Current developments in S corporations.

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

During the period of this S corporation tax update (July 10, 2010-July 9, 2011), several tax law and administrative changes have affected S corporations and their shareholders. There were some major administrative changes that directly affect S corporations and their tax advisers. One key development is that the potential zero capital gain rate (available since 2008) was extended through 2011 and 2012 and continues to be an attractive tax planning tool that may affect S corporations and their shareholders' behavior.

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Examinations and Information Reporting

Audit Rates

Generally, a smaller percentage of S corporation returns is examined than those of individuals. For individual tax returns filed in 2009 and audited in fiscal year 2010, the coverage rates were generally equal to or slightly lower than in the prior audit period, with the exception of wealthy taxpayers and those filing a Schedule C with more than $100,000 of gross revenue. Basically, the IRS audited 1.1% of filed Forms 1040, with 30% of those audited including an earned income credit. Of individual returns examined in 2010, 78% were correspondence audits. The audit rate was 4.7% for nonfarm business returns with gross receipts of between $100,000 and $200,000 (and no earned income tax credit), up slightly from the previous year's rate of 4.2%. The IRS audited individual taxpayers with total positive income of greater than $1 million at a rate of 8.4%, up significantly from 6.4% in 2009. S corporation and partnership returns were audited at a much lower overall rate of 0.4%, unchanged from 2009.

Fast Track Settlement Program Extended to SB/SE Taxpayers

Many S corporations are clients of the IRS's Small Business/Self employed (SB/SK) Division (i.e., they have less than $10 million in gross assets). Previously, the Fast Track Settlement Program was generally available only to clients of the Large and Mid-Size Business (LMSB) Division. (1) With Announcement 2011-5 (2) issued in late 2010, the IRS expanded the program to include SB/SE taxpayers at IRS offices in eight locations: Chicago, Houston, St. Paul, Philadelphia, central New Jersey, and three California cities: San Diego, Laguna Niguel, and Riverside. This program is intended to facilitate efforts by certain taxpayers and the IRS to resolve factual and legal unagreed issues in open tax years under exam, with an auditor and Appeals together in the same room. The expansion was effective December 1, 2010.

Capital Structure Reporting

Another important administrative change was the January 1, 2011, effective date 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 government and by January 15 of the following year to each holder of stock, bonds, or notes (specified securities) or their nominees. (3) The report must describe any organizational action that affects the basis of the specified security, the resulting quantitative effect on the specified security's basis, and any other information the IRS may prescribe. Notice 2011-18 (4) allows taxpayers to delay reporting to the government for organizational actions occurring in 2011 until the IRS issues a reporting form, provided that the corporation informs the government no later than January 17, 2012. Reporting to shareholders is still required on a timely basis.

These rules clearly would cover corporate spin-offs and reorganizations. What is unclear is what other actions affect shareholder basis through the interaction of corporate and individual tax rules in the context of an S corporation. For example, a distribution out of accumulated earnings and profits would presumably not be a covered transaction. But what if the S corporation distributes cash out of its accumulated adjustments account, which clearly affects shareholder basis under Sec. 1368? What if the company distributes appreciated property?

The government recently revised Form W-9, Request for Taxpayer Identification Number and Certification, to better distinguish S corporations from C corporations. This was done because beginning in 2012, under the Sec. 6045 disclosure rules, if a "covered security" (including specified securities acquired through a transaction in the account in which such security is held) is acquired by an S corporation, adjusted basis reporting is required.

Increase in Penalties for Nontimely Filing of Form 1120S or Missing Information

For tax years beginning after December 31, 2009, the Worker, Homeownership, and Business Assistance Act of 2009 (5) more than doubled the Sec. 6699 penalty, from $89 to $195 (on top of the increase from $85 before 2009). This penalty applies per shareholder per month (not to exceed 12 months) if the S corporation does not timely file its Form 1120S, U.S. Income Tax Return for an S Corporation, or fails to provide information required on the return. For this purpose, shareholder husbands and wives count as two; the law also counts a sale or gifting by one shareholder to another as two different shareholders. It is unclear how it would treat community property state ownership where actual ownership may be in only one person's name.

Example 1: Husband and wife H and W and their two children own all the stock of X Corp., an S corporation. In October 2010, the two children gift some stock to their spouses. In 2011, X forgets to include the distribution amount on Schedules K and K-l of 2010 Form 1120S. X could be liable for a penalty of $14,040 ($195 X 6 X 12) for this innocent mistake.

What is particularly disturbing about this provision is that in the authors' experience, rarely, if ever, is the date of distribution included on Schedule K and related K-1s. Yet according to Sees. 6037(a) and (b), this information is supposed to be reported to the government and the shareholders. This provision is a trap for the unwary, since anything left off the Schedule K-l, whether intentionally or not, could trigger the penalty.

Uncertain Tax Position Disclosures

On January 26, 2010, the IRS announced that beginning with the 2010 tax year, LMSB entities (those with more than $10 million in gross assets) would need to disclose on their tax returns FIN 48 (6) uncertain tax position information. (7) In a subsequent announcement, the IRS increased the initial gross asset threshold for reporting to $100 million, with a phased-in reduction to $50 million starting with 2012 tax years and $10 million starting with 2014 tax years. (8) Before a draft form was issued on April 19, 2010, (9) the proposal was to apply to business taxpayers generally, including S corporations (although only S corporations with built-in gain (BIG) tax or excess net passive income tax or those with questionable S status would have been subject to these rules). However, the final instructions to the new Schedule UTP, Uncertain Tax Position Statement, do not require S corporations to file the schedule.

For corporations to which the requirement does apply, the friction between substantial authority (40% probability) to sign a tax return by a preparer and the more likely than not (greater than 50%) criterion of FIN 48 will obviously cause issues between auditors and their clients, as well as between the IRS and companies' representatives. Some observers are predicting more spin-offs to avoid LMSB status as a result.

Final Regulations

Controlled Groups

T.D. 9522 was finalized on April 8, 2011, and became effective on April 11, 2011. It distinguishes a controlled group under Sec. 1563 from the affiliated group rules of Sec. 1561 and has an important impact on S corporations. Many practitioners believed that because S corporations were defined as "excluded corporations," two controlled S corporations could each take a maximum Sec. 179 deduction and pass those through to their shareholders. The new final regulations under Regs. Sec. 1.1563-1 make this treatment inadvisable in light of Mayo Foundation for Medical Education and Research (10) (discussed below) unless the contrary tax return position taken is disclosed on the tax return. Basically, the new rules state that S corporations are excluded corporations for Sec. 1561 purposes, such as Sec. 11 tax rates or accumulated earnings tax and the alternative minimum tax (AMT) exemption...