Current developments in S corporations.

• Author: Howell-Smith, Laura

Although the law known as the Tax Cuts and Jobs Act (TCJA) (1) has demanded most of tax practitioners' attention since its enactment in late 2017, there have been other important developments in the S corporation area. Twenty sections of the Internal Revenue Code are central to the taxation of Subchapter S corporations. Over the last 12-18 months, a number of cases have been decided and IRS guidance issued touching on these sections. The AICPA S Corporation Taxation Technical Resource Panel, a volunteer group of practitioners who pay close attention to these sections of the Code, offer the following summary of selected provisions of the TCJA, case law, and IRS guidance from these sections--and a few extra--that affect S corporations and their shareholders.

Selected updates from the TCJA

Sec. 163(j): Business interest limitation

Beginning in 2018, certain taxpayers are subject to a limitation on deductible interest paid or incurred in a trade or business. This limit applies to both S corporations and shareholders if they meet certain criteria. The amount of business interest deduction for a tax year cannot exceed the sum of the taxpayer's business interest income for the tax year, plus 30% of the taxpayer's adjusted taxable income (2) for the tax year, plus the taxpayer's "floor plan financing interest" (3) for the tax year. (4)

The limitation on the deduction for business interest expense does not apply to certain trades or businesses: providing services as an employee, electing real property businesses, electing farming businesses, and certain regulated utilities. (5) In addition, the limit does not apply to any entity or person with less than $25 million in gross receipts (subject to aggregation rules) for the immediately preceding three years, unless the entity is considered a tax shelter. (6) The aggregation rules and the inclusiveness of the term "tax shelter" could prove troublesome for S corporations and their shareholders. The gross receipts need to be aggregated for the S corporation and all businesses that are under common control (7) The term "tax shelter" encompasses any passthrough entity that allocates more than 35% of a loss to a limited partner or a limited entrepreneur in the current year. (8)

The limits apply to an S corporation when computing its taxable income. Any interest expense in excess of the deduction limit is carried forward. (9) The corporation may be able to deduct this interest in a future year even if it is no longer an S corporation. (10) There are also reporting requirements unique to S corporations.

Sec. 199A: Qualified business income deduction

New Sec. 199A provides a deduction of 20% against certain forms of income from passthrough entities, including S corporations. The role of the S corporation in the scheme of the qualified business income (QBI) deduction is that of a reporting entity. This is not a trivial role, since the regulations prescribe harsh penalties for noncompliance. The failure to report positive items of qualified income from the corporation's activities, W-2 wages attributable to this income, and unadjusted basis immediately after acquisition of qualified property, as well as income passing through from qualified real estate investment trust dividends and qualified publicly traded partnership income received by the S corporation, may result in the presumption that a shareholder's portion of these items is zero. (11) The 2018 version of the Form 1120S, U.S. Income Tax Return for an S Corporation, Schedule K-1, Shareholder's Share of Income, Deductions, Credits, etc., has several codes that the corporation will use to report these items to shareholders.

Sec. 641(c): Charitable contributions and ESBTs

Before 2018, electing small business trusts (ESBTs) were subject to charitable contribution rules governing trusts. However, the TCJA changed the rules so that ESBTs are now subject to the same charitable contribution rules as individuals. (12)

Sec. 1361: Nonresident alien as potential current beneficiary of an ESBT

Before 2018, the Code required that a potential current beneficiary of an ESBT must have been eligible to hold S corporation shares directly. Thus, only a U.S. citizen or resident was an eligible potential current beneficiary of an ESBT. (13) The TCJA removed this requirement, effective Jan. 1, 2018. Accordingly, a nonresident alien now may be a potential current beneficiary and the ESBT will not become a disqualified shareholder.

Sec. 1371(f): Eligible terminated S corporation

Newly enacted Sec. 481(d)(2) defines an "eligible terminated S corporation." To fit within this definition, a corporation must have been an S corporation on the day before the enactment of the TCJA (Dec. 21, 2017) and must revoke its S election before Dec. 22, 2019. The shareholders on the date of revocation must be the same persons who held the shares on Dec. 22, 2017, and must hold stock in the same proportions. The special distribution rule states that the post-termination transition period distribution rules govern the distributions during that period. After the period ends, the corporation is to prorate distributions between the corporations accumulated adjustments account (AAA) and accumulated earnings and profits (AE&P), based on the ratio of AAA to AE&P. (14) An eligible terminated S corporation that changes from the cash to the accrual method of accounting may use a six-year period in which it includes its Sec. 481(a) adjustment.

Selected non-TCJA updates Sec. 61: Assignment of income

In Smith, a retired couple worked as a handyman and an office manager for a country club. (15) They established an S corporation, which was authorized to enter into employment contracts. However, there were never any actual employment agreements between the corporation and the taxpayers. The husband also performed handyman services for other businesses and individuals. Although the couple issued invoices under the business's name, they deposited checks from their clients into their personal bank accounts. The S corporation reported these income items on Form 1120S and issued Schedules K-1 to the shareholders. The corporation did not provide or report any compensation to the taxpayers. The IRS reconstructed the income onto a Schedule C, Profit or Loss From Business, for each shareholder and treated it as self-employment income. One of the principal points relied on by the court in the case was that the country club and other clients assumed that they were dealing with the individuals and not with a corporation. The country club issued Form 1099-MISC, Miscellaneous Income, which it would not have issued to a business entity. (16) Therefore, the income from these activities was properly reported on Schedule C rather than Schedule E, Supplemental Income and Loss. Accordingly, the income would be subject to self-employment tax.

Sec. 267(a)(2): Accruals to shareholders

In Petersen, the Tax Court considered whether an accrual-based S corporation could deduct accrued but unpaid expenses relating to an employee stock ownership plan (ESOP) shareholder. (17) The S corporation had accrued but unpaid payroll expenses, a portion of which were attributable to the ESOP employee participants. In timely filed tax returns, the accrual-based S corporation claimed these amounts as deductions for accrued but unpaid payroll expenses under Sec. 461 and reported the deductions to the shareholders on a pro rata basis. The IRS disallowed these deductions, based upon the rationale that the ESOP participants were beneficiaries of a trust.

Sec. 267(c) deems participant-employees as constructive owners of S stock held by an ESOP and, hence, the ESOP participants and S corporation were related persons for purposes of Secs...