Larry's Tax Law

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.

The Internal Revenue Service (“IRS”) announced in IR News Release 2023-247 (December 21, 2023) its new Voluntary Disclosure Program (“ERC VDP”) that allows employers who may have received questionable Employee Retention Credits (“ERCs”) to pay them back at a discount. The ERC VDP is a part of the government’s ongoing fight against questionable ERC claims. 

IRS Warning

As you may recall, on November 7, 2022, the IRS issued COVID Tax Tip 2022-170.  It warned employers to be wary of third-party vendors offering assistance in applying for ERCs.  In fact, the IRS stated in that notice:

“Employers should be wary of third parties advising them to claim the employee retention credit when they may not qualify.  Some third parties are taking improper positions related to taxpayer eligibility for and computation of the credit.

These third parties often charge large upfront fees or a fee that is contingent on the amount of the refund.  They may also fail to inform taxpayers that wage deductions claimed on the business’ federal income tax return must be reduced by the amount of the credit.

If the business filed an income tax return deducting qualified wages before it filed an employment tax return claiming the credit, the business should file an amended income tax return to correct any overstated wage deduction.

Businesses should be cautious of schemes and direct solicitations promising tax savings that are too good to true.  Taxpayers are always responsible for the information reported on their tax returns.  Improperly claiming the ERC could result in taxpayers being required to repay the credit along with penalties and interest.”

ERC VDP

The government’s stated goal of the ERC VDP is twofold:

On April 5, 2023, Commissioner Daniel I. Werfel issued the Internal Revenue Service Inflation Reduction Act Strategic Operating Plan (“Plan”).  The Plan, which spans over 145 pages, is a roadmap to how the Service will deploy over the next decade the approximately $80 billion in supplemental funding it will receive as a result of the Inflation Reduction Act enacted by Congress last year (“IRA”).

In the Plan, Commissioner Werfel sums up the strategic goals for the IRS as follows:

“We will make it easier for taxpayers to meet their tax responsibilities and receive tax incentives for which they are eligible. We will adopt a customer-centric approach that dedicates more resources to helping taxpayers get it right the first time, while addressing issues in the simplest ways appropriate. We will address noncompliance, using data and analytics to expand enforcement in certain segments. We will become an employer of choice across government and industry. These changes will enable us to serve all taxpayers more equitably and in the ways they want to be served.”

As previously reported, due to the COVID-19 pandemic, remote workforces currently dominate the landscape of most U.S. businesses.  In fact, in many industries, remote workforces may be the new normal post-pandemic.  Unfortunately, as workers become more mobile, the tax and human resources issues become more challenging for employers.

I was asked by Dan Feld, Principal Editor, Tax Journals, of Thomson Reuters, to author an article on this topic for the July 2022 Practical Tax Strategies Journal.  With Dan’s approval, I have provided a link to the complete article, Remote Workforces: Tax Perils and Other Traps For Unwary Employers, for my blog readers. 

The Taxpayer Advocate Service (“TAS”) is an independent body housed within the Internal Revenue Service (the “Service” or “IRS”).  Its mission is to ensure taxpayers are treated fairly by the Service and that taxpayers know and understand their rights with respect to the federal tax system.  Further, the TAS was created by Congress to help taxpayers resolve matters with the IRS that are not resolved through normal IRS procedures.  Additionally, the TAS was established to address large-scale, systemic issues that impact groups of taxpayers.

The TAS is currently led by Ms. Erin M. Collins, who joined the TAS in March 2020.  She serves as the National Taxpayer Advocate (“NTA”).  The NTA submits two reports to Congress each year, namely an “Annual Report” in January and what is called an “Objectives Report” in June.

On June 22, 2022, the NTA submitted the TAS Fiscal Year 2023 Objectives Report to Congress.  In addition to identifying the TAS’s objectives for the upcoming fiscal year, Ms. Collins sets out the good, the bad and the ugly relative to the Service’s performance during the year.  As a report card, it does not appear Ms. Collins gave the IRS all A’s.  She expressed critical comments centered primarily around three areas of customer service that include unprocessed paper-filed tax returns, delays in responding to taxpayer correspondence and failures in answering taxpayer telephone inquiries.  Whether the criticism is warranted may be debatable.

Background

Early in the pandemic, I reported on the widespread newly created remote workforces resulting from stay-at-home orders issued by the governors of most states.  In many cases, neither the employer nor the workers were prepared to take this journey.

Fears were rampant among employers that workplace productivity would diminish, quality of work would be impacted, technology would not support remote workers, culture would be compromised, employee recruiting and retention would be harmed, and customer goodwill would be tarnished.  On top of that, many employers worried that employee fatigue (mental and physical) would accompany the new workforce model.

Preliminary Results

Now that we are over two years into the pandemic, employers and employees alike are surprised to find that their fears, for the most part, were misplaced.  In most cases, it is reported that the remote workforce model is working quite well.    

• • Employees generally like the remote workforce model;
  • In a large number of cases, employees desire to remain remote post-pandemic;
  • The lack of commuting to and from work reduces employee disruption, stress  and household expenses (commuting costs, daycare, meals and clothes), and allows more time for family and leisure activities;
  • Workplace politics are diminished;
  • It creates flexibility as to where employees may live, resulting in housing costs reductions in some cases; and
  • Employee absenteeism is diminished.

Background

During the COVID-19 pandemic, the federal government enacted three major pieces of legislation to provide financial relief to individuals and families.  The American Recovery Plan Act (“ARPA”), the most recent legislation, provides the third round of Economic Impact Payments (“EIPs”), also referred to as stimulus payments (and “recovery rebates” in the acts), to millions of Americans.

It is not unreasonable to anticipate that there will be a federal tax policy transformation following a change in the political control of the White House, the U.S. Senate and the U.S. House of Representatives.  What may be unreasonable, however, is making knee-jerk tax planning decisions in anticipation of possible modifications to the Internal Revenue Code (the "Code").  Reactionary planning, unless it is well thought out and is based upon sound business judgment, could end up being disastrous.  During the present times, tax advisors and their clients need to be cautious in their tax planning and any related decision-making.   

Looking through a lens solely focused on federal taxation, it seems that commentators, tax advisors and taxpayers alike are all worried about the future.  Possible tax policy changes on the horizon that are being bantered about include: