As used in the IRC, the term “domestic” means the S corporation must be created or organized under the law of the United States or any State. Specifically, the IRC states: “[t]he term “domestic” when applied to a corporation or partnership means created or organized in the United States or under the law of the United States or of any State unless, in the case of a partnership, the Secretary provides otherwise by regulations.” (IRC § 7701(a)(4)). This is a strict requirement and even corporations formed in United States’ territories do not qualify as a domestic corporation. (See Sayre & Co. v. Riddell (1968) 395 F. 2d 407 (Holding that a corporation organized in Guam does not qualify as a domestic corporation)). 

 

 

 

 

 

 

 

 

 

 

Voting trusts may own stock in an S corporation. Specifically, voting trusts are created primarily to exercise the voting power of stock transferred to it. In these situations, each beneficiary of the voting trust is treated as a shareholder of the S corporation whose stock is owned by the trust. (IRC § 1361 (c)(2)(B)(iv)). 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Passive and Active Investors - If one or more owners will be actively involved in receiving employment compensation and one or more owners will not be actively involved, but expect to receive regular distributions of profits on their investment, the Subchapter S structure provides a relatively simple business structure which allows payment of employment compensation and regular distribution of profits without tax at the corporate level. The structure also provides better clarity as to what amounts paid to the active owners will be subject to employment tax.

 

Highly Compensated Active Business Owners - If the business owners are engaged in an activity that is highly profitable, a business can reach the point that payment of salaries exceeds what the Service believes is reasonable compensation and if the business is organized as a C corporation, that excess compensation was, in fact, dividends and corporate profit. With an S corporation election, the corporation can provide salary and dividend compensation without incurring the corporate level tax.

 

Saving on Employment Tax Towards Small Businesses – One of the more frequently cited reasons for electing Subchapter S is for small business owners who can justify that reasonable compensation that would be paid to a third party is less than the profits of the business and less than the FICA wage base limit. The discussion below addresses the issues practitioners face in determining what is reasonable compensation in this context.

 

            A significant benefit for small business owners of S corporations is the ability reduce the Federal Insurance Contributions Act (“FICA”) tax by allocating certain distributions to dividends and allocating the remainder to salary. FICA has two components, the old-age, survivors, and disability insurance component of 12.4% (currently applicable on $106,800 of compensation) and the hospital insurance component of 2.9% (no wage base limit). Dividend income is not subject to the FICA taxes whereas earnings from self employment are subject to the FICA tax. Ostensibly, by reducing the earnings from self employment and allocating these payments to dividends, shareholder/employees of an S corporation can reduce the amount of tax by ___% of the dividend payment. However, determining the proper ratio of self employment income to dividend payments is difficult and failure to allocate properly may result in an audit and increased tax liability.

 

            In Radtke v. United States[1], Joseph Radtke was an attorney who formed a professional corporation and elected to be a S corporation for federal income tax purposes. Radtke was the sole incorporator, director, shareholder, and was the firms only full time employee. Radtke’s employment agreement with the S corporation indicated that his annual salary was to be determined by the corporation’s board of directors. Despite spending all of his time working for the corporation, his base salary was set by the board at zero. Incidental to his base salary, Radtke received over $18,000 in dividends annually. According to the court, whenever Radtke needed money the board of directors would declare a dividend allowing Radtke to write a check to himself. While Radtke paid income tax on the dividend income, he did not pay any FICA withholding taxes. The IRS argued that the dividends were really wages and were subject to FICA taxes. The court agreed and Radtke had to pay accordingly.

 

            As the case above demonstrates, an S corporation must pay its employee’s reasonable compensation. Furthermore, the IRS and courts have also found that S corporation “draws” as wages and even “loans to shareholders” qualify for the FICA taxes.[2] Unfortunately, there is no cut and dry rule as to what qualifies as a reasonable salary for self employment tax purposes. Dividends should be declared by board action and reflected in minutes of the board.

 

Practitioners sometimes reference the “60-40” approach for allocating salaries and dividend distributions. Essentially, this theory states that 60% of the S corporation’s distribution should be allocated towards salary and 40% of the distributions should be allocated to dividend distributions. While clear cut and definitive, this theory is not based on any recognizable legal precedent and is not recognized by the IRS. Perhaps some courts have incidentally recognized a 60-40 distribution as reasonable, but what is reasonable is a highly fact specific analysis and is not based upon arbitrary fixed numerical allocations. To date, the IRS has not published any statement indicating that this ratio is a “safe harbor.” Furthermore, as discussed below, it appears the IRS may be revisiting the S corporation tax procedures in the near future.

 

Instead of relying on simple percentage allocations, practitioners need to be cognizant of the varying interpretations of what constitutes a reasonable allocation. Within the different Federal Circuits, there are competing methods of determining what is reasonable compensation. Most Circuits have adopted a five factor test. The following factors are used to determine what is reasonable compensation, none of which alone is determinative: (1) the employee’s role in the company; (2) a comparison of the employee’s salary with those paid by similar companies for similar services; (3) the character and condition of the company; (4) potential conflicts of interest; and (5) evidence of an internal inconsistency in a company’s treatment of payments to employees. (Elliotts, Inc. v. Commissioner of Internal Revenue, 716 F. 2d 1241, 1245-47). Alternatively, some Circuits adopt an “independent investor” approach. Specifically, this test asks whether an inactive, independent investor would be willing to compensate the employee as he was compensated. (See Exacto Spring Corp. v. Commissioner, 196 F. 3d 833). In 2004, the Ninth Circuit, of which California is a part, adopted a hybrid between the two tests. Specifically, the Ninth Circuit indicates that it is beneficial to view the multifactor test from other Circuits through the lens of an independent investor. (Metro leasing and Development Corporation v. Commissioner 376 F.3d 1015). 

 

Based on the foregoing there does not appear to be a cut and dry test for what qualifies as reasonable compensation for self employment tax purposes. Instead, practitioners must be mindful of the various standards and do his or her best to allocate the S corporation earnings accordingly.

 

With regard to income and dividend allocation for S corporations, it must be noted that there are murmurs of possible change. Some estimates indicate that the failure of shareholders to account for self employment income is responsible for “$5.7 billion in employment tax” avoidance.[3] Given the current need for increased tax revenues, closing the self employment tax loophole may prove very popular with Congress. 

 

 

Complex Capital Structures – Many businesses require capital structures that do not easily fit with having only one class of stock. These include, among others, when there is sweat equity along with cash investors, most venture capital financings which demand preferred equity returns and often complex exit strategies. Oftentimes compensation structures to attract key employees require option and other equity incentives that risk being classified as a second class of stock.

 

Appreciating Assets – If the business will hold significant assets which are expected to appreciate over time, an S corporation structure may not be appropriate, particularly if there are multiple owners. In general, an S corporation, like a C corporation, cannot transfer appreciated assets to shareholders whether prior to or at liquidation without the transfer being treated as a taxable disposition of the property. As a consequence, many practitioners avoid any real property and other long term appreciating investment assets in S corporations that owners may want to continue to hold after the business activities of the S corporation cease. Similarly, when multiple parties are bringing intellectual property to the business that could appreciate dramatically, it is better if these appreciating assets are not locked in an S corporation, when the business partners are separating the business and now want to go their own way. If appreciated assets are a part of the business plan, an S corporation may still make sense for the active business, while holding the appreciating assets in a separate entity with a lease or license to the operating business.

 

Very Small Business – Franchise taxes, organizational and maintenance expenses and tax return preparation fees sometimes do not make sense for very small business ventures.  If the reason for incorporating is limitation of liability, buying more insurance may have more value than paying $1,000 to $1,500 annually to have a corporation, whether C or S.

 

 

 

 

As many business lenders scramble for liquidity, particularly in the real estate sector, even borrowers with performing loans are being presented with the opportunity to pay off debt at sometimes steep discounts. On the other hand, financially troubled businesses are faced with the foreclosure and loss of already depreciated assets where the cancellation of the indebtedness may result in significant income recognition. The character of cancellation of debt income depends upon whether or not the debt forgiven is recourse or non-recourse indebtedness. In general, the forgiveness of a non-recourse indebtedness results in a gain or loss as if the collateral assets were sold. On the other hand, the forgiveness of unsecured recourse indebtedness or the portion of secured recourse debt exceeding the fair market value of the collateral property results in recognition of ordinary income.

 

 

·                     There is no gross income from discharge of debt in a federal or state bankruptcy proceeding. Code Sec. 108(a)(1)(A).

·                     A taxpayer who is insolvent after the cancellation of debt recognizes no gross income from the debt cancellation. Code Sec. 108(a)(1)(B).

·                     When a seller of property finances the purchase and later reduces the debt balance, there is no gross income to the borrower. (Section 108 contains the rules for nonrecognition of income when debt is discharged.)

·                     If the borrower is a farmer and the debt is related to the farming business, the lender’s forgiveness may be a reduction of qualified farm indebtedness and excluded from gross income. Code Sec. 108(a)(1)(C). This rule applies to discharge of indebtedness after April 9, 1986.

·                     If the debt is discharged after December 31, 1992, it may not be included in gross income if it is qualified real property business indebtedness. Code Sec. 108(a)(1)(D).

 

In applying the exclusion, S corporations are treated differently than partnerships and limited liability companies, which are taxed as partnerships. For a “partnership,” the exclusion is applied at the partner level and for S corporations the exclusion is applied at the corporation level, but the income after the exclusion, if any, is reported at the shareholder level. The timing of cancellation of debt is often at least partially under the control of the debtor and planning opportunities may arise to most effectively time and place the debt cancellation event such that by making an S election or terminating an S election the economic impact of the debt forgiveness may be different. However, in planning petitioners must carefully consider the impact of built-in gain rules and other intricate aspects of S corporation accounting. The IRS has ruled that income from discharge of indebtedness is a built-in gain under Section 382. See Letter Ruling T932049. Regulations on this issue merely state that such income is a recognized built-in gain if the debt was outstanding at the beginning of the recognition of period. Reg. Section 1.1 of 374-4(f). However, the regulations do not treat any production of indebtedness as a built-in gain if the corporation is able to exclude the reduction from income under Section 108, due to bankruptcy or insolvency.

 

 

            The bankruptcy of an S corporation raises many interesting questions. For example, who reports income, losses and distributions during a bankruptcy, who is entitled to the benefit of net operating loss carrybacks, and who can make and control the benefits determined by making or terminating an S election. Courts have recently addressed these issues.

 

July 22, 2004

123 T.C. 144

 

Taxpayer was sole shareholder for two S corporations used in conjunction with his investment advisor business. Between January 1, 1990 and December 3, 1990, Taxpayer’s S corporations lost significant amounts of money. Taxpayer filed for bankruptcy on December 3, 1990. The court addressed whether Taxpayer or Taxpayer’s bankruptcy estate (“Estate”) was entitled to the 1990 losses.

 

            The court held that the Estate was entitled to the loss for 1990. When a party files for bankruptcy, filing the petition creates a new taxable entity for federal tax purposes, the bankruptcy estate, which is separate and distinct from the individual debtor. The income or loss of an S corporation is determined as of the last day of the corporation’s taxable year. As such, because the Taxpayer filed the petition for bankruptcy on December 3^rd, the Estate was actually the owner of all the stock at the year’s end. Therefore, the Estate and not the Taxpayer was entitled to deduct the losses.

March 23, 2007

481 F. 3d 404

 

            Husband and wife (collectively “Taxpayer”) were 100% stockholders in an S corporation. S corporation became insolvent in 1992. Taxpayer’s lost $7.5 million, but because Taxpayer’s basis in their shares was $3.4 million, taxpayer could only deduct an amount equal to their basis. (Section 1366(d)(1)). In January 1993, an involuntary petition for bankruptcy was filed against the S corporation. In March 1996, the trustee filed his zero bank statement and final account, and the bankruptcy court filed its final decree and closed the case. In April 2000, Taxpayer filed a Form 1040X showing an overpayment due to the fact that Taxpayer’s debt was discharged and thus was entitled to an increase in basis in the amount of the discharged debt for the year 1991.

 

            The Government argued that the discharge of debt occurred in 1996 and Taxpayer argued that discharge of debt occurred within the 3 year bankruptcy period for carrying back losses. Generally speaking, a Taxpayer is discharged from liability “when it becomes clear that the debt will never have to be paid.” Essentially, there must exist an identifiable event which fixes the loss with certainty. 

 

In this case, the court found that Taxpayer did not cite an identifiable event fixing the loss with certainty. Taxpayer attempted to argue that a substantial completion of the bankruptcy was a sufficient event. However, the court rejected this argument stating, “[n]o event identifies the proceedings as ‘substantially’ complete; the proceedings are either complete or they are not. Similarly, the absence of collection activity is, by its own terms, not an event.” Therefore, Taxpayers were not entitled to increase their basis for 1991 and claim additional loss deductions.

 

October 20, 2004

387 F. 3d 27

 

            Taxpayer, received pass through tax benefits from his S corporation up through the date Taxpayer filed for bankruptcy. After filing for bankruptcy, the Trustee sold Taxpayer’s property causing Taxpayer to realize a gain of over $2,000,000.00. Taxpayer argued that filing for bankruptcy terminated the S-election and that the subsequent sale should not be passed along to him. 

 

An S corporation terminates if: (1) more than fifty percent of the corporation’s shareholders vote to revoke the election; (2) the business ceases to be a small business corporation; and (3) the business’s passive investment income exceeds 25 percent of gross receipts for three consecutive years. (26 U.S.C. § 1362 (d)). Taxpayer argued because the Trustee took control of the company for the benefit of its creditors, Taxpayer was not the real owner. Taxpayer stated that this transfer of power over the assets, left the S corporation with new shareholders – the corporate creditors – who were not individuals, and this generated more than one class of stock because the creditors had different rights and preferences in the corporation.  

 

Despite this creative argument, the court rejected this statement because the Trustee nor the creditors actually displaced the Taxpayer as the sole shareholder. In its holding the court stated:

 

“any income of the estate in a bankruptcy case, with certain exceptions not asserted as relevant here, may be taxed only as though such case had not been commenced…reinforcing the view that a Chapter 11 bankruptcy filing does not change the tax relationship between a debtor corporation and its shareholders.”

 

            Therefore, any income and obligations there from received by the S corporation due to a sale of assets were passed onto to Taxpayer. 

 

 

July 28, 2008

Revenue Ruling 2008-42

 

            This Revenue Ruling addresses the impact that life insurance policy premium and benefits have on an S corporation’s accumulated adjustment account (“AAA”). Under the contemplated facts, Employee was a highly compensated employee of the S corporation. The S corporation took out a life insurance policy on Employee to cover expenses the company would incur if the Employee died. The S corporation paid all of the premiums for Employee and upon Employee’s death, received the benefits of the policy.

 

            The Revenue Ruling held that premiums paid by the S corporation do not reduce the AAA. Section 264(a)(1) provides that no deduction is allowed for premiums paid on any life insurance policy if the taxpayer is directly or indirectly a beneficiary under the policy. Specifically, section 1.264-1(a) states that premiums paid on the life of any officer, employee, or person financially interested in a business carried on by the taxpayer are not deductible where the taxpayer is directly or indirectly a beneficiary of the policy.  

           The Revenue Ruling further held that benefits received by the S corporation did not increase the AAA because the employer-owned policy meets a Section 101(j)(2) exception. Specifically, a Section 101(j)(2) exception exists to any amount received by reason of the death of an insured who, with respect to an applicable policy holder (i) was an employee at any time during the 12-month period before the insured’s death, or (ii) is, at the time the contract is issued a director or a highly compensated employee within the meaning of Section 414(q).

 

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