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 Definition: all “outstanding shares” must confer identical rights “outstanding shares” “identical rights” / ”binding agreements” straight debt safe harbor

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

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

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

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.

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

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

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

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

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

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

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

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

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

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

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

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

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)

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

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.

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

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.

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

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

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

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

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

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

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

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

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