We highly recommend speaking to an attorney if you have any legal concerns. 22 The ESOP purchased 5,000 shares of UMLIC - S stock. Z, a single-member LLC, acquired portions of the stock in corporations W, X, and Y, all of which had previously made timely S corporation elections at incorporation. S corporations are flowthrough entities, 1377(a)(2) and Regs. However, Congress eliminated the use of ESOPs for closely held S corporations, effective in 2005. transaction date. The effect of the election is to treat the CFC GILTI inclusion amount as an item of income of the S corporation itself, increasing AAA and shareholder stock basis. However, there is an exception known as the timing difference.. that he or she will not be allocated income earned after does not apply when a new shareholder is admitted or The taxpayers contended, based on a rescission theory, that the "surrender" transaction effectively negated and reversed $42 million of their compensation income. The IRS describes the source rule for an S corporation with AE&P: AAA, previously taxed income (PTI) (rarely applicable), AE&P, OAA, return of capital, and capital gain. SBs total With respect to preparing returns of S corporations, certain new requirements went into effect for the 2020 tax year (relating to Schedule B-1/K-1 reporting), and others will commence in 2021 (international reporting). The premise of it all is to correct and take action by equalizing the distributions once the error has been recognized. When there are Because this rule differs from that currently applicable to distributions made by a corporation during the entity's PTTP, the final regulations revise those rules, as well, to be consistent with the rules applicable to distributions during the ETSC period. You would not pay any payroll or self-employment tax on the $40,000 distribution, saving you around $6,000. If the years results were known The IRS advises examiners of common errors made by taxpayers in their computation of AAA, for example: The IRS also advises its examiners that a significant difference between retained earnings and AAA is an indication of the existence of positive AE&P, that an S corporation may estimate its AE&P based on retained earnings as of its last C year, and that the duty of consistency precludes an S corporation from changing the character of distributions reported in closed statute years from nondividend to dividend. Sec. Sec. No increase to AAA is made for any GILTI inclusion. This Although neither the loan nor the forgiveness would create shareholder basis, would the nondeductible expenses reduce basis? However, shareholders that are not required to include a GILTI amount in income (for example, because they do not meet the 10% threshold) will not increase their stock basis until and unless the CFC distributes a dividend to the S corporation. The taxpayers owned all of the stock of LB Education Corp. (LB), an S corporation. differently, when this is compared with a situation of no Sec. The examples above If a corporation makes distributions to some shareholders and not others because of a misunderstanding of the regulations, the exception applies as long as there is a determination that there was only one class of stock to begin with. On Jan. 1, 2004, the restrictions on the five-year earnout agreement lapsed and the shares became substantially vested. ownership in the S corporation after the transfer In However, if the change of ownership takes place in the middle of the tax year, taxing an S corporation becomes much more difficult. Three months later, the taxpayers attempted to reduce their tax liability on the $46 million of income they each would have to recognize under Sec. 3d 1018 (D. Or. Transition AE&P is also not increased for any transactions or entity classification elections after Sept. 1, 2020, and it cannot be transferred in any corporate transaction. 1368, an S corporation's distribution of cash or property may give rise to three possible tax consequences to the recipient shareholder: a tax-free reduction of the shareholder's basis in the corporation's stock, 1 a taxable dividend, 2 or gain from the sale of the stock (generally resulting in capital gain). We decided to do the close the books election. In order for the shareholder to determine whether the distribution is non-taxable they need to demonstrate they have adequate stock basis. All rights reserved. undergo ownership changes, tax elections are available to 1362 describes the procedures for electing or revoking S corporation status. Taxable They do make tax-free non-dividend distributions unless the distribution exceeds the shareholder's stock basis. 2021-20 that fiscal-year taxpayers who filed a 2020 return on or before Dec. 27, 2020, can deduct eligible expenses on their 2021 return, rather than filing an amended 2020 return. Sec. Michael Koppel is with Gray, Gray & Gray, LLP, in The TCJA provided two generally favorable provisions applicable to ETSCs. 163(j) (the 2020 final regulations) addressing what constitutes interest for purposes of the Sec. 962 election to S corporations might require legislative action, such an election would further simplify reporting for shareholders. Improper inclusion of tax-exempt income and related expenses in AAA; Failure to reduce AAA by other nondeductible expenses; and. A shareholder who had insufficient basis to deduct losses while the S election was in effect may acquire additional basis by cash contributions to the capital and use that additional stock basis to deduct losses suspended before the S election terminated (Sec. 481(d)) after the PTTP, AAA is allocated to the distribution, and the distribution is chargeable to AE&P, in the same ratio as the amount of AAA bears to the amount of AE&P. At that time, the corporation has completed all of the substantive requirements for forgiveness. corporations tax year. S Corporation Distributions. rather, they should be viewed as a means to bring lesser known election under Regs. Partnerships or S corporations may apply the rules described in the notice to specified income tax payments made in a tax year of the partnership or S corporation ending after Dec. 31, 2017, and made before Nov. 9, 2020, provided that the specified income tax payment is made to satisfy the liability for income tax imposed on the partnership or S corporation pursuant to a law enacted prior to Nov. 9, 2020. income for the entire year (January 1, 2010December 31, The district court held that the negative balance in the AAA should have no tax significance after a corporation has terminated its S corporation status. Example 1: S Corporations need to carefully monitor distributions to shareholders to make sure there are no disproportionate distributions. Confirm that an S corporation can simultaneously make both pro rata distributions according to current stock ownership and other distributions that meet the varying interest rule without creating a second class of stock. The trade-off for the exclusion seemed to be that the wages and other expenses paid with the proceeds from the canceled loans would not be deductible.11 The IRS based this position on Sec. Sec. The statute does not specifically address other entities, such as not-for-profit corporations. a single termination during the year): one before the On Nov. 9, 2020, the IRS issued Notice 2020-75, which announces that Treasury and the IRS intend to issue proposed regulations to clarify that certain state and local income taxes imposed on and paid by a passthrough entity, such as a partnership or an S corporation, are allowed as a deduction by the partnership or S corporation in computing its nonseparately stated taxable income or loss for the tax year of payment. Differences in voting rights are disregarded.2 The determination of whether all outstanding shares meet this condition is based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (collectively, the "governing provisions"). Regs. Built in New York, USA. Distributions made after the sale to the 2 remaining shareholders were pro rata (we assume) to these 2 shareholders' ownership. 1.1368-1(g) is The CAA reiterated the rule that forgiveness of loans is exempt from tax.14 However, the CAA specified that forgiven loan amounts are tax-exempt income, within the meaning of Secs. the place to be if you want to be part of a wonderful community of practitioners. Two other cases involved whether to recharacterize income of certain S corporation shareholders. 1377(a)(2) I thought this was going to be simple, but I can't find a definitive answer to my questions on the interwebs. allocate income and expenses to shareholders to take into Through exam, the IRS disallowed the losses reported by the S corporation and claimed by the taxpayer for the 2009 tax year; made correlative adjustments to the 2006 and 2012 NOL deductions; and determined deficiencies for 2006 and 2012. With respect to a S-Corporation maintaining only one class of stock, the general rule is that distributions from S-Corporations to shareholders should be proportional to each shareholder's ownership interest. the election when negotiating the transaction, rather than The legal fees were deemed personal and not business legal fees; and. These were unilateral transactions in which the properties were placed in the trusts without any involvement from the beneficiaries. forums, across a wide range of topics. (See the "no-newcomer" rule discussed under Sec. In spite of a statutory rule Sec. )38 The effective date of the new rule is for tax years beginning after Oct. 20, 2020. The final GILTI regulations covered the determination of pro rata shares of income inclusions but did not completely address their application to passthrough entities. If you choose to be taxed as an S Corporation, you could say that your salary is $50,000 and take the other $40,000 out of your business as a distribution. Now compare the court's reasoning in this case with the government's opinion in FSA 200230030 that basis can be negative. S (seller) and See Exhibit 3. The taxpayers formed UMLIC Holdings LLC (Holdings) in which they each held a 50% interest. 1.1368-1(g) election is its availability in situations Unless However, on their joint individual income tax returns for the years at issue, the taxpayers reported the income as qualified dividend income. Over the 12-month period ending March 2021, these sections and others affecting S corporations have been addressed by recent legislation, court cases, and IRS guidance. In addition, the corporation must furnish information to each shareholder. The following 108(a), there is no adjustment to shareholder basis.32 The CARES Act stated that the forgiveness would not be taxable.33 The CAA specified that forgiven loan amounts are tax-exempt income, within the meaning of Secs. Later in 1998 (after employee stock ownership plans (ESOPs) became eligible S corporation shareholders), the taxpayers caused UMLIC-S to form an ESOP for its employees, including the taxpayers.22 The ESOP purchased 5,000 shares of UMLIC-S stock. All rights reserved. From an accounting viewpoint, this position made sense: Gross income deduction = Exclusion nondeductible expense. However, they are subject certain restrictions, including a requirement that they only have one class of stock. likely just forgo making it because the income allocated S corporations, when compared to other pass-through entities, are relatively user friendly. 26McKenny, 973 F.3d 1291 (11th Cir. The mere difference in timing does not cause the corporation to be treated as having more than one class of stock. The AICPA recognizes that there might need to be additional reporting at the S corporation level to enable the IRS and shareholders to keep track of this special provision. 2019). consisted of two tax years (or more if there is more than Fourteen sections of the Internal Revenue Code are central to the taxation of Subchapter S corporations and their shareholders. This was the case even though the LLC elected S status at the time of its formation. making or forgoing the election. Deciding whether the election Example 3, Ss *Disclaimer: this blog post is not intended to be legal advice. The election, which is irrevocable for all future years, must state: The return, including Schedules K-1 and Form 8992, U.S. Always 100% free to join, and Like agreeing to I think you might be thinking of a Post Termination Transition Period, which applies after the termination of an s-election. OAA has no legal significance; its only purpose, according to the IRS, is to help the S corporation determine the source of the distribution that is not from AAA, PTI, or AE&P. The Tomseth decision would appear to call the reasoning of the FSA into question. Copyright 2023 EPGD ATTORNEYS AT LAW, P.A. involved to address and sign the election on or very close The corresponding variables There will be an 164(b)(6) at the individual level. However, certain partners have special relaxation rules for 2019. 2017-69. Moreover, the taxpayer did not sustain the burden of proof that Clark applied to the facts of the case. Furthermore, Schedule K-1 (Form 1120-S) also requires reporting of the beginning and ending number of shares held by each person. S distributes $50,000 to A in the current year, but does not distribute $50,000 to B until one year later. Unless the time difference of distribution was done pursuant to a binding agreement relating to the distribution or liquidation proceeds, it is not effectively considered to be a difference in shareholders rights. Among these are the overall rules requiring taxpayers to maintain books and records to substantiate business deductions. Dont get lost in the fog of legislative changes, developing tax issues, and newly evolving tax planning strategies. The items are arranged by Code section and often contain a short description of the relevant provision. The IRS issued a notice clarifying GILTI inclusions of S corporation shareholders. Therefore, Treasury does not have the authority to disallow basis to partners or shareholders, or to disallow deductions for payments resulting from forgiven loan proceeds, under any current or prospective PPP loan forgiveness law.17. An often-used provision within this section provides relief for corporations that have failed to meet eligibility requirements, either at the time of the S corporation election or after the election took effect. S Corp Distributions after change of ownership, https://www.facebook.com/groups/BenRoberts/, viewtopic.php?f=8&t=13381&p=121399#p121399. Disproportionate distributions - S-Corporations must make distributions on a pro-rata basis based on ownership percentages - the exception may be a change of ownership Debt cannot appear to be equity or convertible (terms cannot be contingent on profits Stock should not be pledged to ineligible shareholders 250 deduction is allowed for any GILTI inclusion amount. Said Tax Section membership will help you stay up to date and make your practice more efficient. The entity election for GILTI inclusion amounts is being made; and. election, not everyone will save taxes because an election It may amount to receiving a taxable dividend. However, this provision applies only to PPP loans and does not apply to any other COD income exclusions.20. Notice 2020-69 announced Treasury and the IRS's intention to issue regulations for S corporations with AE&P and provided an election for S corporations with AE&P to elect "entity" treatment of GILTI. Sec. In The suit was settled in 2009 for $800,000. than if a Sec. would have no incentive to agree to make the election This through March 31 was $500. Contacting us through our website does not establish an attorney-client relationship. In Liu,25 the Tax Court recharacterized as ordinary income certain qualified dividend income reported by a married couple with respect to their ownership in an S corporation. these elections and addresses why tax advisers should Certain changes have gone into effect for 2020 returns, and others will begin in tax year 2021. books to allocate income and expense disproportionately to shareholders to be allocated income earned only while they associated with CPAmerica International. only make with hindsight. Effect of the CARES Act and CAA: In general, a shareholder in an S corporation includes tax-exempt income of the corporation in adjusting basis for a tax year.31 However, if an S corporation excludes COD income under Sec. The regulations generally adopted an "aggregate" approach for both partnerships and S corporations. "No part of the net earnings of the Organization shall inure to the benefit of, or be distributable to its directors, officers or other private persons.". The court noted that the Clark case has never been applied by the court and is limited to malpractice related to tax preparation, which does not include the planning and advice services provided by the CPA firm. For example, if a calendar-year S corporation made the election for 2020 and distributed all transition AE&P before Jan. 1, 2021, it would use the aggregate method for 2021. allocation could be $250 or $86.30, depending on whether a At the end of 1998, the two taxpayers each owned 47.5% of the corporation, and the ESOP owned 5%. 1366 in determining the partner's or S corporation shareholder's own federal income tax liability for the tax year. 163(j) limitation, which taxpayers and trades or business are subject to the limitation, and how the limitation applies in certain contexts (e.g., consolidated groups and passthrough entities such as S corporations and partnerships).43 The 2020 final regulations generally apply to tax years beginning on or after Nov. 13, 2020. The IRS said in Rev. The courts held that the restricted stock received by the taxpayers in 1998 was subject to a substantial risk of forfeiture (and was presumably nontransferable) at that time due to the five-year earnout agreement and thus was substantially nonvested.23 As a result, the taxpayers were able to defer the compensation income from the receipt of the restricted stock until the stock became substantially vested (namely, when the restriction lapsed) on Jan. 1, 2004. 1367(a)(2) requires that a shareholder reduce basis for losses, deductions, and nondeductible expenses, but does not condition the reduction of basis to this shareholder claiming the losses on a tax return. Sec. 2Secs. 2010) is $2,028. 2020), aff'gAustin, T.C. For many business taxpayers, the limit on the deduction of business interest expense is: For all taxpayers affected by the restriction, except for partnerships, the CARES Act increased the limit from 30% of ATI to 50% of ATI for the year 2019. Taxpayer failed to substantiate expenses: In Sellers,41 the taxpayer owned various entities in both an S corporation and partnership structures. Enjoy! Provide appropriate transition rules relating to the Notice 2020-69 election, which is restricted to only certain S corporations; Issue further guidance on how best to administer the aggregate method; Allow all S corporations to elect an entity method; and. After the end of your S corporation's tax year, the corporation must send you and every other shareholder a Schedule K-1, Shareholder's Share of Income, Deductions, Credits, etc. The draft Schedules K-2 and K-3 intend to standardize the way an S corporation reports international tax information to shareholders, offering greater transparency to the IRS and clarity to both S corporations and their shareholders. The updates are intended to provide greater clarity for shareholders on how to compute their U.S. income tax liabilities with respect to international tax matters, including how to compute deductions and credits. Shareholder Calculation of Global Intangible Low-Taxed Income (GILTI), must be consistent with the election. 25% of the previously outstanding stock to one or more new The new draft schedules are lengthy and complex. Tax Section membership will help you stay up to date and make your practice more efficient. Eric P. Gros-Dubois founded EPGD Business Law in 2013 and is the current head of the firms corporate, estate planning, and tax practice, and manages the firms Washington D.C. office. Any specified income tax payment made by a partnership or an S corporation is not taken into account in applying the SALT deduction limitation to any individual who is a partner in the partnership or a shareholder of the S corporation. detrimental tax consequences by an equal amount. On March 15, 2021, the AICPA Tax Executive Committee sent a letter to IRS Associate Chief Counsel's office recommending that an S corporation should recognize the forgiveness of a PPP loan when it has made the required expenditures from the loan proceeds. election, S I don't read through all these comments but I have a client with a similar issue for 2019. Enter the Beginning Date. In contrast, the lesser-known The units examine the proper determination of the S corporation's items of income, loss, deduction, and distribution amounts; and the amount of the corporation's AE&P as well as shareholder stock basis (in particular the requirement that shareholders maintain adequate books and records to substantiate stock basis). If a partnership or an S corporation makes a "specified income tax payment" during a tax year, the partnership or S corporation is allowed a deduction for the specified income tax payment in computing its taxable income for the tax year in which the payment is made. In In order to preserve the advantages to the majority shareholders of the aggregate method, shareholders should be permitted to make a Sec. The Tax Court held that Deckard had no beneficial ownership rights as a shareholder under state law and the articles of incorporation because Waterfront's articles of incorporation provided, among other things, that: Deckard was thus prohibited from making an S election for Waterfront and was not permitted to claim any losses of Waterfront on his individual return. Later in 1998 (after employee stock ownership plans (ESOPs) became eligible S corporation shareholders), the taxpayers caused UMLIC - S to form an ESOP for its employees, including the taxpayers. A shareholder is able to acquire basis of an S corporation by purchasing stock. The IRS issued a notice of deficiency recharacterizing the losses as passive and denied the deduction for self-employed health insurance. The taxpayer timely filed a petition with the Tax Court. Because the S corporation and the LLC owned the liquidating trusts beyond the close of the 2009 tax year, the losses reported by the S corporation and claimed by the shareholder for 2009 were not bona fide dispositions and not "evidenced by closed and completed transactions, fixed by identifiable events, and actually sustained during" that year pursuant to Regs. 57-47. The final regulations apply the PTTP distribution rules to all shareholders. Sec. a Sec. of the corporations outstanding stock, or (3) there is an "10 However, the forgiveness of debt under the PPP posed additional questions and issues. 1371 and 1377(b): Post-termination transition period. Ask or answer questions in our The shareholders receive distributions of $5,000 each. Deckard subsequently filed a retroactive S corporation election for Waterfront and attempted to claim operating losses for 2012 and 2013, as he had funded approximately $275,000 of Waterfront's expenditures via capital contributions. or to forgo the election. his or her complete interest in the S corporation. Under Sec. However, it was politically unpopular. If the parties had not previously agreed to make A governing provision does not alter the rights to liquidation and distribution proceeds merely because it provides that, as a result of a change in stock ownership, an S corporation makes distributions in a tax year on the basis of the shareholders' varying interests in the S corporation's income in the current or immediately preceding tax year. A new final regulation applies to S corporations that operate a mixed-funds investment in a qualified opportunity fund. the fact. The corporation also must provide each shareholder with an accompanying set of Shareholder's Instructions for Schedule K-1. After the period ends, the corporation is to prorate distributions between the corporation's accumulated adjustments account (AAA) and accumulated earnings and profits (AE&P), based on the ratio of AAA to AE&P. 14 An eligible terminated S corporation that changes from the cash to the accrual method of accounting may use a six - year period in interest, the availability of an election under Sec. Memo. In the S corporation context, uncertainties included: There were no apparent unambiguous answers to these and other issues. With respect to a S-Corporation maintaining only one class of stock, the general rule is that distributions from S-Corporations to shareholders should be proportional to each shareholders ownership interest. This article discusses some procedural and administrative quirks that have emerged with the new tax legislative, regulatory, and procedural guidance related to COVID-19. Dont get lost in the fog of legislative changes, developing tax issues, and newly evolving tax planning strategies. The total of pre-change income and post-change income is S corporations, in general, do not make dividend distributions. You would pay standard payroll tax on that $50,000 for a total of around $7,500. Final regulations issued on PTTP: After an S corporation terminates its S election and becomes a C corporation, there is a post-termination transition period (PTTP). increased likelihood for conflict between the two parties At the end of 1998, the two taxpayers each owned 47.5% of the corporation, and the ESOP owned 5%. Because Sec. Example 1, Ss Sec. apparent why an adviser should get the parties to address Read ourprivacy policyto learn more. The IRS requires attachment of this schedule to Form 1120-S even if the reporting shareholder's TIN appeared on Schedule K-1 (Form 1120-S). Required fields are marked *. less in this case than if the election were forgone. Special rules apply for S corporations that were unaware of the termination until a subsequent audit. In 2012, Clinton Deckard organized Waterfront Fashion Week Inc. (Waterfront), a nonstock, not-for-profit corporation under Kentucky law. Since ESOPs are tax-exempt retirement plans and taxation only occurs upon distribution to the beneficiaries, the McKennys would pay no tax on the S corporation's earnings. Section 1361 of the Internal Revenue Code requires that a S-Corporation obey the following restrictions in order to be qualified and treated as an S-Corporation. If the amount invested in a QOF exceeds the amount of eligible gain, then the taxpayer may have a nonqualifying investment for the amount of gain in excess of eligible gain invested in the QOF and a qualifying investment for the amount of eligible gain invested in the QOF. calculated based on their ownership on each day in the The notice applies to S corporations that hold stock in controlled foreign corporations. With respect to the latter provision, two issues from the final regulations are worth highlighting. The taxpayer had direct control over all of the entities but did not present any of those records at trial to substantiate material participation, basis in the entities, or the cost of the health insurance paid by the S corporation on his behalf. How might these problems be compounded if the expenses were paid in 2020 and the forgiveness occurred in 2021? method. Final regulations issued: In July 2020, the IRS and Treasury released final regulations under Sec. EPGD Business Law is located in beautiful Coral Gables, West Palm Beach and historic Washington D.C. can often be overlooked. The IRS concluded that Z's ownership of W, X, and Y caused an inadvertent termination of those corporations' S elections.