By Andrew M. Brajcich, CPA, J.D., LL.M.; Kristin Hill, CPA; Robert W. Jamison Jr., CPA, Ph.D.; Robert S. Keller, CPA, J.D., LL.M.; Kirk T. Mitchell, CPA; Kenneth N. Orbach, CPA, Ph.D.; Tony Nitti, CPA; Kevin J. Walsh, CPA, CGMA; and Jonathan Williamson, CPA
Fourteen sections of the Internal Revenue Code are central to the taxation of Subchapter S corporations and their shareholders. 1 Over the 12-month period ending March 2023 covered by this article, several of these sections and others affecting S corporations have been addressed by recent legislation, court cases, and IRS guidance. The AICPA S Corporation Taxation Technical Resource Panel, a volunteer group of practitioners who pay close attention to matters affecting S corporations and their shareholders, offers the following summary of recent developments relating to this tax area. The items are arranged by Code section (starting with those in Subchapter S and then other sections) and often contain a short description of the relevant provision.
Sec. 1362: Election; revocation; termination
Sec. 1362 describes the procedures for electing or revoking S corporation status. It also states some rules for terminating S corporation status if the corporation fails to meet one or more of the eligibility requirements of Sec. 1361. Sec. 1362(g) restricts S corporations for which the S election has been terminated from reelecting S corporation status before the fifth tax year after the year of termination, unless the IRS consents to a new election. 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.
Certain relief under Sec. 1362 requires a taxpayer to submit a request for a private letter ruling. User fees for these letter rulings are updated annually. The user fees prescribed by Rev. Proc. 2023-1 for a private letter ruling request submitted after Feb. 2, 2023, were unchanged from those of the previous annual period. 2 However, taxpayers considering requesting a letter ruling for an inadvertent S election termination should review Rev. Proc. 2022-19 for potential relief.
Rev. Proc. 2022-19 adds new relief rules for S corporations: In October 2022, the IRS issued Rev. Proc. 2022-19, dealing with frequently encountered issues concerning the validity of S corporations. Historically, private letter rulings, which are costly for taxpayers and administratively burdensome on the IRS, have often been used to seek relief for noncompliance with S corporation requirements. Rev. Proc. 2022-19 attempts to provide taxpayers with certainty in six areas without having to use private letter rulings. 3 3 These areas include common issues regarding the one-class-of-stock rule and procedural corrections for certain inadvertent errors or omissions.
Sec. 1361(b)(1)(D) provides that an S corporation may not have more than one class of stock issued. For purposes of determining whether more than one class of stock has been issued, voting rights are disregarded. 4 Distribution and liquidation rights, however, must be uniform across all shares. 5
Under Rev. Proc. 2022-19, the IRS will not terminate a corporation’s S status for violating the single-classof- stock requirement through rights arising in certain agreements or arrangements, so long as there is no principal purpose to circumvent the single-class requirement. 6 The taxpayer’s principal purpose is a question of fact. As such, Rev. Proc. 2022-19 states that the IRS will not provide a ruling on a taxpayer’s principal purpose, 7 potentially leaving taxpayers with uncertainty and the inability to seek some level of assurance through the ruling process.
Additionally, Rev. Proc. 2022-19 provides that the IRS will not treat any disproportionate distributions as violating the one-class-of-stock requirement when the governing provisions of the corporation provide for identical distribution and liquidation rights. 8 This position is consistent with the Tax Court’s decision in Mowry, 9 where unauthorized disproportionate distributions to a majority shareholder did not invalidate the S corporation election. In that case, the IRS was in the unusual position of arguing for maintaining S status in what seems to have been an effort by the government to stay out of a shareholder dispute. The question raised by this position in Rev. Proc. 2022-19 is, at what point, if any, are the distributions too disproportionate to continue to maintain S status? The AICPA asked that question in a recent comment letter to Treasury and the IRS. 10
If a governing instrument is inconsistent with the single-class-of-stock rule, referred to as “non-identical governing provisions” in Rev. Proc. 2022-19, the situation is more complicated. 11 A common example of this scenario is a limited liability company (LLC) or limited partnership operating agreement containing partnership tax provisions. Such provisions may appear as boilerplate language in agreements drafted by the uninformed or found online. The IRS has previously ruled that these provisions invalidated or terminated S corporation status; however, the entity could seek to retain its S status under the inadvertent-terminationrelief rules of Sec. 1362(f). 12
When a corporation has a nonidentical governing provision, Rev. Proc. 2022-19 offers retroactive relief if the corporation meets three conditions:
Unlike under earlier revenue procedures dealing with late elections, 14 inadvertent invalid elections, and inadvertent terminations, an S corporation with a nonidentical governing provision may correct this default without filing any request with an IRS Service Center or the National Office. The corporation prepares a statement, signed by a corporate officer, that details the nonidentical governing provision and states the corrective action. It describes the new identical governing provision. It includes a list of all persons who have been shareholders since the nonidentical governing provision took effect until the corporation adopted the new identical governing provision. Each shareholder must attach a statement, signed under penalties of perjury. The corporation retains this documentation in its permanent records. 15
When disproportionate distributions occur in conjunction with nonidentical governing provisions, it appears the corporation is not eligible for the retroactive relief provided in Rev. Proc. 2022-19. In its comment letter, the AICPA recommended that Treasury and the IRS amend Rev. Proc. 2022-19 to provide for retroactive relief when disproportionate distributions are inadvertent.
Also in Rev. Proc. 2022-19, the IRS updated some of its no-rule areas. First, the IRS will not issue “comfort rulings” for any S corporation problem if Rev. Proc. 2022-19 or another pronouncement, such as Rev. Proc. 2013-30, offers relief. Moreover, as mentioned above, it will not rule on the principal purpose of any governing instrument. 16 Therefore, S corporations with nonidentical governing provisions that do not qualify for relief under Rev. Proc. 2022-19 will need to represent that the governing provision in question did not have avoidance of the single-class-of-stock rule as a principal purpose.
Rev. Proc. 2022-19 also outlines procedures on how to address missing shareholder consents, permissible-year errors, missing officer signatures, and other inadvertent errors and omissions, as well as procedures for verifying S or qualified Subchapter S subsidiary (QSub) elections and return filing.
Recent IRS letter rulings provide relief from Sec. 336 late elections: In recent months, the IRS has issued an increasing number of private letter rulings providing relief from late elections under Sec. 336(e). Although the letter rulings 17 do not directly address the reason for the late election, presumably, relief has been necessary in these situations because the target corporation failed to timely file its final tax return for the period ending on the date of sale.
When a taxpayer acquires the stock of a target corporation in a transaction meeting the definition of a “qualified stock purchase” in Sec. 338(d) or a “qualified stock disposition” in Sec. 336(e), the parties may agree to elect to treat the transaction as an asset acquisition for tax purposes, resulting in a stepped-up basis in the acquired assets.
Under Sec. 338(h)(10), the election may only be made when a corporate acquirer purchases the stock of certain types of targets. One such permitted target is an S corporation, and when a purchasing corporation (Purchasing Corporation) acquires the stock of an S corporation (Old Target) in a qualified stock purchase and Purchasing Corporation and the Old Target shareholders make a joint Sec. 338(h)(10) election, the election results in a fictional transaction for tax purposes. 18
First, Old Target is treated as if it sold its assets to a corporation newly formed by the acquiring corporation (New Target) in exchange for the proceeds of the stock sale plus any liabilities of Old Target deemed assumed by New Target. Then, Old Target is deemed to transfer the proceeds from the stock sale to its shareholders in complete liquidation. The sale of stock by Old Target’s shareholders to Purchasing Corporation is disregarded, and Old Target’s S election continues through the end of the acquisition date.
Alternatively, Sec. 336(e) allows an election that results in the same consequences as previously described; as opposed to Sec. 338, however, the Sec. 336(e) election may also be made when the acquirer is not a corporation.
If Old Target is an S corporation, there is often confusion over the due date for its final tax return upon making an election under either Sec. 338(h)(10) or Sec. 336(e). A missed due date for a final return resulting from a Sec. 338(h)(10) election may generate penalties and interest on the unpaid tax liability resulting from the sale. A missed due date for a final return resulting from a Sec. 336(e) election, however, may have catastrophic consequences to the acquirer in the form of an invalid election and lost basis step-up.
As a general rule, a calendar-year S corporation must file its federal income tax return on or before March 15 of the following year. 19 Fiscal-year S corporations must file their returns “on or before the 15th day of the third month following the close of the fiscal year.” 20 To illustrate, an S corporation that has a tax year that ends on June 30 must file its Form 1120-S by Sept. 15. Similarly, if a calendar-year S corporation terminates its year by liquidating on Sept. 9, the final tax return is due by the 15th day of the third month following the end of its fiscal year, or Dec. 15.
Special rules apply, however, to an S corporation when the corporation’s S election is terminated on “a date other than the first day of a taxable year of the corporation.” In this situation, the termination results in an “S termination year,” which consists of the full, uninterrupted tax year of the S corporation. 21 The S termination year is split into an “S short year” and a “C short year.” The S short year starts on the first day of the tax year and ends on the day before the date the S election is terminated. The C short year begins on the date the S election is terminated and ends on the last day of the tax year.
The income for the S termination year is allocated between the S short year and the C short year on a pro rata basis. To accommodate this allocation, the due date for the S short-year return is delayed until the “date by which the return for the C short year must be filed (including extensions).” 22
Example 1: Assume S Co., a calendar-year S corporation, terminated its S election on July 1, 2023, when an ineligible shareholder acquired an interest in the corporation. Pursuant to Regs. Sec. 1.1362-3, the tax return for the S short year from Jan. 1, 2023, through June 30, 2023, is not due until the due date for the C short year, or April 15, 2024.
Many tax advisers have applied the rules of Regs. Sec. 1.1362-3 to determine the due date of the final S corporation tax return for Old Target in a Sec. 338(h)(10) or Sec. 336(e) transaction. This, however, is incorrect and will often result in an untimely filed return.
When an election is made under either Sec. 338(h)(10) or Sec. 336(e), there is no termination of Old Target’s S election. In a letter ruling released Dec. 31, 2004, 23 the IRS concluded that when a Sec. 338(h)(10) election is made, Old Target remains an S corporation until the close of the acquisition date (i.e., the S election remains in effect until the deemed liquidation is complete). Because there is no termination of Old Target’s S election, Regs. Sec. 1.1362-3 does not apply to create an S termination year. As a result, the rules delaying the due date of the final S corporation return also do not apply. The same reasoning should apply to an S corporation target subject to a Sec. 336(e) election.
In addition, as part of the deemed liquidation of Old Target resulting from a Sec. 338(h)(10) election, “the transfer from Old T is characterized for Federal income tax purposes in the same manner as if the parties had actually engaged in the transactions deemed to occur because of this section.” 24 Nearly identical language is found in Regs. Sec. 1.336-2(b)(1)(iii)(A). As a result, in determining the due date for a final S corporation return resulting from a Sec. 338(h)(10) election or a Sec. 336(e) election, one should “follow the fiction” and treat Old Target as if it had liquidated and gone out of existence rather than had its S election terminated. Further evidence for this conclusion is found in the requirement that the stock sale that took place for legal purposes — and would have given rise to a terminating event — is disregarded when a Sec. 338(h)(10) or Sec. 336(e) election is made. Thus, there is no S termination year, and, again, Regs. Sec. 1.1362-3 does not apply.
Instead, the general rule of Sec. 6072 applies. When an S corporation target is acquired in a transaction for which an election is made under either Sec. 338(h)(10) or Sec. 336(e), the due date of the final S corporation return for Old Target is the 15th day of the third month after the end of the month in which the transaction occurs.
Example 2: X Co. Acquires Old Target’s stock on June 30, 2023. X Co. And the shareholders of Old Target jointly file a Sec. 338(h)(10) election. Old Target’s federal income tax return is due on or before Sept. 15, 2023.
A Sec. 338(h)(10) election is to be made by the 15th day of the ninth month after the end of the month in which the qualified stock purchase occurs. 25 The election is made jointly by Purchasing Corporation and the shareholders of Old Target on Form 8023, Elections Under Section 338 for Corporations Making Qualified Stock Purchases, which is filed independent of the tax return. Thus, a late final tax return for Old Target is typically not fatal to making a timely filed Sec. 338(h)(10) election.
A Sec. 336(e) election, however, includes two requirements: 26
Thus, the Sec. 336(e) election is tied directly to the timely filed final tax return of Old Target. As a result, if the final return is not filed by the 15th day of the third month after the end of the month in which the transaction occurs, in addition to the return being late, the Sec. 336(e) election will be invalid, resulting in a costly lost step-up in asset basis to the acquiring corporation. Unfortunately, there currently is no automatic relief procedure for late Sec. 336(e) elections as there is for late Sec. 338(h)(10) elections. 28 Instead, taxpayers seeking to remedy an invalid election under Sec. 336(e) must undergo the costly and time-consuming private letter ruling process.
Sec. 1366: Passthrough of income and losses
The effect of claiming the employee retention credit on items of income and deduction: The employee retention credit (ERC) was a component of the Coronavirus Aid, Relief, and Economic Security Act. 29 The ERC is a refundable credit granted to eligible employers on qualified wages and expenditures. Eligible employers included those affected by COVID-19, and qualified wages and expenditures included those paid during eligible quarters in 2020 and 2021, with varying limits.
One lesser-understood aspect of claiming the ERC, however, is a requirement to reduce wages and expenditures by the amount of the credit claimed. According to IRS guidance, these wages and expenditures are supposed to be reduced in the year in which they were incurred, not necessarily when the credit is claimed or received. 30 For example, if an employer files an ERC claim for 2020 after it had already filed that year’s return, the IRS states that this employer must go back and amend its 2020 return to reduce expenditures. To compound this issue, ERC claims have received attention for being slowly refunded, meaning taxpayers may need to have recognized an increase to taxable income well before receiving the credit that caused the increase.
While the guidance the IRS has issued to date on the ERC does provide a general framework on the effects of the credit, a few areas that specifically affect S corporations have yet to be addressed. First, while guidance provides that wages and expenditures are to be reduced by the amount of the credit, it does not specify how that is done. Should employers reduce expenditures and create a receivable for their ERC claim? Or should they consider those wages as nondeductible expenses and treat the ERC as tax-exempt income? Regardless of the methodology, S corporations also need to be provided guidance that does not create a second layer of taxation due to the creation of basis restraints.
An additional ERC question for S corporations is whether the reduction in wage expense causes a reduction in the amount of W-2 wages shareholders may use toward claiming the Sec. 199A qualified business income deduction. The rules under Sec. 199A use vague language when determining whether wages incurred by a trade or business are eligible W-2 wages for Sec. 199A purposes. As W-2 wages are a key component for most businesses eligible for the Sec. 199A deduction, any reduction to this amount could have significant effects.
Sec. 1368: Distributions
Transfers of property considered constructive distributions: In Starer, 31 the Tax Court determined that an S corporation’s transfers of parcels of land to two individuals resulted in constructive distributions of the parcels from the corporation to its shareholders, followed by gifts to the individuals. An additional constructive distribution was determined to have been made with regard to the shareholders’ rent-free use of a residence owned by the S corporation.
The husband-and-wife taxpayers were the controlling shareholders of an S corporation that operated an agriculture and horse-breeding business, which owned property including the couple’s home, a farm, and several unimproved subdivided lots. The corporation transferred one lot to a friend and business associate, William Messick, for $895,000, with the purchase price to be paid in three installments. The taxpayers had long done business with Messick, who was experiencing financial difficulties at the time of the sale. Messick pledged the acquired parcel as security for a loan from a bank and then failed to make any payments of the purchase price to the S corporation.
The taxpayers did not pursue litigation against Messick for the $895,000 owed to the S corporation, and he ultimately conveyed the lot to the bank in lieu of foreclosure. The S corporation also conveyed a second lot to a single-member LLC owned by the taxpayers’ son-in-law. This transfer was made without any consideration, and neither the S corporation nor its shareholders retained any rights to the lot after the conveyance.
Because the S corporation received no cash consideration related to either sale, it reported no gain related to these transfers on its tax return. In addition, the S corporation owned a home that the shareholders used as their principal residence. The shareholders did not pay the S corporation rent for their use of the residence.
The IRS selected the S corporation’s tax returns for review. Upon audit, the IRS argued that the transfers of the two lots, as well as the rent-free use of the residence, resulted in constructive distributions to the shareholders.
The Tax Court agreed with the IRS and held that the transfers of the lots constituted constructive distributions of appreciated property to the taxpayers, followed by gifts of the property from them to the transferees.
Regarding the transfer of the lot to Messick, the taxpayers argued that the transfer was truly intended to be a sale and that they failed to pursue Messick for the unpaid purchase price only because it would have resulted in “throwing good money after bad.” The Tax Court, however, was unpersuaded and found it unreasonable that any prudent businessperson would sell a high-value asset and then decline to pursue the purchase price to which they were entitled, finding it “far more likely that this transfer served as compensation to Mr. Messick with respect to some act which petitioners have placed an $895,000 value on or as a gift based on their personal relationship to assist him through his financial woes.” As a result, the court concluded that the transfer to Messick by the corporation was made primarily to benefit the taxpayers, who wanted to assist their friend and business partner when he needed cash to finance his floundering business, by allowing him to pledge the land as collateral for a loan.
Regarding the transfer of the second lot, the taxpayers argued that the S corporation had intended to form a joint venture with their son-in-law and that the corporation had contributed the land in a tax-free transfer pursuant to Sec. 721. The court, however, found that because the S corporation retained no legal rights in the lot after transferring it — either directly or through an interest in the son-in-law’s LLC — no joint venture had been formed. Instead, the court concluded, the transfer was made gratuitously by the corporation, primarily for the benefit of its shareholders, who wanted to provide their son-in-law (and, by extension, their daughter) with a valuable asset.
Lastly, the Tax Court determined that the taxpayers’ rent-free use of the home owned by the S corporation resulted in a constructive distribution equal to the per-year fair rent value of the property, which was stipulated as $24,000. The court noted that it is well established that a shareholder’s use of corporate property can result in a constructive dividend to the shareholder, measured by the fair market rental value of the property. 32
Sec. 162: Trade or business expenses
Sec. 162 allows deductions for ordinary and necessary business expenses. There are special rules for certain types of expenses and certain statutory and judicial restrictions on deductibility. Among these are the overall rules requiring taxpayers to maintain books and records to substantiate business deductions.
Nonqualified deferred compensation assumed in sale of business: In Hoops, LP, 33 the Tax Court held that a partnership that owned a National Basketball Association (NBA) franchise was not allowed a deduction in the year it sold the franchise for deferred compensation owed two players that had accrued under a nonqualified plan. Further, even though it denied a deduction, the court also held that the partnership must include the deferred compensation liability assumed by the buyer in the amount the seller realized when computing its gain. The ruling has implications for entities including S corporations and their shareholders when selling a business.
Hoops LP acquired the Vancouver Grizzlies basketball franchise in 2000 and renamed it the Memphis Grizzlies. In 2012 Memphis Basketball LLC (the buyer) agreed to purchase substantially all the assets and to assume substantially all the liabilities and obligations of Hoops (an accrual-method taxpayer). Among the liabilities the buyer assumed were the liabilities and obligations under certain binding agreements, including NBA uniform player contracts for two Grizzlies players that included deferred compensation provisions. As of the date of the 2012 sale, the deferred compensation liability associated with the players had an accrued value of $12,640,000.
For purposes of computing the amount realized by Hoops on the buyer’s assumption of the deferred compensation liability, Hoops discounted the sum of the future payments to be made to the two players by applying a discount rate of 3%. The resulting present value determined by Hoops — and accepted by the IRS and the Tax Court — was approximately $10.7 million as of the date of the sale.
The issues to be decided were whether (1) a deduction for the $10.7 million should be allowed, or (2) in the alternative, if a deduction was not allowed, the $10.7 million should be excluded from the sales proceeds and, consequently, from the gain realized upon the sale.
As to the first question, the allowance of a deduction for compensation paid or incurred by an employer to or on account of an employee is ordinarily governed by Sec. 162. However, when amounts are contributed by an employer under a pension, annuity, stock bonus, or profit-sharing plan, or under any plan of deferred compensation, Sec. 404(a) governs the deductibility of such amounts and prescribes limitations as to the amount deductible for any year. Both the IRS and Hoops agreed that the deferred compensation liability at issue reflected an arrangement described in Sec. 404(a)(5). Further, both parties agreed that Hoops had not paid any of these amounts to the players in 2012 and, therefore, they were not includible in the players’ income for 2012.
Sec. 405(a)(5) and Regs. Sec. 1.404(a)-12(b)(1) provide that in the case of a nonqualified plan, a deduction for deferred compensation paid or accrued is only allowable for the tax year for which an amount attributable to the contribution is includible in the gross income of any employee participating in the plan. Thus, the Tax Court held, under the plain terms of Sec. 404(a)(5), Hoops was not allowed to deduct deferred compensation until the tax year for which an amount attributable to the compensation was includible in either of the employees’ gross income.
Hoops unsuccessfully argued that the economic-performance rules of Sec. 461(h) and its regulations allowed a deduction for the deferred compensation liability for the year of the sale. Unfortunately for Hoops, however, the Tax Court stated that its reliance upon Sec. 461(h) was “misplaced.” The court noted that Regs. Secs. 1.461-1(a)(2)(i) and 1.446-1(c)(1)(ii)(A) instruct taxpayers using an accrual method of accounting that other “[a]pplicable provisions of the Code, the Income Tax Regulations, and other guidance published by the Secretary prescribe the manner in which a liability that has been incurred is taken into account,” and that these other sections essentially override the Sec. 446 rules. Thus, according to the court, “the initial question is whether another provision of the Code or the Regulations prescribes the manner in which the deferred compensation liability is taken into account.”
The court concluded a deduction was not allowed in this instance, as “under the facts of this case, such a result comports with the clear purpose of section 404.”
As to the second question of whether Hoops must include the deferred compensation liability in its amount realized when computing gain on the sale of the franchise, the Tax Court noted that Sec. 1001(b) and Regs. Sec. 1.1001-2(a)(1) provide that the amount realized is the sum of any money received plus the fair market value of property (other than money) received, including the amount of liabilities from which the transferor is discharged as a result of the sale or other disposition.
The court discounted Hoops’ arguments that (1) accrued expenses assumed by a buyer should be included in the sale price only if they were deducted by the seller, and (2) it should be entitled to offset or reduce its amount realized on the 2012 sale by the amount of the deferred compensation liability. The court concluded that Hoops “must include the deferred compensation liability in its amount realized on the 2012 sale and is not entitled to offset or reduce its amount realized by the amount of the deferred compensation liability.”
Unfortunately for Hoops, the Tax Court’s decision left it having to pick up income in the year of the sale from the buyer’s assumption of the nonqualified deferred compensation liability, while Hoops remained unable to claim a compensation deduction at the same time for the relief of the liability (which in theory would have reduced the amount of cash the buyer was willing to pay for the franchise). However, the Tax Court may not have the final say, as Hoops has appealed the Tax Court’s decision to the Seventh Circuit. 34
Sec. 163: Interest expense
Sec. 163(j) limits the deduction for business interest payments. For many business taxpayers, the limit on the deduction of business interest expense is:
One of the adjustments to arrive at ATI is an addback of depreciation, amortization, and depletion deductions. However, this addback is removed for tax years beginning after Jan. 1, 2022, under the law known as the Tax Cuts and Jobs Act (TCJA). 36 This addback may be reinstated by future tax law changes and should be monitored by affected taxpayers, including S corporations.
Sec. 164: Taxes
Due to the TCJA’s $10,000 limitation on state and local tax deductions on individual returns (SALT cap), 37 states have begun to offer passthrough entity taxation (PTET) regimes. The purpose of these regimes is to replace tax historically assessed directly to passthrough entity owners with a tax assessed on the passthrough entity itself, in an effort to work around the SALT cap. In late 2020, the IRS issued Notice 2020-75, which set the rules and reporting requirements for PTET regimes.
It has been over 2½ years since the IRS issued Notice 2020-75; not much has changed since the last S corporation update published in the July 2022 issue of The Tax Adviser. 38 The IRS said in Notice 2020-75 that it would issue proposed regulations to clarify that specified state and local income taxes imposed on and paid by S corporations (and partnerships) are now allowed as a deduction in computing nonseparately stated income or loss. Those proposed regulations had not been issued as of this writing. Numerous issues and questions raised in last year’s article arising from implications of states’ workarounds also remain unaddressed. The only federal tax guidance available to taxpayers is the notice.
Since last year, over a dozen additional states added PTET regimes effective for tax years in 2022. These include Colorado, Indiana, and Kentucky, 39 all of which have provided for retroactive application of the rules. Indiana and Kentucky enacted legislation in 2023 retroactive to 2022, and Colorado passed its legislation in 2022. The West Virginia legislature passed legislation this year that its governor signed on March 28, 2023, 40 also retroactive to 2022. Other states have been tweaking their rules or adding guidance, such as frequently asked questions.
It is beyond the scope of this article to cover each state’s nuances. However, it is extremely important for S corporation owners to review each state’s rules, as they are not uniform in their application. Practitioners and taxpayers are advised to address several questions before making decisions involving PTETs. 41
Sec. 165: Losses
Losses an S corporation incurs must pass several tests and limitations before they may be used by its shareholders. First, the shareholders must have sufficient tax basis in their S corporation stock, as well as sufficient at-risk basis under Sec. 465. Furthermore, Sec. 469 limits the use of losses from passive activities to the extent of passive income, and Sec. 461(l) limits the amount of business losses that can offset nonbusiness income. Developments in these limitation areas, although rare, are critical to understand due to their impact on the utility of losses from passthrough entities.
Determining the effect of separate business lines on material participation: In Rogerson, 42 between 2005 and 2013, the taxpayer was the president and 100% owner of an S corporation engaged in manufacturing aircraft parts and components. The S corporation and its wholly owned entities had multiple product lines. In 2014, the taxpayer reorganized the S corporation such that the taxpayer then held the business lines directly through three separate S corporations. Prior to 2014, the taxpayer reported his involvement in the entire S corporation business (including all lines) as constituting a nonpassive activity for purposes of Sec. 469. Beginning in 2014, however, the taxpayer reported his involvement in one of the S corporations (containing one of the separate product lines) as a passive activity but reported the other two S corporations (containing the other lines) as nonpassive activities for purposes of Sec. 469.
The IRS issued a notice of deficiency asserting, among other things, that the activity from the one S corporation that was treated by the taxpayer as passive should have been treated as nonpassive for purposes of Sec. 469. The Service asserted that the taxpayer had materially participated in the underlying activity in question through his prior material participation in the single S corporation that had contained all business lines prior to the restructuring.
The Tax Court agreed with the IRS and concluded that, pursuant to Temp. Regs. Sec. 1.469-5T(a)(5) and Regs. Sec. 1.469-5(j)(1), the taxpayer materially participated in the S corporation in question during 2014 through 2016 because, prior to the restructuring of the entities, he materially participated in the S corporation entity’s overall business activities (which included the activity in question) for at least five of the 10 immediately preceding years, and his activities in the ensuing tax years in question were substantially similar to those in which he materially participated in the prior period. The result of this determination was that income from the activity must be treated as nonpassive in each of the tax years 2014 through 2016. This precluded the taxpayer from using passive losses from another activity to offset income from the S corporation, resulting in a deficiency for the taxpayer.
Sec. 174: Amortization of research and experimental expenditures
The TCJA, passed in 2017, included a provision that Sec. 174 research and experimentation (R&E) expenditures would be required to be capitalized and amortized for tax years beginning after Dec. 31, 2021. While many in the tax community believed that this capitalization requirement would be either delayed or removed through subsequent legislation, this had not yet occurred at the time of this writing. If no retroactive change is made, calendar-year 2022 tax returns must capitalize all R&E costs under Sec. 174 and amortize them over the proper period.
To adopt the change in treatment of Sec. 174 expenses, affected taxpayers must formally change their accounting method. Generally, a taxpayer adopting a change in accounting method is required to file Form 3115, Application for Change in Accounting Method. However, Rev. Proc. 2023-8 provides for a simplified method of adoption for the Sec. 174 change. In lieu of a Form 3115, taxpayers implementing the Sec. 174 change in the first effective year can adopt the change by attaching a statement to their original federal income tax return. The statement must include specific information related to the taxpayer, the period of change, the designated automatic accounting method change number (265), a description of the R&E costs, the amount of R&E costs paid or incurred during the period of change, and a declaration that such costs will be amortized over the appropriate period. 45 Taxpayers not adopting the change in the first effective year will be required to still file a Form 3115 and calculate a Sec. 481(a) adjustment.
The AICPA considers the Sec. 174 capitalization requirement to be a developing issue, and it should be monitored for future changes. Delaying or eliminating the requirement to capitalize Sec. 174 expenses may be part of a future tax package, even though such a change would relate to closed periods. If such a change is implemented, guidance would be necessary to assist taxpayers with correcting a previously filed return that adopted the Sec. 174 capitalization requirement.
Sec. 6037: Return of S corporation
While the 2022 instructions for Form 1120-S remained mostly unchanged from 2021, changes were made to the S corporation instructions for Schedule K-2 (Form 1120-S), Shareholders’ Pro Rata Share Items — International, and Schedule K-3 (Form 1120-S), Shareholder’s Share of Income, Deductions, Credits, etc. — International.
Schedule K-2 and Schedule K-3, implemented for tax years beginning after Dec. 31, 2020, replace, supplement, and clarify the reporting of certain amounts as foreign transactions formerly reported on a shareholder’s Schedule K-1 (Form 1120-S), Shareholder’s Share of Income, Deductions, Credits, etc. Schedules K-2 and K-3 must be filed by any S corporation that does not meet specific filing exceptions provided by the instructions. Even S corporations without any foreign activity still may need to complete certain parts of the schedules, depending on their facts and circumstances.
The most important change related to the schedules in 2022 is to the requirements for a general filing exception. For 2021, the IRS issued a list of frequently asked questions (FAQs) about the schedules. FAQ 15 provided a general filing exception for domestic S corporations, which required the S corporation to: (1) have no foreign activity; (2) not have reported foreign information in 2020; and (3) have had no knowledge of a shareholder requesting such information for 2021. This filing exception was in effect for the 2021 tax year only and has been replaced with a new domestic filing exception in 2022.
The new domestic filing exception requires an S corporation to:
While the new domestic filing exception has different requirements than the exception available for 2021, it provides the same opportunity for a general exception from filing the schedules. S corporations that would like to use this exception need to familiarize themselves with the new requirements and should document their compliance with them.
1 Subchapter S consists of Secs. 1361–1363, 1366–1368, 1371–1375, and 1377–1379.
2 See Rev. Proc. 2023-1, Appendix A, Schedule of User Fees.
3 (1) Agreements and arrangements with no principal purpose to circumvent the one-class-of-stock requirement; (2) governing provisions that provide for identical distribution and liquidation rights; (3) procedures for addressing missing shareholder consents, errors with regard to a permitted year, missing officer’s signature, and other inadvertent errors and omissions; (4) proceduresfor verifying S or qualified Subchapter S subsidiary (QSub) elections; (5) procedures for addressing a federal income tax return filing inconsistent with an S or QSub election; and (6) procedures for retroactively correcting one or more nonidentical governing provisions.
5 Regs. Sec. 1.1361-1(l)(1).
6 Rev. Proc. 2022-19, §3.01.
8 Rev. Proc. 2022-19, §3.02.
9 Mowry, T.C. Memo. 2018-105.
10 Jan Lewis, chair, AICPA Tax Executive Committee, “Re: Provide Clarification Under Revenue Procedure 2022-19,” to Treasury Assistant Secretary for Tax Policy Lily Batchelder, IRS Principal Deputy Chief Counsel William M. Paul, and IRS Associate Chief Counsel Holly Porter (March 28, 2023).
11 .Rev. Proc. 2022-19, §3.03(6).
12 See, e.g., IRS Letter Rulings 200032018, 200041012, 200103022, 200251005, 200330004, 200330005, 200330006, 200330007, 200330008, 200409012, 201309003, 201312016, 201545012, 201603016, 201614029, 201930023, 201936005, 201949009, 202021007, 202042001, 202042008, 202124002, 202141002, 202219005, 202238009, 202244001, 202247004, and 202249004.
13 Rev. Proc. 2022-19, §3.06(2)(b).
14 See, e.g., Rev. Proc. 2013-30.
15 Rev. Proc. 2022-19, §§3.06(2)(c) and (d); see also appendices A and B for sample statements.
16 Rev. Proc. 2022-19, §4.01.
1 17 E.g., IRS Letter Ruling 202216012.
21 Regs. Sec. 1.1362-3(a).
22 Regs. Sec. 1.1362-3(c)(5).
23 IRS Letter Ruling 200453007.
26 Regs. Sec. 1.336-2(h)(3).
27 The election statement must meet the requirements of Regs. Secs. 1.336-2(h)(5) and (6).
28 Rev. Proc. 2003-33 provides automatic procedures for obtaining extensions to file Sec. 338 elections.
29 Coronavirus Aid, Relief, and Economic Security Act, P.L. 116-136.
30 Notice 2021-49, §IV.C.
31 Starer, T.C. Memo. 2022-124.
32 Citing Nicholls, North, Buse Co., 56 T.C. 1225 (1971).
33 Hoops, LP, T.C. Memo. 2022-9.
34 Hoops, LP, No. 22-2012 (7th Cir. 6/3/22).
35 Secs. 163(j)(1) and (9)(B).
36 The law known as the Tax Cuts and Jobs Act, P.L. 115-97. See Sec. 163(j) (8)(A)(v).
37 Sec. 164(b)(6); see also Mucenski-Keck and Ramos, “Federal Implications of Passthrough Entity Tax Elections,” 53-11 The Tax Adviser 38 (November 2022).
38 Brajcich, Hill, Jamison, Keller, Mitchell, Orbach, Scott, and Walsh, “Current Developments in S Corporations,” 53-7 The Tax Adviser 22 (July 2022).
39 Colo. Rev. Stat. §39-22-340 (effective for tax years beginning on or after Jan. 1, 2022); Ind. Code §6-3-2.1-2, effective for tax years beginning after Dec. 31, 2021; Ky. Rev. Stat. Ann. §141.206, effective for tax years beginning on or after Jan. 1, 2022.
40 40.W.Va. Senate Bill No. 151.
42 Rogerson, T.C. Memo. 2022-49.
43 Regs. Sec. 1.174-2(a)(10).
45 Rev. Proc. 2023-8, §3, modifying Rev. Proc. 2022-14. See also Messner and Ivanova, “Tax Clinic: R&E Expenses: Automatic Accounting Method Change Procedures,” 54-5 The Tax Adviser 24 (May 2023).
Contributors
Andrew M. Brajcich, CPA, J.D., LL.M., is the Jud Regis endowed chair of accounting, associate professor of accounting, and graduate accounting director at Gonzaga University in Spokane, Wash. Kristin Hill, CPA, is the owner of Kristin Hill, CPA, P.C., in Berkeley, Calif. Robert W. Jamison Jr., CPA, Ph.D., is author of CCH’s S Corporation Taxation and professor emeritus of accounting at Indiana University in Indianapolis. Robert S. Keller, CPA, J.D., LL.M., is a partner in KPMG’s Washington National Tax practice. Kirk T. Mitchell, CPA, MST, is a tax senior manager at Schneider Downs & Co. Inc. in Pittsburgh. Kenneth N. Orbach, CPA, Ph.D., is a professor of accounting at Florida Atlantic University in Boca Raton, Fla. Tony Nitti, CPA, MST, is a partner in EY’s National Tax Department in Denver. Kevin J. Walsh, CPA, CGMA, is a partner in Walsh, Kelliher & Sharp, CPAs, APC, in Fairbanks, Alaska; and Jonathan Williamson, CPA, MT, is a tax director with Cohen & Co. in Cleveland. Brajcich, Hill, Keller, Mitchell, Nitti, and Walsh are members, and Jamison and Orbach are associate members, of the AICPA S Corporation Taxation Technical Resource Panel. Williamson, at the time of cowriting this article, was a senior manager–AICPA Tax Policy & Advocacy in Washington, D.C., and staff liaison to the panel. For more information about this column, contact thetaxadviser@aicpa.org.
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