Current developments in S corporations.

• Author: Brajcich, Andrew M.

Fourteen sections of the Internal Revenue Code are central to the taxation of Subchapter S corporations and their shareholders. Over the 12-month period ending February 2022, some of these sections and others affecting S corporations have been addressed by recent legislation, court cases, and IRS guidance. The AICPA S Corporation Taxation Technical Resource Panel, a volunteer group of practitioners who pay close attention to matters affecting S corporations and their shareholders, offers the following summary of recent developments relating to this tax area. The items are arranged by Code section and often contain a short description of the relevant provision.

Sec. 1361: S corporation defined

Sec. 1361(b) lists several conditions that are necessary for a corporation to be eligible for S corporation status. Among these are a limitation on the number of shareholders at any given time; a restriction of eligible shareholders to individuals, estates, and certain trusts; and the requirement that there may only be one class of stock outstanding. There are also specified ineligible corporations, but these are limited to certain banks, life insurance companies, domestic international sales corporations (DISCs) or former DISCs, and corporations that have terminated S corporation or qualified Subchapter S subsidiary status within the past five years. The statute does not specifically address other entities, such as not-for-profit corporations.

Second class of stock created by LLC operating agreement: In a letter ruling released March 12, 2021, (1) the IRS addressed the issue of whether a limited liability company (LLC) that elected S corporation status had just one class of stock for purposes of Sec. 1361. The focus of the letter ruling was on the provisions of the LLC's operating agreement and whether they created a second class of stock. The operating agreement included partnership provisions that applied irrespective of whether the entity was a partnership or S corporation. For instance, one part of the operating agreement provided that in the event the LLC might be liquidated "within the meaning of [section] 1.704-l(b)(2)(ii)(g) of the Income Tax Regulations," then liquidating distributions "shall be made to the members who have positive capital accounts in compliance with [section] 1.704-l(b) (2)(ii)(b)(2)."

In the letter ruling, the IRS concluded that the terms of the operating agreement created a second class of stock for the S corporation. Although the letter ruling does not describe whether the provision above would have resulted in a liquidating distribution that was not proportionate to ownership, the IRS appears to have concluded that the mere existence of the partnership provisions described above in the operating agreement caused the LLC to have a second class of stock.

If a second-class-of-stock issue exists, it may be possible, as the taxpayer in this case did, to obtain Sec. 1362(f) relief from the IRS through the private letter ruling process for an inadvertently invalid S election or an inadvertent termination of an initially valid election. However, that relief generally must be sought at the time the issue is discovered.

Sec. 1362: Election; revocation; termination

Sec. 1362 describes the procedures for electing or revoking S corporation status. It also states some rules for terminating S corporation status if the corporation fails to meet one or more of the eligibility requirements of Sec. 1361. Sec. 1362(g) contains a restriction that prevents a former S corporation from reelecting S corporation status for five tax years unless the IRS consents to a new election. An often-used provision within this section provides relief in certain cases where S corporations have failed to meet eligibility requirements, either at the time of the S corporation election or after the election took effect.

Reduced user fee for private letter rulings: In Rev. Proc. 2022-1, the IRS reduced the user fee for private letter rulings seeking late S corporation election relief. Requests under Sec. 1362(b)(5) for an extension of time for making an S corporation election are now subject to the same user fee as requests for relief under Regs. Sec. 301.9100-3: that is, $12,600. (2) However, there are reduced fees for taxpayers whose "gross income" does not exceed certain levels. The reduced fee is $3,000 if the gross income is less than $250,000. If the gross income is at least $250,000 but less than $1 million, the user fee is $8,500. (3)

For an S corporation, the term "gross income" for purposes of this test is total income (line 6 on Form 1120-S, U.S. Income Tax Return for an S Corporation), plus cost of goods sold (line 2). The corporation must also include gross rents reported on Form 8825, Rental Real Estate Income and Expenses of a Partnership or an S Corporation. The period for testing is the last full (12-month) tax year ending before the date the request is filed. Moreover, if one shareholder owns more than 50% of the corporation's stock, the corporation must include the gross income of the shareholder. (4)

Consent to corporation's S election: Letter Ruling 202205018 addressed a situation involving a spouse's failure to consent to an S election. Under Sec. 1362(a)(2), each person who owns stock on the date the corporation files its S election must consent to the election. (5) If there are joint owners of any block of stock, all the owners must consent. (6) The IRS, by regulation, has permitted late consents if there is reasonable cause for the delinquency.

When the joint ownership is a result of a community property law, Rev. Proc. 2004-35 allows the couple to file a statement with the service center where the corporation files its returns. (7) Unlike Rev. Proc. 2013-30, which deals with certain late elections, there is no time limit on the consent for the community interest holder. (8) Conceivably, the joint owner could have been required to consent to a Subchapter S election in the year 1958 and would still be within the domain of Rev. Proc. 2004-35. Moreover, since the service center administers the relief, there is no need to apply for a letter ruling or pay a user fee. Despite this, Letter Ruling 202205018 requested relief for failure of a spouse to file a timely consent. The problem with the situation here was that there was no joint ownership. The corporation issued stock to one spouse, but the other spouse consented to the corporation's S election.The IRS treated the election as inadvertently invalid and granted the corporation's election.

Sec. 1366: Passthrough of items to shareholders

Sec. 1366 provides that shareholders include their ratable share of separately and nonseparately stated items for the tax year on a per share, per day basis, whether or not any income is actually distributed. Tax-exempt income is among the separately stated items. Generally, ordinary and necessary business expenses paid by the S corporation, including state and local taxes and employee compensation to shareholders, are deducted against nonseparately stated items of income and pass through to the shareholder(s) as net ordinary income or loss.

Timing of PPP deductions and effect on AAA, AE&P, and OAA

Issued Nov. 18, 2021, Rev. Procs. 2021-48, 2021-49, and 2021-50 addressed the timing treatment of tax-exempt income and corresponding basis inclusion from forgiven Paycheck Protection Program (PPP) loans under the Consolidated Appropriations Act, 2021 (CAA). (9) As background to understanding these three revenue procedures, Section 276 of the COVID-related Tax Relief Act of 2020, enacted as part of the CAA, provided that expenses paid with forgiven PPP funds are deductible, that PPP borrowers are not to reduce any tax attributes, and that no basis increase shall be denied by reason of the exclusion of PPP forgiveness from gross income. Section 276 also provided S corporation and partnership PPP borrowers instructions for the tax treatment of the amount excluded from gross income due to PPP loan forgiveness.

Under the CAA, however, numerous timing issues arose if the eligible PPP expenses were deducted in year 1 and the PPP loan was forgiven in year 2. This mismatch created possible basis and at-risk limitations, led to implications for buyers or sellers of S corporation interests in cases where the timing of the basis inclusion could artificially increase or decrease the taxable amount and, in certain situations, produced a taxable dividend out of the S corporation due to the accounting treatment of tax-exempt income between the accumulated adjustments account (AAA) and the other adjustments account (OAA) due to accumulated earnings and profits (AE&P).

These matters were addressed in the revenue procedures issued in November 2021.

Timing issues under the CAA: Before describing the revenue procedures in more detail, it may be helpful to illustrate the timing issues arising under the CAA.

Example 1. Suspended loss carryovers: X, Y, and Z are each one-third shareholders in an S corporation. Assume that the S corporation does not have AE&P from a C corporation year. The three shareholders differ in their beginning-of-the-year stock basis. The S corporation borrows $105,000 from the PPP program in 2020, spending it on qualified expenses. Otherwise, the S corporation breaks even for the year. The PPP loan is forgiven in 2021. Distributions of $20,000 are paid during 2020 to each shareholder. Z's share of the distributions exceeds Z's tax basis, triggering capital gain of $5,000. Because the $105,000 operating loss (due to the deducted PPP expenditures) exceeds their tax bases in the stock, the operating loss allocated to Y and Z creates suspended loss carryovers of $20,000 and $35,000, respectively, as shown in the table "Suspended Loss Carryovers in Example 1." Suspended loss carryovers in Example 1 Shareholders Total X Y z Basis Jan. 1 2020 $95,000 $35,000 $15,000 Distributions $60,000 ($20,000) ($20,000) ($15,000)...