Yesterday we started a 3-part series describing several rulings made in the last year 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. This is Part 2, summarizing these rulings and their significance.
Basis, Losses, and Limitations
One of the reasons that the S corporation status is so popular is its ability to flow entity-level losses to its shareholders. However, shareholders must keep careful track of their stock and debt basis, as adjusted basis is a trigger for IRS review. A shareholder must overcome several hurdles before losses are deductible, including Sec. 183 (hobby loss), Sec. 1366 (adjusted basis), Sec. 465 (at-risk), and Sec. 469 (passive activity loss) rules.
Barnes demonstrated that if a taxpayer fails to deduct a loss the year it occurs, then he or she is no longer eligible to take the loss.
Built-in Gains Tax Holiday
The Small Business Jobs Act of 2010 modified Sec. 1374(d)(7) so that an S corporation’s net unrecognized built-in gain is not subject to built-in gains (BIG) tax if the fifth year in the recognition period precedes the 2011 tax year. The modification is not currently applicable to 2012, however there are tax-planning implications, as AICPA points out:
- If an installment sale of built-in gain property had occurred in a prior year, it may be advisable to recognize the gain in FY 2011, assuming it qualifies as an eligible year. It may even be prudent to trigger the installment gain by using the installment note as collateral for a loan.
- If an asset was sold in FY 2011 on the installment basis that would be covered by these rules but recognized in FY 2012, would it be subject to Sec. 1374 gain recognition? Until clarified, it may be advisable to elect out of Sec. 453 treatment for the exempt year.
- If the taxpayer’s net recognized built-in gain is limited by taxable income in its sixth recognition period year (FY 2011) and in 2012 it is subject to BIG, is the 2011 suspended gain forgiven or subject to Sec. 1374 tax?
- There seems to be a difference between which years qualify as eighth, ninth, or tenth for Sec. 1374 vs. the carryover basis rules of Sec. 1374(d)(8). For the former, tax year seems to be the criteria and, thus, in switching from a C fiscal year to an S calendar year, a corporation may have had a short taxable year.
QSub disregarded-entity rules have resulted in merger-and-acquisitions activities that have been ruled as legitimate.
Letter Rulings 201144002 and 201144003 involved a C corporation that was owned by ineligible shareholders such as corporations and partnerships. The ineligible shareholders distributed their stock to its shareholders/partners in a taxable transaction per Secs. 311 and 301. The shareholders then formed a holding company to hold the stock of the active QSub subsidiary. The government ruled that this would be a qualified S corporation.
The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 maintained the capital gain and dividend 15% tax rates for 2011 and 2012 and extended the alternative minimum tax patch for 2011. It also extended the suspension of the itemized deduction and personal exemption phaseout for 2011 and 2012. In addition, the act allows first-year bonus depreciation at 100% for assets acquired and placed in service on or after Sept. 9, 2010, and before Jan. 1, 2012 (before Jan. 1, 2013, for certain property). For assets placed in service in 2012, 50% first-year bonus depreciation applies.
In addition, the Act reduced the Social Security rate for employees and the self-employed by 2% for 2011, and the Middle Class Tax Relief and Job Creation Act of 2012 extended this reduction in the tax rate through 2012.