The S Corporation Rules And The Use Of S Corporations As Acquisition Vehicles
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The S Corporation Rules And The Use Of S Corporations As Acquisition Vehicles
United States
Tax
By Mark J. Silverman, Steven B. Teplinsky and Aaron P. Nocjar
Originally published in June 2003
I. INTRODUCTION
II. BECOMING AN S CORPORATION
Eligibility
Domestic Corporation
Ineligible Corporation
In General
Prior to the Small Business Act of 1996
Affiliated Subsidiaries Not Permitted
Inactive Subsidiaries Permitted
Transitory Stock Ownership
Nonaffiliated Subsidiaries Permitted
Type of Shareholder
In General
Trusts as Shareholders
In General
Qualified Subchapter S Trust
Electing Small Business Trust
In General
Beneficiaries
Potential Current Beneficiaries
Acquisition By Purchase
ESBT Election
Taxation of ESBTs
Ceasing To Be an ESBT
ESOPs
Ineligible Shareholder Issues
Transitory Ownership by Ineligible Shareholders
Incorporating a Partnership
Number of Shareholders
Single Class of Stock Requirement
In General
Differences in Voting Rights
Identical Rights with Respect to Distribution and Liquidation
Proceeds
General Rule
Exceptions to General Rule
State Law Requirements for Payment and Withholding of Income
Tax
Buy-Sell and Redemption Agreements
Varying Interests
Stock Taken Into Account
Restricted Stock
Deferred Compensation Plans
Straight Debt
Special Rules for Debt Instruments, Obligations, and Other
Similar Arrangements
In General
Debt Arrangements Treated as Equity under General Principles
Short-Term Unwritten Advances
Proportionately Held Obligations
Call Options, Warrants, or Other Similar Instruments
Options Issued to Lenders.
Options Issued to Employees
Call Option Safe Harbor Relief.
Convertible Debt
The Straight Debt Safe Harbor Rules
Miscellaneous Provisions
Inadvertent Terminations
Effective Dates
Permitted Taxable Year
Current Guidance in General
Prior Guidance
Pre-1983
1983-1986
Current Guidance in Detail
Calendar Year or Business Purpose Year
Section 444 Fiscal Year
Grandfathered Fiscal Year
Procedural Requirements Relating to Permitted Taxable Years
Treasury Regulations
Other Guidance
Failure to Adopt, Change To, or Retain Permitted Year
Validity of S Election
Termination of S Election
The S Election
Making the Election
Timing
Consent Required
Qualification as a Small Business Corporation
New Election After Termination
Five-Year Waiting Period
Successor Defined
New Election after Invalid
Election
III. EFFECTS OF AN S ELECTION
Pass-Through of S Corporation Items
In General
Operation of the Pass-Through Rules
Taxable Year of Inclusion
Allocation of Items
Per-Share Per-Day Rule
Election To Close the Books
Termination of Shareholder’s Interest
Dispositions of Substantial Amounts of Stock
Allocation in an S Termination Year
Special Allocations
Limitations on Deductibility of Losses
Allocation of Loss Items
Section 1366(d)
In General
Basis Adjustments
Carryover of Disallowed Losses
At-Risk Limitation - Section 465
Passive Loss Limitation - Section 469
Basis Adjustments
Stock
Increases
Decreases
Debt
Decreases
Increases (or Restoration)
Timing of Adjustments
Stock
Debt.
Ordering Rules for Basis Adjustments
Stock
General Rules
Taxable Years Beginning Before January 1, 1997 (i.e., Prior
to the Small Business Act of 1996)
Taxable Years Beginning on or after January 1, 1997, and
Before August 18, 1998
Taxable Years Beginning on or after August 18, 1998
Elective Ordering Rule
Effects of Change to Stock Basis Adjustment Rules
Comparison to Partnership Interest Basis Adjustment Rules
Debt
Distributions
Corporate-Level Effects
Appreciated Property
Depreciated Property
Other Corporate-Level Effects
Shareholder Effects.
S Corporation Having No Earnings and Profits
S Corporation Having Earnings and Profits
First Layer
Second Layer
Third Layer
S Corporations with Previously Taxed Income
The Accumulated Adjustments Account
Increases to the AAA
Decreases to the AAA
Items Other Than Distributions
For Distributions
For Distributions in Excess of the AAA
Distributions of Money and Loss Property
Effect of Debt Basis Adjustments
Ordering Rules for Adjustments to the AAA
Adjustments to AAA for Redemptions, Reorganizations,
Divisions, and Year Terminations
Redemptions
Reorganizations
Corporate Divisions under Section 368(a)(1)(D)
Year Terminations
Which S Corporations Must (Should) Maintain an AAA?
Elections Relating to AAA Distribution Rules
Election to Distribute Earnings and Profits First
Election to Make a Deemed Dividend
Election to Forego PTI
Planning Issue for S Corporation Having Earnings and Profits
and Insufficient AAA
Special Elections
Termination of Shareholder’s Interest
Dispositions of Substantial Amounts of
Stock
Structuring Financing
Maximizing Basis
Contributions from Shareholders
Loans from Shareholders
Taxation of Shareholder S Corporation Debt
Back-to-Back Loans
Shareholder Guarantees
Sales Financing
Creating Priority for Investors
Special Effects of an S Election
Cancellation of Indebtedness Income and Sections 108 and 1366
Passive Activity Losses Under Section 469
Determination of Alternative Minimum Taxable Income
Charitable Contributions of Appreciated Property
Coordination with Subchapter C of the Code
Treatment of S Corporations as Shareholders of C Corporations
General Tax Treatment of S Corporations as Shareholders
S Corporations as Owners of 80 Percent-Owned Subsidiaries
Qualified Subchapter S Subsidiaries
Introduction
Electing QSub Status
IRS Notice 97-4 – Pre October 10, 2000 Elections
Final QSub Regulations and Form 8869
Extensions to Elect QSub Status
Subsequent QSub Election Apparently Not Prohibited
The Effect of a QSub Election
Termination of a QSub Election
QSubs and Tax-Free Reorganizations
IV. ADDITIONAL EFFECTS OF CONVERTING TO AN S CORPORATION
Corporate Level Tax on Built-In Gains - Section 1374
Purpose
General Rule
Computation of Tax
Recognized Built-In Gain
Recognized Built-In Loss
Limitation - Net Unrealized Built-In Gain
Scope of Provision
S Corporations Covered
Assets Covered
NOL Carryovers , Capital Loss Carryovers, and other Loss and
Deduction Carryovers
Installment Sales
Partnership Interests
Overview
Look-Through Rules: (Treas. Reg. § 1.1374-4(i)(1))
Disposition of a Partnership Interest: (Treas. Reg. §
1.1374-4(i)(3))
Special Rules
Section 704(c) Gain or Loss
Disposition of Distributed Property (Treas. Reg. §
1.1374-4(i)(7))
Effective Date of Section 1374
Regulations Cover Additional Issues
Recordkeeping Issues
Additional Planning Issues
Old Capital Gains Tax
Corporate Level Tax on Passive Investment Income - Section 1375
In General
Definitions
Rules Relating to C Corporation Subsidiaries
Special Rules Relating to Qsubs
Waiver of Section 1375 Tax
Planning To Avoid Section 1375 Tax
LIFO Recapture
Investment Credit Recapture
Estimated Taxes
V. CEASING TO BE AN S CORPORATION
Terminating the S Election
Revocation
Generating Passive Investment Income
Gross Receipts
Sale or Exchange of Capital Assets
Exclusions and Deferrals
Passive Investment Income
Royalties
Rents
Dividends
In General
Dividends from Affiliated Subsidiaries
Interest
Annuities
Sale of "Stock or Securities"
Special Rules for Dealers and Patrons
Accumulated Earnings and Profits
Effective Date of Termination for Passive Income
Planning To Avoid Termination for Passive Income
By Ceasing To Be a Small Business Corporation
What Is Not a Termination
Inadvertent Terminations
Treatment of S Termination Years
Definition
Effect
Post-Termination Distributions
VI. SUMMARY OF OTHER RELEVANT PROVISIONS
Investment Interest Deduction Limitation – Section 163(d)
Acquisitions to Avoid Tax – Section 269
Limitation on the Use of the Cash Method of Accounting – Section 448
Reduction of Paperwork Burden on Certain S
Corporations
VII. COMPARISON OF S CORPORATIONS WITH OTHER ENTITIES AS ACQUISITION
VEHICLES
Factors That Encourage the Use of S Corporations
Repeal of the "General Utilities" Doctrine
Noncorporate Rate Compared to the Corporate Rate
Ordinary Income Rates
Capital Gains Rates
Reduction of the Double Tax on C Corporation Earnings
Former C Corporations Taxed on Built-In Gain
The Alternative Minimum Tax
Types of Pass-Through Entities
Advantages of S Corporations
Compared with C Corporations
Compared with Partnerships
Disadvantages of S Corporations
VIII. ACQUIRING AND CONVERTING C CORPORATIONS TO S CORPORATION
STATUS
Making a C Corporation Eligible
Purchase of Stock
Recapitalization
Divisive D Reorganization
Changing Taxable Years To Obtain Maximum Benefit
New Corporations
Existing Corporations
Acquisition of Existing C Corporation
Effect of Conversion on the Corporation
IX. S CORPORATION AS AN ACQUISITION VEHICLE
Special Concerns with S Corporations
Newly-Formed S Corporation
Avoiding Termination
Other Considerations
Particular Transaction Structures Involving S Corporations
Asset Acquisitions by S Corporations
Taxable Asset Acquisitions
Tax-Free Asset Acquisitions
Effect on Election
Merger
Consolidation
C Reorganization
Acquisitive D Reorganization
Allocation of Income or Loss in the Acquisition Year
Carryover of Corporate Attributes
Pre-Reorganization Distributions
Distributions Pursuant to the Merger
Post-Reorganization Distributions
LIFO Recapture
Stock Acquisitions by S Corporations
Taxable Stock Acquisitions
Effect on Election Prior to the Small Business Act of 1996
Effect on Election Pursuant to the Small Business Act of 1996
Allocation of Income or Loss in the Acquisition Year
Tax-Free Stock Acquisitions
Availability of Tax-Free Treatment
Effect on Election
Pre-Reorganization Distributions
Distributions Contemporaneously with the Reorganization
Post-Reorganization Distributions
Alternatives to S Corporation Acquiring Stock of Target
Brother "S" – Sister "C" Merger
Subchapter C Issues
Subchapter S Issues
Brother "S" – Sister "S"
Structure
X. S CORPORATION AS A TARGET
Asset Dispositions
Taxable Asset Dispositions – Direct Sale of Assets
Taxable Asset Dispositions – Taxable Merger
Installment Sale Issues
Effect on Election
Allocation of Income (Loss) in Year of Disposition
Deemed Asset Dispositions – Section 338(h)(10)
The Election
Consequences of the Election
Effective Dates
Deemed Ownership of Stock Held by a QSST
Tax-Free Asset Dispositions
Availability of Reorganization Provisions
Effect on Election
Allocation of Income (Loss) in Year of Disposition
Carryovers
Suspended Losses
Pre-Reorganization Distributions
Distributions Pursuant to the Reorganization
Post-Reorganization Distributions
Stock Dispositions
Sales of Stock
Effect on Election
Allocation of Income (Loss) Items in the Year
Amount and Character of Gain or Loss on the Sale
Pre-Sale Distributions
Post-Sale Distributions
Section 338(g) Election
Redemptions
Effect on Election
Allocation of Income or Loss in the Year
Distributions
Section 302(a) Redemptions
Section 302(d) Redemptions
Complete Liquidation
General Tax Consequences
Effect on Election
Allocation of Income and Loss in Year of Liquidation
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