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Subchapter S Corporations

Robert R. Oliva, Ph.D., LL.M.(Tax), J.D., CPAUniversity of Arkansas at Little Rock

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Introduction (Class 1)

Cooordination between Subchapter C and S Definition of an S Corporation One class of stock

» Definition: all “outstanding shares” must confer identical rights

» “outstanding shares”» “identical rights” / ”binding agreements”» straight debt safe harbor

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Introduction (p. 2)

Eligible shareholders» Permissible entities» Not permissible

Election of Subchapter S treatment» Effective date» Consents necessary

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Introduction (p. 3)

Termination of Subchapter S treatment » Voluntary» Involuntary

– Failure to meet requirements– EPII

» Inadvertent terminations» Re-elections

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IRC Structure

USC Title 26» Subtittles A: Income Taxes

– Chapter 1: Normal taxes and surtaxes Subchapter A: Tax Liability: IRC 1-60 Subchapter B: Taxable Income: IRC 61-291 Subchapter C: Corporations and Shareholders: IRC

301-385 Subchapter S: IRC 1361-1381

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Coordination between Subchapters C and S

“. . . except when inconsistent with . . . S, . . . C applies . . . .”

Previously: S . . . to be treated as an individual when it is a C shahareholder.

Current version: – 80% owned C may be liquidated into S

shareholder

– IRC 338 election permissible when acquiring C

– However, IRC 243 still not available.

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Definition of an S Corporation: IRC 1361(a)

small business domestic corporation effective election for the year

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Small Business Domestic Corporation:

IRC 1361(b)(2): It must NOT » be an ineligible corporation» have more than 100 shareholders» have more than one class of stock» be an ineligible entity» be owned by a NRA

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AN S cannot be an ineligible corporation

No insurance company» Exception: Some casualty insurance

companies No 936 corporation No DISC or former DISC No financial institution that uses a

reserve method of accounting for bad debts

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An S cannot have more than 100 shareholders

Attribution: » H & W = 1, whether owned separately or

as H and W. – Ancestors and descendants – see textbook

» A & B as joint tenants = 2, even if H and W.» C, D, and E as beneficiaries of a voting

trust = 3

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AN S cannot have more than one class of stock

Shareholders of “outstanding stock” must have “identical rights” to distribution and liquidation» “Identical rights”: as provided by charter,

bylaws, state law, or “binding agreements”.» 1361(c)(4): OK to have different voting

rights

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Some stock is not considered “Outstanding

stock”

substantially nonvested options restricted stock

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“Binding Agreements”

May be an attempt to circumvent 1 class of stock requirements.

If so, then it creates a different class of stock.

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Most “binding agreements” are OK

commercial contracts agreements to redeem stock if death,

disability, termination unwritten shareholders’ advances <

$10,000 reclassifiable debt, held proportionally to

equity

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All others arrangements may be reclassified as

equity if

not in debt “safe harbor” equity” under general principles of tax

law principal purpose was to circumvent

requirements on» “identical rights” and » #/type of shareholders

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Debt “safe harbor”

unconditional promise to pay interest. not contingent on profits

» Except active/regular creditors not convertible into equity

» Except active/regular creditors

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Permissible Shareholders

Individuals (No NRA) Some non-individuals

» Qualified Subchapter S Trust: QSST» Electing Small Business Trust: ESMBT» Estates of individuals

– Death estates If transferred to a trust (pour overs) for < 2 years

– Bankruptcy estates

» Domestic grantor trusts: For < 2 years » Voting trusts» Not-for-profit: IRC 501(c)(3)» Retirement plans under IRC 401(b) but not IRA’s’s

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No NRA’s

Exception: » election» married to US citizen or reside

Beware of community property states Beware of common law marriages

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Prohibited non-individuals shareholders

partnerships corporations

» Exception: Qualified Subchapter S Subsidiary

» Note: An S may own a C– > 80% of a C: dividends from EP from active

trade not considered PII:IRC 1362(d)(3)(E)

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Qualified Subchapter S Trust: QSST

1 income beneficiary » US citizen or resident» May have >1 potential successive beneficiaries

100% of income must be distributed At death of current beneficiary

» Successor beneficiary must refuse to consent to S election.

» If > 1 beneficiary at death, – QSST continues to qualify for < 2 years– QSST may continue if only 1 beneficiary

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Electing Small Business Trust: ESBT

Any eligible S shareholder Unlike the QSST, income may be

accumulated. May have many beneficiaries May have different present and future

beneficiaries, including charities.

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S elections: IRC 1362

Form 2553 Effective date? Who consents? If reasonable cause, IRS may treat an

election to be timely» even if no election ever filed» retroactive to 1/1/83

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When effective:

If done > 15th of 3rd month, effective next year

If done < 15th of 3d month:» retroactive to beginning of year.» postponed to next year.

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Who consents?

all must consent beware of pre-election date

shareholders cotenants must consent

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Tax Year

Y/E December 31 Other Y/E of establishes a business

purpose

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Termination

Voluntary: If shareholders holding > 50% of outstanding (voting and nonvoting) shares desire termination

Involuntary» Failed to meet requirements» Excess Passive Investment Income

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Excess Passive Investment Income

C’s EP at EOY EPII = PII > 25% of gross receipts, for 3

consecutive years S terminates on the first day of the year

after the 3rd consecutive year with EPII

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Gross Receipts

dividends, interest, royalties» But not div. from 80% owned C corp where

EP from active trade s/e of stocks/secs: only gains

» But not receipts in liquidation of >50% subsidiary

» s/e of capital assets: only capital gains net income

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Inadvertent Terminations

Failure was “inadvertent”» to qualify» missing consents» EPII

Steps taken to correct problems S and shareholders agree to

adjustments.

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Year of termination

S short/C short» Last day of S short year = day before

termination event» First day of C short year = day of

termination event

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Measuring income in termination year

If all shareholders do not elect: Books are not closed until EOY; items computed as if no termination; then daily prorata.

If all shareholders elect: Books closed at end of short S year and C short year, report actual results of operation for short S and short C» “all shareholders”

– All who were S shareholders in short year– All shareholders on 1s day as C

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Re-election after Termination

Wait 5 years unless IRS permits it sooner