying Social Security taxes by undercompensating themselves and taking the money out as distributions. Unfortunately this behavior...