Advanced Tax Strategies for S Corporations

• Chapter 1 - S Corporation Current Developments
  • Learning Objectives
  • Introduction
  • The Small Business and Work Opportunity Tax Act of 2007
    • Bank S Corporations
    • Accumulated Earnings and Profits
    • Electing Small Business Trust
    • More Likely Than Not Standard
    • Qualified Subchapter S Subsidiaries
  • The American Jobs Creation Act of 2004
    • S Corporations and Shareholders
    • Increase in the Number of S Shareholders
    • IRA as a Bank S Shareholder
    • Sale of IRA’s Stock
    • Passive Investment Income Exclusions for Bank S Corporations
    • Electing Small Business Trust (ESBT) Potential Current Beneficiary
    • Transfers of Suspended Losses to Spouse or Former Spouse
    • Use of Passive Activity Losses and At-Risk Amounts by a QSST Beneficiary
    • QSub Relief
    • Sec. 357(c)
    • Repayment of Loans for Qualifying Employee Securities
    • Audit-Related PTTP
  • Cost Recovery
    • Bonus Depreciation and Sec. 179
    • Section 179
    • Leasehold/Restaurant Improvements
    • Organization and Start-Up Costs
  • Domestic Production Activities Deduction
    • Applicability
    • Qualified Production Activities Income
    • Limits
    • 2006 Tax Act
  • Other Current Developments
    • LIFO Recapture Tax
    • Late Election of S corporation
    • IRS Coordinated Issue Papers
    • Beneficial Interest in an S Corporation
    • FIN 48 and Private Companies
    • Penalties for Nontimely Filing of 1120S Tax Return Information
• Chapter 2 - Compensation Planning
  • Learning Objectives
  • Introduction
  • Compensation Paid to S Corporation Shareholders
  • Reasonable Compensation
    • Criteria for Reasonable Compensation
  • Excessive Compensation
    • Proposal to Modify the Amount of S Corporation Income Subject to Self-Employment Tax
  • Fringe Benefits
    • Fringe Benefits Are Wages
    • Health Insurance
  • Shareholder Expenses
    • Expenses Paid by Accrual Basis Corporation
    • Unreimbursed Shareholder Expenses
    • Non-Qualified Deferred Compensation (IRC Section 409A) and S Corporations
  • Summary
• Chapter 3 - Basis in S Corporation Stock
  • Learning Objectives
  • Introduction
  • Computation of Basis
    • Business Credit and Recapture Can Affect Basis
    • When Is Basis Adjusted?
    • Basis Adjusted by Share
    • Inherited Basis
  • Basis of Indebtedness to Shareholder
    • Restoration of Basis in Debt
    • Guaranteed Loans
    • Debt Basis Arises Only if Shareholder Experiences Economic Outlay
    • Loans from Related Entity
  • S Corporation Limitations of Deductions of Losses
    • Losses Limited to Basis – Section 1366
    • Treatment of Carryover Losses on Form 1040
    • Losses Limited to Amount At-Risk – Section 465
    • Losses Limited to Passive Activity Rules – Section 469
    • Summary of Loss Limitations
  • Recent Cases Regarding Loss Limits
    • Basis Limitation Cases (Section 1366)
    • At-Risk Cases (Section 465)
    • Passive Activity Loss Cases (Section 469)
  • Carryover after Termination of Election – The Post-Termination Transition Period
    • Definition of Post-Termination Transition Period
• Chapter 4 - Distributions
  • Learning Objectives
  • Introduction
  • Earnings and Profits (E&P)
    • Reduction of AE&P
    • Cash Distributions Made by S Corporations without E&P [Section 1368(b)]
    • Cash Distributions Made by S Corporations with E&P [Sec. 1368(c)]
  • Accumulated Adjustments Account (AAA)
    • AAA Is Reduced by the Full Amount of Loss or Deduction
    • Differences between Basis and AAA Adjustments
    • Calculation of AAA, AE&P, and Basis Illustrated
    • Distributions from Previously Taxed Income (PTI)
    • Other Distributions
    • Section 1368(e) Election
  • Property Distributions
  • Post-Termination Transition Period
  • Summary
• Chapter 5 - Use of Qualified Subchapter S Subsidiaries
  • Learning Objectives
  • Introduction
  • Congressional Intent Regarding QSubs
  • Definition of a QSub
  • Factors to Consider before Using a QSub
  • Eligibility Rules
    • Special Rules to Determine Whether the Subsidiary Is Wholly Owned
    • Disregarded Entities
    • Nominal vs. Beneficial Ownership
    • Stock Disregarded by Reference to the One Class of Stock Regulations
    • Debt vs. Equity and the Straight Debt Safe Harbor
  • QSub Election
    • Elections Involving Tiered Structures
    • Late Elections
    • Effects of a QSub Election
    • Deemed Liquidation and the Step Transaction Doctrine
    • Special Rules for Acquisitions of S Corporation Stock
    • Acquisitions Involving a Section 338 Election
    • Treatment of a QSub as a Separate Corporation
    • LIFO Recapture Tax Triggered by Election
  • Termination of a QSub Election
    • Tax Consequences of a Termination
  • S Corporation and QSub Elections for Consolidated Groups
    • Excess Loss Accounts
    • Intercompany Transactions
    • Taxable vs. Nontaxable Liquidation
    • Section 1374 Issues
    • Insolvent Subsidiaries
  • How Can a QSub Be Used?
    • Utilize Suspended Losses
    • Aggregate Shareholder Debt Basis
    • Eliminate Controversies Involving Intercompany Loans and “Economic Outlays”
    • Reduce or Eliminate Section 1374 Taxes
    • Avoid Unwanted S Terminations and Reduce/Eliminate Section 1375 Taxes
    • Obtain Current Deduction for Expansion Costs
    • Enjoy the Benefits of Using Subsidiaries
    • Flexibility and Legal Liability Protection
    • Avoid State and Local Documentary Transfer or Sales Taxes
    • Section 1031 and 1033 Transactions
• Chapter 6 - Liquidations, Reorganizations, and Redemptions
  • Learning Objectives
  • Introduction
  • Liquidation of an S Corporation
    • Liquidation of a Subsidiary
    • IRC Section 338(h)(10) Subsidiary Liquidation
    • State Consideration of a Section 338 Election
    • Current Developments in S Corporation Liquidations
  • Corporate Reorganizations
    • Judicial Doctrines
    • Tax Impact of Reorganizations
    • Current Events with S Corporations and Reorganizations
  • Redemptions
    • Redemption Is Not Equivalent to a Dividend
    • Substantially Disproportionate Redemption
    • Redemptions Which Completely Terminate a Shareholder’s Interest
    • Redemptions in Partial Liquidation of the Corporations
    • Redemption to Pay Death Taxes
    • Effect of the Redemption on the Redeeming Corporation
    • Current Developments with S corporation Redemptions
• Chapter 7 - Estate Planning and the Use of Trusts
  • Learning Objectives
  • Introduction
  • Eligible Shareholders
  • Qualified Subchapter S Trust
    • QSST Election
    • Current Developments Regarding QSSTs
  • Electing Small Business Trust
    • Current Developments Regarding ESBTs
  • General Rules When an S Corporation Shareholder Dies
    • Buy-Sell Agreements
    • Corporate Redemption Agreements
    • Cross-Purchase Agreements
    • Grantor Trusts
    • Testamentary Trust
    • Current Developments Regarding Testamentary Trusts
    • Estate as an Eligible S Corporation Shareholder
• Chapter 8 - Latest Developments

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Chapter 1 - S Corporation Current Developments

Learning Objectives

Upon completion of this chapter, you will

• Understand the new rules relating to S corporations.

• Be aware of any new rulings or court cases that impact S corporations. Introduction In this chapter, we will discuss the following:

• Changes made by the 2008 Economic Stimulus Bill

• Changes made by The Small Business and Work Opportunity Tax Act of 2007 (SBWOTA)

• Changes made by the Gulf Opportunity Zone Act of 2005 (GOZA)

• Changes made by The American Jobs Creation Act of 2004 (AJCA)

• Changes made to depreciation deductions

• Domestic Production Activities Deduction

• New rulings concerning S corporations

• Potential S Corporation changes in the future

The rules governing the taxation of S corporations were originally enacted in 1958. Substantive revisions were made by the Subchapter S Revision Act of 1982 (SSRA). Additional revisions were made by the tax acts in 1986, 1987, 1996, and 2002. The Small Business and Work Opportunity Tax Act of 2007 (SBWOTA) and the American Jobs Creation Act of 2004 (AJCA) are the latest tax acts to have a major impact on the rules regarding the taxation of S corporations.

In this chapter we will review the changes made by the SBWOTA and the AJCA, as well as changes made by the 2008 Economic Stimulus Act and the Gulf Opportunity Zone Act of 2005. In addition, some of the latest rulings by Treasury, the Internal Revenue Service, and the Court system will be discussed.

The Small Business and Work Opportunity Tax Act of 2007

The SBWOTA '07 had several provisions that affected S corporations. For the most part these provisions were pro-taxpayer and, unless otherwise noted, will be effective for years beginning after December 31, 2006. Some of these will be presented here and others will be discussed in Part II of the article.

Bank S Corporations

Two provisions of the new law relate to banks that have elected to be S corporations. As of March 2005, 2,237 banks had switched to S corporation status. However, only banks (usually community banks) that do not use the reserve method of accounting for bad debts can elect to be S corporations. If the bank changes from the reserve method of accounting for bad debts, a Sec. 481 adjustment must be made; this adjustment generally is included in income over four years. New Sec. 1361(g) allows the bank to elect to take into account 100% of the adjustment the year before it changes to an S corporation, when it is still a C corporation. Therefore, the bank takes the adjustments into account at the entity level (where it enjoyed the benefit of the previous deduction) rather than at the shareholder level.

A second provision helpful to bank S corporations relates to bank director shares. National and state banking laws require a bank's director to own stock. In some cases, a bank will enter into an agreement in which the bank will reacquire the stock when the director ceases to hold the office. Requiring all directors to own stock could create a problem with the shareholder limit, while the repurchase agreement could create a second class of stock. Both of these issues would cause the termination of an S election. New Sec. 1361(f)(1) clarifies that qualifying "restricted bank director shares" are not recognized for any subchapter S provisions. New Sec. 1368(f)(1) also treats any distributions on this restricted stock as income to the director and deductible to the bank. Note. An interesting question is whether this restricted-bank-director-stock-disregarded status would allow directors to own stock in a qualified subchapter S subsidiary (QSub) and not disqualify the subsidiary bank.

Accumulated Earnings and Profits

If an S corporation has accumulated earnings and profits (AE&P) at the end of the year and more than 25% of its gross receipts are from passive investment income (PII), the S corporation will be subject to a corporate-level tax. The 2007 act reduces the possibility of an S corporation being subject to this tax. Under new Sec. 1362(d)(3), capital gains on stocks and securities will not be treated as PII under Secs. 1362(d) and 1375. In a related provision, the new law eliminates S corporation previously taxed income (PTI) attributable to pre-1983 years for corporations that were not S corporations for their first taxable year beginning after December 31, 1996. These two provisions apply to tax years beginning after May 25, 2007.

Electing Small Business Trust

Another new provision makes an S corporation a slightly more attractive vehicle for investments. Sec. 641(c)(2)(C)(iv) allows an electing small business trust (ESBT) to deduct any interest expense it incurs when it borrows funds to purchase S stock. This provision places an ESBT on par will all other taxpayers, including qualified subchapter S trusts (QSST), for the deduction. Because ESBT income is taxed at the highest individual rate, this change allows a tax deduction at a 35% tax rate.

More Likely Than Not Standard

A far more anti-taxpayer provision that affects all taxpayers (including S corporations and their shareholders, as well as tax practitioners) is the expansion of Sec. 6694, under which tax practitioners must use a "more likely than not" standard on undisclosed positions for returns prepared after May 25, 2007. (This is in contrast to the "realistic possibility of success" standard that practitioners previously used.) In addition, the amount of the Sec. 6694 penalty has been increased. The revisions to Sec. 6694 constitute major changes to practice standards and penalties that have been in place for many years. Two instances in which this new provision could affect S corporations are (1) basis in debt due to back-to-back loans and (2) the calculation of built-in gain under Sec. 1374.

Qualified Subchapter S Subsidiaries

The SBWOTA has both direct and indirect impact 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 the part 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.

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