This fourth installment of my multi-part series on Subchapter S is focused on suspended losses of an S corporation. While the rules seem straightforward, their application can be tricky, especially given legislative changes made in recent years.
Background
In general, S corporation shareholders, like the owners of entities taxed as partnerships, are allocated their share of the entity’s losses for the taxable year. A number of rules, however, may limit the ability of the owners to deduct these losses.
This third installment of my multi-part series on Subchapter S is focused on a single Code Section, namely IRC Section 1361(b)(1)(C) and the ineligibility of nonresident aliens as shareholders of Subchapter S corporations.
Background
As we all have come to understand, nonresident aliens are ineligible S corporation shareholders. If a nonresident alien were to become a shareholder of an S corporation, the result is straightforward – as of the date the nonresident alien became a shareholder, the corporation’s S election is terminated. There are, however, some obscure aspects of this well-known rule that are worthy of discussion. One of the obscurities has to do with a 2018 change in the law resulting from the Tax Cuts and Jobs Act. Additionally, there have long existed hidden traps for unwary taxpayers and their advisers as well as some twists and turns in the road in this area of Subchapter S that are also worthy of discussion.
This second installment of my multi-part series on Subchapter S is focused on two Code Sections, namely IRC Section 1375 and IRC Section 1362(d)(3).
Background
While most of my readers are all quite familiar with these two Code sections, there are some obscure practical implications of these provisions that I want to bring to your attention or remind you.
These Code Sections only apply to S corporations that have retained earnings and profits from C corporation years (“C E&P”). In a nutshell, under Code Section 1375, S corporations that have C E&P at the close of the taxable year and “passive investment income” totaling more than 25 percent of gross receipts will be subject to a tax imposed at the highest corporate income tax rate under Code § 11 (which is currently a flat 21 percent). The tax is based upon the lessor of the corporation’s “taxable income” or its “excess net passive investment income.”
In October 2023, I authored a new White Paper, A Journey Through Subchapter S / A Review of The Not So Obvious & The Many Traps That Exist For The Unwary. This year, in a multi-part article, I intend to take our blog subscribers through some of the most significant changes made to Subchapter S over the past 40 years, (i) pointing out some of the not-so-obvious aspects of these developments, (ii) alerting readers to some of the obscure traps that were created by these changes, and (iii) arming readers with various methods that may be helpful in avoiding, minimizing or eliminating the adverse impact of the traps. This first installment is focused on one area of Subchapter S – the Built-In-Gains Tax.
Brief History of Subchapter S
In 1954, President Eisenhower recommended legislation that would minimize the influence federal income tax laws had on the selection of a form of entity by closely held businesses. Congress did not act on the president’s recommendation, however, until 1958. Interestingly, the new law was not contained in primary legislation. Rather, the first version of Subchapter S was enacted as a part of the Technical Amendments Act of 1958. The legislation was, at best, an afterthought.
The original legislation contained numerous flaws and traps that often caught the unwary, resulting in unwanted tax consequences. Among these flaws and traps existed: (i) intricate eligibility, election, revocation and termination rules; (ii) complex operational priorities and restrictions on distributions; (iii) a harsh rule whereby net operating losses in excess of a shareholder’s stock basis were lost forever without any carry forward; and (iv) a draconian rule whereby excessive passive investment income caused a retroactive termination of the S election (i.e., all of the way back to the effective date of the S election). Due to these significant flaws, tax advisers rarely recommended Subchapter S elections.
As song writer and musician Bob Dylan said in his hit song, “The Times They Are A-Changin'”:
Come gather’ round people
Wherever you roam
And admit that the waters
Around you have grown
And accept it that soon
You’ll be drenched to the bone
If your time to you is worth savin’
Then you better start swimmin’ or you’ll sink like a stone
For the times they are a-changin’
The federal tax laws are certainly about to change. With the need to raise revenue as a top priority for the Biden Administration, everyone is expecting dramatic changes to the Internal Revenue Code.
New York Attorney General Barbara Underwood and New York Governor Andrew Cuomo announced today that the state of New York, joined by the states of Connecticut, New Jersey and Maryland, have instituted a lawsuit against the federal government in the U.S. District Court for the Southern District of New York, seeking to strike the $10,000 cap imposed on the state and local tax (“SALT”) itemized deduction by the Tax Cuts and Jobs Act (“TCJA”) as unconstitutional.
The lawsuit, which specifically names Steven Mnuchin, U.S. Treasury Secretary and David Kautter, Acting Commissioner of the Internal Revenue Service, as defendants, asserts that the SALT cap (previously discussed in an earlier blog post) was specifically enacted by the federal government to target New York and similarly situated states, that it interferes with a state’s right to make its own fiscal decisions, and that it disproportionately adversely impacts taxpayers in those states.
Judge Ruwe ruled in Jeremy M. Jacobs and Margaret J. Jacobs v. Commissioner, 148 T.C. 24 (June 26, 2017), that a free lunch may exist today under Federal tax law. In this case, the taxpayers, owners of the Boston Bruins of the National Hockey League, paid for pre-game meals provided by hotels for the players and team personnel while traveling away from Boston for games.
Pursuant to the union collective bargaining agreement governing the Bruins, the team is required to travel to away games a day before the game when the flight is 150 minutes or longer. Before the away games, the Bruins provides the players and staff with a pre-game meal and snack. The meal and snack menus are designed to meet the players’ nutritional guidelines and maximize game performance.
During the tax years at issue, the taxpayers deducted the full cost of the meals and snacks. Upon audit, the IRS contended the cost of the meals and snacks were subject to the 50% limitation under Code Section 274(n)(1) which provides in part:
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Larry J. Brant
Editor
Larry J. Brant is a Shareholder and the Chair of the Tax & Benefits practice group at Foster Garvey, a law firm based out of the Pacific Northwest, with offices in Seattle, Washington; Portland, Oregon; Washington, D.C.; New York, New York, Spokane, Washington; Tulsa, Oklahoma; and Beijing, China. Mr. Brant is licensed to practice in Oregon and Washington. His practice focuses on tax, tax controversy and transactions. Mr. Brant is a past Chair of the Oregon State Bar Taxation Section. He was the long-term Chair of the Oregon Tax Institute, and is currently a member of the Board of Directors of the Portland Tax Forum. Mr. Brant has served as an adjunct professor, teaching corporate taxation, at Northwestern School of Law, Lewis and Clark College. He is an Expert Contributor to Thomson Reuters Checkpoint Catalyst. Mr. Brant is a Fellow in the American College of Tax Counsel. He publishes articles on numerous income tax issues, including Taxation of S Corporations, Reasonable Compensation, Circular 230, Worker Classification, IRC § 1031 Exchanges, Choice of Entity, Entity Tax Classification, and State and Local Taxation. Mr. Brant is a frequent lecturer at local, regional and national tax and business conferences for CPAs and attorneys. He was the 2015 Recipient of the Oregon State Bar Tax Section Award of Merit.
