S corporation current developments.

• Author: Karlinsky, Stewart S.

Since the Tax Reform Act of 1986 was enacted, the number of S corporation tax returns has more than doubled. With S corporations increasingly becoming the tax entity of choice, it is advantageous for practitioners to keep up with current developments in the area. This update will discuss recent court cases, IRS rulings, final and proposed regulations, and other developments through Aug. 31, 1992--specifically, S corporation eligibility issues, corporate level tax issues, basis and distribution rules; and administrative and procedural changes. The article will also survey future trends and legislative proposals that may affect S corporations in the coming year.

S Corporation Eligibility Issues

* One class of stock

In 1990, the Treasury issued strict and controversial proposed regulations on the one class of stock rule, less than one year later, they were replaced by "gentler" proposed regulations.(1) Final regulations, issued May 28, 1992,(2) took the 1991 proposed regulation approach that one class of stock is defined by the shareholders' right to pro rata distributions and liquidation proceeds. If a governing provision holds otherwise, the one class of stock rule would be violated. If an unequal distribution occurs and it is not done to contravene the one class of stock requirement, general tax concepts will be applied (compensation, imputed interest, etc.) to properly reflect the reality of the transaction. The final regulations are generally effective for tax years beginning on or after May 28, 1992, although the corporation and its shareholders may apply these rules retroactively.

* Qualified subchapter S trusts Three revenue rulings were issued in 1992 on the qualified subchapter S trust (QSST) requirements. Rev. Rul. 92-48(3) held that a charitable remainder trust cannot be a valid QSST. Rev. Rul. 92-20(4) held that even though the terms of a trust do not require trust income to be distributed annually, as long as it is actually so distributed, it can be a valid QSST. Rev. Rul. 99,-64(5) held that as long as only one beneficiary at a time is considered to receive the S income, over time there may be different beneficiaries.

IRS Letter Ruling 9235036(6) is representative of a myriad of requests involving some technical mistake on the part of the QSST or its beneficiary, usually resulting in a Regs. Sec. 1.9100 ruling request. In this letter ruling, the beneficiary signed the Form 2553, Election by a Small Business Corporation, but did not timely file the Sec. 1361(d)(2) election. The Service held that the beneficiary was in "substantial compliance" with the rules and, therefore, a valid S corporation election was in effect.(7)

* Dual resident shareholder In April 1992, the Treasury proposed amendments(8) to Regs. Secs. 301.6114-1 and 301.77011b-7, which affect an S corporation with a dual resident alien shareholder. If that shareholder claims a treaty benefit as a nonresident alien, then the S corporation has an ineligible shareholder, and its S status will be terminated. However, the proposed Sec. 7701 modifications include a special exception for the dual resident, who otherwise claims treaty benefits, to be an eligible shareholder. In effect, the shareholder and corporation must agree to have the tax and withholding rules that apply between a foreign partner and a partnership apply to the dual resident. The IRS plans to issue a revenue procedure to explain the withholding procedure required.

* Momentary ownership and affiliated group

IRS Letter Ruling 9215039(9) involved an S corporation that planned to spin off a business tax free under Sec. 368(a)(1)(D) to its shareholders. For one day, a parent-subsidiary relationship would exist. The Service held that under Rev. Rul. 72-320(10) this momentary ownership did not violate the S corporation eligibility rules for either the existing S corporation parent or the newly formed subsidiary.

Corporate Level Tax Issues

* Passive investment income

There are two reasons why the amount of passive investment income (PII) is critical to an S corporation with subchapter C earnings and profits (E&P): the S corporation termination provisions of Sec. 13621d(13)and the Sec. 1375 tax. On Apr. 17, 1992, newly proposed modifications to Prop. Regs. Sec. 1.1362-3 were issued,(11) which give additional examples of how passive income and gross receipts are computed and further define PII. Specifically, the regulations hold that income derived from the active conduct or a trade or business is not PII. They also refer to the personal holding company (PHC)rules/or guidance (e.g., active computer software). For example, royalties derived in the ordinary course of a business of licensing property will not be PII. The regulations define "ordinary course" to include a company that created the property, performed significant services, or incurred substantial costs to develop or market the property. (12)

The proposed regulations state that interest income on obligations acquired in the ordinary course of a trade or business will likewise not be PII.(13) Thus, interest earned on inventory sales or the performance of services will not be PII, nor will gross receipts that are derived from the business of lending or financing, dealing in property) purchasing or discounting accounts receivables, installment obligations or notes; or servicing mortgages.(14) The effective date of these proposed modifications is for tax years beginning after Dec. 31, 1992. However, S corporations may elect to apply these...