Current developments in S corporations.

• Author: Karlinsky, Stewart S.
• Position: Part 2

EXECUTIVE SUMMARY

* The changes to the kiddie tax rules may affect young S shareholders.

* The back-to-back loan strategy was again affirmed by the courts as an economic outlay.

* Sec. 409(p) S corporation ESOP regulations were finalized.

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This two-part article discusses recent legislation, cases, rulings, regulations, and other developments in the S corporation area. Part II covers operational issues in the Small Business and Work Opportunity Tax Act of 2007 (as well as 2006 legislation), Sec. 199 production activity deductions, final ESOP regulations, tax-deferred reorganizations, and many other cases and rulings.

During the period of this S corporation tax update (July 15, 2006-July 15, 2007), the Small Business and Work Opportunity Tax Act of 2007, RU 110-28 (SBWOTA, enacted May 25, 2007), has had an immediate impact on S corporation tax planning, as did the passage of three different 2006 tax acts. Proposed regulations were finalized, several sets of regulations were proposed, and a number of court cases and rulings on an S shareholder's adjusted basis for loss were issued. The IRS also provided significant guidance related to S corporation mergers and acquisitions as well as a unique built-in-gain (BIG) planning technique.

The last 20 years have seen an explosive growth in S corporation filings. The latest IRS Statistics of Income Bulletin (Spring 2007) shows that S corporations continue to grow as the most common form of doing business. For the 2004 tax year there were more than 3.5 million S corporation tax returns filed, representing over 6 million shareholders and accounting for 63% of all corporate returns filed.

SBWOTA

The SBWOTA has both direct and indirect impacts on S corporation tax planning. First, a trap for the unwary has been eliminated. Some S corporations have set up 100%-owned qualified subchapter S subsidiaries (QSubs) for various business, liability protection, and state tax reasons. If the parent S corporation were to sell more than 20% of the QSub stock, a taxable sale would occur, causing recognition of all of the appreciation (not just that associated with the assets sold), as Sec. 351 would not be available to shield the unsold portion of the assets. The new law treats the sale of more than 20% of the stock as a deemed pro-rata sale of the assets (Sec. 1361(b) (3)(C)(ii)).

Consider an S corporation that is setting up a strategic alliance with another company and sells 49% of the stock of its existing QSub to a new partner. Before the 2007 law change, 100% of the gain would have been recognized because the S corporation did not own 80% of the company. Under the new law, if 49% of the stock were sold, only 49% of the appreciation would be recognized. The S corporation would still be deemed to own 100% of the stock, and Sec. 351 would protect the remaining 51% of the gain from being recognized. This tax law change is effective for transactions after December 31, 2006.

The Sec. 179 expense deduction has been increased beginning in 2007. Basically, the first-year deduction allowed is $125,000 (vs. $112,000 under the old law). This deduction is phased out beginning at $500,000 ($450,000 under the old law) in new or used tangible personal property or shrink-wrap software acquisitions in a given year. (These limits are adjusted for inflation beginning in 2008.) The recent law change also codifies and extends the ability to revoke the Sec. 179 election in a later year or to change which assets are covered by the election.

The work opportunity tax credit (WOTC) (Sec. 51) has been extended and expanded and, most important, it may offset alternative minimum tax (AMT) liability rather than just regular tax liability (see Sec. 38(c)(4) (B) (iv)). Thus, if an S corporation in the retail business generates these work hiring credits, the shareholders may use the credits against their individual tax liability, including their tentative minimum tax (TMT). (50)

Because the capital gains rate for individual taxpayers in the lower two tax brackets goes to zero in 2008, many taxpayers are (or were) contemplating gifting appreciated stock (including S stock) to their children, grandchildren, or parents. For 2007, this planning will still be effective if the donee is over age 17 by the end of the year. Thus, in 2007, a 5% capital gains tax rate will apply for those with taxable income under $31,850 (single) or $63,700 (married filing jointly). In 2008, the new law extends the kiddie tax to income (including capital gains and dividends) of 18-year-olds who do not provide more than half of their support, and to 19- to 23-year-olds who are full-time students (51) and do not provide more than half of their own support. Thus, the 0% tax rate generally will not be available to students through age 23 unless they have significant earned income that contributes to their own support. This leads to a balancing act. Parents may hire a child to legitimately work for them and pay him or her enough to meet the 50% support test but not so much that they exceed the first two bracket limits ($31,850), including the capital gains generated. Also, the parent will likely lose the dependency exemption.

Example 1: Assume a $33,000 taxable income bracket limit in 2008. Child C, age 22, is in graduate school and has $5,000 dividend income and $2,000 ordinary income from an S corporation, plus $10,000 earned income from summer work and from helping his parents with computer work in their business. His total support is $18,000. In February 2008, C's parents give him stock worth $24,000, with a basis of $4,000 and a holding period of at least one year. He has a standard deduction and personal exemption that puts his 2008 taxable income in the first two tax brackets. Assuming that C sells the stock in 2008, he will pay no tax (0% tax rate) on the $20,000 capital gain and the $5,000 dividend income, for a tax savings over his parents' hypothetical tax on the dividend and capital gains of $3,750 ($25,000 X 15%).

With the exception of the kiddie tax, most of the 2007 changes were pro-taxpayer. However...