Wednesday, November 6, 2019
Monday’s post discussed some basic estate and business planning considerations for farm and ranch operations. When an intergenerational transfer of the business is desired, often entity structuring is a part of the design. Should there be one entity or more than one? What types of leases should be involved? What type of entities should be utilized? What about an S corporation?
Considerations about the use of S corporations – it’s the topic of today’s post.
S Corporation Issues
Reasonable compensation. An S corporation shareholder-employee cannot avoid payroll taxes by not being paid a salary. This is a “hot button” audit issue with the IRS and, fortunately, recent caselaw does provide helpful guidance on how to structure salary arrangements for S corporation shareholder-employees and the methodology that the IRS (and the courts) uses in determining reasonable compensation. While the incentive in prior years has been to drive compensation low and remove corporate earnings in the form of distributions to avoid employment-related taxes, the advent of the qualified business income deduction may incentivize increasing wages in certain situations, the key is to determine an acceptable range for reasonable compensation and stay within it to avoid IRS scrutiny.
Sales of interests. Obamacare potentially impacts the sale of interests in entities, including S corporations. Gain on sale might be subject to an additional tax of 3.8 percent if the gain is deemed to be “passive” – not related to a trade or business. This means that the stockholder selling an interest in an S corporation must be engaged in the business of the S corporation. There is a somewhat complex procedure that is used to determine the portion of the gain on sale that is passive and the portion that is deemed to be attributable to a trade or business. In many small, family-run S corporations much of the gain may not be subject to the health care law’s “passive” tax. That will be the case if all of the assets of the entity are used in the entity’s business operations and the selling owner materially participates in the business. There are income thresholds that also apply, so if income is beneath that level, then the “passive” tax doesn’t apply in any event.
Redemptions. If interests are redeemed, the IRS issued a private letter ruling in 2014 that can be helpful in succession planning contexts. In Priv. Ltr. Rul. 201405005 (Oct. 22, 2013), The facts of the ruling involved a proposed transfer of ownership of an S corporation from two co-equal owners to key employees. The IRS determined that the profit on the redemption of the co-owners' shares in return for notes would be treated as capital gain in the co-owners' hands and would be spread-out over the term of the notes. The IRS also said that there would be no gain to the S corporation, and that the S corporation was entitled to a deduction for interest paid on the notes. Also, the IRS said that the notes did not constitute a disqualifying second class of S corporate stock. To get these results requires careful drafting.
S corporation stock held by trusts. Trusts may also be a useful planning tool along with an S corporation as part of an estate/succession plan. But, while a decedent’s estate can hold S corporate stock for the period of time that the estate needs for reasonable administration, grantor trusts and testamentary trusts can only hold S corporate stock after an S corporation shareholder dies for the two-year period immediately following death. I.R.C. §1361(c)(2)(A). If that two-year limitation is violated, the S election is terminated, and the corporation is no longer a “small business corporation.” Thus, grantor and testamentary trusts should not hold S corporate stock beyond the two-year period. Clearly, the issue is to make sure the passage of the stock to a trust doesn’t jeopardize the S corporation’s status. During the time that the decedent’s estate holds the stock, there should be no problem in maintaining S status unless the administration of the estate is unreasonably extended. Once a testamentary trust is funded, it must take steps to be able to hold the S corporation stock for no more than two years. After that, the trust must qualify as a trust that is eligible to hold S corporation stock. The types of trusts that might cause issues with holding S corporate stock include credit shelter trusts (a.k.a. “bypass trusts”), grantor retained annuity trusts (GRATS), dynasty trusts (often structured as grantor trusts), self-settled trusts (a.k.a. domestic asset protection trusts), intentionally defective trusts and insurance trusts. If the testamentary trust is an irrevocable trust, the trust language will be the key to determining whether the trust can be appropriately modified to hold S corporation stock.
However, certain types of trusts can own S corporation stock without jeopardizing the S status of the corporation. Thus, proper structuring of trusts in conjunction with S corporations is critical. The basic options are a qualified subchapter S trust (QSST) and an electing small business trust (ESBT). Each of these types of trusts require precise drafting and careful maintenance to ensure that it can hold S corporation stock without causing the S corporation to lose its S status.
Issues associated with the death of a shareholder. Upon an S corporation shareholder’s death, the S corporation’s income is typically prorated between the decedent and the successor shareholder. The proration occurs on a daily basis both before and after death. Income that is allocated to the pre-death period is reported on the decedent’s final income tax return, and income that is allocated to the post-death period is reported on the successor’s income tax return. But an S corporation can make an election to divide the S corporation’s tax year into two separate years. The first of those years would end at the close of the day of the shareholder’s death.
Drawbacks of S Corporations
While S corporations can be beneficial in the planning process, they do have their drawbacks. While the following is not intended to be a comprehensive list of the limitations of utilizing S corporations, each of these points needs to be carefully considered.
Limitations on stock ownership. As indicated above, only certain types of trusts can hold S corporation stock. Also, corporations (except for Qualified S Corporation Subsidiary Corporations (Q-Subs)), LLCs and partnerships cannot be S corporation shareholders. In addition, there is an overall limitation on the number of S corporation shareholders (but it’s high enough that it won’t hardly ever cause problems for family-operated S corporations). But, the limits on trust and entity ownership of S corporation stock could prove to be a limiting factor for estate, business and succession planning purposes.
Special allocations for tax purposes. An S corporation must allocate all tax items pro rata. Special allocations are not permitted. But special allocations are permitted in an LLC or any other entity that has partnership tax treatment. So, for example, an entity taxed as a partnership can allocate (with some limitations) capital gain or loss as well as ordinary income or loss to those members that can best utilize the particular tax items. The special allocation rule doesn’t just apply to income and loss, it applies to all tax items. That would include, for example, depreciation items. An S corporation can’t do special allocations. This often can be a distinct disadvantage.
Death-time basis planning. A partnership (or LLC taxed as a partnership) is allowed to make an I.R.C. §754 election to increase the basis of its assets when a partner’s interest is sold or when a partner dies. That means that the entity can increase its adjusted tax basis in the entity’s assets so that it matches the basis that a buyer or heir takes. That would normally be, for example, the step-up (date of death) basis for inherited property. An S corporation cannot make an I.R.C. §754 election. Consequently, this can be another tax disadvantage of an S corporation.
Business loans. Care must be taken here. A loan to an S corporation can jeopardize the S election. Also, state laws must be followed, and the IRS likes to characterize loan repayments as distributions that are taxable. Also, distributions must also generally be pro rata. There is more flexibility regarding loans to and from the entity for a partnership/LLC. A corresponding concern with S corporation loans involves accounting issues involving the matching of interest and other income. The bottom line is that, in general, it’s more cumbersome to make loans to and from an S corporation compared to an LLC/partnership.
Farm programs. Whenever there is a limitation of liability, the entity involved is limited to a single payment limit. That would be the case with a farming S corporation. So, generally, a general partnership is the entity that best maximizes farm program payment limits – there is a limit for each partner. Each member can hold their interest as an LLC to achieve the liability limitation that an S corporation would otherwise provide, but there wouldn’t be an entity-level limitation.
Asset distribution. An S corporation has the potential to recognize gain when corporate assets are distributed. Generally, LLCs don’t have that issue.
Formalities. The state law rules surrounding formation are more elaborate with respect to S corporations as compared to LLCs.
Dissolution. There generally is less tax cost associated with dissolving an LLC as compared to an S corporation.
S corporations can be a useful estate/succession planning tool. With the general plan now being one of inclusion of assets in the decedent’s estate, creating a separate entity for the successor generation can provide valuation benefits for the decedent. However, care must be taken in utilizing the S corporation. In addition, other entity types (particularly the LLC) can provide greater tax benefits on numerous issues. There are drawbacks to using an S corporation. Also, it’s important to remember that with any type of entity planning as part of an estate/succession plan, there is no such thing as “one size fits all.” As with any type of planning, consultation with experienced professionals is a must.