The Tax Reform Act of 1986 ("TRA 86"), the Revenue Act of 1987 ("RA 87"), and the recently enacted Technical and Miscellaneous Revenue Act of 1988 ("TAMRA 88") have prompted closely held C corporations (C Corp.) to reconsider electing S corporation (S Corp.) status. Prior to TRA 86, C Corp. status was desirable where the corporation remained profitable after reasonable officers' salaries. This was so because corporate tax rates were lower than individual rates. Furthermore, C Corps. were able to avail themselves of the corporate graduated tax brackets. Although this subjected the income to a potential double tax, on a current basis, there were more after tax dollars available for generating future income. Additionally, the unrecognized increase in value of the corporation's assets could eventually be removed free from the double tax created at the corporate level pursuant to the application of Sec. 336 complete liquidations.1

TRA 86 made two extensive changes which affected this decision process. First, the individual tax rate was reduced below the corporate tax rate.2 Second, Congress repealed the General Utilities doctrine previously codified in Sec. 336. Thus, on a current basis, after tax dollars will be maximized if income is taxed at the individual level. Moreover, liquidations are no longer shielded from double taxation. Achieving individual level taxation with corporate limited liability became the prime directive, and S Corps. were back in vogue. 1 Sec. 336 did not exempt from corporate level tax depreciation and other recapture provisions as well as various judicial doctrines such as the tax benefit rule. 2 The maximum corporate tax rate is now 34%, while the individual tax rate was dropped to 28% for tax beginning in 1988. These tax rates increase for certain taxable income levels to recapture the benefits of the graduated tax brackets and individual exemptions. It is reasonable to assume that Congress will persist with the fiscal philosophy it exhibited in TRA 86 and require corporations to continue bearing a greater burden of the tax system. As an S Corp., current corporate income is taxed to the shareholders at their individual tax rates and, although liquidations of S corporations are governed by the C Corp. liquidation provisions, the gain recognized by the S Corp. upon liquidation would simply be passed through as additional S Corp. income ultimately taxed at the individual level.

Congress, however, was fearful that C Corps. contemplating liquidation would simply elect S status before consummating the liquidation, thereby avoiding the corporate level tax. Although this fear was tempered by the then existing Sec. 1374,3 the overriding concern was the escape from corporate asset value created while a C Corp. This was the impetus for the enactment of the built-in gain provisions.

The built-in gain provisions are contained in new Sec. 1374. In general, this section imposes an S Corp. level tax upon the recognition of built-in gains during the first 10 years as an S Corp. Built-in gains were defined as the difference between the fair market value of the assets of the corporation on the first day of its first S Corp. year and the adjusted basis of the assets at that time. TAMRA 88 enacted certain clarifying provisions to these rules. First, there need not be a sale or exchange of an asset to generate recognized built-in gain since the definition of built-in gain is intended to encompass any item of income which is properly taken into account in the 10-year period yet was attributable to periods preceding the first S Corp. year. This change was intended, for example, to capture as built-in gain the collection by a cash basis S Corp. of accounts receivable generated while in C Corp. status.

Another change enacted by TAMRA 88 was the tightening of the taxable income limitation rule. Under TRA 86, the tax was imposed on the lower of the recognized built-in gain or the taxable income (calculated as if the corporation were a C Corp.) of that year. To discourage manipulation of taxable income in the year of built-in gain recognition (i.e., the generation of post S Corp. election losses or deductions in order to reduce taxable income to zero), TAMRA 88 provided for the carryover of the amount of the recognized built-in gain that was free from taxation because of the taxable income limitation. This amount will be subject to the tax if there is taxable income in a subsequent year within the 10-year recognition period.4 Thus, the only way to avoid the built-in gain tax completely is for taxable income to be zero for the entire 10-year recognition period. Manipulation of taxable income for such a period was presumed unlikely.

Although Congress has succeeded in preserving the corporate level tax for up to a 10-year period, an S Corp. election remains the long term solution to TRA 86 if the built-in gains tax can be dealt with during the short term. 3 Old Sec. 1374 imposed a corporate level tax on capital gains recognized by a former C Corp. within the first three years after its S Corp. election. This section continues to apply to corporations that elected S Corp. treatmentprior to December 31, 1986, and to certain qualified corporations that elected after that date but before December 31, 1988. 4 Congress did not want to remove the taxable income limitation completely, since it deemed it improper to tax the corporation if there was no taxable income. This amendment is effective for S Corp. elections made after March 31, 1988.

Personal Service Corporations

Prior to TRA 86, a Personal Service Corporation ("PSC") was defined by Sec. 269A as a corporation of which the principal activity is the performance of personal services, with such services being substantially performed by employee-owners. The term employee-owner meant any employee who owned more than 10% of the stock of the PSC.5

TRA 86 added two other definitions of PSCs. For purposes of the requirement for PSCs to adopt a calendar year end, the 10% ownership condition was dropped. Thus, any amount of stock ownership by an employee-owner (although more than 10% in total is required) will cause the corporation to be a PSC for this purpose.6

To limit the use of the cash method of accounting, TRA 86 provided for a new definition of a PSC, called a Qualified PSC ("QPSC"). These are corporations where substantially all of the activities are the performance of services by employee-owners, and which also meet both a function and an ownership test. The function test requires that the performance of services be in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting. Substantially all of the activities of a corporation are involved in the performance of these services but only if 95% or more of the time spent by employees is devoted to the performance of these services. The ownership test is met if 95% or more of the corporation's stock, by value, is held by employees performing services, retired employees 5 This section authorized the IRS to allocate income, deductions, and other tax attributes between the PSC and its employee- owner if such allocation is necessary to prevent tax avoidance or evasion or to clearly reflect the income of the PSC or any of its employeeowners. 6 See Sec. 441 of TRA 86 and amended by TAMRA 88. The Regulations also contain a 50/20% rule, which requires the corporation's compensation attributable to the performance of services to exceed 50% of the corporation's total compensation cost, and more than 20% of such personal service compensation to be attributable to services performed by employee-owners. who performed services, the estate of such an employee, or any other person who acquired the stock by the death of such employee.

Prior to TRA 86, PSCs were typically cash basis fiscal year taxpayers. The choice of the fiscal year end was geared to provide the greatest amount of income deferral in the initial year. The decision to incorporate may have been stimulated by the benefits of this federral, the ability to establish a corporate qualified plan providing for greater currently deductible contributions,7 the ability to establish and deduct other fringe benefits,8 or simply to provide for some degree of limited liability protection. TRA 86 enacted certain provisions affecting PSCs. Although exempting QPSCs from the new requirements for entities to adopt the accrual method of accounting, PSCs were now required to switch to a calendar year unless there was a business purpose for having a different year. RA 87 retroactively allowed PSCs to maintain their fiscal year end but at the cost of the loss of a current deduction for certain payments made to its employee-owners if the PSC failed to meet certain minimum distribution requirements. In addition, PSCs are subject to the new passive activity rules even though most C corporations are not.9 7 This reason for incorporation was removed as part of the qualified plan parity provisions of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). 8 For example-- group term life insurance, self insured medical plans, and disability insurance. 9 Closely held C Corps. can offset passive losses against active income.

Why Elect S Corp. Status?

RA 87 enacted a critical provision affecting QPSCs in that it disallowed QPSCs the use of graduated tax brackets. Thus, the highest possible corporate tax rate, currently 34%, is applied to any amount of QPSC taxable income. With the individual tax rate lower than the corporate tax rate and the loss of the corporate graduated tax brackests, a premium was placed on accurate year end tax planning for QPSCs. Cash basis QPSCs must now monitor their income at year end to assure that corporate income is reduced to near zero through the mechanism of year end bonuses, acceleration of deductible cash expenditures, or delaying collection of outstanding receivables. Further complexity is created since contributions to the corporate qualified plan are generally contingent on compensation. While year end planning was advisable for PSCs prior to TRA 86 as well, the $100,000 graduated bracket cushion, as well as the availability of the investment tax credit, did not require the exactness now demanded.

This year end scrambling could be avoided if the QPSC elected S Corp. treatment. As an S Corp., year end tax planning would be merged with the overall individual shareholder tax planning. There would be no fear of corporate taxes if the S Corp. income was not reduced to zero. Reduction (not through shareholder bonuses) or accelaration of overall S Corp. income would be dictated by the individual shareholder's tax planning. Thus, no fear of corporate taxes and no need for last minute maneuvering. It should be noted that not every state or local taxing jurisdiction recognizes S Corp. status. Thus, some degree of year end tax planning may still be necessary for state tax purposes.(10) Federal taxes, however, have been saved. In addition, the payment of compensation to the shareholders should still be monitored to insure that the professional is rewarded for his or her labor as intended and not as dictated by the allocation of remaining bottom line S Corp. income based on shareholdings. The compensation level must also be monitored so that the proper amount of qualified plan contribution is made for each shareholder. The greater part of the year end maneuvering, however, has been removed. 10 Individual state law must be analyzed for its own peculiarities. For example, New York State recognizes S Corp., but New York City does not. This may not be that ominous since New York City's alternative tax on officers' salaries creates a point where year end planning involving the payment of bonuses to officers would not reduce the City tax at all.

Potential sale of business assets

The previous discussion focused on how an S Corp. election would save corporate taxes on income generated in the ordinary course of business. Other income, such as income derived from the sale of corporate property not held for sale in the ordinary course of business, can also be shielded from corporate taxes through an S Corp. election. This type of income can include the sale of real or personal property as well as the sale of the business itself. When income of this nature is recognized it is typically too large an amount to be materially reduced by reasonable compensation deductions. Unless an S Corp. election is effected, the result would be the imposition of corporate taxes. Though the built-in gain provisions would operate to create a corporate level tax on the S Corp., the sooner the election is made, the sooner the 10- year period will toll. In addition the election locks in the amount of gain potentially subject to the built-in gain tax at the fair market value of the assets on the first day of the first S Corp. year. Thus, post S election asset appreciation is protected from corporate level taxation.

Cash basis PSCs, however, have an additional obstacle to an S Corp. election. This is the potential built-in gain problem cause by the collection, while an S Corp., of accounts receivable generated while in C Corp. status. By expanding the definition of built-in gain to include these receivables, TAMRA 88 may have effectively locked in a corporate level tax on these receivables, since they are normally collected during the 10-year period, and as explained, the use of the taxable income limitation to avoid built-in gain tax imposition is not viable.

The committe reports to TAMRA 88 may yield a solution. TAMRA 88 expanded the calculation of built-in gain to include both income and deduction items. Deduction items were defined as those items so allowable during the 10-year period but attributable to the pre S Corp. period. The committee report specifically states that these deduction items would include otherwise deductible compensation, paid after the conversion to S Corp. status, to persons who performed the services that produced the receivables includible in the built-in gain calculation. Thus, the amount of built-in gain attributable to accounts receivable could be materially reduced by these potential compensation deductions. The question that remains, however, is how much of the receivables can be offset by these latent compensation deductions. The taxpayer would argue that, as a PSC, there is typically no need for capital retention in the business and that normally all income is distributed as compensation. The Service would counter that this is not necessarily so. In addition, larger PSCs may be unable to offset the receivables in full, since their creation was attributable to services performed by employees, other than shareholders, whose compensation is generally fixed. In either case, the amount chosen as an offset would be somewhat arbitrary and subject to challenge. Without further guidance from the IRS, it may be risky to rely on this method to avoid the built-in gain tax problem created by the accounts receivable.

Perhaps another alternative would be for the C Corp. (immediately prior to its first S Corp. year) to distribute the accounts receivable to the shareholders as compensation.(11) Though this would cause the immediate income recognition of these receivables by the C Corp., the income would be offset by the related compensation deduction, assuming it is reasonable. This does, however, cause an earlier recognition, at the individual level, of compensation income that may not have been taxable until the subsequent calendar year. With the individual tax rates as low as they currently are and with the fear that at any moment the budget deficit would dictate a rate increase, such an acceleration of income may actually be advisable for an individual. Thus, the distribution of the receivables would both solve the built-in gain problem and save taxes at the individual level as well. 11 The C Corp. would then be engaged, for a fee, to act as the collection agent for the shareeholders. The shareholders would have the shareholders could purchase the receivable from the C Corp. followed immediately by the C Corp.'s distribution of the sales proceeds as compensation.

Corporate alternative minimum tax

TRA 86 also revamped the structure of the corporate alternative minimum tax ("AMT"). Prior to TRA 86, the AMT was an add on tax calculated by applying the AMT tax rate to the sum of Code enumerated tax preferences. The current structure of the AMT provides effectively for a dual tax system in that alternative minimum taxable income ("AMTI"), though starting with regular taxable income, is comprised of adjustments (both positive and negative) and preferences. The new AMT system was created to tax those corporations which, through the use of the tax law and its various preference type deductions, have succeeded in reducing current regular tax without affecting the corporation's economic or financial picture. One of the major adjustments in the calculation of AMTI is the book income adjustment.(12) This adjustment increases AMTI by 50% of the amount by which the adjusted net book income of the corporation exceeds the AMTI, determined without regard to this adjustment. The adjusted net book income of the corporation is the net income as reported on the applicable financial statement.

Cash basis PSCs may at time issue audited financial statements (e.g., to banks, for debt incurred by the PSC to finance a move or expansion). If these statements were issued on the accrual basis, there would most likely be a significant difference between the net income as reported on the statement and the AMTI. This would trigger a book income adjustment which would cause the imposition of the AMT. Issuing tax basis financial statements with an accrual basis income footnote disclosure may accomplish the purposes for issuing the financial statements but would not cure the AMT problem. While this problem could be solved in that the Regulations provide for an election to treat net book income as equal to current earnings and profits, this election is not available if audited statements are issued. Moreover, this election must have been made for the first taxable year that the corporation was eligible to make the election. This means that if the corporation did not issue audited statements for its first tax year beginning after 1986 and the election was not made on that return, it can no longer be made. Thus, cash basis PSCs could be subject to the corporate AMT. The obvious solution is an S Corp. election since S Corps. are not subject to the corporate AMT. 12 For taxable years beginning after 198, the book income adjustment is replaced by an adjustment based on adjusted current earnings.

Miscellaneous benefits

The IRS has at time challenged the compensation level of corporate shareholders as unreasonable. If successful, the excess salary is recharacterized as potential dividend income with the concomitant loss of a corporate deduction. While the unreasonable compensation issue is generally not a concern for PSCs, it can arise in situations where the income of the PSC for a particular year was not generated entirely by services. If, for example, a PSC had substantial income from the sale of a capital asset and wishes to distribute the income as salary, the IRS could conceivably argue that the compensation is unreasonable. An S Corp. in the same situation would not need to distribute the income out as salary. Thus, the unreasonable compensation issue is not a concern for S Corps.13

S Corps. are also not subject to the personal holding company tax and the accumulated earnings tax.

TRA 86 revamped the interest expense deduction area by requiring a breakdown of each type of interest expense and applying different rules for each category. Interest expense incurred to carry C Corp. stock is classified as investment interest and is subject to the investment interest limitation rules. Interest expense incurred to carry S Corp. stock is classified based on the activity of the S Corp. and the participation of the shareholder. Thus, interest expense incurred to carry the stock of an S Corp. PSC would generally be fully deductible by the materially participating S Corp. shareholder.

S Corp. characteristics

Before electing S Corp. status, PSCs should consider how they are affected by some of the special characteristics of S Corps. Although the requirement for only one class of stock should not be a concern, the 35 shareholder limit, and the disallowance of nonresident shareholders may present a problem for some of the larger PSCs. The denial of a deduction for the cost of fringe benefits to 2% S Corp. shareholders may disenchant some smaller PSCs that had been using Code fringe benefit entitlements.(14)

Shareholder loans from corporate qualified plans must be repaid before electing S Corp. status. This is because loans from qualified plans to more than 5% shareholder-employees of S Corps. are prohibited transactions subject to the penalty tax of Sec. 4975. In addition, all potential violations of S Corp. status must be cured by the first day of the first S Corp. year. Otherwise, the S Corp. election would be invalid.

S Corps. with C Corp. earnings and profits can be subject to a tax on excess passive investment income if more than 13 To the contrary, the IRS has at times argued that shareholder compensation in an S Corp. was too small. This is sometimes concluded when shareholders wish to reallocate the S Corp.'s income to lower bracket or younger generation shareholders. 14 The nondiscrimination rules of Sec. 89 as part of TRA 86 may have already watered down the availability of fringe benefits to highly compensated employees. 25% of gross receipts consist of passive investment income. This is not a problem for PSCs since they generally do not maintain large amounts of liquid assets. The existence of C Corp. earnings and profits can, however, cause distributions in excess of the accumulated adjustment account ("AAA") to be taxable as dividend income. S Corp. PSCs that do have cash available for distribution probably have sufficient AAA to cover the distribution. Even if the cash was borrowed, or had been on hand since C Corp. status, it could be loaned out to the shareholders with proper repayment and interest rate terms.

S Corp. PSCs do not normally generate losses. However, a loss is possible if, for example, the PSC is in its formative stage, too much compensation was paid out, or a loss was created by the accrual for a qualified plan contribution. In this situation, shareholders would probably have sufficient basis to deduct the loss. Should basis not exist, proper year end planning would dictate an infusion of capital or a loan to the S Corp.

The election of S Corp. status would require those PSCs that retained their fiscal year to switch to a calendar year that retained their fiscal year to switch to a calendar year, unless there exists a business purpose for a different year. The switch to a calendar year would cause the bunching of more than twelve months of income into one shareholder calendar year. This may not necessarily be undesirable considering today's low individual tax rates. Alternatively, the S Corp. can retain its fiscal year with the proviso that it begin making enhanced estimated tax payments as required by Sec. 7519.

While in the past PSCs generally desired C Corp. status, the last three tax acts have sufficiently changed the rules to warrant consideration of S Corp. status. S Corp. status can save overall taxes and is administratively easier to monitor. In addition, the Code constraints inherent with being an S Corp. are not as formidable as they seem and can be factored into the overall plan.