IS THE 2 ½ MONTH RULE FOR CHARITY APPLICABLE TO S CORPORATIONS?
By Abraham Weintraub, CPA, Bloom Hochberg & Co. P.C.
As a general rule, charitable contributions are deductible only in the year payment is made [IRC section 170(a)(1)]. However, an accrual basis corporation is allowed to deduct contributions for the current year if the payment is made by the 15th day of the third month following the close of the year, if the board of the directors authorized the contribution during the taxable year, and if an election was made with the tax return for the tax year [IRC section 174 (a)(2)].
The question has been raised as to whether this rule applies only to C corporations or if it also applies to S corporations. The language in section 170 does not specifically exclude S corporations. However, section 1363(b) states that the taxable income of an S corporation is computed in the same manner as that of an individual. In addition, there is a reference to deductions, referred to in IRC section 703(a)(2), not being allowable to the corporation. These include "the deduction for charitable contributions provided in section 170" [See IRC section 703 (a)(2)(c)].
The IRS has weighed in on this matter in PLR 199908039. This ruling involved an S corporation with a March 31 year end. The board of directors authorized a contribution that was made within 2 wQ months of this year end. Referring to IRC sections 1363(b) and 703(a)(2), and the language in IRC sections 1366(a)(1)(A) and 702(a)(4), the IRS determined that individual rather than corporate limitations on deductibility of charitable contributions apply. Therefore, the shareholders could deduct the contribution only in the year actually paid.
It could be argued that the logic used by the IRS is faulty. While the various code sections cited do make the contribution deductible on the individual return, IRC section 170(a)(2) determines the year of deductibility, which could apply equally to an S corporation or to a C corporation.
One positive thing that can be said about the IRS's position is that it is consistent, which can sometimes inure to a taxpayer's benefit. In PLR 9703028, involving a contribution by an S corporation to a private foundation making distributions in part to charities outside of the United States, the IRS ruled that the contribution was deemed to be made by the individual shareholders. This was important because, pursuant to IRC section 170(c)(2), a corporation can only deduct contributions to U.S. charities.
By Charles E. Price and Leonard G. Weld
The Taxpayer Relief Act of 1997 (P.L. 105-34) created an exemption from the alternative minimum tax (AMT) for small corporations. While the concept was an immediate hit, there were questions about the application of the tests required in the new IRC section 55(e). The tests determine if a corporation meets the definition of a "small corporation" and is, therefore, exempt from AMT. The IRS Restructuring and Reform Act (P.L. 105-206) made technical corrections to IRC section 55(e) to resolve some of these questions.
Taxpayer Relief Act of 1997
There are two tests to establish a corporation's eligibility to be exempt from AMT. Both tests focus on the gross receipts of the corporation. As originally enacted, IRC section 55(e) provides as follows:
(1) In general--the tentative minimum tax of a corporation shall be zero for any taxable year if--
(A) such a corporation met the $5,000,000 gross receipts test of section 448(c) for its first taxable year beginning after December 31, 1996, and
(B) such corporation would meet such test for the taxable year and all prior taxable years beginning after such first taxable year if such test were applied by substituting $7,500,000 for $5,000,000.
The Senate Committee Report (S. Rep. No. 105-174) explains that the AMT is repealed for small business corporations for taxable years beginning after December 31, 1997. The report illustrates the testing criteria by stating the following:
A corporation that had average gross receipts of less than $5,000,000 for the three-year period beginning after December 31, 1994, is a small business corporation for any taxable year beginning after December 31, 1997.
The report continues by explaining that a corporation can continue to be exempt from AMT if its average gross receipts do not exceed $7.5 million. As an additional bonus, if a corporation fails the gross receipts test, it will only have to take into account adjustments and preference items that relate to transactions entered into after the corporation loses its status as a small business corporation.
From reading the above passages, it is probably apparent that there are some date conflicts. In addition, the committee report states the test amount as "gross receipts of less than $5,000,000," but the gross receipts test of IRC section 448(c) uses the phrase "does not exceed $5,000,000." IRC section 448(c)(3) has a special rule in subparagraph (A) to deal with new corporations that have only one or two prior tax years. Subparagraph (B) provides a formula to annualize gross receipts for a prior period shorter than one year. However, IRC section 448(c) does not specifically address the test for a corporation in its first year. So the question arose: Is a new corporation subject to AMT its first year and then able to "exempt out" if the gross receipts meet the test?
IRS Restructuring and Reform Act
The restructuring act answers the timing and test questions that arose due to IRC section 55(e). The Senate Committee Report reiterates that the exemption is effective for tax years after December 31, 1997, and provides two examples of the application of the gross receipts tests.
Test Amounts and Periods. In order to be exempt from AMT, the new IRC section 55(e)(1)(A) requires that a corporation's average annual gross receipts for all three-year periods ending before the current taxable year not exceed $7.5 million. Only tax years after December 31, 1993, shall be taken into account. The new IRC section 55(e)(1)(B) provides that, for the first three-year test period, subparagraph (A) is applied using $5 million instead of $7.5 million. The new phrasing clears up the discrepancy with IRC section 448(c) that existed when the IRC section 55(e) requirement was that gross receipts were of "less than" $5 million, rather than "do not exceed" $5 million.
Example 1. CSA Corporation is in existence on January 1, 1994. To qualify for the AMT exemption, the corporation's gross receipts for the first three-year period must be $5 million or less. If corporate gross receipts were $2 million in 1994, $4 million in 1995, and $6 million in 1996, the corporation would pass the first-year test, since the average for the three-year period is $4 million.
However, to be exempt from AMT in 1998 (the first year the exemption is available) gross receipts for all three-year periods must be considered.
Example 2. The facts are the same as in Example 1. In 1997, the corporate taxpayer has gross receipts of $8 million. The average gross receipts for the second three-year period (1995, 1996, and 1997) is $6 million, which does not exceed $7.5 million. Because the average gross receipts in the first three-year period beginning after December 31, 1993, did not exceed $5 million, and the average gross receipts for the second three-year period did not exceed $7.5 million, all periods therefore pass the gross receipts test, and the taxpayer can be exempt from AMT in 1998.
Another clarification is what to do with a new corporation. The answer depends upon whether the first year of existence is before or after 1998, the first year the exemption is available. If the first year of existence is before 1998, then IRC section 55(e)(1)(B) applies. The corporation's gross receipts are compared to the $5 million test amount, and the corporation is or is not exempt. The authority for the short test period lies in IRC section 55(e)(1)(D), which says the rules of IRC sections 448(c)(2) and (3) apply. IRC section 448(c)(3)(A) provides that, if an entity was not in existence for the three-year test period, the test should be applied to the actual period of existence. For short tax years, the test is applied by annualizing the gross receipts for the short period using the formula in IRC section 448(c)(3)(B). This annualization is calculated by multiplying the gross receipts by twelve and then dividing the result by the number of months in the short period.
Example 3. Ashley Corporation came into existence May 1, 1997, and had gross receipts of $4 million dollars for 1997. The annualized amount of gross receipts is $6 million. The test amount for the first three-year period is $6 million, so Ashley Corporation will not be exempt from AMT in 1998. Because Ashley is not exempt in 1998, the corporation cannot qualify for exemption in any future years.
One problem related to test periods may arise for the IRS in the future. The committee reports explaining the application of IRC section 195, "Start-up Expenditures," and numerous court cases [the leading case is Richmond Television Corporation v. U.S., 345 F.2d 901 (CA-4 1965)] make a distinction between the date a corporation comes into existence (at the articles of incorporation) and the date it begins business. This terminology has been used to prevent taxpayers from deducting operating expenses (often training, travel, and wages) that are incurred after incorporation but before operation as an active trade or business. The expenditures must be capitalized as start-up costs rather than deducted as expenses under IRC section 162, which is only available for an entity carrying on a trade or business. Since IRC section 448(c) uses the term "existence" when describing the test period rather than "in business" or "begins operations," taxpayers could use an early date of incorporation to their advantage.
Example 4. Tara Corporation is incorporated on April 1, 1997, but does not begin business operations until October 1, 1997. The gross receipts for 1997 are $3 million. Using the formula from IRC section 448(c)(3)(B), Tara's annualized gross receipts are only $4 million. Using Tara's months of operations, however, means that Tara will fail the $5 million test, because the annualized gross receipts are $12 million [($3 million x 12 months)/3 months of operations].
If a corporation comes into existence after December 31, 1997, a different rule applies. IRC section 55(e)(1)(C) states that for the first tax year of existence, the corporation is exempt. The committee report clarifies that this first-year rule applies when a corporation's first tax year begins after December 31, 1997, and applies regardless of the amount of gross receipts for the year. However, the gross receipts from the first year are important when calculating the three-year test period to determine small corporation status for the next tax year.
Example 5. Lanta Corporation comes into existence in January 1999. It qualifies for exemption regardless of the amount of its gross receipts. To qualify for exemption in 2000, Lanta's 1999 gross receipts must not exceed $5 million. To qualify for exemption in 2001, the average gross receipts for 1999 and 2000 cannot exceed $7.5 million. If Lanta's gross receipts in 1999 are $5.5 million, the corporation cannot qualify for exemption in 2000 or in any subsequent year.
The "one strike and you're out" clause of the gross receipts test is explicitly stated in the Senate Committee Report's second example and implicitly stated in the IRC section 55(e)(1)(A) phrase that "all three-year periods" after 1993 must be considered.
Special Rule. The last special rule of IRC section 448(c) that applies to taxpayers is the entity aggregation rule of paragraph (2). Entities treated as a single employer under IRC sections 52(a) or (b) or sections 414(m) or (o) are treated as a single employer for purposes of calculating gross receipts.
IRC section 52(a) states that corporations that are members of a controlled group are treated as one employer. The definition of a controlled group is borrowed from IRC section 1563(a) and can apply to a parent-subsidiary, a brother-sister relationship, or a combined group. The only change is that the "vote and value" percentage for the parent-subsidiary test is lowered from 80% to 50%. IRC section 52(b) considers partnerships or proprietorships that are under common control to be one entity.
IRC section 414(m) groups employees of "affiliated service groups" into one entity. An affiliated service group is several service organizations related through shareholders, partners, highly compensated employees, or through regular business services. Subsection (o) simply calls for regulations to provide guidance for subsection (m). *
Charles E. Price, PhD, CPA, is the Charles M. Taylor Professor of Taxation at the School of Accountancy at Auburn University. Leonard G. Weld, PhD, is the chair of the Department of Accounting and Finance and E.H. Sherman Professor of Accounting, at the Sorrell College of Business, Troy State University.
Edwin B. Morris, CPA
Rosenberg, Neuwirth & Kuchner
Joel Rothstein, CPA
Cohen Hacker Rothstein & Pearl, LLC
Richard M. Barth, CPA
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