S Corporation Webinar Series: Webinar 5

Transcription

1 S Corporation Webinar Series Webinar 5: Special Problems with Eligibility and Elections with Jim Hamill, Director of Tax Practice at Reynolds, Hix & Co., P.A. in Albuquerque, NM 4 S Corporation Webinar Series: Webinar 5 Issues with Ineligible Shareholders Issues with Capital Structure Issues with Formations S Corporation Webinar Series: Webinar 5 Issues with Ineligible Shareholders Issues with Capital Structure Issues with Formations 1

2 Shareholder - Type Individuals No NRAs Qualifying trusts and estates Non-US Shareholders NRA is not Eligible NRA spouse ownership may be a function of local law Sec. 6013(h) election by NRA spouse to be taxed on worldwide income cures the defect Dual Residence Generally OK, unless claims treaty benefits May waive with requirements of Regs. Sec (b)-7 Estates Provided the decedent is an eligible shareholder, the estate is also eligible Unlike qualified trusts, flexible beneficiaries and distributions Cannot prolong decedent s estate status A bankruptcy estate is also eligible; problem arises if stock is distributed to an ineligible shareholder 2

3 Trusts Grantor Trust is acceptable if deemed owner is an eligible shareholder A testamentary trust (including a former grantor trust) is acceptable for 2 years after death By statute, a QSST or an ESBT QSST One current income beneficiary Beneficiary must consent (to both QSST and, if applicable, S election) Annual income distributions Beneficiary is taxed on S Corp income QSST may be a permanent shareholder, even after death of the beneficiary QTIP trust can be a QSST ESBT Simplified Explanation More than one beneficiary allowed No current income distribution requirement Trust is taxed on S corporation income All beneficiary distributions are nontaxable Beneficiaries must be qualified shareholders, who cannot acquire their interest by purchase Trust elects ESBT status 3

4 ESOP as S Shareholder Unlike other qualified plan shareholders, ESOPs are not subject to UBTI for S corporation income Nondiscrimination and fiduciary responsibility limit the ability to use ESOPs as a means of exempting the S corporation income from taxation ESOP as a S Shareholder Disqualified person rule (actual or synthetic equity) means ESOP shareholder must be broadly owned ESOP is the shareholder ESOP may distribute cash in lieu of S corporation stock S Corporation Webinar Series: Webinar 5 Issues with Ineligible Shareholders Issues with Capital Structure Issues with Formations 4

5 Single Class of Stock Voting rights may be different Distribution rights may not be different Governing provisions apply Mix ups not caused by governing provisions may be acceptable, provided some corrective action is taken and a logical reporting position is adopted Debt or Equity? Section 385, which also applies to S corporations, notes that a corporate instrument may be debt or equity based upon its substance (not just form) If a debt instrument is reclassified as equity, its terms may be such that it creates a second class of stock. Debt or Equity? Proportionally held debt is OK Single shareholder safe More than one shareholder, no abuse potential Short-term unwritten advance < $10,000 is OK Straight debt, defined in Section 1361(c)(5) 5

6 Straight Debt Safe Harbor Interest not contingent (profits, borrower discretion) Not convertible into equity Creditor is a qualified shareholder This instrument may be reclassified as equity, but cannot violate the SCOS requirement Section 385 Factors Written unconditional promise to pay on demand or specified date a sum certain with interest Not subordinated/preferred to other debt Reasonable debt/equity ratio Not convertible Relationship between holdings of equity and debt LLC S Elections Operating agreements often provide for rights inconsistent with S requirements Simplified procedure of Form 2553; no Form 8832 needed for S election Form 8832 supposed to be filed with 1120S Failure cannot invalidate election But penalties may apply 6

7 LLC S Elections The FATP must conduct a careful review of the operating agreement This cannot be outsourced to the attorney if we file an 1120S The preparer must be convinced the entity is an eligible entity So the switch from default status to S status may be costly (professional fees) Safe Harbor - SCOS 302 Exchange Transactions are Safe Harbored 302 Distributions are Safe Harbored unless Attempt to circumvent SCOS Redemption price not at FMV Certain Compensatory Transfer of Equity Equity Compensation and SCOS 83 vesting (or 83(b) election) is generally the trigger for determining SCOS Non-stock plans such as SARs, phantom stock generally OK (no stock ownership) Options are OK provided they are not substantially certain to be exercised (e.g., deep in the money) 7

8 S Corporation Webinar Series: Webinar 5 Issues with Ineligible Shareholders Issues with Capital Structure Issues with Formations S Corporation Formations 1001 creates a realization event 351(a) creates relief for the shareholder 1032 creates relief for the corporation 351(a) Shareholder Relief No gain or loss shall be recognized Transfer of property to corporation In exchange for stock Transferor(s) are in control immediately after Boot relaxation may apply 351(b) gain for money or non-stock consideration No loss allowed for receipt of boot 8

9 Basis Issues 358(a) for shareholder Stock basis is Basis of property transferred, plus Gain recognized, minus Boot received Boot basis is FMV 362(a) for corporation Carryover from shareholder, plus Gain recognized by shareholder Ancillary Issues Holding Period Shareholder has Substituted Basis: Tack if transfer capital or 1231 asset only Corporation has Carryover Basis: Always tack Depreciation 168(i)(7) for carryover basis Fresh start if shareholder gain triggers basis increase Liability Assumption by Corporation General rule Not boot to the shareholder But stock basis is reduced by assumption Exceptions Liability assumption exceeds basis of property transferred (avoids negative basis) Bad liabilities: no bona fide business purpose or incurred with tax avoidance motive 9

10 357(c) Gain Liability assumption exceeds basis of property transferred This is an aggregate test (avoid negative stock basis) Assumption test of 357(d) - Recourse Corporation agrees to pay All parties expect them to pay Gain Scenarios In some cases, we may want to trigger gain Thus, we need to fail 351, or cause a taxable 351 Sale rather than exchange Trigger 357(b) or (c) Gain Scenarios Controlled Entity Sale Lock-in capital gain pre-development Trigger 121 residence exclusion before rental period hits 3 years Documentation and consideration (avoid debtequity concerns) is essential Accelerate Income into Low Tax Year? 10

11 S CORPORATION PAYROLL TAX Shareholders in an S Corporation may be employees Thus, compensation payments are subject to FICA tax for both the employer and employee 1958 creation of subchapter S envisioned income shifting with low compensation, but not payroll tax savings S CORPORATION PAYROLL TAX Payroll tax avoidance is of particular concern with one shareholder entities, including by attribution The reason is that low compensation would otherwise shift earnings and distributions to other shareholders S CORPORATION PAYROLL TAX A 2002 Treasury study showed that IRS did not raise low compensation enough 22% of audits in question Average compensation in these audits was $5,300 A 2005 Treasury study found 47.1% of profits paid as salary in % of profits paid as salary in

12 2005 TREASURY RECOMMENDATIONS AND IRS RESPONSE For S corporation shareholders owning > 50% of stock (with family attribution), recommend all income subject to payroll tax IRS prefers broader question of integrating S corporations, partners, and self-employed (similar to ABA/AICPA approach) PRACTITIONER ISSUES General issues of professional standards Treasury Circular 230 ABA Opinion 346 AICPA SSTS (last revision effective ) New preparer standards (post-2007 generally) Substantial authority to avoid preparer penalty Reasonable basis to avoid disclosure 2