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Subchapter S Corporations

Subchapter S Corporations. Robert R. Oliva, Ph.D., LL.M.(Tax), J.D., CPA. University of Arkansas at Little Rock. Introduction (Class 1). Cooordination between Subchapter C and S Definition of an S Corporation One class of stock

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Subchapter S Corporations

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  1. Subchapter S Corporations Robert R. Oliva, Ph.D., LL.M.(Tax), J.D., CPA University of Arkansas at Little Rock

  2. 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

  3. Introduction (p. 2) • Eligible shareholders • Permissible entities • Not permissible • Election of Subchapter S treatment • Effective date • Consents necessary

  4. Introduction (p. 3) • Termination of Subchapter S treatment • Voluntary • Involuntary • Failure to meet requirements • EPII • Inadvertent terminations • Re-elections

  5. 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

  6. 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.

  7. Definition of an S Corporation: IRC 1361(a) • small business domestic corporation • effective election for the year

  8. 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

  9. 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

  10. 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

  11. 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

  12. Some stock is not considered “Outstanding stock” • substantially nonvested options • restricted stock

  13. “Binding Agreements” • May be an attempt to circumvent 1 class of stock requirements. • If so, then it creates a different class of stock.

  14. 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

  15. 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

  16. Debt “safe harbor” • unconditional promise to pay • interest. not contingent on profits • Except active/regular creditors • not convertible into equity • Except active/regular creditors

  17. 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

  18. No NRA’s • Exception: • election • married to US citizen or reside • Beware of community property states • Beware of common law marriages

  19. 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)

  20. 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

  21. 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.

  22. 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

  23. 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.

  24. Who consents? • all must consent • beware of pre-election date shareholders • cotenants must consent

  25. Tax Year • Y/E December 31 • Other Y/E of establishes a business purpose

  26. Termination • Voluntary: If shareholders holding > 50% of outstanding (voting and nonvoting) shares desire termination • Involuntary • Failed to meet requirements • Excess Passive Investment Income

  27. 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

  28. 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

  29. Inadvertent Terminations • Failure was “inadvertent” • to qualify • missing consents • EPII • Steps taken to correct problems • S and shareholders agree to adjustments.

  30. 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

  31. 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

  32. Re-election after Termination • Wait 5 years unless IRS permits it sooner

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