During the last year, several rulings were made that affect S corporations. AICPA just published an article in The Tax Adviser that outlines what these rulings were and offers suggestions for tax planning in light of the changes. We’re summarizing these rulings and their significance in a 3-part series.
In order to qualify as an S corp, a corporation must meet several requirements. If these requirements aren’t met, the IRS can terminate the corporation’s S election. (Under Sec. 1362(f), taxpayers can request an inadvertent termination relief ruling. If the IRS grants approval, the corporation can retain its S status continuously.)
- Elections – The rulings this year show leniency in granting inadvertent election and termination relief for failure to file Form 2553, Election by a Small Business Corporation, Form 8832, Entity Classification Election, and Form 8869, Qualified Subchapter S Subsidiary Election (QSub). The IRS also granted inadvertent termination relief when the wrong person signed the election in Letter Rulings 201151004 and 201144018. As long as taxpayers made the corrections and filed accurate paperwork within 120 days, the IRS did not levy penalties.
- Eligible Shareholders – In Taproot Administrative Services, the Ninth Circuit held that a Roth IRA is not an eligible S corporation shareholder.
- One Class of Stock – Santa Clara Valley Housing Group ruled that the issuance of stock warrants used to convert ordinary income into distributions were, in fact, a second class of stock. (However, the district court in California is reexamining the terms of the stock warrants under the safe-harbor rules of Regs. Sec. 1.1361-1(l)(4), so the outcome could change.)
- Earnings and Profits – One of the requirements for a corporation to qualify is that its total passive investment income must not exceed 25% of its gross receipts. If the corporation fails to meet this requirement for three years, its S election will terminate the following year. Each year that it exceeds the 25%, it will be subject to a tax under Sec. 1375 on its excess net passive investment income. In Letter Ruling 201221008, the government permitted a retroactive deemed-distribution election to allow the S corporation not to be considered terminated. Letter Rulings 201226013 and 201222003 allowed corporations to retain their S statuses as long as the companies made a deemed distribution of its AEP.
- Change in Capital Structure Reporting – A statutory change enacted Sec. 6045B, requiring any change in the capital structure of a corporation to be reported within 45 days to the IRS and the shareholder.
S Corporation Disparate Information Reporting
Several rulings involved the way income was reported, and shareholder tax liability:
- In Dickerson, a ruling held that an Alabama Waffle House waitress who received a tip in the form of a lottery ticket and won $5 million was liable for gift tax on 51% of the income that she’d given to family members, even though the money was transferred to an S corporation.
- In Penland, the court ruled that a sole shareholder who disavowed her ownership of an S corporation was liable for the income generated by that S corporation.
- In D’Errico, the owner of several S corporations took out loans from the companies. The court held that the loans were actually distributions because he showed no intent to repay them.
Wages and Self-Employment Taxes
In David E. Watson, an experienced accountant worked 35 to 40 hours per week, 46 weeks a year, but took a salary of only $24,000 and distributed more than $200,000 in cash to himself. The court reclassified $67,000 of Watson’s distributions as salary.
In Cave, a sole shareholder attorney treated himself and all his associates as independent contractors to avoid withholding Social Security taxes. The court held that the shareholder and associates were “statutory” employees and that the company was liable for withholding Social Security taxes.