Requesting a Letter Ruling to Waive the Effect of an Invalid ElectionThe IRS can waive the effect of an invalid election (IRC Sec. 1362). The waiver can apply to invalid elections caused by an inadvertent failure to qualify as a small business corporation or to obtain the required shareholder consents. Furthermore, the IRS may treat a late S election as timely if there was reasonable cause for the delay in filing. The IRS may even exercise this authority if the taxpayer did not actually file an election.Example 2C-5: Requesting a letter ruling to obtain relief for an invalid S election. In February, 2010, ABC Corp. completed an S election, Form 2553. The election was to become effective on January 1, 2010. Due to confusion among ABC, the practitioner, and the attorney, the Form 2553 was inadvertently placed in a file and was not mailed. ABC was unaware that the election was not filed and timely filed a request to extend the filing date of the tax return (Form 1120S). On September 15, 2011, ABC timely mailed Form 1120S. The pass-through items shown on each shareholder's Schedule K-1 were properly reported on the shareholder's Form 1040. On March 14, 2012, the corporation received notification from the IRS that it had no record of receiving ABC's Form 2553. ABC's tax practitioner is informed about the notice on March 21. ABC does not qualify for relief under Rev. Proc. 97-48 because the IRS notice was received within six months of the date the first Form 1120S was filed. (See Example .) In some situations, relief would still be available under Rev. Proc. 2003-43 (see Example ), but that is not true in ABC's case. If a Form 1120S has been filed, the deadline for filing a Form 2553 under Rev. Proc. 2003-43 expires 24 months after the original due date for the S corporation election. ABC's Form 2553 was originally due on March 15, 2010, so, to qualify for relief under Rev. Proc. 2003-43, a new Form 2553 would have to be filed no later than March 15, 2012. ABC can, however, request a letter ruling to determine whether the IRS will waive the invalid election. A user fee applies, as discussed later in this key issue. There seems to be a good chance that the IRS will allow the S election to become effective on January 1, 2010. The IRS has ruled that the corporation had reasonable cause for not filing its election on time and allowed the S election to become effective on the date requested. For example, invalid election relief was granted when the taxpayer relied on other parties to file the Form 2553 (see Ltr. Ruls. 9809033, 200239015, and 200302025), when the corporation was ineligible for S status on the date the election was to become effective (see Ltr. Ruls. 9716015, 9717019, and 200007016), when employees inadvertently failed to mail the Form 2553 (see Ltr. Ruls. 9719009 and 9720019), and even when no reason was given for the late filing except that the corporation intended to elect S status (Ltr. Ruls. 200303039 and 200303049).User FeeAccording to IRS Ann. 97-4, the rules under Reg. 1.1362-4(c)-(f) relating to waiver of inadvertent termination of the S election also apply to relief from invalid elections.Under those regulations, a request for waiver of an inadvertent S termination requires payment of a user fee. The user fee is (1) $625 if the S corporation's gross income is less than $250,000; (2) $2,000 if gross income is $250,000 or more, but less than $1 million; or (3) $14,000 if gross income is $1 million or more. (The procedure for obtaining a letter ruling is set out in Rev. Proc. 2010-1.)
If an S corporation contributes money or other property to a charity, each shareholder takes into accountthe shareholder’s pro rata share of the contribution in determining its own income tax liability.88 Ashareholder of an S corporation reduces the basis in the stock of the S corporation by the amount of thecharitable contribution that flows through to the shareholder.a. In the case of contributions made in taxable years beginning before January 1, 2010, theamount of a shareholder’s basis reduction in the stock of an S corporation by reason of acharitable contribution made by the corporation is equal to the shareholder’s pro ratashare of the adjusted basis of the contributed property. For contributions made in taxableyears beginning after December 31, 2009, the amount of the reduction is theshareholder’s pro rata share of the fair market value of the contributed property.b. The provision extends the rule relating to the basis reduction on account of charitablecontributions of property for two years to contributions made in taxable years beginningbefore January 1, 2012.
Proposed regulations (found in REG-153340-09) would eliminate the rules for using paper-based federal tax deposit coupons because the paper coupon system will no longer be maintained by the Treasury Department after December 31, 2010. Corporate tax payments including estimated taxes, income taxes, excise, payroll, and withholding taxes would be made by electronic funds transfer. The proposed regulations do not change existing rules for determining a taxpayer's status as a monthly or semiweekly depositor, or for determining whether a taxpayer can remit taxes with a return.The proposed regulations are scheduled to become effective for remittances made after the date that final regulations are published, but no earlier than January 1, 2011.
S corporation penalties can add up.We have sent several letter have not gotten a response yet.General consensus is that you can ask for waiver due to circumstances similar to 84-35 – however should not quote it in the letter as it specifically applies to small partnerships only
Raleigh area has significantly increased their small business audit staff – have seen significant increase in audits but not S Corps yet. More Sch Cs
New National Research Program (2,000 returns per year for 2010-2012) focusing on employment status: employee vs. independent contractor, reasonable compensation, S Corp distributions v. salary, and matching taxpayer identification numbers. Of the 2,000 returns, 1,500 per year will be from the Small Business/Self-Employed division. The program began in February 2010. The program is trying to catch taxpayers trying to avoid paying Social Security taxes by under-compensating themselves and taking the money out as distributions.
One instance of disproportionate distribution will not terminate S Corp if correctedGoverning ProvisionsAn S corporation is treated as having only one class of stock if all outstanding shares of stock confer identical rights to distribution and liquidation proceeds and if the corporation has not issued any instrument or obligation, or entered into any arrangement, that is treated as a second class of stock. The determination of whether all outstanding shares of stock confer identical distribution and liquidation rights is based on the “governing provisions,” which include the corporate charter, articles of incorporation, bylaws, applicable state law, and any binding agreements relating to distribution and liquidation proceeds [Reg. 1.1361-1(l)(2)(i)].For example, a payment of excessive compensation may be recharacterized as a distribution for which no deduction is allowed; however, neither the payment nor the distribution created by the recharacterization results in a second class of stock. Similarly, a distribution may be recharacterized in whole or in part as deductible compensation (on which FICA and FUTA taxes may be due), but any difference in distribution rights resulting from such a recharacterization will not result in a second class of stock. This may lead one to believe that the corporation can make disproportionate distributions to shareholders without terminating the corporation's S election. However, the “binding agreement” language in the regulations presents a formidable barrier.The regulations do not require a binding agreement to be in writing. Although not explicitly stated in the regulations, it seems possible that a systematic pattern of distributions favoring one shareholder over another may create a binding agreement relating to distributions, and so terminate the corporation's S election. Furthermore, an effort to avoid classification as a “binding agreement” by including the distribution requirement in a commercial contract will not work because such a contract will be considered a “governing provision” if entered into to circumvent the one-class-of-stock requirement. Therefore, an S corporation should not make disproportionately large distributions to a shareholder on an ongoing basis.
Red text = areas many of my clients fail
The corporation cannot avoid paying the shareholder a reasonable salary by entering into a formal employment contract specifying that no salary is to be paid to the shareholder during the year. In Joseph Radtke, an attorney tried to use the formalities of an employment contract to avoid employment taxes. His scheme failed in the District Court and on appeal to the 7th Circuit Court of Appeals. A similar arrangement failed in Dunn and Clark, P.A.Shareholder-officers of a corporation who are performing services that fall within the scope of duties of corporate officers are employees of the corporation. Therefore, even though a payment for such services is called a distribution or a draw, the payment may be compensation for services, and subject to payroll taxes and withholding [IRC Sec. 3121(d)(1); Rev. Rul. 82-83]. Frequently, an Scorporation will loan funds to shareholders. However, if such payments are not bona fide loans, but instead represent compensation for services rendered to the corporation, the payments may be reclassified as wages. (As discussed in Key Issue , the IRS can adjust income to reflect reasonable compensation for services rendered or capital furnished to the corporation.) The corporation should generate and maintain conclusive evidence that loans are bona fide in order to guard against an IRS argument that the payments to shareholders are disguised wages rather than loans. A loan is bona fide if the corporation and shareholder have a debtor-creditor relationship based on the shareholder's valid and enforceable obligation to pay a fixed or determinable sum of money to the corporation.
Distributions Can Be Recharacterized Even If Wages Are Actually Paid. The IRS can recharacterize all or part of distributions to a shareholder as additional compensation subject to employment taxes, even when the S corporation has both paid a salary for services and made distributions to the shareholder. In Watson, the S corporation's sole shareholder, a CPA, authorized an annual salary of $24,000 for himself and received dividend distributions of $320,000 over two years. When IRS sought to recharacterize $67,044 of the dividend income as compensation, the taxpayer argued that the corporation's intent should control, and that the IRS cannot compel a corporation to pay a higher salary than it chooses. But a District Court, citing Rev. Rul. 74-44 and Joseph Radtke held that the IRS has the power to convert dividends to salary.
Discussion point:Any disallowances seen if not properly recorded on W-2? Remember if paid by shareholder S Corp should reimburse by year-endNC Department of Revenue auditing dentists and doctors have disallowed this deduction if not on W-2.In Notice 2008-1, the IRS provided guidance for when a 2% shareholder can claim the Section 162(l) deduction. According to Notice 2008-1, a 2% shareholder who meets the requirements of IRC Sec. 162(l) is eligible for the deduction if the plan providing the medical care coverage is established by the Scorporation, which means that: 1. the Scorporation pays the premiums for the accident and health insurance policy covering the 2% shareholder (and his or her spouse and dependents, if applicable) in the current tax year; or2. the 2% shareholder pays the premiums and furnishes proof of payment to the Scorporation, after which the Scorporation reimburses the 2% shareholder for the premium payments in the current tax year.In addition, the Scorporation must report the accident and health insurance premiums that are paid or reimbursed as wages on the 2% shareholder's Form W-2 in that same year, and the 2% shareholder must report the premium payments or reimbursements as gross income on his or her Form 1040.
When an eligible entity classified as a partnership elects to be treated for tax purposes as a corporation (or converts into a corporation under a state law conversion statute), the partnership is treated as contributing all of its assets and liabilities to the corporation in exchange for stock. It is also considered to have liquidated by distributing the stock of the corporation to its partners immediately before the close of the day before the election is effective. Thus, if the conversion from partnership to corporation takes place at the beginning of the year, the deemed contribution and liquidation are treated as if they took place immediately before the close of the previous tax year. This means that the entity will be a partnership until the end of the previous year and a corporation at the beginning of the new tax year. If the corporation makes a timely S corporation election for its first year, the corporation will be an S corporation for that year and there will be no intervening period during which the entity was a C corporation (Rev. Rul. 2009-15). If, for example, the partnership becomes a corporation on January 1, it can elect to be an S corporation on that day if the S election, Form 2553, is filed by March 15.
In general, there are no carryforwards and no carrybacks between C and S tax years [IRC Sec. 1371(b)]. However, net operating losses, capital losses, business credits, and minimum tax credits carried over from C corporation tax years can be used to reduce the built-in gains tax [IRC Sec. 1374(b)(2)]. Corporate-level carryforwards and carrybacks cannot arise in S tax years [IRC Sec. 1371(b)(2)]. Thus, corporate-level losses occurring in S tax years pass through to shareholders and do not carry forward or carry back to C tax years.
Section 179An unused Section 179 deduction is evidently subject to IRC Sec. 1371(b)(1) and cannot be carried into an S corporation year. Thus, it appears to be unavailable to either the S corporation or its shareholders. However, the Code authorizes the revocation of a Section 179 election with respect to any property for any open tax year 2003 through 2011 [IRC Sec. 179(c)(2), as amended by the 2010 Small Business Tax Act]. This would allow a corporation with an unused Section 179 deduction to reduce its expense to an amount that falls below the Section 179 expensing limitations.
If an S corporation does not have AE&P, the accumulated adjustments account (AAA) is not used as a measure of nontaxable distributions. In that case, as discussed in this key issue, distributions are nontaxable to the extent of the shareholder's basis. However, the instructions to the Form 1120S state that the AAA and other applicable balances should be calculated each year on Schedule M-2, even if there is no AE&P, because the actual AAA balance must be determined under certain circumstances.
The taxpayers in Russell attempted to claim pass-through losses against debt basis in several ways. First, loans from a bank to the S corporation that were cosigned and guaranteed by the taxpayers did not result in debt basis. Second, a loan from the taxpayers' C corporation to the S corporation did not provide debt basis, even though the taxpayers belatedly attempted to reclassify the loan as notes payable to the taxpayers. Third, short-term notes were actually loans between the taxpayers' partnership and the S corporation. The fact that the S corporation had made adjusting journal entries two years after the loans' origination date reclassifying the loans as notes payable to the shareholders was not sufficient to provide debt basis. Finally, however, the taxpayers were able to claim debt basis for cash advances they made directly to the S corporation.
Reporting Multiple Activities on Schedule K-1If the S corporation conducts more than one activity, the results of each activity must be reported separately to all shareholders. (“Activity” is defined and discussed in Key Issue .) The schedule detailing the activity-by-activity pass-through is attached to each shareholder's Schedule K-1. (See Example and Illustration .) Example 26B-3: Attachments to Form 1120S and Schedule K-1 when there is more than one activity. Jack Cassidy is the sole shareholder in JC, Inc., an S corporation. JC conducts two business activities—manufacturing and operating convenience stores. The corporation also rents real estate and holds portfolio investments that produce dividend income. During the year, it shows income or loss as follows:Manufacturing $ 40,000Convenience stores (30,000)Rental real estate (12,000)Dividend income 7,000JC also owns an interest in ABC Partnership and receives a Schedule K-1 from the partnership showing nonseparately stated income of $25,000 and a long-term capital loss of $6,000. The partnership Schedule K-1 indicates that the $25,000 is net income from self-employment. The income and deduction amounts from the manufacturing and convenience store activities are combined and entered on the appropriate lines on page 1 of Form 1120S. The $25,000 of income from the partnership is included on Form 1120S, page 1, line 5 [Other income (loss)]. Entering the preceding items on page 1 of Form 1120S will result in a net ordinary income amount of $35,000 on line 21 [Ordinary business income (loss)]. The rental income is reported on Form 8825 (Rental Real Estate Income and Expenses of a Partnership or an S Corporation), which is attached to the Form 1120S. The $6,000 long-term loss passed through by the partnership is reported on Form 1120S, Schedule D. A statement should be attached to Jack's Schedule K-1 showing the results of each activity separately because he may not materially participate in all the activities.
The IRS has ruled that the administrative dissolution of an S corporation under state law (because its registration to do business in the state had expired) did not terminate the S election (Ltr. Rul. 200835002). Furthermore, the corporation's subsequent reincorporation was treated as an F reorganization within the meaning of IRC Sec. 368(a)(1)(F). Although in several prior rulings the IRS has held that the administrative dissolution of an S corporation did not terminate its S election where, under state law, the corporation was retroactively reinstated, this appears to be the first ruling holding that the S election did not terminate even though the corporation was not retroactively reinstated under state law.
An S corporation shareholder can rent a portion of the shareholder's home to the S corporation (either for office space or storage). The rental income must be reported on the shareholder's Form 1040. However, the only allowable rental deductions for a home office space that is leased to the individual's employer are the deductions that would be deductible in the absence of any business use, generally mortgage interest and real estate taxes. [See IRC Sec. 280A(c)(6).] Leasing office space to the individual shareholder's S corporation is one way to extract cash from the corporation.
S Corp changes ◦ Not many specific to S Corps ◦ 2010 K-1 appears to be no changes form 2009 Common Issues & Problems with S Corps
User fees for requesting a letter ruling to waive the effect of an invalid S election User Fee If S Corp’s Gross Income is $625 less than $250,000 $2,000 > $250,000 and < $1,000,000 $14,000 $1,000,000 or more
Section 1374(d)(7) – somewhat reduced stress and impact of Sec. 1374 for 2009 and 2010 and 2011
Pre-SBJA holding period is reduced where the 7th taxable year in the holding period preceded the taxable year beginning in 2009 or 2010 SBJA temporarily shortens the holding period of assets subject to the built-in gains tax to 5 years if the 5th taxable year in the holding period precedes the taxable year beginning in 2011
The result is a 7-year holding period for 2009 and 2010 5-year holding period for 2011 – applies to any conversion made in 2006 or before Tip to clients –Consider selling in 2011 any BIG asset if elected prior to 2007 Absent further law changes – will revert back to 10 year period in 2012.
Shareholder’s basis is reduced by the amount of contribution flowing through to the shareholder Contributions made before Jan 1, 2010 – basis is reduced by the shareholder’s pro rata share of the adjusted basis of the contributed property Contributions after Dec 31, 2009 – basis is reduced by the shareholder’s pro rata share of the fair market value of the contributed property
Reg-153340-09 Eliminates rules for using paper-based federal tax deposit coupons Tax payments include estimated taxes, income taxes, excise, payroll, and withholding taxes Proposed regs do not change existing rules for monthly v. semiweekly depositors
If S Corp uses payroll service – they may not be signed up for EFTPS If know may be subject to BIG tax – may have to sign up for EFTPS prior to March 15 to avoid incorrect deposit penalty.
$195 per month per shareholder ◦ Max of 12 months ◦ 1 shareholder = 12 x 195 = $2,340 Can be abated for reasonable cause Any luck on getting penalties waived other than reasonable cause? ◦ Can we use Rev. Proc. 84-35? – used by small partnerships (small partnership all partners file on time reporting income from partnership)
The AICPA has proposed to the IRS a procedure similar to Rev Proc 84-35 The penalty imposed by section 6699 may be abated if reasonable cause can be shown. We are requesting that the Service consider allowing reasonable cause to be deemed automatic if certain requirements are met. Those requirements include the following: ◦ The S corporation must be composed of ten or fewer shareholders; ◦ the S corporation must have no tax liability due at the entity level; and ◦ all shareholders must have included all items of income, deductions and credits from the S corporation on their own timely-filed personal income tax returns
Preliminary results of National Research Program on S Corps which audited 1,200 for tax year 2003 and 3,700 for 2004 showed: ◦ 12% underreporting for 2003 and 16% for 2004 ◦ Small S Corps (< $200,000 in assets) had higher percentages of underreporting than large S Corps Has S- Corp Audit Activity Increased?
2,000 returns per year for 2010-2012 focusing on employment status ◦ Employee v. independent contractor ◦ Reasonable compensation ◦ S Corp distributions v. salary ◦ Matching taxpayer identification numbers Of the 2,000 returns, 1,500 from Small Business/Self-Employed division
S Corporations must only have one class of stock Distribution differences in timing and/or amount are to could be viewed as a second class of stock Avoid making disproportionate large distributions to a shareholder on an ongoing basis A systematic pattern of distributions should be avoided Should be corrected as soon as possible (loans – “catch-up” distributions)
IRS requires that compensation is “reasonable” There is no rigid set of rules for measuring the reasonableness of compensation – no definition of “reasonable” is contained in the Code No single factor controls, but rather a combination of factors must be considered
1. the character and financial condition of the corporation;2. the role the shareholder plays in thecorporation, including the employees position, hoursworked, and duties performed;3. the corporations compensation policy for all employeesand the shareholders individual salary history includingthe corporations internal consistency in establishing theshareholders salary;4. how the compensation compares with similarly situatedemployees of similar companies;5. conflicts of interest in setting compensation levels; and
6. whether a hypothetical independent investor wouldconclude that there is an adequate return on investmentafter considering the shareholders compensation.7. the employees qualifications;8. the size and complexity of the business;9. a comparison of salaries paid to sales and net income;10. general economic conditions;11. comparison of salaries to shareholder distributionsand retained earnings;
12. compensation paid in prior years;13. the corporations dividend history;14. whether the employee and employer dealt atarms length;15. corporate intent; and16. whether the employee guaranteed theemployers debt.
Formal employment contract specifying that no or low salary is to be paid (Joseph Radtke - Dunn and Clarke P.A.) Payment for services called a distribution or a draw (Revenue Ruling 82-83). Compensation disguised as loans to shareholders – (Must be a “bona fide loan”)
Distributions can be recharacterized even if wages are paid ◦ In Watson, S Corp’s sole shareholder, a CPA Annual salary of $24,000 and dividend distribution of $320,000 over two years IRS sought to recharacterize $60,044 of the dividend income as compensation District Court, citied Rev. Rul. 74-44 and Joseph Radtke, and held the IRS has the power to convert dividends to salary
Used to think any compensation greater than zero was OK. IRS seems to be more willing to attack very low salaries What do you do after year-end if no salaries paid? ◦ Reclass some distributions to salary – pay late fees re payroll deposits?
2% shareholder can claim deduction if ◦ S Corp pays the premiums for the accident and health insurance policy covering 2% shareholder (and his/her spouse and dependents); OR ◦ The 2% shareholder pays the premiums and provides proof of payment to the S Corp, and then the S Corp reimburses the 2% shareholder for the premium payments in the current tax year Health insurance premiums paid or reimbursed as wages must be reported on the 2% shareholder’s and family members Forms W-2 If caught, Can we just amend the W-2(s)
Partnership exchanges assets and liabilities for corporation stock Partnership liquidates distributing S Corp stock to partners With a timely election, Corporation becomes an S Corp without ever being a C Corp Potential Problem – Liabilities exceed basis of assets – gain upon contribution to S Corp.
Not required if File 2553 IRS often will incorrectly process the 2553 or incorrectly ask for 8832 for which you have to correspond to correct
In general, no carryovers except against built-in-gains (BIG) (Code Section 1371 (b)) ◦ C Corporation Credits and NOLs generally carryover to the S corporation upon conversion – however can only be used to offset Built in Gain Tax
No carryover from “C” year However, any open tax year, 2003-2011, can be amended to revoke previous section 179 expense
If S Corp doesn’t have AE&P, AAA is not used as a measure of nontaxable distributions If no AE&P – Basis in S corporation Stock determines if distributions are taxable Instructions to Form 1120S state that AAA should be calculated each year, even if there is no AE&P
Loans from bank to S Corp that were cosigned and guaranteed by the taxpayers A loan from the taxpayers’ C Corp to the S Corp Short-term notes that were actually notes between taxpayers’ partnership and the S Corp AJES reclassifying loans 2 years after origination – not accepted
Cash advances made directly to the S Corp Best to have funds transferred and loaned directly from shareholder Court case addressing all of the above ◦ Russell,Donald v Commissioner TC Memo 2008-246
Basis is adjusted by pass-through items and distributions to shareholders Basis is 1. Increased by stockholder’s share of income and gain items; then 2. Decreased by distributions that are a nontaxable return or basis; and, finally, 3. Decreased by the stockholder’s share of loss and deduction items What may be thought as a dist in excess of basis – capital gain – may be ordinary income due to ordering rules (see example)
New Co with a beginning basis of $0 has the following activity in year one ◦ Ordinary Income $20,000 ◦ Section 179 Expense (20,000) ◦ Distributions to S/H 10,000 How should the activity be recorded on the K-1? How much and what character of carry- forward loss?
Basis Order Cumulative CarryforwardBeginning Basis 0 0Ordinary Income 20,000 20,000Distribution 10,000 10,000Section 179 10,000 0 10,000Ordinary Income 20,000Section 179 (10,000)Cfwd Sec 179 10,000Loss
When an S Corp conducts more than one activity, a schedule should be attached to the tax return, Form 1120S and the Schedules K- 1, so the shareholders can identify the income or loss of each separate activity Separate reporting required or proper classification by shareholders re: type of activity and passive activity classification
IRS ruled that administrative dissolution of an S Corp under state law (because its registration to do business in the state had expired) did not terminate the S election. This is the first ruling holding that the S election did not terminate even though the corporation was not retroactively reinstated under state law
An S Corp shareholder can rent a portion of the shareholder’s home to the S Corp Rental income must be reported on the shareholder’s Form 1040 Only allowable rental deductions are deductions deductible in the absence of any business use, generally mortgage interest and real estate taxes May want to rent if shareholder does not itemize deductions or over $ 1 million limit Way to get $ out of corp if have basis limitations
AICPA is petitioning that the following changes be made to tax return due dates Form Orig Due Ext Due 1065 March 15 Sept 15 1120-S March 31 September 30 1041 April 15 September 30 C Corp April 15 October 15 1040 April 15 October 15