S Corporation Tax Update
Fifty‐Third Annual Arkansas Federal Tax Institute Jillian G. Yant, CPA
S Corporation Basis
Tax Extenders
Net Investment Income Tax
Reasonable Compensation
Late S Elections
Overview
Proposed regulations from 2012 were made final on July 23, 2014 – Treasury Decision 9682
Final regulations clarify when a shareholder can increase basis in the S corporation’s indebtedness to the shareholder
Two standards:
Shareholder loan to S corporation – must be bona fide
Guarantee of S corporation debt – actual cash outlay
Basis in S Corporation
Bona Fide Debt
Determined under general federal tax principles
Must consider all facts and circumstances
Final regulations state that the debt must run directly from the S corporation to the shareholder
If loan is bona fide, shareholder’s basis of indebtedness can be increased by the loan amount
Back‐to‐back loan transactions
Treasury Decision 9682
Guarantee of Debt
Under final regulations, shareholder does not obtain basis of indebtedness by merely guaranteeing debt to the S corporation by a third party
If shareholder makes a payment on a bona fide loan of the S corporation that the shareholder guaranteed, basis can be increased by the amount of each payment.
Treasury Decision 9682
Be cautious of circular flow of funds
Potential abuse if loans aren’t actually bona fide, but final regulations don’t require documentation of such
Courts have been inconsistent with defining
economic outlay, so the final regulations don’t rely upon this test
Comments on TD 9682
Congress’s lame duck session will address over 60 tax extenders
Over 50 expired on December 31, 2013, for individuals, businesses and energy tax incentives
What’s up for consideration?
Reduced recognition period for S corp built‐in gains tax attributable to prior C corporation status from 10 years to 5 years (§ 1374)
S corp making charitable contribution of property (§ 170)
Tax Extenders
What’s up for consideration?
§ 179 expense has reverted to a $25,000 deduction with a $200,000 limit
Extender would provide a $500,000 deduction with a $2 million investment limit
Bonus depreciation has expired and extender would put 50% bonus depreciation in place
Some are pushing for permanent bonus depreciation
Tax Extenders
What’s up for consideration?
Work Opportunity Tax Credit (§ 51)
Extension of New Market Tax Credit (§ 45D)
Research Tax Credit at 20% level (§ 41)
Some support for this to be permanent
15‐year straight line recovery period for qualified leasehold/retail improvements and restaurant property (§ 168)
Tax Extenders
NII has definitely impacted our planning and recommendations to taxpayers
Passive v. Active
IRS issued final regulations (TD 9644) in November 2013 to interpret § 1411
Apply to tax years beginning January 1, 2014, and can be retroactively applied to 2013
Because § 469 doesn’t provide sufficient guidance as it pertains to § 1411, proposed regulations have been issued and are still pending.
Net Investment Income Tax
Three general categories of NII
Category 1 – portfolio income not from a T or B
Category 2 – passive income from a T or B
Category 3 – net gains from the sale of property
If the property sold is a nonpassive interest in a S corp, gain from the sale is NII only to the extent that income from a deemed sale of the entity’s property would be NII
IRS has totally rewritten the regs for disposition of interests in a partnership or S corp and reissued them in the pending proposed regs
§ 469 applies to all three categories of NII
Net Investment Income Tax
Trade or Business
§ 1411 does not explain when an activity is a trade or business
IRS has declined to provide bright‐line examples, but refers taxpayers to § 162
The IRS’s position is that this is a factual question
Investment activities are not a trade or business
Net Investment Income Tax
Real Estate Professionals
§ 469 states that rental income is per se passive, and this rule applies to § 1411 to determine if an activity is passive
Exception for real estate professionals who materially participate, which is defined as a taxpayer in real property business (§ 469(c)(7))
Some relief is given in § 1.1411‐4(g)(7) with a safe harbor if the professional participates in rental real estate activities for more than 500 hours per year
Net Investment Income Tax
Grouping and Regrouping
NII may cause taxpayers to reconsider previous groupings
Final NII regulations give taxpayers the opportunity to regroup their activities once, in the first tax year beginning after 12.31.12 in which the taxpayer meets NII income threshold and has NII
This may already be a moot point for some taxpayers, and an outstanding opportunity for others
Net Investment Income Tax
S corporations must pay reasonable compensation to a shareholder‐employee in return for services
provided by the employee before any non‐wage distributions may be made.
To determine reasonable compensation we need to know what the shareholder‐employee has done for the S corporation
Reasonable Compensation
Need to look to the source of S corp gross receipts
Three major sources
Services of the shareholder
Services of non‐shareholder employees, or
Capital and equipment
If gross receipts and profits arise from items 2 and 3, then it should not be associated with shareholder‐
employee’s personal services and it’s reasonable that
Reasonable Compensation
Evaluating the main sources of gross receipts:
If most of the S corporation’s gross receipts are associated with the shareholder’s personal services, then most of the profit distribution should be allocated as compensation
Shareholder‐employee should also be compensated for administrative work performed by other income producing employees or assets
Reasonable Compensation
Factors to Consider:
Training and experience
Duties and responsibilities
Time and effort devoted to the business
Dividend history
Payments to non‐shareholder employees
Timing and manner of paying bonuses to key people
What comparable businesses pay for similar services
Compensation agreements
Use of a formula to determine compensation
Reasonable Compensation
Definitely a prevalent issue in IRS exams
IRS Inspector General found that in 2000 about 440,000 single shareholder S corporations paid no salary to their owners, costing the government billions in lost payroll taxes
IRS has stepped up audits as a result and enforcement on S corps that paid owners little or no salary
This can now be easily identified on Form 1125‐E if an entity has total receipts of $500,000 or more
Reasonable Compensation
Several court cases support the IRS’s authority to reclassify other forms of payment to a shareholder‐
employee as wages, which are then subject to employment taxes (and penalties and interest…)
Joly vs. Commissioner, 211 F. 3d 1269 (6thCir., 2000)
Veterinary Surgical Consultants, P.C. vs. Commissioner, 117 T.C. 141 (2001)
Joseph M. Grey Public Accountant, P.C. vs. Commissioner, 119 T.C. 121 (2002)
David E. Watson, PC vs. U.S., 668 F. 3d 1008 (8thCirc. 2012)
Reasonable Compensation
Rev. Proc. 2013‐30 supersedes Rev. Proc. 2004‐48 and 2003‐43 (effective 09.03.13), which provide late filing relief for the following elections:
S corporation
Electing Small Business Trust
Qualified Subchapter S Trust
Qualified Subchapter S Subsidiary
Late corporate classification elections
Requires more informative statements completed by both the corporation and individual shareholders
Late Elections
Rev. Proc. 2013‐30 includes four flow charts to aid in determining if the entity is eligible for simplified relief
Copies follow the slides
Must satisfy the general requirements of Section 4 and the specific requirements applicable to the taxpayer under Sections 5 through 7 of the revenue procedure
Late Elections
Include statement on the top of Form 2553 – ‘FILED PURSUANT TO REV. PROC. 2013‐30’
Must attach a ‘reasonable cause/inadvertence statement’ with a dated declaration that states:
“Under penalties of perjury, I (we) declare that I (we) have examined this election, including the accompanying documents, and, to the best of my (our) knowledge and belief, the election contains all of the relevant facts relating to the election, and such facts are true, correct, and complete.”
Late S Elections
Must attach a separate statement for each
shareholder of the S corporation stating that his/her pro‐rata portion has been properly reported on all affected tax returns.
