Tax and financial advice from the Silicon Valley expert.

2010 last chance to make special elections to protect S corporation status?

Since the Bush tax cuts are scheduled to end after 2010, this year might be the last chance for S corporations to make a special election that may protect their status as S corporations and the related tax benefits at a “bargain” low tax rate.

S corporations that didn’t make the election from the time of beginning operations or that acquired another corporation that didn’t could have “accumulated (C corporation) earnings and profits”.

When an S corporation with accumulated earnings and profits has “excess passive investment income”, a special tax at the highest corporate tax rate applies to that income. (IRC Section 1375(a).) More importantly, if an S corporation has excess passive income for three consecutive years, its S election will be revoked. (IRC Section 1362(d)(3)(A).)

Passive investment income includes gross receipts from royalties, rents, dividends, interest, annuities and gains from sales or exchanges of stock or securities. There are exceptions relating to certain royalties and rental income that are beyond the scope of this article.

Passive investment income is “excessive” when it exceeds 25% of the S corporation’s gross receipts. This is especially a problem when a corporation is winding down or is holding real estate.

The exposure to the special tax and revocation of the Subchapter S election can be eliminated by distributing the accumulated earnings and profits of the corporation. A consequence of doing this is the distributions will be taxable as dividends income to the shareholders.

Under the Bush tax cuts, “qualified dividends” are taxed at a low 15% tax rate, like long term capital gains but not eligible for reduction by capital losses. After 2010, this tax break is scheduled to expire and dividends could be subject to the same tax rates as ordinary income.

The Obama administration has recommended extending the tax break for qualified dividends, but the maximum rate for qualified dividends for taxpayers with income over $250,000 would be increased to 20%.

Under the ordering rules for distributions for S corporations, income earned when the S election is effective, called the “accumulated adjustments account”, is distributed first and accumulated earnings and profits last.

A special election is available to treat distributions as first made from earnings and profits (IRC Section 1368(e)(3)(A).).

If the corporation made an S election before 1983, the corporation should also elect to forgo distributing and “previously taxed (S corporation) income” accumulated during the period the S election was effective before 1983. (Treasury Regulations Section 1.1368-1(f)(4).)

In addition, if the corporation doesn’t have cash available to distribute, an election can be made to have a “deemed distribution” taxed to the shareholders which is “deemed” to be reinvested in the corporation and added to the shareholders’ tax basis for their stock. (Treasury Regulations Section 1.1368-1(f)(3).) An S corporation that makes this election is also deemed to have elected to distribution accumulated earnings and profits first.

Since 2010 may be the last chance to get this tax benefit “on sale” at reduced tax rates, owners of S corporation stock should be discussing these elections with their tax advisors now, before they miss out!

IRS Circular 230 Disclosure:
As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this communication was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.

Tax and financial advice from the Silicon Valley expert.