The tax practitioner needs to understand the intricacies of the ever-popular S Corporation form of doing business. The ins and outs of planning and reporting successful, complex S Corporation transactions are set out in this course. It also covers the latest tax rules that govern the taxation of S Corporations and will help you minimize your client’s tax bill with winning strategies related to S Corporations.
Objectives:Prerequisite: Completion of the AICPA course S Corporations: The Ins and Outs of Tax Reporting and Planning or equivalent knowledge and experience
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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The rules governing the taxation of S corporations were originally enacted in 1958.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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