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Special Rules for Deducting Unused S Corporation

Losses and Claiming Nontaxable Distributions

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November 21, 2019

Special Rules for Deducting Unused S Corporation Losses and Claiming Nontaxable Distributions

Professor Robert W. Jamison, CPA, Professor Emeritus of Accounting

Indiana University, Indianapolis

[email protected]

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Notice

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The information contained herein is of a general nature and based on authorities that are

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determined through consultation with your tax adviser.

Special Rules for Deducting Unused S Corporation Losses

Robert W. Jamison, CPA, PhD

Live Webinar November 21, 2019

Strafford

Overview

Copyright © Robert W. Jamison 6

• Post-Termination Transition Period• Statute

• Regulations

• Proposed Regulations

• Tomseth case

• Eligible Terminated S Corporations• Statute and legislative history


Citations for this Presentation

Rules

Post-Termination Transition Period

Eligible Terminated S Corporation

Tomseth v. United States,

2019-2 USTC ¶50,257 (DC OR)

Regs

§1.1377-2

Prop. §1.1377-2

Prop. §1.1371-1


Code

§1377(b)

§1371(f)

Slide Layout


• Statute

• Current Final Regulations

Slide Layout


• Tomseth Case


Perspective

• 5.1 million S Corporations filed in 2018

• 4,850 revoked or terminated in calendar 2018

• The U.S. Department of Treasury, Internal Revenue Service, Data Book 2018 (Data Book)


Post-Termination Transition Period


PTTP Defined.

Impact of Post-Termination Period.

Losses In PTTP.

Distributions In The PTTP.

PTTP Defined


• The PTTP begins on the day that the S election is no longer effective.

• The period ends on the latest of:• The due date for the final 1120S, including extensions,

• One year after the termination occurs, or,

• 120 days after a closing agreement or final court decision.

• 120 days after an audit of a Subchapter S item.

Example 1


• A calendar-year corporation terminates its S election on November 5, 2020.

• Its post-termination transition period begins on November 6, 2020, and ends on November 5, 2021.

Example 2


• Paintco, which uses the calendar year, terminated its S election on March 1, 2020.

• Paintco's S termination year does not end prematurely. • If Paintco does not extend its final Form 1120S, its post-

termination transition period ends on March 15, 2021, the due date for its final Form 1120S.

• If Paintco extends its final Form 1120S, the post-termination transition period is also extended until September 15, 2021.

Example 3


• On March 3, 2018, Barbco, an S corporation that used the calendar year, issued a second class of stock.

• Barbco and its shareholders did not realize that this action caused the termination of the S election.

• In 2021, Barbco's 2018 return was audited by the IRS.

• The agent discovered the issuance of the second class of stock and terminated Barbco's S election as of March 2, 2018.

Example 3 continued


• Barbco and its shareholders did not request inadvertent termination relief and did not contest the termination.

• On July 24, 2021, Barbco agreed to the results of the audit. Barbco's S termination year was the calendar year 2018, because its S election terminated in that year.

• Barbco's post-termination transition period began on March 3, 2018, but does not end until November 21, 2021, 120 days after the closing agreement (July 24).

Impact Of the Post-Termination Period


• The S corporation may have incurred losses.

• Shareholders may not have had sufficient basis to deduct those losses. • The amount of the suspended losses may not be known until the S

corporation closes its books for the period before termination.

• Alternatively, the S corporation may have been profitable in its S period• Shareholders may not have had an opportunity to withdraw the

AAA balance.

Losses In The PTTP


• If the shareholder’s basis was not sufficient to deduct losses before the S election terminated, the shareholder carries the excess losses to the PTTP

• If the shareholder restores stock basis during the PTTP, he or she may deduct the previously suspended losses to the extent of the basis increase during the PTTP.

Losses In The PTTP (Cont.)


• Basis of indebtedness created by loans from the shareholder after the S election terminates will not allow the deductibility of losses.

• Accordingly, a shareholder who wishes to take advantage of this rule must either purchase additional shares in the corporation or make a contribution to capital.

Example 4


• Losco was an S corporation that used the calendar year. It terminated its S election on May 2, 2020.

• The corporation's S termination year did not end prematurely, and the corporation extended the due date for its 2020 returns until September 15, 2021.

Example 4 (Cont.)


• Losco has one shareholder, Leona.

• Her basis in her Losco stock on January 1, 2020, was $3,000.

• For its S short year ended May 1, 2020, Losco reported $12,000 loss.

• Leona was unaware of the magnitude of the loss until June 2021, when the accountant was preparing Losco's 2020 returns.

Example 4 (Cont.)


• In the absence of the post-termination transition period rules, Leona's loss deductions would be limited to $3,000, her basis in the Losco stock.

• The corporation was not an S corporation at any time during 2021, but the post-termination transition period does not expire until September 15, 2021.

Example 4 (Cont.)


• In June 2021, when Leona discovers that she needs $9,000 additional basis, she contributes $9,000 to the corporation's capital.

• This contribution increases her basis to $9,000 and allows her to deduct the suspended $9,000 loss in 2021.

• The loss deduction reduces her stock basis back to zero.

Observations re: PTTP and Losses


• For small corporations, the shareholder may still be able to acquire new §1244 basis.

• Contribution to capital will not create §1244 basis.

• Purchase of new shares will create §1244 basis.

Financial Risk


• Additional basis will require an outlay of cash, which may not be a sound investment.

• In some cases, the shareholder would be well advised to forego the loss deduction, rather than make the additional investment.

Financial Risk


• However, if the shareholder is committed to the enterprise or has guaranteed loans that he or she will probably need to pay, it would be wise to contribute to the corporation’s capital or purchase additional shares during the post-termination transition period.

• By doing so, the shareholder could claim a tax deduction on money that he or she would likely be required to pay in any circumstance.

Distributions In The PTTP


• An S corporation may have been profitable immediately before it terminated it S election.

• In that case, the shareholders would need to include their portions of its income on their own tax returns.

• Section 1371(e)(1) allows the shareholders to continue to receive tax-free distributions during the PTTP as if the election were still in effect.

Distributions In The PTTP (Cont.)


• There are some special rules:• The balances that can still be distributed under the Subchapter S

rules are limited to the corporation's AAA, as adjusted through the final day as an S corporation.

• PTI and OAA are not available, and should be closed to paid-in capital.

• According to regulations, the PTTP distribution rules apply to any shareholder who was a shareholder when the S election was in effect (the no newcomer rule).


• According to proposed regulations, the PTTP distribution rules apply to any shareholder wo receives a distribution in the PTTP

• This would repeal the no newcomer rule

• Effect on open years?




• The distribution rule applies only to cash distributions made during the post-termination period.• The corporation may, however, distribute out notes to its

shareholders before the S election terminates.

• Corporations that anticipate terminating the S election, and want to distribute all Accumulated Adjustments Account balances, but are short of cash, must plan carefully to observe all of the formalities of creating valid debt before the election terminates.

Example 5


• Profco terminated its S election on July 2, 2020 (leap year). Profco used the calendar year.

• For 2020, Profco's taxable income was $366,000, all of which was ordinary.

• Profco used the pro rata allocation method of accounting for its S termination year of 2020.

• Therefore, Profco's taxable income is $183,000 for its S short year and also $183,000 for its C short year.

Example 5 (Cont.)


• Profco's income tax for its C short year is $38,430 ($183,000 * 21%).

• Assuming Profco had no adjustments to its earnings and profits other than its income tax, its current earnings and profits for its C short year would be $144,570 ($183,000-$38,430).

Example 5 (Cont.)


• Profco had no balance in its Accumulated Adjustments Account or its accumulated earnings and profits at the beginning of 2020.

• The corporation made no distributions before July 2, 2020.

• Therefore, its AAA as of that date would be $183,000, its taxable income for its S short year.

• Any distribution up to $144,570 (current earnings and profits) made by the corporation between July 2, 2020, and December 31, 2020, would be a dividend to the shareholders, under the general rules of Subchapter C.

Example 5 (Cont.)


• Therefore, under those rules, a shareholder could not even receive a distribution to pay income tax on the income for the S short year without being subject to double taxation.

• According to the post-termination transition period rules, however, distributions up to $183,000 would be from the AAA.

Tomseth Case (Sept. 27, 2019)

• 3 S corporations

• Each started as C

• Each elected S

• Each terminated S

• Each elected S again

• Each terminated S again


Tomseth Issues

1. Did prior S period AAA survive C period and become available again in later S period?

2. Could IRS impute a negative AAA that was not subject to statute of limitations?


Tomseth: LS Warehouse, per Shareholders


Date Status AAA Distribution Balance

1958 - 1986 C corp.

1987 - 1993 S corp.51,627,736 26,743,007 24,884,729

1993 – 2008 C corp.

2009 - 2012 S corp. 17,563,554+24,884,729

2013 C corp.PTTP 42,443,028 *

* Mostly nontaxable distribution of AAA

Tomseth: LS Warehouse, per IRS



1958 - 1986 C corp.

1987 - 1993 S corp.51,627,736 26,743,007 24,884,729

1993 – 2008 C corp.

2009 - 2012 S corp. 17,563,5542013 C corp.

PTTP 42,443,028 ## Mostly taxable distribution of E&P

Tomseth: LS Warehouse, Outcome

• IRS was correct.

• AAA resets to zero when S election terminates. Operates only as measurement of distributions during PTTP.


Tomseth: LS Washington, per Shareholders


1968 - 1987 C corp.

1987 - 1991 S corp. 19,862,658 19,862,6581992 – 2008 C corp.

PTTP 10,225,694 9,636,9642009 - 2012 S corp.

15,104,172+ 9,636,964

2013 C corp.PTTP 24,692,889 *

* Mostly nontaxable distribution of AAA


Tomseth: LS Washington, per IRS


1968 - 1987 C corp.

1987 - 1991 S corp. 19,862,658 19,862,6581992 – 2008 C corp.

PTTP 10,225,694 9,636,9642009 - 2012 S corp. 15,104,1722013 C corp.

PTTP 24,692,889 ## Only about 60% distribution of AAA


Tomseth: LS Washington, Outcome

• IRS was correct.

• AAA resets to zero when S election terminates. Operates only as measurement of distributions during PTTP.


Tomseth: LS Portland, per Shareholders


1973 - 1987 C corp.

1987 - 1993 S corp. 56,645,199 56,645,199

1992 – 2003C corp.PTTP 31,916,781 22,728,418

2004 - 2012 S corp. 21,950,729** 1,968,878 *

2013C corp.PTTP 4,162,185 *

* Nontaxable distribution of AAA in 2005, from old AAA** Accumulation after 2004


Tomseth: LS Portland, per IRS

Date Status AAA Distribution Balance1973 - 1987 C corp.1987 - 1993 S corp. 56,645,199 56,645,1991992 – 2003 C corp.

PTTP 31,916,781 22,728,4182004 - 2012 S corp.

0 1,968,878 # ($1,968,878)2013 C corp.

PTTP 4,162,185 ##


Tomseth: LS Portland, per IRS (Cont.)

# IRS recalculated distribution as mostly taxable, after statute of limitations expired. IRS reduced AAA to ($1,968,878). Treated this deficit as a “suspense” account which is not subject to statute of limitations.

## Offset 2004 – 2012 AAA with 2005 deficit.


Tomseth: LS Portland, Outcome

• IRS could not ignore statute of limitations and require negative AAA balance to offset future distributions.


Eligible Terminated S Corporations


• In order to get the Senate votes necessary to pass the Tax Cuts and Jobs Act of 2017 Congress added two special rules that apply to corporations that terminate their S status and become C corporations.• If the corporation is required to change its accounting method to

accrual, the Section 481 adjustment period is six years, rather than the general four-year period.

• After the PTTP ends, the corporation prorates distributions between the corporation’s AAA and accumulated earnings and profits (AE&P) based on the ratio of AAA to AE&P.

Eligible Terminated S Corporations (Cont.)


• In order to qualify those rules, the corporation must meet these requirements:• It must have been an S corporation on December 22, 2017.

• It must revoke its S election on or before December 22, 2019.

• The same persons must hold shares in identical proportions on December 22, 2017 and the date of revocation.

Distribution from Eligible Terminated S Corporations

• In order to be an eligible terminated S corporation (ETSC), the corporation must meet these requirements:• It must have been an S corporation on December 22, 2017.

• It must revoke its S election on or before December 22, 2019.

• The same persons must hold shares in identical proportions on December 22, 2017 and the date of revocation.

• After the PTTP ends, the ETSC prorates distributions between the corporation’s AAA and accumulated earnings and profits (AE&P) based on the ratio of AAA to AE&P.

Distribution from Eligible Terminated S Corporations (Cont.)

• According to the proposed regulations, the ratio of AAA/Dividends is determined by the relationship of AAA and AE&P on the final day of the final S corporation year.

AAA

AAA + AE&P


Distribution from Eligible Terminated S Corporations (Cont.)

The corporation applies this ratio to distributions until the AAA is exhausted.

The ETSC Period begins on the day after the PTTP ends

When the AAA reaches zero the ETSC period ends

At that time the regular C corporation distribution rules apply


Questions?

?


S CORPORATIONS:TAX PLANNING & COMPLIANCE

STRATEGIES: EXTRAS


S CORPORATIONS:TAX PLANNING & COMPLIANCE

STRATEGIES: EXTRAS


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