Category Archives:S Corporation Modernization Act of 2013

S Corp Shareholder Basis Increase

On July 23, 2014, the Treasury Department and Internal Revenue Service (“IRS”) issued final regulations providing guidance on the circumstances under which an S corporation shareholder may increase their adjusted basis due to indebtedness of the S corporation. Internal Revenue Code (“Code”) Section 1366(d)(1) generally provides that the aggregate amount of losses and deductions taken by a shareholder in any tax year cannot exceed the sum of the shareholder’s adjusted basis in its stock and the adjusted basis of any indebtedness of the S corporation to the shareholder. To the extent a shareholder does not have sufficient basis in their stock to take losses in a particular year, they may use a loan to the S corporation to increase their basis and avoid having to carry forward losses to a subsequent year. The final regulations describe the circumstances under which such loans will be treated as “bona fide” indebtedness of the S corporation to the shareholder – allowing the shareholder to increase their basis by the amount of the indebtedness and recognize the losses currently.

The regulations amend Treasury Regulation Section 1.1366-2(a)(2) to define “basis of indebtedness” which is not otherwise defined in the Code. Finalized without substantive changes from the proposed regulations issued in 2012, the regulations provide that an increase in the shareholders basis is warranted only to the extent that indebtedness of the S corporation to the shareholder is “bona fide” – under general Federal tax principles. Further, shareholders may only increase their basis with respect to a guaranty of bona fide S corporation indebtedness to the extent they actually perform on that guaranty. The new regulations also provide several examples clarifying the interpretation of “bona fide” indebtedness in common situations.

While some courts have held that bona fide indebtedness exists only where a shareholder makes an actual economic outlay and is thus made “poorer in a material sense” as a result of the transaction, the regulations state that a basis increase will be permitted provided the indebtedness of the S corporation to the shareholder is bona fide, without regard to the economic outlay test. This standard would allow a basis increase in situations where a shareholder borrows funds from one wholly-owned S corporation and lends them to another wholly-owned S corporation and other transactions where there is no actual economic outlay by the shareholder, but, nonetheless, bona fide indebtedness exists.

With the implementation of these final regulations, shareholders of S corporation that desire to increase their adjusted basis in S corporation stock related to indebtedness of the S corporation should be mindful to structure debt arrangements as third-party or arm’s-length transactions, including execution of a note at third-party or market interest rates, adherence to repayment schedules and other formalities that would establish the indicia of bona fide indebtedness of the S corporation to the shareholder.

Should you have any questions or need guidance or assistance regarding the new regulations, please contact us at (210) 228-9500.

S Corporation Family Shareholder Rules

One of the defining characteristics of the S corporation is the limit on the total number of allowable shareholders. When Subchapter S of the Internal Revenue Code first came into existence in 1958, an S corporation was limited to 10 shareholders. This limit was first increased to 25 in 1976 and has grown progressively larger over the years. It was most recently raised to 100 as a result of the American Jobs Creation Act of 2004. This most recent increase in the shareholder limit, however, was accompanied by another provision that arguably had a greater impact on the number of individuals who could own S corporation stock. The family shareholder rules allowed for all members of a family to be treated as a single S corporation shareholder for purposes of the shareholder limit.

The family shareholder rules are found in Internal Revenue Code Section 1361(c) and Treasury Regulation 1.1361-1(e)(3) and provide that stock owned by members of a family is treated as owned by one shareholder, but only for purposes of the maximum shareholder limit. Members of a family are defined to include a common ancestor and all lineal descendants, including spouses and former spouses of such descendants. In addition, all legally adopted children, children who have been placed with an individual for legal adoption, and any eligible foster children will be treated as blood-related to such individuals. Finally, estates of deceased individuals, grantor trusts, and beneficiaries of other eligible trusts (such as QSSTs, ESBTs and voting trusts), provided those beneficiaries are members of the family, will qualify for treatment as a single shareholder.

As originally enacted, treatment of a family as a single shareholder required an election by at least one of the members of the family. This election regime, however, was discarded in 2005 by the Gulf Opportunity Zone Act and all family groups holding S corporation stock will automatically qualify for treatment as a single shareholder.

The only additional requirement is that on the applicable date, the common ancestor cannot be more than six generations removed from the youngest generation of shareholders. This “applicable date” is the latest of: (1) the date the Subchapter S election was made; (2) the earliest date that a member of the family held stock in the S corporation; or (3) October 22, 2004 (the effective date of the American Jobs Creation Act). Note that this test only applies for purposes of finding a common ancestor and effectively limits how far back in time one can go to identify a common ancestor. Once this common ancestor has been identified under the “six-generation test,” lineal descendants (and their spouses) more than six generations removed from the common ancestor who later acquire stock in the corporation will also be treated as members of the family.

The result of the family shareholder rules is the potential for a greatly expended shareholder group (well in excess of the statutory 100 shareholder limit). The rules are especially impactful for wealth transfer and estate planning purposes and allow older generations to transfer stock in S corporations to younger generations at an earlier stage without worrying about bumping up against the shareholder limit.

The expansive definition of “members of a family,” however, also creates some complexity for the S corporation in terms of tracking the number of shareholders. It becomes increasingly important to keep detailed records of stock ownership and transfers, especially for S corporations that are approaching the 100 shareholder limit or that have multiple large family groups as shareholders. We highly recommend that S corporations review their stock ownership and transfer records to ensure that family groups are being tracked appropriately. For example, the creation of a family tree for each family group that holds stock in an S corporation can assist with tracking transfers among family members and can avoid an inadvertent increase in shareholders beyond the limit.

S Corporation Tax Extenders Legislation Moves Forward

On June 6th, House Majority Leader Eric Cantor, R-Va., laid out a busy legislative agenda for the remainder of June in a memo to House Republicans. In the memo, Cantor stated that as they return from their summer stretch into the swampy heat of Washington D.C., they will continue to work on an agenda that builds upon their work from the beginning of the year, including everything they accomplished in May.

Cantor noted that during the first part of the year, Chairman Dave Camp put forth a bold tax reform proposal, the Tax Reform Act of 2014, which aimed to address a broken tax code that penalized hard work and innovation, stifles American competiveness, and economic growth. As the Committee continues to receive feedback on the draft, Cantor scheduled floor consideration, for the week of June 9th, on three targeted tax extender bills. Of the three scheduled, two of the bills that were addressed were HR 4453 (permanent S Corporation Built in Gains Recognition Period Act of 2014) and HR 4454 (Permanent S Corporation Charitable Contributions Act of 2014).

As mentioned in our previous email alert, HR 4453, authored by Representative Dave Reichert, would make permanent currently expired provisions that reduces for businesses who are organized as S Corps the built-in gains tax holding period from 10 to 5 years. The Subchapter S Bank Association has long believed that this change will allow banks easier access to their capital to grow and create new jobs. HR 4454, which also is authored by Reichert, would make permanent temporary tax provisions regarding the basis adjustment rules for charitable giving by S Corps.

On June 12th, the House adopted the reforms by a count of 263 to 155. The provisions received strong bipartisan support, with all but two Republicans supporting the measure and forty-two Democrats parted with their leadership and the Administration and voted yes as well. Ways and Means Committee Chairman Dave Camp kicked off the day by offering these remarks on the House floor:

“The bill we have before us today is the right step forward to level the playing field between the small businesses on Main Street and big businesses. If a small business chooses to operate as an S corporation for tax purposes, we should ensure that they have the ability to access certain capital without tax penalties.

…This is a bipartisan, commonsense bill that will give small businesses some much needed relief from the burdens of the tax code, and allow them to make new investments and create new jobs.”

Washington State Congressman Dave Reichert had this to say:

“The BIG tax is a double tax on S corporations who want to sell their assets after converting from C corporation status.

…As we’ve heard from Jim Redpath…who testified before one of our Ways and Means hearings…the BIG tax causes S corporations to hold onto unproductive or old assets that should be replaced. He gave the example of a road contractor which is holding onto old equipment that is sitting in the junkyard…because if he sold them, they would be subject to the BIG, double tax. Instead of selling the assets and using the proceeds to hire new workers or invest in new equipment, the business owners sit on the sidelines. This is a perfect example of the tax code influencing business decisions and needs to stop.”

The measures now will be sent to the Senate side, where new Finance Committee Chair Ron Wyden (D-OR) and Majority Leader Harry Reid (D-NV) will work on how to move the extenders package forward, which includes two year extensions of these to S corporation provisions. Most likely, we will have to wait on the outcome of the November election before we see movement on these bills. However, the passage in the House is a big step and we will continue to press and move the issue forward as it is taken up on the Senate side.

House Ways and Means Committee Addresses S Corporation Tax Extenders

This week the House Ways and Means Committee held a markup of bills that would make permanent certain tax extenders designed to help small businesses. Two of these bills (H.R. 4453 and H.R. 4454) specifically address tax treatment of S corporations. The tax provisions included in both bills were a part of the S Corporation Modernization Act introduced in 2013.

H.R. 4453 would make permanent the reduced five-year recognition period for built-in gains tax. The built-in gains or “BIG” tax, imposes a corporate-level tax on the built-in gains earned by C corporations that later make a Subchapter S election. The Internal Revenue Code imposes a tax on these built-in gains for a 10 year period form the S election. Over the years, temporary reductions or forbearance of this 10 year recognition period have been passed by Congress. H.R. 4453 would replace the 10 year recognition period with a reduced 5 year recognition period. This permanent reduction has the potential to free up access to the capital assets of many S corporations and could spur economic growth.

H.R.4454 would make permanent a rule regarding basis adjustments to stock of S corporations making charitable contributions of property. Under current law, charitable contributions made by an S corporation were accounted for in calculating the income tax liability of each shareholder based on that shareholder’s pro rata share of the contribution. Each shareholder’s pro rata share of the contribution reduces their basis in the corporation’s stock by the fair market value of the contributed property. In situations where the S corporation contributes appreciated property, shareholders would recognize gain on the sale of their stock due to this basis adjustment based on the fair market value of the property. Prior legislation amended this rule to allowed shareholders to reduce their basis in the stock in accordance with their pro rata share of the adjusted basis in the property. This provision has been extended several times, but expired for tax years beginning after December 31, 2013. H.R. 4454 would make this basis adjustment rule related to charitable contributions of property permanent and would encourage S corporations to increase their charitable contributions by reducing the likelihood that it will subject the shareholders to greater tax liability.

Along with several other business-friendly tax extenders, H.R. 4453 and H.R. 4454 were voted out of the House Ways and Means Committee on April 29th. Both bills, especially the permanent reduction in the BIG tax recognition period have the support of a wide range of industry groups.

S Corporation Modernization Act of 2013

On February 28, 2013, House Ways & Means Committee members Dave Reichert (R-WA) and Ron Kind (D-WI) introduced the S Corporation Modernization Act of 2013 (“H.R. 892”). The bill is the most recent iteration of S corporation reform to be introduced in Congress. A prior version of the bill (H.R. 1478) was introduced in 2011 as the S Corporation Modernization Act of 2011. The bipartisan S corporation tax reform bill was touted by its sponsors as “a commonsense update to the tax code that will give S corporations the ability to grow and prosper especially in this tough economic environment.” The bill has wide support from industry organizations that in a joint support letter to Congress indicated that the bill would ensure the continued success of S corporations by “increasing access to capital by reducing S corporation ownership restrictions; easing punitive restrictions that apply to converted S corporations and punish the unwary; and encouraging philanthropy by S corporations.” Industry groups joining in support of the bill include the American Council of Engineering Companies, the American Institute of Architects, the American Supply Association, Associated Builders & Contractors, Associated General Contracts of America, Independent Community Bankers of America, and various other industry organizations.

The reforms included in the bill amend provisions of Subchapter S of the Internal Revenue Code (the “Code”) related to the built-in gains tax on S corporations, the excess passive income rules, the rules governing electing small business trusts (“ESBTs”), shareholder eligibility rules, and the treatment of charitable contributions made by S corporations.

The bipartisan bill proposes significant legislativechanges to Subchapter S to allow for greater access to capital and greater flexibility for S corporations. However, given the current climate in Congress and the tendency towards so-called “legislation by crisis,” it is unlikely that the bill will be taken up by the house this term. Regardless, the bill has become a framework for outlining effective tax reforms for S corporations that may in the future become part of a push for more comprehensive tax reforms. On March 12, 2013, the House Ways & Means Committee released a tax reform discussion draft for
implementation of structural reforms to the taxation of passthrough entities such as S corporations and partnerships. This discussion draft outlines two options for implementing reforms. Option 1 which proposes targeted reforms to both Subchapter S and Subchapter K (taxation of partnerships) draws heavily from the ideas proposed in H.R. 892. Option 2 goes even further, essentially restructuring both Subchapter S and Subchapter K into a single set of rules for the taxation of all nonpublicly traded passthroughs and some publicly traded passthrough entities. This past summer House Ways & Means Committee Chairman Dave Camp and Senate Finance Committee Chairman Max Baucus toured the country in an attempt to solicit feedback on the Small Business and Passthrough Entities reform and other proposals to generate support for comprehensive reforms to the Code. It is clear that support for comprehensive tax reform is slowly building. The question, however, is whether it can overcome the perpetual gridlock that has become commonplace in Congress.

Regardless of the hurdles to passage of the bill, the reforms proposed in H.R. 892 are instructive as to the possibilities for reforming the S corporation and also present an opportunity to review important aspects of Subchapter S for new or existing S corporations.

For more specifics on what the bill accomplishes and to read a detailed legislative summary on the Act please contact Patrick J. Kennedy, Jr.