S corporations.

S Corporation Returns

Sec. 6699 imposes a new penalty in addition to the penalties under Sec. 7203 (willful failure to file, supply information, or pay tax) for failure to timely file (including extensions) an S corporation return. A penalty of $85 per month times the number of S corporation

Health Insurance Premiums of 2% Shareholders

The Service recently issued Notice 2008-1, (21) offering an opportunity for 2% shareholders of an S corporation to receive a deduction for health insurance premiums under Sec. 162(1). A 2% shareholder is defined as a person who owns directly or constructively under Sec. 318 on any day of the S corporation's tax year more than 2% of the corporation's outstanding stock or more than 2% of the combined voting power of all the corporation's stock. (22)

Sec. 162(1)(1)(A) states that when computing adjusted gross income, an employee is allowed to take a deduction for medical insurance paid by the S corporation on behalf of the employee, the employee's spouse, and dependents. The deduction would not be allowed if the employee were eligible to participate in a subsidized plan provided by an employer of the taxpayer or the taxpayer's spouse. Previously, a 2% shareholder was not considered an employee under Sec. 106; therefore, the shareholder was not eligible to exclude insurance premiums paid by an employer from income by way of the deduction afforded to other employees.

When dealing with fringe benefits, an S corporation is treated as a partnership under Sec. 1372(a), which means the 2% shareholder is treated as a partner. In general, when a partner receives payment of insurance premiums as compensation for services, that income is treated as a guaranteed payment under Sec. 707(c). The S corporation is allowed a deduction for the premium payments if the rules of Sec. 162(a) are satisfied. The employee is required to report payments as income under Sec. 61(a).

Under Notice 2008-1, a 2% shareholder is allowed an above-the-line deduction on Form 1040, U.S. Individual Income Tax Return, for accident and health insurance premiums paid under a plan that is "established by the S corporation." This poses the question: What are the requirements for a plan to qualify as being established by the S corporation? A plan can satisfy this requirement in two ways: The S corporation makes the payments on behalf of the qualifying 2% shareholder, or the shareholder makes the payments and is then reimbursed by the S corporation.

In order for the 2% shareholder to deduct the premiums on his or her individual return, the S corporation must include the premium payments in the employee's Form W-2 for the tax year in which it is paid, and the shareholder must report those wages as income on Form 1040. In addition, the employee's earned income from the S corporation must exceed the cost of the premiums under the policy for the shareholder-employee and spouse or dependents, if applicable.

The deduction is also available for prior tax years. If a qualifying taxpayer would have been allowed a deduction in a previous tax year using the new rules, an amended return may be timely filed to claim the deduction with a statement "Filed Pursuant to Notice 2008-1" written on the top of the amended return.

An S corporation is allowed to have only one class of stock. (23) Generally, a corporation is treated as having only one class of stock if all outstanding shares of the corporation's stock confer identical rights to distribution and liquidation proceeds. (24) Notice 2008-1 states that accident and health insurance payments made on behalf of 2% shareholders will not be considered distributions with respect to the S corporation single class of stock requirement.

Simplified Method Relief for Late S and Entity Classification Elections

In Rev. Proc. 2007-62, (25) the Service provides an additional simplified method for certain eligible entities to request relief for late S elections and late entity classification elections that were intended to be effective as of the intended effective date of the S election. This revenue procedure supplements Rev. Procs. 2003-43 (26) and 2004-48. (27)

To obtain relief under Rev. Proc. 2007-62, the entity must file a properly completed Form 2553, Election by a Small Business Corporation, with a Form 1120S, U.S. Income Tax Return for an S Corporation, filed by the entity for the first tax year the entity intended to be an S corporation. The forms must be filed together no later than six months after the due date of the tax return (excluding extensions) of the entity for the first tax year in which the S election was intended. In addition, the Form 2553 must include a statement explaining the reason for the failure to timely file the election(s).

For Rev. Proc. 2007-62 to apply, the entity seeking to make the S election cannot have filed a tax return for the first tax year in which the election was intended prior to requesting relief under the revenue procedure. In addition, the entity must fail to qualify for S corporation status on the first day that status was desired solely because of its failure to timely file a Form 2553 with the correct IRS service center, and the entity must have reasonable cause for this failure.

Further, all taxpayers whose tax liability or tax returns would be affected by the S corporation election (including all shareholders of the S corporation) must have reported consistently with the S corporation election on any affected return for the year the S corporation election was intended. Rev. Proc. 2007-62 is effective for S elections and corporate classification elections intended to be effective for tax years that end on or after December 31, 2007.

Implications

A common issue that arises when a taxpayer discovers the failure to timely file an S election is the type of return the taxpayer must file pending IRS approval of its request to treat a late filed election as timely. Rev. Proc. 2007-62 resolves this issue when the failure to timely file the election is discovered prior to the filing of the tax return by providing that the request for relief should be filed with Form 1120S (i.e., an S corporation return). Because relief under Rev. Proc. 2007-62 requires a finding by the Service of reasonable cause (i.e., it is not automatic), a taxpayer may be required to file an amended return as a C corporation if its request is not granted. However, if relief under Rev. Proc. 2007-62 is not granted, an entity may request relief for a late S corporation election following the procedures of Rev. Procs. 97-48 or 2003-43, or relief for a late S corporation election and a late corporate classification election following the procedures of Rev. Proc. 2004-48. If the entity does not qualify for relief under these procedures, it may also apply for relief by requesting a letter ruling.

Given that the IRS appears willing to allow a taxpayer to file a return as an S corporation pending its approval of the taxpayer's request for relief, it may be appropriate for a taxpayer to file an S corporation return pending approval of a request for relief made under a different revenue procedure or to the IRS National Office. In this case, it would be prudent to disclose the pending request for relief in the S corporation return.

QSubs

SBWOTA provides that when the sale of stock of a qualified subchapter S subsidiary (QSub) results in the termination of the QSub election, the sale is treated as a sale of an undivided interest in the QSub's assets (based on the percentage of the stock sold), followed by a deemed transfer of the assets to the QSub in a transaction to which Sec. 351 applies.

A QSub is a wholly owned subsidiary that the S corporation elects to treat as a QSub. When the S corporation sells QSub stock, the QSub election fails (because the QSub is no longer wholly owned by the S corporation). Formerly, after such a stock sale, the QSub was then treated as a new corporation that had acquired all its assets from the S corporation in exchange for stock. This could result in the S corporation having to recognize gain on all the assets even though it had sold only a portion of the QSub stock. The new provision eliminates that danger by allowing the S corporation to recognize only a portion of the gain.

Accumulated Earnings and Profits

If an S corporation has accumulated earnings and profits (AE&P) at the end of the year and more than 25% of its gross receipts are from passive investment income (PII), the S corporation be subject to a corporate-level tax. SBWOTA reduces the possibility of an S corporation being subject to this tax. Under new Sec. 1362(d)(3), capital gains on stocks and securities will not be treated as PII under Secs. 1362(d) and 1375.

Caution: Other passive income sources are not affected (rents, royalties, etc.).

In a related provision, the new law eliminates S corporation previously taxed income (PTI) attributable to pre-1983 years for corporations that were not S corporations for their first tax year beginning after December 31, 1996. These two provisions apply to tax years beginning Her May 25, 2007.

Electing Small Business Trusts

Another new provision makes an S corporation a slightly more attractive vehicle for investments. Sec. 641(c)(2)(C)(iv) allows an electing small business trust (ESBT) to deduct any interest expense it incurs when it borrows funds to purchase S corporation stock. This provision places an ESBT on par with all other taxpayers, including qualified subchapter S trusts (QSST), for the deduction. Because ESBT income is taxed at the highest individual rate, this change allows a tax deduction at a 35% tax rate.

(20) Sec. 1361.

(21) Notice 2008-1, 2008-2 IRB 251.

(22) Sec. 1372(b).

(23) Sec. 1361(b)(1)(D).

(24) Regs. Sec. 1.1361-1(1)(1).

(25) Rev. Proc. 2007-62, 2007-41 IRB 786.

(26) Rev. Proc. 2003-43, 2003-1 CB 998.

(27) Rev. Proc. 2004-48, 2004-2 CB 172.