August 31, 2009
The Honorable Douglas H. ShulmanThe Honorable William J. Wilkins
Commissioner of Internal RevenueChief Counsel of Internal Revenue
1111 Constitution Avenue, NW, Room 30001111 Constitution Ave, NW
Washington, DC 20224Washington, DC 20224
Re: Proposed Revenue Ruling Regarding the Application of the Small Business Corporation Exception to Golden Parachute Treatment Where the Corporation is Owned by Eligible Trusts
Dear Commissioner Shulman and Chief Counsel Wilkins:
The AICPA is pleased to submit a proposed revenue ruling that attempts to clarify that payments made to “disqualified” employees by a corporation that meets the definition of a small business corporation (whether or not it has a nonresident alien shareholder) will not be treated as golden parachute payments, even if the corporation has not made an S election and even if the corporation is owned by trusts that, while otherwise eligible to be S corporation shareholders, have not made an election to be either an Electing Small Business Trust (ESBT) or a Qualified Subchapter STrust (QSST). Final regulations issued under section 280G on August 4, 2003 make it clear that the corporation does not need to make an S election to qualify for the small business exception. The regulations fail, however, to address whether the definition of small business corporation is met if the corporation is owned by trusts that have not filed certain elections solely because such elections are only permitted if the owned corporation has an S election in effect. Since these trusts cannot make an election to be an ESBT or a QSST unless the corporation first makes an election to be an S corporation and since an S election is not required to meet the exception for golden parachute treatment, there is no policy reason to prevent a corporation from meeting the definition of a small business corporation for purposes of section 280G, and thus preventing application of the exception from the golden parachute rule, simply because the corporate owners have not made an S election.
The AICPA is the national professional organization of certified public accountants comprised of approximately 350,000 members. Our members advise clients on federal, state, and international tax matters and prepare income and other tax returns for millions of Americans. They provide services to individuals, not-for-profit organizations, small and medium-sized businesses, as well as America’s largest businesses.
Should you have any questions or wish to discuss this request in more detail, please contact Horacio Sobol, Chair of the S Corporation Taxation Technical Resource Panel (Panel) at (202) 312-7656 ; Laura Howell-Smith, Immediate Past Chair of the Panel at (202) 220-2076 or ; or Marc A. Hyman, AICPA Technical Manager at (202) 434-9231 or .
Very Truly Yours,
Alan R. Einhorn, Chair
Tax Executive Committee
CC: Jeanne F. Ross, Treasury Attorney-Adviser
Emily M. Lam, Treasury Attorney-Adviser
Curtis G. Wilson, Associate Chief Counsel (Passthroughs & Special Industries)
Catherine L. Fernandez, IRS Branch Chief (CC:TEGE:EB – Executive Compensation)
Thomas Scholz, IRS Assistant Branch Chief (CC:TEGE:EB – Executive Compensation)
William C. Schmidt, IRS Senior Counsel (CC:TEGE:EB – Executive Compensation)
THE AMERICAN INSTITUTE OF CERTIFIED PUBLICACCOUNTANTS
PROPOSED REVENUE RULING REGARDING THE APPLICATION OF THE SMALL BUSINESS CORPORATION EXCEPTION TO GOLDEN PARACHUTE TREATMENT WHERE THE CORPORATION IS OWNED BY ELIGIBLE TRUSTS
Revenue Ruling 2009-XX
ISSUES
- In the situations described below, for purposes of Internal Revenue Code §280G(b)(5)(A)(i), is the corporation a small business corporation (as defined in §1361(b), but without regard to paragraph (1)(C) thereof)?
- If so, are payments made by the corporation exempt from the definition of parachute payment under §280G(b)(2)(A) of the Code?
FACTS
Situation 1. Corporation X is a privately held, diversified domestic holding company. All of the stock of Corporation X is held by Trusts 1 and 2 (the Trusts).
Corporation X (a) has never had in effect, and does not currently have in effect, an election under §1362(a) to be an S corporation, (b) is a domestic corporation which is not an “ineligible corporation” within the meaning of §1361(b)(2), and (c) meets the requirements for the definition of “small business corporation” in subparagraphs (A), (C), and (D) of §1361(b)(1).
With respect to the Trusts,(a) an election under §1361(e) to be an electing small business trust (ESBT) has never been filed by, been in effect for, or applied to, the Trusts; (b) the Trusts havenever been, and currentlyare not, trusts described in clauses (i), (ii), (iii), (iv), or (vi) of §1361(c)(2); and (c) the Trusts havenever owned, and currently does not own, any stock in any S corporation. The Trustsmeet the requirements for the definition of an ESBT in clauses (i) and (ii) of §1361(e)(1)(A) and are not a trust described in subparagraph (B) of §1361(e)(1).
Corporation X entered into agreements with a number of its employees who are disqualified individuals within the meaning of §280G(c) with respect to Corporation X. None of these employees is (a) a shareholder of Corporation X or (b) a trustee or beneficiary of the Trusts. Under these agreements, on the occurrence of certain events, payments that would constitute parachute payments pursuant to §280G(b)(2)(A) will be made to the employees.
Situation 2. Assume the same facts as in Situation 1, except that the Trusts are not trusts that meet the requirements for the definition of anESBT. Instead assume with respect to the Trusts that (a) an election under §1361(d) to be a qualified subchapter S trust (QSST) has never filed by, been in effect for, or applied to, the Trusts; (b) the Trusts have never been, and currently are not, trusts described in clauses (i), (ii), (iii), (iv), or (vi) of §1361(c)(2); and the Trusts have never owned, and currently does not own, any stock in any S corporation. The Trusts meet the requirements for the definition of a QSST in §1361(d)(3) and are not a trust described in §1361(d)(4).
LAW
Section 280G(a) provides that no deduction is allowed for any excess parachute payment. Under §280G(b)(1), an excess parachute payment is defined as an amount equal to the excess of any parachute payment over the portion of the base amount allocated to such payment.
Section 280G(b)(2)(A) defines a parachute payment as any payment in the nature of compensation to (or for the benefit of) a disqualified individual if such payment is contingent on a change in the ownership or effective control of the corporation, or in the ownership of a substantial portion of the assets of the corporation (a change in ownership or control), and the aggregate present value of the payments in the nature of compensation to (or for the benefit of) such individual which are contingent on such change equals or exceeds an amount equal to three times the base amount.
Section 280G(b)(5)(A)(i) provides, in relevant part, that a parachute payment does not include any payment to a disqualified individual with respect to a corporation which (immediately before a change in ownership or control) is a small business corporation (as defined in §1361(b) but without regard to paragraph (1)(C) thereof).
Regulation §1.280G-1, Q/A-6(a)(1), provides that a parachute payment does not include any payment to a disqualified individual with respect to a corporation which (immediately before the change in ownership or control) would qualify as a small business corporation (as defined in §1361(b) but without regard to §1361(b)(1)(C) thereof), without regard to whether the corporation had an election to be treated as a corporation under §1361 in effect on the date of the change in ownership or control.
The preamble to the final §280G regulations indicates that the prior proposed regulations did not clearly address whether a corporation that does not elect to be treated as an S corporation, but could make the election (because, aside from the election, the corporation otherwise meets the requirements to be treated as an S corporation), may use the exemption under Q/A-6(a)(1). The preamble further states that “a corporation that could elect to be treated as an S Corporation under the Code, but does not do so, may nevertheless use the exemption of Q/A-6(a)(1) for any payments to a disqualified individual.” See, 68 Fed. Reg. 45,745.
The legislative history indicates that §280G was enacted to discourage the use of parachute payments because they may be used to prevent a change in ownership or control, they could encourage executives to favor a change in ownership or control that may not be in the best interest of the shareholders, and shareholders may receive less for their shares in the change in ownership or control. See, Joint Committee on Taxation, General Explanation of the Deficit Reduction Act of 1984, at 199-200 (1984). Small corporations, however, were exempted from the application of §280G. As indicated by the legislative history of §280G, Congress believed that the shareholders in a small privately held corporation could protect their own interests due to the nature of those corporations. Specifically, these shareholders were presumed likely to be aware of any potential payments contingent on a change in ownership or control and the change in ownership or control itself. See S. REP. No. 99-313 at 918 (1986). See also, H.R. REP. No. 99-426 at 901 (1985). The legislative history indicates that a corporation qualifies for the small business corporation exemption if it does not have a shareholder who is not an individual (other than an estate or qualifying trust). See, H.R. REP. No. 99-426 at 901 (1985).
Under §1361(a), an S corporation is, with respect to any taxable year, a small business corporation for which an election under §1362(a) (an S election) is in effect for such year. An election is made on Form 2553.
In accordance with §1362(a)(2), an S election is not valid unless all shareholders of the corporation on the date of the S election consent to the S election. Form 2553 (or an attachment thereto) may also be used for shareholder consents.
Section 1361(b)(1) defines the term “small business corporation” as a domestic corporation which is not an ineligible corporation[1] and which does not
(A)have more than 100 shareholders,
(B)have as a shareholder a person (other than an estate, a trust described in [§1361(c)(2)], or an organization described in [§1361(c)(6))] who is not an individual,have a nonresident alien as a shareholder, and
(C)have more than 1 class of stock.
Under §1361(c)(2), certain trusts are permitted as shareholders of an S corporation including, among others, a qualified subchapter S trust (QSST) and an electing small business trust (ESBT).
Section 1361(d)(3)generally provides that a QSST is a trust –
(A) the terms of which require that –
(i)during the life of the current income beneficiary, there is only 1 income beneficiary of the trust
(ii)any corpus distributed during the life of the income beneficiary may be distributed only to the income beneficiary
(iii)the income interest of the income beneficiary in the trust shall terminate on the earlier of the beneficiary’s death or the termination of the trust, and
(iv)on termination of the trust during the life of the income beneficiary, the trust shall distribute all of the assets of the trust to such beneficiary
(B) all of the income (within the meaning of 643(b)) must be distributed or required to be distributed currently to 1 individual who is a citizen or resident of the US.
An election under §1361(d)(2)(B) (QSST election) is made by the income beneficiary and is made separately with respect to each corporation whose stock is held by the trust.Generally, the QSST election applies with respect to successive income beneficiaries, unless such beneficiary affirmatively refuses to consent to such election. See §1361(d)(2)(B)(ii). Under §1361(d)(2)(C), a QSST election once made is irrevocable without the consent of the Commissioner. Section 1361(d)(2)(D) provides that a QSST election shall be effective up to 2 ½ months before the date of the election.
Regulation §1361-1(j)(6)(ii), provides, in relevant part, that a QSST election is made by filing a statement with the IRS Service Center were the S corporation files its tax return. Generally, the statement must include, among other things, the name, address, and taxpayer identification number of the current income beneficiary, the trust and the corporation; specify the date on which the election is to be effective (not earlier than 15 days and two months before the date on which the election is filed); and specifies the date on which the stock was transferred to the trust. Under reg. §1361-1, a QSST Election must be filed within 2 ½ months of the transfer of S corporation stock to the trust (or within 2 ½ months of the effective date of the S election in the case of a converting corporation).
Pursuant to reg. §1361-1(j)(6)(iv) certain protective QSST elections may be made when a person is an owner under subpart E.
Section 1361(e)(1)(A) generally provides that an ESBT is any trust[2] if –
(i) such trust does not have as a beneficiary any person other than (I) an individual, (II) an estate, (III) an organization described in paragraph (2), (3), (4), or (5) of §170(c), or (IV) an organization described in §170(c)(1) which holds a contingent interest in such trust and is not a potential current beneficiary;
(ii) no interest in such trust was acquired by purchase; and
(iii) an election under §1361(e) applies to such trust.
Section 1361(e)(3) provides that an election under §1361(e) (an ESBT election) is made by the trustee and applies to the taxable year of the trust for which made and all subsequent taxable years unless revoked.
Regulation §1.1361-1(m)(2)(i) provides, in relevant part, that an ESBT election is made by filing a statement signed by the trustee with the IRS Service Center where the S corporation files its tax return. Regulation §1.1361-1(m)(2)(ii) indicates that the ESBT election statement must include, among other information: (1) the name, address, and taxpayer identification number of the S corporations in which the trust currently owns stock; and (2) the first date on which the trust owned stock in an S corporation.
Through cross-reference to reg. §1.1361-1(j)(6)(iii) (relating to the timing of elections for QSSTs), reg. §1.1361-1(m)(2)(iii) provides that an ESBT election must be filed within 2 ½ months of the transfer of S corporation stock to the trust (or within 2 ½ months of the effective date of the S election in the case of a converting corporation).
The election timing rule is illustrated in Example 9 of reg. §1.1361-1(k)(1). Example 9 provides the following:
Example 9. (i) Filing the QSST election. On January 1, 1996, stock of Corporation T, a calendar year C corporation, is transferred to a trust that satisfies all of the requirements to be a QSST. On January 31, 1996, Corporation T files an election to be an S corporation that is to be effective for its taxable year beginning on January 1, 1996. In order for the S election to be effective for the 1996 taxable year, the QSST election must be effective January 1, 1996, and must be filed within the period beginning on January 1, 1996, and ending March 16, 1996 (the 16-day-and-2-month period beginning on the first day of the first taxable year for which the election to be an S corporation is intended to be effective).[3]
Pursuant to reg. §1.1361-1(m)(2)(v), a trust may not make a conditional, or protective, ESBT election that would be effective only if the trust fails to meet the requirements for another type of trust that is a permissible shareholder of an S corporation.
Section 641(c) provides special, somewhat complicated, rules regarding the income taxation of an ESBT. Very generally, these rules require the portion of the trust that consists of stock of one or more S corporations to be treated as a separate trust for purposes of computing the income tax attributable to the S corporation stock held by the trust; this portion of the trust’s income is taxed at the highest individual rate. The items taken into account by the subchapter S portion of the trust then are disregarded in determining the tax liability with regard to the remaining portion of the trust.
ANALYSIS
Situation 1. In the present case, the shareholders of Corporation Xarethe Trusts. The Trusts are the type of trusts that can hold shares in an S corporation only by meeting the definition of an ESBT. Although the Trusts meet all substantive requirements for ESBT status, because Corporation X has not filed and is not required to file an actual S election, the Trusts have not filed and cannot file an ESBT election. Additionally, from a practical perspective, the Trusts could not comply with the EBST filing requirements because there is no S corporation, and thus, there is no IRS Service Center with which ESBT elections could be filed. Even if an election were filed, there would be difficulty processing such election if there were no S corporation with which the elections could be associated.
Section 280G and the regulations promulgated thereunder are silent as to whether, for Corporation X to qualify for the exemption in §280G(b)(5)(A) and reg. §1.280G-1, Q/A-6(a)(1), without having made an actual S election, the Trusts must actually file an ESBT election. However, the legislative history and final §280G regulations indicate thatthe nature of the corporation and the corporation’s shareholders is relevant to determining whether the exemption is applicable rather than whether a specific election is filed. Further, because the rationale for the small business corporation exemption in §280G lies in the private and closely-held nature of the corporate ownership, §280G(b)(5)(A)(i) defines the type of corporation eligible for the exemption by cross-reference to §1361(b)(1), not §1361(a)(1). This reflects the statutory intent that actual status as an S corporation is not a requirement for the exemption. That intent is further evidenced in the lifting of the restriction against nonresident shareholders in §280G(b)(5)(A)(i), which permits a corporation with one or more nonresident shareholders to qualify for the exemption even though such a corporation cannot be an S corporation.
Further, an interpretation of reg. §1.280G-1, Q/A-6, that requires the Trusts to make actual ESBT elections conflicts with the scheme of the statute and regulations under §1361 that indicate that an actual ESBT election can be made only where an actual S election is in place for at least one corporation in which the trust owns stock. Such an interpretation would effectively force corporations to file actual S elections to meet the requirements for exemption under §280G(b)(5)(A)(i).
Based on the statutory language of §280G, its legislative history, and the regulations, the Trusts are not required to make an ESBT election for Corporation X to be eligible for the exemption in §280G(b)(5)(A)(i). Thus, any payments made in connection with a change in ownership or control of Corporation X are exempt from the definition of parachute payment.
Situation 2. Similar to Situation 1, the shareholders of Corporation X are the Trusts. The Trusts are the type of trusts that can hold shares in an S corporation only by meeting the definition of a QSST. However, although the Trusts meet all substantive requirements for QSST status, because Corporation X has not filed and is not required to file an actual S election, the Trusts have not filed and cannot file a QSST Election.
For the reasons discussed in Situation 1, the Trusts are not required to make a QSST election for Corporation X to be eligible for the exemption in §280G(b)(5)(A)(i). Thus, any payments made in connection with a change in ownership or control of Corporation X are exempt from the definition of parachute payment.
HOLDINGS
Situation 1. For purposes of §280G(b)(5)(A)(i),Corporation X is a small business corporation (as defined in §1361(b), but without regard to paragraph (1)(C) thereof). Any payments made in connection with a change in ownership or control of Corporation X are exempt from the definition of parachute payment.