Current developments in S corporations.

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

EXECUTIVE SUMMARY

* The American Recovery and Reinvestment Act of 2009 made a number of changes that affect S corporations, including a suspension for 2009 and 2010 of the Sec. 1374 built-in gains tax for S corporations in their eighth, ninth, or tenth year of the recognition period.

* The 2008 Tax Extenders and AMT Relief Act extended to 2008 and 2009 the rule that the decrease in an S corporation shareholder's stock basis for a charitable contribution of property by the S corporation is equal to the shareholder's pro-rata share of the adjusted basis of the property.

* The IRS issued final regulations on how the suspended losses of an S corporation are treated when a shareholder divorces and a portion of the shareholder's shares in the S corporation are transferred to his or her ex-spouse.

* The Mortgage Forgiveness Debt Relief Act of 2007 added a new penalty for S corporations that fail to timely file their returns or fail to provide information required on the return. The amount of the penalty is partially based on the number of shareholders in the corporation.

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This two-part article discusses recent legislation, cases, rulings, regulations, and other developments in the S corporation area. Part I covers operational issues; part II, in the November issue, will cover S corporation eligibility, elections, and termination issues.

During the period of this S corporation tax update (July 9, 2008-July 9, 2009), the American Recovery and Reinvestment Act of 20091 (ARRA) had a direct impact on S corporation operations. The Tax Extenders and AMT Relief Act (2) (TEARA) also had provisions that affect S corporations and their shareholders. Several regulations were issued giving guidance on the proper treatment for suspended losses and divorce as well as open account debt.

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The potential zero capital gain rate for 2008 and 2009 continues to be an attractive tax planning tool that may affect S corporations and their shareholders' behavior. The government has released preliminary information about the National Research Program regarding S corporations audited for tax years 2003 and 2004. The article first looks at tax planning opportunities related to appreciated S corporation stock.

Zero Capital Gains Rate in 2008 and 2009

Because the capital gains rate for individual taxpayers in the lower two tax brackets is zero in 2008 and 2009, 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 (3) and do not provide more than half of their own support. 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 ($33,950), including the capital gains generated. The parent will also lose the dependency exemption.

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 February 2009, C's parents give him stock worth $24,000, with a basis of $4,000 and a holding period of at least one year. He has a standard deduction and personal exemption that puts his 2009 taxable income in the first two tax brackets (i.e., under $33,950). Assuming that C sells the gifted stock in 2009, 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: A retired married couple, A and B, defer pension distributions and invest primarily in tax-exempt bonds. They are living off the interest from those bonds. Their S corporation 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, $57,900 of the gain would be subject to a 0% tax rate. The other $142,100 would be subject to the normal 15% tax rate. This results in a federal tax savings of $8,700.

IRS Audit Rates and NRP Study

To put S corporations and their individual shareholders' audit rates in perspective, it helps to see what other business entities' audit rates are. During the audit period October 1, 2007-September 20, 2008, for C corporations with less than $10 million of assets, the audit rate was 1%, while those with more than $10 million of assets were audited 15.3% of the time. This is to be contrasted with S corporations and partnerships, which had a 0.4% audit rate. Individuals were audited 1% of the time (of which one-third were related to earned income tax credit issues and 77% were correspondence audits). Farm activity was audited at 0.6%. Schedule Cs with less than $25,000 in gross receipts were audited at 1.2%, those with $25,000-$100,000 at 1.9%, those with $100,000-200,000 at 3.8%, and those over $200,000 at 3.1%.

At a recent IRS Tax Research conference (July 8-9, 2009), the preliminary results of the National Research Program on S corporations were reported. The program audited 1,200 S corporations for tax year 2003 and 3,700 for tax year 2004. It 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. It found that this underreporting mirrored the underreporting on Schedule Cs. The interesting question is whether the IRS will adjust small S audit rates to the Schedule C rates described above (1.2%3.8%), rather than the historically low S corporation audit rate of 0.4%.

American Recovery and Reinvestment Act of 2009 (ARRA)

Signed into law on February 17, 2009, ARRA affects S corporations and their shareholders in several ways. First, it extended the increased Sec. 179 deduction limits ($250,000/$800,000) to 2009. Second, it also extended the 50% bonus depreciation rules (Sec. 168(k)) to 2009.

Example 3: In 2009, X, an S corporation, places in service $600,000 of equipment with a five-year class life. X may pass through to its shareholders $250,0004 of Sec. 179 depreciation and $210,000 (5) of bonus and regular depreciation. Thus, the combination of Sec. 179, bonus depreciation, and MACRS results in 77% of the asset being expensed in the year placed in service. The shareholders would reflect their share of the $250,000 Sec. 179 deduction on their individual tax...