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This is the first of a two-part series discussing current issues affecting Subchapter S of the Internal Revenue Code of 1986. This first part discusses the added flexibility
given the Subchapter S corporation by Congress in 1996. Part Two will discuss certain Subchapter S issues that are oft-overlooked by business and estate planning counsel.
I. INTRODUCTION
In 1994 I began practicing law in Washington, D.C., studying tax law at night. At that time several ostensibly wise and seasoned tax lawyers of
national reputation warned me not to waste my time studying Subchapter S of the Internal Revenue Code (the "Code"). The reason was simple - Congress was going to
kill it!
Instead of killing Subchapter S, however, in 1996 Congress gave it new life, throwing off certain historic restraints. The maximum number of shareholders was expanded from 35
to 75, the scope of permissible shareholders was expanded, and the prohibition on S corporations owning corporate subsidiaries was lifted.1
Even so, Subchapter S naysayers continue to predict that the universal acceptance of the limited liability company, coupled with the 1996 introduction of the check-the-box
regulations, will inflict a de facto death on Subchapter S. Former IRS Commissioner Donald C. Alexander boldly suggests that "[n]o rational, reasonably well-informed tax
professional would deliberately choose Subchapter S status over an LLC when there is a choice, and 99 percent of the time there is a choice. The LLC is clearly the choice of
the future if you are dealing with rational people, and most of the time we are dealing with rational people."2
Though I largely agree with Alexander's assessment, the reality is there are still a large number of new corporations organized each year (more than 8,000 in Utah in 1999)3,
and more than half of taxpayers forming those corporations file an election to be taxed under Subchapter S of the Code.4
Several factors, some rational some not, may be behind the continued popularity of the Subchapter S corporation as a business entity choice, including the following:
a. FICA/SECA Tax.
In most cases distributions from S corporations to shareholders are not subject to federal employment taxes. Accordingly, for certain small businesses, organizing as an S corporation can result in employment tax savings of 15.3 percent. In contrast, many distributions from partnerships to partners are subject to federal employment taxes. Additionally, it remains unclear the extent to which distributions from LLCs to members are subject to employment tax. Congress and the IRS have both punted on the issue, leaving tax professionals in a quandary.
b. Exit Strategy.
For some business owners their exit strategy involves a tax-free corporate reorganization pursuant to section 368 of the Code (i.e., tax-free merger, stock-for-stock acquisition, stock-for-asset acquisition, etc.). Of course, only corporations are eligible for tax-free reorganizations, and the Code prohibits incorporation of a partnership on the eve of a corporate reorganization. Accordingly, some business owners choose to incorporate at the outset, with an S election assuring pass-through taxation until the hoped-for merger with Bigco.
c. Client Comfort.
Some business owners are simply more comfortable with the corporation concept than the newer and less established LLC. They understand corporate governance, tax returns, and share ownership and transfer. Moreover, some folks just like bragging to their friends that they own their own corporation! It has more sex appeal than saying you are an LLC member.
d. Professional Inertia.
Some attorneys and CPAs share their older client's comfort with the S corporation. They continue to advise their clients to incorporate and elect Subchapter S because that is what they know. Moreover, the Subchapter S tax rules are conceptually easier to learn and apply than the Subchapter K (partnership) tax rules. In short, steering clients towards Subchapter S makes for less professional headaches.
e. No Other Option.
Until the introduction of the single-member LLC three years ago, the professional corporation (with S election) was the only business entity option for solo professionals such as doctors, attorneys, accountants and engineers. The Utah professional corporation statute generally prohibits shareholders other than licensed professionals.5
Even if no additional S elections were ever filed, nearly 2.6 million S corporation income tax returns were filed in for the 1999 tax year in the United States.6 In that same year S corporation income tax returns exceeded partnership income tax returns by more than 700,000.7 Moreover, the tax cost of liquidating those S corporations and re-organizing them as LLCs would certainly be prohibitive (because liquidating distributions usually generate taxable gain at both the corporation and shareholder levels). Accordingly, the death of the Subchapter S corporation appears to have been greatly exaggerated.
Because the S corporation appears to be a permanent fixture on the Utah business entity landscape, Utah attorneys should have at least a cursory understanding of its workings,
requirements, benefits, and pitfalls. To that end, this article provides a non-comprehensive overview of: (a) some of the new tools available within Subchapter S after the '96
Act and the final regulations adopted in 2000; and (b) some of the most common Subchapter S tax traps of which business and estate planning counsel should be aware.
II. THE QUALIFIED SUBCHAPTER S SUBSIDIARY
A. General Description.
Prior to the '96 Act, S corporations were prohibited from being members of an affiliated group, meaning they were prohibited from owning 80 percent or more of another corporation. The '96 Act changed all that, and an S corporation may now own any number of shares in another corporation. Additionally, the '96 Act allows an S corporation to elect to treat certain subsidiaries as qualified Subchapter S subsidiaries ("QSubs"). A valid QSub election allows an S corporation to treat a wholly-owned subsidiary as a disregarded entity for income tax purposes. Accordingly, all of a QSub's assets, liabilities, and items of income, deduction, and credit are treated as those of the parent S corporation.8
The ability to conduct S corporation operations through subsidiaries, where liabilities can be isolated for state law purposes, is a tremendous advantage over the pre-'96
limitation. Also, the ability to disregard all QSubs and report their tax items on the parent S corporation's income tax return creates tax reporting that is far simpler than
the hideously complex consolidated return regulations used by C corporation affiliated groups.
B. Eligibility for QSub Election. A QSub must be a domestic corporation, 100 percent of the stock of which is held by an S corporation.9 Only outstanding shares are taken into account in determining whether a subsidiary is wholly-owned. Share ownership for federal income tax purposes rather than legal ownership is controlling. Thus, if a parent S corporation owns a single-member LLC that is treated as a disregarded entity for federal income tax purposes, and the LLC holds 100 percent of the shares of a domestic corporation, the parent S corporation will be treated as owning all of the stock of the corporate subsidiary, and the parent is eligible to file a QSub election with respect to that corporate subsidiary.10
A subsidiary must satisfy the QSub eligibility requirement at the time of the election and for all periods for which the election is to be effective.
C. Timing and Formality of Making QSub Election.
A QSub election may be made for either a new or an existing corporation. To simplify filing the election, in September 2000 the IRS prescribed new Form 8869, "Qualified Subchapter S Subsidiary Election." The interim election procedures set forth in Notice 97-4 should no longer be used. Superseded Notice 97-4 provided the QSub election was to be made by completing and filing Form 966, "Corporate Dissolution or Liquidation."
Because the QSub election is made by the parent S corporation, an officer of the parent who is authorized to sign the parent's income tax return must sign the election; the
signature of an officer of the subsidiary is not required, nor is the consent of the parent's shareholders, absent shareholder agreements or covenants to the contrary.
A QSub election may specify an election date that is up to two months and fifteen days prior to the election's filing date. The QSub, however, must qualify as a qualified
Subchapter S corporation during that entire pre-election period. A QSub election may also be filed to be effective prospectively, provided the effective date is not more than
12 months after the filing date.
D. Tax Consequences of Making QSub Election.
A proper election to treat a subsidiary as a QSub means that for federal income tax purposes the subsidiary is disregarded as a separate corporation, and all of the subsidiary's assets, liabilities, and items of income, deduction, and credit are treated as those of the parent S corporation. When a QSub election is made for an existing corporation, the subsidiary is deemed to have liquidated into the parent S corporation. This deemed liquidation is governed by sections 332 and 337 of the Code.
Pursuant to section 332, a corporation does not recognize gain or loss upon receipt of property distributed in complete liquidation of another corporation, if: (a) the parent
corporation owns at least 80 percent of the total combined votes and value of the liquidating subsidiary (which, by definition, a Qsub satisfies), and (b) the distribution is
in complete cancellation or redemption of all shares of the liquidating subsidiary. Section 337 provides that no gain or loss on any property is recognized to the liquidating
subsidiary in a complete liquidation to which section 332 applies.
Section 332 technically requires the adoption of a plan of liquidation at a time when the subsidiary is 80 percent or more owned by the parent; however, obviously a QSub will
remain in existence under state law. To resolve this seeming inconsistency, the regulations indicate that making a QSub election itself satisfies the section 332 plan of
liquidation requirement.11
Multiple QSub elections may be made for a tiered group of corporations, effective on the same date. Unless a different order is specified in the elections, the tiered
subsidiaries are deemed to liquidate starting with the lowest-tier corporation, then moving up the chain.
E. Terminating QSub Election. A QSub election may be terminated by (a) revocation, (b) termination of the parent's S election, or (c) the subsidiary ceasing to qualify
as a QSub. The most common reason a subsidiary ceases to qualify as a QSub is that the parent corporation no longer owns 100 percent of the QSub's shares. A QSub election is
revoked by the parent filing a signed statement to that effect with the IRS Service Center with which the parent files it income tax return. A revocation may specify an
effective date that is no more than two months and fifteen days prior to nor 12 months following the filing date.
When a QSub election is terminated, the terminating subsidiary is treated as a new corporation that acquires all of its assets and assumes all of its liabilities from the
parent corporation in exchange for stock of the subsidiary immediately prior to the termination of the QSub election. Where the terminating event is the sale of greater than
20 percent of the shares of the subsidiary, the parent corporation must recognize gain or loss, if any, on the deemed transfer of assets to the subsidiary. If 100 percent of
the subsidiary's shares are acquired by an unrelated buyer, the buyer is treated as purchasing directly from the parent the assets and assuming the liabilities of the
subsidiary.
Where QSub elections of tiered subsidiaries are terminated simultaneously, the deemed formation of new subsidiaries for tax purposes is treated as occurring starting with the
highest tier subsidiary and proceeding downward to the lowest subsidiary. This "top-down" approach is not discretionary.
F. Other Considerations in Making QSub Election.
A QSub must use the Employer Identification Number ("EIN") of the parent corporation. When the QSub election terminates, the subsidiary must use its own EIN for all tax reporting purposes.
G. QSub Tax Planning.
The final QSub regulations present some interested tax planning opportunities. (i) For example, suppose B is the sole shareholder of two S corporations, one profitable and in which B has high basis in the shares, and the other with suspended and/or current losses and in which B has zero basis in the shares. B may consider forming a new S corporation, a holding company, to which all shares of the existing two corporations are contributed. QSub elections are then made for the two existing corporations.
This simple re-alignment of the corporate structure will allow B to use the current and suspended losses against B's high basis in his holding company shares.
(ii) Prior to the '96 Act, a common corporate group structure was for certain individuals to own the shares of an S corporation, which owned 79 percent of a C corporation. The
same individuals owned the remaining 21 percent of shares in the lower-tier C corporation. This structure was common before the '96 Act because S corporations were prohibited
from owning 80 percent or more of another S corporation.
The advent of the QSub means that the lower-tier C corporation may be converted to an S corporation. Doing so is simple. The individual shareholders contribute their C
corporation shares to the S corporation, making the C corporation a wholly-owned subsidiary of the S corporation. A QSub election is then filed for the lower-tier corporation.
Thereafter the lower-tier corporation ceases to be a taxable entity and is disregarded as a separate corporation for tax purposes.
(iii) A C corporation wishing to convert to S status is prohibited from so doing during the middle of its tax year. It must wait until the beginning of its next tax year.
Suppose, however, that for valid business reasons a holding company is incorporated. All of the C corporation's stock could then be contributed to the holding corporation
tax-free pursuant to IRC section 351. An S election would then be made for the holding corporation and a QSub election made for the C corporation, which immediately converts
the C corporation to an S corporation subsidiary without regard to the former C corporation's tax year beginning.
(iv) Along with the IRS' 1996 introduction of the check-the-box regulations came the concept of the "disregarded entity." A disregarded entity is a state-law business
entity that is tax-invisible. The single-member LLC is the most prominent example of a disregarded entity.
Disregarded entities can make for some interesting Subchapter S planning. For example, ordinarily a partnership or LLC may not own shares of an S corporation. However, because
a single-member LLC is a disregarded entity, if the LLC's owner is a qualified S corporation shareholder, the LLC is ignored for tax purposes and the corporation's S election
does not terminate. The reverse is also true. An S corporation may own a single-member LLC, which owns all the shares of another corporation. Because the LLC is tax invisible,
the lower-tier corporation is eligible for the QSub election.
H. QSub Tax Traps. (i) The QSub final regulations do not insulate taxpayers from the reach of the step transaction doctrine. The step transaction doctrine is a
judicially-developed doctrine that disregards the form of a corporate transaction and re-characterizes the deal according to its economic substance. Accordingly, regulatory
and case authority should always be reviewed to determine whether a transaction involving a QSub may fall within the grasp of the step transaction doctrine.
(ii) The
benefits of QSub status apply only when the subsidiary is wholly-owned by an S corporation. Accordingly, the transfer by the S corporation parent of even one share will not
only terminate the QSub election, but may convert the subsidiary to a taxable C corporation.
Additionally, a terminated QSub is treated for tax purposes as a new corporation that acquires all of its assets and liabilities from the S corporation parent immediately
before termination of the QSub election. In this situation, counsel should be aware that where the new corporation's liabilities exceeds the aggregate basis of its assets,
taxable gain is triggered on the difference pursuant to IRC section 357(c).
III. MISCELLANEOUS S CORPORATION ISSUES
A. Late and Terminated Elections.
Inadvertent failures to file the S election are common. Perhaps the shareholders don't
know about the election requirement, the attorney thought the accountant filed the election, or vice versa. Prior to the '96 Act, the IRS had no authority to allow late S
elections. Now, IRC section 1362(b)(5) gives the IRS power to correct errors in electing S status.
An S election is filed on Form 2553, "Election by a Small Business Corporation." To be effective for the current tax year the election must be filed within two months
and fifteen days of the beginning of the tax year.
The procedure for correcting certain late S elections is set forth in Revenue Procedure 98-55. Revenue Procedure 98-55 grants a corporation an automatic 12-month extension to
file Form 2553, provided the failure to timely file was inadvertent, the corporation otherwise met all Subchapter S requirements for the entire period sought to be covered by
the election, and both corporation and shareholders treated the corporation for tax purposes as though it were a validly-elected S corporation for that period.
If the failure to file the S election is discovered more than 12 months after the election's due date, the corporation's request for permission to make a late election is made
in the form of a request for a private letter ruling from the IRS National Office. The ruling request must contain detailed factual representations concerning the failure to
file the S election, when and how the failure was discovered, and the steps taken to correct the deficiency. The ruling request must precisely follow the form and content
outlined in Revenue Procedure 2001-1 (or the first numbered Rev. Proc. of each subsequent year). The filing fee for that ruling request is currently $5,000. That fee, coupled
with attorney's fees for preparing the ruling request, make this a costly fix. Still, in most instances it is cheaper to petition for late election relief than to await an IRS
audit of the corporation. Once an IRS auditor discovers an S election was not properly filed, the game is up. The Service generally will not then consider petitions for late
election relief. Neither are the courts obligated to grant such relief.
B. Tax-Exempt Organizations as S Corporation
Shareholders.
(i) The '96 Act expanded the list of qualified S corporation shareholders to include certain tax-exempt
organizations. The eligible organizations include those described in both IRC sections 401(a) or 501(c)(3). Section 401(a) describes qualified pension, profit sharing, and
stock bonus plans. Section 501(c)(3) describes non-profit charitable organizations organized and operated exclusively for religious, charitable, scientific, testing for public
safety, literary, or educational purposes, or to foster national or international amateur sports competition, or for the prevention of cruelty to children or animals.
The inclusion of certain tax-exempt organizations as qualified S corporation shareholders is welcome news for estate planning attorneys. S corporation shareholders may now make
lifetime or testamentary contributions of their shares to 501(c)(3) charitable organizations. Doing so reduces the value of the shareholder's taxable estate and generates
charitable contribution deductions on the shareholder's income tax return for lifetime contributions.
The downside, however, is that a charity's pro-rata share of S corporation income and any gain from the sale of S corporation shares is treated as Unrelated Business Taxable
Income ("UBTI"). That is, a charity owning S corporation shares must pay income tax on all S corporation income and gain. Accordingly, the charity does not get the
same bang-for-the-buck when it receives a donation of S corporation shares as when it receives donations of non-UBTI property (e.g., property that produces interest income).
(ii) What if you could combine the pass-through tax treatment of Subchapter S with no tax at the shareholder level. Sound too good to be true? The '96 Act and the Tax
Reform Act of 1997 made it possible. It's the S corporation employee stock ownership plan ("S-ESOP").
As noted above, the '96 Act first made it possible for a qualified pension, stock bonus, or profit-sharing plan (including an ESOP) to hold S corporation shares. Then, the Tax
Reform Act of 1997 repealed the UBTI provisions as they relate to ESOPs. Accordingly, an ESOP's pro-rata share of S corporation income and any gain from the sale of S
corporation shares is not subject to federal income tax. This creates a financial advantage to the corporation because less cash must be distributed to shareholders for income
tax payments.
The details of the S-ESOP, its advantages, disadvantages, and traps exceeds the scope of this article. However, Utah attorneys should be aware of the S-ESOP as it is fast
taking a place as an accepted tax planning strategy.
(iii) Many taxpayers and tax professionals are under the impression individual retirement accounts ("IRAs") may be qualified S corporation shareholders. They assume
that, because certain qualified retirement plans may hold S corporation shares, IRAs (as vehicles of tax-deferred retirement savings) may do so also. They are wrong. In
several recent private letter rulings the IRS indicated that, where an IRA holds S corporation shares, the corporation's S election terminates.12 However, because the IRA's acquisition of S corporation shares was rescinded, and there was no tax avoidance or retroactive tax planning, the Service granted relief from inadvertent termination of the S election. During the period the IRA held the shares, the Service treated the IRA beneficiary as owner of the shares for tax purposes. Accordingly, the IRA beneficiary had to report his pro-rata share of S corporation income on his individual income tax return.
Every year a few taxpayers fall into this IRA tax trap. Counsel should warn S corporation shareholders that IRAs cannot own Subchapter S shares.
C. Under-Compensation.
A long line of cases13 has established that, if an S corporation shareholder performs services for the corporation without compensation, the IRS may re-characterize distributions from the corporation to the shareholder as salary, which is subject to SECA (self-employment tax of 15.3 percent). Cases addressing this issue are especially plentiful where corporations engage in service-type businesses. There is currently no clear guidance as to the appropriate threshold between shareholder salary and distributions of corporate earnings.
1 See The Small Business Job Protection Act of 1996, P.L. 104-188 (the "'96 Act"). For the revised qualifications of a Subchapter S corporation, see IRC ¤
1361(b)(1).
2 Quoted in Tax Notes Today, 2000 TNT 130-1 (July 5, 2000).
3 See statistics cited at website of Utah Department of Commerce, Division of
Corporations and Commercial Code, http//:www.commerce.state.ut.us.
4 Supra note 2.
5 Utah Code ¤ 16-11-7.
6 IRS Statistics of Income Bulletin, Summer 2000 (http//:www.IRS.gov/tax_stas/soi/part_oth.html).
7 Id.
8 IRC ¤ 1361(b)(1)(A).
9 IRC ¤ 1361(b)(3)(B)(i).
10 Treas. Reg. ¤ 1361-2(b)(1).
11 Treas. Reg. ¤ 1.1361-4(a)(2)(iii).
12 E.g., PLR 200003011.
13 E.g., Spicer Accounting, Inc. v. United States, 918 F.2d 90 (9th Cir. 1990).
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