MSCPA FEDERAL TAX COMMITTEE FEDERAL TAX FORUM...

MSCPA FEDERAL TAX COMMITTEE FEDERAL TAX FORUM SUBCOMITTEE

S CORPORATIONS By Lorraine A. Travers

1

Passive activity losses—plastics recycling and manufacturing—S corp. owners—material participation—married taxpayers; joint filers—proof.

Code Sec. 469 passive activity loss limitations didn't apply to married shareholders' passthrough losses from S corps. involved in plastics recycling and manufacturing businesses: taxpayers show-ed that husband/businesses founder met Reg. § 1.469-5T(a)(7)'s regular, continuous, and substan-tial basis test for material participation with proof that although he lived out of state and although his son oversaw daily operations, he still spent more than 100 hours on nonmanagement, noninvest-ment activities, focusing among other things on new technology research and development, se-curing financing, visiting facilities and meeting with employees. In effect, he played vital role in businesses and they couldn't have continued to operate without his contacts and expertise. Also, fact that wife wasn't herself shown to materially participate was irrelevant since she and husband as joint filers were for purposes of passive loss rules treated as single taxpayer, with participation of 1 spouse treated as participation by other. (Charles E. Wade, et ux. v. Commissioner, (2014) TC Memo 2014-169, 2014 RIA TC Memo ¶2014-169 )

What type of LT care insurance qualifies for tax breaks? A LT care insurance contract qualifies for tax breaks only if it:

(a) provides insurance coverage only for qualified LT care services (defined below); (b) doesn't pay or reimburse expenses to the extent the expenses are reimbursable under Medicare (or would be reimbursable but for a deductible or coinsurance amount). This require-ment doesn't apply to expenses which are reimbursable under Social Security only as a se-condary payor; (c) is guaranteed renewable; (d) doesn't provide for a cash surrender value or other money that can be paid, assigned, or pledged as collateral for a loan, or borrowed; (e) provides that all refunds of premiums (other than refunds on the death of the insured or on a complete surrender or cancellation of the contract, which can't exceed the aggregate premiums paid under the contract) and policyholder dividends or similar amounts, are to be applied as a reduction of future premiums or to increase future benefits; and (f) satisfies consumer protection requirements carried in Reg. § 1.7702B-1 , as well as disclo-sure and nonforfeitability requirements. ( Code Sec. 7702B(b)(1) , Code Sec. 7702B(b)(2) , Code Sec. 7702B(c)(2) , Code Sec. 7702B(g)(1) )

To satisfy the consumer protection requirements, the issuer of a LT care insurance policy must disclose in the policy and in the required outline of coverage that the policy is intended to be a qualified LT care insurance contract under Code Sec. 7702B . ( Code Sec. 4980C(d) , Code Sec. 7702B (g)(1)(B) , Code Sec. 7702B (g)(3) )

Qualified LT care services are necessary diagnostic, preventive, therapeutic, curing, treating, mitigating, and rehabilitative services, and maintenance or personal care services (below), which are:

• required by a chronically ill individual, and • provided under a plan of care prescribed by a licensed health care practitioner (LHCP), i.e., a

physician, registered professional nurse, licensed social worker, or other individual who meets IRS requirements. ( Code Sec. 7702B(c)(1) , Code Sec. 7702B(c)(4) )



2

RIA observation: The Code doesn't specify the type of facility where the LT care services are performed. It could be a nursing home, an assisted-living facility, or the patient's home.

Maintenance or personal care services consist of any care whose primary purpose is providing needed assistance with any of the disabilities as a result of which the individual is chronically ill (including protection from threats to health and safety due to severe cognitive impairment). ( Code Sec. 7702B(c)(3) )

A chronically ill individual is one who has been certified within the previous 12 months by a LHCP as:

(1) being unable to perform, without "substantial assistance" from another individual, at least two of the activities of daily living (eating, toileting, transferring, bathing, dressing and conti-nence) for at least 90 days due to a loss of functional capacity; (2) having a level of disability similar to that in (1), above, as determined by IRS in consultation with the Department of Health and Human Services; or (3) requiring "substantial supervision" to protect the individual from threats to health and safety due to "severe cognitive impairment," even if the individual is physically able. ( Code Sec. 7702B(c)(2) , Notice 97-31, 1997-21 IRB 1 )

LT health care coverage of self-employed persons. A self-employed person can deduct the premiums paid on LT care coverage for himself, spouse, dependents, and any child who hasn't attained age 27 as of the end of the tax year. ( Code Sec. 162(l)(1) , Code Sec. 213(d)(1)(C) ) However, the amount deductible is limited to the premium amounts deductible as medical insurance under Code Sec. 213(d)(10) (see "Medical expense deduction," above). ( Code Sec. 162(l)(2)(C) ) Thus, for example, the deduction for a 55-year-old self-employed who pays for his own LT health care coverage can't exceed $1,400 for 2014.

The deduction is claimed as an above-the-line deduction to arrive at AGI, and is not subject to the percentage floor beneath itemized medical deductions. ( Code Sec. 62(a)(1) , Code Sec. 162(l) )

RIA observation: Since LT health care coverage is treated like an accident and health plan under Code Sec. 7702B(a)(3) , a self-employed person who employs his or her spouse as a bona fide employee can arrange for the business to buy LT health care coverage for the spouse-employee and deduct all of the premiums, in the same way that any other business would. See Rev Rul 71-588, 1971-2 CB 91 .

One final point: Under Code Sec. 162(l)(2)(B) , no individual who's eligible to participate in any subsidized health plan maintained by any employer of the individual or of the individual's spouse is entitled to the self-employed health insurance deduction. This test for eligibility is made for each calendar month. This rule is applied separately to (1) plans that provide coverage for qualified LT care services, or are qualified LT care insurance contracts and (2) plans which don't include such coverage and aren't such contracts.

RIA observation: Thus, an individual eligible for employer-subsidized health insurance may still be able to deduct LT care insurance premiums, so long as he isn't eligible for employer-subsidized LT care insurance.

Partners' and more than 2%-S-corporation shareholders' LT health care coverage. Partners are treated the same way as self-employed persons for purposes of the health insurance deduction



3

rules. ( Rev Rul 91-26, 1991-1 CB 184 ) And under Code Sec. 162(l)(5) and Code Sec. 1372 , more-than-2% S corporation shareholder-employees are subject to the rules that apply to partners, and S corporations are treated as partnerships. Since qualified LT health care coverage generally is treated as health insurance:

• If a partnership pays the premiums for a partner, it generally can deduct them as guaranteed payments. The partner includes the payment in income, but under Code Sec. 162(l)(2)(C) , may deduct the premiums, limited to the amount deductible as medical insurance under Code Sec. 213(d)(10) (see ¶ 54 ).

• If an S corporation pays the premiums for more-than-2% shareholder-employees, it generally can deduct them, but must also include them in the shareholder's wages subject to federal income tax withholding. Under Code Sec. 162(l)(2)(C) , the shareholder may deduct the LT care premiums, limited to the amount deductible as medical insurance under Code Sec. 213 (d)(10) . (Code Sec. 162(l)(5) ; Rev Rul 91-26, 1991-1 CB 184 ; IRS Pub. 535 (2013), p. 18)

The deduction for partners and more-than-2% S shareholders is claimed as an above-the-line deduction and is not subject to the percentage floor beneath itemized medical deductions. ( Code Sec. 62(a)(1) , Code Sec. 162(l) )

Other conditions. To be entitled to the tax rules outlined above for LT care insurance, the policy must be established, or considered to be established, as follows:

(1) For self-employed individuals filing a Schedule C, C-EZ, or F, a policy can be either in the name of the business or in the name of the individual. (2) For partners, a policy can be either in the name of the partnership or in the name of the partner. Partners can either pay the premiums themselves or their partnership can pay them and report the premium amounts on Schedule K-1 (Form 1065) as guaranteed payments to be included in partners' gross income. However, if the policy is in a partner's name and he pays the premiums himself, the partnership must reimburse him and report the premium amounts on Schedule K-1 (Form 1065) as guaranteed payments to be included in the partner's gross in-come. Otherwise, the insurance plan will not be considered to be established under the part-ner's business. (3) For more-than-2% shareholders, a policy can be either in the name of the S corporation or in the name of the shareholder. The shareholder can either pay the premiums himself or the S corporation can pay them and report the premium amounts on Form W-2 as wages to be in-cluded in the shareholder's gross income. However, if the policy is in the shareholder's name and he pays the premiums himself, the S corporation must reimburse him and report the pre-mium amounts on Form W-2 as wages to be included in gross income. Otherwise, the in-surance plan will not be considered to be established under the shareholder's business. ( Rev Rul 91-26, 1991-1 CB 184 ; Notice 2008-1, 2008-2 IRB 251 ; IRS Pub. 535 (2013), p. 18)

© 2014 Thomson Reuters/Tax & Accounting. All Rights Reserved.

Taxpayer whose son took over management of business still "materially partici-pated"--Wade, TC Memo 2014-169

The Tax Court has found that a taxpayer who turned over certain management responsibilities with respect to 2 S corporations to his son, but remained involved and was in fact vital to the businesses' survival during an economically difficult time, wasn't subject to the passive activity loss (PAL) limita-



4

tions. The Court further found that the taxpayer's activities were sufficient to establish material participation for both him and his wife under Reg. § 1.469-5T(f)(3) and Reg. § 1.469-1T(j)(4) .

Background. Under Code Sec. 469 , individuals may not deduct "passive activity losses" for the year in which they are sustained. A passive activity loss is the amount by which the aggregate losses from all passive activities for a tax year exceed the aggregate income from all passive acti-vities for such year. ( Code Sec. 469(d)(1) ) A passive activity is any activity that involves the conduct of any trade or business in which the taxpayer does not materially participate. (§469(c)(1) )

Reg. § 1.469-5T(a) provides a series of tests to evaluate whether a taxpayer materially participated in a given trade or business. One such test is relevant to this case: the "regular and continuous" test (whether the individual participates in the activity on a regular, continuous, and substantial basis during the year, for at least 100 hours) under Reg. § 1.469-5T(a)(7) .

Facts. In '80, Charles Wade and a colleague founded the company that later became Thermoplas-tic Services, Inc. (TSI). TSI's business involved acquiring plastic waste from chemical companies and converting it into usable products. Paragon Plastic Sheeting, Inc. (Paragon) receives raw materials from TSI and uses them to make building and construction materials. TSI and Paragon are both S corporations of which Mr. Wade and his wife are substantial owners. Mr. Wade develop-ed the manufacturing processes that the companies use and established and managed their Indus-trial facilities.

In '94, after several years at Lockheed Corp., the Wades' son, Ashley, moved to Louisiana and began helping Mr. Wade manage TSI and Paragon. Ashley received stock in each company and, in 2008, owned 30% and 70% of the shares of TSI and Paragon, respectively. The remaining stock was owned half each by Mr. Wade and his wife, Betty. With Ashley there to handle day-to-day development, Mr. Wade became more focused on product and customer development, and since he didn't have to live near business operations to do these things, he and Mrs. Wade moved to Florida. However, he continued to make periodic visits to the facilities in Louisiana and regularly spoke on the phone with plant personnel.

In 2008, TSI and Paragon began struggling financially as prices for their products plummeted and revenues declined significantly. Mr. Wade's involvement in the businesses became crucial during this crisis. He made three visits to the companies' industrial facility that year, redoubled his research and development efforts, invented a new technique for fireproofing polyethylene partitions, develop-ed a method for treating plastics that would allow them to destroy common viruses and bacteria on contact, and secured a new line of credit. Without his involvement, the companies likely would not have survived.

On their 2008 Federal income tax return, Mr. and Mrs. Wade claimed a deduction for approximately $3.8 million in nonpassive losses from three flowthrough entities (Paragon, TSI, and a third entity), which they carried back to 2006 and 2007. IRS reclassified $3.4 million of the losses as passive on the basis that the Wades had not materially participated in 2008, resulting in deficiencies for 2006, 2007, and 2008. The Wades conceded that the losses from the third flowthrough entity were pass-ive. Only the losses from the companies (approximately $3.3 million) were at issue in this case.

The Wades argued before the Tax Court that they satisfied two of the material participation tests-the 500-hour test and the "regular and continuous" test.

Court finds that taxpayers materially participated. The Tax Court easily concluded that Mr. Wade materially participated in the companies' activities in 2008. The record showed that he spent over 100 hours participating in the companies' activities during that year and that his participation con-sisted primarily of product development and customer retention activities (in contrast, the Court



5

noted that taxpayers who participate in management or investment-related capacities are generally subject to more stringent requirements in order to prove material participation, see Reg. § 1.469-5T(b)(2) , Reg. § 1.469-5T(f)(2)(ii) ). The Court found that, although Mr. Wade "took a step back" when his son became more involved, he still played a major role in the companies' 2008 activities by, among other things, developing new technology to improve products and securing financing to allow the companies to continue operations. Since these efforts were continuous, regular, and substantial during 2008, the Court found that Mr. Wade materially participated.

IRS then argued that the Wades failed to prove that Mrs. Wade participated in TSI and Paragon, but the Court rejected this argument as irrelevant because, for purposes of the passive loss limi-tation, married taxpayers who file a joint return are treated as a single taxpayer ( Reg. § 1.469-5T(f)(3) ), and participation by a married taxpayer is treated as participation by his or her spouse. (Reg. § 1.469-1T(j)(4) ) In this case, Mr. Wade's material participation in the companies was suffi-cient to establish material participation for both spouses.


Revocation of parent's S status means former QSub must separately account for income, etc.--Chief Counsel Advice 201433014

In Chief Counsel Advice (CCA), IRS has determined that an S corporation that became a C corp-oration during the tax year cannot prorate, between the S corporation and C corporation, any items that arose with respect to its former QSub after the date on which its S status terminated. IRS also found that the former S corporation could either prorate or close its books under Code Sec. 1362(e) (2) and Code Sec. 1362(e)(3) with respect to all items of its, and the Qsub's, income, gain, loss, deduction, and credit that arose before the termination, as well as all such items that arose only in the former S corporation after the termination.

Background. Under Reg. § 1.1361-4(a)(1) , in general, a corporation that is a QSub is not treated as a separate corporation ; and all of its assets, liabilities, and items of income, deduction, and credit are treated as assets, liabilities, and items of income, deduction, and credit of the S corp.

Reg. § 1.1361-5(a)(1) provides that the termination of a QSub election is effective at the close of the last day of the parent's last tax year as an S corporation if the parent's S election terminates under Reg. § 1.1362-2 (which includes, as relevant to this ruling, if the parent revokes its S corp election). Under Reg. § 1.1361-5(b)(1)(i) , if a QSub election terminates under Reg. § 1.1361-5(a) , the former QSub is treated as a new corporation acquiring all of its assets (and assuming all of its liabilities) as they existed immediately before the termination from the S corporation parent in ex-change for stock of the new corporation . The tax treatment of the formation of the new corpora-tion is determined under general tax principles-meaning that the transaction is tax-free only if it would qualify as a tax-free transaction under the Code (e.g., as a tax-free Code Sec. 351 transfer to a corporation controlled by the transferor). ( Reg. § 1.1361-5(b)(1)(i) )

If, as a result of a revocation or termination of a Subchapter S election, a corporation's tax year is split into an S short year and a C short year (respectively, ending before, and beginning on, the 1st day for which the termination is effective; Code Sec. 1362(e)(1) ), the amount of both separately computed items of income, loss, deduction, and credit, and nonseparately computed income and loss, with some exceptions, is determined for the entire tax year. The amount of each item for the entire tax year is then allocated pro rata to the S short year and to the C short year. ( Code Sec. 1362(e)(2) ) However, Code Sec. 1362(e)(3)(A) provides that a corporation may elect to have



6

Code Sec. 1362(e)(2) not apply, and instead have items assigned to each short tax year under normal tax accounting rules (i.e., elect to "close its books" and attribute items to each year generally based on the time they were incurred or realized).

Code Sec. 1362(e)(5)(A) provides that the taxable income for the C short year, whether deter-mined by a pro rata allocation or under normal tax accounting rules, must be "annualized"-meaning that the taxable income allocated to the C short year must be multiplied by the number of days in the full tax year, then the result is divided by the number of days in the C short year. The tax shall be the same part of the tax computed on the annual basis as the number of days in such short year is of the number of days in the S termination year.

Facts. Before Date 3, Taxpayer, an S corporation, was a holding company that held a subsidiary for which it made a QSub election (Sub). Effective Date 3, Taxpayer revoked its S corporation election by filing a revocation with IRS and became a C corporation, and Sub also became a C corporation. Sub had significant bank bad debts arise during Year, some of which occurred during its post-termination C period.

On Date 4, Sub was closed by Government Agency, which appointed Regulator as receiver. In receivership, Taxpayer still held all of the Sub stock, but Regulator had functional control over Sub.

Taxpayer and its shareholders have a sufficient accumulated adjustments account (i.e., a corporate account consisting of a corporation's income that was previously taxed to its shareholders but not distributed) and basis to absorb Sub's losses if it is permitted to use the pro rata method because, under that method, n/12 (i.e., number of months in short S year divided by 12 months) of the losses will be attributed to the short S year (Date 1 through Date 2). Thus, the issues to be resolved in the CCA were: (i) whether, after a mid-year S election termination, the annual income of Taxpayer and Sub is pro-rated under Code Sec. 1362(e)(2) , or whether Taxpayer and Sub must use a "closing of the books" method; and (ii) whether Taxpayer and Sub must follow the same method.

Consequences of termination. IRS first determined that, while Sub and Taxpayer were treated as the same entity until Taxpayer's voluntary revocation of its S corporation status, they became two separate C corporations after the termination. Under Reg. § 1.1361-5(b)(1)(i) , Sub became a new corporation that didn't exist prior to the termination, acquiring all of the assets of Sub immediately before the termination from Taxpayer in exchange for stock of the new corporation .

Assuming that all the requirements are met, the CCA concluded that Taxpayer's deemed transfer of all the assets and liabilities of Sub to Newco in exchange for Newco stock is treated as a § 351 transaction. Thereafter, unless Taxpayer and Newco elected to file on a consolidated basis, New-co's income must be separately accounted for on its own return, and Newco's items of income, gain, loss, deduction, and credit cannot be combined with those of Taxpayer for proration under Code Sec. 1362(e)(2) .

However, if Taxpayer's deemed transfer of liabilities exceeded the fair value of the transferred assets, and the transaction fails to qualify for tax-free treatment under §351, then Taxpayer will be required to recognize gain or loss on the transaction, and if any of the transferred assets have a basis in excess of fair value, then the loss will be deferred under Code Sec. 267(f) until transferred outside of the Code Sec. 267(f) controlled group. In this case, this would mean that Taxpayer could recognize the loss on the transferred assets, if any, when Regulator took over Newco on Date 4.

The CCA ultimately concludes that Newco cannot prorate any items that arose after the S election termination. However, Taxpayer may choose to either prorate or elect to close its books pursuant to Code Sec. 1362(e)(2) and Code Sec. 1362(e)(3) . Prorated items include all items of income,



7

gain, loss, deduction, and credit that arose in either Taxpayer or Sub prior to the S election termi-nation, as well as all items of income, gain, loss, deduction, and credit that arose in Taxpayer only after the S election termination.


Final regs provide that only bona fide shareholder loans to S corporation create basis--T.D. 9682 , 07/22/2014 ; Reg. § 1.108-7 , Reg. § 1.1366-2 , Reg. § 1.1366-5

IRS has issued final regs that provide that S corporation shareholders may increase their adjusted basis in any indebtedness of the S corporation to them-and thus use that basis to allow them to deduct their pass-through deductions and losses-only if the indebtedness is bona fide. The final regs are unchanged from earlier-issued proposed regs, except they give taxpayers an option with respect to their effective date.

Background. Deductions and losses of an S corporation are passed through to shareholders and (except as otherwise limited by the Code) claimed on their own returns. However, a shareholder may deduct his pro rata share of these passed-through items only to the extent of his adjusted basis in the S corporation stock, determined by taking into account the increases in basis for his share of the S corporation income during the year, and the decreases in basis for nondividend dis-tributions for the year ( Code Sec. 1366(d)(1)(A) , plus his adjusted basis in any indebtedness of the S corporation to him. ( Code Sec. 1366(d)(1)(B) , Reg. § 1.1366-2 ) The Code does not define basis of indebtedness.

Proposed regs issued in June, 2012 on the basis of indebtedness(Preamble to Prop Reg 06/11/12).

Final regs. The final regs contain no substantive changes from the proposed regs.

The final regs require that loan transactions represent bona fide indebtedness of the S corporation to the shareholder in order to increase basis of indebtedness. General Federal tax principles (many of which have developed outside of Code Sec. 1366 ) determine whether indebtedness is bona fide. ( Reg. § 1.1366-2(a)(2)(i) )

Illustration 1: A is the sole shareholder of two S corporations, S1 and S2. S1 loaned $200,000 to A, and A then loaned $200,000 to S2. Whether the loan from A to S2 is bona fide indebtedness from S2 to A is determined under general Fed-eral tax principles and depends upon all of the facts and circumstances. If A's loan to S2 is bona fide indebtedness from S2 to A, then A's back-to-back loan increases A's basis of indebtedness in S2. ( Reg. § 1.1366-2(a)(2)(iii) , Example 2)

In line with the decisions of an overwhelming majority of courts considering the issue, the regs provide that an S corporation shareholder who merely acts as a guarantor or in a similar capacity (e.g., surety or accommodation party) hasn't created basis of indebtedness unless the shareholder actually makes a payment, and then only to the extent of such payment.( Reg. § 1.1366-2(a)(2)(ii) )

Effective date. The proposed regs provided that they would apply to loan transactions entered into on or after final regs were published. (Prop Reg § 1.1366-5)

The final regs apply to indebtedness between an S corporation and its shareholder resulting from any transaction occurring on or after July 23, 2014. ( Reg. § 1.1366-5(b) )

In addition, because IRS believes that allowing taxpayers to rely on these regs will provide greater



8

certainty for determining when shareholders have basis of indebtedness ( T.D. 9682, 07/22/2014 ), taxpayers may rely on these regs with respect to indebtedness between an S corporation and its shareholder that resulted from any transaction that occurred in a year for which the period of limi-tations on the assessment of tax did not expire before July 23, 2014. ( Reg. § 1.1366-5(b)


Tax-saving opportunities for "active" S corporation owners by EDWARD G. PTASZEK, JR. and DANA ROUNTREE ANDRASSY, partners in the Cleveland office of BakerHostetler LLP.

S corporations now provide business owners with a unique opportunity to minimize earnings subject to both the recently imposed additional tax on net investment income and increased employment taxes.

As the dust settles on the two major pieces of tax reform legislation that went into effect in 2013, S corporations emerge as the entity of choice for many closely held businesses. Taking into account the impact of the two income-based Medicare taxes, the self-employment tax, and the rate differen-tial between individual and corporate tax rates, businesses eligible to be treated as S corporations have opportunities to take advantage of unique provisions not applicable to other types of entities.

Effective 1/1/2013, the Patient Protection and Affordable Care Act (PPACA) and the American Tax-payer Relief Act of 2012 (ATRA) increased the Medicare tax on earned income and introduced a new tax on the net investment income (NII) of high-income individuals.( Code Sec. 1411 ) Although the focus of this article is on individual business owners, the NII tax also applies to trusts and esta-tes. ( Code Sec. 1411(a)(2) ) In addition, 2012 marked the end of the 2% payroll tax holiday, and the expiration of Bush-era tax rates for high-income individuals. These changes come together to create a tax climate in which choice of entity can affect the cost of doing business in a way that is big enough to warrant a fresh look at tax planning for closely held businesses and their owners.

Increased Medicare taxes. For 2013 and thereafter, the Medicare tax on compensation and self-employment income increased from 2.9% to 3.8%. ( Code Secs. 3101(b)(2) and 1401(b)(2) ) The .9% increase applies to the extent an individual's compensation or self-employment income ex-ceeds the specified threshold amounts ($250,000 for married individuals filing jointly and $200,000 for single individuals). ( Code Sec. 1411(b) ) The full brunt of the increase falls on the employee, or self-employed individual, with no change to the employer portion of the tax. There is no cap on the amount of compensation or self-employment income subject to the tax. Further, the threshold a-mounts for the Medicare tax are not indexed for inflation, so an increasing number of taxpayers will be subject to the tax as time passes. The combined effect of increased income and Medicare tax rates on earned income puts employees at a top rate of up to 39.25%, and self-employed indivi-duals at a top rate of up to 40.7%.

New 3.8% tax. The new 3.8% Medicare tax on NII functions as a corollary to the Medicare tax on earned income. Subject to limited exceptions, most income of an individual taxpayer is covered by one (but only one) of these taxes. ( Code Sec. 1411(c)(6) ) Individuals are subject to the NII tax on the lesser of their NII or modified adjusted gross income over the specified threshold amounts ($250,000 for married individuals filing jointly and $200,000 for single individuals, i.e., the same thresholds as for the Medicare tax on earned income). ( Code Sec. 1411(b) ) There is no cap on the amount subject to the tax, and the thresholds are not indexed for inflation. An individual's NII is the sum of the individual's passive income (generally, all interest, dividends, annuities, rents, royal-ties, capital gains, and certain income from a trade or business) less applicable deductions. ( Code



9

Sec. 1411(c)(1) ) Trade or business income is included in NII if the business activity is a passive activity with respect to the taxpayer under Code Sec. 469 , or involves trading in financial instru-ments or commodities. ( Code Sec. 1411(c)(2) ) NII does not include any item taken into account in determining self-employment income for the relevant tax year. ( Code Sec. 1411(c)(6) )

Individual rate now tops corporate. For the first time since 2003, corporate and individual rates have flip-flopped, and the maximum income tax rate applicable to individuals is now significantly higher than the rate applicable to corporations. The top individual income tax rate for 2013 is 39.6% for ordinary income and 20% for long-term capital gains and qualified dividends. The top corporate income tax rate for 2013 remains at 35% however, for both ordinary income and capital gains.

Less obvious tax increases. In addition to higher individual income tax rates, the phase-out of personal exemptions and disallowance of itemized deductions results in an even higher effective marginal tax rate for high-income taxpayers. Beginning in 2013, an individual's personal exemptions are partially phased out for adjusted gross income over the specified amount ($254,200 for 2014), and itemized deductions are disallowed in an amount equal to 3% of adjusted gross income over the specified amount, with the maximum amount disallowed equal to 80% of itemized deductions.

Disparity in treatment of different entity types. Entity owners must navigate the rules relating to the various taxes that are potentially applicable to their business income, whether in the form of dividends, salary, or sale proceeds. The application of these rules varies significantly with the choice of entity as discussed below.

C corporations. For C corporation shareholders, the NII tax applies to any dividends paid by the corporation and to any gain on the sale of the C corporation stock. The level of a C corporation shareholder's participation in the corporation's business is irrelevant for purposes of the NII tax. In contrast to partnerships, limited liability companies (LLCs), and S corporations, the NII tax applies to income from a C corporation regardless of whether the corporation's business is active or pass-ive with respect to any shareholder.

The self-employment tax does not apply to C corporation dividends or to any gain on the sale of C corporation stock. ( Code Sec. 1402 ) The salary of a C corporation shareholder who is employed by the corporation is subject to the Medicare tax on earned income, at the new higher rate for 2013, with no cap on the compensation subject to the tax.

C corporations benefit from the relatively lower corporate income tax rate, when compared to the top individual income tax rate. However, this corporate-level advantage is generally outweighed by the increased tax burden at the shareholder level. The cost of withdrawing corporate earnings has substantially increased, with rising individual rates and the addition of the NII tax. Every dollar earn-ed by a C corporation is subject to tax at 35% at the corporate level, and then again on distribution as a dividend to shareholders at the applicable individual income tax rate, with the addition of the 3.8% NII tax for high-income shareholders.

Partnerships and LLCs. The treatment of an owner of a partnership interest, including interests in an LLC taxed as a partnership, depends on whether the business is passive with respect to the owner for purposes of the NII tax rules, and whether the owner is treated as a "limited partner" for purposes of the self-employment tax rules.

An individual partner's NII includes the partner's share of flow-through income from a partnership only to the extent the income is derived from a partnership activity that is a passive activity with respect to the partner (or from trading in financial instruments or commodities), or represents a share of the partnership's investment income. The material participation test under Code Sec. 469 applies to determine whether an activity is passive with respect to a partner. Under the test, a part-



10

ner materially participates in an activity if the partner's involvement in the operation of the activity is regular, continuous, and substantial. ( Code Sec. 469(h) ) Thus, in the case of a passive partner, the new NII tax applies to the partner's entire distributive share of partnership income. On the other hand, if a partner materially participates in the partnership's business, the NII tax does not apply to the partner's income from the partnership except to the extent the partner receives a guaranteed payment for services.

The gain or loss included in NII with respect to the sale of a partnership interest is limited to the gain or loss that would be recognized in a hypothetical sale of the partnership's assets. Any gain reco-gnized on the distribution of money in excess of a partner's adjusted basis in the partnership inter-est is also treated as gain from the sale or exchange of the partnership interest, for purposes of the NII tax. Unfortunately, even a partner whose level of participation avoids the NII tax will likely be subject to self-employment tax on the partner's entire distributive share of the partnership's income, as well as any gain on sale of a partnership interest.

S corporations. Passive shareholders in an S corporation are treated much like passive investors in partnerships. The NII tax applies to the entire distributive share of S corporation income allocable to a shareholder, to the extent the income is derived from activity that is passive (or from trading in financial instruments or commodities) or represents the corporation's investment income. As with partners, the material participation test under Code Sec. 469 applies to determine whether an acti-vity is passive with respect to an S corporation shareholder. A shareholder who materially partici-pates in the business avoids the NII tax on the shareholder's entire distributive share of the S corp-oration's income. As with a partnership, gain or loss on the sale of S corporation shares is included in NII only to the extent of the gain or loss that would be recognized in a hypothetical sale of the S corporation's assets, i.e., to the extent gain or loss is derived from an activity that is passive as to the S corporation shareholder.( Code Sec. 1411(c)(4) ) Any gain recognized as a result of a dis-tribution of money in excess of a shareholder's adjusted basis in the S corporation's stock is treated as gain from the sale or exchange of the stock. In the case of sale of S corporation stock with a Code Sec. 338(h)(10) election, NII includes the shareholder's pro rata share of the corporate level gain on the deemed asset sale, as well as any additional gain on the deemed liquidation.

A shareholder-employee of an S corporation is subject to employment taxes (including the Medi-care tax on earned income at the new higher rate for 2013) on compensation for services that the shareholder provides to the S corporation. However, the self-employment tax does not apply to an S corporation shareholder's distributive share of the corporation's income.

Conclusion. The ability to bifurcate an S corporation shareholder's compensation for services from the shareholder's distributive share of the corporation's income provides an opportunity to minimize earnings subject to the additional layer of NII and employment taxes. The caveat is that reasonable salary must be paid. With the increase in taxes on earned income, IRS has added incentive to challenge the allocation of S corporation payments between salary and distributions. If IRS deter-mines that salary paid to an S corporation shareholder is too low, a portion of distributions to the shareholder might be recharacterized as wages. ( Rev Rul 74-44, 1974-1 CB 287 )

The bottom line for S corporations is that a passive shareholder is subject to the NII tax on the shareholder's distributive share of the corporation's income as well as any gain on sale, while a shareholder who materially participates avoids both the NII tax and self-employment tax on the shareholder's distributive share of income and any gain on sale of the S corporation stock. S corporation shareholders who are actively involved in the corporation's business will want to look at planning opportunities to meet the material participation standard. New entities that can be struc-tured as an S corporation should consider a careful allocation of payments to active shareholders,



11

between compensation for their personal services and distributions, representing a share of the corporation's profits as a return on investment.


IRS finalizes regs on FICA, FUTA and tanning tax treatment of disregarded entities-- T.D. 9670, 06/25/2014 , Reg. § 1.1361-4, Reg. § 31.3121(b)(3)-1 , Reg. § 31.3127-1 , Reg. § 31.3306(c)(5)-1 , Reg. § 301.7701-2

IRS has finalized, without any substantive changes, regs that: a) extend certain exceptions from taxes under the Federal Insurance Contributions Act (FICA) and the Federal Unemployment Tax Act (FUTA) to disregarded entities; and b) treat disregarded entities as separate entities for pur-poses of the Code Sec. 5000B indoor tanning services excise tax.

Background-disregarded entities. A qualified subchapter S subsidiary (QSub) is any domestic corporation that is not otherwise ineligible to be an S corporation if: (1) the corporation is 100% owned by an S corporation parent; and (2) the S corporation elects to treat the subsidiary as a QSub. ( Code Sec. 1361(b)(3)(B) )

In general, a business entity that has a single owner and is not a corporation under Reg. § 301. 7701-2(b) is disregarded as an entity separate from its owner. ( Reg. § 301.7701-2(c)(2)(i) )

Since Jan. 1, 2008, QSubs and single-owner eligible entities that are disregarded as entities sepa-rate from their owner for any purpose under Reg. § 301.7701-2 (collectively, disregarded excise tax entities) have been treated as separate entities for purposes of most, but not all, excise taxes. (Reg. § 1.1361-4(a)(8) , Reg. § 301.7701-2(c)(2)(v) )

A disregarded entity is treated as a separate entity (specifically, as a corporation) for employment tax purposes and related reporting requirements. As a result, the entity, rather than the owner, is considered to be the employer of any individual performing services for the entity.(Reg. § 301.7701-2(c)(2)(iv) )

Background-certain exceptions to FICA and FUTA tax. Code Sec. 3121(b)(3) provides an excep-tion to the FICA tax for certain individuals who work for certain family members. Code Sec. 3127 provides a FICA tax exception where both the employer and employee are members of faiths op-posed to Social Security. Code Sec. 3306(c)(5) provides a FUTA tax exception for persons employ-ed by children or spouses and for children under 21 employed by their parents.

Before the promulgation of the final and temporary regs discussed below, these exceptions were not available where the employer was a disregarded entity because that entity was treated as a corporation .

Background-indoor tanning services excise tax. Under Code Sec. 5000B , recipients of any indoor tanning service must pay an excise tax equal to 10% of the amount paid for such service, whether paid by insurance or otherwise. Under Code Sec. 5000B(c)(2) , the person receiving the payment on which tax is imposed generally must collect the tax from the payor and pay the tax over quarterly to the government.

Previous temporary regs regarding certain exceptions to FICA and FUTA tax. 2011 temporary regs allowed disregarded entities to qualify for the FICA & FUTA exceptions of Code Secs. 3121(b)(3) , 3127 and 3306(c)(5) . For purposes of applying these exceptions only, the owner of the disregard-ed entity is treated as the employer, and the employee is considered to be an employee of the own-



12

er.(Reg. § 31.3121(b)(3)-1T(d), Reg. § 31.3127-1T(c), Reg. § 31.3306(c)(5)-1T(d) )

The temporary regs also contained a provision under which, if an entity is disregarded as an entity separate from its owner for any purpose under Reg. § 301.7701-2 , the owner is subject to the backup withholding requirements imposed by Code Sec. 3406 . (Reg. § 301.7701-2T(c)(2)(iv)(A))

These changes applied for wages paid after Oct. 31, 2011.(Regs. §§ 31.3121(b)(3)-1T(e), 31.3127-1T(d), 31.3306(c)(5)-1T(e) and 301.7701-2T(e)(5))

Previous temporary regs regarding tanning tax. 2012 temporary regs added Chapter 49 (which contains the Code Sec. 5000B excise tax) to the list of excise taxes for which excise tax disregard-ed entities are treated as separate entities. (Reg. § 1.1361-4T(a)(8)(iii), Reg. § 301.7701-2T(c)(2) (vi)) These changes were effective for taxes imposed on amounts paid on or after July 1, 2012.

Final regs make no substantive changes. IRS has now finalized the above regs. The final regs reorganize and revise the regs discussed above for clarity. But, IRS says that no substantive changes are intended. ( T.D. 9670, 06/25/2014 )

© 2014 Thomson Reuters/Tax & Accounting. All Rights Reserved

Active-participation exception to farming syndicate not limited to individuals--Burnett Ranches, Limited v. U.S., (CA 5 5/22/2014) 113 AFTR 2d ¶ 2014-848

The Court of Appeals for the Fifth Circuit, affirming the district court, has concluded that the Code Sec. 464(c)(2)(A) active-participation exception to a partnership being classified as a farming syn-dicate could be met by an individual who actively participated and owned a super-majority interest in the farming partnership through her wholly owned S corporation. As a result, the partnership wasn't a syndicate required to use the accrual accounting method.

Background. A farming syndicate is a tax shelter arrangement by which a farmer with tax losses sells a partnership interest in the farm to a high-income individual taxpayer who has no genuine interest in farming, with the purpose of providing the taxpayer loss deductions on his federal income-tax return. (Estate of Wallace v. C.I.R., (CA 11 1992) 70 AFTR 2d 92-5349 ) Specifically, under Code Sec. 464(c)(1)(B) , a farming syndicate is defined as a partnership or any other enterprise (other than a C corporation ) engaged in the trade or business of farming, if more than 35% of the losses during any period are allocable to limited partners or limited entrepreneurs.

Code Sec. 464(c)(2)(A) provides that "in the case of any individual" who has actively participated (for a period of not less than five years) in the management of any trade or business of farming, any interest in a partnership or other enterprise that is attributable to the active participation must be treated as an interest that is not held by a limited partner (the active-participation exception). Thus, when computing the total amount of partnership losses that are allocable to limited partners for purposes of Code Sec. 464 , any interest in the partnership that is attributable to an individual's five-plus years of active participation in the management of a farming business must be excluded form the total.

Code Sec. 448(a)(3) generally provides that a tax shelter can't use the cash receipts and disburse-ment method of accounting (cash accounting method). For this purpose, a syndicate is considered a tax shelter. ( Code Sec. 461(i)(3)(B) )

Facts. Burnett Ranches was a limited partnership that operated cattle and horse breeding opera-tions in West Texas principally on two ranches-the 6666 Ranch (Four Sixes Ranch) and the Dixon



13

Creek Ranch. For over 100 years, ownership of these ranches was passed down from generation to generation within the Burnett family.

For the 2005 tax year, Burnett Ranches consisted of three partners: (1) the Tom L. and Anne W. Burnett Trust (TLAB Trust), which owned a general-partnership interest; (2) Burnett Ranches, Inc. (the BR Corporation, a subchapter S corporation, wholly owned by Ms. Anne Burnett Windfohr Marion), which owned a limited-partner interest; and (3) the LP Trust, which owned a limited-partner interest. For the 2006 and 2007 tax years, Burnett Ranches had two partners: the TLAB Trust and the BR Corporation .

Ms. Marion was the current family member who oversaw the operation of the ranches. She was the sole owner of the Four Sixes Ranch, where some aspects of Burnett Ranches's livestock business was conducted, and she was half owner, individually and through the TLAB Trust, of Dixon Creek Ranch, where other facets of that business was conducted.

Throughout 2005, 2006, and 2007 (the years at issue), Burnett Ranches paid various expenses that it incurred in connection with its ranching operations. For those same years, Burnett Ranches claimed deductions for those expenses under the cash method. Burnett Ranches ultimately report-ed losses for the tax years 2005, 2006, and 2007, and allocated those losses to its partners. The losses allocated to the BR Corporation passed through to, and deducted by, Ms. Marion on her individual tax return.

In a partnership proceeding, IRS determined that Burnett Ranches was a farming syndicate pre-cluded from using the cash method. IRS disallowed its deductions based on the cash method and using the accrual method increased its partnership income for each of the years at issue.

Parties' positions. Burnett Ranches contended that it should be allowed to use the cash method for the years at issue. Ms. Marion actively participated in the management of her family's cattle ranch-es for decades and her indirect interest in Burnett Ranches (through her 100% ownership of BR Corporation) was attributable to her active participation. Accordingly, it contended that her interest should be treated as an interest that was not held by a limited partner, and so the active-participa-tion exception should take Burnett Ranches outside the definition of a farming syndicate.

On the other hand, IRS contended that Burnett Ranches was required to use the accrual method. IRS argued that Code Sec. 464(c)(2)(A) 's use of the phrase "in the case of any individual" indi-cates Congress's intent to reserve the active-participation exception for individuals only, meaning that Burnett Ranches cannot avail itself of those protections.

District court's conclusion. The district court found that the active-participation exception in Code Sec. 464(c)(2)(A) applies to any interest that is attributable to an individual's five-plus years of active participation in ranch management. The exception was not limited solely to interests held by individuals, as IRS maintained. The court reasoned that Congress, in enacting Code Sec. 464 , was primarily concerned that high-bracket taxpayers who were not full-time farmers were using tax benefits available to farmers to shelter income. Congress did not intend to deprive genuine farmers or ranchers of their previously enjoyed tax benefits. In carrying out these objectives, the court saw no meaningful basis for distinguishing between the partnership interests of a rancher who had structured his business as a sole proprietorship and a rancher who had structured his business as a corporation. (Burnett Ranches, Lts. v. U.S., (DC TX 10/24/2013) 113 AFTR 2d ¶ 2014-847 )

The appellate court decision. After an exhaustive statutory analysis, the Fifth Circuit, affirming the district court, concluded that an otherwise qualified individual who has participated in management of the farming operations for not less than five years comes within the active-participation exception in Code Sec. 464(c)(2)(A) , irrespective of the fact that the legal title of the individual's attributable



14

interest happens to be held in the name of the taxpayer's wholly owned S corporation rather than in the taxpayer's own name.

The Court found that in Code Sec. 464(c)(2)(A) , Congress expressly provided that any interest in an agricultural venture that is "attributable to" an individual's active participation in the management of the farming activity for more than 5 years is not to be treated as the interest of a proscribed limited partner or limited entrepreneur. Congress did not restrict the exception in § 464(c)(2)(A) to interests of which such an actively participating manager holds legal title in his or her name.

The Court pointed out that neither IRS nor anyone else contended that tax sheltering or minimiza-tion had anything whatsoever to do with the S corporation arrangement. There was no question here that for a cash-basis taxpayer, the income tax results would be exactly the same, with or without the S corporation in the chain of title. Whether Ms. Marion's interest in Burnett Ranches were held in her own name or in the name of her wholly owned S corporation (which, the Court noted, were universally recognized as being purely pass-through entities for federal income tax purposes), she would owe precisely the same income taxes. Moreover, Ms. Marion's business and ownership history with these ranches and their operations was the very antithesis of the farming syndicate's tax shelters that Code Sec. 464 was enacted to thwart. In fact, the Court added, "her and her family's uninterrupted history with the farming operations and the lands on which they are conducted could be the poster child for Congress's inclusion of the Active-Participation Exception in Code Sec. 464 to exempt such entities and their substantial hands-in-the-dirt owners and operators from that Code section's reach."


IRS advice on its processing amended S corp return after running of statute of limi-tations--Chief Counsel Advice 201409005

In Chief Counsel Advice, IRS has said that it will decide on a case-by-case basis whether to pro-cess an amended S corporation return that is submitted after the date that additional tax could be assessed on the S corporation and after the date that the S corporation could make a refund claim, where that amended return doesn't report any change to the S corporation tax reported on the original S corporation return.

Background. Code Sec. 6501 provides time limits for assessment and collection of tax, and Code Sec. 6511 provides time limits on the filing of claims for credits or refunds of overpayments of tax.

Facts. The taxpayer is an S corporation that promptly filed its return (Form 1120S). After the ex-piration of the Code Sec. 6501 and Code Sec. 6511 deadlines, the S Corporation filed an amended return reporting no change in tax. The amended Form 1120S was submitted to support a timely filed claim for refund by an individual who was a shareholder of the corporation; the corporation had determined that there was a reduction in its previously-reported flow-through income or an increase in flow-through tax credits.

IRS disallowed the shareholder's claim for refund due to the fact that the amended Form 1120S was not filed within the time periods delineated by Code Sec. 6501 or Code Sec. 6511 .

IRS will decide to process such S corporation returns on a case-by-case basis. IRS said that it isn't aware of any authority which requires IRS to process, or prohibits IRS from processing, an amend-ed return of an S Corporation after the expiration of the time periods delineated by Code Sec. 6501



15

or Code Sec. 6511 , if that amended return makes no change to the corporation's tax liability. IRS must make the business decision on a case by-case basis as to whether to process the amended Form 1120S.

In this particular case, IRS should consider the fact that the late-filed amended Form 1120S will impact the shareholder's claim for refund on a timely filed Form 1040X, which may provide some justification for processing the late 1120S.

IRS's thoughts on the shareholder's amended return. IRS also noted that it, upon examination of the individual's claim for refund, is free to examine whether the underlying flow-through items are correctly reported/claimed by the taxpayer. If the corporation has not properly filed a return that matches up with the amounts claimed by the taxpayer, IRS may disallow the claim based on a lack of substantiation. But, IRS said, should the shareholder file a refund suit, the fact that IRS does or does not process the late-filed amended Form 1120S may prove to be wholly irrelevant to that shareholder being able to substantiate that he is entitled to a refund and prove his claim in court.


Third Circuit affirms: QSub election doesn't increase shareholder's basis in S corp-oration--R. Ball et al, (CA 3 2/12/2013) 113 AFTR 2d ¶ 2014-494

The Third Circuit, affirming a Tax Court opinion, has ruled that an election by an S corporation to treat its subsidiary as a qualified Subchapter S subsidiary (QSub) did not increase the basis of the S corporation's shareholders in their S corporation stock.

Background. In computing his tax, an S corporation shareholder must take into account his pro rata share of the corporation's items of income (including tax-exempt income), loss, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder. (§1366(a)(1)(A) )

Under §61(a)(3) , gross income means all income from whatever source derived, including gains derived from dealings in property.

The basis of each shareholder's stock in an S corporation is increased for any period by several amounts, one of which is the items of income described in Code Sec. 1366(a)(1)(A) . ( Code Sec. 1367(a)(1)(A) )

A QSub is a wholly owned subsidiary of a parent S corporation for which all assets, liabilities, and items of income, deduction, and credit of the subsidiary are treated as assets, liabilities, etc. of the S corporation. ( Code Sec. 1361(b)(3)(A)(ii) )

After a QSub election, the subsidiary is deemed to have liquidated into the parent under §§332 and 337. ( Reg. § 1.1361-4 ) Under Code Sec. 332 , no gain or loss is recognized on the receipt by a corporation of property distributed in complete liquidation of another corporation. (§ 332(a) )

Under Code Sec. 331 , amounts received by a shareholder in a distribution in complete liquidation of a corporation are treated as in full payment in exchange for the stock. Code Sec. 332 is an ex-ception to Code Sec. 331 . ( Reg. § 1.332-1 )

Facts. A series of trusts (the Trusts) owned Wind River, an S corporation, which, in turn, owned 100% of another corporation, AIS. Wind River elected to treat AIS as a QSub. Right before Wind River made that election, the aggregate bases of all the Trusts' shares of Wind River was $5.6



16

million. The Trusts then sold Wind River. In reporting the sales transaction on their tax returns, the Trusts reported as their basis in the Wind River stock the $5.6 million plus the amount of income that would have been recognized under Code Sec. 331 on the deemed liquidation of AIS that took place as a result of the QSub election.

IRS challenged the basis used by the Trusts, saying that it was the $5.6 million, with no increase for the income that would have been recognized under Code Sec. 331 .

Tax Court rules in favor of IRS. The issue before the Tax Court was whether a QSub election cre-ates an "item of income" for the parent corporation under Code Sec. 1366(a)(1)(A) . The Trusts argued that the election resulted in a gain derived from dealings in property and, therefore, created an item of income under Code Sec. 61(a). More specifically, the Trusts argued that the deemed liquidation of AIS was, under Code Sec. 331 , a sale or exchange of property creating a realized gain to Wind River. They further claimed that gains from dealings in property are expressly included in gross income under Code Sec. 61(a) . They then contended that, although Code Sec. 332 pro-vides for the nonrecognition of that gain, the gain was still "an item of income (including tax exempt income)" under Code Sec. 1366(a)(1)(A) , which passed through to them and increased their bases in Wind River stock under Code Sec. 1367(a)(1)(A) . To support their position, the Trusts looked to the Supreme Court's holding in Gitlitz (S Ct 2001), 87 AFTR 2d 2001-417 , that cancellation-of-debt income that is excluded from gross income under Code Sec. 108 is an item of tax-exempt income that increases the shareholder's basis in the S corporation.

The Tax Court rejected the Trusts' arguments, relying on the differences between "realization" and "recognition" of income in determining what constitutes an "item of income" under Code Sec. 1366 (a)(1)(A) . The Tax Court held that gain from a QSub election is "realized" and calculated under Code Sec. 1001 , yet it is not "recognized" due to the nonrecognition provision of Code Sec. 332 . The Court distinguished Gitlitz; it said that Gitlitz only established that the nature of "discharge of indebtedness" as income is not affected by an exclusion elsewhere in the Code. Here, however, "realized gain from the QSub election was never included explicitly in gross income and was never excluded from gross income."

The Third Circuit affirms the Tax Court. The Third Circuit couched the issue before it in the same terms as did the Tax Court-i.e., whether a QSub election creates an "item of income" for the parent corporation under Code Sec. 1366(a)(1)(A) )-and then found several reasons to find that it doesn't create an item of income.

The Court first noted that the term "item of income" in Code Sec. 1366(a)(1)(A) is not defined in the Code and that regs provide only guidance that isn't helpful here. It then looked to a Supreme Court decision that defined "gross income" as "accessions to wealth, clearly realized, and over which the taxpayers have complete dominion." (Glenshaw Glass Co. (S Ct 1955), 47 AFTR 162 ) The Third Circuit then said that the QSub election did not add wealth, but merely changed the tax treatment of the income flowing from the QSub. This reformation by liquidation did not provide an "accession to wealth" for the corporation and therefore could not create "income" for the Trusts.

It then looked to the Trust's second argument, which involved realization versus recognition of income and the relationship of Code Sec. 332 and Code Sec. 331 .

The Trusts contended that the Tax Court confused the concepts of realization and recognition. The Trusts asserted that the crux of the Tax Court's error was its determination that unrecognized gain does not rise to the level of income. They argued that the Code cannot be parsed to create some realized gain that is income and some realized gain that, by virtue of nonrecognition, is not. According to the Trusts, realized gain is always income, a categorization that does not change if



17

that realized gain is then unrecognized.

The Court said that inherent in this argument is which statutory provision, Code Sec. 331 or Code Sec. 332 , applies to the liquidation of AIS via the QSub election. It characterized the Trusts' argu-ment as follows: 1) Code Sec. 331 applies to "realize" the gain. 2) Code Sec. 332 's nonrecognition provision applies only after realization under Code Sec. 331 , without effect on whether the gain is an "item of income." 3) This realized but unrecognized gain is considered an "item of income," and they are permitted to increase their bases in their Wind River stock.

The Court concluded that Code Sec. 332 , which governs the liquidation of certain subsidiaries, applies here, not Code Sec. 331 , which governs all other liquidations. The Trusts failed to address the fact that Code Sec. 332 , by its plain text, applies to a special set of liquidations that are treated under a different statutory scheme and do not create "items of income." It pointed out that, under Reg. § 1.1361-4 (see Background, above), a QSub election results in a Code Sec. 332 liquidation.

The Trusts then noted argued that Code Sec. 332(d) ("Recognition of gain on liquidation of certain holding companies") provides that "subsection (a) and Code Sec. 331 shall not apply to such dis-tribution." ( Code Sec. 332(d)(1)(A) ) This, according to them, was proof that Code Sec. 332 and Code Sec. 331 are not mutually exclusive, because, if they were, there would be no need for Code Sec. 332(d)(1)(A) . But the Court said that that subsection does not affect the analysis of a Qsub liquidation at issue here. That is, it is not incongruous to say that a Qsub liquidation, governed by Code Sec. 1361 , is only covered by Code Sec. 332 , but that other liquidations, covered by other sections of the Code, may be covered by both Code Sec. 332 and Code Sec. 331 .

The Trust then argued that it should prevail under the reasoning in Gitlitz, regardless of whether Code Sec. 331 and Code Sec. 332 are viewed as separate corporate liquidation schemes. But, the Third Circuit approved of the Tax Court's reasoning with respect to this argument, noting that the Trust's argument ignored the crucial difference between Gitlitz and this case: Gitlitz addressed payments that explicitly were included in gross income under Code Sec. 61(a) , while the gain in this case was not recognized nor was it income, and thus it could not be an "item of income."


IRS gives green light to favorable tax results on transfer of S corporation to employ-ees--PLR 201405005

In a private letter ruling, IRS has issued favorable tax rulings for a proposed transaction to transfer ownership of an S corporation from the two equal retiring co-owners to key employees. Specific-ally, IRS concluded that profit on a redemption of the owners' shares by the company for notes will be taxed to them as capital gain spread out over several years, the company will have no gain on the redemption and may deduct interest paid on the notes, and the notes won't be a prohibited second class of stock.

Background on S corporations. An S corporation is a small business corporation for which an e-lection to be taxed under Subchapter S of the Code is in effect for the year. (§1361(a)(1) A C corporation is a corporation that isn't an S corporation for that year. (Code Sec. 1361(a)(2)) Except as otherwise provided in the Code, or to the extent inconsistent with the Subchapter S rules, the Subchapter C rules for the recognition of gain or loss on corporate organizations, reorganizations, distributions, insolvency reorganizations, liquidations, etc., apply to an S corporation and its share-



18

holders. ( Code Sec. 1371(a) )

An S corporation may not have more than one class of stock.( Code Sec. 1361(b)(1)(D) ). Straight debt is not treated as a second class of stock. Straight debt is a written unconditional obligation, whether or not contained in a formal note, to pay a sum certain on demand, or on a specified due date. The obligation may not provide for an interest rate or payment dates that are contingent on profits, the borrower's discretion, the payment of dividends on the corporation's common stock, or similar factors. In addition, to be straight debt, an obligation may not be convertible (directly or indirectly) into stock or any other equity interest of the S corporation and must be held by an indivi-dual (other than a nonresident alien), an estate, a trust that is eligible to be an S corporation share-holder, or entities (i.e., not individuals) that are actively and regularly engaged in the business of lending money. ( Code Sec. 1361(c)(5) )

Background on redemptions. If a stock redemption does not qualify under Code Sec. 302(a) , it will be treated as a distribution to which Code Sec. 301 applies (i.e., a dividend). A distribution qualifies under Code Sec. 302(a) if it not essentially equivalent to a dividend under Code Sec. 302(b)(1) , is a substantially disproportionate redemption under Code Sec. 302(b)(2) , is a complete redemption under Code Sec. 302(b)(3) , or is a redemption in partial liquidation of a noncorporate shareholder under Code Sec. 302(b)(4) .

Background on installment method. Code Sec. 453 provides that income from an installment sale is taken into account under the installment method, that is, a portion of the total gross profit from an installment sale is included in income in each year in which the seller receives payment. An install-ment sale is a disposition of property where at least one payment is to be received after the close of the tax year in which the disposition occurs. ( Code Sec. 453(b)(1) )

Facts. Two individuals whom we'll call Andy and Bob own a calendar-year, accrual-basis corpora-tion that's been an S corporation since its inception (Corporation). Andy and Bob wish to retire and transfer ownership of Corporation to four key employees (Key Employees).

Corporation has shares of common voting stock (and no other stock) outstanding. Its shares are held in equal part by Andy and Bob. To effect the transfer, Corporation proposes to undertake the following transactions (together, Proposed Transaction):

... First, Corporation will redeem all of its outstanding shares from Andy and Bob (Redemption) in exchange for promissory notes (Notes). The redemption price was determined by a third-party appraisal. ... Second, immediately after Redemption, Corporation will reissue some shares (which will be subject to transfer restrictions and service-related risks of forfeiture) to Key Employees. Corpo-ration will retain its remaining shares for issuance to future employees.

After Proposed Transaction, the only outstanding shares of Corporation stock will be common stock owned by Key Employees.

Notes will require semiannual payments of principal and interest over a set period of years starting in Year 1. Notes will provide for a fixed interest rate that will exceed the mid-term applicable Fede-ral rate (compounded semiannually) in effect as of the day on which the Notes are issued. The in-terest rate and payment dates won't be contingent on Corporation's profits, Corporation's discretion, the payment of dividends with respect to Corporation's common stock, or similar factors. Notes won't be convertible (directly or indirectly) into stock or any other equity interest of Corporation .

Andy and Bob will have continuing relationships with Corporation after Proposed Transaction. Andy will remain employed by Corporation for a predetermined period and will continue to serve as Vice-Chairman of Corporation's Board of Directors for until a specified date. Likewise, Bob will remain



19

employed by Corporation for a predetermined period and will continue to serve as Chairman of Cor-poration's Board of Directors until the date that Andy's service on the board terminates. LLC (an-other company wholly owned by Andy and Bob) will continue to own the building in which Corpora-tion rents space.

Favorable rulings. IRS issued the following favorable rulings:

... Notes will constitute straight debt as defined in Code Sec. 1361(c)(5)(B) .

... Redemption will be a complete termination of Andy's and Bob's respective interests in Corpo-ration within the meaning of Code Sec. 302(b)(3) . The amount distributed in Redemption will be treated as a distribution in full payment in exchange for the stock surrendered as provided in Code Sec. 302(a) . ... As provided in Code Sec. 1001 , Andy and Bob will realize and recognize gain on Redemp-tion. For each share of stock surrendered, gain will be measured by the difference between the redemption price and the adjusted basis of such share as determined under §1011. Provided that Corporation stock is a capital asset in Andy's and Bob's hands, the gain will be capital gain. ... Andy and Bob will qualify to report gain on Redemption using the installment method under Code Sec. 453 . In the event Notes are cancelled or otherwise become unenforceable, they will be treated as if they were disposed of for fair market value, which will be treated as not less than their face amount under Code Sec. 453B(f)(1) and Code Sec. 453B(f)(2) . ... Interest received by Andy and Bob on Notes will be taxable as ordinary income under Code Sec. 61(a)(4) in the year of receipt. ... Corporation won't recognize gain or loss on the distribution of Notes in redemption of its stock under Code Sec. 311(a) . ... Interest paid by Corporation on Notes will be deductible under Code Sec. 163(a) .


CCA determines tax treatment of S corp's disallowed loss from property distribution-- Chief Counsel Advice 201421015

In Chief Counsel Advice (CCA), IRS has concluded that an S corporation's disallowed Code Sec. 311(a) loss will be treated as nondeductible, noncapital expenses under Code Sec. 1367(a)(2)(D) . Accordingly, the Code Sec. 311(a) loss will reduce shareholders' bases in S corporation stock, and the S corporation must reduce its accumulated adjustments account.

Background. Code Sec. 311(a) provides that, except as provided in Code Sec. 311(b) , no gain or loss shall be recognized to a corporation on the distribution (not in complete liquidation) with res-pect to its stock of: (1) its stock (or rights to stock); or (2) property. Thus, if a corporation's basis for distributed property exceeds the property's fair market value, the loss inherent in the property is not recognized.

Code Sec. 1366(a)(1) provides that in determining the tax under Chapter 1 of a shareholder for the shareholder's tax year in which the tax year of the S corporation ends (or for the final tax year of a shareholder who dies, or of a trust or estate which terminates, before the end of the corporation's tax year), the shareholder takes into account his pro rata share of the corporation's:

... items of income (including tax-exempt income), loss, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder; and ... nonseparately computed income or loss.



20

Under Code Sec. 1367(a)(2) , the basis of each shareholder's stock in an S corporation is de-creased for any period (but not below zero) by the sum of the following items determined with respect to the shareholder for such period:

(A) distributions by the corporation which were not includible in the income of the shareholder by reason of Code Sec. 1368 ; (B) the items of loss and deduction described in Code Sec. 1366(a)(1)(A) ; (C) any nonseparately computed loss determined under Code Sec. 1366(a)(1)(B) ; (D) any expense of the corporation not deductible in computing its taxable income and not properly chargeable to capital account (more details below); and (E) the amount of the shareholder's deduction for depletion for any oil and gas property held by the S corporation to the extent such deduction does not exceed the proportionate share of the adjusted basis of such property allocated to such shareholder under §613A(c)(11)(B) .

Reg. § 1.1367-1(c)(2) provides that, for purposes of Code Sec. 1367(a)(2)(D) , expenses of the corporation not deductible in computing its taxable income and not properly chargeable to a capital account (noncapital, nondeductible expenses) are only those items for which no loss or deduction is allowable and do not include items for which the deduction is deferred to a later tax year. Examples of noncapital, nondeductible expenses include illegal bribes, fines and penalties, and expenses and interest relating to tax-exempt income.

Under Code Sec. 1368(a) , a distribution of property made by an S corporation with respect to its stock to which (but for Code Sec. 1368(a) ) Code Sec. 301(c) would apply, is treated in the manner provided in Code Sec. 1368(b) or Code Sec. 1368(c) (below), whichever applies.

Code Sec. 1368(b) provides that, in the case of a distribution described in Code Sec. 1368(a) by an S corporation which has no accumulated earnings and profits (E&P): (1) the distribution isn't included in gross income to the extent that it does not exceed the adjusted basis of the stock; and (2) if the amount of the distribution exceeds the adjusted basis of the stock, the excess is treated as gain from the sale or exchange of property.

Code Sec. 1368(c) provides that, in the case of a distribution described in Code Sec. 1368(a) by an S corporation which has accumulated E&P: (1) that portion of the distribution which does not exceed the accumulated adjustments account (AAA; see below) is treated in the manner provided by Code Sec. 1368(b) ; (2) that portion of the distribution which remains after the application of (1) is treated as a dividend to the extent it does not exceed the accumulated E&P of the S corporation; and (3) any portion of the distribution remaining after the application of paragraph (2) is treated in the manner provided by Code Sec. 1368(b) .

Under Code Sec. 1368(d) , Code Sec. 1368(b) and Code Sec. 1368(c) are applied by taking into account, to the extent proper: (1) the adjustments to the basis of the shareholder's stock described in Code Sec. 1367 ; and (2) the adjustments to the AAA which are required by Code Sec. 1368(e) (1) . In the case of any distribution made during any tax year, the adjusted basis of the stock is determined with regard to the adjustments provided in Code Sec. 1367(a)(1) for the tax year.

Code Sec. 1368(e)(1)(A) provides that the term AAA means an account of the S corporation which is adjusted for the S period in a manner similar to the adjustments under Code Sec. 1367 , except that: no adjustment is made for tax-exempt income (and related expenses); the phrase "but not below zero" is disregarded in Code Sec. 1367(a)(2) ; and no adjustment is made for Federal taxes attributable to any tax year in which the corporation was a C corporation.



21

Under Reg. § 1.1368-2(a)(3) , the AAA is decreased for the tax year of the corporation by the sum of the following items with respect to the corporation for the tax year:

(A) the items of loss or deduction described in Code Sec. 1366(a)(1)(A) ; (B) any nonseparately computed loss determined under Code Sec. 1366(a)(1)(B) ; (C) any expense of the corporation not deductible in computing its taxable income and not properly chargeable to a capital account, other than Federal taxes attributable to any tax year in which the corporation was a C corporation and expenses related to tax-exempt income; and (D) the sum of the shareholders' deductions for depletion for any oil or gas property held by the corporation described in Code Sec. 1367(a)(2)(E) ).

Code Sec. 1371(a) states that, except as otherwise provided and except to the extent inconsistent with subchapter S, subchapter C shall apply to an S corporation and its shareholders.

Facts. The taxpayer, A, was formed as C corporation on Date 1. It elected S status on Date 2 and has been operating as an S corporation ever since. On Date 3, A transferred corporate-owned real estate to B, which is taxed as a partnership. (The CCA noted that the title for the real estate passed directly from A to B, but that on its Form 1120S, A treated the transfer as a distribution of property to the shareholders who then contributed the property to B, and IRS has not challenged this treat-ment.) The real estate's fair market value at the time of transfer was less than its net book value and tax adjusted basis. The shareholders did not reduce stock basis and A did not reduce its AAA by the unrecognized losses attributable to the real estate transfer.

Issue. The issue raised in the CCA is the proper treatment of Code Sec. 311(a) by an S corpora-tion and its shareholders.

Conclusion. In the CCA, IRS concluded that disallowed Code Sec. 311(a) losses will be treated as nondeductible, noncapital expenses under Code Sec. 1367(a)(2)(D) . Accordingly, the Code Sec. 311(a) loss will reduce shareholders' bases in S corporation stock, and the S corporation must reduce its AAA.

IRS initially noted that Code Sec. 311 does apply to S corporations because of Code Sec.1371(a) , which states that the C corporation rules apply to S corporations unless they are inconsistent with subchapter S. Code Sec. 1367(a)(2)(D) provides that a nondeductible noncapital expense will re-duce a shareholder's stock basis, but does not explicitly list Code Sec. 311(a) losses as nondeduct-ible noncapital expenses. So, IRS looked to general tax policy and practical considerations in de-termining whether Code Sec. 311(a) losses reduce a shareholder's basis in S corporation stock and S corporation AAA.

IRS then observed that most treatises provide that Code Sec. 311(a) losses reduce AAA and shareholder basis. The CCA cited one which states:

"In the case of a distribution of depreciated property, corporations are prohibited from reco-gnizing loss under Code Sec. 311(a) . In PLR 8908016 , an S corporation distributed appre-ciated and depreciated passive income property to reduce its exposure to a termination under Code Sec. 1362(d)(2) . The IRS ruled that the distributing corporation would recognize gain under Code Sec. 311(b) on the distribution of appreciated property but no loss would be recognized with respect to the depreciated property distributions. Further, the amount of the distribution was determined to be the total of any cash and the fair market value of any property distributed. Although not stated in the ruling, the AAA would be reduced by the fair market value of the distribution. In addition, the AAA would be decreased by any loss not allowable under Code Sec. 311(a) with respect to the depreciated property."



22

IRS then, by way of analogy, looked to the treatment of nondeductible capital expenses under the investment adjustment (i.e., consolidated return) regs, after noting that, while Code Sec. 1367(a)(2) (D) requires S corporation shareholders to reduce basis for nondeductible, noncapital expenses, the concept of a nondeductible noncapital expense isn't provided for in subchapter C.

IRS noted that the purpose of the investment adjustment rules is to treat the members of a conso-lidated group as a single entity so that consolidated taxable income reflects the group's income. (Reg. § 1.1502-32(a)(1) ) So, a member's basis in a subsidiary's stock is increased by positive adjustments and decreased by negative adjustments ( Reg. § 1.1502-32(b)(2) ), with one of these negative adjustments being for noncapital, nondeductible expenses. Reg. § 1.1502-32(b)(2)(iii) specifically provides that "[i]n general, S's [a subsidiary's] noncapital, nondeductible expenses are its deductions and losses that are taken into account but permanently disallowed or eliminated under applicable law in determining its taxable income or loss, and that decrease, directly or indi-rectly the basis of its assets (or an equivalent amount)." Thus, a member's basis in its subsidiary stock is reduced by the amount of the Code Sec. 311(a) loss. ( Reg. § 1.1502-13(f)(7) , Ex. 1(d).

Lastly, IRS analyzed the relevant policy considerations and noted that often, losses are delayed rather than permanently disallowed. It cited to Code Sec. 267(d) , Code Sec. 336(d)(1) , Code Sec. 465 , Code Sec. 469 , Code Sec. 704(d) , and Code Sec. 1091 -all of which restrict a tax-payer's ability to make an immediate use of a loss from an activity but allow the loss to be used in the future under certain circumstances. However, IRS noted that sometimes losses are permanent-ly disallowed, such as Reg. § 1.1366-2(a)(5)(i), which provides for the nontransferability of losses from a shareholder to another person. In the subchapter C context, Code Sec. 311(a) is a perma-nent loss disallowance. Furthermore, Code Sec. 1371 provides that subchapter C shall apply to an S corporation and its shareholders to the extent that it is consistent with subchapter S.


S corps.-adjustments to basis of stock of shareholders-allocations-accumulated adjustments account - tax -exempt income.

Shareholders were allowed to increase basis in their stock of S corp. under Code Sec. 1367(a)(1) to extent that they were allocated share of tax-exempt income from subaward received by low-income apartment complex in which S corp. held interest, since S corp. wouldn't include that tax-exempt income in its accumulated adjustments account under Code Sec. 1368(e)(1)(A) . ( PLR 201440013 )


MSCPA FEDERAL TAX COMMITTEE FEDERAL TAX FORUM...

Documents

Transcript of MSCPA FEDERAL TAX COMMITTEE FEDERAL TAX FORUM...