Larry's Tax Law

Overview

In the S corporation arena, tax advisors generally do not focus much attention on unreasonable compensation.  As we delve into the issue in this Part VII of my multi-part series on Subchapter S, it will become apparent that reasonableness of compensation in the S corporation setting is important.  Failure to pay attention to the issue can place S corporations and their shareholders in peril.

Closely held C corporations have historically been incentivized to distribute profits as compensation to shareholder employees.  A corporation is allowed, under IRC § 162(a)(1), to deduct “a reasonable allowance for salaries or other compensation for personal services actually rendered.”  There is, however, no corresponding deduction for dividend distributions, which end up being taxed twice:  once at the corporate level upon earning the income that funds the dividend, and again at the shareholder level upon receipt of the dividend.  Consequently, treating distributions of profits as compensation for services rendered could significantly reduce a corporation’s tax liability. 

Overview

I am taking a break from my multi-part blog series, A Journey Through Subchapter S / A Review of the Not So Obvious & The Traps That Exist For The Unwary, to provide another update on the Corporate Transparency Act (“CTA”).  The CTA continues to get a lot of media attention as there have been judicial and legislative efforts to obtain its repeal or to strike it down as unconstitutional.

As reported on June 7, 2023, the CTA is a new federal law that requires most U.S.-based companies, including corporations, partnerships and limited liability companies, to report information regarding their “beneficial owners” to the federal government through the Financial Crimes Enforcement Network (“FinCEN”) and a new FinCEN IT system known as the Beneficial Ownership Secure System (“BOSS”).  Lawmakers enacted the CTA to help the government combat money laundering, financing of terrorist activities, tax fraud and other illegal activities.

This sixth installment of my multi-part series on Subchapter S is focused on the revocation of an S corporation election.^[1]  While the rules relating to revocation are fairly straightforward, there are a few nuances that may create traps for unwary taxpayers and their tax advisers.

Background

An S election may be revoked with the consent of greater than 50 percent of the shares held on the date of revocation.^[2] 

Revocation of an S election does not require the Secretary’s consent.  Rather, to revoke an S election, the corporation simply must file a written statement with the Service Center where it files its IRS Form 1120S.  The statement must include:

This fifth installment of my multi-part series on Subchapter S is focused on married individuals who own shares of an S corporation.  While the rules relating to shareholder eligibility seem straightforward, their application relative to spouses may create traps for unwary taxpayers and their tax advisers.

BACKGROUND

Number of Shareholders Limitation

Prior to 1996, an S corporation could have no more than 35 shareholders.  The Small Business Job Protection Act of 1996 (“SBJPA”) amended Code Section 1361(b)(1)(A), increasing the maximum number of permitted shareholders of an S corporation to 75.  In 2004, Congress enacted the American Jobs Creation Act (“AJCA”). The AJCA further amended Code Section 1361(b)(1)(A), increasing the maximum number of permitted shareholders of an S corporation to 100.  This change was effective for tax years beginning in 2005.  Today, the maximum number of permitted shareholders of an S corporation remains at 100.

This fourth installment of my multi-part series on Subchapter S is focused on suspended losses of an S corporation.  While the rules seem straightforward, their application can be tricky, especially given legislative changes made in recent years.

Background

In general, S corporation shareholders, like the owners of entities taxed as partnerships, are allocated their share of the entity’s losses for the taxable year.  A number of rules, however, may limit the ability of the owners to deduct these losses.

I am taking a short break between the third and fourth installment of my multi-part series on Subchapter S.  Before I publish the fourth installment on that topic, my colleague Steven Nofziger and I want to alert our readers to some recent developments relative to the Corporate Transparency Act (“CTA”).

CTA

As previously reported, the CTA is a new federal law that requires most U.S.-based companies, including corporations, partnerships and limited liability companies, to report information regarding their “beneficial owners” to the federal government through the Financial Crimes Enforcement Network (“FinCEN”) and a new FinCEN IT system known as the Beneficial Ownership Secure System (“BOSS”).  The intent of the CTA and the reporting to FinCEN is to combat money laundering, tax fraud and other illegal activities.

This third installment of my multi-part series on Subchapter S is focused on a single Code Section, namely IRC Section 1361(b)(1)(C) and the ineligibility of nonresident aliens as shareholders of Subchapter S corporations.

Background

As we all have come to understand, nonresident aliens are ineligible S corporation shareholders.  If a nonresident alien were to become a shareholder of an S corporation, the result is straightforward – as of the date the nonresident alien became a shareholder, the corporation’s S election is terminated. There are, however, some obscure aspects of this well-known rule that are worthy of discussion.  One of the obscurities has to do with a 2018 change in the law resulting from the Tax Cuts and Jobs Act.  Additionally, there have long existed hidden traps for unwary taxpayers and their advisers as well as some twists and turns in the road in this area of Subchapter S that are also worthy of discussion.

This second installment of my multi-part series on Subchapter S is focused on two Code Sections, namely IRC Section 1375 and IRC Section 1362(d)(3).

Background

While most of my readers are all quite familiar with these two Code sections, there are some obscure practical implications of these provisions that I want to bring to your attention or remind you. 

These Code Sections only apply to S corporations that have retained earnings and profits from C corporation years (“C E&P”).  In a nutshell, under Code Section 1375, S corporations that have C E&P at the close of the taxable year and “passive investment income” totaling more than 25 percent of gross receipts will be subject to a tax imposed at the highest corporate income tax rate under Code § 11 (which is currently a flat 21 percent).  The tax is based upon the lessor of the corporation’s “taxable income” or its “excess net passive investment income.”

In October 2023, I authored a new White Paper, A Journey Through Subchapter S / A Review of The Not So Obvious & The Many Traps That Exist For The Unwary.  This year, in a multi-part article, I intend to take our blog subscribers through some of the most significant changes made to Subchapter S over the past 40 years, (i) pointing out some of the not-so-obvious aspects of these developments, (ii) alerting readers to some of the obscure traps that were created by these changes, and (iii) arming readers with various methods that may be helpful in avoiding, minimizing or eliminating the adverse impact of the traps.  This first installment is focused on one area of Subchapter S – the Built-In-Gains Tax.

Brief History of Subchapter S

In 1954, President Eisenhower recommended legislation that would minimize the influence federal income tax laws had on the selection of a form of entity by closely held businesses.  Congress did not act on the president’s recommendation, however, until 1958.  Interestingly, the new law was not contained in primary legislation.  Rather, the first version of Subchapter S was enacted as a part of the Technical Amendments Act of 1958.  The legislation was, at best, an afterthought.  

The original legislation contained numerous flaws and traps that often caught the unwary, resulting in unwanted tax consequences.  Among these flaws and traps existed: (i) intricate eligibility, election, revocation and termination rules; (ii) complex operational priorities and restrictions on distributions; (iii) a harsh rule whereby net operating losses in excess of a shareholder’s stock basis were lost forever without any carry forward; and (iv) a draconian rule whereby excessive passive investment income caused a retroactive termination of the S election (i.e., all of the way back to the effective date of the S election).  Due to these significant flaws, tax advisers rarely recommended Subchapter S elections.

As you may be aware, the Corporate Transparency Act (the “CTA”) is a new federal law that requires most U.S.-based companies, including corporations, partnerships and limited liability companies, to report information regarding their “beneficial owners” to the federal government through the Financial Crimes Enforcement Network (“FinCEN”) and a new FinCEN IT system known as the Beneficial Ownership Secure System (“BOSS”).  The intent of the CTA and the reporting to FinCEN is to combat money laundering, tax fraud and other illegal activities.

The CTA reporting requirements will become effective on January 1, 2024, for newly formed companies (which do not otherwise qualify as exempt); provided, however, existing non-exempt companies have until January 1, 2025 to comply.