Mark Lubin article on "Common Errors in S Corp Taxes"
This article was originally published on the Pennsylvania Institute of Certified Public Accounts PICPA’s Blog CPA Now on March 16, 2022 and is republished here with permission from the publication.
Common Errors in S Corp Taxes
By Mark L. Lubin
Busy tax practitioners can be susceptible to making errors regarding corporate-level tax and termination exposures affecting S corporations (including S corporations that are former C corporations). Through familiarity with potential exposures and the exercise of due caution, steps can be taken to avoid unnecessary tax consequences.
S corporations are often favorable vehicles for holding closely held businesses. S corporation income is generally not subject to federal corporate taxation; instead, their income flows through to owners in a manner similar to partnerships and disregarded entities. There are, however, some differences between the taxation of S corporations and other pass-throughs entities. For example, gain is generally recognized when S corporations distribute appreciated property, whereas distributions from other flow-through entities typically do not trigger recognition.
The ability to avoid corporate-level tax through subchapter S is not unlimited. S corporations are subject to eligibility requirements and must file valid, timely elections. Corporate-level income taxes and potential subchapter S termination sometimes apply to S corporations that were former C corporations. S corporations can also be subject to taxes other than the federal income tax.1 Those all present potential hazard areas for S corporation owners and buyers (including buyers of C corporations for which a future S election is contemplated). Failure to recognize and mitigate those hazards can be costly. Common hazards include failing to meet qualification requirements and adverse consequences resulting from the status as a former C corporation.
Requirements for S corporation qualification include the following:
- Domestic corporate status for U.S. tax purposes
Partnerships and LLCs that elect to be taxable as corporations under the “check-the-box” regulations2 are considered corporations for this purpose.
- 100 shareholder limitation
Certain related persons are counted as one shareholder in applying this limit.
- Eligible S corporation shareholders
Individual shareholders must be U.S. citizens or residents. Certain trusts (including domestic qualified subchapter S trusts, electing small-business trusts, and grantor trusts) are permitted. Special rules apply regarding estates and other trusts.
- One class of stock limitation
Outstanding shares must have identical distribution and liquidation rights. Differences in voting rights are allowed. All relevant authorities and documents (e.g., not only the corporation’s charter and bylaws) are considered in applying this requirement, and interests that do not legally constitute stock (convertible debt, options, etc.) are sometimes treated as a second class of stock.
- Timely election3
If a corporation is ineligible for the pre-election portion of a taxable year for which an election is filed, the election will generally become effective for the following taxable year.
S corporations that are former C corporations, or otherwise have earnings and profits (E&P) from C corporation taxable years, are subject to further provisions, including the following:
- Corporate-level tax on certain dispositions of assets that either had “built-in” gain when the taxpayer’s S election became effective or were acquired in a carryover-basis transaction.4
- Corporate-level “excess net passive income” tax (generally, applicable where passive investment income exceeds 25% of gross receipts) on S corporations with E&P.5
- Termination of S corporation status where an S corporation with E&P has excess passive investment income for each of three consecutive taxable years.6
S corporation owners and buyers (including buyers of C corporations for which an S election is contemplated) should be vigilant to avoid unanticipated liability or exposure under these provisions. For example, they should ensure that the subchapter S eligibility requirements were satisfied for all periods where S corporation status may be material. Eligible shareholder status, the existence of only one class of stock, and confirmation of a valid election (particularly for long-standing S corporations where limited records are available) are sometimes difficult to establish. Audit adjustments can result in unanticipated E&P (including from corporations that were acquired by a corporation under consideration), causing corporate-level taxes or even termination.
Relief is sometimes available to avoid harsh consequences under these rules, and corporate-level taxes or subchapter S termination are sometimes avoidable. For example, the built-in gain tax can sometimes be avoided by establishing what assets a corporation held when its S election became effective, obtaining appraisals or basis studies to negate or minimize built-in gains (or demonstrate a lack of net unrealized built-in gain when the S election became effective), deferring dispositions of gain assets beyond the five-year recognition period, and timing recognition of built-in losses. Similarly, the passive income tax and associated potential termination may be avoidable by managing income streams, electing distribution of E&P as dividends, or otherwise seeking IRS relief.
1 These taxes may include federal employment taxes and various state and local taxes.
2 See Treas. Reg. Section 301.7701-3
3 Subchapter S elections must be filed on IRS Form 2553 and include shareholder consents. Treas. Reg. 1.1362-6
4 IRC Section 1374. This tax generally applies to gains recognized within a five-year recognition period
5 IRC Section 1375
6 IRC Section 1362(d)(3)
Mark L. Lubin, CPA, JD, LLM, is special counsel at the law firm Chamberlain Hrdlicka in Philadelphia, where he specializes in tax planning and complex business transactions. He can be reached at email@example.com.