Recent Reform and Simplifications for S Corporations

By Zev Landau

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[A]fter the Treasury’s blessing of the limited liability company, plus the Treasury’s adoption of check-the-box rules, partnership tax treatment (correctly called “tax nirvana”) has been conferred upon entities that were not formerly treated as partnerships … It is no wonder the recent wave of aggressive tax shelters typically used a partnership as the vehicle to transfer tax benefits. But some entities, like banks, must conduct their businesses in corporate form and others are required to do so by state laws or other rules. They must use Subchapter S. Many Subchapter S corporations are locked into elections made years ago; while they would prefer to adopt the tax-favored partnership form, they cannot without a heavy tax toll charge. Subchapter S corporations are found on Main Street, not Wall Street. They are not asking for the famous “level playing field,” i.e., the favored tax treatment granted to partnerships. Instead, they are simply asking that some of the fetters imposed in another era be removed.

Congress apparently also believed that the initial legislation was not good enough for S corporations, and sought better laws. So far it has taken 45 years to modify, correct, and reform the law, and more remains to be done. Initially, the maximum number of shareholders was set at 10, and Congress accepted this until 1976, when the number of shareholders was increased to 25 persons. Only domestic corporations could be S corporations, none of the shareholders could be nonresident aliens, and all shareholders had to consent to treat their entity as an S corporation. Only one class of stock was allowed, although having voting and non-voting stocks did not violate the single-class requirement.

In 1982, Congress decided to adopt many aspects of partnership taxation, leaving out the complexities that applied to partners and partnerships. Legislatures and lobbyists wanted more flexibility and realized that converting S corporations to partnerships exposed both corporations and shareholders to taxation. Congress decided to change the tax regime of S corporations and to treat them as pass-through entities, although under rules different from partnership taxation rules.

More significant changes were made in 1996, including the following: 1) the number of S corporation shareholders was increased from 35 to 75; 2) S corporations were allowed to own subsidiaries; 3) certain types of tax-exempt organizations and trusts were allowed to own S corporation stock; 4) certain banks were permitted to elect S corporation status; 5) S corporations were allowed to create an employee stock ownership plan; 6) the IRS was empowered to provide relief for late or invalid S corporation elections; and 7) S corporations were made exempt from the unified audit and litigation procedures.

The congressional records of the American Jobs Creation Act of 2004 articulate the substance of the new law and the congressional intent. Speakers at the congressional sessions believed that it was imperative to offer more incentives to S corporations, because the relative effectiveness of S corporations was likely diminished somewhat as a result of the Jobs and Growth Tax Relief Reconciliation Act of 2003. By reducing the tax rate on qualified dividends to 15% percent, the 2003 Act lessened (but did not eliminate) the double tax on corporate income, thereby reducing (but again not eliminating) the tax advantage offered by S corporations.

Another good reason to offer more and better incentives for S corporations was that many business incentives did not consider the choice of a specific entity. For example, the increase of the IRC section 179 deductions, from $25,000 to $100,000, was welcome as a business incentive, but it applied to all entities and did not consider the selection of the capital structure and organizational form of the business that an entrepreneur wished to conduct.

Reforms, Modifications, Simplifications, and Explanations

Family members treated as one shareholder. The new law provides that the members of one family should be considered as one shareholder. Congress decided to focus on common ancestors. For taxable years beginning after December 31, 2004, a family may elect to have all the members of the family (as defined in the following paragraphs) that hold stock directly or indirectly in an S corporation treated as one shareholder for purposes of the number-of-shareholders limitation. The election may be made by any family member.

The rule that a husband and wife (and their estates) shall be treated as one shareholder continues to apply, and both must sign the election, with some exceptions. The term “members of the family” refers to individuals with a common ancestor, lineal descendants of the common ancestor, and the spouses (or former spouses) of such lineal descendants or common ancestor.

This means that not all family members are counted as one shareholder and not all shareholders can qualify as common ancestors. It is also important to ascertain how many lineal descendants the common ancestor has. A spouse (or former spouse) would be treated as being of the same generation as the individual to which such spouse is (or was) married.

A lineal descendant is not the same as a “collateral” descendant, who would be from the line of a brother, sister, aunt, or uncle. A single shareholder would consist of a qualified common ancestor and would include only his lineal descendants as well as the spouses, or former spouses, of these individuals. An individual shall not be a common ancestor if more than six generations removed from the youngest generation.

The S election shall be made by any member of the family, rather than by all the shareholders, and shall remain in effect until the time of revocation or involuntary termination. Congress emphasized that, for the purpose of determining the number of shareholders, an eligible family member could be counted because of a direct holdings of stock, or by reason of being a beneficiary of an electing small business trust or Qualified Subchapter S Trust.

Increase in eligible shareholders to 100. When Congress created Subchapter S in 1958, the number of shareholders could not be more than 10. Over the years, this limitation was increased to 15 (1976), to 25 (1981), to 35 (1982), and to 75 (1996). In 2004, one representative emphasized that an increase in the limit on the number of shareholders, either numerically or through attribution, would make Subchapter S corporations more broadly available and therefore be good policy. It is not uncommon for a corporation to exceed the current limitation on the number of shareholders as a result of employee ownership. If an increase in the permissible number of shareholders to 150, the optimal number in that representative’s view, does not meet the needs of those interested in the family shareholder provision, he suggested that they either choose a more appropriate number of shareholders or, alternatively, that the limit on the number of eligible shareholders be removed entirely. The Subchapter S Revision Act of 1999 targeted these small businesses by “improving their access to capital preserving family-owned businesses, and lifting obsolete and burdensome restrictions that unnecessarily impede their growth. It will permit them to grow and compete in the next century.” Congress’s ultimate decision in 2004 was to expand the limitation, allowing a maximum of 100 shareholders, effective after December 31, 2004.

An expansion of the shareholder limitation found many supporters in the banking community. A spokesperson for the Independent Community Bankers of America (ICBA) explained that:

[I]n many cases community banks have made a decision that their institutions are widely owned, often by the members of the communities they serve. The provisions of the S corporation rules limiting the number of shareholders to no more than 75 often forces community banks that wish to become an S corporation to disfranchise shareholders, severely limit[ing] ownership and its ability to raise capital in the future. Additionally, other business structures such as an LLP or LLC do not have any limitations on the number of owners. Unfortunately, community banks with more than 75 shareholders must somehow force out some of their shareholders—even when they would prefer to be more broadly held.

At first, expanding the shareholder limit and treating members of a family as one shareholder sounded like a good idea. Not everyone was comfortable with these changes, however. As time goes on, new generations are born and others pass away. Because a family is measured in terms of the number of lineal descendants linked to a common ancestor, and the combined number of includable generations cannot exceed seven, the tax identity of a family may change, as may the identity of the common ancestor. There is a reasonable likelihood that the number of shareholders would inadvertently exceed 100. The timing factor is an open issue.

As part of these changes, Form 2553, Election by a Small Business Corporation, and its accompanying instructions were revised in March 2005. Under the caption “who may elect” it states that a member of a family can elect to treat all members of the same family as one shareholder. The definitions of a family and a common ancestor, as well as the effective date for that privilege, are not mentioned, nor is the manner of such election described. The instructions to page 1 of the form indicate that all the shareholders must be listed and all must consent to the election, just like earlier versions of the form.

It is worth noting how tremendously the definition of a small corporation under Subchapter S changed in 2004 in comparison to the initial definition in 1958, when no more than 10 shareholders were permitted, or even in comparison to any other measurement in subsequent legislations before the 2004 reform.

Expansion of bank S corporation eligible shareholders to include IRAs. In 1996, IRAs, unlike certain banks and qualified plans, could not be shareholders of S corporations. The apparent reasoning was that certain transactions were prohibited between an IRA and its beneficiary, including a sale of property of an IRA to the individual. If a prohibited transaction occurred, the account would cease to be an IRA, and its fair market value would be deemed a distribution to the beneficiary. The new law allows both traditional and Roth IRAs to own stock of banks (as defined in IRC section 581) that have made an S election, effective only to the extent of the stock held by such trusts in such banks on October 22, 2004.

Community banks supported changes to encourage their customers to open IRAs but wanted to minimize the draining of resources when buying stock back from IRA holders. ICBA explained that a sale of IRA assets to a disqualified party is a prohibited transaction and the IRA owner was a disqualified party prohibited from purchasing the community bank’s stock from the IRA trust. The transaction was prohibited regardless of the price the owner was to pay the IRA for the stock. Such a situation would occur where an IRA owner does not want to give up the future benefits of stock ownership, preferring to purchase the stock from the IRA trust rather than have the community bank redeem the stock. The Department of Labor has granted exemptions from the prohibited transactions rules, on a case-by-case basis, when an IRA trust wanting to sell stock to a disqualified party has asked for a ruling.

The new law amended the prohibitive transaction rules in the context of S corporations. There is now an exemption from prohibited transaction treatment for the sale by an IRA trust to the IRA beneficiary of bank stock held by the IRA on the date of enactment of the provision if the following conditions are met: 1) the sale is pursuant to an S corporation election by the bank; 2) the sale is for fair market value (as established by an independent appraiser) and is on terms at least as favorable to the IRA as they would be for a sale to an unrelated party; 3) the IRA incurs no commissions, costs, or other expenses in connection with the sale; and 4) the stock is sold in a single transaction for cash not later than 120 days after the S corporation election is made.

Disregard of unexercised power of appointment in determining potential current beneficiaries of ESBT. An electing small business trust (ESBT) within the meaning of IRC section 1361(e) is treated as two separate trusts. The portion of an ESBT that consists of stock in one or more S corporations is treated as one trust. The portion of the ESBT that consists of all the other assets is treated as a separate trust. The grantor or another person may be treated as the owner of all or a portion of either or both such trusts. The ESBT is treated as a single trust for administrative purposes; it has one taxpayer identification number and files one tax return.

The 1996 act permitted multiple beneficiary trusts to own S corporation stock, provided such trusts meet the requirements of an or ESBT, and provided that all of the potential current beneficiaries of an ESBT are counted for the purposes of the 75-shareholder limitation and are permitted S corporation shareholders in their own right.

An individual entitled to receive a distribution from an ESBT only after a specified time or upon the occurrence of a specified event is not a potential current beneficiary until such conditions are met. On the other hand, the final regulations provide that the existence of a currently exercisable power of appointment, such as a general lifetime power of appointment that would permit distributions to be made from the trust to an unlimited number of appointees, would cause the S corporation election to terminate, because the number of potential current beneficiaries will exceed the 100-shareholder limit. The new law clarifies that unexercised powers of appointment are disregarded in determining the potential current beneficiaries of an ESBT. In addition, the period during which an ESBT can dispose of S corporation stock after an ineligible shareholder becomes a potential current beneficiary has been increased from 60 days to one year.

Transfer of suspended losses incident to divorce. The old law did not cover S corporation stock transfers between spouses, or between ex-spouses incident to divorce proceedings. IRC section 1366(d)(2) said simply that any loss or deduction that is disallowed for any taxable year due to insufficient basis or lack of at-risk amount shall be treated as incurred by the corporation in the next taxable year with respect to that shareholder. The new law mentions IRC section 1041, which states that transfers of property between spouses or incident to divorce are treated as gifts, and the transferee’s basis is the same as the transferor’s basis.

The AICPA believed that “because of the frequency of stock transfers in divorce situations, an exception for divorce situations from the general rule in section 1366(d) that losses are not available to transferees would be very meaningful and helpful.” Thus, it supported this provision and had the following comment on the law:

As drafted, by referring to ‘any loss or deduction … attributable to such stock,’ the provision appears to suggest that if a shareholder transfers only some of his/her stock incident to a decree of divorce, only a portion of the suspended losses of the shareholder will become available to the transferee and the remaining amount will remain with the transferor shareholder. This approach is equitable and clearly preferable to making all of the suspended losses of a transferor shareholder available to the transferee. However, the provision is not completely clear. Thus, it may be helpful to explain, perhaps in the legislative history, that a prorating concept is contemplated when suspended losses become available upon the transfer of a portion of stock to a transferee incident to a decree of divorce.

The 2004 act did not mention prorating of suspended losses in divorce situations. The rule under prior law did not mention divorce and focused on the transferors, as follows:

Any loss or deduction which is disallowed for any taxable year by reason of paragraph (1) [i.e., basis limitations] shall be treated as incurred by the corporation in the succeeding taxable year with respect to that shareholder.

For tax years beginning after December 31, 2004, two changes were made. First, the section described in the previous paragraph stated that the rule does not apply to divorce situations described in section 1041. Secondly, a new section was added specifically for transfers of stock incident to divorce. It stated that suspended losses in a divorce shall be treated as incurred by the corporation in the succeeding taxable year with respect to the transferee.

Exclusion of investment securities income from the passive income test for bank S corporations. Under the new law, certain income will not be considered “passive” investment income for a bank, a bank holding company, or a financial holding company, including the following: interest income and dividends on assets required to be held by such an entity, including stock in the Federal Reserve Bank, the Federal Home Loan Bank, or the Federal Agricultural, Mortgage Bank, or participation certificates issued by a Federal Intermediate Credit Bank.

Under prior law, an S corporation election was terminated whenever the S corporation had accumulated earnings and profits at the close of each of three consecutive taxable years and had gross receipts for each of those years more than 25% of which was passive investment income.

Relief from inadvertently invalid QSSS elections and terminations. Under present law, inadvertent invalid subchapter S elections and terminations may be waived. Congress was reminded that under IRC section 1362(f), the IRS has authority to grant relief if a taxpayer inadvertently terminates its S corporation election or inadvertently makes an invalid S corporation election. There was no similar relief for qualified subchapter S subsidiaries (QSSS). It will be equitable to offer the same relief in the case of inadvertent terminations of QSSS status. Congress agreed and approved.

Information returns for qualified subchapter S subsidiaries. Under the new law, an S corporation wholly owned by another S corporation is treated as a qualified subchapter S subsidiary if the S corporation so elects. The assets, liabilities, and items of income, deduction, and credit of the subsidiary are treated as assets, liabilities, and items of the parent, also an S corporation. The IRS will have authority to provide guidance regarding information returns of qualified subchapter S subsidiaries.

Repayment of loans for qualifying employer securities. A representative of the Employee-Owned S Corporations of America (ESCA) explained at the congressional hearings that prior law had made it difficult for S corporation ESOPs to repay debt incurred to purchase employer stock and limited the retirement savings of employee-owners: “In this regard, current law is at odds with the economic interests of the employees who participate in S corporation ESOPs.”

The IRS had taken the position in private letter rulings that Treasury Regulations under IRC section 4975(d)(3) do not allow an ESOP to repay an exempt loan with distributions on shares of S corporation stock that have been allocated to the accounts of plan participants and do not serve as collateral for the loan. IRC section 404(k)(5)(B) allows an ESOP to use “dividends” received with respect to shares of employer stock to make payments on an exempt loan, regardless of whether such shares have been allocated to the accounts of participants and are no longer pledged as collateral to secure the loan. This provision, however, does not apply to distributions by S corporations, because they are not “dividends” for federal income tax purposes. Thus, S corporation ESOPs are precluded from repaying exempt loans with distributions on S corporation stock that has been allocated to the accounts of participants, even though a comparable distribution from a C corporation could be so used.

The final version of the law helps S corporations maintain ESOPs. An ESOP maintained by an S corporation would not be treated as violating the IRC qualification requirements or as engaging in a prohibited transaction merely because (in accordance with plan provisions) a distribution made with respect to S corporation stock that constitutes qualifying employer securities held by the ESOP is used to make payments on a loan (payments of interest as well as principal) that was used to acquire the securities (whether allocated to participants or not).

Proposals Which Were Excluded from the Final Law

Modifications to passive income rules. The AICPA took the position that it did not further any policy goal for an S election to be terminated simply because 1) a corporation has earnings and profits remaining from its history as a C corporation, regardless of whether the earnings and profits were generated from passive income of the type prohibited by IRC section 1375, and 2) a corporation earns too much passive income, too often. Repealing these terminating events would have simplified the Code and S corporation recordkeeping.

An increase from 25% to 60% of gross receipts for the amount of an S corporation’s allowable passive investment income was also proposed, partially because it would diminish the exposure to tax on excess passive income and partially because it would conform this tax to the Personal Holding Company regime. The AICPA supported the removal of capital gains on the sale of stocks and securities from the category of passive investment income, which hasn’t been a part of the Personal Holding Company regime for about 40 years.

The AICPA also suggested that IRC section 1375(a) be changed to lower the tax rate on passive investment income to 15%, rather than tying it to the highest personal income tax rate.

Adjustment to basis of S corporation stock for certain charitable contributions. Under prior law, the IRS’s position is that an S corporation shareholder must reduce its basis in the S corporation by the amount of any charitable contribution deduction flowing through from the S corporation to the shareholder. If an S corporation donates an appreciated stock and reports a deduction based on fair market value, the shareholders must reduce their stock basis by the same amount. In a partnership scenario, the outside basis is reduced by the basis of stock donated to a charity rather than by the fair market value. The AICPA took the position that partnerships and S corporations should be treated similarly.

Under the new law, a shareholder of an S corporation realizes a deferred gain on future disposition of his stock because the basis will be reduced by the full fair market value of the appreciated stock. A partner, on the other hand, will reduce her outside basis by the basis of the donated property. Therefore, an increase in stock basis by the appreciation would prevent a trap for taxpayers that do not realize that gifting appreciated property through an S corporation effectively results in recognition of the inherent gain when the stock is disposed of in a taxable transaction.

Treatment of sale of interest in a qualified subchapter S subsidiary. The sale of an interest in a QSSS will cause a termination of the election. The QSSS will be treated as a new corporation, immediately acquiring all the assets (and assuming all of the liabilities) from the S corporation parent, in exchange for stock of the new corporation.

The transfer of the assets by the S corporation parent to the “new” corporation in exchange for stock may not qualify as an IRC section 351 transaction, because of lack of control immediately after the “transfer.” The AICPA has warned that “many taxpayers that sell less than 100% will be unpleasantly surprised by this trap for the unwary. This result is counter to sound tax policy because the S corporation, in effect, is required to recognize gain on assets without making any disposition of those assets.”

Under current law, if an S corporation sells more than 20% of the stock of a QSSS, the S corporation will recognize gain and loss on all of the assets of the subsidiary. An alternate approach preferred by some would be to change the rule so that a proportionate gain is recognized based on the percentage of stock sold.

Inability to elect fiscal years. A wide range of business owners and their advocates were unhappy about the requirement that S corporations and partnerships use a calendar year in reporting their income. This neither considers the natural business year of the enterprise, nor allows tax professionals to make their workload smoother.

Built-in gains. IRC section 1374 imposes a corporate-level tax on gain from certain property sales made in the 10-year period following an S election by a C corporation. After that period, the sale of assets that appreciated during C corporation years will only result in one level of taxation. It is not uncommon that, because of this provision, S corporations decide to hold unproductive assets that could otherwise be better utilized.

In the debate over the 2004 act, one congressman introduced a provision that would have relieved S corporations from the double taxation of built-in gains, as long as the proceeds of the asset sale are put right back into the business. Another congressman proposed eliminating the tax altogether because built-in gain taxes can be triggered surprisingly and unexpectedly in certain mergers. A third congressman proposed reducing the waiting period from 10 to seven years.

Intentions and Results

Based on testimonies and on articles in the media, the impression is that Congress was friendly to S corporations in 2004, and the revisions to subchapter S were well received by the advocates that pressed for changes. The testimonies before Congress voiced a wide range of good reasons for the reform and simplification of S corporation rules. Some mentioned and emphasized economic growth, competitiveness, and serving the community; others focused on hurdles, obstacles, and confusions caused by the old law. Another group emphasized the ability to select the entity and business structure most appropriate for conducting one’s business affairs. Cross-reference to other subchapters of the IRC was also mentioned as a reason to change subchapter S, including prohibitive transactions and partnership rules.

Reading the congressional record helps one understand the congressional intent. Not all of the changes recommended to Congress were ultimately enacted in the American Jobs Creation Act of 2004, because of either IRS opposition, public groups’ objections, or differences in priorities. The list of the rejected proposals is long enough to initiate more reforms in the future.