Current developments in S corporations.

• Author: Karlinsky, Stewart S.
• Position: Part 1

EXECUTIVE SUMMARY

* The IRS clarified the requirements that must be met for a 2% shareholder-employee of an S corporation to deduct medical insurance premiums paid on his or her behalf by the S corporation.

* The Mortgage Forgiveness Debt Relief Act of 2007 included a new penalty for nontimely filing of an S corporation return.

* Two courts ruled on when an S corporation shareholder had transferred beneficial ownership of his shares in the S corporation.

* The IRS provided guidance on the need for an employer identification number for QSubs and corporations involved in certain F reorganizations.

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This two-part article discusses recent legislation, cases, rulings, regulations, and other developments in the S corporation area. Part I covers operational issues, including new guidance on the treatment of medical insurance premiums for wholly owned S corporations, new built-in gain developments, and the impact of charitable giving by S corporations on shareholders' adjusted basis in stock. (1)

During the period of this S corporation tax update (July 8, 2007-July 8, 2008), the 2008 Economic Stimulus Act has had an indirect impact on S corporation operations. Treasury also seems to have renewed its focus on employer/taxpayer identification numbers. The Mortgage Forgiveness Relief Act of 2007 enacted a penalty provision that tax practitioners must be aware of regarding timely filing of S corporation tax returns and information included therein.

An unusual number of court cases involved beneficial ownership of S corporations and when that ownership terminates. The IRS issued a ruling on the exploitation of mineral rights and its impact on Sec. 1374 built-in gains. The potential zero capital gain rate for 2008 and 2009 is an attractive tax planning tool that may affect S corporations and their shareholders' behavior.

S Corporation Growth

The past 20 years have seen an explosive growth in S corporation filings. The latest IRS Statistics of Income Bulletin (Spring 2008) shows that S corporations continue to be the most common business entity. (2) For the 2006 tax year there were over 3.3 million S corporation tax returns filed, accounting for 61.9% of all corporate returns filed. There were 343,000 first-time S corporation tax forms filed, of which 253,000 were newly incorporated entities and 90,000 were converted C corporations.

While the number of S corporations has greatly increased, the audit rate on S corporations and their shareholders has held relatively steady. In March 2008, the IRS published its data book on audit rates for the October 2006-September 2007 fiscal year. (3) Of 134.5 million individual returns filed, 1,380,000 individuals, or about 1%, were audited. Of this 1%, almost half were earned income tax credit audits and only 23% were by revenue agents. For individuals whose total positive income (TPI) was greater than $200,000 but less than $1 million, the audit rate was 2%. If the taxpayer's income was within those parameters and a business return (Schedule C) was also filed, the audit rate went up to 2.9%. If TPI was greater than $1 million, the audit rate was 9.3 %.

On the other hand, S corporations were audited at a rate of .5% (up from .38 % the year before), while for partnerships and LLCs the figure was .4% (up from .36%). To put this in perspective, C corporations with less than $10 million in assets were audited at a .9% rate. These findings were highlighted in the National Taxpayer Advocate's 2007 Annual Report to Congress, in which she pointed out that in fiscal year 2006, an S corporation was half as likely to be audited as a C corporation (4 out of 1,000 versus 8 out of 1,000, respectively). (4)

Zero Capital Gains Rate in 2008

Because the capital gains rate for individual taxpayers in the lower two tax brackets went to zero in 2008, many taxpayers are (or were) making gifts of appreciated stock (including S stock) to their children, grandchildren, or parents. In 2008, the new law extends the "kiddie tax" to the income (including capital gains and dividends) of 18-year-olds who do not provide more than half of their own support and to 19- to 23-year-olds who are fulltime students and do not provide more than half of their own support. (5) Thus, the 0% tax rate generally will not be available to students through age 23 unless they have significant earned income or possibly trust fund 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% self-support test but not so much that the child's income exceeds the first two bracket limits ($32,550), including the capital gains generated. The parent will also lose the dependency exemption.

Example 1: 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 put 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%).

Example 2: A retired married couple deferred pension distributions and invested primarily in tax-exempt bonds, and they are living off that interest. Their S corporation K-1 shows ordinary income of $40,000, and they receive distributions of $50,000 during the year. They file jointly and have itemized deductions of $30,000. Their net ordinary income is $10,000 (40,000-30,000). Therefore, if they recognized $200,000 in capital gains or dividend income through the S corporation or otherwise, $55,100 of the gain (assuming a $65,100 limit for the first two brackets) would be subject to a 0% tax rate. The other $144,900 would be subject to the normal 15% tax rate. This results in a federal tax savings of $8,265.

Alternative Minimum Tax

At the entity level, an S corporation generally does not have to worry about the alternative minimum tax (AMT), but its shareholders definitely do. The Tax Relief and Health Care Act of 2006 (6) allows 20% of long-term unused minimum tax credits (MTCs) (i.e., those older than three years) to be refundable credits if the taxpayer's adjusted gross income (AGI) is below the personal exemption phaseout threshold, beginning in 2007 and ending in 2012. (7) If AGI is above this level, the refundable credit is phased out in the same manner as the personal exemption.

Tax professionals should make sure that their clients' AGI, including income from flowthrough entities such as S corporations, is below the threshold. Note that the long-term unused MTC concept is a rolling computation of the MTCs that arose more than three years ago. Thus, 2007 AMT and regular tax may be offset by MTCs that arose before 2004. Long-term unused MTCs for 2008 would include 2004's MTC because it is now more than three years old.

Example 3: Coming into 2008, taxpayer N has a $300,000 MTC from the exercise of incentive stock options in 2001, and her 2008 AGI is $220,000. In 2008, her regular tax is...