The recent passage of comprehensive federal tax reform (see the law formerly titled the Tax Cuts and Jobs Act of 2017, P.L. 115-97) has taxpayers of all types evaluating the impact of the new rules on their current tax positions. For example, S corporations may be considering whether it may be more advantageous to be taxed as a C corporation, despite the double taxation of C corporation dividend distributions. S corporations that perform this analysis and conclude that it may be more advantageous to be taxed as a C corporation should consider, among others, the following issues.
Revoking an S election
S corporations need not incur a ‘traditional’ terminating event to end an S election. With majority shareholder consent (Sec. 1362(d)(1)(B)), an S corporation may simply revoke its election. Contrast that with the unanimous consent that will be required if, in the future, the entity reelects Subchapter S status (Sec. 1362(a)(2)).
S corporations can choose the day on which the revocation is effective; the key is to be aware of the timing for filing the revocation. Unless a different date is specified, a revocation filed by the 15th day of the third month of the tax year will be effective retroactively to the first day of the tax year, and a revocation filed after the 15th day of the third month will be effective on the first day of the following tax year (Sec. 1362(d)(1)(C)). Alternatively, S corporations also may revoke their election midyear on a specified date, provided the selected date is on or after the date the revocation is made (Sec. 1362(d)(1)(D)).
Income allocations for midyear revocations
If the taxpayer chooses a revocation date in the middle of the S corporation's tax year, then two short-period returns will be required in the termination year — one S corporation return covering the period from the beginning of the tax year through the day preceding the revocation date, and one C corporation return covering the remainder of the tax year (sections 1362(e)(1)(A) and 1362(e)(1)(B)). When the taxpayer allocates income between the S return and the C return, the default method is to prorate the company's income using the number of days covered by each return (section 1362(e)(2)). Alternatively, a taxpayer can elect to allocate its income on the basis of its normal tax accounting method (section. 1362(e)(3)). But be aware that this second option is an election that requires the consent of all persons who were S corporation shareholders at any time during the short S year as well as anyone holding shares on the first day of the C corporation short period (section 1362(e)(3)).
While the default proration may seem simpler, taxpayers should analyze their own facts and circumstances to evaluate whether electing to use the second method could make a significant difference.
Tax accounting considerations
For the termination year (and all subsequent C corporation years), numerous income and deduction items will be treated differently as a C corporation. For example, the deduction timing for shareholder accruals differs for a C corporation from the timing rules that apply to an S corporation (section 267). Furthermore, the treatment of charitable contributions, fringe benefits, and capital losses differs under the S corporation (and, ultimately, individual shareholder) rules from the C corporation rules.
If the S election is revoked in the middle of the S corporation's tax year, the shareholders will still report the S corporation short-period income in the same tax year that they otherwise would have, regardless of when the revocation takes place (Reg. Sec. 1.1362-3(c)(6)). For example, if an S corporation with a Sept. 30 tax year end terminates its S election effective Dec. 31, 2017, the shareholders will report the income for the S corporation short period from Oct. 1, 2017, through Dec. 31, 2017, on their 2018 Forms 1040, U.S. Individual Income Tax Return, even though the S corporation short period ended in 2017.
Subsidiaries
S corporations with qualified Subchapter S subsidiaries (QSubs) should also consider the implications for their subsidiaries of terminating the S election. Once an S corporation's status terminates, its subsidiaries' QSub elections also terminate (Reg. Sec. 1.1361-5(a)(1)). As a consequence, the former QSub will be treated as a new corporation, acquiring its assets and liabilities from the former S corporation in exchange for stock of the new corporation. In most cases, gain will not be recognized on this deemed exchange (section 351). But taxpayers should be aware of certain exceptions to this general rule. For example, in situations where the former QSub's liabilities exceed the tax basis of its assets, gain will be triggered under section 357(c).
In addition, taxpayers with subsidiaries should also keep in mind that a consolidated C corporation may generate more state filings than as an S corporation with QSubs.
Distributions following a revocation
In the context of the voluntary revocation under section 1362(d)(1), the corporation's post-termination transition period (PTTP) is defined under section 1377(b)(1) as the period beginning on the day after the termination and ending on the later of (1) one year after the termination date, or (2) the due date for filing the final S corporation return (including extensions). The PTTP is a grace period during which the former S corporation may take advantage of the rules of section 1371(e)(1) to distribute ‘money’ tax free to its shareholders to the extent of (1) its accumulated adjustments account (AAA), and (2) the shareholders' basis in the corporation's stock. This helps mitigate the risk that the S corporation's earnings will get ‘locked in’ if they are not distributed during the S corporation years.
When S corporations consider whether to convert to C corporation status, a key concern is whether the corporation has sufficient cash to distribute its AAA during the PTTP. If the company cannot distribute its AAA during the PTTP, any remaining AAA essentially disappears, at least according to the IRS's recent position in Chief Counsel Advice 201446021.
Tax reform, however, has softened this blow in certain circumstances. P.L. 115-97 provides that S corporations meeting certain requirements can treat distributions following the PTTP as coming proportionately from AAA and from accumulated earnings and profits (E&P). Thus, a portion of these distributions would be tax free to shareholders, at least to the extent of the shareholders' basis. Note, however, that this opportunity applies only to S corporations that revoke their election within two years of the enactment of P.L. 115-97, where the share ownership on the date of revocation is identical to that on the date of the law's enactment (section 1371(f), as added by P.L. 115-97, section 13543(b)).
Requirement that 'money' be distributed
Note again that only distributions of ‘money’ during the PTTP are treated as coming from AAA. Although ‘money’ is not defined in the Code for this purpose, case law has defined it to mean cash or, in certain limited circumstances, its equivalent. In Clark, 58 T.C. 94 (1972), the Tax Court held that the distribution of the corporation's promissory notes was not tax free, as the notes did not constitute ‘money’ for purposes of section 1375(d). (Section 1375(d) preceded section 1377(b)(1) in allowing an S corporation a 2½-month grace period after the end of its tax year to distribute its taxable income to its shareholders.) Similarly, in Fountain, 59 T.C. 696 (1973), the Tax Court found that the distribution of the corporation's checks drawn on an account with insufficient funds were also not ‘money’ for purposes of former section 1375(d).
The Tax Court in Roesel, 56 T.C. 14 (1971), however, found that checks issued on the last day of the S corporation's tax year constituted distributions of ‘money’ for purposes of former sections 1373(c) and 1375(d) to the extent that the proceeds were not loaned back to the corporation, even though not all of the checks were cashed on this date.
There may be hope that something other than cash may constitute ‘money’ under the Code and receive tax-free distribution treatment during the PTTP. One might question whether a corporation could borrow money from a third party and distribute it to the shareholders, who in turn loan money back to the corporation so that it may pay back the third-party lender. With appropriate forethought, there may be a strategy to generate funds to take maximum advantage of the opportunity to distribute AAA tax free during the PTTP.
Suspended shareholder losses at the time of revocation
In the case of losses disallowed to an S corporation shareholder in the last S corporation year because of insufficient basis, an additional opportunity may exist. The shareholder can use the suspended losses on the last day of the PTTP under section 1366(d)(3)(A) to the extent of the shareholder's basis in the corporation's stock (but not the basis in debt) on that date. To generate that additional basis, the shareholder would need to make a capital infusion, e.g., through an acquisition of shares or a contribution of capital to the corporation.
Closing thoughts
It is axiomatic that when individual income tax rates decrease relative to corporate income tax rates, more business owners will choose to organize as pass-through entities than as C corporations. Federal tax practitioners have seen this phenomenon over the past 40 years. Accordingly, it is reasonable to expect that as a result of tax reform, which provides for a significant decrease in the federal corporate tax rate from 35 percent to 21 percent and a more modest decrease in pass-through tax rates, business owners may consider revoking S corporation elections that were made when the corporate rates were higher. There are certainly other considerations with such a change, but the applicable tax rate is undoubtedly a big one, and it may be the catalyst for many entities to revisit pass-through treatment.
The grace period of the PTTP helps to prevent earnings from being ‘locked in’ the S corporation (and double-taxed to the C corporation's shareholders), provided that the corporation has or can borrow sufficient cash to distribute the AAA to its shareholders tax free. Tax reform has further increased the attractiveness of revoking an S election in favor of C corporation tax treatment, not only through a reduced C corporation federal income tax rate but also by increasing the spread on unfavorable section 481(a) adjustments necessitated by those conversions, e.g., required changes from the cash method to the accrual method.
Entities considering such a change should consider all of the related implications. Failure to consider these less obvious ramifications can create unpleasant surprises for the company and its owners.
Excerpted from the April 2018 issue of The Tax Adviser. Copyright © 2018 by the American Institute of Certified Public Accountants, Inc.
