The Sub S Bank Report – October 2013 (Volume 16, Issue 3)

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.”1 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.”2 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. Specifically, the bill would accomplish the following:

• Section 2 – Makes permanent the reduced five-year recognition period for built-in gains.
• Section 3 – Increases allowable excess passive income from 25% to 60% of gross receipts.
• Section 4 – Eliminates rule providing for termination of the S election for corporations with three consecutive years of excess passive income and accumulated earnings and profits.• Section 5 – Expands the definition of qualifying beneficiaries of an ESBT to include nonresident aliens.

• Section 6 – Expands definition of eligible S corporation shareholder to include individual retirement accounts (“IRAs”).
• Section 7 – Allows ESBTs to take deductions for charitable contributions made by S corporation.
• Section 8 – Permanently extends existing rule for shareholder basis limitation for pro rata share of charitable contribution made by S corporation.

The bipartisan bill proposes significant legislative changes 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.3 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. The sections below describe the specific reforms set forth in each section of the bill along with the larger context within which the reforms have been proposed. The goal is to provide an update of current proposals for S corporation reform in the context of a review of major concepts within
Subchapter S.

Section 2 of the legislation provides for a permanent reduced recognition period for built-in gains. This provision changes the recognition period for builtin gains from ten years to five years and would make permanent the temporary shorter recognition periods enacted under economic stimulus legislation in 2009, 2010 and 2012.

The current built-in gains tax on S corporations imposes a tax on gains from disposition of certain built-in gain assets (BIGs) of an S corporation.4 The tax is applicable in two situations: 1) a C corporation conversion to an S corporation, or 2) an acquisition by an S corporation of assets of a C corporation in a tax free transaction. The purpose of the tax is to foreclose the possibility of tax avoidance by a C corporation wishing to undergo a sale or dispose of assets. In both instances, without the built-in gains tax, there is an opportunity to circumvent the corporate-level tax on dispositions of those assets by converting to an S corporation prior to the sale. After the conversion, the corporation could dispose of the assets and pass the gain through to its shareholders, free of the corporate level tax.

To prevent this tax avoidance scheme, Code section 1374 requires S corporations to monitor the disposition of these built-in gain assets over a ten year period beginning on the date the conversion or tax free transaction was effective.5 If assets are sold during this recognition period, the tax is triggered on the built-in gains (the difference between the fair
market value of the assets and their adjusted basis on the effective date) at the highest corporate rate.6 The result is a substitute for the corporate-level tax that the corporation would have recognized had it not made the conversion. This ten year recognition period imposes a heavy burden on newly converted S corporations, requiring them to hold assets for a long time to avoid the tax, and can be an impediment for C corporations considering an S election.

In recent years, as a part of legislation aimed at stimulating the economy during the recession, the recognition period was temporarily shortened for certain S corporations. The American Recovery and Reinvestment Act of 2009 provided for a reduced recognition period of seven years for assets being sold in 2009 and 2010.7 Under this law, S corporations that had held assets for at least seven years could dispose of those assets free of the BIG tax that otherwise would have been triggered. The recognition period was further reduced to five years under the Creating Small Business Jobs Act of 2010 and the American Taxpayer Relief Act of 2012.8 This legislation allowed S corporations that had held assets for at least five years in 2011, 2012, and 2013 to dispose of those assets tax free. Note that these provisions provided only temporary relief for assets sold in 2009 through 2013. Taxpayers wishing to take advantage of this reduced recognition period have until December 31, 2013, before expiration of the legislation. These temporary provisions sought to expedite asset sales in these years as a method of economic stimulation.

In contrast to the economic stimulus legislation, H.R. 892 seeks to make the five year recognition period permanent. This permanent reduced recognition period would apply on a prospective basis for S corporations whose effective date begins on or after January 1, 2013. Corporations that made a S conversion prior to that date, who are not eligible for the temporary reduced recognition periods would still be subject to the original ten year holding period. Cutting the recognition period in half could increase the attractiveness of the S election for corporations already considering such a conversion and would allow S corporations to more effectively deploy assets.

This prospective application, however, creates a situation whereby S corporations who were not eligible for a reduced recognition period under the prior temporary amendments in 2009 through 2013 are still subject to the original 10 year holding period. In contrast, a retroactive application of a permanent reduced recognition period would ensure that the benefit of this provision inures to all S corporations and would create parity among S corporations regardless of their date of conversion “effective date.”

Sections 3 and 4 of H.R. 892 modify rules related to penalties imposed on excessive passive income of an S corporation. Like the built-in gains tax, these provisions prevent C corporations that have recently converted to S corporations from avoiding corporate level tax. In some circumstances, C corporations that make an S election will retain profits earned as a C corporation as accumulated earnings and profits (“E&P”). If the C corporation had not converted to an S corporation, this accumulated E&P would eventually be subject to a corporate tax. Under the excessive passive income rules an S corporation with accumulated E&P from its prior existence as a C corporation may be subject to a tax equal to the highest corporate rate or even termination of its S election.

As discussed, S corporations with accumulated E&P can encounter problems under two different scenarios. Code section 1375 provides for a tax on the excess passive income of an S corporation with accumulated E&P.9 The tax is triggered if the S corporation has 1) accumulated E&P, and 2) gross passive income exceeding 25% of its gross receipts for the year.10 Passive income is defined to include, with some exceptions, gross receipts derived from dividends, interest, royalties, rents and annuities.11 If the 25% threshold is exceeded, the S corporation is subject to a tax on the lesser of 1) net passive income (passive income less expenses) or 2) taxable income (determined as if the corporation were a C corporation). 12 To avoid triggering the tax on excess passive income, an S corporation can distribute accumulated E&P to its shareholders as a dividend, ensure the corporation has sufficient operating income to prevent passive income from exceeding 25% of gross receipts, or reduce taxable income in a given year. Even if an S corporation is not subject to the tax on excessive passive income because it has no taxable income, a far steeper penalty may still apply, if the corporation has accumulated E&P and excess passive investment income for three consecutive years. In that case, the Code provides for termination of the corporation’s S election beginning in the fourth year.13

In situations where the excess passive income tax or termination is triggered, taxpayers can request a waiver for either penalty from the Service. Code section 1375(d) provides for a waiver from the tax provided the taxpayer establishes that it 1) determined in good faith that it had no accumulated E&P at the close of the tax year, and 2) within a reasonable time after discovering that it did have accumulated E&P at the end of the tax year, accumulated E&P was distributed to shareholders.14 The taxpayer is required to make such a request to the Service in writing, explaining that the mistake was inadvertent and the steps taken to distribute the E&P upon discovery.15 In the case of a termination triggered by three consecutive years of accumulated E&P and excess passive income, Code section 1362(f) allows the taxpayer to request a waiver from the Service if it can prove that the termination was inadvertent and the necessary steps were taken to cure such termination. 16

H.R. 892 provides significant relief for taxpayers that may encounter issues with excess passive income. Section 3 provides for a complete repeal of the termination provisions of Code section 1362(d) (3) for tax years beginning after December 31, 2012. Section 4 increases the threshold for excess passive income from 25% to 60%, reducing the number of S corporations that may be subject to the tax on excess passive income. Like Section 2 (related to the builtin gains tax), Sections 3 and 4 provide increased flexibility for newly converted S corporations and would likely increase the attractiveness of the S election to certain C corporations.

While Sections 3 and 4 provide significant relief for many S corporations, prior Subchapter S reforms have largely eliminated banks and financial institutions organized as S corporations from the dangers of the excess passive income tax and termination rules. The American Jobs Creation Act of 2004 created an exception that excludes certain interest and dividend income on assets held by S corporation banks from the definition of passive investment income for purposes of applying the excess net passive income rules.17 Code section 1362(d)(3)(C)(v) provides that for Subchapter S banks“passive investment income shall not include –
(I) passive income earned by such a bank or company, or
(II) dividends on assets required to be held by such a bank or company, including stock in the Federal Reserve Bank, the Federal Home Loan Bank, or the Federal Agricultural Mortgage Bank or participation certificates issued by a Federal Intermediate Credit Bank.”

This provision largely protects Subchapter S banks and depository institution holding companies from the excess passive income tax.

Sections 5 and 7 of H.R. 892 provide for modifications to the rules regarding electing small business trusts (“ESBTs”). One of a limited number of trusts that are allowed to hold Subchapter S corporation stock, ESBTs were created as part of the Small Business Job Protection Act of 1996.18 Unlike a qualified Subchapter S trust, ESBTs can have multiple current beneficiaries and the trustee is not required to distribute all trust income to the beneficiaries each year. These characteristics allow the trust to accumulate income and sprinkle income among the beneficiaries as desired by the grantor and the trustee.19 Another feature of ESBTs is that income from the S corporation is taxed at the highest individual rate, but no tax is levied on income distributed to the beneficiaries of the trust.20 To qualify as an ESBT, the trust beneficiaries, i.e. all individuals who could receive a distribution of income or principal from the trust, must be eligible S shareholders (domesticpersons, estates, or eligible trusts).21 Furthermore, interests in the trust may not be purchased, but must be obtained by gift, bequest, or devise.22 Finally, the trustee must elect for the trust to be treated as an ESBT.23 In short the flexibility allowed by an ESBT provides for significant wealth planning and business succession planning opportunities for an S corporation and its shareholders that were not previously available.

Section 5 of H.R. 892 provides for a significant change to the definition of eligible beneficiaries of an ESBT. Under current law, all ESBT beneficiaries are required to be eligible S corporation shareholders, as defined in IRC section 1361(e)(1)(A). Section 5 would alter this definition, permitting nonresident aliens to be eligible shareholders for purposes of defining eligible ESBT beneficiaries. Currently, the only non-U.S. citizens that are allowed to hold S corporation stock are “resident aliens” (i.e. individuals that have green cards or are in the country for more than 183 days – the substantial presence test).24 Section 5 would relax this prohibition by removing the residence requirement for beneficiaries of ESBT’s. While such individuals would still be prohibited from holding S corporation stock directly, they could nonetheless enjoy the income or benefit from S corporation stock without regard to their residency in the U.S. This provision grants even greater flexibility than previously enjoyed by ESBTs. However, this modification to the definition of eligible beneficiaries may have unforeseen consequences. If an ESBT with a nonresident alien as a beneficiary attempted to distribute S corporation stock directly to that individual, they revert to an ineligible S shareholder for purposes of directly holding the S corporation stock. Such a transaction could potentially jeopardize the S election of corporation. 

Section 7 amends the provisions applicable to charitable deductions allowed by an ESBT. Currently, ESBTs are allowed a charitable deduction in accordance with the provisions of IRC section 642(c) which limits charitable deductions to amounts paid by the trust for a charitable purpose, pursuant to its governing instrument. Furthermore, trusts are not limited in the amount of charitable deductions that can be taken in any given year, but are not allowed to carryforward unused charitable deductions.25 Section 7 would remove ESBTs from the charitable deduction rules applied to trusts, and instead, subject them to the rules applied to individuals under Code section 170. This provision limits charitable deductions taken by individuals to a certain percentage of adjusted gross income and allows carryforward of a deduction for five years.26 Section 7 would apply to ESBTs the same charitable deduction rules that apply to most other S corporation shareholders, which are individuals and would create parity among those individuals and ESBTs. Furthermore, the amendment would eliminate the requirement that allows for charitable deductions only to the extent they are made pursuant to the trust’s governing instrument. This would allow charitable deductions to pass through the S corporation and be taken by the trust.

Only certain types of trusts are allowed to hold S corporation stock. Among those are grantor trusts and other certain trusts described in Code section 678,27 testamentary trusts,28 voting trusts,29 Qualified Subchapter S Trusts,30 ESBTs,31 and tax-exempt IRC section 401(a) qualified plan trusts (e.g. ESOPs and 401(k) plans).32 However, under current law Individual Retirement Accounts (“IRAs”) are not eligible S corporation shareholders. While not specifically codified, this prohibition stems from Revenue Ruling 92-73 which reasons that IRAs cannot hold S corporation stock because the owner or beneficiary of an IRA does not pay tax on the current income of the IRA. Rather, tax is deferred until income is distributed to the beneficiary of the IRA. The American Jobs Creation Act of 2004, provided a limited exception to the prohibition, allowing IRAs (both traditional and Roth) to own stock in S corporation banks so long as the stock was held on the date of enactment (October 22, 2004).33 Furthermore, any income to the IRA from such an S corporation is treated as unrelated business taxable income, and taxed upon receipt.34 This limited exception in the Code is further evidence of the ineligibility of IRAs as S corporation shareholders. This position was recently upheld by the Ninth Circuit Court of Appeals in Taproot Administrative Services, Inc. v. Commissioner. 35 In that case, the court held that a Roth IRA was ineligible to hold S corporation stock based on the reasoning of Revenue Ruling 92-73 and the absence of any action or intent by Congress indicating otherwise.

If the law is amended to permit IRAs to hold S corporation stock, like most other tax free or tax deferred vehicles (e.g. charitable organizations and 401(a) qualified plans such as 401K’s), these IRAs would be subject to the unrelated business income tax (“UBIT”) on income from the S corporation. The UBIT seeks to prevent the shifting of business assets from a taxable corporation to tax exempt entities. In furtherance of this purpose, Code section 512(e) imposes UBIT on 501(c)(3) charitable organizations, and 401(a) qualified plans such as 401Ks that hold S corporation stock.36 Such entities are subject to UBIT on all items of income, loss, or deduction that flow through to the entity as an owner of S corporation stock and also on any gain or loss from the disposition of that S corporation stock. Depending on the organizational structure of the entity (e.g. corporation or trust) the UBIT rate is equal to the top tax rate for that entity.37 At one time, ESOPs were also subject to UBIT, but Congress repealed this provision through the Taxpayer Relief Act of 1997 to encourage more ESOP ownership structures for S corporations.38 To prevent the benefits of tax deferral from accruing only to the top executives or owners of an S corporation, the rules provide for limitations on the ownership stock by individuals participating in the plans. The goal of these rules and the exemption from UBIT is to benefits of the S corporation to be shared among all employees of the company and to setup an efficient retirement plan for employees of the company.

Through the implementation of UBIT it would be possible to eliminate the concerns raised in Taproot and Revenue Ruling 92-73 that S corporation stock held by IRAs would defer tax on S corporation income, putting IRAs on equal-footing with other tax deferred structures such as 401Ks and tax exempt entities such as charitable organizations. If H.R. 892 is adopted, this provision would allow for significant tax planning opportunities for S corporations and their shareholders and would provide greater access to capital for S corporations. However, without an explicit exemption from UBIT as in the case of ESOPs, the benefits would not go so far as to provide significant deferral of tax due in S corporation income.

Deductions related to charitable contributions made by S corporations flow through to the S corporation’s shareholders and are accounted for based on each shareholder’s pro rata share of the contribution.39 Prior to 2006, a charitable deduction passed through to a shareholder reduced the shareholder’s basis in the S stock by an amount equal to that shareholder’s pro rata share of the fair market value of the contributed property.40 In situations where the corporation made a contribution of appreciated property to a charity, shareholders would recognize gain on the sale of their stock due to the basis adjustment related to the fair market value of the property. In 2006, however, the Pension Protection Act changed this rule to allow shareholders to decrease their basis in S corporation stock by an amount equal to their pro rata share of adjusted basis in the property.41 This temporary change, effective for tax years 2006 and 2007 reduced the burden imposed by these rules on S corporations interested in charitable giving. This provision was extended several times and is currently set to expire for tax years beginning after December 31, 2013. H.R. 892 would make the amendment to IRC section 1367(a)(2) permanent for tax years beginning after December 31, 2012. This provision would make the basis adjustment rules permanent and provide further incentives for charitable giving by S corporations.

As discussed above, H.R. 892 offers several reforms that may greatly increase the attractiveness of the S corporation organizational structure and assuage some of the major concerns held by C corporations that are considering or have previously considered conversion. Permanent modifications to the builtin gains and excess passive income rules make Subchapter S a much friendlier place for recently converted corporations. These reforms also increase existing S corporations’ ability to access capital and efficiently deploy existing assets. Additionally, loosening certain eligibility restrictions by allowing IRAs as eligible S corporation shareholders and nonresident aliens as eligible ESBT beneficiaries will increase access to capital and existing S corporations and provide greater flexibility in terms of business succession and estate planning. Finally, adjustments to the rules governing treatment of charitable contributions made by an S corporation will foster greater charitable giving among S corporations.

Footnotes

1 Reps. Reichert and Kind Introduce Bipartisan Tax Legislation to Increase Small Business Access to Job-Creating Capital, http://reichert.house.gov/press-release/reps-reichert-and-kindintroduce-bipartisan-tax-legislation-increase-small-business, (Feb 28, 2013).

2 Industry Letter to Congress (April 15, 2013), http://www.icba.org/files/ICBASites/PDFs/ltr041513a.pdf.
3 See Ways and Means Committee, ‘‘Technical Explanation of the Ways and Means Committee Discussion Draft Provisions to Reform the Taxation of Small Businesses and Passthrough Entities’’ (Mar. 12, 2013)
4 I.R.C. § 1374(a).
5 I.R.C. § 1374.
6 I.R.C. § 1374(d)(7).
7 American Recovery and Reinvestment Act of 2009, Pub. L. No. 111-5.
8 Creating Small Business Jobs Act of 2010, Pub. L. No. 111-240; American Taxpayer Relief Act of 2012, Pub. L. 112-240.
9 I.R.C. § 1375.
10 I.R.C. § 1375(a)(1)-(2).
11 I.R.C. § 1375(b)(3).
12 I.R.C. § 1375(b)(1)-(2).
13 I.R.C. § 1362(d)(3).
14 I.R.C. § 1375(d).
15 Treas. Reg. § 1.1376-1(d).
16 I.R.C. § 1362(f).
17 American Jobs Creation Act of 2004, Pub. L. 108-357.
18 Small Business Jobs Protection Act of 1996, Pub. L. 104-188. Prior to enactment of this legislation trust that could hold S corporation stock were limited to grantor trusts, testamentary trusts, voting trusts, and qualified subchapter S trusts (QSSTs).
19 I.R.C. § 1361(e)(2).
20 I.R.C. § 641(c)(2)(A).
21 I.R.C. § 1361(e)(1)(A).
22 I.R.C. § 1361(e)(1)(C).
23 I.R.C. § 1361(e)(3).
24 I.R.C. § 1361(b)(1)(C); IRC § 7701(b).
25 I.R.C. § 642(c).
26 I.R.C. § 170(b)(1).
27 I.R.C. § 1361(c)(2)(A)(i).
28 I.R.C. § 1361(c)(2)(A)(iii).
29 I.R.C. § 1361(c)(2)(A)(iv).
30 I.R.C. § 1361(d).
31 I.R.C. § 1361(e).
32 I.R.C. § 1361(c)(6)(A).
33 American Jobs Creation Act of 2004, Pub. L. 108-357; see I.R.C. § 1361(c)(2)(A)(vi).
34 I.R.C. § 512.
35 Taproot Administrative Services, Inc. v. Comm’r., 679 F.3d 1109 (9th Cir. 2012), aff’g 133 T.C. 202 (2009).
36 I.R.C. § 512(e)(1).
37 I.R.C. § 511(a)-(b).
38 Pub. L. 105-34; IRC § 512(e)(3).
39 I.R.C. § 1366(a)(1)(A).
40 I.R.C. § 642(c).
41 Pension Protection Act of 2006, Pub. L. 109-280.