This article discusses major changes and developments that directly affect S corporations and their tax advisers during the period of this update (July 10, 2012-July 9, 2013). It also presents tax planning ideas for S corporations and their shareholders concerning several provisions, including the 3.8% net investment income tax.
Sec. 1374(d)(7) BIG Tax Holiday
The Sec. 1374 built-in gain (BIG) rules were significantly and favorably liberalized by the American Taxpayer Relief Act of 2012 (ATRA). (1) ATRA also added certainty to several lingering issues. For tax years beginning in 2012 or 2013, if the prior year was the fifth calendar year or later in the recognition period, then any recognized gain is not subject to the BIG tax (the BIG tax holiday). Note that this rule requires five 12-month periods and not necessarily five tax years; the latter often are a shorter period. The built-in gains period will be 10 years for years after 2013. The new law clarified two important issues concerning the BIG tax holiday: First, it allows gain from an installment sale of qualified property to be exempt from Sec. 1374 tax, even if it is recognized in a year after 2013 in which the BIG tax applies. Second, a technical amendment to Sec. 1374(d)(2) provides that the rule requiring the excess of net recognized built-in gain over taxable income for a tax year to be carried over and treated as recognized built-in gain in the succeeding tax year applies only to gain recognized within the recognition period. For example, built-in gain recognized in a tax year beginning in 2013, from a disposition in that year that occurs beyond the end of the temporary five-year recognition period, will not be carried forward under the income limitation rule and treated as recognized built-in gain in the tax year beginning in 2014 (after the recognition period is again 10 years).
Example 1: In January 2007, a calendar-year C corporation switches to S status. In 2013, it is qualified for the BIG tax holiday, since six calendar years have elapsed in the recognition period. It sells a BIG asset on the installment basis in 2013, with gain recognized in 2015, a nonexempt year. The recognized gain in 2015 will not be subject to Sec. 1374. Example 2: In January 2007, a calendar-year C corporation switches to S status. In 2013, it is qualified for the BIG tax holiday. In 2013 it has recognized BIG of $200,000 and taxable income of $140,000. Normally, the $60,000 difference would be subject to BIG tax in 2014, but the technical amendment to Sec. 1374(d)(2) exempts the $60,000 carryover from Sec. 1374 tax in 2014. Chief Counsel Advice (CCA) 201324013 (2) opines against an attempt to use the partnership and S corporation rules to circumvent Sec. 1374 BIG tax. Essentially, one party contributed money (and received property), and the other party contributed property and received the cash funds. It is widely speculated that the ruling involved the Tribune Co., which publishes the Chicago Tribune newspaper, divesting itself of the Long Island Newsday newspaper similarly to how it divested itself of the Chicago Cubs a few years earlier. The IRS ruled that Sec. 707(a)(2)(B) and Regs. Sec. I.752-2(j) should be applied to treat the transaction as a disguised sale, and hence the Sec. 1374 rules would apply to the taxpayer.
S Corporation Data
The 2012 Data Book (3) reports that the number of S corporation tax returns filed increased 0.8% in 2012 over 2011; partnerships and LLCs increased by 1.5%; and C corporations decreased by 2.2%. S corporations and partnerships were audited 0.5% of the time, while small business C corporations were audited at a rate of between 0.9% and 2.6%, depending on their asset size. Interestingly, individual returns with nonfarm business income (and without an earned income tax credit) were audited between 1.2% and 3.6% of the time, depending on gross receipts reported.
Qualifying as an S Corporation
To qualify as an S corporation, a corporation must meet requirements concerning its type, number and type of shareholders, type of stock, and type of income. In addition, the corporation must elect to be treated as an S corporation. If applicable, it may also elect to treat a subsidiary as a qualified subchapter S subsidiary (QSub), and certain trusts may elect to be treated as eligible shareholders. If any of the requirements are not met at any time, the corporation's S election is 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 asked the IRS to be lenient in granting inadvertent election and termination relief, and it is clear from numerous letter rulings that the IRS has abided by congressional intent.
In all of the recent letter rulings on failures to make a timely election by, or related to, an S corporation, if the taxpayer could establish reasonable cause 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; Form 8832, Entity Classification Election; and Form 8869, Qualified Subchapter S Subsidiary Election; (4) as well as the elections required by the beneficiary of a qualified subchapter S trust (QSST) and the trustee of an electing small business trust (ESBT) to be an eligible S corporation shareholder. Nontimely filing was deemed inadvertent in a number of rulings. (5) The IRS also granted inadvertent termination relief involving trusts that were intended to be ESBT trusts but whose trustees failed to make the election. (6)
Likewise, in at least two letter rulings, (7) a shareholder transferred S stock to a grantor trust. When the shareholder died, the irrevocable trust was a qualified shareholder for two years. After that, the stock was transferred to a QSST, but the beneficiary failed to sign the election. The IRS allowed the S status to continue under Sec. 1362(f) without a termination. The IRS also forgave the termination of a corporation's S status due to a trust's failure to satisfy the QSST requirements. (8) Unlike baseball, in an example of three strikes and you are not out, two letter rulings (9) involved an S corporation that filed Form 2553 with the wrong date and a wrong signature on behalf of one of its two shareholders and failed to properly file an ESBT election, and yet it was permitted to be an S corporation from inception.
Sec. 1361(b) restricts ownership in an S corporation to U.S. citizens and resident individuals, estates, certain trusts, certain pension plans (but not individual retirement accounts (IRAs)), and certain tax-exempt charitable organizations.
Historically, S corporations have been more successful if they are proactive and request inadvertent termination relief from the IRS before they are audited and the issue is decided in court. The IRS issued inadvertent termination relief to S corporations that had various ineligible shareholders. Letter Rulings 201245001 and 201245002 (10) involved shareholders that were partnerships. In other rulings, (11) the IRS did not make it clear why the shareholder was ineligible, but it allowed continued S status. In Letter Ruling 201325003, (12) an LLC elected to be treated as an S corporation. At one point, an ineligible shareholder had ownership, but the error was corrected when recognized. The IRS allowed continuous S status, but the eligible shareholders had to include the ineligible person's income on their tax returns.
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 necessarily equal voting rights). Regs. Sec. 1.1361-1(1) provides that a corporation generally is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds. Whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds is determined based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (collectively, the governing provisions). However, any distributions (including actual, constructive, or deemed distributions) that differ in timing or amount are given appropriate tax effect in accordance with the facts and circumstances.