Larry's Tax Law

Basic Rules

IRC § 6501(a) generally requires the IRS to assess tax within three (3) years after a tax return is filed by the taxpayer. 

There are two (2) notable exceptions to this rule under IRC § 6501(c) and (e), namely:

1. Under IRC § 6501(c), an unlimited assessment period exists in the case of a false or fraudulent return where the taxpayer has the intent to evade tax; and
2. Under IRC § 6501(e), a six (6) year period for assessment exists in the case where the taxpayer understates gross income by more than 25 percent, unless there is adequate disclosure on the taxpayer’s original tax return.

In the case of a shareholder of an S corporation, the analysis is generally conducted at the shareholder level.  In other words, the focus is on the shareholder’s tax return, and the issue is whether there is a problem with that return that would extend the limitation period for assessment.

As we know from the basic rules, absent fraud or an undisclosed substantial understatement of gross income, the limitation period for assessment is three (3) years.  Likewise, absent fraud, an undisclosed substantial understatement of gross income extends the limitation period for assessment to six (6) years.

In this Part XII of my multi-part series on some of the not-so-obvious aspects of S corporations, I explore a consistent theme – taxpayers lose fights with taxing authorities when they fail to maintain adequate records.  Keeping adequate records is vitally important to S corporations and their shareholders or, for that matter, all taxpayers. 

Background 

Time and time again, taxpayers lose their battles with the IRS and other taxing authorities for the same reason – failure to maintain adequate records.  One of the greatest services that tax advisers can provide their clients is preaching the virtues of maintaining good records.

In this Part XI of my multi-part series on some of the not-so-obvious aspects of S corporations, I explore a topic that should be obvious but which appears to be ignored by many taxpayers and their tax advisers – accurate computation of shareholder basis for purposes of taking losses flowing through from the S corporation is important.

Background

In 2005, the Internal Revenue Service launched a study to assess the reporting compliance of S corporations.  The study, carried out under the National Research Program (“NRP”), involved the examination of roughly 4,800 randomly selected S corporation returns from tax years 2003-2004.  Based upon the portions of the study disclosed by the Service to the public, six major areas of noncompliance in the S corporation arena were detected:

Introduction

When considering converting a C corporation to an S corporation, tax advisers and taxpayers need to pay careful attention to the many perils that exist.  Failure to pay close attention to the road in this area could result in a disaster.  This Part X of my multi-part series on Subchapter S is designed to illuminate some of the road hazards that exist along the roadway traveling from Subchapter C to Subchapter S. 

Before converting an existing C corporation to an S corporation, an analysis of several matters should be undertaken, including the impact of the election on the shareholders and the corporation.  These matters include, but are not limited to, the topics briefly discussed below.

Unlike the rules contained in Subchapter K surrounding partnership distributions, which tend to be somewhat complex, the distribution rules contained in Subchapter S are fairly straightforward.  Nevertheless, from time to time, taxpayers and tax advisers appear to experience difficulty navigating through the applicable S corporation distribution rules.  This Part IX of my multi-part blog series on S corporations is designed to take some of the mystery out of the S corporation distribution rules.  The following is a brief overview of the S corporation distribution rules.

Background

The purpose of pass-thru taxation under Subchapter S is to avoid the imposition of an entity-level tax.  Shareholders of S corporations are taxed on their proportionate share of the corporation’s income, regardless of whether it is actually received; therefore, distributions from S corporation income should not be taxed again, otherwise there would be a second tax on such income, undercutting the purpose of pass-thru taxation.  IRC §1368 allows for shareholder distributions in a manner that avoids double-taxation of S corporation income, but it still imposes an entity-level tax on the earnings and profits (“E&P”) remaining from any prior operations as a C corporation. Much of the complexity within the Subchapter S distribution rules is due to these latter rules, which are designed to prevent C corporations from avoiding double-taxation on C corporation earnings by simply electing S corporation status.

At a fundamental level, distributions from S corporations must be analyzed in one of two categories: S corporations without E&P and S corporations with E&P.

Overview

In the S corporation arena, tax advisors and taxpayers generally do not focus a lot of attention on the S corporation shareholder eligibility rules other than at the time the S election is made.  As we dive into shareholder eligibility rules in this Part VIII of my multi-part series on Subchapter S, it should become apparent that the eligibility rules can be complex and require that S corporations and their shareholders keep a close eye on shareholder eligibility after the S election is made. 

Instances where S corporations and their shareholders may find the S election in peril for violating the shareholder eligibility rules include: (i) when a shareholder sells or otherwise transfers shares to a person or entity other than an existing eligible shareholder; (ii) when the corporation issues shares to a new shareholder; and (iii) when an existing shareholder transfers shares to a vehicle intended to be used for estate planning and/or creditor protection purposes.  Failure to pay close attention to the eligibility rules can result in disastrous consequences to the S corporation and its shareholders.

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. 

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.