Definition of a Small Business Corporation

Chapter 12 Digging Deeper

Contents:

DEFINITION OF A SMALL BUSINESS CORPORATION

1. One Class of Stock. The determination of whether stock provides identical rights to distribution and liquidation proceeds is made based on the provisions governing the operation of the corporation. These governing provisions include the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds. Employment contracts, loan agreements, and other commercial contracts are not considered governing provisions.1 Such contracts violate the one-class-of-stock requirement only if their principal purpose is to circumvent the requirement.

Example:Blue, a small business corporation, has two equal shareholders, Smith and Jones. Both shareholders are employed by Blue and have binding employment contracts with the corporation. The compensation paid by Blue to Jones under her employment contract is reasonable in amount. The compensation paid to Smith under his employment contract, however, is excessive, and a constructive dividend results. Smith’s employment contract was not intended to circumvent the one-class-of-stock requirement. Because employment contracts are not considered governing provisions, Blue has only one class of stock.

DEFINITION OF A SMALL BUSINESS CORPORATION

2. One Class of Stock.Straight debt issued in an S corporation year is not treated as a second class of stock and will not disqualify the S election.2 The key characteristics of straight debt are listed below.

The debtor is subject to a written, unconditional promise to pay on demand or on a specified date a sum certain in money.
The interest rate and payment date are not contingent on corporate profits, management discretion, or similar factors.
The debt is not convertible into stock.
The creditor is an individual (other than a nonresident alien), an estate, or qualified trust.
Straight debt can be held by creditors actively and regularly engaged in the business of lending money.

In addition to the straight debt safe harbor, short-term unwritten advances from a shareholder that do not exceed $10,000 in the aggregate at any time during the corporation’s taxable year generally are not treated as a second class of stock. Likewise, debt that is held by stockholders in the same proportion as their stock is not treated as a second class of stock, even if it would be reclassified as equity otherwise.3

S CORPORATION CONSENTS

3. Both husband and wife must consent if they own their stock jointly (as joint tenants, tenants in common, tenants by the entirety, or community property). This requirement has led to considerable taxpayer grief—particularly in community property states where the spouses may not realize that their stock is jointly owned as a community asset.

Example:Three shareholders, Amy, Monty, and Dianne, incorporate in January and file Form 2553. Amy is married and lives in California. Monty is single and Dianne is married; both live in South Carolina. Because Amy is married and lives in a community property state, her husband also must consent to the S election. South Carolina is not a community property state, so Dianne’s husband need not consent.

Finally, for current-year S elections, persons who were shareholders during any part of the taxable year before the election date, but were not shareholders when the election was made, must also consent to the election.4

Example:On January 15, 2009, the stock of Columbus Corporation (a calendar year C corporation) was held equally by three individual shareholders: Jim, Sally, and LuEllen. On that date, LuEllen sells her interest to Jim and Sally. On March 14, 2009, Columbus Corporation files Form 2553. Jim and Sally indicate their consent by signing the form. Columbus cannot become an S corporation until 2010 because LuEllen did not indicate consent. Had all three shareholders consented by signing Form 2553, S status would have taken effect as of January 1, 2009.

ALLOCATION OF INCOME AND LOSS

4. The Short-Year Election. In the case of the death of a shareholder, a short-year election can prevent the income and loss allocation to a deceased shareholder from being affected by post-death events.

Example:Joey and Karl equally own Orchid, Inc., a calendar year S corporation. Joey dies on June 29 (not a leap year). Orchid has income of $250,000 for January 1 through June 29 and $750,000 for the remainder of the year. Without a short-year election, the income is allocated by assigning an equal portion of the annual income of $1 million to each day (or $2,739.73 per day) and allocating the daily portion between the shareholders. Joey is allocated 50% of the daily income for the 180 days from January 1 to June 29, or $246,575.70 [($2,739.73/2)  180]. Joey’s estate is allocated 50% of the income for the 185 days from June 30 to December 31, or $253,425.02 [($2,739.73/2)  185].

If the short-year election is made, the income of $250,000 from January 1 to June 29 is divided equally between Joey and Karl, so that each is taxed on $125,000. The income of $750,000 from June 30 to December 31 is divided equally between Joey’s estate and Karl, or $375,000 to each.

SCHEDULE M-3: NET INCOME OR LOSS RECONCILIATION

5.S corporations that have total assets on Schedule L at the end of the tax year thatequal orexceed $10 million must file Schedule M-3 in lieu of Schedule M-1. For purposesof measuringtotal assets at the end of the year, assets may not be netted or offsetagainst liabilities. Totalassets may not be reported as a negative number. Totalassets must be determined on an overallaccrual method of accounting unless bothof the following apply: (1) the tax return of thecorporation is prepared using anoverall cash method of accounting, and (2) no entity includible inthe U.S. taxreturn prepares or is included in financial statements prepared on an accrual basis.

Part I of Schedule M-3 asks certain questions about the corporation’s financialstatements, and itreconciles financial statement net income or loss to the income orloss per the income statementfor the U.S. tax return. Parts II and III reconcile financialstatement net income or loss for the U.S.tax return on Schedule M-3, Part I, line11, to total income or loss on Form 1120S, page 3,Schedule K, line 18.

WORKING WITH S STOCK BASIS

6. The basis rules for S corporation stock are similar to the rules for determining a partner's interest basis in a partnership. However, entity-level debt is not included in a shareholder’s stock basis. The fact that a shareholder has guaranteed a loan made to the corporation by a third party has no effect upon the shareholder's loan basis, unless payments actually have been made as a result of that guarantee.5 If the corporation defaults on indebtedness and the shareholder makes good on the guarantee, the shareholder's indebtedness basis is increased to that extent.6

A flow-through deduction is available for a shareholder loan only where there is clear evidence that the S corporation is liable to the shareholder. A shareholder looking for this result should borrow the money from the bank and then loan the money to the S corporation.

TAX ON PRE-ELECTION BUILT-IN GAIN

7. General Rules. The maximum amount of gain that is recognized over the 10- (or 7-) year period is limited to the aggregate net built-in gain of the corporation at the time it converted to S status. Thus, at the time of the S election, unrealized gains of the corporation are reduced by unrealized losses. The net amount of gains and losses sets an upper limit on the tax base for the built-in gains tax. Any appreciation after the conversion to S status is subject to the regular S corporation pass-through rules.

Example:Waxx is a former C corporation whose first S corporation year began on January 1, 2009. At that time, Waxx had two assets: X, with a value of $1,000 and a basis of $400, and Y, with a value of $400 and a basis of $600. The net unrealized built-in gain as of January 1, 2009, is $400 (Asset X $600 built-in gain  Asset Y $200 built-in loss). If asset X is sold for $1,200 during 2009, and asset Y is retained, the recognized built-in gain is limited to $400. The additional $200 of appreciation after electing S status is not part of the built-in gain.

Loss assets on the date of conversion reduce the maximum built-in gain and any potential tax under § 1374.7 In addition, built-in losses and built-in gains are netted each year to determine the annual § 1374 tax base. Thus, an incentive exists to contribute loss assets to a corporation before electing S status. However, contributions of loss property witha tax avoidance motive do not reduce the corporation’s net unrealized built-in gain.8

Example:Connor owns all the stock of an S corporation, which in turn owns two assets on the S conversion date: asset 1 (basis of $5,000 and fair market value of $2,500) and asset 2 (basis of $1,000 and fair market value of $5,000). The S corporation has a potential net realized built-in gain of $1,500 (i.e., the built-in gain of $4,000 in asset 2 reduced by the built-in loss of $2,500 in asset 1). However, if Connor contributed the loss asset to the corporation within two years before the S election, the built-in gain potential becomes $4,000 (i.e., the loss asset cannot be used to reduce built-in gain).

PASSIVE INVESTMENT INCOME PENALTY TAX

8. Avoiding the Passive Investment Income Tax. Too much passive investmentincome (PII) may cause an S corporation to incur a § 1375 penalty taxand/or terminate the S election. Severalplanning techniques can be used to avoidboth of these unfavorable events. Where a smallamount of AEP exists, an AAAbypass election may be appropriate to purge the AEP, therebyavoiding the passiveincome tax altogether. Alternatively, the corporation might reduce taxableincome below the excess net passive income; similarly, PII might be acceleratedinto years inwhich there is an offsetting NOL.

In addition, the tax can be avoidedif the corporation manufactures needed gross receipts. By increasing grossreceipts without increasing PII, the amount of PII in excess of 25 percent of grossreceipts is reduced. Finally, performing significant services or incurring significantcosts with respect to rental real estate activities can elevate the rent income tononpassive.

Example:An S corporation has paid a passive income penalty tax for two consecutive years. In the next year, the corporation has a large amount of AAA. If the AEP account is small, an AAA bypass election may be appropriate to purge the corporation of the AEP. Without any AEP, no passive investment income tax applies, and the S election is not terminated. Any distribution of AEP to the shareholders constitutes taxable dividends, however.

Another alternative is to manufacture a large amount of gross receipts without increasing PII through an action such as a merger with a grocery store. If the gross receipts from the grocery store are substantial, the amount of the PII in excess of 25% of gross receipts is reduced.

Notes:

1 Reg. § 1.1361–1(l)(2).

2 § 1361(c)(5)(A).

3 Reg. § 1.1361–1(l)(4).

4§ 1362(b)(2)(B)(ii).

5See for example, Estate of Leavitt, 90 T.C. 206 (1988), aff'd 89-1 USTC ¶9332, 63 AFTR2d 89-1437, 875 F.2d 420 (CA-4, 1989); Selfe v. U.S., 86-1 USTC ¶9115, 57 AFTR2d 86-464, 778 F.2d 769 (CA-11, 1985); James K. Calcutt, 91 T.C. 14 (1988).

6 Rev.Rul. 70-50, 1970-1 C.B. 178.

7 §§ 1374(c)(2) and (d)(1).

8 Reg. § 1.1374-9.