New IRS Regulations Clarify S Corporation Issues

When a shareholder joins or leaves an S corporation during the year it can cause many problems. Among these problems is the question of how to allocate income for tax purposes. The Internal Revenue Service (IRS) has recently issued new regulations to clarify how to deal with some of these situations.

Ever since the Tax Reform Act of 1986, many previously incorporated family businesses have elected to switch to S status. Most new closely held corporate entities whose shareholders are all permissible S corporation shareholders have also become S corporations.

The S corporation’s structure is fairly simple. Basically, there is no tax at the entity level and the shareholders have elected to pick up all of the corporation’s income, retaining its character, on their own personal tax returns.

While this is easy in concept, applying it can be fairly complex. Questions arise as to what to do when shareholders are bought out or buy-in during a year. What happens when a shareholder dies? What happens if the S election is terminated during a year? What happens if an individual goes bankrupt?

Stock Sales Can Cause Confusion
Here is an example of how these issues can create problems. Assume Annette and Bernie are 50/50 owners of an S corporation. The corporation shows a $500,000 loss from Jan. 1 through June 30, 1997. Because of the poor results, Bernie wants out and sells all of this shares to Annette. Annette continues to run the corporation through the rest of the calendar year and by the end of December 1997, the corporation has actually turned a profit of $500,000 for the entire year. Obviously, since Bernie is not participating in management or ownership of the company from July 1 through Dec. 31, he will not be entitled to compensation or distributions based on profits.

Depending on how income is allocated, however, this may put Bernie at a severe disadvantage. The general rules specify that shareholders must be allocated income prorated on a per-share, per-day basis. Bernie will receive a schedule K-1 showing approximately $125,000 of income without having received any distributions. This will add to his basis and produce either a lesser capital gain on the sale of his stock or a capital loss in the amount of the income he picked up. Thus, Bernie could end up with $125,000 of ordinary income from the S corporation and a $125,000 capital loss that he can only apply against capital gains, and only up to $3,000 per year during his lifetime.

However, there is a rule that provides that if a shareholder disposes of his or her entire interest during a year, the shareholders may elect to actually close the books as of the date of that disposition. To do this, however, every person who was a shareholder on any day during that year must consent.

If the shareholders make this election and the company actually closes its books on June 30, Bernie will receive a schedule K-1 showing a $250,000 ordinary loss that will also affect his basis and will increase his capital gain on the sale of his stock. This is generally a better result for someone in Bernie’s position.

Therefore, if Bernie wants to be sure that he gets the proper tax result, he will insist that, upon the sale of his shares, everyone who has been a shareholder at any time during the year sign a consent election to be held in the files. Also, in the buyout agreement, Bernie should get the corporation and shareholders to agree to attach the election to the corporation’s tax return for that year and compute the tax allocation accordingly.

Complications Clarified by IRS
This election isn’t as simple as it sounds. Although you are closing the book as of the date of disposition, the corporation will not file two tax returns for that period. Instead, the corporation files one return at the same time that it would have been due if there had been no disposition. Therefore, Bernie may have to wait more than a year to receive the schedule K-1 showing the income allocable to him.

In addition, practitioners have long questioned what happens at the date of disposition with respect to accrual-basis corporations. Ordinarily, an amount that is accrued but unpaid to an S corporation shareholder may not be deducted by the corporation until the year actually paid, even if the corporation is an accrual-basis taxpayer. What happens on the date of disposition? The rules require an actual closing of the books, but this is not technically the year end for the corporation.

In recent regulations, the IRS answered this question. The result: the date of disposition is treated as if it were the year end for this purpose. Therefore, if there are any accrued but unpaid expenses, those expenses fall in the part of the year in which they are actually paid –– if the recipient is a shareholder or a member of his or her family. This would also be true of accruals to related companies unless those companies are also themselves accrual-basis recipients.

As stated above, the rules allowing for an actual closing of the books are applicable only when a shareholder disposes of his or her entire interest in the corporation. However, the IRS has recently relaxed this requirement also. In regulations under Internal Revenue Code Sec. 1368, the IRS has determined that if there is more than a 20% change of ownership in the corporation during a year, the corporation may elect, by consent of all of its shareholders, to allocate income on an actual closing of the books basis as of the date the change of ownership hits 20% during any taxable year. This is a significant liberalization of the rules and will provide needed flexibility, but also unwanted complexity.

The above rules are important in many respects, but are most important when an owner is selling his or her entire interest of an S corporation to other owners. If you are contemplating a sale of S corporation stock, be aware of these rules and be sure that if you want to do an actual allocation of income and loss, all the corporation’s shareholders must agree to consent to this election.