Florida Tax Section

Florida Tax Section

2005 Ullman Annual Year in Review

S Corporations

Charlene Davis Luke[*]

I.Legislation

A.§ 1361(b)(1)(A), Jobs Creation Act (“JCA”); effective after Dec. 31, 2004: Increased the maximum number of S corp. shareholders from 75 to 100. For all the JCA provisions described below, see 2005 TNT 108-16 (JCT explanation).

B.§ 1361(c)(1), JCA; effective for tax years beginning after Dec. 31, 2004: New election allowing all members of a family (and their estates) to be treated as one shareholder in determining the number of shareholders. “Members of the family” is defined to include “the common ancestor, lineal descendants of the common ancestor, and the spouses (or former spouses) of such lineal descendants or common ancestor.” At the time the S corporation election is made, the youngest generation of shareholders may not be more than six generations removed from the common ancestor. A spouse or former spouse is treated as being in the same generation as the member of the family to whom the individual is (or was) married.

C.§ 1361(c)(2)(A)(vi) & § 4975(d)(16), JCA; effective as of Oct. 22, 2004 (date of enactment): Allows an IRA (including a Roth IRA) to be a shareholder of a bank that is an S corporation, but only to the extent of bank stock held by the IRA on the date of enactment of the provision (October 22, 2004). Rules treating S corp. stock held by a qualified retirement plan (other than an employee stock ownership plan) or a charity as an interest in an unrelated trade or business apply to the IRA with respect to its holding in the stock. The Act provides an exemption from prohibited transaction treatment for the sale by an IRA to the IRA beneficiary of bank stock held by the IRA on Oct. 22, 2004, if: (1) the sale is pursuant to an S corp. election by the bank; (2) the sale is for FMV and is on terms at least as favorable to the IRA as the terms would be on a sale to an unrelated party; (3) the IRA incurs no commissions, costs, or other expenses in connection with the sale; and (4) the stock is sold in a single transaction for cash not later than 120 days after the S corp. election is made.

D. §1361(e)(2), JCA; effective after Dec. 31, 2004: Allows powers of appointment to the extent not exercised to be disregarded in determining the potential current beneficiaries of an electing small business trust. Also increases the period during which an ESBT can dispose of S corporation stock, after an ineligible shareholder becomes a potential current beneficiary, from 60 days to one year.

E.§1366(d)(2)(B),JCA, effective for transfers after Dec. 31, 2004: Provides that if a shareholder's stock in an S corporation is transferred to a spouse or to a former spouse incident to a divorce, any suspended loss or deduction with respect to that stock is treated as incurred by the corporation with respect to the transferee in the subsequent taxable year.

F.§ 1361(d)(1)(C), JCA; effective for transfers made after Dec. 31, 2004: Generally allows the beneficiary of a qualified subchapter S trust to deduct suspended losses under the at-risk rules and the passive loss rules when the trust disposes of the S corp. stock.

G.§ 1362(d)(3)(F),JCA; effective after Dec. 31, 2004: Provides that in the case of a bank, a bank holding company or a financial holding company, interest income and dividends on assets required to be held by the bank or holding company are not treated as passive investment income for purposes of the S corp. passive investment income rules.

H.§ 1362(f),JCA; effective for elections and terminations made after Dec. 31, 2004: Allows IRS to waive inadvertent errors occurring in connection with QSub elections and terminations.

I.§ 1361(b)(3)(A),JCA; effective after Dec. 31, 2004: Provides authority to the Secretary to provide guidance concerning information returns of QSubs, although QSubs are generally treated as disregarded entities.

J.§ 4975(f)(7), JCA, effective for distributions made after Dec. 31, 1997: An ESOP maintained by an S corp. is not treated as violating the qualification requirements of the Code or as engaging in a prohibited transaction merely because, in accordance with plan provisions, a distribution made with respect to S corp. stock that constitutes qualifying employer securities held by the ESOP is used to repay a loan that was used to acquire the securities (whether or not allocated to participants). This relief does not apply in the case of a distribution with respect to S corp. stock that is allocated to a participant unless the plan provides that stock with a FMV of not less than the amount of such distribution is allocated to the participant for the year which the distribution would have been allocated to the participant.

K.§ 199,JCA; effective for S corps tax years beginning on and after January 1, 2005: Allows a deduction for certain qualified production activities. With respect to S corps, the deduction is determined at the shareholder level with each shareholder generally taking into account his or her allocable share of the components of the deduction calculation. In calculating the wage limitation each shareholder is treated as having been allocated wages from S corporation in an amount equal to the lesser of: (1) such person's allocable share of wages, as determined under regulations prescribed by the Secretary; or (2) twice the appropriate deductible percentage (e.g., 2 x 3% in 2005) of such person's qualified production activities income attributable to items allocated from the S corp. IRS and Treasury are developing regulations. See Notice 2005-14 (limited interim guidance).

L.§ 1397E(i), Working Families Tax Relief Act of 2004 (“WFTRA”): “Basis adjustments for QZAB held by S corporation. Shareholders of eligible financial institution S corps may receive a credit with respect to a qualified zone academy bond ("QZAB") held by the S corporation. The credit amount is included in the shareholder’s gross income. The new provision clarifies that the shareholder may not increase S corp. stock basis by the amount of the QZAB credit. See 2005 TNT 108-16 (JCT explanation).

M.§ 1377(b)(3)(A), WFTRA; effective for determinations made after December 31, 1996: Correction to Small Business Job Protection Act of 1996, which could have allowed an S corporation shareholder to argue that an audit adjustment allowed shareholders to utilize suspended losses and deductions in excess of the amount of the audit deficiency. The new statute provides that the 120-day post-termination transition period does not apply for purposes of allowing suspended losses to be deducted and allows tax-free distributions of money during the 120-day period only to the extent of any increase in the AAA by reason of adjustments from the audit. 2005 TNT 108-16 (JCT explanation).

N. I.R.C. § 409(p) & § 4979A, added/amended by EGTRRA; generally effective after December 31, 2004 (although earlier effective date for certain plans — e.g., ESOPs established after March 14, 2001): Intended to prevent S corps. controlled by a small group from using ESOPs as tax shelters; it imposes (1) income tax on a disqualified person (generally, a member of a deemed 20% shareholder group or a deemed 10% shareholder) allocated aprohibited allocation and (2) a 50% excise tax on the S corp. employer(a) with respect to prohibited allocations or synthetic equity owned by a disqualified person and (b) with respect to all deemed-owned ESOP shares and all synthetic equity of disqualified persons in the first nonallocation year. Generally, a prohibited allocation meansan accrual of ESOP assets attributable to the employer S corp. and for the benefit of a disqualified person during a nonallocation year — a year in which disqualified persons own at least 50% of the S corp.’s outstanding shares (including deemed-owned ESOP shares). New temporary regulations issued — see below.

II.Final Regulations

A.Association Election Regulations: Final regulations (§ 301.7701-3(c)(1)(v)(C)) published May 23, 2005; effective July 20, 2004. Deems eligible entities making a timely and valid election to be classified as an S corp. to have simultaneously elected to be classified as an association taxable as a corporation. See 2005 TNT 98-29 (May 23, 2005).

B.§ 1361 Disregarded Entities Regulations: Final regulations (1.1361-4(a)(6)) published Feb. 25, 2005, clarify that Q Subs that are disregarded entities are treated as separate entities for purposes of federal tax liabilities for which the entity is liable (e.g., because successor to separately taxed entity). See 2005 TNT 37-6.

C.Adjustments to S Corporation Built-in Gains in § 1374(d)(8) Acquisitions: Final regulations on published Feb. 23, 2005; generally effective for tax years beginning after Feb. 23. but may apply earlier if taxpayer follows procedures outlined in reg. Provides that if an S corp. acquires assets of a C corp. in a carryover basis transaction, some or all of the stock of the C corp. from which such assets were acquired was taken into account in the computation of NUBIG for a pool of assets of the S corp., and some or all of such stock is redeemed or canceled in such transaction, then, subject to certain limitations, such NUBIG is adjusted to eliminate any effect any BIG or BIL in the redeemed or canceled stock had on the initial computation of NUBIG for that pool of assets. 2005 TNT 35-10 (Feb. 23, 2005).

III.Temporary and Proposed Regulations

A.§ 1503(d)Dual Consolidated Loss: Proposed regulations issued May 20, 2005; effective after proposed published as final regs. For purposes of the dual consolidated loss rules, an S corporation is not treated as a domestic corporation, which is intended to clarify that the dual consolidated loss regulations do not apply to the S corporation itself, or to foreign branches or interests in certain flow-through entities owned by an S corporation. Further, the proposed regulations add as a new triggering event for recapture of previously allowed dual consolidated loss the election of either an unaffiliated dual resident corporation or unaffiliated domestic owner to be an S corporation. 2005 TNT 97-7 (May 20, 2005).

B.Application of § 1374(d)(8) to S corps to Transactions Post-Dec. 27, 1994; Effect of Revocation and Re-election of S Corp. Status: Proposed and temporary regulations issued Dec. 22, 2004. Regs. confirm that § 1374(d)(8) applies to any transaction described in that section that occurs on or after Dec. 27, 1994 (the effective date of Reg. § 1.1374-8), regardless of the date of the S corp.’s election. Also take action against 10th Cir. Opinion in Colorado Gas Compression, Inc. v. Commissioner, 366 F.3d 863 (10th Cir. 2004), which allowed § 1374 transition rule to apply to S corp. that was eligible for transition rules but revoked S status and later re-elected. Regs. provide that transition rules apply only if most recent election was made before Jan. 1, 1989. IRS will continue to assert this position for prior taxable years even though the regs. apply only to built-in gain recognized in taxable years beginning after Dec. 22, 2004. See 2004 TNT 246-7 (Dec. 22, 2004) (text of temp. regs). For minor technical corrections to these regulations, see 2005 TNT 20-11 (Feb. 1, 2005); 2005 TNT 34-5 (Feb. 22, 2005); 2005 TNT 86-6 (May 5, 2005); 2005 TNT 98-40 (May 23, 2005).

C.§ 409(p) Regulations: Temporary and proposed regulations issued Dec. 17, 2004; generally effective for plan years beginning on and after Jan. 1, 2005. These regs provide additional definitional guidance for “prohibited allocations” and “disqualified persons.” The regs explain the effects of prohibited allocations; for example, they provide that prohibited allocations in a nonallocation year will cause the plan to cease to be an ESOP. The regs also change the synthetic equity calculation to a person-by-person approach to prevent dilution of ownership interests, and they include a standard for determining whether a synthetic equity ownership structure constitutes avoidance or evasion. See 2004 TNT 243-6 (Dec. 17, 2004).

D. LIFO Recapture Regulations: Proposed regulations (§ 1.1363-2(b) et seq.) issued Aug. 13, 2004; proposed to be effective for S elections made on or after Aug. 13, 2004. Provides that a C corp. holding an interest in a partnership owning LIFO inventory must include the lookthrough LIFO recapture amount in gross income if the corporation either elects to be an S corp. or transfers its interest in the partnership to an S corp. in a nonrecognition transaction. The lookthrough LIFO recapture amount is determined by calculating the amount of income that would be allocated to the corporation if the partnership sold its entire LIFO inventory for its FIFO value. The corporation increases its partnership interest basis by the lookthrough LIFO recapture amount; the partnership is allowed to make basis adjustments as well patterned after the § 743(b) adjustment. See 2004 TNT 157-6 (Aug. 13, 2004).

III. Other AdministrativeActions

A. Rev Proc. 2004-48, 2004-32 I.R.B. 172 (Aug. 9, 2004): provides simplified method for taxpayers to request relief for late S corp. elections and late corporate classification elections.

B.Notice 2005-8, reprinted 2005 TNT 9-5 (Jan. 13, 2005): Describes tax treatment for S corp.’s contributions to a 2% shareholder-employee’s Health Savings Account. Contributions are deductible by S corp. under § 162 and includible in shareholder-employee’s gross income. If shareholder-employee is eligible individual under HSA statute, an above-the-line deduction is allowed for the contribution. Shareholder-employee is treated as an employee subject to FICA and not SECA; if contribution meets § 3121(a)(2)(B) requirements (relating to payments made on account of medical or hospitalization expenses) then contributions are not wages subject to FICA even though required to be reported on W-2.

C.LTR 200450012, reprinted 2004 TNT 239-25 (Dec. 13, 2004): Conversion of S corp. to general partnership that elects corporate entity classification and continues to be taxed as an S corp. constitutes an F reorg.

D.LTR 200441023, reprinted 2004 TNT 197-42 (Oct. 12, 2004): Held that a split-dollar life insurance agreement did not create a second class of stock. The agreement did not alter rights to distribution and liquidation proceeds because the recipients were obligated to reimburse the company to the extent the payments conferred an economic benefit to the recipients.

E.SC2 Settlement Offer: Non-publicized settlement offer requiring complete disallowance of the tax aspects, imposing a mandatory 10% penalty on taxpayers who did not disclose, allowing deduction of certain transaction costs including 50% of promoter fees. 2005 TNT 66-1 (Apr. 7, 2005).

F.§ 409(p) letters: IRS issued around 1700 letters warning S corporation ESOPs reporting 10 or fewer participants about ESOP-related tax abuses, including violations of § 409(p). See 2004 TNT 274-4 (Dec. 23, 2004).

IV.Cases

A.Mourad v. Commissioner, 387 F.3d 27 (1st Cir., Oct. 20, 2004): Affirmed Tax Court decision holding that filing for bankruptcy protection does not terminate an S corp. election.

V.Recent Proposals

A.2006 Budget Proposal: “In order to preserve the benefit of providing a charitable contribution deduction for contributions of appreciated property and to prevent the recognition of gain on the contributed property on the disposition of the S corporation stock, the Administration proposes to allow a shareholder in an S corporation to increase his or her basis in the stock of an S corporation by an amount equal to the excess of the shareholder's pro rata share of the S corporation's charitable contribution over the stockholder's pro rata share of the adjusted basis of the contributed property. The proposal would be effective for taxable years beginning after December 31, 2004.” 2005 TNT 25-12 (Feb. 8, 2005).

B.Payroll Tax Proposal: “Under the proposal, for purposes of employment tax, an S corporation is treated as a partnership and any shareholders of the S corporation are treated as general partners. Thus, S corporation shareholders are subject to self-employment tax under the same rules described above for partners.” 2005 TNT 72-32 (Apr. 15, 2005) (JCT).

C.Recognition Period for Built-in Gains: Proposals to reduce the § 1374(d)(7) from 10 years to 7 years. See 2005 TNT 88-105 (May 9, 2005) (proposal by S. Fin. member Gordon Smith); 2005 TNT 99-44 (May 24, 2005) (proposal by W&M member Jim Ramstad).

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[*] Assistant Professor, FloridaStateUniversityCollege of Law.