Management companies used with S corporations can cause problems for the unwary. (Subchapter S corporations)by Fecteau, Macr N.
The idea behind creating the management company is simple. The S corporation shareholders create a new C corporation to conduct certain administrative or management functions currently performed by the S corporation operating company. The management company charges a fee to the operating company, sufficient to generate taxable income of $50,000. Because the management company is a C corporation in the 15% bracket and the shareholders would have been taxed at 28% individually from the S corporation income, a savings of 13% results.
The dangers of such an arrangement are numerous. The pitfalls can, however, be grouped into three time frames: 1) the pitfalls at creation of the entity:2) during the active period of the company's existence; and 3) upon termination of the entity.
Issues During Creation
The key criterion which must be met during the creation of a management company is demonstration of a clear business purpose. If the business purpose test cannot be passed Sec. 269 could disallow the benefit of the graduated C corporation rates. Sec. 269 comes into play when three factors exist: 1) the principal purpose of the incorporation was to avoid taxes; 2) the tax advantage would not be available without the incorporation; and 3) such benefit is inconsistent with congressional intent.
If the primary motive is a clear, logical separation of activities or functions, Sec. 269 may be avoided. For example, consolidation of administrative duties for multiple S corporations, to eliminate repetitive functions and cost duplications may provide the prerequisite business purpose.
Concerns over the business purpose test do not end with Sec. 269. If an incorporation of the management company is executed under Sec. 351, the business purpose test will also apply to determine the non- taxability of the incorporation transfers. An additional area of concern is Sec. 1551, disallowing the benefit of the graduated rates when certain non-cash transfers are made as part of incorporation. Under Sec. 1551, if a corporation, or five or fewer individuals who are in control of a corporation, transfers property other than money to a corporation and the new corporation was either created primarily to acquire that property or was otherwise inactive at the time of transfer, then the IRS may disallow the benefit of both the graduated rates and the accumulated earnings credit. It seems clear that upon incorporation a "cash only" transfer by the shareholders will avoid the Sec. 1551 disallowance,
Having navigated successfully through the incorporation, you are now faced with five issues during operation: 1) personal service corporation (PSC) status; 2) Sec. 482; 3) personal holding company (PHC) status; 4) cash accumulations; and 5) the accumulated earnings tax (AET).
PSC status. PSC status results (under Sec. 448) when a corporation meets both the function and ownership tests of Temp Regs. Sec. 1.448-IT. Classification as a PSC brings with it a flat 34% tax bracket. The function test is met if 95% or more of all employees' time is spent in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting. The ownership test is met when 95% of the stock value is owned by those who are also employees performing services for the corporation, retired employees, or their heirs. Limited attribution rules apply to indirect ownership via partnerships, S corporations or other PSCs. Assuming the function test is met, PSC status could be avoided by restricting employees to non- owners or assuring that more than 5% of the stock by value is owned by non-employees.
Sec. 482. Under Sec. 482 the IRS has authority to reallocate items of income and expense among related taxpayers. The potential impact of this section is avoided by recording all activity between the management company and the operating company at an arm's length rate. Although the power vested in the IRS is broad, Sec. 482 should not play a major role in such arrangements, provided the fee structure is reasonable and appropriate.
Since the idea behind creating a management company is to take advantage of lower corporate tax rates, it is unlikely that the company would declare any dividends, that would generate a second laver of tax. Therefore, the accumulation of cash within the company is the basis for the other three concerns that must be considered during its existence.
PHC status. A 28% tax, in addition to the regular corporate income tax, is imposed on PHCS. A PHC is a corporation with 60% or more of its adjusted ordinary gross income consisting of dividends, rents, royalties, or personal service contracts. This applies only to corporations that have five or fewer shareholders. The tax would most likely surface in later years, when the cash accumulations are large enough to generate a major portion of the company's taxable income. Avoiding the PHC tax is done relatively easily by investing excess funds in tax-exempt offerings or non-income producing investments, or alternatively, by simply having six or more unrelated shareholders.
Cash accumulation. The accumulation of cash within the management company is a major non-tax consideration. From a business perspective, owners may be hesitant or unwilling to accumulate large amounts of cash in the management company. This may lead to intercorporate borrowing. If the interest rate is in line with the AFR, the loan is properly documented, and a payment schedule is adhered to, such a loan is workable. Note, however, that interest earned by the management company must be considered within the PHC guidelines above.
AET. Finally, the AET could create problems once the corporation's accumulated earnings exceed the statutory $250,000 accumulated earnings limit. If the AET kicks in, 28% of accumulated taxable income, in addition to the regular corporate tax, is payable. The AET arises when the corporation cannot demonstrate a valid business reason for the accumulation, and it applies regardless of the number of shareholders. it does not apply to a PHC or to an S corporation. Unless a corporation can demonstrate the need for an accumulation, and it appears difficult for most management companies to do so, the S election may be the only alternative to avoid the AET.
Once the decision is made to wind down the management company, either because of the shadow of the PHC, AET, or other tax consequences, three basic options exist: 1) operate as an S corporation; 2) liquidate; or 3) merge.
Operating as an S corporation Operating under a subsequent S election may remove concerns over the PHC and AET taxes, but it introduces new concerns. Assuming the operating S corporation's shareholders also own the management company, it is unlikely that earnings will be taxed at the lowest individual rate of 15%. In addition, the income generated by the accumulated C earnings may result in the application of the excess net passive income tax, (Sec. 1375), at 34%. This tax applies when an S corporation has both Subchapter C Earnings and Profits (E&P), and gross receipts consist of more than 25% of passive investment income. In addition, if prior C corporation E&P is distributed by an S corporation, taxable dividends (to the extent of basis) or capital gain treatment will result. Thus, the earnings would be subject to the individual level tax at up to 28% plus the 15% C corporation tax previously paid.
Liquidation. Similariy, under the straight liquidation option, two levels of tax will result. Sec. 336 will apply at the corporate level resulting in fully taxable gains on the management company's assets "as if sold at fair market value." However, this corporate tax would be minimal if the assets of the corporation consist primarily of the cash accumulated during the active period. At the individual level, the shareholder treatment is governed under Sec. 331 that generally results in sale or exchange treatment, thus exposing the liquidating distribution to the 28% individual tax. Again, this second level of tax defeats the reason the management company was created in the first place.
There are indications that an upstream Sec. 332 subsidiary liquidation subsequent to a B reorganization could be accomplished successfully. in such a case the management company momentarily becomes both a shareholder and subsidiary of the operating S corporation. Whether or not the IRS would condone a transitory corporate shareholder is unclear. However, it is clear that an S corporation may have a transitory subsidiary. The IRS's position acknowledges that S corporations may be parties to a reorganization. An interesting discussion can be found in General Council Memorandum 39768, which discusses the role of S corporations in reorganizations. In particular, it references approval of A reorganizations (Rev. Rul. 79-52, Rev. Rul. 70-232), C reorganizations (Rev. Rul. 71-266) and D reorganizations (Rev. Rul. 72- 320). Notably absent, however, is any discussion of a B reorganization in a transitory mode. Without an immediate liquidation of the management company, the S election would certainly be lost. Of course, as with the initial incorporation, a reorganization is only valid if it is conducted with a valid business purpose.
Merge. Finally, the management company could be merged into the S operating company provided the business purpose test can be met. As discussed above, the service agrees that an S corporation may be a participant in an A reorganization.
Although an attractive tax planning technique, using multiple companies to obtain the benefit of graduated corporate and individual tax rates is, at best, a trap for the unwary. In some cases, however, all the pieces may fit together and allow such operative formations. in all cases, care must be exercised to assure taxpayers are not faced with taxes beyond operating as a single S corporation.
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