Bank Tax Institute S Corporations

Transcription

1 Bank Tax Institute S Corporations Brett E. LaBelle, Partner Crowe Horwath LLP Kevin F. Powers, Partner Crowe Horwath LLP Justin Horst, CFO Pinnacle Bancorp, Inc. November 4, 2010

2 Disclaimers These slides are for educational purposes only and are not intended, and should not be relied upon, as legal, tax or accounting advice. Pursuant to Circular 230 promulgated by the Internal Revenue Service, please be advised that these slides were not intended or written to be used, and that they cannot be used, for the purpose of avoiding federal tax penalties unless otherwise expressly indicated. 2

3 Agenda TEFRA Interest Expense Disallowance Small Business Jobs Act of 2010 Effect of Tax Rate Sunset Provisions on S Corp Shareholders Tax Planning CFO s Perspective Trust Shareholders Other Current Issues 3

4 TEFRA Interest Expense Disallowance 4

5 TEFRA Interest Expense Disallowance What is the issue? Starting in 1997, banks (and bank holding companies) were allowed to elect S Corp status Code Section 1363(b)(4) provides that the income of an S Corp shall be computed in the same manner as in the case of an individual, except that Code Section 291 shall apply if the S Corp was a C Corp for any of the three (3) immediately preceding taxable years Thus, for banks (or bank holding companies) that elected S Corp status prior to 2006, there should be no interest expense disallowance under Code Section 291(a)(3) 5

6 TEFRA Interest Expense Disallowance IRS Proposed Regulations On August 24, 2006, the IRS proposed new regulations (Prop. Regs. Section (b)) subjecting S Corp banks to the 20% TEFRA disallowance under Code Section 291, without regard to the three-year limit under Code Section 1363(b)(4), effective for the 2007 tax year Third-party comments universally said the IRS has no authority to override statute with regulations IRS says comments are unpersuasive Regulations still not finalized Impact from appeals court reversal of Vainisi Tax Court case? 6

7 TEFRA Interest Expense Disallowance Vainisi v. Commissioner, 132 T.C. No. 1 Tax Court ruled in favor of IRS (1/15/2009) Notice of Appeal filed (9/4/2009) Judge Foley ruled that Congress did not intend that the exclusion from Code Section 291 after the 3 rd S Corp year was to apply to QSub banks Congress did not amend Code Section 1363(b)(4) back in 1996, when banks were first allowed to elect S Corp status, to specifically exclude QSub banks Thus, Congress purposely intended, through their inaction, for this provision to not apply to QSub banks What are the flaws in the Tax Court ruling?? 7

8 TEFRA Interest Expense Disallowance Vainisi v. Commissioner, 132 T.C. No. 1 Flaws in the Tax Court ruling 1. The word QSub was not added to other operative sections applicable to S Corps, including built-in gains Are we to assume that because Congress did not add the word QSub to Code Section 1374 that built-in gains tax does not apply to a QSub bank? 2. The Tax Court never addressed the impact of its ruling on stand-alone S Corp banks with no holding company Since the Tax Court only focused on the QSub language, there would now appear to be inconsistent treatment between QSub banks and stand-alone S Corp banks 8

9 TEFRA Interest Expense Disallowance Vainisi v. Commissioner, 105 AFTR 2d U.S. Court of Appeals, Seventh Circuit reversed the decision of the Tax Court (3/17/2010) Judge Posner ruled that the Tax Court erred on the following grounds: There is no evidence that Congress never intended for Code Section 1363(b)(4) to apply to banks; it applies to all S Corps banks and non-banks alike Excluding Qsub banks from the Code Section 1363(b)(4) provisions, because the term QSub does not appear in that section, would exempt all QSub banks even those that converted during the past 3 years from Code Section 291 How should S Corp/QSub banks deal with this on a prospective basis? 9

10 Small Business Jobs Act of

11 Small Business Jobs Act of 2010 Built-In Gains Tax: Effective for S Corp tax years beginning in 2011 Built-in gains recognition period temporarily reduced from ten years to five years Thus, for 2011 only, the recognition period is the 5-year period beginning with the first taxable year for which the corporation was an S Corp American Recovery & Reinvestment Act (ARRA) had previously reduced the built-in gains recognition period from 10 to 7 years, but only if the seventh taxable year in the recognition period preceded either 2009 or 2010 See chart on next slide 11

12 Small Business Jobs Act of 2010 Built-In Gains Tax: Including overlap of ARRA provision Tax year converted to S Corp BIG Tax applicable for 2009? BIG Tax applicable for 2010? BIG Tax applicable for 2011? BIG Tax applicable for 2012? 2001 NO NO N/A N/A 2002 NO NO NO N/A 2003 YES NO NO YES YES YES NO YES 2007 or later YES YES YES YES 12

13 Small Business Jobs Act of 2010 Built-In Gains Tax: When ARRA was enacted in 2009, the AICPA S Corporation Technical Resource Panel requested clarification from Treasury on a number of issues related to the BIG Tax suspension For example, an S Corp which converted from a C Corp to an S Corp in 2002 has a built-in gain from a sale of property in 2009, but has no taxable income in 2009 or 2010 Absent ARRA, the built-in gain would be suspended and treated as a built-in gain in the subsequent tax years i.e., 2011 Since the built-in gain was generated during a suspension year, will it now be subject to BIG Tax in 2011? Is there a similar impact from suspension of 2011 built-in gains under the Small Business Jobs Act? 13

14 Small Business Jobs Act of 2010 General Business Credits: 2 related provisions 1. Eligible small business ( ESB ) credits can offset AMT liability for credits generated during the first tax year beginning after Dec. 31, 2009, including carrybacks of those credits 2. ESB credits generated during the first tax year beginning after Dec. 31, 2009 can be carried back 5 years (current law allows for only a 1-year carryback period) Eligible small business A non-publicly traded corporation, a partnership, or a sole proprietorship whose average gross receipts for the prior 3 tax years does not exceed $50 million 14

15 Small Business Jobs Act of 2010 General Business Credits: The amount of the general business credit allowable in any tax year generally cannot exceed the excess, if any, of the taxpayer's net income tax (i.e., regular tax liability, plus AMT) over the greater of: (a) The tentative minimum tax for the tax year, or (b) 25% of so much of the taxpayer's net regular tax liability as exceeds $25,000 For purposes of the above computation, tentative minimum tax is treated as zero WARNING: If company still has a net regular tax liability, ESB credits may not be fully utilized (but could be carried back or forward) 15

16 Small Business Jobs Act of 2010 General Business Credits: ESB credits include 1. Low-income housing credit 2. Rehabilitation credit 3. New markets tax credit 4. Work opportunity credit 5. Welfare-to-work credit 6. Other credits as provided in Code Sec. 38(b) 16

17 Small Business Jobs Act of 2010 General Business Credits: Credits determined with respect to an S Corp are not treated as ESB credits by any shareholder unless the shareholder meets the gross receipts test as well In other words, the gross receipts test must be satisfied at the S Corp level and the shareholder level However, no rules are provided for determining the gross receipts of an individual S Corp shareholder Do the gross receipts of an individual shareholder include his/her pro-rata share of the gross receipts of the S Corp? Do the gross receipts of an individual shareholder include the gross receipts of his/her spouse? 17

18 Small Business Jobs Act of 2010 General Business Credits: EXAMPLE Facts Individual D is an S Corp shareholder Both D and the S Corp qualify as an ESB D has a net regular tax liability of $30,000 (before ESB credits) D has tentative minimum tax of $45,000, and thus $15,000 of AMT (before ESB credits) D has $50,000 of ESB credits that pass-thru from the S Corp and no other tax credits 18

19 Small Business Jobs Act of 2010 General Business Credits: ANSWER The ESB credit can be used to the extent D s net income tax - $30,000 regular tax, plus $15,000 AMT, or $45,000 - exceeds the greater of: 1. Tentative minimum tax = $0 (for purposes of ESB credits), or 2. 25% of net regular tax liability ($30,000) in excess of $25,000 = $1,250 Thus, the ESB credit limitation is $43,750 The unused ESB credit of $6,250 can be carried back 5 years or forward 20 years 19

20 Effect of Tax Rate Sunset Provisions On S Corp Shareholders 20

21 EGTRRA Sunset Provisions The tax cuts enacted by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) will sunset after Dec. 31, 2010 This includes the enhanced capital gains and dividends tax rates in the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) Plus, for tax years effective after Dec. 31, 2012, higherincome taxpayers will be subject to an additional 0.9% Medicare tax on earned income above $250,000 (married filing joint) and a 3.8% Medicare tax on the lesser of net investment income or modified AGI in excess of $250,000 (married filing joint) Investment income will include S Corp pass-thru income for passive investors in an active trade or business 21

22 Sunset of Individual Tax Rates Income Type Pre-2011 Rates Post-2010 Rates Ordinary 35.0% 39.6% Dividends 15.0% 39.6% Capital Gains 15.0% 20.0% * * 18% capital gains rate for assets held over 5 years 22

23 S Corporation Planning Opportunities Assuming EGTRRA rates are not extended: Conversion from C Corp to S Corp should be even more advantageous See examples on next slides Consider deferral of deductions (e.g., bad debt chargeoffs), until after 2010, to reduce pass-thru taxable income that will be taxed to shareholders at higher rates Consider elections to distribute C Corp accumulated earnings & profits and/or make deemed dividend distributions 23

24 C Corp vs. S Corp Tax Benefit Analysis EGTRRA Rates: C CORP S CORP Pre-tax income $ 1,000,000 $ 1,000,000 Corporate level income tax $ (340,000) $ N/A Tax $ 0 $ (350,000) After-tax income $ 660,000 $ 650,000 Capital retention $ (500,000) $ (500,000) Additional dividend $ 160,000 $ 150,000 Income dividend rate $ (24,000) $ N/A Net cash to shareholders $ 136,000 $ 150,000 Benefit from increase in basis $ 0 $ 75,000 Total return to shareholders $ 136,000 $ 225,000 Net benefit from S election = $89,000 NOTE: Assumes all shareholders are in 35% tax bracket and amounts are rounded to nearest $1,000. The tax benefit of the stock basis adjustment is equal to 15% multiplied by the net basis increase of $500,000 (not discounted for future value). 24

25 C Corp vs. S Corp Tax Benefit Analysis Post-EGTRRA Rates: C CORP S CORP Pre-tax income $ 1,000,000 $ 1,000,000 Corporate level income tax $ (340,000) $ N/A Tax $ 0 $ (396,000) After-tax income $ 660,000 $ 604,000 Capital retention $ (500,000) $ (500,000) Additional dividend $ 160,000 $ 104,000 Income dividend rate $ (63,000) $ N/A Net cash to shareholders $ 97,000 $ 104,000 Benefit from increase in basis $ 0 $ 90,000 Total return to shareholders $ 97,000 $ 194,000 Net benefit from S election = $97,000 NOTE: Assumes all shareholders are in 39.6% tax bracket and amounts are rounded to nearest $1,000. The tax benefit of the stock basis adjustment is equal to 18% multiplied by the net basis increase of $500,000 (not discounted for future value). 25

26 S Corp Distribution Rules If S Corp has AE&P: 1. AAA = Tax-free 2. PTI = Tax-free 3. C Corp accumulated earnings and profits (AE&P) Taxed as dividends 4. OAA Cannot make non-dividend distributions from this account Shareholder = Return of capital to extent of basis Balance = Capital gain If S Corp has no AE&P, distributions simply reduce basis in stock (excess = capital gain) 26

27 S Corp Distribution Planning The AAA account is reduced by distributions, as well as losses and deductions recognized during the year This can limit tax-free distributions from AAA and/or cause future distributions to be taxed as dividends from C Corp AE&P Assuming the EGTRRA rates will sunset after Dec. 31, 2010, these dividend distributions from C Corp AE&P will be taxed at a maximum 39.6% rate Can anything be done to reduce this increased tax exposure? 27

28 S Corp Distribution Planning Election to distribute C Corp AE&P first: S Corps can modify the order in which distributions are applied An S Corp can elect to treat its distributions for the year as being made first out of C Corp AE&P Any distributions in excess of C Corp AE&P are then applied to AAA The election is made on an annual basis and applies to ALL distributions made during the year The election is made by attaching a statement to the tax return it must also indicate that all affected shareholders have consented to the election 28

29 S Corp Distribution Planning Deemed dividends: The S Corp can make an irrevocable election to distribute part of its C Corp AE&P without having to actually distribute cash The deemed dividend is considered to have been distributed in cash and then immediately contributed back to the S Corp The deemed dividend cannot exceed the amount of the C Corp AE&P at year-end (reduced by actual distributions from AE&P during the year) This can be advantageous for shareholders with NOL carryovers, current-year losses, or large itemized deductions 29

30 S Corp Distribution Planning EXAMPLE - FACTS Individual D is the sole shareholder of S Corp S Corp has an ordinary business loss for the year of $500,000 S Corp made no distributions during the year S Corp has AAA of $300,000 as of year-end (after reduction for $500,000 current-year ordinary business loss) S Corp also has C Corp AE&P of $750,000 as of year-end D s basis in S Corp stock is $900,000 (after reduction for $500,000 current-year ordinary business loss) S Corp elects to make a deemed dividend of $750,000 to eliminate all of the C Corp AE&P 30

31 S Corp Distribution Planning EXAMPLE - ANSWER D will report the $750,000 as dividend income on his/her personal tax return D will also report the $500,000 current-year ordinary business loss passed through from the S Corp on his/her personal tax return D will increase his/her basis in the S Corp stock by the $750,000 deemed capital contribution For 2010, the net $250,000 dividend income will be taxed at a maximum 15% tax rate In addition, the basis increase will reduce the tax liability from a future disposition of the stock 31

32 Tax Planning CFO s Perspective 32

33 Maximizing the Cash Basis Election Certificates of deposit Set the payment dates to fall on quarter ends regardless of the maturity of the certificate of deposit so that interest expense is paid and therefore creates an additional tax deduction Federal Home Loan Bank borrowings Send the accrued interest payment to the FHLB on the last day of the tax year, rather than waiting for the FHLB to take the interest payments on the first day of the next month; again creates an additional tax deduction 33

34 Maximizing the Cash Basis Election Prepaid and accrued expenses Attempt to prepay all items that would normally be paid within the first 2 to 3 months of the next tax year to accelerate the deduction into the current tax year 34

35 Individual Income Tax Issues Tax distributions Multiple federal income tax brackets, itemized deduction phase-outs, new investment income taxes and state income tax issues make accurate determination of S Corp distributions much more challenging than C Corp estimated tax calculations Timing of K-1 issuance to shareholders Balancing the timing of tax preparation for a large group of shareholders can be tricky A fiscal year-end, versus a calendar year-end, can be utilized to speed up distribution of K-1 s 35

36 Individual Income Tax Issues State tax incentive programs If S Corp has shareholders in multiple states, the impact of these state tax incentives can be diminished for out-of-state shareholders Charitable contributions Set a review process for donations through the accounts payable department to assist in determining whether some of the amounts recorded as donations can be classified as promotions such as sponsorship of community events; donations pass-thru to shareholders as separately-stated items and can be subject to itemized deduction phase-outs 36

37 Other Thoughts IRS examinations Bad debts / conformity election Built-in gains Passive investment income Shareholder stock transfers Compliance with shareholder agreements Transfers to trusts for estate planning Family shareholder groups 37

38 Trust Shareholders 38

39 Trust Shareholders The rules for S Corp trust shareholders are very complicated Disqualified trust shareholders are a common cause for an S Corp to inadvertently lose its election There are special relief provisions to correct this problem, but it can be costly (often requires a PLR) This should be an area of focus for due diligence on S Corp acquisitions Review of trust agreements is also a crucial step when making the initial S election 39

40 Trust Shareholders Types of eligible trust shareholders: Grantor Trust Voting Trust Testamentary Trust For 2 years only Electing Small Business Trust (ESBT) Qualified Subchapter S Trust (QSST) Employee Benefit Plan 501(c)(3) Organization IRA Limited applicability 40

41 Trust Shareholders Grantor Trust Qualifications: Revocable trust is most common, but any grantor trust (even if irrevocable) qualifies U.S. citizen or resident is the deemed owner of the entire trust Qualifies while the deemed owner is alive Continues to qualify as an eligible shareholder for 2-year period following grantor s death, however can extend to entire period of estate administration if trustee makes a Code 645 election 41

42 Trust Shareholders Grantor Trust Pitfalls: Cannot be a foreign trust S Corp shares held for more than 2 years after grantor s death Unless a Code 645 election is made Becomes an irrevocable trust However, may qualify as an ESBT or QSST if election timely made 42

43 Trust Shareholders Voting Trust Qualifications: Trust created, pursuant to a written agreement, primarily to exercise the voting power of S Corp stock transferred to it Requires current distribution of income Requires ownership of stock to be transferred to beneficiaries upon termination Trust must terminate, under its terms or by state law, on or before a specific date or event 43

44 Trust Shareholders Voting Trust Pitfalls: Cannot be a foreign trust Each beneficiary is counted as a separate shareholder 44

45 Trust Shareholders Testamentary Trust Qualifications: Trust created pursuant to a Will Can hold S Corp stock for up to 2 years following transfer of stock to the trust Note that the estate can hold the S Corp stock until the estate is settled, then the trust to which the stock is transferred pursuant to the Will can hold the stock for another 2 years 45

46 Trust Shareholders Testamentary Trust Pitfalls: Cannot be a foreign trust S Corp shares held for more than 2 years after transfer to trust 46

47 Trust Shareholders - ESBT Qualifications: Trust can only have individuals, estates, or qualified exempt organizations as beneficiaries No interest in the trust acquired by purchase Cannot be a charitable remainder trust Election must be made to treat as ESBT If shareholder at time of S election, ESBT election must be filed within 2½ months after earlier of 1) date on which S election filed or 2) effective date of the S election If S election was effective before corporate stock was transferred to trust, then ESBT election must be filed within 2½ months after date of transfer 47

48 Trust Shareholders - ESBT Pitfalls: Cannot be a foreign trust ESBT election not filed, or not filed in a timely fashion Trust has a disqualified beneficiary Interest in trust acquired by gift or will Every Potential Current Beneficiary counts as a separate shareholder 100% of S Corp earnings are taxed at the trust level, at the maximum income tax rate 48

49 Trust Shareholders - QSST Qualifications: Trust can only have one income beneficiary during the current income beneficiary s life The current income beneficiary must be a U.S. citizen or resident Beneficiary s income interest in the trust must terminate on earlier of death of beneficiary or termination of the trust If trust terminates during beneficiary s life, all trust assets must be distributed to that beneficiary 49

50 Trust Shareholders - QSST Qualifications: Trust income must either be: (A) Required to be distributed to beneficiary, OR (B) Actually distributed to beneficiary at least annually Any trust assets distributed during the life of the current income beneficiary can only be distributed to such beneficiary Election must be made to treat as QSST If shareholder at time of S election, QSST election must be filed within 2½ months after earlier of 1) date on which S election filed or 2) effective date of the S election If S election was effective before corporate stock was transferred to trust, then QSST election must be filed within 2½ months after date of transfer 50

51 Trust Shareholders - QSST Pitfalls: Cannot be a foreign trust QSST election not filed, or not filed in a timely fashion Trust has more than one current income beneficiary Trust has a disqualified beneficiary Trust improperly administered for example, trustee fails to actually distribute income 51

52 Other Current Issues 52

53 Bargain Purchases Tax Implications No gain recognized for tax purposes (could have book income recognition under FAS 141R) If stock purchase Tax basis in stock = Consideration paid If asset purchase Tax basis in assets determined in accordance with Code Section 1060 (and the Regulations thereunder) Consideration allocated to classes of assets, starting with Class I (Cash and Cash Equivalents) and finishing with Class VII (Goodwill) If insufficient consideration exists to fully allocate to all assets within a particular class, then allocate pro-rata based on relative fair market values Note: There may not be any consideration left at the end to allocate to tax goodwill 53

54 Code Section 382 Sec. 382 limits the amount of net operating losses or built-in losses a corporation may use after experiencing an ownership change In general, an ownership change occurs where certain groups of shareholders increase their ownership of the loss corporation by more than 50% (by value) as compared to their ownership of the corporation before the change in ownership Loss corporation Corporation with NOL, unused credits or net unrealized built-in losses for the tax year in which an ownership change occurs The rules under Sec. 382 can be quite complex 54

55 Code Section 382 If an ownership change occurs, a Sec. 382 limitation is computed by multiplying the value of the loss corporation by a published IRS rate This Sec. 382 limitation then represents the maximum amount of net operating losses or built-in losses that may be claimed by the corporation in tax years following the ownership change For built-in losses, the Sec. 382 limitation only applies for the 5 tax years following the ownership change 55

56 Code Section 382 Built-in losses The Sec. 382 limitation only applies if the loss corporation has net unrealized built-in losses (i.e., aggregate net losses) at the time of the ownership change There is also a de minimis rule that treats the net unrealized loss as being zero if the NUBIL is not greater than the lesser of: 1. 15% of the value of the variable assets of the corporation immediately before an ownership change, OR 2. $10 million Variable assets are all assets except: 1. Cash and cash items (e.g., Treasury securities), and 2. Marketable securities that have not changed significantly in value from their bases See Notice for identification of built-in items 56

57 Code Section 382 Question Does Code Section 382 even apply to S Corps? Answer Would not apply to NOL carryforwards, since these all pass through to shareholders However, S Corps could certainly have built-in losses with respect to their assets At least one author suggests that it should not apply, since disallowing the built-in losses of a shareholder who bore those losses because of changes in the stockholdings of others is inconsistent with pass-through treatment Bottom line: No clear guidance exists 57

58 Small Business Lending Fund Treasury authorized to invest up to $30 billion in eligible institutions banks with less than $10 billion in total assets Banks can convert TARP securities/debentures into the new program Securities have a 10-year term Preferred stock Initial dividend rate is 5%, but would be reduced to 1% if small business lending increases by 10% After 4½ years, the dividend rate increases to 9% Similar to TARP, S Corps would receive debentures instead of preferred stock no second class of stock 58

59 Small Business Lending Fund Interest rate on S Corp debentures will likely be grossed up using the highest marginal federal income tax rate for individuals (35 percent) Thus, the interest rate would initially be 7.7% - same as initial interest rate on TARP debentures Higher interest rate based on S Corp banks receiving a tax deduction for the interest payments on the debt Advantages over TARP debentures No warrants No dividend restrictions No compensation restrictions 59

60 Small Business Lending Fund Debt Issuance Costs: Book treatment Capitalize and amortize over expected life of debt May have been expensed if immaterial?? Tax treatment Capitalize and amortize over full maturity of debt See Reg. Sec Taxpayer can choose to amortize on straight-line basis or using constant yield method 60

61 Uncertain Tax Positions Applicable corporations must file Schedule UTP if 2 conditions are satisfied: 1. The corporation has taken a tax position on its U.S. federal income tax return for the current or a prior tax year 2. The corporation recorded a reserve with respect to that position in audited financial statements For 2010, applicable corporations are corporations that meet ALL of the following criteria: File Form 1120, 1120-F, 1120-L or 1120-PC Assets equal or exceed $100 million Issued audited financial statements One or more tax positions that must be reported on Sch. UTP S Corps not required to file Schedule UTP for

62 Failure to File S Corp Returns Initially enacted as part of the Mortgage Forgiveness Debt Relief Act of 2007 Original penalty was $85 per shareholder per month (not to exceed 12 months) if the S Corp does not timely file its tax return or fails to provide information required on the return See next slide for Code Sec disclosure requirements Worker, Homeownership, and Business Assistance Act (Nov. 6, 2009) increased the penalty to $195 per shareholder per month 62

63 S Corp Return Disclosure Requirements Code Sec requires the following information to be disclosed on the S Corp return: Items of gross income and deductions Names and addresses of all shareholders Number of shares of stock held by each shareholder Amount of money and other property distributed by the S Corp to each shareholder Date of each such shareholder distribution Each shareholder s pro rata share of each item of the S Corp 63

64 Brett E. LaBelle Partner Crowe Horwath LLP One Mid America Plaza P.O. Box 3697 Oak Brook, IL Tel (630) Fax (630)

65 Kevin F. Powers Partner Crowe Horwath LLP One Mid America Plaza P.O. Box 3697 Oak Brook, IL Tel (630) Fax (630)

66 Justin Horst CFO Pinnacle Bancorp, Inc W. Dodge Road Omaha, NE Tel (402) Fax (402)

67 Questions?? 67