Fourteen sections of the Internal Revenue Code are central to the taxation of Subchapter S corporations and their shareholders. 1 Over the 12-month period ending March 2024 covered by this article, several of these sections and others affecting S corporations have been addressed by recent legislation, court cases, and IRS guidance. The AICPA S Corporation Taxation Technical Resource Panel, a volunteer group of practitioners who pay close attention to matters affecting S corporations and their shareholders, offers the following summary of recent developments relating to this tax area. The items are arranged by Code section (starting with those in Subchapter S and then other sections).
Sec. 1362: Election; revocation; termination
Sec. 1362 provides procedures for electing or revoking S corporation status and rules for terminating S corporation status if the corporation fails to meet one or more of the eligibility requirements of Sec. 1361.
Sec. 1362(b)(5) instructs the IRS to accept late S elections if the delinquency is due to reasonable cause. Rev. Proc. 2013-30 permits S corporations to file for relief with the appropriate IRS service center if no more than three years and 75 days have elapsed from the intended effective date, along with certain other requirements. Rev. Proc. 2013-30 also applies this rule to late qualified Subchapter S subsidiary (QSub) elections and entity classification elections for unincorporated entities electing S corporation status.
Sec. 1362(g) restricts S corporations for which the S election has been terminated from reelecting S corporation status before the fifth tax year after the year of termination, unless the IRS consents to a new election.
In order for an election to be valid, the corporation must be eligible for S corporation status on the day that it files Form 2553, Election by a Small Business Corporation. Moreover, the corporation must retain eligibility on each day that it claims S corporation status.
Relief for inadvertent ineffective elections and inadvertent terminations
Sec. 1362(f) permits an S corporation or QSub to cure an otherwise defective election or a later violation if the defect is inadvertent. In most cases, the corporation, and perhaps the offending shareholder, must request a ruling from the IRS National Office or apply for relief with the appropriate IRS service center. Filing with the National Office entails preparing a ruling request and paying the user fee. In contrast, filing with a service center is considerably less complicated and requires no payment to the IRS.
Certain relief under Sec. 1362 requires a taxpayer to submit a request for a private letter ruling. User fees for these letter rulings are updated annually. The user fees prescribed by Rev. Proc. 2024-1 for a private letter ruling request submitted after Jan. 1, 2024, were unchanged from those of the previous annual period. 2 However, taxpayers considering requesting a letter ruling for an inadvertent S election termination should review Rev. Proc. 2013-30 and Rev. Proc. 2022-19 for potential relief without requesting a ruling and paying the user fee. However, in spite of the lenient and simple cures in these revenue procedures, the IRS National Office still issues several letter rulings each year in situations where the corporation, the shareholders, and the tax professionals involved have all missed the deadlines for the simpler options.
Rev. Proc. 2013-30 continues to be an important remedy: Rev. Proc. 2013-30 permits a service center to deal with a request for inadvertent ineffective election or inadvertent termination relief if the sole cause for ineligibility is the failure of the parties to file a late qualified Subchapter S trust (QSST) or electing small business trust (ESBT) election. In case of a QSST, the beneficiary must file the election that permits the trust to be eligible within the specified period. 3 The trustee is the proper party for filing the ESBT election. 4 Rev. Proc. 2013-30 permits the proper party to file one of these trust elections with the service center if fewer than three years plus 75 days have elapsed from the date the trust needed to qualify. 5 Since publication of the last S corporation update in the July 2023 issue of *The Tax Adviser,* 6 the IRS has issued approximately 30 letter rulings granting relief for failure to file timely trust elections. 7 The logical inference is that the persons involved had failed to notice the problem and take corrective action within three years after the trust acquired the stock.
Authority to make or revoke S election: In a bankruptcy case, 8 the debtor corporation had sold all assets for around $370 million. The corporation had a valid S election in place, and thus the 9 taxation of the sale would have flowed through to the sole shareholder. The shareholder sought to revoke the S election, thus changing the corporation to a C corporation, with the result that taxes due on the sale would be owed by the corporation in bankruptcy. Citing numerous other cases on this subject, and after providing a short course in logic as applied to a tax election, the district court held that the S election was property of the bankruptcy estate. The sole shareholder was not currently an officer of the corporation and did not have the power to revoke the corporation’s election.
Sec. 1366: Passthrough of income and losses
Sec. 1366(d) limits a shareholder’s loss deductions (before considering the amount at risk, passive activity loss, and excess business loss limitations) to the shareholder’s adjusted basis in S corporation stock and debt.
Passthrough of tax-exempt income and nondeductible items
Under Sec. 6417, an S corporation may elect to receive direct payments from the IRS in lieu of claiming certain credits that would otherwise pass through to the shareholders. Sec. 6418 allows for the sale of certain other credits to private investors if the corporation does not claim the credit. In either case, the S corporation reports the direct payment or the sale price as tax-exempt income. This tax-exempt income increases the shareholders’ bases and flows to the other-adjustments account rather than the accumulated-adjustments account. If an S corporation purchases a credit from another passthrough entity, the cost is a nondeductible expense, passing through to the shareholders and causing reductions of shareholder basis (see the discussion under Secs. 6417 and 6418 below).
Stock and debt distinguished
A recent Tax Court case emphasizes that even open account indebtedness must satisfy judicially created tests to be treated as debt. In Fry, the Tax Court held that, notwithstanding that two S corporations that were wholly owned by Thomas Fry recorded certain transfers as open account indebtedness on tax returns for several years, the amounts were not debt but rather deemed distributions from one S corporation, Crown Disposal Inc. (Crown), and contributions to a second, commonly controlled S corporation, CR Maintenance Services Inc. (Maintenance).9
It is not unusual for taxpayers to ‘lend’ to their related entities without full documentation.
The Frys were assessed a deficiency for underpayment of tax and accuracy and late-payment penalties related to their untimely filed 2013 individual income tax return. At issue was whether they were allowed to deduct flowthrough losses allocated to them from Maintenance. The IRS claimed that the Frys lacked sufficient basis to deduct the losses.
Beginning in 2010, Maintenance was unprofitable and required support to continue operations. From 2010 to 2013, Crown provided such support by either transferring funds to Maintenance or directly paying expenditures on behalf of Maintenance (no money was distributed to the Frys or contributed to Maintenance by them as it relates to these transfers).
The total amount of the transfers for the four years was approximately $36 million. In the respective ledgers, Maintenance recorded the transfers as a “Loan Payable” or “Due to Crown,” and Crown recorded the transfers as “Due from CR [Maintenance].” The companies also reported these balances as payables and receivables on their tax returns filed from 2010 to 2020. Repayment was to be made if Maintenance was profitable. In 2015, Crown and Maintenance sold their assets, and, although not clear from the facts, it appears that Maintenance was able to use the money to repay the transfer, as the facts state that by 2020 Maintenance transferred back to Crown the total amounts transferred to it from Crown.
On audit, the Frys claimed that amounts shown as accounts payable and receivables on the tax returns of Maintenance and Crown, respectively, for funds transferred from Crown to Maintenance were debts and repayments. The IRS held that the advances were not debt.
In Tax Court, Ruth Fry and the estate of Thomas Fry (who had died during the Tax Court proceedings) changed their tune and claimed that the advances should have been treated as deemed distributions by Crown to them and contributions by them to Crown to establish the requisite basis and allow them to utilize the loss at issue. The IRS in turn asserted that Sec. 385(c) prohibited the recharacterization of the transfers and the payments from debt to equity because their original characterization was debt.
On the Sec. 385(c) argument, the court held that Sec. 385(c) did not apply to bar Fry and the estate from arguing against the transfers’ form because there was no documentation relating to the transfers other than the tax returns and that Sec. 385(c) had never been applied to S corporations.
The court then went on to analyze whether the transfers would be treated as debt under case law. The court cited 11 factors from *Hardman.* 10 Based on the facts and judicial tests, the court found that the only factor that weighed in favor of treating the transfers as debt was the intent of the parties, which was evidenced by their reporting of the transfers. The court found that six factors weighed in favor of treating the amounts as equity:
Four factors were neutral:
Accordingly, the court ruled that the transfers and payments were not indebtedness. It then went on to determine the characterization of the fund flows.
Based on relevant case law, the court held that the payments made by Crown to Maintenance did not result in a deduction to Crown. Instead, because there was an economic benefit to the Frys, the transfers should be treated as deemed distributions by Crown to the Frys and subsequent contributions by them to Maintenance, creating basis in Maintenance to the Frys.
Since there was insufficient information to recalculate the basis Thomas Fry had in Crown and Maintenance under the recharacterization, the court ordered the parties to redetermine basis to properly calculate the flowthrough losses available to him in 2013; determine whether any harm would inure to the government as a result of the petitioners’ now taking inconsistent positions on closed years; and determine the amount of any underpayment and penalties and interest associated with the late filing of the 2013 return.
It is not unusual for taxpayers to “lend” money to their related entities without full documentation. In fact, the IRS acknowledges such transactions in the open account indebtedness regulation addressing basis in indebtedness. 11 Based on the holding of Fry, taxpayers must be careful to also substantiate that such “loans” also qualify as debt under general debt vs. equity considerations. In the case of shareholder open account indebtedness that does not have sufficient debt characteristics, depending upon the facts, gift tax or compensation consequences may arise if such amounts are deemed contributions and are not proportionate to ownership.
In addition to the extent of related-party open account indebtedness, taxpayers need to make sure there is sufficient basis in the “lending” entity to avoid deemed distributions in excess of basis. Similarly, if the ownership between the “lending” entity and “borrowing” entity is not identical, along with the gift and compensation issues related to shareholder open account indebtedness, recharacterization as a deemed distribution ought to be considered in analyzing whether the “lending” entity has made disproportionate distributions.
The Fry holding is at least partially ironic. The IRS had sought to limit losses to the sole shareholder of both corporations by denying debt basis. The court held that the IRS was correct in this respect. However, by reclassifying the debt as constructive distributions from the lender to the shareholder and contributions to capital by the shareholder to the borrower, the shareholder was allowed to claim the losses. The decision was subject to Tax Court Rule 155, which leaves the final calculations to the IRS and the taxpayer. The court stated that if there were any underpayment in the final analysis, it would be subject to penalties.
Sec. 1367: Shareholder stock and debt basis
In a technical advice memorandum (TAM) the IRS has previously ruled that subsequent income must be offset by losses deducted in prior years, whether or not the taxpayer had sufficient basis to claim the deduction. 12 The IRS has based this position on Regs. Sec. 1.1016-6(a), which permits adjustments to “eliminate double deductions or their equivalent,” the TAM stated.
Continuing this analysis in Field Service Advice memorandum 200230030, the IRS explained that the Tax Court may consider facts from closed years to determine a deficiency, although it does not permit an adjustment to income in a closed year.
In 2018, four shareholders in an S corporation challenged the IRS suspense account in Tax Court. 13 The principal issue is the IRS’s ability to use a suspense account when the shareholder has claimed losses in a year closed by the statute of limitation.
The plaintiffs’ argument is that a deduction in excess of basis is not a double deduction and is not covered by Regs. Sec. 1.1016-6(a). The loss in the year deducted does not reappear in a later year. Any loss in a later year is independent from the earlier year’s loss. Moreover, the Code does not permit negative basis. The parties entered into stipulated decisions in these cases in April 2024; what was stipulated to is not clear from the record and the Tax Court did not issue an opinion, so the issue remains unresolved.
Sec. 61: Gross income defined
Recently, the Tax Court had to grapple with the relationship between Secs. 61(a)(3) and 1001 (gains derived from dealings in property) and Sec. 61(a)(11) (cancellation-of-debt, or COD, income) when a debt is treated as a nonrecourse liability instead of a recourse liability. In Parker, a solely owned S corporation sold property subject to liabilities to an unrelated buyer. 14 The debts in question were nonrecourse liabilities of the corporation, but the sole shareholder had personally guaranteed payment. The unrelated lender agreed to cancel certain debt as part of the agreement. The Tax Court had to decide whether the sole shareholder’s personal guarantee of S corporation debt affected the determination of whether the debt was nonrecourse or recourse, which in turn affected to what extent Secs. 61(a)(3) and (11) applied to the complex transaction.
Facts: Michael Parker was the sole shareholder of Exterra Realty Partners LLC, an S corporation for federal income tax purposes. Exterra had purchased 24 acres of real property (Livermore property) through several single-member limited liability companies (LLCs). Parker individually had purchased another property (Iowa property) through a single-member LLC that he owned. The Livermore property was financed by four loans (two senior and two junior) from an unrelated lender (L) to Exterra, all nonrecourse as to Exterra and all personally guaranteed by Parker. L also loaned money to finance Parker’s purchase of the Iowa property.
Five years after the purchases, Exterra entered into an agreement, all elements of which were executed on the same day, to sell for nominal consideration the Livermore property to unrelated buyers (B). B agreed to assume Parker’s guarantee obligations with respect to the two senior mortgages and to make a partial payment of $7.4 million to L on one of the senior mortgages. Parker agreed to deliver the deed to the Iowa property in escrow with release of the property to L three years later.
As part of the sale, L agreed to cancel the unpaid balances of the two junior loans owed by Exterra to L, including all accrued interest and related fees and costs. Exterra, L, and B all agreed that the cancellation was “in connection with the proposed sale.”
On its original return Exterra included the balances of the encumbering senior mortgages and junior loans as part of the sale proceeds. After offsetting the cost of goods sold and deductions, Exterra reported income of $2.7 million.
Exterra subsequently amended its return to reduce its sale proceeds by this $2.7 million, which it attributed to the cancellation of the junior loans. Instead, on its amended return, Exterra classified the $2.7 million as COD income that it was able to exclude under Sec. 108(a) (1)(B) because its amount of insolvency was at least that much. The amendments to Exterra’s S corporation return were reflected in Parker’s individual return.
The issue in this case was whether the entire amount of the S corporation’s relevant debt should be included in its amount realized when determining recognized gain or, alternatively, whether part or all of the cancellation of the junior debt should be treated as COD income eligible for exclusion from Exterra’s gross income.
Analysis: The amount realized by the seller on a sale of property generally includes the fair market value (FMV) of all the benefits received by the seller. 15 Under Regs. Sec. 1.1001-2(a), the amount realized from a sale of property includes the amount of liabilities from which the seller is discharged as a result of the sale, 16 but with two exceptions:
In Parker, the Tax Court treated the debt discharge as occurring in connection with the sale of the underlying property. In addition, the court determined that an exception to Sec. 1001 gain or loss treatment did not apply because the canceled debt was nonrecourse debt. Clearly, debt cancellation of the junior debt was of benefit to the seller, Exterra. So, unless the taxpayer could show that the cancellation was independent of the sale or that the underlying debt was recourse debt, the canceled debt had to be included in the amount realized under Regs. Sec. 1.1001-2(a) and Tufts (nonrecourse debt included in full in the amount realized). 17
The Tax Court dismissed Parker’s contention that facts related to him personally as shareholder were relevant to whether the underlying debt was recourse or nonrecourse debt, which would have affected the determination of whether Sec. 61(a)(3) or 61(a)(11) or both applied to the Exterra transaction. That Parker had guaranteed the debt did not matter to the court, which noted that the debt was still nonrecourse as to Exterra because the guarantees did not change the assets that the creditor could seize from Exterra on default. 19 In addition, the court observed that Exterra’s existence was separate from Parker, notwithstanding that Parker was the S corporation’s sole shareholder.
Observation: The Tax Court could have undertaken a different approach in evaluating the taxpayer’s argument about the effect of his personal guarantee on the nonrecourse nature of Exterra’s debt. Although it is strictly true that L could not proceed against Exterra’s other assets based on the terms of its agreement with Exterra, Parker’s personal guarantee as the sole shareholder fundamentally altered the substance of the arrangement. Because of Parker’s personal guarantee, L could have proceeded against all of Parker’s assets, which included 100% of the stock of Exterra and, by extension, 100% of Exterra’s assets (i.e., not just the property pledged by Exterra to the lender).
Finally, the court determined that the cancellation of the junior debt depended on Exterra’s sale of the property and was a part of the sale. The debt termination agreements represented that the loan cancellation was made “in connection with” the sale and was in fact executed on the same day as the sale; L accepted new personal guarantees and a partial payment by B; and Parker delivered the deed to the Iowa property in escrow for L in consideration of the cancellation. Thus, the canceled debt was treated as nonrecourse debt. As a result, the portion of the debt that was canceled did not result in excluded COD income. Instead, the entire amount of the debt secured by the transferred property was included in the calculation of Exterra’s gain under Sec. 1001 and the principles of Tufts.
The road to Sec. 108(a)(1) and potentially excludable COD income runs through Sec. 61(a)(11). In Parker, the junior debt was treated as nonrecourse debt canceled as part of a property sale, meaning it was not COD income under Sec. 61(a)(11) subject to potential exclusion under Sec. 108(a)(1). Instead, the entire amount of the underlying debt, including the portion of the debt that was extinguished, was included in Exterra’s amount realized on the sale of the Livermore property, resulting in increased gain to Exterra under Sec. 61(a)(3), Sec. 1001, and Tufts.
Sec. 162: Trade or business expenses
Sec. 162 allows deductions for ordinary and necessary business expenses. There are special rules for certain types of expenses and certain statutory and judicial restrictions on deductibility. Among these are the overall rules requiring taxpayers to maintain books and records to substantiate business deductions.
Nonqualified deferred compensation assumed in sale of business
In Hoops, LP, in August 2023, the Seventh Circuit affirmed a 2022 Tax Court decision denying an accrual-method taxpayer a deduction for deferred compensation. 20 However, the assumption of the liability for the compensation was included in gross proceeds from a sale of substantially all the assets of the employer. This decision has implications for all entities, including S corporations and their shareholders, and needs to be considered when selling a business with a deferred compensation liability.
Hoops LP acquired the National Basketball Association (NBA) Vancouver Grizzlies basketball franchise in 2000 and renamed it the Memphis Grizzlies. In 2012 Memphis Basketball LLC (the buyer) agreed to purchase substantially all the assets and to assume substantially all the liabilities and obligations of Hoops (an accrual-method taxpayer). Among the liabilities and obligations the buyer assumed were those under certain binding agreements including NBA uniform player contracts for two Grizzlies players that included deferred compensation provisions. As of the date of the 2012 sale, the deferred compensation liability associated with the players had an accrued value of $12,640,000.
For purposes of computing the amount realized by Hoops on the buyer’s assumption of the deferred compensation liability, Hoops discounted the sum of the future payments to be made to the two players by applying a discount rate of 3%. The resulting present value determined by Hoops — and accepted by the IRS and the Tax Court — was approximately $10.7 million as of the date of the sale.
The issues before the Tax Court were whether (1) a deduction for the $10.7 million accrued liability should be allowed, or (2) in the alternative, if a deduction was not allowed, the $10.7 million accrued liability should be excluded from the sales proceeds and, consequently, from the gain realized upon the sale.
The Tax Court decided against the taxpayer on both issues, ruling that Hoops was required to include the deferred compensation liability in its amount realized on the 2012 sale and was not entitled to offset or reduce its amount realized by the amount of the deferred compensation liability.
In its appeal, Hoops did not raise the second issue, that the assumption of the liability should be excluded from sales proceeds. Rather, it chose to appeal only the disallowance of the deduction.
Sec. 404(a)(5) and Regs. Sec. 1.404(a)-12(b)(1) provide that in the case of a nonqualified plan, a deduction for deferred compensation paid or accrued is allowable only for the tax year for which an amount attributable to the contribution is includible in the gross income of any employee participating in the plan.
Again, and unfortunately for the taxpayer, the Seventh Circuit, “given the clear instructions from Congress in [Sec.] 404(a)(5),” found “no basis, in the Tax Code or its regulations, to deviate from this clear rule,” and held that Hoops could not take a deduction for that accrued liability when the employees were not paid their deferred compensation in the year of the sale.
Sec. 163: Interest expense
Sec. 163(j) limits the deduction for business interest payments. Many business taxpayers are limited to a deduction of business interest expense of:
One of the adjustments to arrive at ATI is an addback of depreciation, amortization, and depletion deductions. However, this addback is removed for tax years beginning on or after Jan. 1, 2022, under the law known as the Tax Cuts and Jobs Act (TCJA). 22 This addback may be revived with future tax law changes and should be monitored by affected taxpayers, including S corporations. As of early 2024, retroactive amendment seems to have little chance of passage.
Sec. 164: Taxes
Due to the TCJA’s $10,000 limitation on state and local tax (SALT) deductions on individual returns (SALT cap), states have begun to offer passthrough entity tax (PTET) regimes. 23 The purpose of these regimes is to replace tax historically assessed directly to passthrough entity owners with a tax assessed on the passthrough entity itself, in an effort to work around the SALT cap by avoiding the treatment of such taxes as itemized deductions. In late 2020, the IRS issued Notice 2020-75, which announced forthcoming proposed regulations governing the federal income tax treatment of PTET payments. At the time of this writing, no such proposed regulations have been issued. Moreover, there is no mention of the PTET in the current IRS priority guidance plan. Thus, the sole IRS authority on the matter as of mid-2024 is Notice 2020-75.
Since the last S corporation update in the July 2023 issue of *The Tax Adviser,* 24 several more states have enacted PTET provisions. As of early 2024, 36 states permit S corporations and partnerships to elect to treat state income taxes as payments imposed on the entity, even though many of these states allow shareholders and partners to claim credit against their personal income tax liabilities for their allocable portions of the PTET paid by the entity.
It is beyond the scope of this article to cover each state’s nuances. However, it is extremely important for S corporation owners to review each state’s rules, as they are not uniform in their application. Practitioners and taxpayers are advised to address several questions before making decisions involving PTETs. 25
Sec. 165: Losses
Losses an S corporation incurs must pass several tests and limitations before they may be used by its shareholders. First, the shareholders must have sufficient tax basis in their S corporation stock or debt, as well as sufficient at-risk basis under Sec. 465. Furthermore, Sec. 469 limits the use of losses from passive activities to the extent of passive income, and Sec. 461(l) limits the amount of business losses that can offset nonbusiness income. Developments in these limitation areas, although rare, are critical to understand due to their impact on the utility of losses from passthrough entities.
Sec. 174: Amortization of research and experimental expenditures
The TCJA, passed in 2017, included a provision that Sec. 174 research and experimentation (R&E) expenditures would be required to be capitalized and amortized for tax years beginning after Dec. 31, 2021. While many in the tax community believed that this capitalization requirement would be either delayed or removed through subsequent legislation, this has not yet occurred at the time of this writing. If no retroactive change is made, calendar year 2022 and later tax returns must capitalize all R&E costs under Sec. 174 and amortize them over the proper period.
Numerous groups have lobbied for the repeal or postponed application of this rule. As of this writing, no such proposals have cleared both houses of Congress.
Sec. 280A: Disallowance of certain expenses in connection with business use of home, rental of vacation homes, etc.
Sec. 280A disallows certain deductions connected with residences. In the S corporation context, one of the important limits is rental of a shareholder’s home. If a shareholder of an S corporation rents all or part of the home to the S corporation, the rental income is generally includible in the shareholder’s gross income. However, if the rental does not exceed 14 days in the tax year, the shareholder-lessor excludes the income and claims no deductions in connection with the rental. 26
Rental of taxpayers’ residence to their S corporation
In *Conrad,* 27 the Tax Court addressed whether an S corporation shareholder could deduct expenses of renting a home to the S corporation. The husband-and-wife taxpayers owned 51% of an S corporation that, in turn, was the general partner of a hedge fund. The husband, Thomas Conrad, provided management services to the S corporation through his sole proprietorship. In both 2008 and 2009, the Conrads rented a portion of their primary residence to the S corporation for use by the corporation as office space. The space was never used exclusively by the S corporation, however, because extended family would occasionally visit the Conrads and make personal use of the rooms located in portions of the residence set aside for the S corporation’s office use.
On their jointly filed 2008 tax return, Conrad reported $222,207 of income on his Schedule C, Profit or Loss From Business, for the services rendered to the S corporation. This income was offset by $222,207 of home office deductions — composed of mortgage interest expense, real estate taxes, utilities, insurance, and depreciation — attributable to Conrad’s business use of the home. In addition, the Conrads reported $144,000 of income on Schedule E, Supplemental Income and Loss, related to the rental of their home to the S corporation. This income was not reduced by any rental expenses.
On their jointly filed 2009 tax return, Conrad reported $288,000 of income on his Schedule C, composed of $183,667 of income for services rendered to the S corporation and $104,333 of rental income received from the S corporation. The income was offset by home office deductions totaling $288,000.
The IRS denied the home office deductions in both 2008 and 2009, concluding that Conrad’s use of the home did not meet the requirements of Sec. 280A(c)(1) because the portion of the residence was not used exclusively as his principal place of business.
The home office deduction: Sec. 280A disallows otherwise deductible expenses related to a taxpayer’s residence. Exceptions are made, however, for mortgage interest and taxes that would otherwise be deductible as itemized deductions, for deductions attributable to the rental use of a home, and for certain expenses attributable to the business use of a home.
Specific to the home office exception, Sec. 280A(c)(1) allows a taxpayer to deduct expenses allocable to a portion of a residence that is used exclusively as either:
In general, Sec. 280A(c)(5) limits the home office deduction to the gross income derived from the activity, reduced by any deductions allocable to the trade or business unrelated to the home office.
The Tax Court’s decision: The court sided with the IRS that the Conrads were not entitled to the home office deductions of $222,207 and $288,000 claimed in 2008 and 2009, respectively, but notably, based its decision on different reasoning than the notice of deficiency had. The court concluded that the home office deduction was inapplicable here because the nonpersonal portion of the Conrads’ home was not used by Conrad’s sole proprietorship but rather was rented to the S corporation, which, in turn, permitted Conrad and other workers to use that portion of the home. As a result, the nonpersonal portion of the residence was not a home office but rather a rental property.
All was not lost for the Conrads, however. Sec. 280A(c)(3) allows a taxpayer to deduct expenses attributable to the rental of a residence or a portion of a residence. Importantly, unlike the home office rules of Sec. 280A(c)(1), the rental rules of Sec. 280A(c)(3) do not require that the rented portion of the residence be exclusively used as a rental. Under Sec. 280A(d)(1), a rental home is also used as a residence if the home is used for personal purposes for a number of days that exceeds (1) the greater of 14 days or (2) 10% of rental days.
When a home is used both as a rental and a residence during the year, Sec. 280A(e)(1) requires the taxpayer to allocate expenses between personal and rental use. Then, Sec. 280A(c)(5) — just as it did with respect to home office deductions — limits the deductible rental expenses to the amount of rental income for the year less any direct deductions attributable to the rental.
Applying these provisions, the Tax Court concluded that while the Conrads were entitled to rental expense deductions on Schedule E for 2008 and 2009, the deductions were limited to the rental income derived in each year, $144,000 and $104,333, respectively.
One of the most unusual aspects of the case was that the IRS did not challenge the parties’ characterization of the Conrads as self-employed, even though they were officers of the corporation. For over 30 years, cases have abounded where shareholders have treated themselves as self-employed and the IRS has reclassified them as employees. In nearly all of these cases, the IRS has been successful. If the IRS had treated the Conrads as employees, they would not have been allowed to deduct any of the expenses related to the office in the home. 28 However, as self-employed persons, they were able to deduct these expenses, albeit within the limits permitted.
In summary, the Conrads originally claimed home office deductions in amounts that fully offset income of $222,207 and $183,667 earned on Schedule C, which reduced not only their income tax liability but also their self-employment tax liability. The Tax Court, however, allowed deductions for rental expenses only up to the amount of rental income — $144,000 and $104,333 — increasing not only the Conrads’ income tax liability but also their self-employment tax liability as a result of the increase to Conrad’s Schedule C income.
Rental amounts for meeting space in shareholders’ homes held unreasonable
The Tax Court addressed another Sec. 280A issue involving an S corporation in *Sinopoli,* 29 which focused on the rental rates an S corporation paid shareholders to use their homes for monthly business meetings. There, three individual shareholders jointly owned a Planet Fitness franchisee that was established as an S corporation. Beginning in 2015, the shareholders arrived at a plan to have the S corporation pay them rent for the use of their homes for monthly business meetings. The S corporation paid each shareholder between $3,000 and $4,000 for each meeting, with one meeting purportedly taking place at the residence of each of the three shareholders each month, for a total of 36 meetings per year.
In total, the S corporation deducted rental expense of $96,400 in 2015; $113,500 in 2016; and $81,000 in 2017 for amounts paid to the shareholders for the use of their homes as a monthly meeting place. In turn, each of the shareholders excluded their respective rental income from the taxable income reported on Form 1040, U.S. Individual Income Tax Return, for each year.
Upon examination of the S corporation’s returns, the examining agent determined that the local rental rate for meeting space was approximately $500 per day, and that the $3,000 to $4,000 paid by the S corporation to its shareholders was unreasonable. Because the S corporation could only substantiate zero, 12, and 9 meetings in 2015, 2016, and 2017, respectively, the IRS disallowed all of the S corporation’s rental expense deductions in 2015 and allowed rental expenses deductions of $6,000 in 2016 and $4,500 in 2017.
The Tax Court, in siding with the Service, stated, “We agree with respondent that it seems that petitioners adopted a tax savings scheme to distribute Planet’s earnings to petitioners through purported rent payments, claim rent deductions, and exclude the rent from their gross income relying on section 280A(g).”
Observation: Sec. 280A(g) provides a unique opportunity for a homeowner to receive rental income tax-free. It provides that the homeowner may exclude the rental income from taxable income if the dwelling unit is used as a residence during a tax year under the rules previously discussed in the summary of the Conrad case and is rented for fewer than 15 days during the year. To avoid a double benefit, no deduction is permitted for any expenses incurred by the homeowner in providing the rental.
As exemplified in Sinopoli, the benefit provided by Sec. 280A(g) can quickly lead to abuse in arrangements between individual shareholders and their closely held corporation. As the Tax Court noted, the S corporation deducted nearly $300,000 in rental expense over three years, and because each individual shareholder was careful not to rent their home to the S corporation for more than 14 days in any one year, the income was all excluded at the individual level. Of course, rental rates — particularly those agreed to between related parties — must withstand scrutiny as to their reasonableness, and in Sinopoli, the Tax Court sided with the IRS that $500 per day was much more reflective of a reasonable rental rate than the $3,000–$4,000 paid by the S corporation to its shareholders. In one bit of good news for the shareholders, the court conceded that 12 meetings had taken place in 2015, ultimately allowing the S corporation to deduct $6,000 in rental expense in each of 2015 and 2016, and $4,500 in 2017.
Sec. 641(c): Special rules for taxation of ESBTs
Only certain types of trusts are allowed to hold stock in an S corporation, and one is an ESBT. Under Sec. 641(c)(2) (C), an ESBT, in calculating its income, takes into account its income and deductions to the extent they have been allocated to the trust by Sec. 1366, plus:
However, the IRS has permitted certain other deductions. Regs. Sec. 1.199A-6(d)(3)(vi) permits an ESBT to claim a qualified business income deduction based on the items flowing through from the S corporation. However, there is no statute, regulation, revenue ruling, or revenue procedure dealing with a net operating loss (NOL) deduction by an ESBT.
In Chief Counsel Advice (CCA) 202335014, the IRS clarified the application of NOL carryforward rules to an S corporation shareholder that is an ESBT. Specifically, the S portion of an ESBT may carry NOLs sustained from its allocable share of the S corporation’s taxable losses to the S portion’s future tax years.
The IRS previously denied the carryover of an NOL to the S portion of an ESBT when the NOL was sustained by another taxpayer and succeeded to by the trust. In CCA 200734019, a residuary testamentary trust was created to receive stock of an S corporation and other assets from a deceased individual’s estate. Prior to the transfer of the S corporation stock to the trust, the estate sustained an NOL due to the loss allocation from the S corporation. Upon the trust’s receipt of the S corporation stock and the termination of the estate, the trust succeeded to the estate’s NOL carryover under Sec. 642(h)(1). The trust later elected to be an ESBT to continue to be an eligible shareholder of the S corporation. Notwithstanding the fact that the NOL was sustained due to the loss allocation from the S corporation to the estate under Sec. 1366, the IRS concluded that the S portion of the ESBT was precluded from taking into account the NOL carryover because Sec. 641(c)(2)(C) does not include an NOL succeeded to by the trust under Sec. 642(h)(1). After the issuance of CCA 200734019, commentators noted that one potential interpretation of it would preclude the S portion of an ESBT from deducting any NOL carryover because the NOL carryover is provided in Sec. 172, which is not an item specifically listed in Sec. 641(c)(2)(C).
In CCA 202335014, the IRS clarified that the conclusion in CCA 200734019 was reached due to the fact that the ESBT did not sustain an NOL due to the loss allocation from an S corporation to the ESBT under Sec. 1366. Conversely, if the S portion of an ESBT sustained an NOL from the loss allocated from an S corporation under Sec. 1366, the IRS clarified that the NOL carryover of that loss is still an item taken into account under Sec. 1366 and, therefore, an item listed in Sec. 641(c)(2)(C) to be taken into account by the S portion. Accordingly, the S portion of an ESBT may take into account that NOL carryover in its future tax years.
Sec. 2512: Valuation of gifts
In Cecil, 30 a gift tax deficiency case, the Tax Court addressed the valuation of intrafamily gifts of stock in an S corporation. The taxpayers, William A.V. Cecil Sr. and Mary Ryan Cecil, owned shares in the Biltmore Co., an S corporation. The corporation owns a historic mansion and museum called the Biltmore House (and surrounding acreage and attractions) in the Blue Ridge Mountains of Asheville, N.C. The taxpayers gifted certain interests to their children and grandchildren and filed gift tax returns. The IRS selected the returns for audit.
The Tax Court looked at issues involving the valuation approach and the use of valuation discounts. The Tax Court agreed with experts for both the IRS and the taxpayers that “tax affecting” was appropriate in reducing the value of gifted shares of the S corporation stock. Tax affecting refers to determining the FMV of a passthrough entity by assuming it is taxed at a corporate tax rate. The method used for tax affecting was the S corporation economic adjustment model (SEAM).
SEAM produces a valuation based on continuing cash flows and, in doing so, assumes that an entity-level tax is imposed on an S corporation to reflect federal, state, and local income taxes owed by the shareholders. SEAM discounts the pretax value of the cash flow stream to reflect this hypothetical tax. SEAM generally values S corporation stock higher than stock in an equivalent C corporation, based on the difference between the double tax (C corporation) and single tax (S corporation) imposed on distributions of cash to shareholders. SEAM does not assume a zero tax effect.
In Cecil, the Tax Court gave a brief history of its positions regarding tax affecting, including occasions when the court ruled in favor of or against the practice. While holding that tax affecting should be applied in this case, the Tax Court was clear that it was not taking the position that tax affecting would necessarily be appropriate in all circumstances when valuing an S corporation.
Sec. 6417: Elective payment of applicable credits
The passage of the Inflation Reduction Act 31 extended and expanded energy credits that can be earned by taxpayers making investments in the type of property necessary to generate a credit. Prior to the enactment of the Inflation Reduction Act, the Code’s energy-related income tax incentives did not contain direct-payment features, nor were they otherwise refundable. Additionally, while several energy tax credits contained limited transferability features, most could not be transferred to other taxpayers.
The act encouraged investment in certain energy property by taxpayers who may not otherwise benefit from energy credits, by enacting Secs. 6417 and 6418. These sections allow for cash payments from the federal government through a direct-pay option or the sale of designated applicable credits to unrelated parties for cash. In addition to tax-exempt organizations, partnerships and S corporations can also use the provisions of both sections. An examination of the detailed rules related to the energy credit provisions, coupled with the many aspects of direct-pay and transferability, is beyond the scope of this discussion.
Worth mentioning here, however, are the impacts on tax basis of the direct-pay option. Under Sec. 6417 and related regulations, an S corporation can elect to treat the amount of three types of applicable credits (the carbon sequestration, qualified clean hydrogen production, and advanced manufacturing production credits) as a direct payment against federal income tax. When an S corporation elects this treatment, the IRS will make a payment to the S corporation (or partnership) equal to the amount of the applicable credit, unless other federal taxes are owed, in which case the payment will be reduced by the amount owed. 32 For a year in which this direct-pay election is effective, there is no credit available to be separately passed through to the shareholders. 33
The payment received by an S corporation is treated as tax-exempt income as of the date the applicable credit is treated as received or accrued by the S corporation. 34 The shareholders will take their pro rata share of the tax-exempt income into consideration for purposes of adjusting their basis in their S corporation stock.
In terms of character, the tax-exempt income resulting from the direct-pay election is treated as arising from an investment activity and not from the conduct of a trade or business within the meaning of Sec. 469(c)(1)(A) and is not treated as passive income. 35
Sec. 6418: Transfer of certain credits
As noted above, energy credits can also be transferred. Under Sec. 6418 and related regulations, an S corporation can be either a transferor or transferee of eligible credits.
For a transferor, similar to the rules under Sec. 6417, the payment received by an S corporation is treated as tax-exempt income. The shareholders will take their pro rata share of the tax-exempt income into consideration for purposes of adjusting their basis in their S corporation stock. Also, in terms of character, the tax-exempt income resulting from the election to transfer credits is treated as arising from an investment activity and not from the conduct of a trade or business within the meaning of Sec. 469(c)(1)(A) and thus cannot be treated as passive income for purposes of Sec. 469.
For a transferee S corporation acquiring credits from an unrelated party, the purchase is treated as a nondeductible expense described in Sec. 1367(a)(2)(D) that will reduce shareholders’ basis in their stock. Each shareholder is allocated a pro rata share of the transferred credit just as with any other allocation of tax items. 36
FinCEN beneficial ownership information reporting
The Corporate Transparency Act (CTA) 37 took effect on Jan. 1, 2024. The act mandates beneficial ownership information (BOI) reporting by many U.S. businesses. Many S corporations fall within this rule and must report information about beneficial owners and certain persons who control the corporations to the Financial Crimes Enforcement Network (FinCEN).
As of this writing, BOI reporting is the law. S corporations created before 2024 must file their reports by Jan. 1, 2025, and those created in 2024 must file reports within the first 90 days that their charters take effect. The general rules and controversies concerning BOI reporting are not unique to S corporations and receive extensive discussion elsewhere. However, a few issues may require special attention for S corporations and their shareholders.
Although most shareholders are individuals, a few are estates and trusts. While an estate holds the shares, there is no beneficial owner of that stock. When the estate distributes the shares, there will be new owners. Thus, from the death of the prior shareholder until the distribution of the shares by the estate, there will be a transitional period.
Ownership of stock by a trust poses another problem (in addition to the myriad tax issues involved). In some cases, a grantor or a controlling beneficiary is treated as the beneficial owner of the trust’s shares. However, the CTA ownership rules differ from the tax rules regarding trusts. In many cases, the trustee will be treated as the beneficial owner of one of these trusts, even though the tax laws treat the trust as a grantor trust or deemed grantor trust. QSubs also require attention. Even though these corporations do not file federal income tax returns, they may be reporting entities for BOI purposes. As 2024 progresses, these and other problems involving BOI reporting will emerge to the forefront of professional concerns for CPAs with S corporation clientele.
Several lawsuits have been filed against the Treasury Department concerning BOI reporting. In *National Small Business United v. Yellen,* 38 a district court judge held that the statute, as written, was unconstitutional. The Treasury Department has appealed the decision.
Authors’ note: The AICPA S Corporation Taxation Technical Resource Panel dedicates this article to the memory of Sydney S. Traum (1938–2024). Syd was a longtime member of this panel. We are all grateful for his wisdom and wit. RIP, Syd.
1 Subchapter S consists of Secs. 1361–1363, 1366–1368, 1371–1375, and 1377–1379.
2 See Rev. Proc. 2024-1, Appendix A, Schedule of User Fees.
3 Sec. 1361(d)(2); Regs. Sec. 1.1361-1(j)(6)(iii).
5 Generally, Rev. Proc. 2013-30 also requires that there be no other violation of the corporation’s eligibility for the S election.
6 Brajcich et al., “Current Developments in S Corporations,” 54-7 The Tax Adviser 26 (July 2023).
7 Letter Rulings 202317014, 202317015, 202322018, 202345006, 202307004, 202319004, 202319005, 202319008, 202326004 (five trusts), 202329002 (four trusts), 202316002, 202340011, 202345001, 202303002, 202340002, 202340008, 202342001, 202310003, 202323008, 202325004, 202337001, 202340005, 202344005, 202349004, 202349005, 202349006, 202403001, 202403002, 202401004.
8 In re Vital Pharmaceuticals, No. 22-17842-PDR (Bankr. S.D. Fla. 10/6/23).
9 Fry, T.C. Memo. 2024-8.
10 Hardman, 827 F.2d 1409 (9th Cir. 1987).
11 Regs. Sec. 1.1367-2(a)(2).
13 Kanwal, No. 23766-18 (T.C. 12/12/18) (petition filed); Singh, No. 23769-18 (T.C. 12/3/18) (petition filed); Ahmed, No. 23776-18 (T.C. 12/3/18) (petition filed); and Chatterjee, No. 23842-18 (T.C. 12/3/18) (petition filed).
14 Parker, T.C. Memo. 2023-104.
15 See Regs. Sec. 1.1001-1(a).
16 See also Tufts, 461 U.S. 300 (1983).
17 E.g., Estate of Franklin, 544 F.2d 1045 (9th Cir. 1976).
18 To the same effect, see Regs. Sec. 1.1001-2(c), Example (7).
19 In the partnership context, a nonrecourse loan for Sec. 1001 purposes is not necessarily a nonrecourse loan for Sec. 752 purposes. For example, assume an LLC is classified as a partnership for federal tax purposes. If a bank loans money on a nonrecourse basis to the LLC that a member guarantees, the loan generally remains nonrecourse to the LLC for Sec. 1001 purposes, even though it would be recourse for Sec. 752 purposes. (Conversely, a loan to an LLC that is recourse for Sec. 1001 purposes would, without more, generally be nonrecourse for Sec. 752 purposes.) See CCA 201525010 (released 6/19/15). Of course, in Parker, the entity was an S corporation. But as in the context of an LLC (taxed as a partnership), a loan guarantee by a shareholder of an otherwise nonrecourse loan to an S corporation does not make the loan recourse for Sec. 1001 purposes.
20 Hoops, LP, 77 F.4th 557 (7th Cir. 2023), aff’g T.C. Memo. 2022-9. The Tax Court proceedings are discussed in Brajcich et al., “Current Developments in S Corporations,” 54-7 The Tax Adviser 26 (July 2023).
21 Secs. 163(j)(1) and (j)(9)(B).
22 The law known as the Tax Cuts and Jobs Act, P.L. 115-97. See Sec. 163(j)(8)(A)(v).
23 Sec. 164(b)(6); see also Mucenski-Keck and Ramos, “Federal Implications of Passthrough Entity Tax Elections,” 53-11 The Tax Adviser 38 (November 2022).
24 Brajcich et al., “Current Developments in S Corporations,” 54-7 The Tax Adviser 26 (July 2023).
25 See Sherr, “Questions to Consider Before Electing Into a PTE Tax,” 53-9 The Tax Adviser 26 (September 2022).
27 Conrad, T.C. Memo. 2023-100.
29 Sinopoli, T.C. Memo. 2023-105.
30 Cecil, T.C. Memo. 2023-24.
31 >Inflation Reduction Act of 2022, P.L. 117-169.
32 Regs. Sec. 1.6417-4(c)(1).
35 Regs. Sec. 1.6417-4(c)(3).
36 Regs. Sec. 1.6418-3(e)(8), Example (8).
37 Corporate Transparency Act, P.L. 116-283.
38 National Small Business United v. Yellen, No. 5:22-cv-1448-LCB (N.D. Ala. 3/1/24).
Contributors
Robert W. Jamison Jr., CPA, Ph.D., is author of CCH’s S Corporation Taxation and professor emeritus of accounting at Indiana University in Indianapolis. Robert S. Keller, CPA, J.D., LL.M., is a partner in KPMG’s Washington National Tax practice. Kirk T. Mitchell, CPA, MST, is a tax senior manager at Schneider Downs & Co. Inc. in Pittsburgh. Tony Nitti, CPA, MST, is a partner in EY’s National Tax Department in Denver. Kenneth N. Orbach, CPA, Ph.D., is a professor emeritus of accounting at Florida Atlantic University in Boca Raton, Fla. Kevin J. Walsh, CPA, CGMA, is a partner in Walsh, Kelliher & Sharp, CPAs, APC, in Fairbanks, Alaska. Keller, Nitti, and Walsh are members, and Jamison, Mitchell, and Orbach are associate members, of the AICPA S Corporation Taxation Technical Resource Panel. For more information about this article, contact thetaxadviser@aicpa.org.
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