Current developments in S corporations.

• Author: Karlinsky, Stewart S.

During the period of this S corporation tax update (July 10, 2011-July 9, 2012), some major changes that directly affect S corporations took place, which will be discussed here. This article then presents some tax planning ideas for S corporations and their shareholders.

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Qualifying to Be an S Corporation

A corporation must meet several requirements to qualify as an S corporation. Some of those requirements include the type of corporation that will qualify; the number of shareholders the corporation can have; the type of entity that can be an eligible shareholder; the type of stock the corporation can issue; and the type of income it can generate. In addition, there are several types of elections that the corporation or its shareholders must make to qualify as an S corporation, including an election to be treated as an S corporation; an election to treat a subsidiary as a qualified S corporation subsidiary; and elections by trusts to be treated as eligible shareholders. If any of the requirements are not met at any time, the corporation's S election will be inadvertently terminated. However, the taxpayer can request an inadvertent termination relief ruling under Sec. 1362(f) and, subject to IRS approval, retain its S status continuously. Congress requested that the IRS be lenient in granting inadvertent election and termination relief, and it is clear from the rulings presented here and in past years that the IRS has abided by congressional intent.

Elections

In all of the rulings this year, if the taxpayer could establish reasonable cause for not making a timely election and show that granting the relief would not prejudice government interests, the taxpayer was granted inadvertent termination relief as long as a proper election was filed within 120 days of the ruling. These rulings applied to the failure to file Form 2553, Election by a Small Business Corporation, (1) Form 8832, Entity Classification Election, (2) and Form 8869, Qualified Subchapter S Subsidiary Election (QSub), (3) as well as the elections required by the beneficiary of a qualified subchapter S trust (QSST) (4) and the trustee of an electing small business trust (ESBT) (5) to be an eligible S corporation shareholder. The IRS also granted inadvertent termination relief when the wrong person (in these cases, the trustee and not the beneficiary) signed the election in Letter Rulings 201151004 and 201144018. (6)

A more complicated situation occurs when S corporation stock is held by a trust and the beneficiary dies. The trust can continue to hold the S corporation stock for two years. After that time, the trust must distribute the stock to individual shareholders or to a new trust that will qualify as either a QSST or an ESBT. Many times the stock is transferred correctly to a QSST or an ESBT, but the appropriate person forgets to make the required election and causes a termination. In those cases, the IRS granted relief from inadvertent terminations this year. (7)

Eligible Shareholders

Sec. 1361(b) restricts ownership in an S corporation to U.S. citizens, resident individuals, estates, certain trusts, certain pension plans (but not IRAs), and certain tax-exempt charitable organizations. In Taproot Administrative Services, (8) the Ninth Circuit reaffirmed that a Roth IRA is not an eligible S corporation shareholder.

Historically, S corporations have been more successful with the IRS if they request inadvertent termination relief before they are audited and the issue is decided in the courts. This yea; the IRS issued inadvertent termination relief to S corporations that had shareholders who were corporations, (9) a limited liability company, (10) a partnership, (11) another S corporation, (12) a nonresident alien, (13) and nonqualifying trusts. (l4) In each case, the S corporation rectified the problem upon discovery and agreed to make any adjustments required by the IRS. The IRS allowed the S corporation to retain its status in these situations, but it otherwise did not rule on the tax consequences of the transactions.

One Class of Stock

Sec. 1361(b)(1)(D) prohibits an S corporation from having more than one class of stock, defined as equal rights to distributions and liquidations (but not voting rights). Santa Clara Valley Housing Group (15) involved an S corporation owned by the Schott family using a technique, SC2, marketed by an accounting firm. The technique allowed the Schotts to convert ordinary income of the S corporation into distributions taxable as capital gains through a multistep plan involving the issuance of stock warrants. The key issue was whether the warrants were a second class of stock and therefore would invalidate the S status of the corporation and cause the distributions to be subject to tax as ordinary income under Sec. 301. The district court in California originally decided that the stock warrants were a second class of stock, but it is currently reexamining the terms of the stock warrants under the safeharbor rules of Regs. Sec. 1.1361-1(l)(4). (16) Two letter rulings (17) issued this year allowed the S corporation inadvertent termination relief when warrants were issued.

Letter Ruling 201218004 (18) presents a fairly typical redemption agreement based on fair market or book value purchase price that is allowed without causing a violation of the one-class-of-stock requirement. On the other hand, Letter Ruling 201216034 (19) deals with a fairly complicated trust agree-ment where the primary beneficiary is the trustee and has discretion to distribute, substitute trust property, etc. The ruling holds that since the beneficiary is a qualified shareholder, the trust is an eligible shareholder.

Letter Rulings 201220024 and 201150030 (20) involved S corporations that made non--pro rata distributions to their shareholders. When the corporations realized that this violated the one-class-of-stock requirement, they immediately rectified the situation. The government held that the termination event was inadvertent and allowed the S status to continue unbroken.

In an interesting Chapter 7 bankruptcy case, In re Kenrob Information Technology Solutions, (21) the shareholders had an agreement with the S corporation that a distribution would be made each year equal to the tax owed at the individual level at the hypothetical C corporation tax rate. In two years at issue, the corporation paid these taxes directly to the IRS on the shareholders' behalf. The court held that these payments were not fraudulent transfers. The contact only looked at the federal tax rate. If the state tax impact had been included and they lived in different states, then a second class of stock would have been in evidence.

Earnings and Profits

If an S corporation has subchapter C accumulated earnings and profits (AEP), it will be subject to a tax under Sec. 1375 on its excess net passive investment income if its total passive investment income exceeds 25% of its gross receipts. In addition, if an S corporation's total passive investment income exceeds 25% of its gross receipts for three years, its S election automatically terminates the first day of the fourth year.

A ruling with multiple sins being forgiven, Letter Ruling 201221008 (22) involves three consecutive years of AEP with too much passive investment income, along with disproportionate distributions causing a second class of stock. The government permitted a retroactive deemed-distribution election to allow the S corporation not to be considered terminated. Likewise in Letter Rulings 201226013 and 201222003, (23) an S corporation with AEP and excess passive investment income for three years was allowed to retain its S status as long as the company made a deemed distribution of its AEP.

Change in Capital Structure Reporting

An important statutory change that affects S corporation administration is the enactment of Sec. 6045B, which requires any change in the capital structure of a corporation (including S corporations) to be reported within 45 days to the IRS and the shareholder. (24) What needs to be disclosed regarding a specified security (stock or debt) is a description of any organizational action that affects the basis of the specified security of the issuer; the quantitative effect on the specified security's basis resulting from the organizational action; and any other information the IRS may prescribe.

Corporate spinoffs and reorganizations would clearly be covered. What is unclear is what other actions that affect shareholder basis through the interaction of corporate and individual tax rules in the context of an S corporation would be included. For example, a distribution out of AEP would presumably not be a covered transaction. But what if the S corporation distributes cash out of the corporate accumulated adjustments account, which clearly affects shareholder basis under Sec. 1368?

Also, the IRS has recently issued a new Form W-9, Request for Taxpayer Identification Number and Certification, to better identify S corporation classification vis-a-vis a C corporation. This was done because, beginning in 2012, under the Sec. 6045 disclosure rules, if a covered security is acquired by an S...