Tax and Estate Planning with S Corporations

A.     Introduction

Although LLCs and partnerships possess attractive tax attributes, the fact remains that in 2004, 48.1 percent more returns were filed by S corporations than were filed by entities taxed as partnerships. An S corporation is a domestic small business corporation with respect to which an election has been made. The S corporation passes through to its shareholders items of income, gain, loss, deduction and credit in proportion to their ownership interest.

S corporations and partnerships share common tax and legal attributes. Contributions of property to both in exchange for an ownership interest are generally tax-free. Both are tax “conduits” which pass entity income through to owners. The character of income of both is determined at the entity level. Owners of both (except for the general partner of a partnership) are insulated from entity liability. However, the partnership’s existence as a separate taxable entity is more ephemeral than that of an S corporation. IRC §701 provides that a partnership “as such shall not be subject to the income tax imposed by this chapter.” A single member LLC is entirely disregarded for federal income tax purposes. Subchapter S does not go so far: IRC §1363 states only that “[e]xcept as otherwise provided . . . an S corporation shall not be subject to the taxes imposed by this chapter.”

B.     Stock Basis and Reporting Gain

An S corporation shareholder has both stock basis and debt basis. At the close of each taxable year, stock basis is increased by the shareholder’s share of income items; and decreased by the shareholder’s share of (a) nontaxable distributions; (b) nondeductible expenses; and (c) loss and deduction items. Distributions will generally be nontaxable provided the shareholder has sufficient stock basis. Distributions exceeding basis are taxed as capital gain. Therefore, having reported a pro-rata share of income, which results in a basis increase, subsequent distributions generally incur no further tax. However, the shareholder must report income without regard to whether the S corporation actually distributes anything. Distributions sufficient only to cover the shareholder’s current tax liabilities are termed “tax distributions”.

Distributions from an S corporation with accumulated earnings and profits (which can arise only when a C corporation converts to an S corporation) involve the Accumulated Adjustments Account (“AAA”), which represents undistributed income. The effect of the computation procedure is to treat as dividends that part of the distribution which reflects the accumulated earnings and profits of the predecessor C corporation.

C.     Debt Basis

Although partners (and LLC members) receive basis for their share of partnership debt under IRC §752(a), no correlative provision exists in Subchapter S. For this reason (and also for reasons relating to liquidations) LLCs are preferable to S corporations for real estate investments.

A shareholder’s share of S corporation losses and deductions is deductible to the extent of the shareholder’s combined stock basis and debt basis. While S shareholders do receive debt basis for their loans made directly to the S corporation, a shareholder’s mere guarantee of a bank loan to the corporation will not result in debt basis. Therefore, instead of merely guaranteeing a bank loan, the shareholder may prefer to borrow the money from the bank directly and then, in a separate transaction, loan the funds to the S corporation. (However, even if the shareholder has sufficient stock and debt basis, losses may be disallowed under IRC §465(a) to the extent the shareholder (or the S corporation itself) is not “at risk” with respect to the activity.)

D.      Permissible Shareholders

In 2004 the number of permissible S corporation shareholders was increased to 100. Since members of a “family” are treated as a single shareholder, and that term includes ancestors and lineal descendants, and current and former spouses of lineal descendants and ancestors, the 100-shareholder limitation is in some respects a paper tiger.

The Code prohibits S corporation stock ownership by C corporations, partnerships, multi-member LLCs, or other business entities. Only U.S. residents, certain trusts, certain estates, certain other S corporations, and single member LLCs, may own S corporation stock. The effect of an ineligible person owning S stock is that the S election is voided, likely with adverse tax consequences. However, relief may be available if an inadvertent S termination occurs. Since a nonresident may not own S corporation stock, the intended investment might be accomplished by the nonresident investing in a separate LLC together with the S corporation.

Four types of trust may own S corporation stock: (i) grantor trusts; (ii) testamentary trusts; (iii) qualified subchapter S trusts (QSSTs); and (iv) electing small business trusts (ESBTs).

A grantor trust is a trust deemed to be owned by the grantor under IRC §§671-678. A grantor trust is effectively disregarded for federal income tax purposes because its income is taxed to the grantor. Therefore, transfers of S corporation stock to a wholly owned grantor trust should not jeopardize the S corporation election.

Testamentary trusts may own S corporation stock for the two-year period beginning on the date the stock is transferred to the trust. Following that two-year period, the trust must qualify as a QSST, an ESBT, or a grantor trust for the S election to continue. During the two-year period in which the trust owns S corporation stock, tax must be paid by the trust itself if no other person is deemed to be the owner for federal income tax purposes.

A qualified subchapter S trust (QSST) is a domestic trust with only one income beneficiary (a U.S. citizen or resident) during that beneficiary’s life (unless each beneficiary has a separate share of the trust). To become a QSST, the beneficiary must make a QSST election. The current income beneficiary reports all items of S corporation income. The QSST instrument must provide that (i) distributions of principal may be made only to the current income beneficiary during that beneficiary’s lifetime; (ii) no person other than the beneficiary may be entitled to distributions of income or principal during the trust term; (iii) no payments may be made from the trust which discharge another person’s obligation to support the income beneficiary; (iv) the income beneficiary’s interest shall terminate at his death or at an earlier fixed time; and (v) if the QSST terminates during the current income beneficiary’s lifetime, all assets must be distributed to him.

The fourth eligible trust is an electing small business trust (ESBT), which may qualify if it has only individuals, estates, or qualified organizations as present, remainder or reversionary beneficiaries. Three significant limitations apply: First, a trust cannot qualify as an ESBT if any person acquired an interest in the trust by purchase; second, each potential current beneficiary must be an eligible S corporation stock shareholder; and third, the trust cannot be a charitable remainder trust or otherwise exempt from income tax. While it is somewhat easier for a trust to qualify as an ESBT rather than a QSST, there is a trade off:  a flat tax of 35 percent is imposed on the ESBT’s taxable income attributable to S corporation items.

E.       One Class of Stock Rule

An S corporation may have only one class of stock. In practical terms, this means that the legal and tax flexibility afforded by the partnership form must be foregone if the decision is made to incorporate and elect S status. However, the apparent harshness of the one class of stock rule is tempered by the fact that differences in voting rights are disregarded in applying the rule. Therefore, in an estate planning context, if both voting and nonvoting shares exist, the nonvoting shares (which may be discounted for transfer tax purposes) could be sold or given to family members without loss of control by the parent over the business. If only voting shares exist, the transfer could be preceded by a tax-free recapitalization into voting and nonvoting shares.

Determining whether the single class of stock rule has been satisfied begins with an inquiry into the corporation’s governing provisions, which include the corporate charter, bylaws, and agreements. However, the governing instruments themselves may not be dispositive with respect to the issue of whether only a single class of stock exists: If an event occurs which indicates the existence of a second class of stock, S corporation status may be nullified. For example, a disproportionate distribution would indicate a second class of stock. So too would a constructive distribution, which could occur where a shareholder receives unreasonably high compensation. Even shareholder loans to the corporation may be reclassified as a second class of stock if the loan resembles equity. To avoid recharacterization the debt owed to shareholders should be (i) in proportion to stock holdings or should be (ii) “straight debt” (i.e., a written, unconditional obligation to pay a sum certain on demand or at a specific date for a fixed rate of interest).

F.     Electing S Status

All shareholders must consent to an S election. Once made, the election is effective for the taxable year following the year of election, except that an election made within the first two and a half months of a year will be effective for that taxable year. A separate election must be made with the NYS Department of Taxation. A partnership wishing to avail itself of S corporation status would first convert to a C corporation and then elect S status.

Electing S corporation status will not operate to negate inherent gain before the S election was made. IRC §1374 imposes tax on “built in gains,” during each of the ten years following the S election. Built-in gains are gains attributable to taxable years before the S election was made. Any disposition, whether it be by sale or by distribution to shareholders, will trigger this gain. IRC §311(b); §1375(d)(2)(A).

Two other provisions may also discourage an existing C corporation from making an S election: First, IRC §1363(d) operates to recapture as ordinary income certain inventory. Second, IRC §1375 imposes a penalty tax on “accumulated earnings and profits” which preceded the S corporation election, if the the S corporation’s “passive investment income” exceeds 25 percent of its gross receipts. The penalty operates to impose the highest IRC §11 rate of tax (currently 35%) on the corporation’s “excess net passive income”. If the IRC §1375 penalty tax is imposed for three consecutive years, the S election is revoked.

An election may be terminated by (i) agreement among the shareholders; (ii) operation of law if the corporation ceases to qualify as a small business corporation; or (iii) as noted, if the S corporation has earnings and profits for three consecutive years and, during those years derives more than 25 percent of its gross receipts from investment income.  IRC §1362(d)(3).

G.     Other Considerations

S corporation shareholders risk losing certain employment benefits if their stock holdings become too great. Thus, if an employee owns more than two percent of the S corporation’s stock, he may no longer receive certain employee benefits tax-free. IRC §1372(a). Some benefits not excludable from income by a two percent shareholder rule include the cost of health insurance (IRC §§105 and 106), meals and lodging furnished for the convenience of the employer (IRC §119), and cafeteria plans (IRC §125).

One significant advantage of operating a one-person business as an S corporation rather than a single member LLC or a sole proprietorship relates to self-employment tax. While salary paid to the sole shareholder of an S corporation is subject to employment tax, other operating income is not. Rev. Rul. 73-361. A recent Treasury report found that the percentage of S corporation profits paid to sole shareholder-employees was 41.5 percent in 2001. (Statement of J. Russell George, Treasury Inspector General for Tax Administration; Senate Finance Committee (May 25, 2005). The Joint Committee on Taxation estimated that treating all net income from partnerships and S corporations as self-employment income would generate revenues of $57.4 billion from 2006 through 2014. (Options to Improve Tax Compliance and Reform Tax Expenditures (JCS-02-05) (2005) at 426). The rules relating to estimated tax payments may also be less burdensome for a business operating as S corporations rather than one operating as a sole proprietorship.

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