Current developments in S corporations.

• Author: MacDonough, Laura M.

In 2016 and 2017, courts have decided several cases involving S corporations and their shareholders. In addition, the IRS has issued guidance that should be of interest to S corporation owners. The AICPA S Corporation Taxation Technical Resource Panel offers the following summary of the court decisions and IRS guidance affecting S corporations and their shareholders that the panel believes will be of interest to tax practitioners.

Final regulations under Sec. 385

The IRS and Treasury in 2016 issued proposed regulations under Sec. 385 addressing when a purported debt instrument would be recharacterized as equity for income tax purposes. (1) These proposed regulations caused significant concerns from an S corporation perspective because their effect on a corporation's ability to satisfy the small business corporation requirements (2) was unclear. Specifically, the proposed regulations raised concerns about whether the recharacterization of a purported debt instrument as equity would cause the issuing corporation to be treated as having more than one class of stock and/or cause the holder to be treated as a shareholder of the issuing corporation. However, in the final and temporary regulations issued in October 2016, S corporations are exempt from all aspects of these regulations. (3)

Reforming a trust to qualify as a qualified Subchapter S trust

In two private letter rulings, (4) the IRS ruled that a trust was a qualified Subchapter S trust (QSST) following its reformation pursuant to a binding, non-judicial settlement agreement.

Under the facts of the letter rulings, the terms of a trust that provided for discretionary distributions to the descendants of the primary beneficiary during the primary beneficiary's lifetime were reformed pursuant to a binding, nonjudicial settlement agreement so that the QSST requirement limiting distributions to the current beneficiary during the beneficiary's lifetime would be satisfied. (5) Under the laws of the state that governed the trust, interested parties could enter into a binding, nonjudicial settlement agreement with respect to the validity, interpretation, or construction of the terms of the trust that would be final and binding on the trustee, all current and future beneficiaries of the trust, and all other interested persons, as if ordered by a court.

These letter rulings highlight a practical alternative to a probate court ruling for modifying the terms of a trust to qualify it as a permissible S corporation shareholder. However, it is important to note that modifications to a trust, whether via a nonjudicial settlement agreement or a probate court ruling, will likely not be given retroactive effect for purposes of the trust's qualifying as an S corporation shareholder, even if effective retroactively under applicable state law. (6)

Extension of time granted to file a 'closing of the books' election

If an S election terminates on a date other than the first day of the corporation's tax year, an "S termination year" results, consisting of an "S short year" and a "C short year." (7) Unless a closing of the books is required, the corporation's items of income, gain, loss, deduction, credit, etc., are allocated between the S short year and the C short year on a daily, pro rata basis. (8) However, a corporation may elect to not have the pro rata allocation rule apply and instead assign the items of income, gain, loss, deduction, credit, etc., for the S termination year to the S short year and the C short year under normal tax accounting rules (the "closing of the books election"). (9) The election is made by filing a statement with the corporation's return for the C short year. (10) In a recent letter ruling, (11) the IRS granted the taxpayer an extension of time to file a closing-of-the-books election pursuant to Regs. Secs. 301.9100-1 and 301.9100-3.

Passive investment income (Secs. 1362(d)(3) and 1375) S election termination from excess passive investment income was inadvertent Under Sec. 1362(d)(3), if, for three consecutive tax years, an S corporation has accumulated earnings and profits at the close of each tax year and has excess passive investment income (12) for each tax year, then the corporation's S election terminates at the beginning the first day of the first tax year following the third...