Larry's Tax Law

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.

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:

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.

The NYU 78th Institute on Federal Taxation (IFT) takes place in New York City on October 20-25, 2019, and in San Francisco on November 10-15, 2019.  This year, I will be presenting a new White Paper entitled “The Road Between Subchapter C and Subchapter S – It May Be a Well-Traveled Two-Way Thoroughfare, but It Isn’t Free of Potholes and Obstacles.”  We will explore the obstacles and complexities that may impede travel on this two-way road, including the built-in-gains tax, LIFO recapture, excessive passive income, unreasonable compensation, personal holding company status, excessive accumulated earnings, and re-election hindrances and restrictions.

Joining me to co-present this expansive topic is my esteemed colleague Wells Hall of Nelson Mullins Riley & Scarborough LLP.

Please join me later this month in New York City for NYU’s Tax Conferences in July. I will be speaking at the program’s Advanced Subchapter S Conference on July 25-26, 2019.

I will be presenting my new White Paper entitled “The Road Between Subchapter C and Subchapter S – It May Be a Well-Traveled Two-Way Thoroughfare, but It Isn’t Free of Potholes and Obstacles.” We will explore the complexities that may impede travel on this two-way road, including the built-in-gains tax, LIFO recapture, excessive passive income, unreasonable compensation, personal holding company status, excessive accumulated earnings, and re-election hindrances and restrictions.